Integrated AuditPractice Case FIFTH EDITION David S, Kerr o Randal J. Elder > Alvin A, Arens ARMOND DALTON PUBLISHERS INC. Armond Dalton Publishers, Inc. Okemos, Michigan Table of Contents — Assignments Booklet and Permanent File Guidelines for completing the Integrated Audit Practice Case: Overview of the practice case Introduction, page 1 Learning objectives Introduction, page 2 Student's role Introduction, page 2 Guidelines for preparing audit documentation Introduction, page 2 Workpaper fonts used in the practice case Introduction, page 4 Typical set of audit files Introduction, page 4 Indexing Introduction, page 4 Cross-referencing Introduction, page 6 Electronic workpapers in the Integrated Audit Practice Case Introduction, page 6 Acknowledgments Introduction, page 7 Assignments: 1 Review client background information Assignment 1, page 2 Perform preliminary analytical procedures Assignment 2, page 3 Determine materiality and assess risks Assignment 3, page 4 Assess control risk and plan tests of controls and substantive Assignment 4, page tests of transactions 5 Perform tests of controls and substantive tests of transactions Assignment 5, page 6 Perform audit of accounts receivable Assignment 6, page 7 Perform audit of accounts payable Assignment 7, page 8 Perform audit of cash Assignment 8, page 9 Perform audit of inventory Assignment 9, page 10 Complete the audit Assignment 10, page Permanent File: Permanent file index Permanent file, page 1 Client background information Permanent file, page 2 Chart of accounts Permanent file, page 7 Client acceptance form Permanent file, page 9 Organization chart Permanent file, page 17 Appointment of auditors letter Permanent file, page 18 Audit takeover letter and reply Permanent file, page 19 Shareholder resolutions Permanent file, page 21 Note: The permanent file is a separate file containing information of a permanent, on-going nature about the client. The permanent file is normally maintained separate fi*om the current year audit files and is included behind the assignments in this booklet for convenience. INTRODUCTION Guidelines for completing the integrated Audit Practice Case Overview of the practice case The Integrated Audit Practice Case consists of one booklet containing the assignments and permanent file, a shrink-wrapped set ofthree-hole punched workpapers, and one folder containing client documents. (1) Assignments and Permanent File (this booklet) Assignments Provides an overview of this practice case and guidance for preparing workpapers, as well as the 10 assignments you will complete in this practice case. The assignments are as follows: Assignment 1: Review client background information Assignment 2: Perform preliminary analytical procedures Assignment 3: Determine materiality and assess risks Assignment 4: Assess control risk and plan tests ofcontrols and tests of transactions Assignment 5: Perform tests of controls and substantive tests of transactions Assignment 6: Perform audit of accounts receivable Assignment 7: Perform audit of accounts payable Assignment 8: Perform audit of cash Assignment 9; Perform audit of inventory Assignment 10: Complete the audit Permanent File This booklet contains the permanent file workpapers that provide information about the client's business, industry and accounting system. (2) Workpapers These three-hole punched workpapers are used to complete the assignments and include workpapers used when (1) planning the audit, (2) studying and testing internal controls, including related substantive tests of transactions, (3) performing test of balances, and (4) completing the audit. Note: You will need to purchase a I Vi inch three-ring binder, remove the workpapers from the shrink wrapping, and place the workpapers in the binder. (3) Client Documents Folder Contains vouchers, invoices, receiving reports, purchase orders, and other documents you will use to perform many of your audit procedures. Note: Many of the workpapers are also provided in Microsoft Excel format on the CD included with this practice case. Introduction ♦ Page 1 and you have just replaced Bill. pencil (not pen) should be used to facilitate corrections. you must perform each of the requirements to complete the assignment. At the beginning of each assignment is a flowchart showing the overall flow of audit procedures and where the assignment fits in that flow. CPAs. Learning objectives The learning objectives for the Integrated Audit Practice Case are: • To help you understand the interrelationships among the audit decisions involved in audit planning. Proper workpapers constitute the first line of defense in any legal proceeding against an auditor. Information on each workpaper should be clear to the reader. This booklet contains the specific assignments you need to perform to complete the audit. Guidelines for preparing audit documentation Audit workpapers provide the principal source of support for the auditor's opinion. another member of the audit staff at Lilts Berger & Associates. complete. General guidelines 1. Any document prepared (by the client or auditor) during an audit to support the audit conclusion is considered audit documentation and is appropriately indexed and placed in the audit file. including compliance with auditing standards. • To obtain hands-on practice in the preparation of an audit workpaper file. Initial a workpaper as having been prepared only when the workpaper is completed. You are to complete the audit and prepare the audit file for Charles Ward's review. You have been assigned by Charles Ward. 2. • To develop skills in analyzing transactions and applying auditing knowledge. Workpapers are a permanent record of the quality and extent of work performed. • To develop skills in the application of auditing standards. You will be replacing Bill Cullen. to participate in the audit of Oceanview Marine Company's 2012 financial statements. the engagement partner. The shrink- wrapped material contains the workpapers you will complete during the audit. as it will be reviewed several times in the audit process. The assignment's requirements are then presented. logical. concise. Workpapers should not contain too much information. audit testing. 3. Following the flowchart in each assignment is a discussion of important auditing concepts related to the assignment. who is working on other audits and does not have the time to complete the audit of Oceanview Marine Company. accurate. they must be clear. and complete. Therefore. • To evaluate the audit evidence accumulated to support the auditor's opinion and the issuance of the audit report. 4. An auditor's work should be a source of pride. Be concise. For workpapers completed manually. Be neat in preparing workpapers. These discussion questions are optional—your instructor will tell you which questions he or she would like you to answer. Introduction ♦ Page 2 . Oceanview's year-end is December 31. 2013. Student's role You are a first-year member of the audit staff at Lilts Berger & Associates. and "speak for themselves". A list of discussion questions concludes each assignment. The current date is February 18. and the formation of the auditor's opinion. Audit tickmark explanations should be complete but also concise. For example. Any workpapers prepared for the auditor by the client should be marked as "PBC" (Prepared By Client). describe specifically which document was used (for example.. • In the tickmark legend. • Use different tickmarks for different tests. Client involvement Prior to an audit.. when explaining tickmarks that refer to another document (for example. • Date the workpaper was completed. and partners. all tickmarks used on a particular workpaper should be explained in a "tickmark legend" at the bottom of the workpaper. • Standardize tickmarks within a section as much as possible.Workpaper information The preparer should make sure that each workpaper includes the following information: At the top ofeach page: • Client name • Title describing workpaper contents • Client's year-end date In the top right corner ofeach page: • Workpaper index number. "traced to. In the case of a multiple-page document such as the accounts receivable listing. the tickmark legend may appear at the end of that document. • Initials (either hand-written or typed) of the staff person who completed the workpaper (initial after you have completed all the procedures required for that workpaper). "traced to cash receipts journal"). This policy saves time and reduces audit fees. Audit tickmarks Each CPA firm uses a standard set of audit tickmarks. in many CPA firms. Introduction ♦ Page 3 . • Initials of the senior. and partner who reviewed the workpaper (these will be left blank in the Integrated Audit Practice Case as the audit file is yet to be reviewed). managers. the capital letter F is a standard tickmark used to indicate that a column of numbers has been footed by the auditor (footed means the numbers have been re-added to verify that the total is correct). • In this practice case. manager. The following guidelines should be adhered to: • Make sure audit tickmarks are neat and distinguishable. the client should be requested to gather the necessary records and (where possible) prepare certain analyses and workpapers. • Prepare an explanation for each tickmark only after all work performed for the procedure has been completed. Standardization facilitates substitution of staff on audit engagements and review of workpapers by seniors."). Time and Fee Budget Current Workpapers Assess Control Risk. this practice case) and other tax information. When completing workpapers manually. CPAs. • Corporate tax file Contains tax returns as filed and/or amended together with (not included in notice(s) ofassessment or reassessment. you should use the "Arial" font (to distinguish your work from that ofBill's). initials. The files typically established by auditors for each audit client include: • Current audit file Contains all workpapers applicable to the year under audit. you should use pencil handwriting to conform to common practice. In this practice case. Perform Test of Controls and Substantive Tests of Transactions 10 Study of Internal Control Environment Current Workpapers 11 Study of Controls — Sales and Cash Receipts Current Workpapers 12 Tests of Controls and Substantive Tests of Transactions Current Workpapers — Sales and Cash Receipts 13 Study of Controls— Acquisitionsand Cash Disbursements Current Workpapers 14 Tests of Controls and Substantive Tests ofTransactions Current Workpapers — Acquisitions and Cash Disbursements Introduction ♦ Page 4 . Lilts Berger & Associates. Typical set of audit files Workpapers are grouped into audit files according to content. workpapers in an audit file have various types of handwritten notes. and signatures. When completing workpapers using the computer. notice(s) of objection. initials and signatures are represented by various and fonts. Each firm develops a standard method of indexing workpaper files. Your firm.Workpaper fonts used in the practice case Ordinarily. uses the following indexing system for current audit files: Section Number Description Location in this practice case Audit Planning 1 Financial Statements Current Workpapers 2 Analytical Procedures Current Workpapers 3 Working Trial Balance Current Workpapers 4 Engagement Letter Current Workpapers 5 Assessments of Risks and Materiality Current Workpapers 6 Audit Planning Checklist. Audit work performed by Bill Cullen is indicated on the workpapersby the Times New Roman Italic font. • Permanent file Contains information of a historical or continuing nature about the audit and the client. indexing Indexing is used to organize the workpapers and to facilitate the cross-referencing and filing of information. Section Number Description Location in this practice case Tests of Balances 20 Cash Current Workpapers 21 Accounts and Notes Receivable Current Workpapers 22 Inventories Current Workpapers 23 Prepaid Expenses Not included 24 Long-term Investments Not included 25 Property. The audit program lists the procedures that are to be performed by the auditor and ends with a conclusion as to whether the account balance is fairly presented. 102-1. which summarizes the balance(s) and adjustment(s) for that account(s). beginning with section 20 (cash)..g. Behind the audit program are the workpapers that document the tests performed by the auditor. Plant. "20-1" for the cash leadsheet) and the pages following are sequencedin order: 20-2. 102-2. workpapers are arranged from general to specific. In the unlikely event that another workpaper needed to be inserted between workpaper 20-1-a and workpaper 20-1-b.20-3. and so on. it would be indexed as 20-1-a-i. Within each section. Introduction ♦ Page 5 .101-2. Lilts Berger & Associates adds a lower case letterto such workpapers. Each leadsheet is indexed as the first workpaper in each section (e. Occasionally. Behind each leadsheet is the audit program. as follows: 20-1-a and 20-1-b. workpapersare indexed as 101-1. Each section begins with a leadsheet. and so on. an additional workpaper or workpapers must be inserted after indexing of a section is complete. and Equipment Not included 30 Accounts Payable Current Workpapers 31 Accrued Liabilities Not included 32 Notes and Loans Payable Not included 33 Taxes Payable Not included 34 Long-term Debt Not included 35 Other Liabilities Not included 40 Common Stock Not included 41 Additional Paid-in Capital and Retained Earnings Not included Completing the Audit 90 Summaiy of Possible Misstatements Current Workpapers 91 Subsequent Events Current Workpapers 92 Representation Letter Current Workpapers 93 Management Letter Current Workpapers Permanent File 101 Client backgroimd information Permanent file (at end ofthis booklet) 102 Chart of accounts Permanent file (at end ofthis booklet) 103 Client acceptance form Permanent file (at end ofthis booklet) 104 Organization chart Permanent file (at end of this booklet) 105 Appointment of auditors letter Permanent file (at end of this booklet) 106 Audit takeover letter and reply Permanent file (at end of this booklet) 107 Shareholder resolutions Permanent file (at end of this booklet) Each account balance on the financial statements is supported by workpapers organized into sections. In the permanent file. " If you need to change any of these cells. UNPROTECT SHEET on the menu bar in Excel. reviewed. many (but not all) of the workpapers are available in Microsoft Excel format on the CD included with this practice case. PROTECTION. In this practice case. and storedelectronically. click REVIEW. If you're using Excel 2010. Use a computer to complete the workpapers available on the CD. Before you begin work on the practice case. and Microsoft Excel. or undemeath. use of a computerto complete the practice case provides efficiency advantages over completingthe case manually. If you use options 2 or 3. completed. UNPROTECT SHEET. copy all files on the CD to your computer's hard drive and store the CD in a safe place (see the following section "Copying the workpaper files"). you can ignore the rest of this section. the amount comesfrom another workpaper or source).. check with your instructor to determine which of the following three options you should use when completing the audit workpapers: 1. Introduction ♦ Page 6 . Complete all workpapersmanually.. save the completed workpapers. Note: To prevent accidental modifications of the Excel files. ignoring the Excel files on the CD. or leadsheet). many of the cells have been "locked" and "protected. In addition. you will need access to a computer with a CD-ROM drive. However. you must first unprotect them by clicking on TOOLS. and many firms perform "paperless audits" in whichworkpapers are created.. a printer. cross-references written to the right of. Be sure to make backup copies of all your completed workpaper files. and print out copies of the workpapers as you complete them. the amount is carried forward to another workpaper. Use a computer to complete the workpapers available on the CD. and submit the file along with the remaining workpapers completed manually to your instructor for grading. Before beginning your work on the practice case. you need a basic understanding of how to use Microsoft Excel and Microsoft Windows. paper copies of all of the workpapers needed to complete the case manually are provided in the Workpaper materials.Cross-referencing Cross-referencing is used to indicate when one workpaper has information relevant for another workpaper. Electronic workpapers In the Integrated Audit Practice Case Most CPA firms use notebook computers extensively in the audit process.." (in other words. If you will be using option 1. Microsoft Excel is used extensively by CPA firms in the audit process to create workpapers. 2. financial statements. an amount are read "to. working trial balances. summary. 3. Cross-references written to the left of an amount are normally read "fi-om. and to perform analytical procedures such as ratio and trend analysis. Accordingly." (in other words. . Our fiiend and colleague has used these materials in auditingcourses many times and has provided significant guidance and suggestions for their improvement. a professor at Lynchburg College. Her dedication. CPA. Ph. CPA. Ambrose Jones III. Ph. CMA.Acknowledgments We express our appreciation to CGA-Canada for permission to adapt materials from the CGA Public Practice Manual and the CGA Practice Set 3. CPA. Nancy. D. Dewey Ward. Steve Glover. DSK RJE AAA Introduction ♦ Page 7 . and perseverance are greatly appreciated.D. competence. She spent hundreds of hours doingthe entire case. This practice case has benefited significantly from the input of CGA-Canada. CPA. Steve is a professor at Brigham Young University and has provided useful comments to help improve the case.. Mark Beasley. Nancy Schneider. He spent five years as a practicing auditor before becoming an Ernst & Young AICPA fellow and an AICPAtechnical staff manager for the Auditing Standards Board.D. There are several individuals who played key roles in designing. MPA. We are grateful for their contributions and efforts. testing. Ph.making recommendations for revisions and making certain that the materials and related worlqiapers are relevant and realistic. Ambrose is a professorat The University of North Carolina .Greensboro and has used the case several times in the last four years and has provided several suggestions for the current edition. Carol is a CPAwho spent eight years working on the audit staff of a large CPA firm. Carol Borsum. CPA. and finalizing these materials. Lynne has provided valuable assistance in formatting the materials.D. His extensive and valuable comments have made a significant contribution to this practice case. Lynne Wood. Ph. We appreciatethe time she has taken to send us her comments and suggestions for improving the case. Mark is a professor at North Carolina State University.D. has used the case since its first edition. Perform substantive substantive <5* engagement letter tests of the audit Obtain client tests of tests of (Assignment 1) controls procedures representation letter transactions transactions O" 5. Select s analytical sample items procedures <d" Decide client Design and Design and for testing acceptance Design and perform perform o and obtain perform 4. Assess Control Risk. Evaluate fi) the results o PT Perform preliminary of the tests Evaluate (Q anaiyticai procedures audit results Decide preliminary ssue materiality level auditor s report 3 a) Assess acceptable Communicate with O audit risk. Decide the Obtain Review subsequent o specific audit 3 understanding of events procedures client's business Combined approach Substantive approach 2. Decide (Assignment 1) sample size 7) Perform final I 3. the client's audit 3 inherent risk committee and and fraud risk management . Perform Tests of Controls Perform Substantive Tests Overall Audit Plan and Substantive Tests of Transactions of Account Balances Complete the audit > Establish Understand Design Review contingent tfi independence tfi internal control and perform liabilities tests of balances s and assess 3 control risk 3 1. auditprocedures. By performing all of these procedures. Auditing concepts Client acceptance Before accepting a company as a new audit client. Theengagement letter should include: • a statement specifying which financial statements will be audited (names and dates of the statements). The successor CPA firm may also wish to contact the prospective client's banker and attorney to evaluate the company's acceptability. Unacceptable clients mightinclude those where the risk of litigation is high. • a statement that the purpose of the audit is to form an opinion as to whether the financial statements are fairly presentedand in accordance with generally accepted accounting principles. The purpose of this communication is for the predecessor auditor to have the opportunityto inform the successor auditor of any disagreements withthe company over accounting issues. or management's integrity. If another public accounting firm previously audited the company. • review the CLIENT ACCEPTANCE FORM supporting the partners' decision to accept the engagement. • a statement informing the client that the audit will be performed in accordance with generally accepted auditing standards (or other auditing standards where applicable). Engagement letter An engagement letter is the written agreement between a CPA firm and its client for the performance of an audit or related services. the successor auditor is required to communicate with the predecessor auditor. a CPA firm must establish whether it is independent and has the staffand expertise necessary to perform the audit. or client personnel are uncooperative. the auditors must understand the company's business. • review the ENGAGEMENT LETTER. and management. a CPA firm can reduce the risk of being associated with a client that the firm's partners would prefernot to serve. • a statement informing the client that the CPA firm is not responsible for discovering all errors. ownership. industry.ASSIGNMENT 1 Review client background information Overview In this assignment you will: • review the client's background information and audit history. acts of fraud. collection problems mayarise. or illegal acts. Assignment ONE ♦ Page 2 . • a statement that the responsibility for the preparation of the financial statements rests with management of the company. Before beginning the audit. fees. • estimated dates for completing the engagement and issuing the auditor's report. tax. • any assistanceto be provided by the client during the engagement. The CPA firm retains the letter in its workpaper files or in a separate file. Assignment ONE ♦ Page 3 . includingmethod of billing and payment terms. review. • any restrictions that will be imposed on the auditor's work. it is included in the current workpapers (see workpapers 4-1 and 4-2). The signed engagement letter represents the client's agreement with the terms of the engagement. In addition. the engagement letter should include a description of: • the level of services to be performed by the CPA. • the fee arrangement. such as audit. In this practice case. the client's officer or a member ofthe board of directors signs the letter and returns it to the CPA firm. compilation. or management advisory services. After reviewingthe engagement letter. read the guidelines for completing this practice case on pages 1 through 7 in the Introduction section of thisbooklet. • Engagementletter (workpapers 4-1 and 4-2). Scan the unaudited financial statements for OceanviewMarine Company (workpapers 1-1 through 1-5). When finished. question 24 (see workpaper 103-6 in the Permanent File). A critical part of client acceptance is establishing that the audit firm is independent from the audit client. and audit history. This is documented in the Client Acceptance Form. operations.DOC" on the IntegratedAudit Practice Case CD). Completing the assignment After you have completed this assignment. the audit engagement partner) initials on the top right-hand comer of both pages of the engagement letter. Assignment ONE ♦ Page 4 . Pay particular attention to factors that are most likely to affect a CPA firm's decision whether to accept Oceanview Marine Company as a client. write your initials and date below CW's (Charles Ward. paying attention to any factors that might affect a CPAfirm's decision whether to accept Oceanview Marine Company as a client. Assume you are completing this procedure on 2/19/2013. b. • Answers to discussion questions 1 through 4 (see next two pages) if required by your instmctor. make any additions and changes to the letter that you believe are appropriate (you may also make changes on the file "ASSIGN l. and the assignment number.Requirements a. If you have not already done so. Using a pencil. The letter is missing a few important key phrases. Assume that Lilts Berger & Associates made the appropriate inquires to establish that the firm is independent. Read the Permanentfile included in the back of this bookletto become familiar with Oceanview Marine Company's background. staple the following items together in the order listed and submit them to your instructor for grading: • Coverpagewithyourprinted name. your signature. Review the ENGAGEMENT LETTER for Oceanview Marine Company (workpapers 4-1 and 4-2). Be sureto follow the Guidelinesfor preparing audit documentation on pages 2 and 3 in the Introduction section when completing each assignment. 000 (see the engagement letter).510 (see the fee budget on workpaper 6-5). Factors Favoring Acceptance Concerns About Acceptance I. the estimated total costof performing this year's auditis $27. 2. The client and our firm have agreed on an initial estimated audit fee of $21. has already completed the CLIENT ACCEPTANCE FORM in the permanent file. However. Indicate three concerns you have about accepting Oceanviewas a client. 3. Based on the information you studied in the Permanent File and the unaudited financial statements included in the current workpapers (workpapers 1-1 through 1-5). Responses to inquiries of predecessor 1. competence. the engagement partner.Discussion questions 1. Discuss possible reasons why a CPA firm might charge a new client an audit fee that is lower than the estimated first-year costs of performing the audit. and dedication to running a successful business. auditor were complimentary about Oceanview. Assignment ONE ♦ Page 5 . 3. b. 2. Charles Ward. a. Indicate two favorable factors most important to the client acceptance decision (one factor has been provided as an example). evaluate the client acceptance decision. Predecessor auditor spoke highly of Oceanview's employees' integrity. Organize your answer usingthe two-column format shownbelow. 3. What is the primary purpose of reviewingthese workpapers? 4. a. Auditing standards require auditors who are considering accepting an audit engagement to communicate with the previous auditors. Oceanview Marine is currently a private company. How would the engagement letter (workpapers 4-1 and and 4-2) change if Oceanview were a publicly traded company? In what way would this affectyour firm's ability to provide additional services to Oceanview? Assignment ONE ♦ Page 6 . Why is the client's permission required before this communication cantake place? The successor auditor also often reviews the predecessor auditor's workpapers. What is the primary purpose of this communication between the new (successor) and old (predecessor) auditors? b. Communicate with Q. *< Decide preiiminary o' Issue 0) materiaiity ievei auditor's report o o Assess acceptable (D audit risk. Decide sample size Decide client Perform final acceptance 3. inherent risk the ciient's audit committee and O and fraud risk management . Perform 5 substantive substantive I tests of the audit tests of tests of Obtain client controis procedures Perform preliminary transactions transactions representation letter 3 analytical 5. Assess Control Risk. Evaluate 0) procedures the results (Assignment 2) of the tests fi) Evaluate 3 audit results 3. Decide the 3 Obtain understanding Review subsequent specific audit ro of ciient's business events • • procedures Combined approach Substantive approach 2. Seiect analytical §• 1 and obtain sampie items procedures 3 Design and Design and for testing engagement letter Design and •o perform perform perform 4. Perform Tests of Controls Perform Substantive Tests Overall Audit Plan and Substantive Tests of Transactions of Account Balances Complete the audit > W Establish (0 Understand Design Review contingent independence iiabiiities S internal control and perform 3 and assess tests of balances 3 control risk (D 1. Assignment TWO ♦ Page 2 . Preliminary analytical procedures are also used to evaluate the client's financial condition. sales.e. the auditor investigates whether they are caused by misstatements or by valid business events. or owners' equity. The evaluation of going concem is done at the completion of the engagement as part of the issuance of the audit report. eamings). the auditor must assess whether the company is likely to continue as a going concem for one year from the date of the financial statements. If the fluctuations are relatively large. For example. Ratio analyses are commonly performed to assess a company's liquidity. comparisons of the current year's ending account balances with those of last year may reveal unexpected fluctuations. Solvency represents the company's ability to meet its debt obligations regardless of cash flow. Liquidity represents the company's ability to convert its assets to cash. and • identify which account balances are most likely to be misstated. The client's financial condition affects audit risk and the amount of audit evidence.ASSIGNMENT 2 Perform preliminary analytical procedures Overview In this assignment you will perform preliminary analytical procedures to: • evaluate Oceanview's financial condition. which is needed to make day-to-day payments of bills and others debts. Auditing concepts Nature and use of analytical procedures Analytical procedures are used during various phases of an audit: • during the planning phase • during the substantive testing phase • during the final review phase of the audit Auditing standards (AU Section 329) require auditors in the United States to use analytical procedures during the planning and final review phases of the audit. and solvency. The preliminary evaluation of the client's financial condition generally focuses on key financial ratios and trends in net income. For example. a lower than normal current ratio combined with a higher than normal debt-to-equity ratio and a declining trend in net income may suggesta relatively high risk of future financial difficulty. Profitability represents the company's ability to eam a profit (i. and profitability ratios measure how much the company is eaming in relation to its assets.. Analytical procedures performedduring the planning phase are called preliminary analytical procedures. Preliminary analytical procedures are used to identify accounts that may present a relatively high risk of misstatement. profitability. In addition. and solvency ratios measure how much debt the company has in relation to its assets or owners' equity. Assignment TWO ♦ Page 3 . if certain fluctuations are expected but are not found. For example. the extent of detailed testing can be reduced. the auditor may conclude that no additional audit work is necessary for that account. then the reason for the lack of fluctuations should be investigated. In addition. The auditor must then go beyond management's explanation and investigate whether or not the explanationis supportedby audit evidence. One of the most important aspects of analytical procedures is to investigate the cause of significant unexpected fluctuations in account balances or ratios. depending on its relative significance. In the final review phase of the audit. an auditor might compare the current year's ending balance in the "prepaidexpenses" account with the prior year's audited ending balance. however. If the two amounts are roughly the same. Certain changes would lead the auditor to expect that the value of the current year's balance will be differentthan the previous year's balance. to any changes that may have occurred during the year in the client's policies regarding prepayments. The logical starting point is to obtain and document an explanation from management. Analytical procedures can also be used as substantive evidence since they may detect material misstatements more efficiently and effectively than detailed substantivetests. When analytical procedures are used as substantive evidence. analytical procedures provide an overall review of the financial statements and assist the auditor in evaluating the appropriateness of the audit conclusions reached. The auditor should be alert. Protection. click on the sheet tabs on the bottom of the screen. To prevent accidental modifications of his work.Requirements a." "View" on the menu bar at the top of your screen. using 2/19/2013 as the completion date. divide column 3 (change) by column 2 (2011). click REVIEW. Workpapers 1-1 (balance sheet). verify continued on next page Assignment TWO ♦ Page 4 . Assessment ofclient'sfinancial condition b. Also determine the change and percent change for each of the profitability ratios. not by column 1 (2012). Note: To sign off on a workpaper. Sign off on each workpaper as you complete it. you will complete and print workpaper 2-1 using Microsoft Excel. 3-1. make sure the "Show sheet tabs" option is checked in "Tools. You may disregard the copy of workpaper 2-1 included in the Current Workpapers. use the left and right arrows in the bottom left comer of your screen to see all of the sheet tabs. If you need to change any of these locked cells. write your initials and date in the top right comer of the workpaper. 1-4. Complete the workpaper by calculating the 2012 and 2011 values for the profitability ratios. 1-5 (notes to financial statements). unprotect sheet in the main Excel menu at the top of the screen. and (3) the date it was completed. 3-2. Electronic workpaper option: In this assignment. UNPROTECT SHEET. and 3-3 (working trial balance) are also included in the file. In Excel 2010. Your initials and date indicate: (1) that all the audit work related to that workpaper has been completed. sheet tabs are displayed by default. you will need to first unprotect the workpaper by clicking on TOOLS. 1-2 (income statement). Bill has "locked" and "protected" many of the cells in the Excel workpapers. If you're using Excel 2010. Electronic workpaper option: Workpaper 2-1 is included in the file named "Assign 2 and 10 EXCEL_5ed. If necessary. but if you do not see them. In preparation for this assignment you should obtain the following workpapers: • 2-1 through 2-5-b {Current Workpapers—Audit Planning) • 93-1 and 93-2 {Current Workpapers—Completing the Audit) These workpapers will be completed in this assignment and turned in to your instructor for grading. To assess the client's financial condition. if sheet tabs are not visible. (2) who completed the work. Round all ratios to two decimal places. 1-3 (statementof cash flows). Bill has calculated several liquidity and solvency ratios on workpaper 2-1. Tip: To calculate the percent change from 2011 to 2012. below the index number.xls" on the Integrated Audit Practice Case CD. In Excel. To switch between workpapers after you have opened the file in Excel." "Options. you can "Copy" and "Paste" the formulas to the 2011 column and Excel will adjust each formula and display the 2011 values for the ratios.4) Excel would then display 27. go to "File.). you should disable the "print gridlines" option. When calculating the Change and Percent Change. (Bill has already written comments on the liquidity and solvency ratios. Print workpaper 2-1 when completed. On the Excel menu bar at the top of the screen. Note: to round all subsequent ratios to two decimal places. and make sure the "Gridlines" box is not checked."clickthe "Sheet" tab. link columns D and E to columns B and C so the Change and Percent Change values will be updated if the income statement and/orbalance sheetaccounts are adjusted during the audit. use the round command as follows: =round((ce// referencelcell reference). go to "File.xls at this time. Use Excel to calculate the profitability ratios by dynamically "linking" the ratios in workpaper 2-1 to the related cells in the income statement and/or balance sheet (workpapers 1-1 and 1-2). Also examine the industry data presented on workpaper 2-1. For example." and make sure the "Print." "Print. to determine the 2012 gross profit margin (rounded to two decimal places). Internet sites on financial ratio analysis. Use workpaper 2-2 to write a brief commentary on trends in the profitability ratios. once you have entered the formulas for 2012. Gridlines" box is not checked. A second advantage is that you do not have to input the formulas for 2012 and 2011 separately. Assignment TWO ♦ Page 5 . Study Oceanview Marine Company's current and prior years' financial ratios shown on workpaper 2-1. the Change and PercentChange for gross profit margin would be determined by inputting the following formulas in cells D24 and E24.) Refer to reference materials as needed (textbooks. respectively: =B24-C24 =D24/C24 Before printing Excel sheets in this and all other assignments." click "Page Setup. For instance. etc. you would input the following formula in cell B24 in Excel workpaper 2-1: =round(('income statement* !B10/'income statement*!B8)." "Options").58%.!) An important advantage of linking your ratios to the income statement and balance sheet is that the ratios are automaticallyupdated if the income statement and/or balance sheet accounts are adjusted. You should not print the other workpapers in file Assign 2 and 10 Excel." "Sheet." "Page setup. continued from previous page that the Show sheet tabs check box is selected in the Advanced category of the Excel Options dialog box ("File. If you're usingExcel2010. Review each of the divisional income statements (workpapers 2-8 through 2-12). Also state how each account balance differs from your expectations. the change is unexpected. Lilts. which division is most responsiblefor the incomestatement fluctuation you identified in step e.Also state how each account balance differs from your expectations. Berger assesses whether the client is likely to continue in business for the following two years. However. For example. in column one of workpaper 2-4-b. identify significantdivisional fluctuations for the same accounts you identified in step e. Use the top of workpaper 2-4-a to list two additional balance sheet accounts that you believe present the highest risks of misstatement requiring follow-up. an expense account may reflect a material increase in dollars compared to the prior year. d. Based on your and Bill's analyses in step (c) above. complete the Assessment ofFinancial Condition workpaper (workpaper 2-3). Note: If possible. Similarly. Assignment TWO ♦ Page 6 . but is likely not material. Note that in assessing financial condition as part of performing preliminary analytical procedures. if an expense account increases from $100 in the prior year to $200 in the currentyear. if the expense is expected to vary with sales and the expense as a percentage of sales has remained fairly constant. Review the common-size balance sheet and income statement (workpapers 2-6 and 2-7). Use workpaper 2-4-b to list the three divisional accounts that you believe are most likely to be misstated as indicated by unexpected fluctuations or lack of fluctuation where expected. Use the bottom of workpaper 2-4-a to list three income statement accounts that you believe warrant follow-up due to unexpected fluctuations or lack of fluctuations where fluctuations were expected. the change is not unexpected. Tip: Remember that you want to identify material unexpected fluctuations. noting accounts that may require follow-up with the client because of material unexpected fluctuations or lack of fluctuations where fluctuations were expected. Identification ofaccounts with unusualfluctuations e. and identify. Note: As you analyze the divisional common-size income statements as well as the combined common-size income statement. Also state how each account balance differs from your expectations. and based on what you learned about the client in Assignment 1. noting any significant fluctuations that should be investigated and discussedwith the client. you may find that the divisional statements reveal underlying trends and fluctuations not apparent in the combined income statement. 2-4-b. your signature. Tip: You should base your management letter recommendations primarily on the analytical procedures you performed in this assignmentand on your imderstanding of the client gained in Assignment 1.e. management. (ii) why adopting a change is important. or reducing taxes. For each account (except Sales). On workpapers 93-1 and 93-2. provide at least two such suggestions for Oceanview's management. Bill has already completed this section for Sales. (Bill's comments #1 through#4 are based on work he performed prior to his re-assignment. you should consider possible misstatements and/or fraud the client could have committed during the year that would cause each observed fluctuation.) Completing the assignment Make sure yousignedoff on each workpaper thatyou completed in thisassignment (2-1 through 2-5-b. recommendations can be basedon concqpts learned in other accounting and business courses such as finance.. g. your firm is anxious to impress the client by sending a management letter with suggestions that will improve Oceanview's operations by increasing operational efficiency. (iii) your suggestion and plan of implementation. Assignment TWO ♦ Page 7 . In addition. since it has not been completed. 2-4-a. using 2/19/2013 as the completion date. Workpapers 2-1. Answers to discussion questions 1 through 5 (see next two pages) if required by your instructor. For example. h. For each account (except Sales). i. (i) problem or area for improvement. Workpapers 93-1 and 93-2. Your recommendations should be drafted in this format. you will be adding additional items to that workpaper in subsequent assignments. and the assignmentnumber. improving financial condition. you should suggest audit tests that could be used later in the audit to determine whether the year-end balance in the account is misstated. complete the section labeled "Nature of potential misstatemenfTo do this. See Bill's comment #1 on workpaper 93-1 for an example. Bill has already completed this section for Sales. Because this is a first-year audit. and 2-5-b.2-3. complete the section labeled "Effect on audit procedures". Do not sign off on workpaper 93-2 yet. Bill has identified several significant fluctuations in income statement accounts. 2-2. 2-5-a. you may have a recommendation conceming the client's financing based on concepts leamed in your finance course(s). To do this. and marketing. On workpapers 2-5-a and 2-5-b. and 93-1). Staple the following items together in the orderlisted and submit themto your instructor for grading: Cover page with your printed name. along with client explanations for those fluctuations. For example.Discussion questions 1. Assignment TWO ♦ Page 8 . or trends you identified in this assignment that might represent an increased fi-aud risk. then the auditor should be concerned that revenue may be materially overstated due to fraudulent revenue transactions. ratios. which information did you find most helpful — comparisons ofthe current year's and prior year's balances. or comparisonsof the current year's and prior year's balances as a percentage of sales? Explain. AU Section 316 indicates that the auditor should consider the results of analytical procedures performed in planning the audit that indicate possible implausible or unexpected relationships in assessing the risk of firaud.e. if the auditor compares revenue reported by product line each month (i. ratios. or trends might suggest an increased risk of fraud? Discuss any relationships. and determines that the number of items reported as sold exceeds capacity.. monthly sales volume) with sales (or production) capacity. When you identified income statement fluctuations in steps (e) and (f) of this assignment. The auditor reviews important financial statement numbers and ratios at both the beginning and the completion of the audit. What other types of unexpected relationships. Compare and contrast the purposes of (1) preliminary analytical procedures and (2) analytical procedures performed near the completion of the audit. Describe some other types of procedures the auditor could perform that may identify conditions and events indicating there could be substantial doubt about a client's ability to continue as a going concern. Indicate reasons why the auditor should also address the company's going concern status in the planning stage of the audit. If the auditor believes there is substantial doubt about the client's ability to continue as a going concern. you performed analytical procedures involving various financial ratios and trends in order to assess the client's ability to continue as a going concern. The client's "going concern" status is an audit reporting issue that is addressed at the conclusion of the audit.AU Section 341 requires the auditor to assess whether the client is likely to continue in existence for a reasonable period of time after the date of the financial statements. Read AU Section 341 (available on the AICPA or PCAOB web sites) and then answer the following questions: a. Assignment TWO ♦ Page 9 . AU Section 341 describes the auditor's responsibilities for evaluating the client's "going concern" status. In this assignment. 5. what actions should the auditor take? b. Decide the (D Obtain understanding specific audit Review subsequent 3 of client's business events procedures CO • • Combined approach Substantive approach 2. inherent risk Communicate with (ft and fraud risk the client's audit ?r (ft (Assignment 3) committee and management . Perform Tests of Controls Perform Substantive Tests Overall Audit Plan and Substantive Tests of Transactions of Account Balances Complete the audit > 0) Establish Understand Design Review contingent (0 independence internal control and perform liabilities tests of balances 3 and assess control risk 3 1. Perform (D substantive substantive tests of the audit Obtain client tests of tests of 3 controls procedures representation letter fi) Perform preliminary transactions transactions If 5. Decide sample size a Decide client Perform final (D f-K 3. ssue fi) (ft auditor s report (ft (D Assess acceptable (ft (ft audit risk. Assess Control Risk. Evaluate <D analytical procedures the results I of the tests E! Evaluate audit results *< Decide preliminary fi) materiality level 3 (Assignment 3) Q. Select analytical (D acceptance sample items procedures and obtain Design and Design and for testing engagement letter Design and perform perform perform 4. timing. Tolerable misstatement After determining an appropriate materiality level. such as cash or notes payable. another for total assets. the auditor might conclude for a given audit that net income before taxes could be misstated by as much as ±3 to 10% without materially affecting the fair presentation of the financial statements. Tolerable misstatement is the largest amount by which an individual account can be misstated and still be considered fairly stated. and assessments of inherent risk are decisions the auditor makes when planning the audit. Auditing concepts Preliminary judgment about materiaiity An auditor's preliminary judgment of materiality reflects the largest amount by which the financial statements could be misstated without affecting the decisions of a person relying on the financial statements. Tolerable misstatement influences the auditor's decisions regarding the extent. Assignment THREE ♦ Page 2 . Tolerable misstatement is usually set lower for account balances that have no expected misstatements and can be audited at minimal cost. Tolerable misstatement is usually set higher for account balances that have a high number of expected misstatements or are difficult to audit. For example. the auditor allocates this materiality level to individual financial statement accounts. • determine the level of inherent risk associated with specific balance sheet accounts. the preliminaryjudgment about materiality. • determine an acceptable level of audit risk for the audit of Oceanview. such as inventory or accounts receivable. • determine an appropriate materiality level for the audit. and another for equity. others select one amount for income. See Lilts Berger & Associates' POLICY STATEMENT included in this assignment for a description of the firm's policies regarding the preliminaryjudgment about materiality. Most auditors use the current and previous years' financial statements to determine the preliminary level of materiality.ASSIGNMENTS Determine materiality and assess risks Overview In this assignment you will: • study Oceanview Marine Company's business. Some auditors decide on a single amount for the audit. The determination of acceptable audit risk. Several factors affect the size of the auditor's tolerable misstatement for individual accounts. and nature of audit procedures for each account. Materiality allocated to an individual account is called "tolerable misstatement". and (3) the risk that the auditor will not detect the misstatement (detection risk). however. and (2) there may be offsetting misstatements as some accounts are overstated while others are understated. and the dollar amount of the account is usually large. and the dollar amount involved is relatively small. and whether client business risk is associated with increased likelihood of material misstatements in the financial statements. which reduce detection risk. For example. inventory usually is associated with high inherent risk because it is susceptible to theft. Most CPA firms permit the combined tolerable misstatement for all accounts to exceed the preliminary judgment about materiality because (1) it is highly unlikely that each account will be misstated by the full amount of its tolerable misstatement. the auditor assesses inherent risk and control risk. As a result. (2) the risk that the client's internal controls will not prevent or detect the misstatement (control risk). numerous calculations are needed to determine the inventory's year-end valuation. Audit risk Audit risk is the risk that the auditor will issue an unqualified (favorable) audit opinion on financial statements that are materially misstated. The following factors are likely to cause an account's inherent risk to be high: • The account balance is large. numerous transactions affect inventory in each period. it is possible that when the audit is completed. prepaid insurance usually has less inherent risk because it is less susceptible to theft. • The account comprises large individual transactions. As shown in the equation below. audit risk is a combination of (1) the risk that a material misstatement will occur in an account (inherent risk). the auditor considers the nature of the client's business and industry. the auditor must accumulate additional evidence in certain accounts or request that the client adjust the financial statements. If that occurs. The auditor should examine more extensively those accounts that are most likely to contain material misstatements and examine less extensively those accounts that are least likely to be materially misstated. The purpose of assessing risk early is to help the auditor plan the audit by deciding which parts of the audit to emphasize and the extent of testing. some substantive testing is usually necessary for material accounts. the combined estimated misstatement for all accounts might exceed the preliminary judgment of materiality. Even when material misstatements are unlikely. In contrast. • There are a large number of transactions affecting the account. it involves relatively few transactions. the extent of testing can be less than when material misstatements are likely. The auditor reduces audit risk to an acceptable level by performing substantive tests. even though no account is misstated by more than its tolerable misstatement. In developing these assessments of risk. however. calculations to determine prepaid insurance are relatively simple. Assignment THREE ♦ Page 3 . • The account comprises unusual or difficult transactions requiring professional judgment or technical expertise to record properly or is based on subjectively determined estimates. Audit risk = Inherent risk x Control risk x Detection risk The combined assessment of inherent risk and control risk is the risk of material misstatement in the financial statements and consists of the first two risks listed above: • risk related to the nature of the account or transaction (inherent risk) • risk related to the client's internal control (control risk) Early in the audit. Acceptable audit risk is typically assessed as high. the auditor may be required to defend the quality of the audit (i. The extentofusers' reliance on financial statements is influenced by severalconditions. or sale ofthe company. the lower the auditor's acceptable level of audit risk. when acceptable audit risk is low. • Management has low integrity. Therefore. This likelihood. Assignment THREE ♦ Page 4 . • Ownership of the client. more substantive testing will need to be done during the audit than when acceptable audit risk is moderate or high. including: • Future public offering. is influenced by three factors: • the extent to which users of the financial statements will rely on those statements. The predecessor auditors of Oceanview Marine Company have indicated to your firm that last year's audit revealed no material misstatements in Oceanview's accounting records. Creditors rely on financial statements to decide whether or not to grant credit or expand loans. Deciding an acceptable level of audit risk Auditors use the audit risk model to help plan how much evidence to gather during the audit. the auditor generally seeks to achieve relatively low levels of audit risk. moderate. • Material misstatements were discovered in the account during the previous year's audit. merge. when auditing larger companies. The more the company is leveraged. you will begin this assignment by assuming a relatively low risk of misstatements and proceed by identifying and documenting any high-risk factors you believe are present. Assignments 4 and 5 deal with the evaluation of internal controls and control risk.e. sometime in the future. This reduces the auditor's acceptable level of audit risk. in turn. The auditor normally begins by determining an "acceptable" ("allowable" or "target") level of audit risk. merger. • There are related-party transactions affecting the account. • Size ofthe client. or be sold will be relied on heavily by potential buyers/investors. • the likelihood that the client may experience financial trouble in the near future. • Several steps are involved from the initiation of a transaction to its posting in the general ledger. or low. • Extent ofdebt. The financial statements of a company that is about to go public.. Generally. • The assets are highly susceptible to theft. more people will rely on the financial statements of widely-held public companies than those of closely-held or private companies. Generally speaking. The larger the ownership. Thus. A portion of Assignment 3 focuses on identifying factors affecting inherent risk. • There is major motivation by management to "window dress" or misstate the financial statements. • management's integrity. the lower the auditor's acceptable level of audit risk. The financial statements of larger companies will generally be relied on by a greater number of people than statements of smaller companies. the likelihood of being sued). The primary factor the auditor considers when determining an acceptable level of audit risk is the likelihood that. In assessing the likelihood that a company will experience financial difficulty or failure, the auditor should consider: • profitability and solvency • competency of management • industry in which the company operates • capital structure The following chart illustrates the risk factors and their effects on acceptable audit risk: Risk factors: Acceptable audit Acceptable audit Acceptable audit (one or more risk will be risk will be risk will be may be relevant) relatively high moderate/normal relatively low Extent ofreliance Financial statements are Financial statements are Client is a widely-held on financial used primarily used primarily by public company or is statements internally by management for normal about to go public or management. Client business loans. Client be sold (fmancial is probablyprivately could be eitherprivately statements will be relied owned (low reliance). or publicly owned on heavily by extemai (moderate reliance). users). Likelihood of Low likelihood of Low to moderate Moderate to high financial difficulty fmancial difficulty. likelihood of fmancial likelihood of fmancial difficulty. failure in near future. Management Management has high Management has Management'sintegrity integrity integrity. reasonably high is low. integrity. Assessing the risk of fraud Misstatements affecting the financial statements can either be due to errors, which are unintentional misstatements, or fraud, which is an intentional misstatement. In addition to risk model assessments of acceptable audit risk, inherent risk, and control risk, auditors must assess the risk of fraud on every audit. Two types of fraud are misappropriation of assets, often called defalcation or employee fraud, and fraudulentfinancial reporting. Auditors use the following framework, often referred to as the "fraud triangle", to assess whether three conditions exist that increase the likelihood of fraud from fraudulent financial reporting and misappropriation of assets: 1. Incentives/Pressures. Management or other employees have incentives or pressures to commit fraud. 2. Opportunities. Circumstancesprovide opportunities for management or employees to commit fraud. 3. Attitudes/Rationalization. An attitude, character, or set of ethical values exist that allow management or employees to commit a dishonest act or they are in an environment that imposes sufficient pressure that causes them to rationalize committing a dishonest act. Assignment THREE ♦ Page 5 LILTS BERGER & ASSOCIATES, CPAs Ocean City, Florida POLICY STATEMENT Title: Materiality Guidelines—Preliminary Judgment about Materiality and Tolerable Misstatement Preliminary Judgment about Materiality Professional judgment Is to be used at all times in setting and applying materiality guidelines. Materiality must be measured in relation to the appropriate base. As a general guideline, the following policies are to be applied: 1. For profit-oriented companies, the appropriate materiality base will be pre-tax income. The preliminary judgment about materiality should ordinarily be measured between 5 and 10% of net income before taxes for private companies. A combined total of misstatements or omissions in the financial statements exceeding 10% is normally considered material. A combined total of less than 5% is presumed to be immaterial in the absence of qualitative factors. Combined misstatements or omissions between 5 and 10% require the greatest amount of professional judgment to determine their materiality. Acceptable audit risk is a major consideration in the decision. When acceptable audit risk is low, the preliminary judgment about materiality would typically be 5 to 6% of pre-tax income. When acceptable audit risk is high, the preliminary judgment about materiality would be 9 to 10% of pre-tax income. Ifnet income before taxes in a given year is not considered representative (unusually high, low, or negative), it would be desirable to use a different base such as total assets (see 2 below). 2. Often there is more than one base to which misstatements could be compared. Normalized pre-tax income may not be an appropriate base for not-for-profit enterprises. Also, if a company operates in an industry where size is more relevant than operations or where net income before taxes is unusually low or high for the size of the company, the preliminary judgment about materiality should be measured using either balance sheet or income statement amounts as a base. Even ifthe preliminaryjudgment about materiality is based on pretax income, a balance sheet- based calculation is useful for evaluating the materiality of misclassifications between balance sheet accounts. For total assets, the guidelines should be between Vz and 1% of assets. 3. Qualitative factors should be carefully evaluated in the final evaluation of materiality on all audits. In many instances, they are more important than the guidelines applied to the income statement and balance sheet. The intended uses of the financial statements and the nature of the information in the statements, including footnotes, must be carefully evaluated. Tolerable Misstatement Professional judgment is to be used in setting and applying tolerable misstatement. As a general guideline, the following policies are to be applied: 1. Tolerable misstatement will be established only for balance sheet accounts. 2. Tolerable misstatement will be established for every balance sheet account except retained earnings. 3. The maximum tolerable misstatement to be applied to any account is 75% of the preliminaryjudgment about materiality. 4. The combined tolerable misstatement for all accounts shall not exceed three times the preliminary judgment about materiality. 5. The following are major factors affecting the setting of tolerable misstatement for individual balance sheet accounts: • Tolerable misstatement should be set higher for accounts with a high cost to audit (i.e., larger accounts, and accounts that are relatively difficult to audit). • Tolerable misstatement, as a percent of the account balance, should be set higher for accounts with a higher expectation of misstatement Assignment THREE ♦ Page 6 Requirements In preparation for this assignment, obtain workpapers 5-1 through 5-4 from the current workpapers. These workpapers will be completed in this assignment and turned in to your instructor for grading. Sign off on each workpaper as you complete it, using 2/22/2013 as the completion date. Electronic workpaper option: In this assignment, you will complete and print workpaper 5-4 using Microsoft Excel. You may disregard the copy of workpaper 5-4 included in the Current Workpapers. Assessment ofinherent risk b. Use workpaper 5-1 to assess inherent risk for accounts receivable, allowance for bad debts, inventory, prepaid expenses, property, plant & equipment, and accounts payable. Bill Cullen has completed the assessment of inherent risk for each of the other accounts on workpaper 5-1. Decision about the acceptable level ofaudit risk c. Use workpapers 5-2-a and 5-2-b to decide and document the acceptable level of audit risk for the audit of Oceanview Marine Company. Tip: Your assessment of the Likelihood of Financial Difficulty on workpaper 5-2-a should be consistent with your assessment on workpaper 2-3. Cross reference workpaper 5-2-a to workpaper 2-3 by writing "2-3" next to "Source W/P reference" in section A on workpaper 5-2-a (see the discussion of cross referencing on page 6 in the Introduction section of this booklet). When completing sections B, C, and D on workpaper 5-2-a, you may want to review the Client Background Information and Client Acceptance Form in the Permanentfile (workpapers 101-1 to 101-3, and 103-1 to 103-8). Preliminaryjudgment about materiality d. Use workpaper 5-3-a to make a preliminary estimate of the materiality level for the Oceanview audit (round your materiality level to the next lowest $5,000). Tip: To complete section 2 of workpaper 5-3-a, use your CPA firm's POLICY Statement included with this assignment to help you choose an appropriate base and percentage). Assignment THREE ♦ Page 7 Complete and print workpaper 5-4 using Excel. On workpaper 5-3-b.XLS" on Integrated Audit Practice Case CD. On workpaper 5-4. Allocation ofmateriality—tolerable misstatement f. Electronic workpapers: Workpaper 5-4 is included in the file named "Assign 3 Excel_5ED. In making your allocations. • Answers to discussion questions 1 through 5 (see next two pages) if required by your instructor. using 2/22/2013 as the date. you should attempt to allocate the maximum total allowable allocation of three times your preliminary materiality level. Bill has already established tolerable misstatement for several of the accounts. complete the "Tolerable Misstatement" column to establish a tolerable misstatement for each balance sheet account. link it to your earlier assessment of acceptable audit risk (i. explain and support your choice of the base and percentage for determining materiality. Review ofaudit planning checklist and audit budgets g. Staple the following items together in the order listed and submit them to your instructor for grading: • Cover page with your printed name. Bill Cullen completed the audit-planning checklist and prepared the time and fee budgets for the Oceanview Marine Company engagement (see workpapers 6-1 to 6-5). your signature. state your acceptable level of audit risk and how it influenced your choice of the percentage). Tip: When explaining your choice of percentage. Study these workpapers to familiarize yourself with the audit planning process and the issues addressed therein. Follow the guidelines provided in the bottom section of your firm's POLICY STATEMENT included with this assignment to establish a tolerable misstatement for each of the remaining accounts.e. and the assignment number. Completing the assignment Make sure you signed off on all workpapers included in Section 5 of the Current Workpapers. • Workpapers 5-1 to 5-4. Complete the bottom portion of workpaper 5-4 and make sure that your total tolerable misstatement does not exceed the maximum allowable allocation of three times your preliminary materiality level. Assignment THREE ♦ Page 8 . Specifically. the preliminary judgment about materiality.Discussion questions 1. Opportunities. and Attitudes/Rationalization — in developing your response. 2. what effect would lower levels of acceptable audit risk and materiality have on the audit compared to the levels you selected? 3. What is your assessment of the likelihood of ffaiidulent financial reporting by Oceanview? Use the three conditions in the fraud triangle (AU Section 316) — Incentives/Pressures. Explain why decisions about acceptable audit risk. and the allocation of materiality should be made early in the audit during the planning phase. inherent risk. Assignment THREE ♦ Page 9 . Explain how the levels of acceptable audit risk and materiality you selected in this assignment might affect the remainder of the audit. Explain/justify how you chose your tolerable misstatement amounts for each of the following accounts: (a) Accounts receivable. Explain/justify why the sum of tolerable misstatements is allowed to exceed the preliminary judgment about materiality. In requirement (f) of this assignment. (b) Allowance for bad debts. Assignment THREE ♦ Page 10 . (c) Accrued liabilities. 5. you established a tolerable misstatement level for each of several balance sheet accounts. Decide sr 5 (A sample size Perform final a: o 3. Perform Tests of Controls Perform Substantive Tests (0 Overall Audit Plan and Substantive Tests of Transactions of Account Balances Complete the audit St 3 3 Establish Understand Design Review contingent (D independence internal control and perform liabilities and assess tests of balances control risk 1. Communicate with the client's audit S inherent risk and fraud risk committee and 3 management (A 0 3 a . Decide the (Assignment 4) Review subsequent Obtain understanding specific audit events of client's business procedures £• (0^ Combined approach Substantive approach w (D 2. Select analytical < o Decide client sample items (D 3 acceptance procedures Design and Design and for testing ST and obtain Design and 0 3 perform perform 4. Evaluate Perform preliminary 3 the results 0) CL analytical procedures of the tests Evaluate (A ^ audit results 3 o Decide preliminary 3 0 (A materiality level Issue <A (A auditor's report O O Assess acceptable o audit risk. > (0 Assess Control Risk. Perform (A — engagement letter perform substantive substantive (A tests of the audit Obtain client tests of tests of (A controls procedures O transactions transactions representation letter fi) 5. and equity. process. Assignment FOUR ♦ Page 2 . and report transactions and to maintain accountability for the company's assets. Monitoring involves management's assessment of whether the system of internal control is operating effectively. which includes the accounting system. These factors include: o management's philosophy and operating style o organizational structure o assignment of authority and responsibility o management control methods o audit committee participation o internal audit function o personnel policies and procedures • Risk assessment. These are the policies and procedures that help ensure that the company's objectives are achieved. analysis. This is the client's identification. Auditing concepts Internal Control Internal Control-Integrated Framework published by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) describe the following five components of a company's internal control: • The control environment. and management of risks relevant to the preparation of financial statements. The client's information system. assess Oceanview Marine Company's control environment. • Control activities. summarize. liabilities. consists of the methods and records established to record. The control environment consists of several factors that reflect management's attitude toward internal control.ASSIGNMENT 4 Assess control risk and plan tests of controls and substantive tests of transactions Overview In this assignment you will: gain an understanding of Oceanview Marine Company's internal controls. plan tests of controls and substantive tests of transactions for acquisitions. make a preliminary assessment of control risk for acquisitions. • Information and communication. • Monitoring. Whenever the auditor's preliminary assessment of control risk is less than the maximum level (i. if tests of controls reveal that some of the controls have not been operating satisfactorily. an auditor may believe that controls relating to sales transactions are effective in preventing the recording of fictitious sales {existence or occurrence assertion) but are weak in preventing omissions in the recording of sales transactions {completeness assertion). Assignment FOUR ♦ Page 3 . After the auditor has performed the tests of controls.e. observation of the client's activities. the auditor would initially assess control risk for the existence or occurrence of sales as low and control risk for the completeness of sales as high. the auditor uses that assessment. along with the audit risk model. Control risk is assessed with respect to the financial statement assertions. "the auditor must obtain a sufficient understanding of the entity and its environment. However. and to design the nature. For example. and inspection of the client's documents and electronic records. he/she believes the controls can be relied upon to some extent).Understand the client's Internal controls Auditing standards state. final control risk can be assessed at some level less than 100%. and extent of further audit procedures. or altematively. After making the final assessment of control risk. This documentation usually takes one or more of the following forms: • flowcharts showing the flow of documents through the accounting system and the related control activities • narrative (written) descriptions of the client's intemal controls • intemal control questionnaires related to the intemal controls Assess control risk Once the auditor has obtained and documented an understanding of the client's intemal controls. then control risk would be assessed at 100% for the assertions and/or objectives associated with those controls. the auditor must perform tests of the controls to support that initial assessment. to determine the appropriate extent of substantive testing for each balance sheet and income statement account affected. to assess the risk of material misstatements of the financial statements whether due to error or fraud. Control risk represents the likelihood that the internal controls will neither prevent material misstatements from occurring nor detect misstatements if they do occur. As part of the study of the client's intemal controls. timing. the auditor documents his/her understanding of intemal controls in the audit workpapers. Accordingly. including its intemal control.. the audit objectives." The auditor's study of the client's intemal controls is accomplished primarily through inquiries of the client. Tests of controls are used to determine whether the controls have been operating effectively throughout the period under audit. he/she makes a final assessment of control risk. If the results of the tests of controls indicate that the controls operated effectively. he/she then makes an initial assessment of control risk. Plan substantive tests of transactions The primary distinction between tests of controls and substantive tests of transactions is that tests of controls are used to gain assurance that internal controls are operating effectively. one or more tests of controls should be performed to determine if the control is functioning properly. Here is an example: Control: Test of Control: Purchase orders are properly authorized. Here is the usual decision process: 1. If the auditor has identified a control that he/she intends to rely on to reduce control risk. For most audits. Design substantive tests of transactions for each objective. Associate controls to be tested and related tests of controls with financial statement assertions and related audit objectives. tests are performed for each audit objective. Decide which controls will be tested. The planned tests of controls often affect the planned substantive tests of transactions because both are normally applied to the same sample of transactions.) 4. the account balances related to the acquisition of goods and services and cash disbursements are: • cash • inventory • prepaids and accruals • property. Assignment FOUR ♦ Page 4 . whereas substantive tests of transactions are used to gain assurance that the data produced by the accounting system are accurate. plant. If control risk is assessed at less than maximum. It is best to design substantive tests of transactions on an objective-by-objective basis to be sure that sufficient. but not excessive. Examine a sample of purchase orders for indication of proper authorization. (Note that a control may satisfy more than one objective. depending on the amount of evidence you plan to obtain from these tests. and equipment • accounts payable • most operating expenses Substantive tests of balances for some or all of these accounts can be reduced if: • the auditor concludes that controls are effective after performing tests of controls and/or • the auditor concludes that transactions are correctly recorded after performing substantive tests of transactions. Design the appropriate tests of controls for each control identified in step 1. 3. substantive tests of transactions are often combined with tests of controls. 2. Plan tests of controls The design of the tests of controls depends on two things: the internal controls identified in the auditor's study of internal control and the preliminary assessment of control risk. and (3) plan the tests of controls and substantive tests of transactions for acquisitions. and control activities. Your assignment will be to (1) assess the overall level of control in the control environment. Bill has partially completed the assessment of the overall level of control in the control environment. and has planned the tests of controls and substantive tests of transactions for sales. (2) complete the preliminary assessment of control risk for acquisitions.Background information Bill Cullen met several times with Cynthia—Oceanview's controller—^and other accounting personnel to obtain information about Oceanview's internal control. Assignment FOUR ♦ Page 5 . including the control environment. He has completed the preliminary assessment of control risk for sales. the accounting system (information and communication). and workpaper reference. These workpapers will be completed in this assignment and turned in to your instructor for grading.) d. On workpaper 10-8. 13-4. Remember to sign off on each workpaper as you complete it. the absence of an internal audit department or audit committee does not automatically mean that the control environment is weak.Requirements In preparation for this assignment. Bill has partially completed the audit program for the evaluation of intemal control over acquisitions (workpaper 13-1). you will need to study workpapers 10-1 through 10-7. Include workpaper references in the "comments" column. date. Tip: Completethe intemal control questionnaire on workpaper 13-3 using the flowchart on workpaper 13-2 as your source of information. indicate the name of the person. Complete the "conclusions" section of workpaper 10-8 by stating whether the control environment appears to be strong or weak. the "comments" section of number 4 refers to workpaper 10-7 on the IT (Information Technology) department. fill in the columns for your initials. as indicated on workpaper 10-7. Study those workpapers to familiarize yourself with the client's accounting system and intemal controls over sales. In the "remarks" column on workpaper 13-3. 13-1. remove the following workpapers: 10-8. Assignment FOUR ♦ Page 6 . Numbers 2 to 4 on workpaper 10-8 have been completed to provide you with examples of how to fill in number 1.14-1. when completed. Tip: Workpaper 10-8 summarizes the results of the control environment questionnaire (workpapers 10-1 to 10-7) to enable you to make an overall assessment of the control environment. who performs each intemal control procedure. Use workpaper 11-3 as a guide. Complete step 5 on the audit program and. Your conclusion should be based on whether the majority of your assessments in the summary are strong or weak. c. Use 2/23/2013 as the completion date for each workpaper you complete in this assignment. and 14-2. (Note that due to the relatively small size of Oceanview. if necessary. segregation of functions between the IT department and users is lacking. To complete workpaper 10-8. if applicable. The control level has been assessed as weak because. For instance. Bill Cullen has completed the preliminary assessment of control risk for sales (workpapers 11-1 through 11-4). complete number 1 to assess the level of control in Oceanview Marine Company's control environment. 13-3. Substantivetests of transactions are used to test for monetary misstatements in the transactions. Assignment FOUR ♦ Page 7 . 14-2. Study these workpapers to familiarize yourself with the manner in which tests of controls and substantive tests of transactions are designed. Keep in mind that the audit procedures commonly used to test controls are (1) inspection of client documents. f. Tip: The "Preliminary Assessment of Control Risk—Acquisitions" matrix referred to in step 6 is found on workpaper 13-4. Bill has written one test of control for each control listed in column two. (2) observation of client activities and events. Complete column three on workpaper 14-1 to design the tests of controls for acquisitions. or (4) reperformance. Completing the assignment Make sure you signed off on each workpaper you completed in this assignment. date. Tip: For each control in column two on workpaper 14-1. • Answers to discussion questions 1 through 6 (see following three pages) if required by your instructor. • Workpapers 10-8. (3) inquiry of client personnel. fill in the columns for your initials. and the assignment number. Staple the following items together in the order listed andsubmit them to yourinstructor for grading: • Cover page with your printed name. 13-1. write one test of control in column three that could be used to test the control. Bill has written substantive tests of transactions to directly test each of the audit objectives for sales. Complete column two on workpaper 14-2 to design the substantive tests of acquisitions transactions. whereas tests of controls are used to test internal controls. On workpaper 12-2. Complete step 6 on the audit program (workpaper 13-1). Note: In column three on workpaper 12-1. Note: Column two on workpaper 14-1 has been completed for you to reduce the time requirements of this assignment. 13-4. 14-1. Use workpapers 12-1 and 12-2 as a guide. Use workpapers 11-1 through 11-4 as a guide. using 2/23/2013 as the date. if necessary. Notice that each test of control shown in column three relates to a specific existing control in column two. and workpaper reference.13-3. Bill Cullen designed the tests of controls for sales and the substantive tests of sales transactions (workpapers 12-1 and 12-2). When completed. Use workpaper 13-3 to identifythe client's existing controls and deficiencies. if necessary. e. your signature. the auditor may choose not to rely on controls. 3. the auditormay choose to test some of the controls. the auditor may then rely on those controls. After obtaining an understanding of the client's internal controls. Assignment FOUR ♦ Page 8 . Indicate the effect on (a) the extent of tests of controls. What is the primary reason for relying on controls? What are other potential benefits from testing controls? On some audits. Indicate circumstances in which the auditor would choose not to test controls. and (b) the extent of substantive tests of balances if the auditor's preliminary assessment of control risk is below the maximum. and no tests of controls are performed. If the results of those tests are satisfactory.Discussion questions 1. Some of these deficiencies may be considered significant deficiencies or material weaknesses as defined by auditing standards (SeeAU 325 at http://pcaobus. Do you consider any of the weaknesses in Oceanview's controls over acquisitions to be significant deficiencies or material weaknesses! Assignment FOUR ♦ Page 9 . Describe significant deficiencies and material weaknesses and the auditor's responsibility for communicating them to the client.org/Standards/Auditing/Pages/ AU325. Oceanview Marine Company's internal controls were evaluated using both a flowchart and a questionnaire. the auditor may discover deficiencies in the client's system of internal control.aspx). Discuss the relative advantages and disadvantages of using each type of control documentation. 5. During the audit. A company's management and its independent auditor both have responsibilities related to the company's system of internal control. 6. discuss (1) management's responsibilities related to internal controls. and (2) the auditor's responsibilities related to internal controls. Assignment FOUR ♦ Page 10 . In the context of the audit of a private company. Assess Control Risk. Decide the Review subsequent Obtain understanding specific audit Ol events of client's business procedures Combined approach Substantive approach 2. Select analytical O* Decide client O sample items procedures acceptance 3 Design for testing and obtain Design Design and and perform perform 4. Evaluate O Perform preliminary (Assignment 5) o O the results 3 3 analytical procedures of the tests (A Evaluate audit results 3 (A 0) Decide preliminary 3 materiality level a auditor s report (A C O" (A Assess acceptable audit risk. Communicate with 3 i-#* inherent risk the client's audit committee and < and fraud risk 0 management . Perform engagement letter and perform substantive the audit tests of substantive Obtain client tests of procedures 0) o controls tests of representation letter transactions o (Assignment 5) transactions 5. Decide O •0 sample size (A (D —I Perform final (A 3. Perform Tests of Controls Perform Substantive Tests Overall Audit Plan and Substantive Tests of Transactions of Account Balances Complete the audit > W (A Establish Understand Design Review contingent S and perform liabilities 3 independence internal control and assess tests of balances 3 (D control risk 3 1. the planning format audit program must be converted to a "performance format" audit program. • perform andevaluate tests of controls andsubstantive tests of transactions foracquisitions. For example. An example of a situation where sampling is not practical is deciding whether or not there is adequate separation of duties. the auditor must first determine if sampling is practical.ASSIGNMENT 5 Perform tests of controls and substantive tests of transactions Overview In this assignment you will: • review and evaluate the results of tests of controls and substantive tests of transactions performed by Bill Cullen for sales. the auditor gains a better perspective for performingsubsequenttests. • perform all audit procedures in the most efficientorder. This involves rearranging the audit procedures so that they are performed in the mostefficient orderpossible. Assignment FIVE ♦ Page 2 . • perform all procedures on a given document at one time. Decide the sample size for tests of controls and substantive tests of transactions Before deciding the sample size. An example of a practical sampling situation is the examination of supporting documents for cash disbursements transactions. • eliminate duplicate procedures. Theprimary objectives of rearranging the audit program from a planning format to a performance format are: • combine tests of controls and substantive tests of transactions to provide greater efficiency. you designed tests of controls and substantive tests of transactions by preparing a "planning format" audit program (workpapers 14-1 and 14-2). Prior to performing the tests. There is no need to determine sample size if sampling is not practical. The auditor willnot add or delete procedures. Auditing concepts Rearrange the "planning format" audit programs into "performance format" audit programs In Assignment 4. by footing a journal and reviewing the journal for unusual items first. or change the wording of the audit procedures during the conversion from the planning format to the performance format. inclusive. theauditor must select thesample items fi-om thepopulation for testing. it might be as high as 7 or 8%. An essential part of performing the tests is the documentation of every exception found in the sample. Generalize to the population The auditor is interested in the effectiveness of intemal controls and whether transactions are properly recorded for the entire population.. TER can be 10% or higher. planned sample sizes will also increase. Assignment FIVE ♦ Page 3 . not operating reliably). • Acceptable Risk ofAssessing ControlRisktoo low (ARACR). It is also necessary to document the sample size for each attribute tested and the total number of exceptions found. in fact. In mostcases. W^en using non-statistical sampling.e. EPER is sometimes referred to as the "expected population deviation rate". the sample must be selected randomly. When auditing effective intemal control systems. When using statistical sampling. For unimportant or low effectiveness controls (high control risk). In addition to documenting the sample size. TERcanvaryfor different attributes. TER is sometimes referred to as the "tolerable deviation rate" or "tolerable rate of occurrence". EPER can vary for different attributes. ARACR is sometimes referred to as the "acceptable risk of overreliance". planned sample sizeswill increase. ARACR is setbetween 5% and 10%. After thesample size is determined. The primary step auditors perform when testing transactions is examining documents and related records. As EPER increases. Forsituations in which sampling is practical. A reader of the workpapers should be able to re-perform the same test and achieve the same results. the sample can be selected either judgmentally or randomly. not just for those items sampled. TER is the highest exception ratethe auditor will permit in the population and still be willing to keep assessed control risk at the level originally planned. Both of these stepsare done for each attribute tested. Evaluate the results There are three steps to evaluating the results of tests of controls or substantive tests of transactions: 1. As ARACR decreases. EPER is likely to be 0 or 1%. For important and highly effective controls (low control risk). however. TER is typically between 2% and 7%. ARACR is the risk the auditor is willing to take of relying on a control when the true population exception rate is greater than the TER (i. As TER decreases. the risk of incorrectly relying on a control that is. planned sample sizes will increase. Perform the tests The most time-consuming part of tests of controls and substantive tests of transactions is actually performing the tests. the auditor must specifically identify which transactions were examined. EPER is the exception rate (deviation rate) the auditor expects to find. including: • Tolerable Exception Rate (TER). • Expected Population Exception Rate (EPER). For ineffective systems. Most auditors use audit software or spreadsheet programs to select and document random samples. There are two steps to determining the computed upper exception rate (CUER): calculate the sample exception rate and estimate the sampling error. TTie auditor generalizes to the population by computing the upper exception rate for each attribute tested. several factors influence thesample size. For example.. When using statistical sampling. When using non-statistical sampling. Other non-statistical evaluation methods may not include a numerical amount for sampling error. When CUER exceeds TER. one way to calculate CUER is to sum the sample exception rate and an estimated allowance for sampling error. Reach conclusions about the effectiveness of internal control and the accounting system To determine whether the internal control or accounting system is operating effectively. the auditor must compare the computed upper exception rate (CUER) to the tolerable exception rate (TER) for each attribute. but sampling error should be considered by the auditor. if the sample exception rate is 1% and estimated sampling error is 4%. This is the approach followed in this assignment. the computed upper exception rate (CUER) is determined by using attribute sampling tables which incorporate an appropriate allowance for sampling error. Assignment FIVE ♦ Page 4 . The most important determinant of sampling error is sample size. CUER is 5%. and smaller ARACRs all increase the estimate of sampling error. If CUER exceeds TER. Sampling error is the potential estimation error resulting from sampling a portion of the population instead of auditing the entire population. which supports an assessment of control risk at less than the maximiun level (100%) for one or more objectives. The sample exception rate is calculated by dividing the actual number of exceptions found in the sample by the sample size (e. it is unnecessary to expand the audit tests beyond those originally planned. the auditor needs to determine the nature and cause of every exception found in the sample. 3. Analyze exceptions Regardless of whether CUER exceeds TER. If CUER is less than or equal to TER. the most likely action is to increase assessed control risk for one or more objectives. and increase related substantive tests. the auditor will usually decide that controls operated effectively during the period under audit. but acceptable risk of assessing control risk too low (ARACR) and the actual number of exceptions also affect sampling error. if CUER is less than or equal to TER. two exceptions from a sample of 50 is a sample exception rate of 4%). 2. Normally. the likely conclusion is that the control or accounting system is less effective than originally thought. Smaller sample sizes.g. more exceptions. 14-7. 14-4. Testing the eight attributes will satisfy the requirements of steps la to Ih on workpaper 14-3. Tip: Since Bill used statistical sampling when testing sales transactions. Study these workpapers to familiarize yourself with the work alreadyperformed by Bill. The audit procedures remaining to be performed have been circled on workpaper 14-3. c. Complete this column now by determining the computed upper exception rate (CUER) for each attribute. 14-3. Bill has not completed the final columnon the Statistical Attributes Sampling Data Sheet (workpaper 12-6). Design tests ofcontrols and substantive tests oftransactions b. On workpapers 12-3 to 12-9. On workpaper 12-4. In preparation for this assignment. On workpaper 14-7. Tip: Workpaper 14-7 includes descriptions of eight attributes. Remember to sign off on each workpaper as you complete it. use a pencil to change Bill's conclusions if necessary. complete the sample size column under "Planning". continued on next page Assignment FIVE ♦ Page 5 . Use 2/23/2013 as the completiondate for each workpaperyou complete in this assignment. These workpapers will be completed in this assignment and tumed in to your instructor for grading. along with the information in the Sample Size column and the Number of Exceptions column in the Actual Results section of workpaper 12-6. to determine CUER you should use the second attributes statistical sampling table in the Assignment 5 appendix (Assignment FIVE ♦ Page 10). review Bill's conclusions regarding the effectiveness of the intemal controls and the accounting system for sales to ensure that they are consistent with your CUER results on workpaper 12-6. Bill Cullen has nearly completed documenting the results of tests of controls and substantive tests of transactions for sales. using 2/23/2013 as the date. remove the following workpapers: 12-6. compare CUER with TER to determine whether the related internal control has been operating effectively or whether the rate of monetary misstatements is acceptable. Sign off on workpaper 12-4. and 14-8. For each attribute in column one on workpaper 12-6. Bill has partially completed the audit program for tests of controls and substantive tests of transactions for acquisitions. Follow the steps below to complete these remaining procedures: Decide sample size d.Requirements a. Now. write an "X" in the appropriate column on workpaper 14-8 to indicate an exception. Assume Bill Cullen has performed tests on 65 of the 70 voucher packages and found no exceptions. For each of the five vouchers indicated on workpaper 14-8. To provide a reference. are summarized on workpaper 14-6. along with information taken from the voucher register. To test attribute #7. ignoring your answer in step (d) above. however. you will perform tests of controls and substantive tests of transactions on the remaining five vouchers. Keep in mind. this will result in an exception for each attribute that requires the examination of that document. Bill has randomly selected 70 purchase voucher packages for testing(seeworkpaper 14-5). performtests of controls and substantivetests of transactions for attributes 1 through 8 listed on workpaper 14-7 using the client documents provided in the Client Documents booklet. the attributes numbers (1 through 8) across the top of the "Record of Exceptions" matrix refer to the attributes in column one on workpaper 14-7. For each voucher tested. On workpaper 14-8. If a document typically used for the type of transaction you are testing is missing. In step (f) below. Tip: The five vouchers. As a result. the third to last line on the "Record of Exceptions" matrix indicates that Bill did not find any exceptions when he tested the other 65 voucher packages. Perform the tests f. Assignment FIVE ♦ Page 6 . Complete the sample size column in the Actual Results section on workpaper 14-7 using 70 as the sample size. continued fromprevious page Determine the sample size for attributes 1 through 8 using the attributes sampling table in your auditing textbook or the first table provided in the appendix to this assignment. that workpaper 12-6 uses a statistical approach whereas workpaper 14-7 uses a non-statistical approach. You may also use workpaper 12-6 as a guide for completing workpaper 14-7. Select sample items e. assume that the sample size for all eight attributes is 70 items. the "actualresults"sections ofthese two workpapers differ. the sample size for the first attribute has already been entered on workpaper 14-7. you can identify account classifications based on the chart of accounts in the Permanentfile (102-1 and 102-2) located near the end of this booklet or the working trial balance in the booklet titled Current Workpapers (3-1 to 3-3). On workpaper 14-8. i. You should also indicate the effect of the test results on substantive testing. classification. you might want to re read the section titled '^''Reach conclusions about the effectiveness of internal control and the accounting system" on page 4 of this assignment. rather than a sample of individual transactions. Using the information on the bottom of workpaper 14-8. When testing occurrence. if necessary. The completeness objective must be tested separately. Note: On workpaper 14-7. you are testing transactions in the acquisitions journal (voucher register) for the occurrence (existence). The direction in which you test the occurrence and completeness objectives is critical to the effectiveness of your tests. When completed. Tip: You might want to re-read pages 3 and 4 in this assignment if you are unsure how to calculate CUER. accuracy. Tip: Before writing your conclusion on workpaper 14-4. Complete workpaper 14-4. You should state whether. based on the results of the tests performed on workpaper 14-3. and workpaper 14-10). In contrast. Evaluate the results g. Posting & summarization is usually tested on a block of transactions.e. Assignment FIVE ♦ Page 7 . Keep in mind that Bill tested 65 vouchers besides those you tested. as described in step 4 on workpaper 14-9. you test in the opposite direction. control risk for any of the internal control objectives should be increased. as must the posting & summarization objective. you must begin by selecting a sample of transactions Jrom the journal and then vouch them back to the supporting documents (receiving reports) to ensure all acquisitions recorded in the journal have been received (see step lb on workpaper 14-3). you begin by selecting a sample of receiving reports and then trace them to the journal to ensure that all acquisitions have been recorded in the journal (see step 2a on workpaper 14-3. and timing objectives. Use workpaper 12-4 as a guide. Complete the rows for the "Total Number of Exceptions" and "Total Sample Size" on the bottom of workpaper 14-8. complete the remaining columns in workpaper 14-7. For your recommendations in number 3. briefly summarize any suggestions you might make to the client for improving specific controls or aspects of the accounting system.. transfer your recommendations from the bottom of workpaper 14-4 to the draft of the management letter (workpaper 93-2. which you began working on in Assignment 2). Remember that you are using non-statistical sampling. when testing the completeness objective. if the client has not already corrected them. you will want to bring them to the client's attention so they can be corrected. and the assignment number. • Answers to discussion questions 1 through 3 (see next page) if required by your instructor. 14-7.14-4. • Workpapers 12-6. The auditor does not normally propose adjustments for misstatements detected when performing tests of transactions. using 2/23/2013 as the date: 12-6. 14-4. your signature. Note: Although not required in this assignment.14-8. Staple the following items together in the order listed and submit them to your instructor for grading: • Cover page with your printed name. Completing the assignment Make sure you signed off on the following workpapers completed in this assignment. Assignment FIVE ♦ Page 8 . Also make sure you signed off on each sub-step in step 1 on workpaper 14-3 by writing your initials in the "INIT" columns. and 93-2. and 14-8. 14-3.14-3. whenever you find monetary misstatements in the client's accounting records. 14-7. unless the misstatements are individually material and have not been previously corrected by the client. Discussion questions For this assignment, the expected population exception rate (EPER) was specified as 1% or 3%, the tolerable exception rate (TER) was specified as 7 or 8%, and the acceptable risk of assessing control risk too low (ARACR) was specified as 10% for all attributes in the audit of acquisitions transactions. Indicate how each of these variables (EPER, TER, and ARACR) should be determined. What is the effect on sample size of lowering each variable (EPER, TER, and ARACR)? When the computed upper exception rate (CUER) exceeds the tolerable exception rate (TER), the auditor will likely increase the assessed level of control risk and increase one or more related substantive tests. What other courses of action are available to the auditor when CUER exceeds TER? 3. The study and evaluation of internal controls in Assignment 4 identified deficiencies in internal controls over acquisitions. Did any of these deficiencies result in misstatements in the recording of transactions? Explain why deficiencies in internal controls may not always result in significant misstatements in recording transactions. Assignment FIVE ♦ Page 9 ASSIGNMENT 5 Appendix ATTRIBUTES STATISTICAL SAMPLING TABLES' Determining Sample Size ARACR-10% Expected Exception Tolerable Exception Rate (In Percentage) Rate 2 3 4 5 6 7 8 9 10 .00 114 76 57 45 38 32 28 25 22 .50 194 129 96 77 64 55 48 42 38 1.00 — 176 96 77 64 55 48 42 38 1.50 — — 132 105 64 55 48 42 38 2.00 — — 198 132 88 75 48 42 38 2.50 — — — 158 110 75 65 58 38 3.00 — — — — 132 94 65 58 52 Determining CUER ARACR—10% Actual Number of Exceptions Sample Size 0 1 2 3 4 5 6 7 25 8.8 14.7 19.9 — — — — — 30 7.4 12.4 16.8 — — — — — 40 5.6 9.4 12.8 16.0 19.0 — — — 50 4.6 7.6 10.3 12.9 15.4 17.8 — — 55 4.1 6.9 9.4 11.8 14.1 16.3 18.4 — 60 3.8 6.4 8.7 10.8 12.9 15.0 16.9 18.9 70 3.3 5.5 7.5 9.3 11.1 12.9 14.6 16.3 90 2.6 4.3 5.9 7.3 8.7 10.1 11.5 12.8 100 2.3 3.9 5.3 6.6 7.9 9.1 10.3 11.5 120 2.0 3.3 4.4 5.5 6.6 7.6 8.7 9.7 160 1.5 2.5 3.3 4.2 5.0 5.8 6.5 7.3 200 1.2 2.0 2.7 3.4 4.0 4.6 5.3 5.9 * Source: AICPA (1999) Audit Sampling Audit Practice Release. Assignment FIVE ♦ Page 10 Assess Control Risk; Perform Tests of Controls Perform Substantive Tests Overall Audit Plan and Substantive Tests of Transactions of Account Baiances Compiete the audit > Establish Understand Design and Review contingent 0) liabilities (0 independence internal control perform tests of accounts S and assess 3 control risk receivable 3 Review subsequent <D Obtain understanding 1. Decide the 3 events 1-^ of client's business specific audit Combined approach Substantive approach o> procedures 2. Decide Perform final •o sample size (D Decide client analytical 3. Seiect procedures acceptance Design and Design and sampie Items and obtain Design and perform perform for testing engagement letter perform 0) substantive substantive tests of 4. Perform Obtain client c tests of tests of Q. controls the audit representation letter transactions transactions procedures Perform preliminary 5. Evaluate analytical procedures fi) the results Evaluate O of the tests o audit results o (Assignment 6) c 3 Decide preliminary (A materiality level Issue auditor's report 0 O 0 Assess acceptable <• 0 audit risk, Communicate with 2 inherent risk the client's audit 0 and fraud risk committee and management Decide the specific audit procedures to be performed for each audit objective. 2. In addition to testing whether the gross amount of accounts receivable is fairly stated. One of the primary procedures performed to determine whether gross accounts receivable are fairly stated is the confirmation of a sample of accounts receivable balances. Thomas. Auditing Theory and Practice'. You should use one of these methods as indicated by your instructor. There are five closely related steps in the audit of accounts receivable: 1. Decide the sample size for each audit procedure. Auditing and Assurance Services: An Integrated Approach'. Evaluate the results of the tests and conclude whether the accounts receivable balance is fairly stated. 3. This method is used in the following textbooks: Arens. This assignment allows you to complete the testing of accounts receivable using any of four acceptable sampling methods. 3. Elder and Beasley. Ward and Henke. Select sample items for testing. Option B — Monetary unit sampling using attributes sampling. use the first option involving the use of non-statistical sampling based on the AlCPA Audit Sampling Au6\i Practice Release. Option D — Difference estimation. Assignment SIX ♦ Page 2 . Perform the audit procedures. 4. 1. and Montgomery's Auditing. If your instructor does not suggest a method. Auditing concepts Nature of the audit of accounts receivable The audit of the year-end accounts receivable balance involves accumulating sufficient appropriate evidence to evaluate whether accounts receivable balances are fairly stated and properly disclosed in the financial statements. 5. 4. the auditor must determine whether accounts receivable are stated at net realizable value by testing the adequacy of the allowance for bad debts. Option A — Non-statistical sampling based on the AlCPA Audit Sampling Audit Practice Release 2. Option C — Monetary unit sampling using the Poisson distribution method. Note: Sampling is an essential element of the testing of accounts receivable.ASSIGNMENT 6 Perform audit of accounts receivable Overview In this assignment you will audit Oceanview Marine Company's accounts receivable balance. and the other planned substantive procedures address the assessed risk. when the auditor chooses to employ statistical sampling. and adequate consideration should be given to sampling error. the auditor needs to determine whether sampling is practical for the audit procedures to be performed. Both statistical and non-statistical sampling methods are acceptable and used in practice. unless (1) accounts receivable are immaterial. Misstatements detected in the sample should be projected to the population. existence. accuracy.Confirmation of accounts receivable Confirmations are considered highly reliable evidence because they originate with a third party. While sampling is usually appropriate when confirming accounts receivable. completeness. but confirmations are often sent one or two months prior to year-end to facilitate timely completion of the audit. Plan the sample Audit procedures are designed for each audit objective (i. Statistical and non-statistical sampling Auditors generally do not test all transactions or balances that make up a particular account. Auditing standards provide guidance to auditors when audit tests are based on a sample from a population. Assignment SIX ♦ Page 3 . the auditor will perform alternative procedures to verify the balance. Thus. If a response is not received to the confirmation request. it is assumed that confirmations were sent at year-end. On the other hand. and cutoffobjectives. In this assignment. Both statistical and non-statistical sampling methods are allowed and auditing standards do not explicitly endorse one method over the other. systematically (with a non-random start). Common altemative procedures include tracing the receivable balance to subsequent payment. and (2) quantify sampling error. or (3) the auditor's assessed level of risk of material misstatement at the relevant assertion level is low. cutoff. The two primary differences between statistical and non-statistical sampling are (1) the sample selection method. using either a purely random selection method. accuracy. It is desirable to confirm year-end balances.e. or randomly. (2) external confirmation procedures would be ineffective. or a systematic selection method with a random start. sample items must be selected randomly. Confirmation of accounts receivable is required by U. However. sampling is not possible when performing procedures such as footing the aged listing of accounts receivable and tracing the total to the general ledger. the auditor may select sample items non-randomly (judgmentally).S auditing standards. Both methods of sampling have their own advantages. The most important audit procedure for accounts receivable is confirmation of accounts receivable. while it is done mathematically for statistical sampling. and (2) measurement of sampling error.. Statistical sampling can (1) help the auditor determine an efficient sample size. and so on). When using non-statistical sampling. Confirmation of receivables helps satisfy the existence. The measurement of sampling error is performed judgmentally when using non-statistical sampling. non-statistical sampling is less complex and less time consuming than statistical sampling. or tracing the receivable balance to supporting invoices and shipping documents. Sampling for tests of balances Sampling methods involve the following five general steps: 1. The auditor must determine whether the difference is a client misstatement. Several factors influence the appropriate extent oftesting (i. An important part of performing the tests is reconciling differences between the client's recorded amounts and amounts supported by the auditor's evidence.. and the sampling unit in difference estimation is individual accounts. Formulas are often used to determine the appropriate sample size for various sampling methods. Judgmental selection is permissible with non-statistical testing. timing difference. and less testing on other sub-populations. Systematic selection with a random start is a third method and is used in this assignment. The auditor then examines supporting documentation or other evidence to support the client's conclusions and to determine the amount of the misstatement. A second method is to use a computer to generate a list of random numbers. such as analytical procedures and substantive tests of transactions. or customer misstatement. suppose a customer disagrees with the amount shown on the confirmation request. the emphasis on overstatements more than understatements in the audit of accounts receivable motivates auditors to concentrate on certain items more than others. Auditors may stratify the population (account balance) into sub-populations. Such formulas generally take into considerationeach ofthe above factors. ARIA depends on risk model assessments and the results of other substantive tests. the larger the sample will be). These factors include: • Tolerablemisstatement—^inversely related to sample size (the smaller the tolerable misstatement. auditors emphasize customer accounts with large balances. the larger the sample will be). The auditor ordinarily reconciles the recorded amount and the confirmation by first requesting that the client investigate the difference. the auditor must determine the appropriate extent of tests of balances for each audit objective for accounts receivable. Determine sample size In situations where sampling can be used. In the confirmation of accounts receivable. performing extensive testing on some of the sub- populations. Select sample items for testing When using statistical sampling methods such as monetary unit sampling or difference estimation. 4. The sampling unit in monetary unit sampling is individual dollars in accounts receivable. the larger the sample needs to be). For instance.e. sample size). 3. sample items must be selected randomly. • Book value ofthe recorded population—directly related to sample size (the larger the account's year-end balance. although the actual factors determining sample size will depend upon the sampling method used. Perform the audit procedures The most time-consuming part of auditing accounts receivable or any other account is performing the tests. The sample items selected depend upon the testing method used. • Expected misstatementin thepopulation—directly related to sample size (the larger the expected misstatement in the population. the larger the sample will be). • Acceptable risk of incorrect acceptance (ARIA)—inversely related to sample size (the smaller the auditor's acceptable risk of incorrect acceptance. such as examining confirmation responses. 2. but random selection is recommended. One method of random selection is to use a random number table. if any. Assignment SIX ♦ Page 4 . For example. the auditor will need to re-audit the population. the primary objective is to decide whether the account is materially misstated. If the computed misstatement bounds exceed tolerable misstatement. not just the misstatements found in the sample. a. given the new information. then an adjusting journal entry to correct the misstatements may reduce projected misstatement sufficiently to make the account acceptable. it is unnecessary to expand the audit tests beyond those originally planned. the client may need to determine the account balance again. The sample misstatements are projected to the population to estimate the misstatements in the account balance. The auditor must also decide whether prior assessments of control risk and inherent risk require revision based on the findings in the tests of the account balance. The auditor must compare the computed misstatement bounds to tolerable misstatement to determine if the account balance is fairly stated. If this is necessary. This conclusion is likely if the computed misstatement bounds are within tolerable misstatement. c. if the misstatement bounds are less than or equal to tolerable misstatement. b. The auditor should also give appropriate consideration to sampling error. the auditor should analyze the nature and cause of every misstatement found in the sample. even when non-statistical methods are used.5. Compare computed misstatement bounds to tolerable misstatement and decide acceptability of the recorded account balance. The auditor is primarily interested in an estimate of the misstatements in the account balance. the auditor may expand substantive tests of balances. Normally. In rare cases. Auditors should always inform their clients of any misstatements found in an account balance. However. either by increasing the sample size or performing other tests. • Request that the client re-work the population. • Request the client to adjust the population. Evaluate the results of the tests and conclude whether accounts receivable is fairly stated When the auditor evaluates the results of the tests for an account such as accounts receivable. • Expand audit tests. If neither of the first two options apply. Regardless of whether the auditor accepts or rejects the recorded account balance. the auditor may decide that the original assessment of control risk or inherent risk may require revision. Analyze misstatements and reassess risks. Assignment SIX ♦ Page 5 . Generalize to the population. There are several possible actions: • Accept the population as stated. Use 2/24/2013 as the completion date for each workpaper you complete in this assignment. Complete step 1 on the audit program (workpaper 21-3).Option A: Audit of accounts receivable using non-statistical sampling based on AiCPA Sampling Guide Requirements a. and has cross-referenced the accounts receivable balance from workpaper 21-9 to workpaper 21-1. You may disregard the copies of workpapers 21-17 through 21-21 in the Current Workpapers. Note: On workpaper 21-1. carefully read through the audit program to be sure that you understand the purpose of each audit procedure. To prevent accidental modifications of the Excel file. remove the following workpapers: 21-1. you will need to first unprotect the sheet by clicking on TOOLS. 21-6. PROTECTION. notice that Bill has agreed the figures for accounts receivable and the allowance for bad debts to the general ledger. c. Bill has completed the first three rows for you. Plan the sample b.option A ♦ Page 6 ." If you need to make changes to a sheet. you will complete and print workpapers 21-17 through 21-21 using Microsoft Excel. Remember to sign off on each workpaper as you complete it. Also study the work completed by Bill on workpapers 21-7 to 21-16. UNPROTECT SHEET. Electronic workpaper option: In this assignment.21-19. Assignment SIX . click REVIEW. Before continuing. UNPROTECT SHEET in the main Excel menu at the top of the screen. Tip: The Planned Tests ofBalances Matrix mentioned in step 1 is found on workpaper 21-6. 21-2. These workpapers will be completed in this assignment and turned in to your instructor for grading. 21-5. If you're using Excel 2010. In preparation for this assignment. and 21-21. 21-3. 21-20. including those procedures already completed by Bill Cullen. each sheet has been "protected. Specific audit procedures for accounts receivable have been designed by your firm and form the Audit Program for Accounts Receivable on workpapers 21-3 to 21-5.21-18.21-17. Bill has also agreed both amounts for 2011 to the prior year's workpaper file. as inherent risk or control risk increases. $30.1 1. as acceptable audit risk increases. the combined dollar value of these accounts is $1.. AF risk factor from Audit Sampling (AICPA 1999).4 2.2 Low 2.3 2. i.0 1. along with the following information.0 1. Decide sample sizefor confirmation ofaccounts receivable d.6 Moderate 2. The second stratum consists of all remaining accounts (accounts less than.7 2. acceptable audit risk. the extent of testing increases.197. e. Complete and print workpaper 21-17 using Excel.000).0 Slightly below maximum 2.6 1. the extent of testing decreases. is inversely related to the extent of testing. The first factor. TM tolerable misstatement for accounts receivable. Each of the other factors is directly related to the extent of testing.000. Assume you have decided to stratify the sample in your testing of accounts receivable.2 1.xls" on the Integrated Audit Practice Case CD. There are 14 customer accounts greater than tolerable misstatement.3 2.. to determine an appropriate sample size for the confirmation of receivables.7 2.g. Note: The Planned Tests of Balances Matrix summarizes the factors that influence the extent of tests of balances for accounts receivable. A random sample of the customer accounts in stratum two will be selected based on the following formula: n= X AF TM where: n sample size BV book value of accounts receivable (excluding individually material customer accounts).option A ♦ Page 7 .0 2. Notice that each factor is evaluated separately for each audit objective.0 Assignment SIX . Use worlq)aper 21-17.e.6 1. determined as follows: Assurance Factors Assessment of Risk That Other Substantive Procedures Inherent and Control Risk Will Fail to Detect a Material Misstatement Slightly Below Maximum Maximum Moderate Low Maximum 3. The first stratum consists of individually material customer accounts greater than tolerable misstatement of $30.792. Electronic workpaper option: Workpaper 21-17 is included in the file named "Assign 6 Option A EXCEL_5ED. or equal to. 000. Select sample items for testing Independent of your answer in requirement (d). Additional Information: Since (1) inherent risks for the existence and accuracy objectives are medium (see workpaper 21-6). There are many other methods of selection that would be acceptable in practice. In selecting accounts in stratum 2. After reading Bill's comments. assume your sample size consists of the following: • All 14 customer accounts greater than tolerable misstatement. Also assume your tolerable misstatement for accounts receivable is $30. To reduce the time demands. The sampling interval is usually larger for companies with a large number of customers.option A ♦ Page 8 . because this is a first year audit. stratification and systematic selection with a random start are used to select accounts for testing. • A random sample of 35 of the remaining 72 customer accounts. or whether they are customer misstatements or timing differences that can be disregarded. Bill has entered a formula to determine the sample size. Assume that you mailed 49 confirmations and all have been returned to you from the customers. decide whether the differences are client misstatements and should be projected to the population. The results of substantive tests of transactions and analytical procedures were generally favorable. make corrections if necessary. Electronic workpaper option: In cell B20 on workpaper 21-17. Use workpaper 21-18 to document your selections. the risk that other procedures will fail to detect a material misstatement was set at slightly below maximum. Assignment SIX . select the first five customer accounts from each stratum to be confirmed. remember to skip accounts greater than tolerable misstatement that are part of stratum 1. The first account for each stratum and the random starting point(1^account) for stratum 2 have been selected for you. Document your decisions by completing workpaper 21-19. Perform the audit procedures f. However. you are only required to select the next four items for each stratum. begin by calculating the sampling interval in the space provided on 21-18. Information regarding the selection of the appropriate risk factor is already indicated on workpaper 21-17. You should verify that the formula is correct. Bill Cullen investigated the differences and wrote explanations on each of these five confirmations. Electronic workpaper option: Complete and print workpaper 21-18 using Excel Tip: For stratum 2. Note: In this assignment. and (2) the results of tests of controls and substantive tests of transactions for the sales cycle were generally favorable. the combined assessment of inherent and control risk is moderate. Using the year-end accounts receivable listing (workpapers 21-7 to 21-9). Five of the 49 customers disagreed with the client regarding the amount owed (see workpapers 21-10 to 21-14). Recall that stratum 1 consists of accounts whose book value exceeds $30.000. You might want to re-read page 5 of this assignment before completing this workpaper. You should include the entry already proposed for the allowance for doubtful accounts. Note: When the auditor finds immaterial misstatements. Make any necessary corrections to the formulas. overstatements should be treated as positive numbers and understatements as negative numbers.option A ♦ Page 9 . and write the new account balance in the "2012 Adjusted Balance" column on the leadsheet. Verify that the allowance for sampling error has been calculated correctly on workpaper 21-20. However. indicate whether. Complete the first three of the four sections on workpaper 21-21 to document your decision regarding the acceptability of the account balance. On workpaper 21-20. Also verify that the "stratum 2 projected misstatement" has been calculated correctly using the formula provided on workpaper 21-20. while stratum 2 consists of accounts whose book value is equal to. • Write the net effect (on accounts receivable and the allowance for bad debts) of the entry(ies) in the "Net Adjustments" column on the accounts receivable leadsheet (workpaper 21-1). be sure to list each difference in the appropriate stratum. Electronic ivorkpaper option: Complete and print workpaper 21-19 using Excel Tips: When completing workpaper 21-19. the client normally corrects these in the subsequent period. Assignment SIX . accounts receivable is fairly stated or whether further testing will be necessary based on the results of your confirmations of accounts receivable. verify that the "net misstatement in stratum 1" amount has been transferred correctly from workpaper 21-19. Make any necessary corrections to the formulas. Electronic workpaper option: Complete and print workpapers 21-20 and 21-21 using Excel Follow these steps: 1. will be posted to the trial balance in Assignment 10. Evaluate the results of the tests and conclude whether accounts receivable isfairly stated g. The entry(ies). including the effect on accounts other than accounts receivable. Assume the client agrees with the adjusting journal entries proposed on workpaper 21-2.000. In the "Conclusion" section. When calculating the net misstatement for each stratum on workpaper 21-19. the client has asked you to propose adjusting journal entries to correct actual misstatements found in accounts receivable regardless of whether the misstatements are material or not. 2. Complete workpaper 21-20 to project misstatements to the population and calculate the allowance for sampling error. • Cross-reference the Adjusting Joumal Entries workpaper (21-2) to the adjustments shown on the accounts receivable leadsheet (21-1). in your opinion. Use workpaper 21-2 to propose an adjusting journal entry(ies) to correct the actual misstatements found in your confirmation tests. or less than. $30. and 21-21. If your adjustingjournal entries had not been recorded at this time. 3c. 21-17 to 21-21. k. and added a reference to workpaper 21-6 in the "W/P" column. and the assignment number. on workpaper 21-5. j." and "Income Before Taxes" columns on workpaper 90-1. Tip: Since the client has already agreed to your proposed adjusting entry to correct the actual misstatements found in your confirmation tests. 21-18. Carry forward any remaining unadjusted projected misstatement to the Summary of Possible Misstatements (workpaper 90-1). your signature. and the net projected misstatement would have been entered in the "Likely Aggregate Misstatement. Assignment SIX . 21-17." "Current Assets. Staple the following items together in the order listed and submit them to your instructor for grading: Cover page with your printed name. 2.21-6. using 2/24/2013 as the date: 21-1 to 21-3. and 3 (Assignment SIX ♦ Page 30) if required by your instructor. step 22. Also make sure you signed off on step 1 on workpaper 21-3 by writing your initials in the "INIT" column." and "Income Before Taxes" columns. The net amount of the actual misstatements would have been entered in the "Identified Misstatement" column. Complete the bottom section of workpaper 21-21 by deducting the amount of the adjusting journal entry made to correct the actual misstatements found in your confirmation tests.21-3. and to the entryproposed by Bill to adjust the allowance account. and 3d on workpaper 21-3.21-5.21-19.21-2." "Current Assets. Completing the assignment Make sure you signed off on the following workpapers completed in this assignment. then the actual and projected misstatements on workpapers 21-19 and 21-21. added references to the appropriate workpapers in the "W/P" column. from the projected misstatement (do not include the adjusting journal entry to the allowance for doubtful accounts prepared by Bill Cullen).option A ♦ Page 10 . Complete the conclusion section. the Summary of Possible Misstatements will be reviewed and compared to materiality to decide if further adjusting entries are required to reduce the misstatements to an acceptable level. you will enter "0" in the "Identified Misstatement" column on workpaper 90-1. Workpapers 21-1. 3b. 21-5. Also make sure you signed off on steps 3a. and added any necessary explanations in the "COMMENTS" column. Note: Unadiusted actual and projected misstatements are carried forward to the SummaryofPossible Misstatements (workpaper 90-1). 21-20. along with the adjustment proposed by Bill on workpaper 21-2. Answers to discussion questions 1. would have been carried forward to the Summary ofPossible Misstatements. Your remaining unadjusted projected misstatement on workpaper 21-21 should be entered in the "Likely Aggregate misstatement. 21-6. At the conclusion of the audit. Option B: Audit of accounts receivabie using monetary unit sampling based on attributes sampling tables Requirements a. Ifyou're using Excel 2010.21-24. You may disregard the copies of workpapers 21-22 through 21-28 in the Current Workpapers. c. Also study the work completed by Bill on workpapers 21-7 to 21-16. and has cross-referenced the accounts receivable balance from workpaper 21-9 to workpaper 21-1." If you need to make changes to a sheet. including those procedures already completed by Bill Cullen. Plan the sample b. and 21-28. Electronic workpaper option: In this assignment. UNPROTECT SHEET. you will complete and print workpapers 21-22 through 21-28 using Microsoft Excel. each sheet has been "protected. 21-25. UNPROTECT SHEET in the main Excel menu at the top ofthe screen. 21-2. 21-3. carefully read through the audit program to be sure that you understand the purpose of each audit procedure. In preparation for this assignment. Before continuing. click REVIEW. PROTECTION. 21-5. Bill has also agreed both amounts for 2011 to the prior year's workpapers file. Use 2/24/2013 as the completion date for each workpaper you complete in this assignment. These workpapers will be completed in this assignment and turned in to your instructor for grading. Note: On workpaper 21-1. Bill has completed the first three rows for you.option B ♦ Page 11 .21-6. Complete step 1 on the audit program (workpaper 21-3). To prevent accidental modifications of the Excel file. 21-22. remove the following workpapers: 21-1. 21-27. Remember to sign off on each workpaper as you complete it. Assignment SIX . notice that Bill has agreed the figures for accounts receivable and the allowance for bad debts to the general ledger. you will need to first unprotect the sheet by clicking on TOOLS.21-23. Tip: The Planned Tests ofBalances Matrix mentioned in step 1 is found on workpaper 21-6. 21-26. Specific audit procedures for accounts receivable have been designed by your firm and form the Audit Program for Accounts Receivable on workpapers 21-3 to 21-5. and (3) Oceanview's financial condition is strong. (2) the results of tests of controls and substantive tests of transactions for the sales cycle were generally favorable. assume that your acceptable risk of incorrect acceptance for accounts receivable is 30% (medium). e. assume your sample size is 80 dollar units.g. acceptable audit risk. Note: The Planned Tests of Balances Matrix summarizes the factors that influence the extent of tests of balances for accounts receivable. Electronic workpaper option: Complete and print workpaper 21-23 using Excel Assignment SIX . the extent of testing decreases. Notice that each factor is evaluated separately for each audit objective.000 for both overstatements and understatements. along with the following information. Select sample itemsfor testing e. The estimated misstatement in accounts receivable is $1. Tip: Use Table 1 in the Appendix to Assignment 6—option B (page 17) to look up the sample size.. Each of the other factors is directly related to the extent of testing. Use workpaper 21-22.e. as inherent risk or control risk increases.. the extent of testing increases.option B ♦ Page 12 . Use workpaper 21-23 to document your work. The first factor. Decide sample sizefor confirmation ofaccounts receivable d. Also assume your tolerable misstatement for accounts receivable is $30.000 overstated. Use systematic selection to select the sample items for confirmation. is inversely related to the extent of testing.XLS" on the Integrated Audit Practice Case CD. as acceptable audit risk increases. Independent of your answer in requirement(d). Complete and print workpaper 21-22 using Excel Additional Information: Since (1) inherent risks for the existence and accuracy objectives are medium (see workpaper 21-6). Electronic workpaper option: Workpaper 21-22 is included in the file named "Assign 6 Option B Excel_5ed. i. and your average percent of misstatement assumption (tainting) is 100% for both overstatements and understatements. to determine an appropriate sample size for the confirmation of receivables. Notice that customers with large year-end account balances may be selected more than once.89 would be rounded down to $500. write the customer's total balance.000) and the first and last sample items have been selected for you. to project these misstatements to the population. decide whether the differences are client misstatements and should be projected to the population. (In the "Amount Confirmed" column on workpaper 21-23. Tip: Round the sampling interval downward to rounded hundred dollars (e.g. Verify that the unit misstatements in column seven of workpaper 21-24 are correct. although only one confirmation letter would be sent to each. 1/3 would be rounded to . and to decide the acceptability of the account balance. you are required to select the next 8 sample items instead of all 80. not the cumulative total. or whether they are customer misstatements or timing differences that can be disregarded.g. Complete column seven on workpaper 21-24. Complete workpapers 21-24 to 21-28 using the following steps: Electronic workpaper option: Complete and print workpapers 21-24 through 21-28 using Excel 1..) Note: The random starting point ($8. write "N/A" in column seven. Electronic workpaper option: Complete and print workpaper 21-24 using Excel Evaluate the results of the tests and conclude whether accounts receivable is fairly stated g. For differences not involving a client misstatement. Bill Cullen investigated the differences and wrote explanations on each of these five confirmations.option B ♦ Page 13 . Tip: Round unit misstatements up to four decimal places (e. Go to step 2 below. Use the cumulative total colunm on workpaper 21-7 to identify the names of the customers whose accounts contain the dollar units selected for testing.) For differences not involving a client misstatement. enter "N/A" in column seven. Workpapers 21-24 to 21-28 are used to summarize the client misstatements found. (Each unit misstatement should be rounded up to four decimal places. $567.. Five of the 39 customers disagreed with the client regarding the amount owed (see workpapers 21-10 to 21-14). To reduce the time demands. Document your decisions by completing the first six columns on workpaper 21-24. After reading Bill's comments. Perform the audit procedures Assume that you mailed 39 confirmations and all have been returned to you from the customers. 1.00).3334) Assignment SIX . Tip: In column four. 2. write your conclusion regarding whether accounts receivable is fairly stated or whether further testing will be necessary based on the results of your confirmations of accounts receivable. not understatements. In the second section of workpaper 21-25. However. The sum of the misstatement bound portions in column five is the initial overstatement bound. you should use only the unit misstatements for overstatements. calculate the adjusted overstatement bound and the adjusted understatement bound. In the first section of workpaper 21-25.) 5.option B ♦ Page 14 . calculate the initial understatement bound. Note: When the auditor finds immaterial misstatements. However. not overstatements. the unit misstatements calculated in step 1 should be ranked from largest to smallest. 3. The sum of the misstatement bound portions in column five is the initial understatement bound. the absolute values of the unit misstatements calculated in step 1 should be ranked from largest to smallest. You might want to re-read page 5 of this assignment before completing this workpaper. the client normally corrects these in the subsequent period. h. 1. Use the bottom of workpaper 21-26 to calculate the point estimate for understatements. calculate the initialoverstatement bound. However. 8. you should use only the unit misstatements for understatements. 4. Tip: In column four. the client has asked you to propose adjusting joumal entries to correct actual misstatements found in accounts receivable regardless of whether the misstatements are material or not Assignment SIX . 6. Use the top of worlqiaper 21-26 to calculate the point estimatefor overstatements.000. The sum of the amounts in the last column is the overstatement point estimate. Complete the bottom half of workpaper 21-27 to document your decision regarding the acceptability of the account balance. In the top section of workpaper 21-27. In the top section of workpaper 21-28. (The point estimate will be zero if no overstatementswere found in your sample. Tip: Recall that the tolerable misstatement for accounts receivable is $30. Use workpaper 21-2 to propose an adjusting journal entry(ies) to correct the actual misstatements found in your confirmation tests. i. You should include the entry already proposed for the allowance for doubtful accounts. Assignment SIX . will be posted to the trial balance in Assignment 10." "Current Assets. The entry(ies). and write the new account balance in the "2012 Adjusted Balance" column on the leadsheet. Carry forward any remaining unadjusted projected misstatement to the Summary of Possible Misstatements (workpaper 90-1)." "Current Assets. Assumethe client agrees with the adjustingjournal entriesproposed on workpaper21-2. Complete the bottom section of workpaper 21-28 by deducting the amount of the adjusting joumal entry made to correct the actual misstatements found in your confirmation tests. on workpaper 21-5. would have been carried forward to the Summary of Possible Misstatements. • Write the net effect (on accounts receivable and the allowance for bad debts) of the entry(ies) in the "Net Adjustments" column on the accounts receivable leadsheet (workpaper 21-1). from the projected misstatement (do not include the adjusting joumal entry prepared by Bill Cullen). and the net projected misstatement would have been entered in the "Likely Aggregate Misstatement. If your adjusting joumal entries had not been recorded at this time. and to the entry proposed by Bill to adjust the allowance account. Tip: Since the client has already agreed to your proposed adjusting entry to correct the actual misstatements found in your confirmation tests. step 22. you will enter "0" in the "Identified Misstatement" column on workpaper 90-1. k. the Summary of Possible Misstatements will be reviewed and compared to materiality to decide if further adjusting entries are required to reduce the misstatements to an acceptable level. Your remaining unadjusted projected misstatement on workpaper 21-28 should be entered in the "Likely Aggregate Misstatement. along with the adjustment proposed by Bill on workpaper 21-2. Note: Unadjusted actual and projected misstatements are carried forward to the Summary ofPossible Misstatements (workpaper 90-1). • Cross-reference the Adjusting Journal Entries workpaper (21-2) to the adjustments shown on the accounts receivable leadsheet (21-1).option B ♦ Page 15 . j. At the conclusion of the audit. including the effect on accounts other than accounts receivable. Complete the conclusion section. The net amount of the actual misstatements would have been entered in the "Identified Misstatement" column." and "Income Before Taxes" columns on workpaper 90-1." and "Income Before Taxes" columns. then the actual and projected misstatements you discovered in your confirmations of accounts receivable on workpaper 21-24. and added a reference to workpaper 21-6 in the "W/P" column. using 2/24/2013 as the date: 21-1 to 21-3.21-22 to 21-28. 21-6. Assignment SIX . your signature. 21-22. 3b.option B ♦ Page 16 . • Workpapers 21-1. and 3d on workpaper 21-3. 2. 21-25. 21-5. • Answers to discussion questions 1. 3c. added references to the appropriate workpapers in the "W/P" column. and added any necessary explanations in the "COMMENTS" column. 21-6. 21-27 and 21-28.21-5. 21-3. Also make sure you signed off on steps 3a. Staple the following items together in the order listed and submit them to your instructor for grading: • Cover page with your printed name. and 3 (Assignment SIX ♦ Page 30) if required by your instructor. 21-26. and the assignment number. 21-2. Also make sure you signed off on step 1 on workpaper 21-3 by writing your initials in the "INIT" column. 21-24. 21-23.Completing the assignment Make sure you signed off on the following workpapers completed in this assignment. 1309 50 .1178 80 .option B ♦ Page 17 .0952 .1587 .0300 .Appendix to Assignment 6—Option S.0542 .0724 .06% 145 75 50 40 32 28 26 22 20 18 Tabie 2 Evaiuation of Sampie Resuits ARIA = 30% Actual Number of Misstatements Found in Sample Sample Size 0 1 2 3 4 30 .0548 .0267 .0488 .0804 .0423 .0670 TABLES FOR OPTION B ONLY Assignment SIX .0905 .0292 .0697 .1190 .1473 45 .1058 .0156 .0610 .0400 .0343 .1034 .1360 .1207 .1963 35 .1683 40 . TABLES FOR OPTION B ONLY Table 1 Determination of Sampie Size ARiA = 30% Estimated Population Misstatement Tolerable Misstatement Rate tin nercentaee) Rate (in percentage) 1 2 3 4 5 6 7 8 9 10 0 120 60 40 30 24 20 18 15 14 12 .0813 .0240 . Electronic workpaper option: In this assignment.option C ♦ Page 18 . 21-3. To prevent accidental modifications of the Excel file. Assignment SIX . Specific audit procedures for accounts receivable have been designed by your firm and form the Audit Program for Accounts Receivable on workpapers 21-3 to 21-5. carefully read through the audit program to be sure that you understand the purpose of each audit procedure. Note: On workpaper 21-1. 21-29. If you're using Excel 2010. notice that Bill has agreed the figures for accounts receivable and the allowance for bad debts to the general ledger. Remember to sign off on each workpaper as you complete it. each sheet has been "protected. UNPROTECT SHEET in the main Excel menu at the top of the screen. click REVIEW. UNPROTECT SHEET. 21-32. You may disregard the copies of workpapers 21-29 through 21-34 included in the Current Workpapers. and has cross-referenced the accounts receivable balance from workpaper 21-9 to workpaper 21-1.Option C: Audit of accounts receivabie using monetary unit sampiing based on the Poisson distribution Requirements a. 21-6. Before continuing. you will need to first unprotect the sheet by clicking on TOOLS. remove the following: 21-1. 21-2. c. including those procedures already completed by Bill Cullen. Tip: The Planned Tests ofBalances Matrix mentioned in step 1 is found on workpaper 21-6. 21-31. 21-33. 21-5. PROTECTION. These workpapers will be completed in this assignment and tumed in to your instructor for grading. Plan the sample b. Bill has also agreed both amounts for 2011 to the prior year's workpapers file. In preparation for this assignment. and 21-34. Also study the work completed by Bill on workpapers 21-7 to 21-16." If you need to make changes to a sheet.21-30. you will complete and print workpapers 21-29 through 21-34 using Microsoft Excel. Use 2/24/2013 as the completion date for each workpaper you complete in this assignment. Complete step 1 on the audit program (workpaper 21-3). Bill has completed the first three rows for you. as inherent risk or control risk increases. Select sample itemsfor testing e.g. The first factor. the extent of testing decreases. along with the following information. Use workpaper 21-29.g. Each of the other factors is directly related to the extent of testing. Electronic workpaper option: Complete and print workpaper 21-30 using Excel. (2) the results of tests of controls and substantive tests of transactions for the sales cycle were generally favorable. e. is inversely related to the extent of testing. and (3) Oceanview's financial condition is strong.000 for both overstatements and understatements. write the customer's total balance.option C ♦ Page 19 . Use the cumulative total column on workpaper 21-7 to identify the names of the customers whose accounts contain the dollar units selected for testing. Note: The Planned Tests of Balances Matrix summarizes the factors that influence the extent of tests of balances for accounts receivable.. to determine an appropriate sample size for the confirmation of receivables. (In the "Amount Confirmed" column on workpaper 21-30.. Electronic workpaper option: Workpaper 21-29 is included in the file named "Assign 6 Option C Excel_5ed. Also assume your tolerable misstatement for accounts receivable is $30.) Assignment SIX .89 would be rounded down to $500. Decide sample sizefor confirmation ofaccounts receivable d..xls" on the Integrated Audit Practice Case CD. the extent of testing increases. $567. assumeyour samplesize is 80 dollar units. Use workpaper 21-30 to document your work. Tips: Round the sampling interval downward to rounded hundred dollars (e. Additional Information: Since (1) inherent risks for the existence and accuracy objectives are medium (see workpaper 21-6). not the cumulative total. Notice that each factor is evaluated separately for each audit objective. Complete and print workpaper 21-29 using Excel.e.00). acceptable audit risk. i. Independent of your answer in requirement (d). assume that your acceptable risk of incorrect acceptance for accounts receivable is 30%.000 overstated. as acceptable audit risk increases. Use systematic selection to select the sample items for confirmation. and your estimated (or "expected") misstatement in accounts receivable is $1. although only one confirmation letter would be sent to each.000) and the first and last sample items have been selected for you. enter "N/A" in column seven. Go to step 2 below. Notice that customers with large year-end account balances may be selected more than once. calculate the net projected misstatement. Complete workpapers 21-31 to 21-34 using the following steps: Electronic workpaper option: Complete and print workpapers 21-31 through 21-34 using Excel. Tip: Round each projected misstatement to the nearest cent. calculate the projected misstatement for each overstatement and each understatement. After reading Bill's comments. to project these misstatements to the population. Bill Cullen investigated the differences and wrote explanations on each of these five confirmations. 2. decide whether the differences are client misstatements and should be projected to the population. Complete column seven in the top section of workpaper 21-31. and to decide the acceptability of the account balance. Tip: Round taintings up to four decimal places (e. Assignment SIX . 1. Document your decisions by completing the first six columns in the top section of workpaper21-31. On workpaper 21-31. 1/3 would be rounded to . Note: The random starting point ($8. For differences not involving a client misstatement. Perform the audit procedures Assume that you mailed 39 confirmations and all have been returned to you from the customers. or whether they are customer misstatements or timing differences that can be disregarded. Verify that the formula entered by Bill in column seven of workpaper 21-31 are correct (each tainting should be rounded up to four decimal places. write "N/A" in column seven.) For differences not involving a client misstatement. First.g.3334. Five of the 39 customers disagreed with the client regarding the amount owed (see workpapers 21-10 to 21-14). Workpapers 21-31 to 21-34 are used to summarize the client misstatements found. Electronic workpaper option: Complete and print workpaper 21-31 using Excel. The net projected misstatement is calculated by subtracting the projected understatements from the projected overstatements. To reduce the time demands. 1. Evaluate the results ofthe tests and conclude whether accounts receivable isfairly stated g. you are required to select the next 8 sample items instead of all 80.option C ♦ Page 20 . the actual amount of the misstatement is used as the projected misstatement. calculate the upper misstatement limit and the lower misstatement limit. testing the entire population of "large" customer accounts. Calculate basic precision in the top section on workpaper 21-32.0. On workpaper 21-33. Thus. 5.option C ♦ Page 21 . Since all of these "large" customer accounts will always be included in your sample and tested. Rather. calculate (1) the incremental allowance for overstatements. this is true only for misstatements found in customer accounts whose recorded value is less than the sampling interval. when calculating projected misstatement for any "large" customer accounts. Assignment SIX . in column 2 on workpaper 21-32. On workpaper 21-32. write the actual misstatement found in the customer's account. Electronic workpaper option: Verify that the upper and lower misstatement limits determined by Bill are correct. minus 1. Follow a similar methodology to calculate the incremental allowance for under statements. However. Make corrections if necessary. Bill has written the appropriate incremental increases in reliability factors (based on an ARIA of 30%). you are. in the Projected Misstatement column. Make corrections if necessary. Accordingly.0.) Electronic workpaper option: Verify that basic precision as determined by Bill in cell Fll is correct. Tip: To calculate the incremental allowance for overstatements.Tip: Misstatements are normally projected to the population by multiplying their tainting by the sampling interval. (Round basic precision to the nearest cent. and (2) the incremental allowance for understatements. begin by ranking the projected overstatements from largest to smallest (but do not include misstatements found in customer accounts whose book value equals or exceeds the sampling interval). and. Each projected misstatement is then multiplied by the incremental increase in the reliability factors. minus 1. write "N/A" in the Tainting and Sampling Interval colunms on the bottom section of workpaper 21-31. Misstatements found in customer accounts whose recorded value is equal to. in effect. or exceeds. 3. there is no need to project misstatements found in accounts whose recorded value equals or exceeds the sampling interval. the sampling interval are not projected in this manner. The incremental allowance for overstatements is the sum of the resulting products. 4. option C ♦ Page 22 . Tip: Since the client has already agreed to your proposed adjusting entry to correct the actual misstatements found in your confirmationtests. write your conclusions regarding whether accounts receivable is fairly stated or whether further testing will be necessary based on the results of your confirmations of accounts receivable. Carry forward any remaining unadjusted projected misstatement to the Summary of Possible Misstatements (workpaper 90-1). Complete the bottom section of workpaper 21-34 by deducting the amount of the adjustingjoumal entry made to correct the actual misstatements found in your confirmation tests. you will enter "0" in the "Identified Misstatement" column on workpaper 90-1. You should include the entry already proposed for the allowance for doubtful accounts. including the effect on accounts other than accounts receivable. • Write the net effect (on accounts receivable and the allowance for bad debts) of the entry(ies) in the "Net Adjustments" column on the accounts receivable leadsheet (workpaper 21-1). Tip: Recall that the tolerable misstatement for accounts receivable is $30. and to the entry proposed by Bill to adjust the allowance account. Note: When the auditor finds immaterial misstatements. The entry(ies). will be posted to the trial balance in Assignment 10. the client normally corrects these in the subsequent period. Your remaining unadjusted projected misstatement on workpaper 21-34 should be entered in the "Likely Aggregate Misstatement. In the top section of workpaper 21-34." and "Income Before Taxes" columns on workpaper 90-1. the client has asked you to propose adjusting journal entries to correct actual misstatements found in accounts receivable regardless of whether the misstatements are material or not.000. and write the new account balance in the "2012 Adjusted Balance" column on the leadsheet. • Cross-reference the Adjusting Joumal Entries workpaper (21-2) to the adjustments shown on the accounts receivable leadsheet (21-1). Assume the client agrees with the adjusting journal entries proposed on workpaper 21-2. Use workpaper 21-2 to propose an adjusting journal entry(ies) to correct the actual misstatements found in your confirmation tests. You might want to re-read page 5 of this assignment before completing this workpaper. 7. from the projected misstatement (do not include the adjustingjoumal entry prepared by Bill Cullen)." "Current Assets. Assignment SIX . Complete the bottom half of workpaper 21-33 to document your decision regarding the acceptability of the account balance. However. k. using 2/24/2013 as the date: 21-1 to 21-3. and 3d on workpaper 21-3.21-2.21-3. Note: Unadjusted actual and projected misstatements are carried forward to the Summary of Possible Misstatements (workpaper 90-1). Assignment SIX . and added a reference to workpaper 21-6 in the "W/P" column. and 21-34. on workpaper 21-5. At the conclusion of the audit.21-29.21-31. 2. your signature. If your adjusting journal entries had not been recorded at this time. Completing the assignment Make sure you signed off on the following workpapers completed in this assignment. and the assignment number. added references to the appropriate workpapers in the "W/P" column. and 3 (Assignment SIX ♦ Page 30) if required by your instructor.21-5." "Current Assets.21-5. Also make sure you signed off on step 1 on workpaper 21-3 by writing your initials in the "INIT" column. and the net projected misstatement would have been entered in the "Likely Aggregate Misstatement. then die actual and projected misstatements you discovered in your confirmations of accounts receivable on workpaper 21-31. would have been carried forward to the Summary of Possible Misstatements. • Workpapers 21-1. Staple the following items together in the order listed and submit them to your instructor for grading: • Cover page with your printed name.option C ♦ Page 23 .21-29 to 21-34. step 22.21-6. 3c. the Summary of Possible Misstatements will be reviewed and compared to materiality to decide if further adjusting entries are required to reduce the misstatements to an acceptable level." and "Income Before Taxes" columns.21-30. along with the adjustment proposed by Bill on workpaper 21-2.21-6. Also make sure you signed off on steps 3a.21-33. Complete the conclusion section. 3b. • Answers to discussion questions 1. and added any necessary explanations in the "COMMENTS" column.21-32. The net amount of the actual misstatements would have been entered in the "Identified Misstatement" column. you will complete and print workpapers 21-35 through 21-40 using Microsoft Excel.21-35. 21-2. You may disregard the copies of workpapers 21-35 through 21-40 in the Current Workpapers. Specific audit procedures for accounts receivable have been designed by your firm and form the Audit Program for Accounts Receivable on workpapers 21-3 to 21-5.21-37.option D ♦ Page 24 . 21-38. Use 2/24/2013 as the completion date for each workpaper you complete in this assignment. Assignment SIX . you will need to first unprotect the sheet by clicking on TOOLS. These workpapers will be completed in this assignment and turned in to your instructor for grading. each sheet has been "protected." If you need to make changes to a sheet. c. PROTECTION. Complete step 1 on the audit program (workpaper 21-3). 21-5.21-36. UNPROTECT SHEET in the main Excel menu at the top of the screen. Electronic workpaper option: In this assignment. 21-39. Tip: The Planned Tests ofBalances Matrix mentioned in step 1 is found on workpaper 21-6. remove the following workpapers: 21-1. click REVIEW. UNPROTECT SHEET. Bill has also agreed both amounts for 2011 to the prior year's workpapers file. and 21-40. Plan the sample b. Also study the work completed by Bill on workpapers 21-7 to 21-16.21-6. Note: On workpaper 21-1.Option D: Audit of accounts receivable using variables sampling based on difference estimation Requirements a. To prevent accidental modifications of the Excel file. Remember to sign off on each workpaper as you complete it. 21-3. including those procedures already completed by Bill Cullen. notice that Bill has agreed the figures for accounts receivable and the allowance for bad debts to the general ledger. In preparation for this assignment. carefully read through the audit program to be sure that you understand the purpose of each audit procedure. If you're using Excel 2010. Bill has completed the first three rows for you. Before continuing. and has cross-referencedthe accounts receivable balance from workpaper 21-9 to workpaper 21-1. assume that your acceptable risk of incorrect acceptance for accounts receivable is medium — 30%. Notice that each factor is evaluated separately for each audit objective. Second. (2) the results of tests of controls and substantive tests of transactions for the sales cycle were generally favorable.option D ♦ Page 25 . Decide sample sizefor confirmation ofaccounts receivable d.e. Use workpaper 21-35. The confidence coefficients (Za and Zr) corresponding to these ARIA and ARIR values are indicated on workpaper 21-35. as inherent risk or control risk increases. to determine an appropriate sample size for the confirmation of receivables. Assignment SIX . the extent of testing increases. Also assume the acceptable risk of incorrect rejection is high — 60%. Note: The Planned Tests of Balances Matrix summarizes the factors that influence the extent oftests of balances for accounts receivable. Complete and print workpaper 21-35 usingExcel.000. There are twounique aspects to determining the sample sizeusing difference estimation.. as well as the acceptable risk of incorrect acceptance (ARIA). the auditor specifies an estimate of the standard deviation ofthe misstatements expected in the population. The formula for determining sample size using difference estimation is as follows: 2 SD\Za-^Zr)N n = TM -E* where: n = sample size SiS = estimate of standard deviation of population Za = confidence coefficient for ARIA Z/f = confidence coefficient for ARIR N = population size TM = tolerable misstatement for the account = estimated population misstatement Additional Information: Since (1) inherent risks for the existence and accuracy objectives are medium (see workpaper 21-6). the auditor specifies the acceptable risk of incorrect rejection (ARIR). is inversely related to the extent of testing. i. Electronic workpaper option: Workpaper 21-35 is included in the file named "Assign 6 Option D Excel_5ED. and (3) Oceanview's financial condition is strong. Each of the other factors is directly related to the extent of testing. Also assume your tolerable misstatement for accounts receivable is $30. e.000. as acceptable auditrisk increases.XLS" on the IntegratedAudit Practice Case CD.g. acceptable audit risk. The first factor. and the expected misstatement in accounts receivable is $1. First. the extentof testing decreases.. along with the following information. Bill Cullen investigated the differences and wrote explanations on each of these five confirmations. verify that the formula entered by Bill in column seven correctly calculates the squared misstatement.option D ♦ Page 26 . Perform the audit procedures Assume that you mailed 35 confirmations and all have been returned to you fi'om the customers. After reading Bill's comments. decide whether the differences are client misstatements and should be projected to the population. 0 continued on next page Assignment SIX . to project the misstatements to the population. assume your sample size is 35 accounts. Use systematic selection to select the sample items for confirmation. Use workpaper 21-36 to document your work. Complete workpapers 21-37 to 21-40usingthe following steps: Electronic workpaper option: Complete and print workpapers 21-37 through 21-40 using Excel Follow these steps: 1. Use your sampling interval to count from the first account to select the next account on the accounts receivable listing (workpapers 21-7 to 21-9). Electronic workpaper option: Be sureto verify that Bill's formulas and calculations on workpaper 21-35 are correct. Workpapers 21-37 to 21-40 are used to summarize the client misstatements found. Continue using this procedure until 10 accounts have been selected. Select sample itemsfor testing e. Document your decisions by completing the first six columns in the top section of workpaper 21-37. Five of the 35 customers disagreed with the client regarding the amount owed (see workpapers 21-10 to 21-14). Electronic workpaperoption: Complete and print workpaper 21-36 using Excel. Tip: Begin by calculating the sampling interval in the space provided on 21-36. For each client misstatement in the top section of workpaper 21-37. Electronic workpaper option: Complete andprintworkpaper 21-37 using Excel. Evaluatethe results of the tests and conclude whether accounts receivable isfairly stated g. To reduce time demands. The random starting point (I®' account) has been selected for you. Make any necessary corrections. (For differences not involving a client misstatement. you are required to select the next 8 customers' accounts instead of all 35. The tenth account has also been entered on workpaper 21-36 for you. Independent of your answer in requirement (d). or whether theyare customer misstatements or timing differences that can be disregarded. andto decide the acceptability of the account balance. Round all amounts to the nearest whole number. treat overstatements as positive numbers and understatements as negative numbers. 2. Complete column seven in the top section of workpaper 21-37 by calculating the squared misstatement.) 2. Sum the total misstatements (column six) and squared misstatements (column seven). precision interval.option D ♦ Page 27 . Complete the bottom section of workpaper 21-37 to calculate the projected misstatement.mean misstatement in sample n = sample size 4. (When summing column six. Make corrections if necessary. Calculate the precision interval in the lower section of workpaper 21-38 using the following formula: C?\ =NZa^ " N where: CPI = computed precision interval N = population size Za = confidence coefficient for ARIA The other terms are as described previously. overstatements should be treated as positive numbers and understatements as negative numbers. 5. and upper and lower confidence limits. Go to step 6 on the next page.continued from previous page should appear in column seven. Assignment SIX . When summing column six. Calculate the standard deviation of the sample misstatements in the top section of workpaper 21-38 based on the following formula (round all amounts to the nearest whole number): SD V n-\ where: ^ey =summation of individual misstatements in the sample e . Compute the upper and lower confidence limits in the top section of workpaper 21-39. 3. For differences not involving a client misstatement. write 0 in column seven.) Also verify that columns six and seven have been summed correctly. 1. 3. Study the formulas and calculations used by Bill on workpapers 21-38 and 21-39 to determine the sample standard deviation. Complete the bottom section of workpaper 21-37 to calculate the projected misstatement. • Cross-reference theAdjusting Joumal Entries workpaper (21 -2)to the adjustments shownon the accounts receivable leadsheet (21-1)." "Current Assets. Complete the bottom section ofworkpaper 21-40 by deducting the amount ofthe adjusting joumal entry made to correct theactual misstatements found inyour confirmation tests. However. the client normally corrects these inthe subsequent period. Your remaining unadjustedprojected misstatement on workpaper 21-40 should be entered in the "Likely Aggregate Misstatement. j. will be posted to the trial balance in Assignment 10. and to the entry proposed by Bill to adjust the allowance account. Assume the client agrees with the adjusting journal entries proposed on workpaper 21-2. Complete the bottom half of workpaper 21-39 to document your decision regarding the acceptability of the account balance. You should include the entry already proposed for the allowance for doubtful accounts. Note: When the auditor finds immaterial misstatements.000. Use workpaper 21-2 to propose an adjusting journal entry(ies) to correct the actual misstatements found in your confirmation tests. • Write the net effect (on accounts receivable and the allowance for bad debts) of the entry(ies) in the "Net Adjustments" column on the accounts receivable leadsheet (workpaper 21-1). from the projected misstatement (do not include the adjusting joumal entry prepared by Bill Cullen). Assignment SIX. In the top section of workpaper 21-40. The entry(ies). the client has asked you to propose adjusting journal entries to correct actual misstatements found in accounts receivable regardless of whether the misstatements are material or not. including the effect on accounts other than accounts receivable. and write the new account balance in the "2012 Adjusted Balance" column on the leadsheet. You might want to re-read page5 of this assignment before completing thisworkpaper. 6." and "IncomeBeforeTaxes" columns on workpaper 90-1. i. 7. Tip: Recall that the tolerable misstatement for accounts receivable is $30.option D ♦ Page 28 . write your conclusion regarding whether accounts receivable is fairly stated or whether further testing will be necessary based on the results of your confirmations of accounts receivable. Carry forward any remaining unadjusted projected misstatement to the Summary of Possible Misstatements (workpaper 90-1). Tip: Since the client has already agreed to your proposed adjusting entry to correct the actual misstatements found in your confirmation tests. you will enter "0" in the "Identified Misstatement" column on workpaper 90-1. k. 21-38. 21-35 to 21-40. 2. 21-35. would have been carried forward to the Summary of Possible Misstatements." "Current Assets. 21-6. 3c. then the actual and projected misstatements you discovered in your confirmations of accounts receivable on workpaper 21-37. and the net projected misstatement would have been entered in the "Likely Aggregate Misstatement. If your adjusting journal entries had not been recorded at this time. Assignment SIX. the SummaryofPossible Misstatements will be reviewed and compared to materiality to decide if further adjusting entries are required to reduce the misstatements to an acceptable level. and 3 on the following page if required by your instructor. Note: Unadjusted actual and projected misstatements are carried forward to the Summary ofPossible Misstatements (workpaper 90-1). your signature. 21-2. and added a reference to workpaper 21-6 in the "W/P" column. 21-6. and added any necessary explanations in the "COMMENTS" column. 3b. 21-5. • Workpapers 21-1. • Answers to discussion questions 1. Complete the conclusion section. step 22. Also make sure you signed off on steps 3a. and 3d on workpaper 21-3. and the assignment number. along with the adjustment proposed by Bill on workpaper 21-2. Completing the assignment Make sure you signed off on the following workpapers completed in this assignment. 21-39. 21-3. Staple the following items together in the order listed andsubmit them to your instructor for grading: • Coverpage with your printed name. added references to the appropriate workpapers in the "W/P" column.option D ♦ Page 29 . 21-36. and21-40.21-37. using 2/24/2013 as the date: 21-1 to 21-3. 21-5. on workpaper 21-5. The net amount of the actual misstatements would have been entered in the "Identified Misstatement" column. At the conclusion of the audit." and "Income Before Taxes" columns. Also make sure you signed off on step 1 on workpaper 21-3 by writing your initials in the "INIT" column. Discussion questions 1. Therefore. When confirming accounting receivable. negative confirmations. the auditor may use positive confirmations. Although the use of negative confirmations is less expensive than positive confirmations. What are the circumstances under which confirmation of accounts receivable is not required? 2. negative confirmations are less reliable. Discuss those circumstances. AU Section 316 indicates that the auditor should ordinarily presume that there is a risk of material misstatement due to fraud relating to revenue recognition. How might this concern related to revenuerecognition affect the nature and extent of confirmation procedures? Assignment SIX ♦ Page 30 . AICPA auditing standards address the confirmation of accounts receivable for private company audits. or a combination of both. negative confirmations should be used only in certain circumstances. Perform Obtain client fi) tests of tests of c controls the audit representation letter transactions transactions a procedures Perform preliminary 5. Decide Perform final sample size Decide client analytical 3. Communicate with (D inherent risk the client's audit and fraud risk committee and management . Evaluate analytical procedures the results Evaluate 0) of the tests o audit results o (Assignment 7) o c Decide preliminary 3 materiality level (A auditors report T3 &) 0) Assess acceptable 2 audit risk. Perform Tests of Controls Perform Substantive Tests Overall Audit Plan and Substantive Tests of Transactions of Account Balances Complete the audit Establish Understand Design and Review contingent > liabilities 0) independence internal control perform tests w and assess of accounts (5' control risk payable 3 Review subsequent 3 1. Assess Control Risk. Select procedures acceptance Design and Design and sample Items i- and obtain Design and perform perform for testing engagement letter perform substantive substantive tests of 4. Decide the (D Obtain understanding events specific audit 3 of client's business Combined approach Substantive approach procedures 2. In this assignment. Because the focus is on omitted payables. and does not explicitly endorse one method over the other. Auditing standards provide guidance to auditors when audit tests are based on a sample from a population. Statistical and non-statistical sampling Auditors generally do not test all transactions or balances that make up a particular account. and sending confirmations to vendors with which the client does business. Statistical sampling is less commonly used for the audit of accounts payable than for accounts receivable. tracing vendor statements to the accounts payable trial balance. Perform the audit tests on the sample items. This guidance is applicable to both statistical and non-statistical sampling methods. Althoughthe auditor is concemedwith whetherrecorded accounts payable exist and are accurately recorded. it is difficult to define the population and determine the population size in accounts payable. you will auditOceanview Marine Company's accounts payable balance. 3. you will use non- statistical sampling to complete the audit of accounts payable. confirmation of accounts payable is less common than confirmation of accounts receivable. There are five closely related steps in the audit of accounts payable: 1. Evaluate the results of the tests and conclude whether the accounts payable balance is fairly stated. Select sample items for testing. The search for unrecorded liabilities may also include tracing receiving reports issued before year-end to vendor invoices. 4. Because of the availability of external documentation such as vendor invoices and statements. 5. Decide the specific audit proceduresto be performed for each audit objective. The primary audit procedure performed to determine the completeness of the accounts payable balance is the search for unrecorded liabilities. the primary concems are whether the accountspayable balance is complete and whether an accurate cutoff of accounts payable has been achieved.ASSIGNMENT 7 Perform audit of accounts payable Overview In this assignment. 2. This involves examining cash disbursements after year-end and unpaid invoices to determine whether they represent liabilities as of the balance sheet date. Decide the sample size for each audit procedure. Assignment SEVEN ♦ Page 2 . Auditing concepts Nature of the audit of accounts payable The audit of the year-end accounts payable balance involves accumulating sufficient appropriate evidence to evaluate whether accounts payable is fairly stated and properly disclosed in the financial statements. sampling is not possible when performing procedures such as footing the year-end listing of accounts payable and tracing the total to the general ledger. desired from the test (a high level of assurance is associated with a low level of risk). the auditor must determine an appropriate sample size. the auditor needs to determine whether sampling is practical for each audit procedure to be performed. The most important audit procedure for accounts payable is the search for unrecorded liabilities. Inherent risk—higher inherentrisk increasesrequired assurance and sample size. d. accuracy. Control risk (after performing tests of controls)—higher control risk increases required assurance and sample size. Results ofsubstantive tests oftransactions—if the results of substantive tests of transactions for acquisitions and cash disbursements indicate a high potential for misstatements in accounts payable. the larger the sample will be). Acceptable audit risk—lower acceptable audit risk increases required assurance and sample size. • Book value of the recorded population—directly related to sample size (the larger the population size. including the search for unrecorded liabilities. required assurance and sample size would increase. Plan the sample Audit procedures are designed for each audit objective (i. • Expected misstatement in the population—directly related to sample size (the larger the expected population misstatement. c. the larger the sample will be). which helps satisfy the completeness and cutoff objectives. cutoff. • Acceptable risk of incorrect acceptance (ARIA)—inversely related to sample size. ARIA is the risk the auditor is willing to take of concluding that the balance is fairly stated when it is actually materially misstated. ARIA is influenced by the following five factors: a. 2. ARIA is very similar to "planned detection risk" from the audit risk model. existence. While sampling is usually appropriate for many tests in the audit of accounts payable. Assignment SEVEN ♦ Page 3 . required assurance and sample size would increase. These factors include: • Tolerable misstatement—inversely related to sample size (the smaller the auditor's tolerable misstatement.. ARIAis the complement of the amount of assurance. Several factors are considered when determining the sample size. the larger the sample will be). Thus. Results of preliminary analytical procedures—if the results of preliminary analytical procedures indicate a high potential for misstatements in accounts payable. and so on).Sampling for tests of details of balances Sampling methods involve the following five general steps: 1. completeness. or confidence. b. Determine sample size In situations where sampling can be used.e. e. There are alternative ways for auditors to assess tolerable misstatement.— Sample Size (m dollars) Note that the population in the search for unrecorded liabilities is defined as the transactions after year-end. the primary objective is to decide whether the account is fairly stated or is materially misstated.All items greater than tolerable misstatement will be selected for testing. One approach is to assess each of them in terms of low. 3./• j 11 ^ Population Size (in dollars) Sample Misstatement (m dollars) x — . the emphasis is on large amounts recorded in the acquisitions and cash disbursements joumals during the first month after year-end. One common approach to project misstatements is to multiply the total sample misstatement (in terms of dollars) by the ratio of the population size (in terms of dollars) divided by the sample size (in terms of dollars): o 1 x. medium. and journal entries to determine whether all liabilities have been recorded. The total population misstatement is the sum of the misstatements in each stratum. When using a non-statistical sampling approach. rather than the recorded account balance. a.. and whether they have been recorded at the correct amounts. The auditor is primarily interested in an estimate of the misstatements in the account balance. other supporting documents.r. these tests include examining receiving reports. expected misstatement. Perform the audit procedures The most time-consuming part of auditing accounts payable or any other account is performing the tests.. or large. the auditor begins by determining the average misstatement in the sample for each stratum and then projects this misstatement to the stratum population. In the search for unrecorded liabilities. population size. Evaluate the results of the tests and conclude whether the accounts payable balance is fairly stated When the auditorevaluates the results of the tests for an account such as accounts payable. The sample misstatements are used to estimate the misstatements in the account balance. ^ . 5. . The sample size in this assignment will be determined judgmentally using stratified sampling. whether they have been recorded in the proper period. and then judgmentally determine whether the sample size should be small. Select sample items for testing When using non-statistical sampling. and acceptable risk of incorrect acceptance when using non- statistical sampling. Option A. Generalize to the population. medium. When auditing accounts payable. The auditor must also decide whether prior assessments of control risk and inherent risk require revision based on the results of the tests of balances.giving adequate consideration to the factors describedabove. the sample items can be selected either judgmentally or randomly. plus a judgmental sample of items less than or equal to tolerable misstatement. not just the misstatements in the sample. or high. Another approach is to use the formula in the AICPA Sampling Guide described in Assignment 6. Assignment SEVEN ♦ Page 4 . 4. the auditor should determine the nature and cause of every misstatement found in the sample. Normally. If the account is not acceptable as stated. Assignment SEVEN ♦ Page 5 . This difference is the actual allowance for sampling error. the client may need to determine the account balance again. Analyze misstatements and reassess risks. The auditor may decide that the original assessment of control risk or inherent risk may require revision. In practice. What constitutes "large enough" and "too small" is a matter left to the auditor's professional judgment after due consideration of the acceptable risk of incorrect acceptance (ARIA) and the sample size. However. the auditor will need to re-audit the population. Auditors should always inform their clients of any misstatements found in an account balance. given the findings of the substantive tests. If neither of the first two options apply. In making this comparison.b. • Request the client to adjust the population. smaller ARIAs and smaller sample sizes would require larger differences before the auditor would be willing to accept the account as fairly stated. If this is necessary. c. an adjusting journal entry to correct the misstatements (actual misstatements. rather than the entire population. the allowance for sampling error is often calculated as tolerable misstatement minus projectedmisstatement. • Request that the client re-work the population. the auditor must allow for sampling error since the true (but unknown) amount of misstatement in the population is likely to be different than the projected misstatement. if the difference between tolerable misstatement and projected misstatement is too small (or negative). Compare projected misstatement to tolerable misstatement and decide acceptability of the recorded account balance. All other things being equal. The auditor must compare the projected misstatement to tolerable misstatement to determine if the account balance is fairly stated. the auditor may expand substantive tests of balances. Regardless of whether the auditor accepts or rejects the recorded account balance. If the difference is large enough (and positive). if tolerable misstatement is significantly greater than projected misstatement. either by increasing the sample size or performing other tests. then the auditor would probably accept the account as fairly stated. • Expand audit tests. This conclusion is likely if tolerable misstatement exceeds projected misstatement by a large amount. the auditorprobably would not acceptthe accoimt. In rare cases. Sampling error occurs whenever a sample is tested. There are several possible actions after the auditor compares tolerable misstatement to projected misstatement: • Accept the population as stated. not projected misstatement) may reduceprojected misstatement sufficiently to make the accountacceptable. it is unnecessary to expand the audit tests beyond those originally planned. Review the Planned Tests of Balances Matrix for accounts payable (workpaper 30-6) completed by Bill.. You may disregard the copies of workpapers30-21 through 30-24 included in the Current Workpapers. Before continuing. incorporating information about tolerable misstatement. inherentrisk. carefully read through the audit program to be sure that you understand the purpose of each audit procedure. i. including those procedures alreadycompleted by Bill Cullen. In preparation for this assignment. acceptable audit risk. Bill has already determined the sample size for the tests of subsequent cash disbursements (step 4a).. Plan the sample b. the extent of testing increases. 30-4. e.g. and 30-24. is inversely related to the extent of testing. Use 2/25/2013 as the completion date for each workpaper you complete in this assignment. The first factor. Note: Notice that Bill used his judgment in determining the sample size. Your primary responsibility in this assignment is to complete steps 4b through 4e on workpaper 30-4. 30-23. Rememberto sign off on each workpaper as you complete it. control risk. Notice that eachfactor is evaluated separately for eachauditobjective. Decide sample sizefor searchfor unrecorded liabilities d. Note: The matrix summarizes the factors that influence the extent of tests of balances for accounts payable. as inherent risk or control risk increases. and results of analytical procedures. Eachof the otherfactors is directly related to the extent of testing. 30-5. c. the extent of testing decreases. as acceptable audit risk increases.e. These workpapers will be completed in this assignment and turned in to your instructor for grading. 30-2.Requirements a. Studyworkpaper 30-20to leam how Bill determined the sample size to be used. acceptable auditrisk. you will complete and print worlq)apers 30-21 through 30-24 using Microsoft Excel. Electronic workpaper option: In this assignment. Also study the work completedby Bill on workpapers30-7 to 30-19. 30-22. 30-21. Assignment SEVEN ♦ Page 6 . expected misstatements. Specific audit procedures for accounts payable have been designed by your firm and form the audit program on workpapers 30-3 to 30-5. remove the following workpapers: 30-1. testing is limited to January cash disbursements in this practice case. your selection process will involve counting by the length of the sampling interval. Indicate the 2"**. making sure to exclude the disbursements included in stratum one. Assignment SEVEN ♦ Page 7 . your sample should be drawn from the disbursements (check totals). Note: The search for unrecorded liabilities involves testing of subsequent cash disbursements. the computed sample size consists of the following: • All 20 disbursements greater than tolerable misstatement. Because many disbursements after year-end will represent payments against valid accounts payable included in the year-end accounts payable listing. Perform the audit procedures Assume that Bill has examined the supporting documents for 29 of the 35 subsequent cash disbursements selected for testing and found no misstatements. The purpose of examining each type of transaction is to determine whether any liabilities have been omitted from the year-end list of accounts payable. Because the objective of each test is the same. the accuracy of amounts in the year-end list of accounts payable can be tested simultaneously with the test for omitted liabilities. Select sample itemsfor testing e. and invoices which have not yet been recorded in the acquisitions journal. and 4*^ cash disbursements selected for testing in each stratum on workpaper 30-21. rather than the individual vouchers amounts that make up each disbursement. For stratum one. your selections should consist only of disbursements that exceed tolerable misstatement. Use the top half of workpaper30-21 to determinethe sampling interval for the sample of 15 disbursements that are less than or equal to tolerable misstatement. Complete and print workpaper 30-21 using Excel. To complete the tests for omitted liabilities. Since the sample is being drawn from subsequent cash disbursements.xls" on the Integrated Audit Practice Case CD. as well as testing purchases recorded in the acquisitions journal after year-end. As determined in step (d). Electronic workpaper option: Workpaper 30-21 is included in the file named "Assign 7 Excel_5ed. Tips: Selectyour samplefrom the list of cash disbursements (checkregister) beginning on workpaper 30-11. 3^*^. For stratum two. you are to examine the supporting documents for the remaining six cash disbursements and trace each disbursement representing a liability at year-end to the year-end Accounts Payable List (workpapers 30-7 to 30-10). • A random sample of 15 of the remaining 134 disbursements. Evaluate the results ofthe tests and conclude whether accounts payable isfairly stated g. Assume all shipments from vendors are shipped FOB destination (title passes. receiving report #5895 relates to check #6281. except the receiving report from Lift King which is for a fixed asset. and to decide the acceptability of the account balance using your professionaljudgment.) Document any misstatements you find by completing the "Summary of Misstatements" sections on workpaper 30-22. When calculating the net misstatement for each stratum on workpaper 30-22. Write appropriate tickmarks on the year-end Accounts Payable List (workpapers 30-7 to 30-10) and on the Check Register (workpapers 30-11 to 30-18) to indicate the work you performed and the results. Tips: The six disbursements you will test are the same as the 2"''. and 4*^^ cash disbursements you should have selected in each stratum on workpaper30-21. 3'''. and receiving report #5901 relates to check #6298. when the goods are received by Oceanview). Note: In order to ensure adequate coverage of accounts payable testing. and workpapers 30-23 and 30-24 are used to project those misstatements to the population. and the invoice for Salt. For Anderson Marine. Sand & Sea Advertising. Assignment SEVEN ♦ Page 8 . and 30-24 to complete steps f and g. (Use the tickmarks created by Bill. You are testing the six cash disbursements to determine (1) that those disbursements thatrepresent accounts payable at December 31®' were properly included in theyear-end list of accounts payable. Workpaper 30-22 is used to summarize the client misstatements detected. and Anderson Marine (two). 30-23. You will use the following documents as you trace each of the six disbursements to the year-end accounts payable list: receiving reports for Tradewind Marine. you need to examine the related invoice to determine the date the service was received by Oceanview. errors should be projected for each stratum. You will need to create additional tickmarks if you discover any misstatements. and the liability is created. Great Outdoor Boats. For each payment for a service. Bill chose to use stratified sample selection (see workpaper 30-20). and (2) that those disbursements that did not represent liabilities at December 31®' were properly excluded from the year-end list of accounts payable. Lift King. see tickmarks d and e on workpaper 30-19 and tickmark d on workpaper 30-10. Electronic workpaper option: Use Excel workpapers 30-22. When a stratified sample is selected. For each payment for a purchase of goods. These documents are included in the Client Documents booklet. you need to examine the date on the related receiving report to determine whether the purchase created a liability as of December 31®'. overstatements should be treated as positive numbers and understatements as negative numbers. All receiving reports are for inventory. use the bottom of workpaper 30-23 to calculate the allowance for sampling error. Use workpaper 30-2 to propose an adjusting journal entry(ies) to correct the actual misstatement(s) found in your tests. the net effect on accounts payable of the adjusting joumal entry shown of workpaper 30-2. Use workpaper 30-24 to document and justify your decision. Write the net effect of your entry(ies) in the "Net Adjustments" column on the accounts payable leadsheet (workpaper 30-1) and on the leadsheet(s) (if included as part of this practice case) of the other account(s) affected by your adjusting joumal entry(ies). Using your professional judgment. • expand your audit tests of accounts payable. 3. In the middle section of workpaper 30-24.Complete workpapers 30-23 and 30-24 using the following steps: 1. At the end of the audit. Write "none" if the allowance is zero or negative. • request the client adjust the account. write your conclusions regarding whether accounts payable is fairly stated or whether further testing will be necessary based on the results of your tests. 2. The entry(ies) will be posted to the trial balance in Assignment 10.and understatements. Assignment SEVEN ♦ Page 9 . since the test is for omitted liabilities. the population size (in dollars) is the amount of January disbursements indicated on workpaper 30-20. workpaper 90-1 will be reviewed and compared to materiality to determine if further adjusting entries are required to reduce the misstatements to an acceptable level. Tip: When calculating projected misstatement. Calculate the projected misstatement using the formula provided on workpaper 30-22. from projected misstatement. Complete the bottom section of workpaper 30-24 by deducting. decide whether to: • accept the population as fairly stated. Sample size (in dollars) is the sum of the stratum 1 population size (in dollars) and the stratum 2 sample size (in dollars) from workpaper 30-21.000 for both over. Re-read step 5(b) of the non-statistical sampling steps earlier in this assignment for clarification of this process. Assume the client has agreed to record your proposed adjustingjoumal entry(ies). Write the new account balance in the "2012 Adjusted Balance" column on the leadsheet(s). 4. or • request the client re-work the account. Cross-reference the Adjusting Joumal Entries workpaper (30-2) to the adjustment(s) shown on the accounts payable leadsheet (30-1) and the other leadsheets affected. Carry forward any remaining unadjusted projected misstatement to the Summary of Possible Misstatements (workpaper 90-1). Given a tolerable misstatement of $30. 30-23 and 30-24. 30-4. added a reference to workpapers 30-21 to 30-24 in the "W/P" column. Note: Unadjusted actual and projected misstatements are carried forward to the Summary of Possible Misstatements (workpaper 90-1). 30-4. k. Staple the following items together in the order listedand submitthemto your instructor for grading: • Cover page with your printed name. 30-21. on workpaper 30-5. you will enter "0" in the "Identified Misstatement" column on workpaper 90-1. 30-2. 30-22. 30-5. If your adjusting journal entries had not been recorded at this time. 30-2. and 30-24. and addedSample per 30-21" in the "COMMENTS" column next to step b. and the net projected misstatement would have been entered in the "Likely Aggregate Misstatement. Your remaining unadjusted projected misstatement on workpaper 30-24 should be entered in the "Likely Aggregate Misstatement. • Workpapers 30-1. step 9." "Current Liabilities." and "Income Before Taxes" columnson workpaper 90-1. 30-21. "Current Liabilities. Completing the assignment Make sure you signed off on the following workpapers completed in this assignment. on workpaper 30-4 by writing your initials in the "INIT" column. and the assignmentnumber." and "Income Before Taxes" columns. The net amount of the actual misstatements would have been entered in the "Identified Misstatement" column. Assignment SEVEN ♦ Page 10 . sub-steps b through e. your signature. 30-5. Tip: Since the client has already agreed to your proposed adjusting entry to correct the actual misstatements found in your tests. 30-23. Completethe conclusion section. using 2/25/2013 as the date: 30-1. 30-22. • Answers to discussion questions 1 through 3 (see next page) ifrequired by your instructor. then the actual and projectedmisstatements you discovered in your tests of accounts payable would have been carried forward to the Summary ofPossible Misstatements. Also make sure you signed off on step 4. Confirmations were emphasized in tests of accounts receivable. but are rarely used in tests of accounts payable. The client received and recorded a large shipment of inventoiy on January 3rd that was shipped FOB shipping point on December29th. What factors account for this difference? When would confirmation of accounts payable be appropriate? What is the primary objectivein the audit of accounts payable? How might this affect the sampling method used and how the sample is evaluated? 3.Discussion questions 1. How should the auditor account for this in the search for unrecorded liabilities? Assignment SEVEN ♦ Page 11 . Decide 3 sample size 3 Perform final <D 3. Decide the > specific audit Review subsequent Obtain understanding events tf) of client's business procedures (Q* Combined approach Substantive approach 2. Select 3 Decide client analytical sample items procedures Op acceptance Design and Design and for testing and obtain Design and perform perform "D engagement letter perform 4. Evaluate 3 Perform preliminary the results 0) analytical procedures c of the tests Evaluate Q. Perform substantive substantive (D tests of the audit Obtain client tests of tests of controls procedures representation letter i" transactions transactions 5. Assess Control Risk. Communicate with inherent risk the client's audit and fraud risk committee and management . Perform Tests of Controls Perform Substantive Tests Overall Audit Plan and Substantive Tests of Transactions of Account Balances Complete the audit Establish Understand Design and Review contingent independence internal control perform tests liabilities and assess of cash control risk 1. (Assignment 8) audit results Decide preliminary O materiality level fi) ssue (P auditor s report Assess acceptable audit risk. General and imprest payroll cash accounts To begin the audit of cash accounts. the auditor must evaluate internal controls over cash. deposits in transit. Auditing concepts Audit of cash balances The audit of year-end cash balances involves accumulating sufficient evidence to evaluate whether cash balances are fairly stated and properly disclosed on the financial statements. Assignment EIGHT ♦ Page 2 . If the auditor determines that the intemal controls over cash are inadequate. including outstanding checks. • Confirm the cash balance directly with the client's bank and reconcile the balance given by the bank with the bank balance shown on the bank reconciliation. the auditor obtains from the client a year-end bank reconciliation for each bank account. The audit procedures discussed in the following sections apply when the auditor has identifiedno significant deficienciesin the intemal controls over cash. • Request a cutoff bank statement along with copies of canceled checks from the client's bank for a 7 to 10 day period after the client's balance sheet date. he or she will most likely extend the year-end audit procedures to include one or more of the following items: extended tests of bank reconciliations. Most audit procedures are limited to obtaining assurance that the information on the bank reconciliation is correct. To determine the extent of testing of cash. to be sent directly from the bank to the auditor. • Investigate any significant checks listed on the bank reconciliation that did not clear the bank as of the cutoff statement date. • Trace the book balance from the bank reconciliation to the general ledger.ASSIGNMENTS Perform audit of cash Overview In this assignment you will audit Oceanview Marine Company's general bank account. and other reconciling items. Examples of these controls include but are not limited to: • proper segregation of duties • the signing of checks by an authorized person • the use of prenumbered checks • the use of a prelisting of cash receipts • a monthly reconciliation of all bank accounts by someone independent of the handling or recording of cash receipts and cash disbursements. Typical audit procedures include: • Test the clerical accuracy of the client's bank reconciliation. a proof of cash. and other procedures that may detect possible fraud. Trace checks received with the cutoff bank statement dated on or before the balance sheet date to the list of outstanding checks on the bank reconciliation. • Trace deposits in transit on the bank reconciliation to the cutoff bank statement and verify other reconciling items. 12. You would trace and cross-reference the transfer to the year-end bank reconciliation for the disbursing account to verify that the reconciliation contains an adjustment to the balance per books to reflect the unrecorded disbursement. then the transfer is an outstanding item (check or wire transfer) at year-end. respectively. Bill also did not complete step 19 on workpaper 20-4. Assignment EIGHT ♦ Page 3 . 10. then the transfer is an unrecorded deposit at year-end. assume the balance sheet date is 12/31/2012. The transfer should then be cross-referenced from the schedule of transfers to the outstanding item on the bank reconciliation. Petty cash Typical procedures performed during the audit of petty cash balances include: • Review and evaluate the client's procedures for maintaining and recording petty cash. If. plus vouchers. 13. For example. if the dates per books and bank for the receiving account were 12/27/2012 and 1/5/2013. Similarly. and general bank account. You would trace the transfer to the year-end bank reconciliation for the disbursing accoimt to verify that the transfer appears in the list of outstanding items. you should also verify that each partially completed transfer at year-end is properly reflected in the bank reconciliation(s). then the transfer is a deposit-in-transit at year-end. Background information Oceanview's cash balance includes the following accounts. Bill Cullen performed all of the cash audit program procedures except steps 9. When analyzing a schedule of intercompany and interbank transfers. 11. respectively. You would trace and cross-reference the transfer to the year-end bank reconciliation for the receiving account to verify that the reconciliation contains an adjustment to the balance per books to reflect the unrecorded deposit. • Test the client's schedule of intercompany and interbank transfers for a few days before and after the balance sheet date and determine that each transfer was recorded in the proper period for both accounts. Similarly. respectively. He completed these steps for the payroll bank account but did not perform them for the general bank account. payroll bank account. and 16 on workpapers 20-2 and 20-3. If the dates per books and bank for the disbursing account were 1/5/2013 and 12/27/2012. • Count petty cash funds and agree petty cash on hand. respectively. petty cash. the date per books and the date per bank for the disbursing account were 12/27/2012 and 1/5/2013. then the transfer is an unrecorded disbursement at year-end. if the dates per books and bank for the receiving account were 1/5/2013 and 12/27/2012. You would trace and cross-reference the transfer to the year-end bank reconciliation for the receiving account to verify that the deposit-in-transit appears on the reconciliation. for one of the transfers shown on the schedule of interbank transfers. to the general ledger. keep in mind that the last check written in 2012 was #6269. Use 2/25/2013 as the completion date for each workpaper you complete in this assignment. 10. and 20-8. and then cross-reference the balance from workpaper 20-6 to workpaper 20-1 (the cash leadsheet). As you perform step 9. (Assume that Bill Cullen received the cutoff bank statements directly from the bank. the payroll bank account. When performing step 12. In preparation for this assignment. These workpapers will be completed in this assignment and turned in to your instructor for grading. remove the following: 20-1. Create additional tickmarks as needed. 12. b.Requirements a. Also assume that all such checks cleared by January 31. 11. Note: The cutoff bank statements for the payroll account and the general bank account are located at the end of the Client Documents booklet. write the tickmark "F" below each column of numbers on the reconciliation (workpaper 20-6) after you verify the numbers have been added (or subtracted) correctly. 2013 and appeared on the January 2013 bank statement Assignment EIGHT ♦ Page 4 . 20-6. assume that you reviewed the January 2013 monthly bank statement to investigate checks that had not cleared the bank by the cutoff statement date (January 8. Bill Cullen has completed the audit of Oceanview's payroll bank account. 20-2. 2013). and has also agreed all three amounts for 2011 to the prior year's workpapers file. when using the cutoff statements in the following steps. Make sure the unadjusted balance per books on workpaper 20-6 agrees with the 2012 balance shown on workpaper 20-1. Bill also cross- referenced the unadjusted balance per books on workpaper 20-5 to workpaper 20-1. and the general bank account to the general ledger. When performing step 11. you should not write any tickmarks on them. Use workpaper 20-5 as a guide. 20-4. notice that Bill has agreed the figures for petty cash. Study workpapers 20-2 to 20-5 to familiarize yourself with the work already performed by Bill. Accordingly. 20-7.) c. Tip: Use workpapers 20-6 and 20-7 to document your work. Complete steps 9. Remember to sign off on each workpaper as you complete it. 20-3. and 13 on workpapers 20-2 and 20-3 for the general cash account. Note: On workpaper 20-1. and that they will be given to the client when the auditors are finished with them. and the assignment number. your signature. 20-2. and 16 by writing your initials in the "INIT" column. Staple the following items together in the order listed and submit them to your instructor for grading: • Cover page with your printed name. 13. 20-6. • Answers to discussion questions 1 through 4 (see next two pages) if required by your instructor. you should determine whether each transfer has been handled properly on the bank reconciliation for each account. document your procedure by creating a new tickmark. 20-6 to 20-8. In the tickmark legend on the bottom of workpaper 20-8. write the appropriate workpaper reference(s) below the amount(s) on the transfer schedule (workpaper 20-8). As you perform step 16d. step 19. d. e. 12. As you perform step 16b. added references to appropriate workpapers in the "W/P" column. Complete steps 16a. payee and payor information on the transfer schedule are correct. 20-3. Also make sure you signed off on workpapers 20-2 and 20-3. For guidance. review the notes on "General and imprest payroll cash accounts" in the Auditing Concepts section earlier in this assignment. Tip: Bill has already verified that the dates. on workpaper 20-4. amounts. Write the net effect of any adjustments you believe should be made to the year-end cash balances in the "Net Adjustments" column on the cash leadsheet (workpaper 20-1). • Workpapers 20-1. 10. and 16d on workpaper 20-3. and added any appropriate comments in the "COMMENTS" column. f. Complete the conclusion.20-7. (If no adjustments are needed. write an explanation for the tickmark you create. Assignment EIGHT ♦ Page 5 . Document your performance of step 16a by writing your initials in the "INIT" column on workpaper 20-3. steps 9. and 20-8. You should analyze the pattern of dates for each transfer to determine whether kiting has occurred (see workpaper 20-8). using 2/25/2013 as the date: 20-1 to 20-4. and complete the "2012 Adjusted Balance" column. 11. Briefly summarize the results of your procedure in the "COMMENTS" column. 16b.20-4. write "0" in the "Net Adjustments" column.) Completing the assignment Make sure you signed off on the following workpapers completed in this assignment. In addition. Discuss the possible cause(s) of this. 2. Suppose there were several large outstanding checks on the year-end bank reconciliation that did not clear the bank by the cutoff date. Discuss the possible cause(s) of this.Discussion questions 1. Assignment EIGHT ♦ Page 6 . and discuss the nature of the potential misstatement(s) that could result. Suppose there was a deposit-in-transit on the year-end bank reconciliation that was not received by the bank by the cutoff date. and discuss the nature of the potential misstatement(s) that could result. Assignment EIGHT ♦ Page 7 . Assume that the fUnds were transferred from the general cash account to the payroll cash account. Refer to workpaper 20-8. In addition. and the check clearedthe disbursing bank on 1/4/2013. Suppose there was a third transfer on the interbank transfer schedule for $16.e. for which audit objective are you testing the deposits in transit: existence or completeness! Explain why it was important to trace deposits in transit from the bank reconciliation to the cutoff statement instead of going the other direction. from the cutoff statement to the reconciliation. Discussthe concerns you would have about this transfer. i.500. assume that the transfer was recorded in the client's cash receipts journal on 12/26/2012 and was received by the receiving bank on 12/26/2012." a.. One of the audit procedures you performed when testing Oceanview's general cash account was "Trace all deposits-in-transit from bank reconciliation to cutoff statement(s). Also assume that the transfer was recorded in the client's cash disbursements journal on 1/4/2013. When tracing deposits in transit from the reconciliation to the cutoff statement. Decide (D sample size 3 Perform final 3. Select CO analytical • • Decide client sample items procedures acceptance Design and Design and for testing and obtain Design and "S perform perform engagement letter perform 4. Perform substantive substantive i" tests of the audit Obtain client tests of tests of controis procedures representation letter transactions transactions 5. analyticai procedures of the tests Evaluate (Assignment 9) audit results 3 Decide preliminary < (D materiality ievel Issue 3 f-^ auditor's report O <3 Assess acceptable audit risk. Evaluate fi) Perform preliminary c the results Q. Assess Control Risk. Communicate with inherent risk the client's audit and fraud risk committee and management . Decide the tn Review subsequent Obtain understanding specific audit cq' events procedures 3 of ciient's business Combined approach Substantive approach 3 2. Perform Tests of Controls Perform Substantive Tests Overall Audit Plan and Substantive Tests of Transactions of Account Balances Complete the audit Establish Understand Design and Review contingent independence internal control perform tests iiabiiities and assess of Inventory > control risk 1. Even if the intemal controls over inventoryappear to be adequate. The last few shipping documents prepared prior to the count should be checked to ensure these goods are excluded from inventory. You are to audit only the boat inventory listed on workpapers 22-8 to 22-10. Checking cutoffaccuracy involvesexaminingreceivingreportsprior to and after the count date to ensure all major items are correctly included in the inventory count if received prior to the count. it is often more cost efficient not to perform tests of controls but to rely on extended substantive procedures and the year-end inventory count. and that goods shippedafter year-end are included in year-end inventory. Due to the bulkiness of the final listings. To plan the appropriate extent of testing. the auditor must evaluate intemal controls over inventory. The receiving reports should also be checked to purchases and payables accounting records for an accurate cutoff in the general ledger. No misstatements were found. Examples of these controls include but are not limited to: • authorization of purchase orders by an appropriate person • the maintenance of inventory records by someone independent of the custody of inventory • periodic inventory counts • documents authorizing the movement of inventory If the auditor determines that intemal controls over inventory are inadequate. Auditing concepts Nature of the audit of inventory The audit of the year-end inventory balances involves accumulating sufficient evidence to evaluate whether inventory balances are fairly stated and properly disclosed in the financial statements. or excluded. repair parts. used boats. Background information Oceanview's inventory includes new boats. Bill Cullen tested the repair parts and marine supplies inventory. 33. This assignment assumes that relying on extended substantive procedures is the approach that will be taken for the audit of inventory. and marine supplies. Bill Cullen performed all of the inventory audit program procedures except steps 32. Assignment NINE ♦ Page 2 . if after. including cutoff procedures and the valuation of the inventory. they have been filed in a separate file. and 38 on workpapers 22-6 and 22-7. he or she will most likely extend the year-end audit procedures to include more emphasis on the observation of the inventory count.ASSIGNMENT 9 Perform audit of inventory Overview In this assignmentyou will audit OceanviewMarine Company's inventoryaccount. 22-6. Tip: You are to gain assurance that all the boats counted by the client as listed on their Inventory Count Sheet (workpapers 22-12 to 22-14) appear on the Final Inventory Listing (workpapers 22-8 to 22-10) (testing the completeness assertion). and 22-20. and vice versa. These workpapers will be completed in this assignment and turned in to your instructor for grading. Bill decided to carry this amount forward to the Summary ofPossible Misstatements (workpaper 90-1). Assume that a listing was not available at the time of Oceanview's physical inventory observation. 22-7. Perform audit program procedure 32 on workpaper 22-6 by following steps one and two described on the next page. 22-18. As shown on workpaper 22-11. as described on the next page. completed the physical inventory count section of the audit program (workpapers 22-3 and 22-4) and foundno discrepancies exceptfor the provision for obsolete items.00 of repair parts and supplies that were obsolete. You may disregard the copy of workpaper 22-18 in the Current Workpapers. This is done by selecting a sample of boats and comparingthe count sheet to the final inventory listing. you will complete and print workpaper 22-18 using the computer. Note that the auditors counted 100% of the boat inventory." Since Bill and Don could not agree on this issue.Requirements In preparation for this assignment. remove the following workpapers: 22-1. Use 2/25/2013 as the completiondate for each workpaper you complete in this assignment. Assignment NINE ♦ Page 3 . Detailed perpetual records would often be available for large. Note: Bill Cullen attended the physical inventory count performed at year-end.900. Although these items were all very old. and that all boats which appear on the final inventory listing are in the possession of the client (testing the existence assertion). 22-15. Study workpapers 22-3 to 22-7 to gain a better understanding of the audit procedures required to audit the inventory account. Remember to sign off on each workpaperas you complete it. rather than only a sample. specific identification inventory such as boats. because of the significant dollar value of individual boats. Note: The two-way test count tracing described earlier is often performed when a detailed inventory listing is not available at the time of the physical observation. Don Phillips did not believe that an adjustment was requiredas he felt that "these thingswill come in handy someday. 22-19. Electronic workpaper option: In this assignment. Bill noted $10. your last number should be 8778. Assignment NINE ♦ Page 4 .) Next. using the top half of worlqjaper22-15 to record the boat numbers selected. Bill compared the price listed on the client's Final Inventory Listing with recent vendors' invoices.) Next. After reviewing the invoices and reading Bill's notes on workpaper 22-10. included in the year-end physical inventory count). As you do this.xls" on the IntegratedAudit Practice Case CD. Electronic workpaper option: Workpaper 22-18 is included in the file named "Assign 9 Excel_5ed. As you do this. d. it is unnecessary to also document your testing on either the Final Inventory Listing or Inventory Count Sheet. manufacturer name. manufacturer name. Begin by selecting every tenth item from the Inventory Count Sheet (workpapers 22-12 to 22-14). and c on workpaper 22-10. for each of the 30 items selected for testing on workpaper 22-17. complete the six columns in the top section of workpaper 22-18 for the exceptions noted. verify that the stock number. Tip: When calculating the "Net misstatement in sample" on workpaper 22-18. Perform audit program procedure 33 on workpaper 22-6. trace each of these boat numbers to the Final Inventory Listing (workpapers 22-8 to 22-10) to verify that the boats are listed on the Final Inventory Listing. Note: Your testing will be documented on workpaper 22-15.e. Bill foundno differences withthe exception of three inventory items. and model number are the same on the inventory listing and the count sheet. your last number should be 8679. 2. Completethe six columns in the top section of workpaper22-18 using Excel. (Your first stock number should be 8009. (Your first stock number should be 8111. b.Therefore. and model number are the same on the count sheet and the inventory listing. trace the boat numbers to the Inventory Count Sheet (workpapers 22-12 to 22-14) to verify that the boats were in the client's possession at year-end (i.. The invoices for these three items are the last three items in the Client Documents booklet. using the bottom half of workpaper 22-15 to record the boat numbers selected. Bill Cullen has chosen a systematic sample of 30 items on workpapers 22-16 and 22-17. Information on the nature of the differences is explained in tickmarks a. 1. To help you perform this step. verify that the stock number. Select every tenth item from the Final Inventory Listing (workpapers 22-8 to 22-10). overstatements should be treated as positive numbers and understatements as negative numbers. Assume that. Re-readstep 5(b) of the sampling steps in Assignment 7 for clarification ofthis process. 2. Assignment NINE ♦ Page 5 . decide whether to: • accept the population as fairly stated. Using your professional judgment. "Sample size (in $)" is the sample total from worlqjaper 22-17. Go to step 3 below. 1. and 90-1 below or to the right of the net sample misstatement and the projected misstatement on workpaper 22-18. Round projected misstatement to the nearest dollar. Cross-reference the two workpapers by writing 22-18 in the "W/P ref. 3. Assuming the tolerable misstatement is $50. Use workpaper 22-19 to document and justify your decision. Calculate the projected misstatement using the formula provided on workpaper 22-18.and imderstatements.000 for both over. Studythe numbers and formulas used by Bill on worlqjaper 22-18 to determine the projected misstatement and the allowance for sampling error." column on workpaper 90-1. 1. On workpaper 22-20. Complete workpapers 22-18 and 22-19 using the following steps: Electronic workpaper option: Complete and print workpaper 22-18 using Excel. use the bottom of workpaper 22-18 to calculate the allowance for sampling error. write your conclusion regarding whether inventory is fairly stated or whether further testing will be necessary based on the results of your tests." "Current Assets. Make any necessary corrections.e." and "Income Before Taxes" columns on workpaper 90-1. "Population size (in $)" is the boat inventory total from workpaper 22-10. Tip: Write the net total actual misstatement in the "Identified Misstatement" column and the projected misstatement in the "Likely Aggregate Misstatement. • expand your audit tests of inventory. Follow these steps. Carry forward to workpaper 90-1 your actual and projected misstatement amounts from workpaper 22-18. • request the client to adjust the account. or • request the client re-work the account. workpaper 22-2 will be left blank. Workpapers 22-1. Unadjusted actual and projected misstatements are carried forward to the Summary ofPossible Misstatements (workpaper 90-1). In addition. Complete step 38 on workpaper 22-7." and "Income Before Taxes" columns. the assumption is made that the client has. The "Net adjustments" column on workpaper 22-1 will also be left blank.22-18. 22-19. Thus. and the assignment number. you would enter "0" in the "Identified Misstatement" column on workpaper 90-1. and added any appropriate comments in the "COMMENTS" column. 22-15. complete the "Net Adjustments" and "2012 Adjusted Balance' columns for each inventory category. and 22-20. In step (g). Your remaining unadjusted projected misstatement would be entered in the "Likely Aggregate Misstatement. Also make sure you signed off on steps 32 and 33 on workpaper 22-6 by writing your initials in the "INIT" column. and the net projected misstatement is entered in the "Likely Aggregate Misstatement. Completing the Assignment Make sure you signed off on the following worlq)apers completed in this assignment. h. Assignment NINE ♦ Page 6 . 22-7. your signature. Note. Since the client is not correcting the misstatements at this time. using 2/25/2013 as the date: 22-1." and "Income Before Taxes" columns on workpaper 90-1. and 22-20. then the actual and projectedmisstatements you discovered in your tests of inventory are carried forward to the Summary ofPossibleMisstatements.22-7. If the clienthad chosento correctthe misstatements. The net amount of the actual misstatements is entered in the "Identified Misstatement" column." "Current Assets. On workpaper 22-1. added references to appropriate workpapers in the "W/P" column. 22-6. you would document the adjusting journal entry on workpaper 22-2 and write the net effect of the entry in the "Net adjustments" column on workpaper 22-1." "Current Assets. 22-15. chosen not to record an adjusting journal entry to correct the actual misstatements found in your tests. 1. Staple the following items togetherin the order listedand submitthem to your instructor for grading: Cover page with your printed name. for now. Answers to discussion questions 1 through 3 (see next page) ifrequired by your instructor. unless you identified adjustments affecting inventory in other assignments.22-6.22-19. 22-18. Oceanview's inventory consists primarily of boats. and involves a comparatively small number of inventory items. and the client did not have a detailed list of inventory on hand at the time of the inventory observation? Oceanview identified some potentially obsolete inventory items. What tests should the auditor perform to identify inventory that is obsolete or inventory that should be reduced from historical cost to net realizable value? 3.Discussion questions 1. The client received a large shipment of inventory on December 31st during the inventory observation. How would inventory observation and test count tracing tests differ if the client has a large number of inventory items. What procedures should the auditorperform to verify that the acquisition of inventory is properly accounted for? Assignment NINE ♦ Page 7 . the client's audit inherent risk committee and and fraud risk management . Select 3 Decide client analytical sample items procedures acceptance Design and Design and for testing and obtain Design and perform perform 4. Assess Control Risk. Decide 3 sample size 3 Perform final (D 3. Evaluate •o Perform preliminary the results (D f-K analytical procedures of the tests Evaluate (D l-K audit results (D 0) Decide preliminary materiality level auditor's report Assess acceptable Communicate with audit risk. Perform Tests of Controls Perform Substantive Tests Complete the audit Overall Audit Plan and Substantive Tests of Transactions of Account Balances (Assignment 10) Establish Understand Design Review contingent independence internal control and perform liabilities and assess tests of balances control risk 1. Decide the Review subsequent > Obtain understanding specific audit U) procedures events 0) of client's business Combined approach Substantive approach (5' 2. Perform engagement letter perform substantive substantive tests of the audit o tests of tests of Obtain client controls procedures o transactions transactions representation letter 3 5. 7. but less than probable. 1. Perform final analytical procedures. • perform audit procedures involved in completing the Oceanview Marine Company audit engagement. • remote—^the chance of the occurrence of the future event(s) is slight. Obtain the management representation letter. Each of these seven steps is briefly explained below. Evaluate results and determine the sufficiency of audit evidence. The outcome of a contingent liability is determined by a future event or events. Review contingent liabilities A contingent liability is a potential future obligation to an outside party for an unknown amount that results from events occurring before the balance sheet date. he or she must summarize the results of the testing andperform certain general audit procedures before completing the auditengagement. 6. Review subsequent events. 3. Completing the auditincludes the following seven steps: 1. Review contingent liabilities. Auditing concepts Seven steps to completing the audit After the auditor completes detailed testing of account balances. 2. 5. • reasonably possible—^the chanceof the occurrence of the future event(s) is more than remote. prepare financial statements (or assess overall financial statement presentation). Generally accepted accounting principles specify three levels of probability that a future payment will be made: • probable—^the chanceof the occurrence of the future event(s) is high.ASSIGNMENT 10 Complete the audit Overview In this assignment you will: • study the final phase of the audit process. 4. Communicate with the client's audit committee and management. Post final adjusting journal entries. Assignment TEN ♦ Page 2 . The most common type of contingent liability is a lawsuit thathas been filed but not yet resolved. and issue the auditor's report. to: • inquiring of management as to the existence of contingent liabilities. • reviewing minutes of boardof directors' meetings for the year. but are not limited. related-party transactions. or local taxes. if material. you can assume that no subsequent events require any adjustments to the financial statements or disclosure. and (2) significant conditions that did not exist as of the balance sheet date and have no direct effect on the financial statements. If the potential loss is probable but cannot be reasonably estimated. • Review the client's general ledger and all journals through the last day of fieldwork. state. Assignment TEN ♦ Page 3 . assessments of federal. The second type of subsequent event does not require adjustment to the general ledger. If a potential loss isprobable and the amount can be reasonably estimated. 2.and dividendpayments. including court costs. but disclosure in the financial statement footnotes may be required. purchases of major capital items. If an outstanding lawsuit is a contingent liability. the loss should be accrued as of the balance sheet date. the auditor should also obtain the professional opinion of the client's attomey on the expected outcome of the lawsuit and the likely amount of the liability. Other audit procedures that may indicate the existence of contingent liabilities include. initiation of new lawsuits. Discussion items may include but are not limited to sales and profit trends. The first type of subsequent event. Review subsequent events The auditor is required to review certain transactions and events occurring during the period between the balance sheet date and the auditor's last day of fieldwork. • Review minutes of board of directors' meetings held after the year-end. losses of important customers. Note: For the purpose of this practicecase. or if the potential loss is reasonably possible^ the loss should be disclosed in the notes to the financial statements but not accrued. Each letter should include a discussion of all pending or threatened litigation handled by the attomey. If the likelihood of potential loss is remote^ neither accrual nor disclosure is required. There are two types of subsequent events: (1) those that directly affect the financial statements because they provide additional information as to the valuation of an account as of the balance sheet date. • Discusswith management events occurring after the balance sheet date but before the last day of fieldwork. changes in accountingor financial policies. • reviewing legal invoices supporting legal expense for the year. One of the most important audit procedures when reviewing contingent liabilities is to obtain and review letters from the client's attomey(s). changes in inventory prices or sales prices. • Request that the client include a discussion of subsequent events in the representation letter. requires adjustment to the general ledger. • reviewing bank confirmations for the existence of discounted notes receivable or loan guarantees. Typical audit procedures performed during subsequent events testing include: • Review the subsequent year's interim financial statements prepared by the client through the last day of fieldwork. The auditor must use professional judgment in analyzing contingent liabilities. The letter is prepared on the client's letterhead and is typically signed by the chief executive officer and chief financial officer. A final step in evidence accumulation and evaluation is the review of the auditworkpapers. A convenient workpaper for summarizing these misstatements is the Summary ofPossible Misstatements (workpaper 90-1). as well as in the planningstage. It also helps the firm evaluate the performance of its audit staff. Preparation of the representation letter also increases the likelihood that management will better understand its responsibility for the assertions in the financial statements. Two other steps in evaluating the sufficiency of evidence are deciding whether the evidence supports the auditor's opinion and deciding the adequacy of the client's financial statement disclosures. the letter is still useful to the auditor.3. 5. Another important step is to summarize the misstatements discovered in each audit area. Material misstatements should be corrected by the client. Immaterial misstatements from each audit area should be summarized so that the combined effect of immaterial misstatements can be compared to the auditor's computed materiality. 4. Evaluate results and determine the sufficiency of audit evidence After completing the specific audit procedures in each audit area. The first step is to review the audit program and results of each audit area to determine whether the audit objectives have been met. The management representation letter documents management's oral representations made during the audit. the auditor must evaluate whether sufficient evidence has been accumulated to justify the conclusionthat the overall financial statements are fairly stated in accordance with GAAP. analytical procedures provide an overall review of the financial information and assist in the evaluation of the appropriateness of the audit conclusions reached. Obtain the management representation letter Auditing standards require the auditor to obtain a letter of representation from the client's management. Many CPA firms use a standard financial statement disclosure checklist to assist auditors in this process. Analytical procedures performed during the final stage are an inexpensive final test for material misstatements. Assignment TEN ♦ Page 4 . Proper review helps the firm to be sure that the audit was performed and documented in accordance with professional and firm standards. The letter provides written documentation of responses to management inquiries should there be a legal dispute between the auditor and the client. In the final review stage. Although themanagement representation letter cannot be regarded as reliable evidence due to its nonindependent source. auditing standards require the use of analytical procedures in the final review stage of every audit. Perform final analytical procedures As explained in Assignment 2. After posting the entries. and issue the auditor's report After completing each audit area and analyzing the Summary ofPossible Misstatements (workpaper 90-1). The auditor is also required to communicate all significant deficiencies and material weaknesses identified in the audit to those charged with governance. such as an audit committee. the auditor should assess the overall financial statement presentation. and prepare the financial statements. In addition to the required communications described previously. the auditor prepares the financial statements (including the auditreport) by combining the trial balance line items intological categories for financial statement presentation. Post final adjusting journal entries. prepare financial statements. the client will postall final adjusting journal entries. give the auditor a final trial balance. the auditor usually accumulates several suggestions for improving the client's accounting system or business operations. The auditor then issues the auditor's report. 6. the auditor reviews all final adjusting journal entries with the client and posts them to the trial balance. In some cases. In either case. The management letter often promotes good relations between the client and the CPA firm and gives the CPA firm the opportunity to inform the client of additional tax and management advisory services offered by the firm. 7. Communicate with the audit committee and management The auditor is required to communicate certain matters to those charged with governance of the client. the auditor usually includes these items in a management letter. Although not required. Assignment TEN ♦ Page 5 . These matters include: The auditor's responsibility under GAAS Significant accounting policies Significant audit adjustments Other information in documents containing audited financial statements Disagreements with management Consultation with other accountants Major issues discussed with management prior to retention Difficultiesencountered in performingthe audit AU Section 317 andAU Section 316 require that the auditor communicate all illegal acts and firaud to the client's audit committee or other group with governance. ) 2. complete the "adjustments" column on the trial balance. total credits. c. verify that the amount shown in the Income Statement or Balance Sheet column is correct. Assuming the client has recorded each of the proposed adjusting journal entries shown on workpapers 21-2 and 30-2. b. 4. Make corrections if necessary. Study each step Bill performed on these worlqjapers to familiarize yourself with the types of audit procedures performed near the end of an audit. For each account adjusted in step 1 above. 2013) and has been signed by Oceanview Marine Company's Chief Executive Officer and Chief Financial Officer. (Although net income before taxes has changed as a result of the adjusting journal entries. (You may need to "unprotect" the worksheet before making corrections by clicking on TOOLS. and 3-3 using Excel (These workpapers are found in the file named "ASSIGN 2 AND 10 ExcEL_5ed.2013). Make corrections if necessary. If you're using Excel 2010. 5. the financial statements. verify that the formulas used by Bill to calculate total debits. and the notes to financial statements. Print the working trial balance. the financial statements.) Follow these steps: 1. Assignment TEN ♦ Page 6 . Bill Cullen has completed the subsequent events testing for the Oceanview engagement up to the last day of fieldwork (February 26. and the notes to financial statements.xls" on the IntegratedAuditPractice Case CD. click REVIEW. 6. Unprotect Sheet.Requirements a. Completethe last three columns of the working trial balance (workpapers3-1 to 3-3). assume no adjustments to Income Tax Expense are needed. Make corrections if necessary. For the last three rows on the trial balance. He documented his work on the subsequent events audit program on workpapers 91-1 and 91-2. Electronic workpaper option: Complete and print workpapers 3-1. and net income are correct. PROTECTION. Read the management representation letter on workpapers 92-1 to 92-3. 3-2. Verify that the account balances on the financial statements and notes (workpapers 1-1 to 1-5) have been updated correctly to reflect the changes made in the trial balance. Initial and date (2/26/2013) the working trial balance. UNPROTECT SHEET in the main Excel menu at the top of the screen. Verify that the date of the letter is the same date the audit was completed (February 26.) 3. ) Type an appropriate auditor's report. total credits (adjusted). Initial and date (2/26/2013) the working trial balance. Assuming the client has recorded each of the proposed adjustingjournal entries shown on workpapers 21-2 and 30-2. after any adjustments. respectively. The 2011 and 2010 financial statements were audited by a different CPA firm . Row b: Enter. and net income (adjusted). both of which expressed unqualified opinions. your audit report should express an opinion only on the 2012 financial statements. the measurement base used on workpaper 5-3-a. On workpaper 90-1 {Summary of Possible Misstatements) are several unadjusted misstatements that have been identified during Oceanview's audit. state your opinion whether the amount remaining for fiirther possible misstatements is adequate. Date and sign the report. 1. Row c: Enter.) 4. Talbert & Johnson has agreed to reissue its audit reports for 2011 and 2010. Note: Although Oceanview is issuing comparative financial statements for three years (2012. 2. after adjustments. In the conclusion section on the bottom of workpaper 90-1. and 2010). Next.") 2. the financial statements. 2011. Review and complete the various columns on this sheetby following the steps below: 1. (Although net income before taxes has changed as a result of the adjustingjournal entries.2013).Talbert & Johnson. 5. Row a: Total each column by adding the overstatements and subtracting the understatements. (The amount remaining for further possible misstatements is similar in concept to an "allowance for sampling error. (Assume no other unadjusted differences were found in the other sections of the audit. At the request of Oceanview's management. Row e: For each column. the percentage used on workpaper 5-3-a. Use a pencil to update the accoimt balances on the financial statements and notes as needed (workpapers 1-1 to 1-5). 2012 and March 15. 3. Assignment TEN ♦ Page 7 . compute the amount remaining for fiirther misstatements by subtracting the absolute value of the column total (row a) from materiality (row d). after any adjustments. in each column. Complete the last three rows by calculating total debits (adjusted). These reports were dated March 29. 6. in each column. Complete the income statement column by transferring the balances shown in column three for each income statement account. and the notes to financial statements. (The audit was completed on February 26. 2011.000. Row d: Compute materiality by multiplying the adjusted measurement base (row b) and the percentage (row c). assume no adjustments to Income Tax Expense are needed. CPAs. using your firm's name. complete the balance sheet column by transferring the balances shown in column three for each balance sheet account. rounding your materiality level to the nearest $5. begin by completing the "adjustments" column on the trial balance. 90-1. 93-2. your signature. and the assignment number. using 2/26/2013 as the date. Initial and date workpapers 93-1 and 93-2. • Answer to discussion questions 1 and 2 (see next page) if required by your instructor. Completing the Assignment Staple the following items together in the order listed and submit them to your instructor for grading: • Cover page with your printed name. Add one additional recommendation to the management letter items (workpapers 93-1 and 93-2. 3-1 to 3-3. • Workpapers 1-1 to 1-5. and your typed auditor's report. Assignment TEN ♦ Page 8 . which you turned in for grading previously) based on your work in Assignments 1 through 10. f. Why is it necessary to compare unadjusted misstatements to other bases of materiality? What should the auditor do if the unadjusted misstatements exceed one or more materialitythresholds? Assignment TEN ♦ Page 9 . Your preliminary judgment of materiality was based on net income.Discussion questions 1. and a subsequent event that would require adjustment to the financial statements. What period is covered by the auditor's review for subsequent events? Give an example of a subsequent event that should result in disclosure. retained earnings Permanent File ♦ Page 1 . partners. only the workpapers in section 100 (Audit Planning) of the permanent file have been included. In this practice case. on-going nature about the client as shown in the permanent file index below.PERMANENT FILE Note: A permanent file contains information of a permanent. shareholders. executive. The rest of the workpapers in the permanent file are not needed for this practice case and have not been included. Permanent File Index Section 100—^Audlt Planning: Client background information Chart of accounts Client acceptance form Organization chart Appointment of auditors letter Audit takeover letter and reply Shareholder resolutions Section 200—^Articles of Incorporation and Contracts: 201 Articles of incorporation and partnership agreements 202 Amendments to articles and agreements 203 Bylaws 204 Minutes — directors. members 205 Mortgages 206 Leases 207 Bond indemnities 208 Pension plans. additional paid-in capital. profit sharing plans 209 Executive compensation agreements (including stock options) 210 Union or other employee agreements Section 300—Carryforward Schedules: 301 Long-term assets 302 Long-term debt 303 Stock. and their children by name and operates the business in a friendly. boats. Boats sold by Oceanview range in price from more than $200. He works hard to minimize employee turnover. Oceanview Marine Company 101-1 December 31. Customers who purchase a boat of any size from Oceanview are granted credit for that purchase and for any services and products. Donald Phillips. Permanent File ♦ Page 2 . Florida. including a unique credit policy. Repair services are available for motors. suntan lotions. it accepts checks ofup to $2. and paddleboats.000 for small sailboats.000 for 40-foot cabin cruisers to less than $2. unless the receivable is more than $500 and more than 90 days outstanding. A major reason for Oceanview's success has been the way customers are treated. boats. Oceanview's products include new and used powerboats and sailboats. Oceanview also has dock space available for monthly or daily rental. knows most of the customers. Most employees also know customers by name and treat them with extreme courtesy. Oceanview provides several services and rents smaller powerboats. interest rates are 2% above the prime rate. Marine supplies include hundreds of items of interest to marine enthusiasts including clothing. In effect. sailboats. the company president." Although Oceanview does not accept credit cards. a customer can buy a boat interest- free for the first three months. These liberal credit policies have resulted in extraordinary customer loyalty. It is not uncommon for regular customers to come off of the lake and order sodas and candy bars and "put it on the tab. There is no interest charged on accounts receivable. as well as launching ramps for boats. After three months. and related equipment.500 from anyone without obtaining a credit check. Parts include a variety of replacement items for motors. sails. water-ski equipment. In addition to products. and equipment. 2012 BC 11/23/2012 Client background Information History of Oceanvlew Marine Company Oceanview Marine Company (Oceanvlew) operates a marina and is the largest dealer of new and used boats in Ocean City. Oceanview rents a warehouse to keep its boats and parts inventory. customer satisfaction- oriented manner. their spouses. and fishing equipment. and general marine supplies. customers often get a feeling of belonging to a marine club without a membership fee. repair parts for boats. Donald. He immediately incorporated the business and changed the name of the business to Oceanview Marine Company. Don decided to leave the CPA firm to go into the marine business. 2011. The bank reviews the line of credit annually. and Arvin and Cynthia each own 10% of the shares. Upon Roger's death in 1984. Don has been in negotiations to buy-out Southeastern's interest. inherited Phillips Boats and Minnows. Interest is calculated on the daily balance and charged to the account once a month. Southeastern Enterprises (Southeastern). joined the firm in 2008 as controller. the principal is repayable at $5.000. Don considers the Southeastern members cooperative in managing the business. the company grew rapidly and successfully. For 2012. with a final balloon payment of the remaining loan balance due in the year 2014. The company operated as a sideline for Roger. Don also arranged with the bank for a revolving line of credit secured by accounts receivable and inventory. The current members from Southeastern are Nathan Andrews and Elva Schmidt. Oceanview Marine Company 101-2 December 31. Shortly thereafter. The interest rate has been set at bank prime rate plus 1%. Both Arvin and Cynthia are involved very closely in the business operations and are familiar with the computer systems and software used in the business. The interest is calculated and paid monthly. Don graduated from Florida State University in 1977 with an accounting degree and was working for a CPA firm in Jacksonville at the time of his grandfather's death. During the past three years. Cynthia Rathberg.642 per year. Phillips started the company in 1955 under the name of Phillips Boats and Minnows. Arvin Phillips. Under Don's entrepreneurship. Don's daughter. joined the company in 2002 after finishing his education in marketing at his father's alma mater. Don wishes he had not used outside investors' money to finance Oceanview's growth. Permanent File ♦ Page 3 .200 to Oceanview at an interest rate equal to the bank prime rate. Don decided to finance the growth by selling 30% of the business to an outside investor group. the credit limit was set to 40% of the audited book value of inventory and net accounts receivable at December 31. Cynthia graduated in accounting from Michigan State University in 2005 and spent three years with a national CPA firm in Atlanta. who was semi-retired and an avid fisherman. Don currently holds 50% of the shares. the company's rapid growth created a severe cash shortage. In retrospect. Don has gradually transferred some ownership of the business and management responsibilities to the two children. however. In addition to interest. Don's son. usually after the audit. The agreement permits Southeastern to have two members on the Board of Directors. his grandson. they object if officers' salaries or fringe benefits are excessive. Oceanview Marine Company pays annual dividends to provide a return on Southeastern Enterprise's investment. Southeastern also made a long-term loan of $564. but they have not been able to agree on terms. 2012 BC 11/23/2012 Roger T. for $300. In 2002. Oceanview Marine Company JO1-3 December 31, 2012 bC 11/23/2012 History of the Audit In 2000, after the Internal Revenue Service assessed the company $28,000 for underpayment of taxes and penalties, Don decided he wanted a CPA firm to prepare the company's tax returns. Don engaged the Tampa CPA firm of Talbert and Johnson, PC. In 2002, Southeastern required an independent audit as part of the investment agreement. Oceanview hired Talbert and Johnson to do the audit. On several occasions during the past three years, Cynthia expressed to her father the belief that a CPA firm in the local community would be more accessible and provide better services at the same or lower cost. Her father agreed to change auditors for the current year's audit (December 31, 2012). After receiving bids and interviewing the three largest CPA firms in Ocean City, Don and Cynthia selected our firm. Lilts Berger & Associates, CPAs. In early October 2012, the engagement partner, Charles Ward, did an extensive investigation of Oceanviewbefore acceptingthe engagement. The most importantpart of the investigation was to talk with Bob Talbert of Talbert and Johnson to investigate his firm's relationship with, and attitudes about, Oceanview and its employees. Bob Talbert was complimentary about Oceanview and spoke highly of its employees' integrity, competence, and dedication to running a successful business. Mr. Talbert understood the reason for the change in auditors and was not surprised. He offered to provide our firm access to the prior years' workpapers as long as Oceanview granted written permission and Talbert and Johnson was paid for any time spent. Oceanview authorized our firm to review the prior years' workpapers and compensated Talbert and Johnson accordingly. Mr. Ward contacted Oceanview's banker and attorney and several local suppliers who do business with Oceanview. He also examined Oceanview's 2010 and 2011 audited financial statements and calculated several financial ratios. Based upon all of the information he obtained, Mr. Ward concluded that Oceanview would be an excellent client. He completed the CLIENT ACCEPTANCE FORM and Audit Take-over Letter (see workpapers 103-1 to 103-8 and 106-1 in the permanent file). He also prepared an Engagement Letter outlining the terms of the audit engagement. Don Phillips signed the engagement letter indicatinghis agreement with those terms. The engagement letter is in the current workpaper file, workpapers 4-1 and 4-2. Permanent File ♦ Page 4 Oceanview Marine Company 101-4 December 31, 2012 BC 11/23/2012 Significant Accounting Policies— Oceanview Marine Company 1. Allowance for bad debts Oceanview Marine Company computes an allowance for bad debts based on the amount and age of receivables outstanding. The allowance for bad debts is based on: Current receivables 3% of balance Outstanding 31 to 60 days 10% of balance Outstanding 61 to 90 days 15% of balance Over 90 days 30% of balance 2. Inventories Inventories are recorded at the lower of cost or market using specific identification for boats and FIFO for all other inventories to determine cost of goods sold and cost of ending inventory. Perpetual inventory accounting procedures are followed. 3. Fixed Assets a. Trade-ins: The company's policy is not to record a gain or loss on disposal of similar (like-kind) property. b. Depreciation: Automobiles and equipment are depreciated at 30% and 20% respectively using the declining balance method. Other fixed assets are depreciated using the straight-line method. The company's policy is to record a half-year of depreciation in the year of acquisition and disposal. 4. Pension Plan The company has a defined contribution pension plan for employees who qualify. The company keeps the contributions current, and there is no difference between the value of the pension assets and the value of the pension plan liabilities at each year-end. Permanent File ♦ Page 5 Oceanview Marine Company 101-5 December 31, 2012 BC 11/23/2012 Accounting Records In early 2009, Cynthia recommended that the company implement a computerized, networked accounting system based on Sage ACCPAC accoimting software and six Intel Xeon personal computers running on a Windows 7 network. The Board of Directors approved the acquisition in May, and the company purchased the equipment and software on June 15,2009. Cynthia spent the remainder of the year experimenting with the system, including running the new computer system and the old manual system simultaneously. The company converted to the computerized system on January 1,2010. The following records are on the ACCPAC accoimting system: Records Cash receipts journal Cash disbursements journal Sales journal Payroll journal and related records General ledger Subsidiary records: Accounts receivable Accounts payable Perpetual inventory The ACCPAC accounting system generates comparative financial statements on the company's networked printer, a Hewlett-Packard LaserJet printer. Cynthia examines this data in detail and discusses it with Don if there are any significant changes or indications of business problems. Cynthia also has the system generate monthly listings of accounts receivable and accounts payable, a trial balance, and a perpetual inventory listing in terms of quantities and dollars. Cynthia uses a backup system to ensure that no disruption of service would arise during a system failure. Permanent File ♦ Page 6 170 1300 Prepaid expenses 15.556 Permanent File ♦ Page 7 .613 1531 Accum.983 1215 Inventory — supplies 143.947 6050 Depreciation 46.636 CR 1205 Inventory — boats 12.247 1210 Inventory — repair parts 182.000 CR 2500 Long-term debt — current portion 5.750 6020 Advertising 27.500.484 1500 Land 100. depreciation — equipment 34.060 CR 4500 Sales returns and allowances 27.530.417 1511 Accum. depreciation — docks 21.229 CR 1530 Office equipment 42.195.809 6530 Fuel 53.820 CR 1520 Equipment 118.000 1020 Bank — general 1.000 1551 Accum. depreciation — automobiles 26.402. depreciation — building 131.229 1110 Allowance for bad debts 116.344 6120 Business publications 872 6240 Cleaning service 12.589 CR 2200 Federal income taxes payable 45.000 CR 3200 Additional paid-in capital 2.460 CR 1550 Docks 21.000 CR 3500 Retained earnings 6.247 CR 2100 Wages and salaries payable 154.826 1400 Deposits 5.250. Accum.990 CR 2300 Interest payable 26.118 CR 1540 Building 525. Oceanview Marine Company 102-1 December 31.625 CR 2110 Payroll withholdings payable 35.789 CR 2400 Notes payable — bank 4.087.000 4100 Sales revenue 22.237 1521 Accum. 17.114 6010 Accounting fees 46.642 CR 2710 Long-term debt 415.000 CR 2010 Accounts payable — trade 1.636 CR 3510 Dividends paid 100.840 1541. 2012 BC 11/23/2012 Chart of Accounts 12/31/2011 Account Description Balance 1010 Petty cash 200 1015 Bank — payroll 2.740 5100 Cost of goods sold 16. depreciation — office equip.778 1100 Accounts receivable 1.466 CR 3100 Common stock 10.030.889.578 6100 Bad debts 162.000 1510 Automobiles 35.403. 439 7710 Security 100.962 7580 Property taxes 27.917 9110 Salaries — office 46. Oceanview Marine Company 102-2 December 31.000 7630 Repairs and maintenance 26. 2012 BC 11/23/2012 Chart of Accounts 12/31/2011 Account Description Balance 6810 Garbage collection 4.631 7420 Office supplies 23.405 9500 Payroll benefits 461.914 7130 Licensing & certification fees 27.624 9610 Pension expense 37.214 9600 Medical benefits 4.406.289 7560 Postage 20.142 7150 Linen service 1.303 6830 Interest 364.00 Permanent File ♦ Page 8 .578 9120 Salaries — sales 2.919 9100 Salaries — management 374.303 7980 Utilities 41.474 9220 Wages — warehouse 838.092 7850 Travel and entertainment 16.406 Totals: 67 Accounts 0.411 9200 Wages—mechanics 210.098 7810 Telephone 7.674 6820 Insurance 16.939 7230 Miscellaneous 16.947 7620 Rent — warehouse 120.263 9900 Income tax expense 239.312 7110 Legal 29.317 9210 Wages — rental 93. This form should be reviewed annually by the engagement partner and the office managing partner before the engagement begins. CLIENT: oemi/mmmeomm 103-1 YEAR END: OecmBeRdt 2072 6l/(f 17/23/2012 Client Acceptance Form INSTRUCTIONS: This form should be prepared by the in-charge senior. 70% ffotfnp' Son C^tkia RatkSe^ 70% iH>t(K^ skctf^ Sodthe^aste^ EHte^pMS&s 2 30% ffotinO' w 0(iitsi(le> fnoestot^ hoot!^ Permanent File ♦ Page 9 . Part I — Basic Client Information Legal Name Ooe>aniHm Godfomf Phone 555-2522 Legal Address 36 lci£e' Rood FAX 555-2523 Oo&m FloM'da ZIP Code 33140 Year end 37. 56^ skme>s Fatke^ Ar^'n Pkiiii'lis l//ce Pt*e>s. engagement manager. The in-charge senior and engagement manager should update and review the form annually during the pre-engagement planning as a basis for maintaining a basic understanding of the client and for retaining or terminating die client. 2012 Primary Contact C^tUoi Phone 555-2522 Organization: Corporation — publicly-held Corporation — non-public Partnership Association/Society Trust Other 798^ in Ocem iGittp. FioMJa Significant Shareholders/Partners: Name Position Shareholdings Relationship DonoM C. or engagement partner for all new clients. The engagement partner and the office managing partner should review the data as a basis for initially accepting or rejecting the client. Client's Lawyer: Name Address /^a/^ttjs &: Cane.i*e.^ost. Client's TransferAgent (if applicable): Name Address /d/A —pnitHnted^/oe&lcompanf Client's Insurance Agent: Name Address Hanson &: Row 14 /don'th /(da/n Stneet Ocean Gitf. Client's Financial Institution: Name Address Fi/^st /dationajlSan^ 0^ Ocean Git^ 317 Fi^fb Aoenae Ocean Gitf. Related Companies: Name Relationship Dee^ &a Ckcti*'t&f^ 50% ome/PoncM PkiM'f/s /dote. Hoioe4fe4^^ tke. 2012 Cl/if 11/23/2012 Officers and Directors: Name Position DoncMG. Ocean Cit^. PkiltiliS Ai*'m Pkfl&ps /i&er-pt^(de4it 5. CLIENT: oemwai/mmeomm 103-2 YEAR END: DeemER31. keen no maUModtrortsaotio/fS kettoeett tke> two cooponies daHnp^ t/te.: C/t^tef^ is a /asiness tkat^ in the. 3611 Pine. Company. Aoenae. kom. FRo/dJa 331^2 7. Fdonida 33140 8. FRonida 33142 Permanent File ♦ Page 10 . kas tkeif^ /oats Ooeonoi&w /Marine. 6. R&ta/l0^ioats. CLIENT. Oo&an Git^. oe5A/\/i/mmRMcomm 103-3 YEAR END: DRCmBRRSt 2012 Ci/i/ fi/23/2012 10. Gonfon^ is aton(^ onC' (o&ation: 36 G&2WtoaUf^ laie. 13. se>t^me^ andandioat totals. tasme^s ia2 mstedtkon 50^ea/'-e. List major suppliers and nature of supply. List major sources of revenue and major customers (include percentage of revenue). o/^ankatfon okof^t 12. See. Ffo^doi. and warehouses). Describe the client's business. mc^f' supp&'et^s: eon^an^ kas nmeMas sapp&e^s. Road. mM'on and 0^S26 midm. plants. List the location. Permanent File ♦ Page 11 . loeafboat omet^s —no eaj^tomef^s: eompotn^ kas n(UKeMus ac&Ottnts. 11. purpose and number of employees of all business premises (office. List major sources of financing (loans. 2012 Ci/i/ 11/23/2012 14. such as changes in buyers. leases). Re^Of^ salofy andafc^>eef>Ras out odJitionc/ionousfxu'd in De^&e^i&/^ 0/^ Jcutact/^ 0^ tke —de^te^mk&d PoncM PkfM'l>s. not/xu'din Pece^mie/^. Are there any external conditions or trendsthat may have a significant impact on the client. changes in suppliers. CLIENT: oemwEi//mRmcomm 103-4 YEAR END: DRemRR31. or new competitors? Will these changes impact the client as a going concem? fi/o Permanent File ♦ Page 12 . 0^ luitk Fit*^ /Vat/onalScuf^ 0/f O&em G/t^. 17. Describe compensationand employee benefit plans. Are there any statutes or regulations that may directly affectthe client's financial statements? fi/o 18. itis om&t^ed tki (mid 16. Doesthe client's industry adhere to any specialized accounting practices? /fag otUf^ tkan (^AP. ^oan Q^/*ement uiitk ska/^ko&le>/*' —SodLtk&ost&f^ Ente^MS&s 15. Services to be provided: Year 2072 2073 207^ Description Audit of financial statements SEC Reporting: Annual Quarterly reviews Registration Other Accounting: Review Compilation Bookkeeping Taxes: Return preparation Retum review Consultation: Tax planning Consulting services Other reports and services: Will the financial statements and audit report be used for high risk purposes such as SEC filings.(ker-o^-cf^t o^femettt a/itk Fir^ TlotfonoT Permanent File ♦ Page 13 .!^ £(te^pf^eee 70 A&o. or litigation (yes. FkoTT^. tie aaclf't k ander. performance bonds. CLIENT: o e m w a i / c o m m 103-5 YEAR END: DeemeR31. 2012 Gl/if ri/23/2012 19. Describe how the financial statements and audit report will be used: Tie asJit kas ieen oh 0^ Soajtke^iste. mQj(apemef(t Mee to aj^ F/SmOHOfe^e^ntin^t^iKotton ondeontt^f. no)? /\/o * Ifyes. explain: *GOmpcin^ k oonside^'n^ pM'o mtkin tk& n^tttoo ot^ to exfOHsm to odditional^oooitions. * 2012 Chif 17/23/2012 20. no)? Comments 2012 fl/o andsoltmt 2013 20H 23. Ratkie^ ancf w'((moMiKm assietctnoe. no. describe any major concerns on separate sheet)? Going Concem Year Problems (ves. describe)? fi/o Permanent File ♦ Page 14 . Are there any financial. . satmtCe/ to tke^ c&entp&t^'oJi6a&^ as tk& (nvoioe^ o/^ affonp/^entation. G&'&nt to ie^ notice/ ctn^ chcin^ in e^'mcuUd 22. !(/& skoa&lpfiiie' o(i&nt notice^ cl((f^a/i^cuadit s&l(ie/a(&s anddo&me^t /^ae^ts. Total cj^ e>st(moite/ to i& $21. Billing arrangements: AaJit and tax se^mes ie> iasedon koat^^ t^tee. CLIENT: OCEAMIEUMARtmCOMPAm lOS-6 YEAR END: PPCmSPPSt. if yes. in data and Jo&ments andi^o/^s. 24. Are there potential going-concern problems with which we should be concemed (yes. Expected client assistance: G^kGuq. employment. Schedule for performanceand completion: Type of Service/Report Deadline 2012 2013 20H Beff'n 12-15(2012) Goiif&'tion 0^ 3-15 (2013} 0^manofe^mnt 3-22 (2013} 0^ aaj/t 3-29 (2013) De£/o^t*'^ 0^ t(jtx> 3-29 (2013} 21. no. or family relationships among our firm's staff or partners and client personnel that would appear to impair our independence(yes.000. fnvnioe^ ie. Have the prior auditors been consulted? If not. Are there any fees owed to the prior auditors? fi/o e. Ratktet^. d. Name and address ofpredecessor auditors Name Address and JolMtm 509 fi/ot^tk Flonda Ta/i^ei. Have the requirements of AU 315. Flof^Ja 33673 b. Reason for changing auditors? G^tkia.01-10 conceming communications with predecessor auditors been met? c. Communication with predecessor auditors: a. wonts to aiitk aCPA in Ooe^m Gitf. why not? Paf^tfK^ ufos f. 20f2 Chi/ 11/23/2012 Part 11— Initial Client Acceptance Information 1.01-07 or AR 400. Do you believe the prior auditorswill cooperatewith us? ^ g. Can we review the prior auditor's workpapers? Permanent File ♦ Page 15 . CLIENT: oemma/MARmcomm 103-7 YEAR END: DR6mSRR3r. New Client Data: a. credit bureau: Ci/if 70-72-2072 iv. Personal acquaintance of firm personnel: ii. By attorney: iv. Source of referral: Type Name and Affiliation i. CLIENT: OCmi/za/COmM 103-8 YEAR END: DEeEmBRSf. Contact predecessor CPAs: ei/if 70-72-2072 ii.. or partner) Client Acceptance: Approved by: Gkof^fe^ h/of^ Date 70-79-2072 (Engagement partner) Approved by: ^efdent JLdiU Date 10't9'20t2 (Managing partner) Permanent File ♦ Page 16 . manager. Contact client references.g. Review recent financial statements and accountant's reports.: Ci/if 70-72-2072 V. others: ei/if 70-72-2072 iii. c. Other: CfiS'Kt —DoncM PkiM'ps mte^iMewe/ CPA mOceoH Git^. e. D&B. attorneys. By another client: iii. New client investigation procedures: Done bv: Date i. By banker: V. banks. e. Firm personnel developing client: b.g. tax returns. etc. 2012 einf 77/23/2012 2. Obtain credit report for company and/or principal officers.. Evaluate firm's independence of conflict of interest problems: ehif 70-79-2072 Prepared by: Gkci/^^ h/at^ Date 70-79-2072 (In-charge senior. Todd D. Diane S. Oceanview Marine Company 104 Organization Chart BC 11/23/2012 December 31. Peter B. Doug M. Ray C. Sheila K. Larry J. Sales Dept. Manager Scott L. Rental Dept.2012 Donald C. Phillips President Cynthia Rathberg Arvin Phillips Kathleen S. Asst. Doug N. Inventory Clerk Accounts Accounts Receptionist Secretary Receivable Payable Clerk Clerk Bruce T. Manager David L. Mark K. Controller Vice-president Office Manager Linda B. Dawn B. Jack C. Repair Service Manager Manager Dept. Louise J. Manager Asst. Manager Asst. Sales Sales Sales Repair Repair Repair Representative Representative Representative Technician Technician Technician Permanent File ♦ Page 17 . John M. Charles Ward Lilts Berger & Associates Certified Public Accountants Ocean City. Accordingly.2012 Mr. Cyfit'liia Cynthia Rathberg. We advise that our prior auditors have been discharged. President Authorized Signature Permanent File ♦ Page 18 . PL 33140 Dear Mr. Yours very truly. Controller Authorized Signature Donald Phillips. you have been authorized to request any pertinent information needed from our prior auditors. OCEANVIEW MARINE COMPANY 105 36 Clearwater Lake Road ei/if 11/23/2012 Ocean City. and notice ofsuch discharge has been forwarded to them. Ward: Re: Oceanview MarineCompany Please accept this letter as confirmation that we have appointed your firm to act as our auditors. Florida 33140 October 30. Enclosed is a copy of Oceanview Marine Company's authorization letter. Lilts Berger & Associates Per: Charles Ward. Talbert Talbert and Johnson Certified Public Accountants 509 North Florida Avenue Tampa. Florida 33140 October 30. Should there be no professional reason that would preclude our acceptance of this appointment. J. Talbert: Re: Oceanview Marine Company We have been approached by Oceanview Marine Company. CPA Partner Permanent File ♦ Page 19 . LILTS BERGER & ASSOCIATES 106-1 Certified Public Accountants Cli/ fi/23/2012 Ocean City. werequest thatyou provide us with a copy of your financial statement workpaper files. We would appreciate your response in writing. Please advise whether or not there is any reason that may preclude our acceptance of this appointment. or any information of which we should be aware. PL 33613 Dear Mr. Sincerely. 2012 Mr. which has requested our firm to act as their auditors. rt J.2012 Mr. Taibfi. Talbert. Talbert and Johnson I. CPA Partner Permanent File ♦ Page 20 . FL 33140 Dear Mr. Sincerely. Oceanview Marine Companv In reply to yourletter regarding acceptance of yourappointment as the auditors forthe above- mentioned company. TALBERT AND JOHNSON i06-2 Certified PubiicAccountants eit/ tr/23/2or2 Tampa. Ward: Re. Fiorida 33613 November 4. Enclosed isa copy of our financial statement worlqjaper files as requested. Charles Ward Lilts Berger & Associates Certified Public Accountants Ocean City. we know ofno professional reason that should preclude your acceptance of this appointment. at a remuneration to be fixed by the directors. Ocean City. 2012. which minutes were duly considered and. OCEANVIEW MARINE COMPANY 107 36 Clearwater Lake Road Cif/ 11/23/2012 Ocean City. IT WAS UNANIMOUSLY RESOLVED that the appointment of the currentauditor. the secretary of the meeting read the minutes of the meeting of Directors held on August 28. and that Lilts Berger & Associates. the meeting then adjourned. Auditor UPON MOTION duly made and seconded. PRESENT: Donald Phillips Arvin Phillips Cynthia Radiberg *Nathan Andrews *Elva Schmidt (being all the directors of the Company) ♦representing Southeastern Enterprises Donald Phillips acted as chairman and Arvin Phillips acted as the secretary of the meeting. on October 30.'fiiUiP6 Donald Phillips PJuUifui Arvin Phillips Permanent File ♦ Page 21 . There being no fiirther business. Certified PublicAccountants. insofar as the directors are capable were duly approved as read. the meeting was declared to be regularly constituted. Florida 33140.2012. Held at the registered office of the Company. Florida 33140 Minutes of Meeting of Directors of Oceanview Marine Company. be terminated. 36 Clearwater Lake Road. Talbertand Johnson. All the directors being present and having waived notice of the meeting. Certified Public Accountants. be appointed auditors of the company effective immediately. '^axaM. On the direction of the chairman. NOTES . NOTES .