Solution manual auditing theory by cabrera chapter 11 to 29

CHAPTER 11
A RISK-BASED AUDIT APPROACH – PART II
I.

Review Questions
1.

Use the model AR = IR x CR x DR to solve for different values of Audit Risk
(AR) when internal control risk (CR) is given different values. In all cases IR =
0.90 and DR = 0.10, therefore, AR = 0.90 x CR x 0.10
When CR is
0.10
0.50
0.70
0.90
1.00

2.

AR is
0.009 or 0.9 percent
0.045 or 4.5 percent
0.063 or 6.3 percent
0.081 or 8.1 percent
0.090 or 9.0 percent

a.

Risk of Assessing Control Risk Too Low or Overreliance is a matter of
judgment about the importance (“key”) characteristic of a particular client
control procedure. An auditor can take more risk of assessing control risk

too low on unimportant controls than on important (“key”) ones.
Alternatively, the risk of assessing control risk too low can be considered a
constant (say, 0.05) and the importance of a control can be measured in
terms of a smaller or larger tolerable rate. (The authors prefer the latter
approach.)

b.

Risk of Assessing Control Risk Too High or Underreliance is a matter of
judgment about the efficiency of an audit engagement. The risk can be
quite high when the audit team is willing to do extensive substantive work
anyway. If the work budget is tight, auditors need to find objective ways
(e.g., larger test of controls audit samples) to mitigate the risk.

c.

Tolerable Deviation Rate is a judgment about how many control deviations
can exist in the population, yet the control can still be considered effective.
Auditors need to be careful about brushing aside findings of deviations.

d.

Expected Deviation Rate in the Population is an estimate, usually based on
assumptions or sketchy information, of the imbedded incidence of control
deviations. The only use of this estimate in classical attribute sampling is to
figure a sample size in advance. The statistical evaluation (CUL
calculation) does not use it.

e.

Population Definition might be called a judgment about identification of the
population of control performances that correspond to an audit objective.
For example, an auditor would want to be sure he is sampling from a file of


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recorded documents if his objective is to audit the controls over transaction
validity.
3.

Assessing the control risk too low causes auditors to assign less control risk
(CR) in planning procedures than proper evaluation would cause them to assign.
The result could be (1) inadvertently conducting less audit work than properly
necessary and taking more audit risk (AR) than originally contemplated, perhaps
to the unpleasant results of failing to detect material misstatements (damaging
the effectiveness of the audit) or (2) discovering in the course of the audit work
that control is not as good as first believed, causing an increase in the audit
work, perhaps at a time when doing so is very costly (damaging the efficiency of
the audit).

4.

The important consideration involved in judging an acceptable risk of assessing
control risk too high is the efficiency of the audit. Assessing control risk too
high causes auditors to think they need to perform a level of substantive work
which is greater than a proper evaluation of control would suggest. Assessing

control risk too high leads to overauditing.
Some auditors may be willing to accept high risks of assessing the control risk
too high because they intend to overaudit anyway, and the audit budget can
support the work.
Other auditors want to minimize their work (within acceptable professional
bounds of audit risk) and thus want to minimize the risk (probability) of
overauditing by mistake.
Technically, the risk of assessing control risk too high in relation to an attribute
sample is the probability of finding in the sample (n) one deviation more than
the “acceptable number” for the sampling plan. For example, if the plan called
for a sample of 100 units and a tolerable rate of 3 percent at a 0.10 risk of
assessing control risk too low, the “acceptable number” is zero deviations.
The probability of finding 1 or more deviations when the population rate is
actually 2 percent is:
Probability (x > 0 : n = 100, r = 0.02)

5.

=
=
=

1 – (1 – r) n
1 – (1 – 0.02) 100
0.867 or 86.7 percent

All the elements of the risk model are products of auditors’ professional
judgments. Auditors must judge:
Inherent risk – the probability that material errors or irregularities have entered
the accounting system used to develop financial statements.

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Internal control risk – the probability that client’s system of internal control
policies and procedures will fail to detect material errors and irregularities,
provided any enter the data accounting system in the first place.
Analytical procedures risk – the probability that auditors’ analytical procedures
will fail to produce evidence of material errors and irregularities, provided
any have entered the accounting system in the first place and have not been
detected and corrected by the client’s internal control procedures.
Audit risk – the probability that auditors will not discover by any means errors
and irregularities that cause an account balance to be materially misstated.
Test of detail risk appears at first glance to be the product of a formula and not a
professional judgment. However, everything in the risk model is a judgment, so
the test of detail derived from the model is no less a judgment.
6.

An incorrect acceptance decision directly impairs the effectiveness of an audit.
Auditors wrap up the work and the material misstatement appears in the
financial statements.
An incorrect rejection decision impairs the efficiency of an audit. Further
investigation of the cause and amount of misstatement provides a chance to
reverse the initial decision error.

7.

Detection risk is the component of audit risk that is controllable by the auditor.

It may be raised or lowered by reducing or increasing the amount of substantive
audit testing. It is determined by the auditor’s assessment of inherent risk and
control risk.

8.

The auditor deals with both inherent risk and control risk during the planning
phase of the audit. Inquiry of client personnel, study of the business and
industry, application of analytical procedures, and documentation of the
auditor’s initial understanding of internal control are all performed during the
planning phase of the audit. Further study of internal control procedures may
occur after the planning phase if the auditor wishes to further reduce the
assessed level of control risk, and considers it economically feasible to do so.

9.

An auditor would assess control risk to be at maximum when (1) effective
controls for the assertion have either not been designed or not put in place, or (2)
when the auditor believes performing substantive tests of the assertion is more
cost effective. When an auditor assesses control risk to be below the maximum,
the auditor should believe that effective controls are present to prevent or detect
misstatements in the financial statement assertions.

10. When the auditor assesses control risk at a level lower than maximum, the
auditor may generally perform fewer substantive tests.


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11. The audit risk model is useful in managing audit risk for assertions. By
determining planned audit risk for an assertion, assessing inherent and control
risks, an auditor can determine the allowable detection risk (the amount of
detection risk an auditor can allow) for an assertion. Allowable detection risk is
used to determine the nature, timing, and extent of audit procedures for the
assertion.
12. Detection risk exists because auditors (1) may use an inappropriate audit
procedure, (2) may misapply an audit procedure, (3) may misinterpret the
findings, or (4) do not examine 100 percent of an account balance or transaction
class.
13. The amount of audit evidence an auditor must gather varies inversely with
allowable detection risk. As allowable detection risk decreases, the amount of
evidence required increases, and vice versa. Chapter 12 introduces audit
procedures and discusses how auditors modify audit procedures to obtain
sufficient competent evidential matter by changing (1) the nature, (2) the timing,
or (3) the extent of procedures.
14. The audit risk model is
Audit risk (AR) = Inherent risk (IR) x Control risk (CR) x Detection risk (DR)
15. Risks identified at the financial statement level may have a substantial impact on
the assessment of inherent risk for specific assertions. For example, concern
about management integrity, identified as a risk at the financial statement level,
would cause an auditor to assess a higher level of inherent risk for existence of
sales.
II. Multiple Choice Questions
1.
2.
3.
4.

5.
6.
7.
8.
9.
10.
11.

d
d
c
d
a
b
a
a
b
b
a

12.
13.
14.
15.
16.
17.
18.
19.
20.
21.

22.

d
a
d
d
c
b
a
a
b
d
a

23.
24.
25.
26.
27.
28.
29.
30.
31.
32.
33.

c
c
d
d

c
b
d
a
a
b
a

34.
35.
36.
37.
38.
39.
40.
41.
42.

c
d
b
d
d
c
a
c
d


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III. Comprehensive Cases
Case 1. Factors that will affect your evaluation of audit risk include






integrity of management – Jimenez’s reputation and lawsuit.
trend toward domination of operating and financial decisions by
Jimenez.
increased management compensation based on performance.
aggressive attitude toward financial reporting by new personnel.
profitability inconsistent with the industry.

Case 2. The factors that will affect Josefina’s audit risk and business risk are (a) this is a
special audit, (b) the audit will be used to set the value of certain assets, (c) the
auditor is to evaluate any disputed amount (although this is a common provision
in purchase agreements, one might question whether auditors should agree to
such terms), and (d) the materiality level is set at P50,000, even though that is
considerably below an amount that might be determined using a percentage of
assets and/or income. These factors will increase the risk at the financial
statement level and potentially increase business risk.
Case 3. a.

The audit risk model gives the following results:
AR = IR x CR x DR (or) DR x AR / (IR x CR)

(1) 2.5%
(2) 0.67%
(3) 1

(4) 3.33%
(5) 2.5%

In the third situation, the auditor does not have to accumulate any evidence
because inherent risk and control risk give the appropriate level of planned
audit risk.
b.

Case 4. a.

b.

(1) 3 (tied)
(2) 5
(3) 1

(4) 2
(5) 3 (tied)

(1) Medium (4) Low
(2) Low
(5) Low
(3) Low
(1) Least
(2) 2 (tied)
(3) 2 (tied)

(4) 2 (tied)
(5) 2 (tied)


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Case 5. 1.

a.
b.

2.

a.

b.
3.

a.
b.

4.

a.

b.

5.

a.
b.

This will have an impact on audit risk for valuation of accounts
receivable.
Accumulation of additional evidence regarding collectability of
receivables will be necessary.
This situation may or may not affect overall audit risk, depending on
the impact of the financing needed and whether the company will
become so heavily leveraged that profitability becomes inadequate.
This situation might create increased business risk because of the
potential change in ownership. It would have an impact on audit risk
for valuation of stockholders’ equity.
Additional evidence will have to be accumulated relating to
stockholders’ equity, as well as any additional debt incurred.
The client’s changing of its accounting system will affect control risk in
each cycle, primarily for existence, completeness, and valuation.
Additional information will have to be accumulated about the system in
each cycle.
This will affect risk at the financial statement level, which may also
have an impact on risk for assertions relating to earnings and valuation
of assets. For example, the volatility in the industry may indicate the
potential for inadequate industry earnings or for a client’s earnings
being inconsistent with the industry.
Additional evidence will have to be accumulated about the financial
viability of the client and to provide evidence that management fraud
does not exist.

The increase in inventory will affect existence and valuation of
inventory.
Additional evidence will have to be accumulated about the existence
and valuation assertions.

Case 6. 1.

a.
b.
c.

Sales and collection
Primarily affects existence, completeness, and valuation assertions
Increase

2.

a.
b.
c.

Acquisitions and payments
Potential impact on all assertions
Increase

3.

a.
b.
c.

Sales and collections
Valuation, cutoff, and existence
No effect

4.

a.
b.
c.

Production and warehousing
Valuation
Increase


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CHAPTER 12
AUDIT PROCEDURES
I.

Review Questions
1.

“Procedures” relate to acts to be performed. “Standards” deal with measures of
the quality of performance of those acts and the objectives to be attained by the
use of procedures. The standards are less subject to change. The standards

provide the criteria for rejecting, accepting, or modifying a procedure in a given
circumstance. An example of the relative stability of standards and procedures
is found in the change from non-EDP to EDP systems. New procedures were
required to audit EDP systems, but auditing standards remained unchanged and
were the criteria for determining the adequacy of the new procedures.

2.

A “substantive audit procedure” is any action (resembling a specific variation of
one of the seven general audit procedures) undertaken for the purpose of
producing evidence about a peso amount of a disclosure that appears in the
financial statements under audit.
The nature of a procedure is its description – usually associated with one of the
seven general audit procedures. For example, the nature of a procedure may be
confirmation, document, vouching, etc.
The timing of a procedure is the period during which it is performed – usually
distinguished as interim (before the balance sheet date), year-end (on or close to
the balance sheet date), and subsequent (after the balance sheet date).
The extent of a procedure is the number of details audited with it, or another
measure of intensity or frequency. Oftentimes, extent is measured by the sample
size.

3.

Inspection techniques include physical examination of assets, examination of
documents and records, performance of mechanical accuracy tests, and
analytical procedures.

4.

Vouching and tracing are two types of commonly performed documentation.
Vouching involves the examination of documents that served as a basis for
recording the transaction. Vouching usually starts with a recorded transaction
and works back to the documents and addresses existence. Tracing involves
determining whether source documents have been recorded properly in the


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accounting records. By tracing, an auditor can obtain evidence that the
recording of the transaction is complete.
5.

An inquiry involves requesting information from client personnel and receiving
their response. The request and response may be either written or oral. A
confirmation is a response a third party makes directly to the auditor on the
request of a client.
The response includes information about certain
transactions, relationships, and/or balances that have an impact on a specific
financial statement assertion.

6.

Confirmations are usually considered more reliable because they are from
outside parties, while inquiries are made of client personnel.

7.

When equivalent procedures are available to satisfy the need for evidence, an
auditor may consider cost in selecting among the alternatives.

8.

Vouching is relevant to testing the existence of sales; tracing is not. Tracing is
relevant to testing the completeness of sales, but vouching is not.

II. Multiple Choice Questions
1.
2.

c
d

3.
4.

c
a

5.
6.

c
c

7.
8.

a
d

9.

d

III. Comprehensive Cases
Case 1. The objectives for the audit of Wesson’s securities investments at December 31
are to obtain evidence about the assertions implicit in the financial presentation,
specifically:
1. Existence. Obtain evidence that the securities are bona fide and held by
Wesson or by a responsible custodian.
2. Occurrence. Obtain evidence that the loan transaction and securities
purchase transactions actually took place during the year under audit.
3. Completeness. Obtain evidence that all the securities purchase transactions
were recorded.
4. Rights. Obtain evidence that the securities are owned by Wesson.
Obligation. Obtain evidence that P500,000 is the amount actually owed on
the loan.
5. Valuation. Obtain evidence of the cost and market value of the securities
held at December 31. Decide whether any writedowns to market are
required by GAAP.
6. Measurement.
7. Presentation and Disclosure. Obtain evidence of the committed nature of
the assets, which should mean they should be in a non-current classification


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like the loan. Obtain evidence that restrictions on the use of the assets is
disclosed fully and agrees with the loan documents.
Case 2. Types of procedures used by auditors in general, with examples:
1.

Recalculation by the auditor
* recomputing the client’s calculation of depreciation expense

2.

Observation by the auditor
* observation, test-counting of client’s physical inventory-taking

3.

Confirmation by letter
* obtaining accounts receivable confirmations
* obtaining client’s lawyer’s letter

4.

Inquiry and written representations
* ask client personnel about accounting events
* complete an internal control questionnaire
* obtain written client representation letter

5.

Vouching
* find brokers’ invoices and cancelled checks showing agreement with
record amounts for securities investments

6.

Tracing
* select a sample of shipping documents and trace them to sales invoices,
sales journal recording and posting to general ledger

7.

Scanning
* scan expense accounts for credit entries
* scan payroll check lists for unusually large checks

8.

Analytical procedures – any example that fits one of these:
* compare financial information with prior periods
* compare financial information with budgets and forecasts
* study predictable financial information patterns (e.g., ratio analysis)
* compare financial information to industry statistics
* study financial information in relation to nonfinancial information

Case 3. a.
b.

An audit confirmation is a written statement to the CPA from someone

outside the enterprise on a fact that a person is qualified to affirm.
The two main characteristics a confirmation should possess are:
1. The party supplying the information requested must be knowledgeable
and independent, i.e., he must have knowledge of information of interest to
the auditor and he must be outside the scope of influence of the organization
being audited, and


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2. The auditor must obtain the information directly from the informed
party.

Case 4. 1.

Scanning for debit balances in accounts payable
Recalculation of amounts on supporting documents
Vouching of account entries to supporting documents

2.

Vouching of policies from expense and prepayment entries
Recalculation of expiration of insurance premium
Analysis of interrelationships – compare insurance coverage to assets
owned and leased

3.

Scanning inventory records for “old” last-issue dates
Verbal inquiry – question inventory control personnel about slow-moving
inventory
Vouching – examine journal entries for evidence of actual book write-down
of the specific inventory items

4.

Tracing – trace remittance amounts to appropriate customer’s account
Recalculation – recalculate amount of discounts and allowances
Vouching – examine authoritative documents supporting unusual discounts
and/or allowances

5.

Observation and examination by the auditor – of the inventory and the
inventory-taking procedures
Confirmation by letter – of inventory held in outside warehouses
Recalculation – of the accuracy cost-flow calculations

Case 5. a.

A material decline in sales may indicate unrecorded sales; a decrease in cost
of goods sold may be due to unrecorded purchases; and an increase in cost
of good sold may be the result of omissions from the ending inventory. An
increase or decrease in gross profit will result from any one or a
combination of the above omissions.

b.

A decline in the miscellaneous revenue account balance, or the absence of a
previously existing source of miscellaneous revenue, could be attributable
to a failure to record miscellaneous revenue.

c.

Unrecorded accounts payable at year-end would cause an increase in
calculated accounts payable turnover.

d.

An apparent increase in accounts receivable turnover may, in fact, be the
result of failure to record credit sales transactions.


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e.

A higher than average operating return may be indicative of unrecorded
purchases or operating expenses; a lower than average return could result
from unrecorded sales.

Case 6. a.

This is an inappropriate application of cost/benefit to auditing. The second
standard of audit field work states that the auditor is to gather sufficient

competent evidential matter to support the audit opinion. If two or more
sets of audit procedures are available for satisfactorily achieving a set of
specific audit objectives, the cost/benefit concept suggests selection of the
least costly set of procedures. In the present instance, the cost savings from
not observing the branch inventories is achieved only at the sacrifice of
obtaining sufficient evidence to support the audit objective concerning
existence of the inventories.

b. This is an appropriate application of the cost/benefit concept. Confirmation
with the trustee, who is an independent third party, achieves the audit objectives
concerning existence and ownership just as satisfactorily as examination of the
securities – and it is a less costly procedure.
Case 7.
1.
2.
3.
4.
5.
6.
7.

f
l
h
e
p
m
d

8.

9.
10.
11.
12.
13.
14.

n
k
c
a
g
b
j

Case 8.
1.
2.
3.
4.
5.
6.
7.
8.

observation
inspection (analytical procedures)
inspection (examination of documents)
inspection (examination of documents)
inquiry

inspection (mechanical accuracy tests)
inspection (examination of documents)
confirmation


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CHAPTER 13
audit evidence
I.

Review Questions
1.

Refer to page 494, 2nd and 4th paragraphs of the textbook.

2.

Refer to page 494, 3rd paragraph of the textbook.

3.

Refer to page 496, 3rd paragraph of the textbook.

4.

Refer to page 497, 1st paragraph of the textbook.

5.

Refer to page 497, 2nd paragraph of the textbook.

6.

Refer to page 498, 4th paragraph of the textbook.

7.

External documentary evidence is evidential matter obtained from the other
party to an arm’s-length transaction or from outside independent agencies.
External evidence reaches the auditor directly and does not pass through the
hands of the client.
External-internal documentary evidence is documentary material that originates
outside the bounds of the client’s data processing system but which has been
received and processed by the client.
Internal documentary evidence consists of documentary material that is
produced, circulates, and is finally stored within the client’s information system.
Such evidence is not touched by outside parties at all or is several steps removed
from third-party attention.

8.

Auditors can help the effectiveness of confirmation requests by:

a.

Having the confirmation letters printed on the client’s letterhead and signed by a
client officer.


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b.

Being careful to be assured of reliable addresses for recipients; that is, being
assured that the confirmations are not misdirected (for example, to a client’s
accomplices in fraud).
c. Asking confirmation of information that recipient can supply, like the
amount of a balance or the amounts of specified invoices or notes (not the
balances of homeowners’ mortgages or financial amounts, like certificates
of deposit with accrued interest, for which people usually do not keep their
own accounting records).
d. Controlling the mailing and return of confirmations so the client cannot
tamper with them.
e. Receiving the reply directly, so the client cannot intercept and alter them.

9.

Factual evidence is direct evidence, in that conclusions may be drawn from the
evidence without further corroboration. An example of factual audit evidence is
physical observation of inventory for existence. Inferential evidence is indirect,
in that direct conclusions cannot be drawn from the evidence. The auditor
typically examines other evidence to further corroborate the inferences drawn.
An oral statement by a product manager that one or more products are fully

saleable and not obsolete is an example of inferential evidence. The auditor may
perform inventory turnover tests and/or determine the date of last sale of the
product to further corroborate the product manager’s statement.

10. Sufficiency of audit evidence is a matter of audit judgment. Materiality and the
quality of internal control are important ingredients in determining sufficiency.
If internal control produces over sales processing and cash receipts, for example,
are effective, the auditor may elect to confirm fewer customers’ accounts
receivables than under conditions of weak internal control.
11. Physical evidence tests the existence assertion. Examples of physical evidence
are inventory observation, examination of securities, inspection of plant asset
additions, and count of cash on hand.
12. The quality of existing internal control is the major factor supporting the
strength of documentary evidence. A voucher produced under conditions of
strong internal control over the processing of vendors’ invoices, for example,
possesses greater validity and is therefore stronger evidence than vouchers
produced under weak control conditions.
13. Auditing standards define an accounting estimate as “an approximation of a
financial statement element, item or amount.” Estimates are used because (1) an
amount is uncertain pending specific future events or (2) relevant data cannot be
accumulated on a timely, cost-effective basis. Examples of accounting estimates
include allowance for uncollectible accounts, obsolete inventory, useful lives
and residual values of fixed assets, natural resources and intangibles, accruals
for taxes on real and personal property, accruals based on actual assumptions in


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pension plans, contract revenue using percentage of completion method,
litigation losses, fair values in nonmonetary exchanges, and current values in
personal financial statements.
14. In evaluating the reasonableness of accounting estimates, an auditor should
consider the internal controls related to the estimates in order to reduce the
likelihood of material misstatements in the estimates, whether the accounting
estimates are reasonable given the situation, and whether the accounting
estimates are presented in accordance with appropriate accounting principles.
15. Evidence is persuasive if the auditor considers the evidence to be sufficient and
competent enough to afford a reasonable basis for an opinion.
II. Multiple Choice Questions
1.
2.
3.

d
d
c

4.
5.
6.

c
a
d

7.
8.

9.

d
b
d

10. d
11. a
12. b

13. b

III. Comprehensive Cases
Case 1. a.

Evidential matter obtained from independent sources outside an enterprise
provides greater assurance of reliability (competency) than that which is
secured solely within the enterprise.

b. Accounting data and financial statements developed under satisfactory
conditions of internal control are more reliable (competent) than those which are
developed under unsatisfactory conditions of internal control.
c.

Case 2. 1.

Direct personal knowledge obtained by the independent auditor through
physical examination, observation, computation, and inspection is more
persuasive than information obtained indirectly.
Types of evidence

Evidential items/sources
d. Letter from creditor
a. Monthly statements
b. Voucher register
c. Audit computation of discounts

in reliability rank
1. External
2. External-internal
3. Internal
4. Mathematical (based on
unaudited data)

2.
c.

Audit computation of expense
amounts

1.

Mathematical (based on
unaudited data)


Audit Working Papers
a.
d.
b.

Letter from bond trustee
Cancelled checks
Minutes of directors’ meetings

2.
3.
4.

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External
External-internal
Internal

CHAPTER 14
audit working papers
I.

Review Questions
1.

2.

Refer to page 522, 3rd paragraph of the textbook.
The major function of audit workpapers is to provide evidence of conformance
with generally accepted auditing standards. As a body, the workpapers are
the principal record of the evidence which the auditor has gathered and
evaluated in support of the audit opinion.

3.

Refer to pages 524 to 525 of the textbook.

4.

Refer to page 524, 2nd paragraph of the textbook.

5.

With electronic spreadsheets, audit adjustments need only be entered once – in
the supporting schedule. The adjustments are then automatically reflected
in lead schedules and in the working trial balance through equations entered
in appropriate cells. The cell equations “link” the workpapers such that an
adjustment need be entered only once in order for all affected workpapers to
be automatically updated.
6.

Permanent files contain information that is of a continuing interest to the auditor.
A permanent file typically contains (1) copies or abstracts of significant
company documents and (2) auditor- or client-prepared information on accounts.
Current-year files contain working papers prepared to support the assertions
embodied in the financial statements.

7.

Client personnel may prepare working papers to reduce the time spent by the
auditor on the engagement. When client personnel prepare working papers, the
auditor should give the client personnel detailed instructions. Working papers
prepared by the client should be identified as PBC (prepared by client) and
should involve no decision making. The auditor should test completed working

papers against underlying documentation.


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8.

9.

The lead schedule, especially on larger engagements, is designed to bridge the
gap between the working trial balance and the general ledger by listing all
general ledger accounts that are reported as one account in the financial
statements. Supporting schedules is a term for working papers that support the
amounts presented in the financial statements by providing support for a detailed
account on a lead schedule. Supporting schedules represent the bulk of working
papers.
In general, a properly prepared working paper should meet firm policy, have a
proper heading, clearly indicate the work performed, clearly meet the audit
objective for which it was designed, and clearly state the auditors’ conclusion.

10. The prior year’s audit working papers are a useful guide to staff assistants
because the audit procedures performed in the prior year usually are similar to
those of the current year. By referring to last year’s working papers, the
assistant can see how the procedures were documented and is given a possible
format for organizing the current year’s working paper. In addition, exceptions
noted in last year’s working papers may alert the assistant to possible problems
in the current year. Finally, the prior year’s working papers contain information

substantiating the beginning balances for the current year.
11. The more common types of audit working papers and their principal purposes
may be summarized as follows:
(1) Audit administrative working papers – aid the auditors in planning and
administration of the audit, and include such items as the audit programs,
questionnaires and flowcharts, decision aids, time budgets, and
engagement letters.
(2) Working trial balance – represents the backbone of the auditors’ working
papers, for it contains the balances of the ledger accounts, the adjustments
and reclassifications deemed necessary by the auditors, and the adjusted
amounts that appear in the financial statements. It also contains references
to all supporting schedules and analyses, thus serving to control the other
types of working papers.
(3) Lead schedules – working papers that serve to combine similar general
ledger accounts, the total of which appears on the working trial balance.
(4) Adjusting journal entries – material misstatements in the accounts disclosed by
the auditors’ investigation are corrected by means of adjusting journal entries.
These appear on the auditors’ working trial balance, and in addition, a list of
such entries is turned over to the client at the conclusion of the audit with the
request that they be approved and entered in the accounting records.


Audit Working Papers

14-17

(5) Reclassification entries – entries necessary to properly reflect financial
results but not representing misstatements in the financial records of the
client.
(6) Supporting schedules – although the term schedule is at times applied to

various types of working papers, the preferred usage is to designate a
listing of the details or elements comprising the balance in an account at a
specified date. Preparation of such a listing is often an essential step in
determining the nature of an account.
(7) Analyses – consist of working papers showing the changes which occurred in an
account during a given period. By analyzing an account, the auditors determine
its nature and contents.
(8) Reconciliations – working papers that prove the relationship between two
amounts obtained from different sources.
(9) Computational working papers – used to verify such data as interest
expense, income taxes, and earnings per share.
(10) Corroborating documents – working papers that provide support for specific
representations made in the financial statements, such as letters of
representations from clients, lawyers’ letters, audit confirmations, and copies of
the contracts.
12. Audit working papers are the property of the auditor; however, they must not
violate the confidential relationship between client and auditors by making the
papers available to outsiders or even to the client’s employees without specific
permission from the client.
13. Refer to page 535, 1st and 2nd paragraphs of the textbook.
14. Refer to page 535, 3rd paragraph of the textbook.
II. Multiple Choice Questions
1.
2.
3.
4.
5.
6.
7.
8.

d
d
c
a
d
c
c
d

9.
10.
11.
12.
13.
14.
15.
16.

III. Comprehensive Cases

b
b
a
d
d
b
d
d

17.
18.
19.
20.
21.
22.
23.
24.

d
c
c
d
b
d
a
b

25.
26.
27.
28.
29.
30.
31.
32.

b
d
d

c
d
c
d
d


14-18

Solutions Manual - Principles of Auditing and Other Assurance

Services
Case 1. a.

(1) The functions of audit working papers are to aid the CPA in the conduct
of his work and to provide support for his opinion and his compliance
with auditing standards.
(2) Working papers are the CPA’s records of the procedures performed, and
conclusions reached in the audit.

b.

The factors that affect the CPA’s judgment of the type and content of the
working papers for a particular engagement include:
1. The nature of the auditor’s report.
2. The nature of the client’s business.
3. The nature of the financial statements, schedules or other information
upon which the CPA is reporting and the materiality of the items
included therein.
4. The nature and condition of the client’s records and internal controls.

5. The needs for supervision and review of work performed by assistants.

c.

Evidence which should be included in audit working papers to support a
CPA’s compliance with generally accepted auditing standard includes:
1.
2.
3.
4.
5.

d.

Evidence that the financial statements or other information upon which
the auditor is reporting were in agreement or reconciled with the
client’s records.
Evidence that the client’s system of internal control was reviewed and
evaluated to determine the nature, timing, and extent of audit
procedures.
Evidence of the auditing procedures performed in obtaining evidential
matter for evaluation
Evidence of how exceptions and unusual matters disclosed by auditing
procedures were resolved or treated.
Evidence of the auditor’s conclusions on significant aspects of the
engagement with appropriate commentaries.

The CPA should perform an adequate examination at minimum cost and
effort and the preceding year’s programs will aid in doing this. The
preceding year’s audit programs ordinarily contain information useful in the

current examination (such as descriptions of the unique features of a client’s
operations or records, a formalized sequence of audit steps in logical order,
and approximate time requirements to perform various phases of the work).
The auditor should decide whether to use the old program or prepare a new
one.

Case 2. In general, the working paper is not set up in a logical manner to show what the
auditor wants to accomplish. The primary objective of the working paper is to
verify the ending balance in notes receivable and interest receivable. A
secondary objective is to account for all interest income, cash received and cash


Audit Working Papers

14-19

disbursed for new notes, collateral as security, and other information about the
notes for disclosure purposes.

Specific deficiencies of the working paper presented in the question are:

1.

2.
3.
4.

a.
DEFICIENCY
Tick mark explanation “tested”

does not indicate specifically
what was done.

Explanation of some tick marks is
not given.
Classification of long-term
portion indicates no verification.
Paid-to-date row is confusing.

5.

Due dates are missing for C.C.
Co., P. Pablo and Tetra Co.

c.

SPREADSHEET SOLUTION

b.
IMPROVEMENT
Should have separate tick marks
meaning:
 Agreed to confirmation
 Footed
 Traced to cash receipts journal
 Recomputed, etc.
Explain all tick marks on the same
page of the working paper.
Recompute portions of notes which are
long-term.

Column should say “date paid to” and
this should be confirmed.
Include due dates on working paper
for these notes.

The purpose of using an Excel spreadsheet in this problem is to give the
student some experience in preparing a simple working paper using an
Excel spreadsheet. It should be explained to students that this type of
working paper may or may not be prepared in actual practice, and that often
templates are used to prepare more time-consuming working papers. Also,
whether or not tick marks are computerized is a matter to be decided. The
advantage is that the completed audit work can then be stored and reviewed
electronically, a direction many firms are going. On the other hand, it may
be more efficient to indicate audit work manually as it is performed, and a
contrast in the color of the tick marks through use of a colored pencil may
be desirable.


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Solutions Manual - Principles of Auditing and Other Assurance

Services
The formulas used are self-evident, so no listing is provided. Two items
deserve comment:
1.

An advantage of using a spreadsheet program for these types of
analyses is that footing and crossfooting are done automatically.

2.

When auditor tick marks are done by computer, a problem arises as
to how to place them on the worksheet. One could use narrow
columns inserted between the scheduled client data, or, as done
here, the tick marks are placed in blank rows beneath the related
data.


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Solutions Manual - Principles of Auditing and Other Assurance Services

FOURTH PACIFIC COMPANY
A/C # 110 – NOTE RECEIVABLE
12/31/03

Schedule
Prepared by
Approved by
Account # 110 – Notes Receivable

Maker
Alba Co.

c*

Barrios, Inc.

c*

C.C. Co.

c*

P. Pablo

c*

Martin Cruz

c*

Tetra Co.

c*

Date
Interest
Made /
Rate /
Due
Date Paid to
6/15/02 /
5% /
6/15/04
None pd.
11/21/02 /
5% /
Demand

12/31/03
11/1/02 /
5% /
4/1/08
12/31/03
(P200/Mo.)
7/26/03 /
5% /
8/1/05
9/30/03
(P1000/Mo.)
5/12/02 /
5% /
Demand
12/31/03
9/3/03 /
6% /
2/1/06
11/30/03
(P400/Mo.)

Balance
12/31/02
4000
tp
3591
tp
12780
tp

Value of
Security
None

3591

None

13180

24000

25000

50000

0

25000
r

5000
r

20000

2100

None

0

10000

12000
r

2100
r
1600
r

0

12000

2100
tp
0
22471

37000

f
tp

f

0
0

Payments
1000
r
3591
r
2400
r

Date
1/21/04
2/15/04

Interest

Face
Amount
5000

Additions
0

N-1
JD
PP

Balance
12/31/03
3000

Receivable
12/31/02
104
tp
0
tp
24
tp

Receivable
12/31/03
279

Earned
175
<
102
<
577
<

Received
0
102
r
601
r

0

0

468
<

200
r

268

105
<
162
<

105
r
108
r

0

10400

0
tp
0

15691

43780

128

1589

1116

601

f

f, cf
wtb

f
tb

f
op

f

f, cf
wtb

0
10380

Legend of Auditor’s Tick Marks

f
Footed
cf
Crossfooted
tp
Traced to prior year working papers
wtb
Traced total to working trial balance
op
Traced total to operations working paper – OP6
*
Examined note for payee, made and due dates, interest rate, face amount, and value of
security. No exceptions noted.
c
Received confirmation, including date interest paid to, interest rate, interest paid during 2003,
note balance, and security. No exceptions noted.
r
Traced to cash receipts journal
<
Recomputed for the year

0

54


MANAGEMENT ACCOUNTING (VOLUME II) - Solutions Manual
CHAPTER 15
BASIC CONCEPTS AND ELEMENTS
OF INTERNAL CONTROL

I.

Review Questions
1.

Refer to page 548, 3rd paragraph and page 549, 1st paragraph of the textbook.

2.

Internal control systems are defined as “. . . the process by which an entity’s
board of directors, management and/or other personnel obtain reasonable
assurance as to the achievement of specified objectives.”

3.

The basic elements of internal control are:
a.
b.

Control environment, and
Control procedures.

4.

All internal control systems, due to the human factor, contain certain inherent
limitations. Because of these inherent limitations, internal control provides
reasonable, but not absolute, assurance as to the achievement of control
objectives.

5.

Management support of internal control is prerequisite to its effectiveness. That
is, no matter how sound the other components, the system will not be effective if
management does not support it and communicate that support throughout the
organization. An organizational awareness that management takes internal
control seriously, helps to maximize the effectiveness of the control activities.
A management operating style that supports proper ethical behavior also
enhances the effectiveness of the entity’s internal control. If employees perceive
that management conducts itself in accordance with proper ethical behavior,
such conduct will tend to reflect itself throughout the organization. Proper
ethical behavior, in turn, minimizes the probability that financial statements will
be intentionally misstated.

6.

A centralized, efficient human resources function, an integral part of the control
environment, enhances competence by placing the right people in the right jobs
and training them properly to perform their assigned tasks.

7.

An effective set of internal controls requires a careful analysis of decision
alternatives, and the assumption of high risk only where warranted. A

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Application of Quantitative Techniques in Planning, Control and Decision Making
– II Chapter 18
8.

9.

management attitude geared toward excessive risk-taking hampers goal
attainment and thereby compromises control.
Monitoring affects all of the other controls by assuring their effectiveness over
time. “Ongoing” monitoring is recurring and somewhat automatic. An example
is the periodic analysis of cost variances and follow-up control where the
variance is material and controllable. “Separate evaluation” applies to those
controls not conducive to ongoing monitoring. Integrity, ethical values, and
competence, for example, cannot be monitored on a “real-time” basis, but
require periodic review for effectiveness.
Fixing of responsibility enhances control by providing accountability for assets.
The person responsible for prelisting incoming cash receipts, for example, will
be initially accountable for any discrepancy between such prelisting and the
receipted deposit ticket obtained from the bank. Knowledge of such
accountability, in turn, will encourage care in preparing the prelisting and in
transferring the cash receipts to the person designated as responsible for
preparing and making bank deposits.

10. Any internal control system, regardless of how sound it is, has certain inherent
limitations. The system can be circumvented by collusion among two or more
employees; management can override the structure; and the procedures can
break down temporarily causing a lag in the adaptation of the controls. For
these reasons, an effective system of internal control provides reasonable, but
not absolute assurance as to the prevention and detection of material errors or
irregularities. Auditors, therefore, must not rely totally on a sound control
system as support for their audit opinion. Rather, they must recognize the
inherent limitations and, at the very least, perform a minimum amount of
substantive audit testing.

11. Small entities, typically, cannot afford the degree of separation of functional
responsibilities existing in larger firms. Also, small firms, typically, cannot
support a separate internal audit staff. For these reasons, compensating controls
are necessary in smaller organizations. Such compensating controls ordinarily
require that the owner/manager assume an active role in reviewing transactions,
examining documents, reconciling bank accounts, and otherwise performing
many of the tasks normally done by internal auditors in larger organizations.
12. Separating recordkeeping from custody of the related assets provides an
independently maintained record which may periodically be reconciled with
assets on hand. This independent record holds the personnel of a custodial
department accountable for assets entrusted to their care. If the accounting
records were maintained by the custodial department, opportunity would exist
for that department to conceal its errors or shortages by manipulating the
records.

18-23


Chapter 18 Application of Quantitative Techniques in Planning, Control and
Decision Making - II
13. Most controls can be classified as either prevention controls or detection
controls. A control environment, for example, that reflects strong
management support of effective control activities and proper ethical
behavior, will encourage organizational personnel to be conscientious in
performing their assigned tasks, and thereby assist in preventing errors or
irregularities. Periodic inventories and comparisons, on the other hand, will
assist in detecting errors or irregularities which have already occurred.
Both types of controls are vital to an effective system of internal control.
14. A company control procedure is an action taken for the purpose of preventing,
detecting, or correcting errors and irregularities in transactions.

15. Examples of periodic comparisons:
Count of cash on hand.
Reconciliation of bank accounts.
Count of securities.
Confirmation of accounts receivable.
Confirmation of accounts payable.
Physical count of inventory.
16. Four kinds or functional responsibilities that should be segregated:
1. Authorization to execute transactions.
2. Recording of transactions (bookkeeping).
3. Custody of assets.
4. Periodic reconciliation (comparison) of existing (real) assets to
recorded amounts.
17. Key factors in protecting against losses through embezzlement include an
adequate internal control structure, fidelity bonds, and regular audits by
independent public accountants.
18. Assuming that the general category of transaction has already been authorized
by top management, at least three employees or departments should usually
participate in each transaction to achieve strong internal control. One employee
approves the transaction after determining that the details conform to company
policies, another employee records the transaction in the accounting records, and
the third employee executes the transaction by releasing and/or taking custody
of the related assets. (Note: the approval function may be omitted in an
extremely simple transaction such as a cash sale not involving a check).
19. Refer to page 557 of the textbook.
II. Multiple Choice Questions

18-24

Application of Quantitative Techniques in Planning, Control and Decision Making
– II Chapter 18
1. d
4.
2. d
5.
3. b
6.
III. Comprehensive Cases

d
d
b

7.
8.
9.

b
a
d

10. a
11. c
12. c

Case 1.
RELEVANT TO
AUDIT?

ASSERTION
AFFECTED

HOW
AFFECTED?

a.

Yes

Completeness
Valuation

Year-end adjustments for accruals
and/or allocations may be
overlooked.

b.

Yes

Existence
Valuation

Customers may be billed for goods
not shipped. If so, customer
accounts may not be valid.

c.

No

N/A

N/A

d.

Yes

Valuation
Presentation

Debits and credits to incorrect
accounts are likely to cause
materiality errors.

e.

Yes

No assertions are adversely affected, given the
compensating control of conducting an annual physical
inventory

f.

Yes

Completeness

Some cash receipts may not be
deposited.

Valuation

Cash in bank and/or accounts
receivable may be overstated,
depending on whether or not
undeposited cash was recorded.

g.

Yes

Presentation

Trade accounts receivable should
be kept separate from nontrade
receivables. Credit balances in
customer accounts should be
reported as current liabilities.

h.

Yes

Existence
Valuation

Invoices may be submitted a
second time for payment and the
signed disbursement checks
misappropriated. The result may
be debits to inventory or other
accounts for nonexistent goods or
services.

i.

No

N/A

N/A

18-25