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Questions 1) James M. Peters, CPAs has audited the financial statements of XYZ, Inc. as of December 31, 2014 and gave them a clean opinion on their financial statements. Since XYZ is publicly traded, they also audited the firm's internal controls. They identified material weaknesses related to the method of accounting for sales commissions and separation of duties related to purchasing transactions. Peters was able to gather sufficient evidence and did not encounter any scope limitations. Review their draft audit report on internal controls attached to the end of this exam and identify five errors or omissions in the report. Group your errors or omissions by paragraph in the report and provide a brief explanation of why you feel they were errors or omissions. a) b) Error or Omission #2 - c) Error or Omission #3 - d) Error or Omission #4 - e) 2) Error or Omission #1 - Error or Omission #5 - You are auditing the accounts receivable balance of a cable television provider. Individual accounts receivable balances tend to be similar in amount and cover one or two months of unpaid fees. However, there are a lot of customer balances due at the end of any period. The client has a computerized billing system that makes it easy to access individual customer's records. The total accounts receivable balance makes up 23% of the firm's total assets. You did the audit last year and found few exceptions in internal controls and few errors in their accounts receivable balance. a) What would be the primary test of balances procedure you would use on the accounts receivable balance and why? Make sure you are clear about what balancerelated audit objective(s) your test would cover and how. b) Given the test you selected in a), answer the following questions and explain your answers. Make you explanations as complete as you can and cover as many reasons as possible to support your position. i) Would you use a sampling technique to execute the test or not? ii) Assuming that you would use a sampling technique, would you use a statistical or non-statistical method? iii) Assuming you used a statistical sampling approach, would you use MUS or VS? 1 2) You are auditing Southwest Appliance, an appliance wholesaler. Select the most appropriate audit procedure from the following list and enter the number in the appropriate place on the grid. "Most appropriate" means you can only select one procedure per row. Provide an explanation of how the audit procedure would support the balance-related audit objective listed for the row. An audit procedure may be selected once, more than once, or not at all. The audit procedures are: 1. Review of bank confirmations and loan agreements 2. Review of drafts of the financial statements 3. Selection of a sample of revenue transactions and determination that they have been included in the sales journal and accounts receivable subsidiary ledger. 4. Selection of a sample of shipping documents for a few days before and after yearend. 5. Confirmation of accounts receivable 6. Review of aging of accounts receivable with the credit manager 2 Balance Audit Objective Audit a. Ensure that the entity has legal title to accounts receivable (rights and obligations) b. Confirm that recorded accounts receivable include all amounts owed the client (completene ss) c. Verify that all accounts receivable are recorded in the correct period (cutoff) d. Confirm that the allowance for uncollectabl e accounts is properly stated (realizable value) e. Confirm that 3 Explanation recorded accounts receivable are valid (existence) 3) The following table contains a list of typical audit procedures for acquisition activities. For each procedure, classify them as either substantive analytical procedures (AP), tests of details of account balances (TB), tests of controls (TC), or substantive tests of transactions (ST). Finally, list one audit objective that the test is designed to support and include an explanation of how the test supports that audit objective. 4 Procedure Classifica tion Audit Objective and Explanation 1. Test a sampl e of purch ase requis itions for proper author izatio n. 2. Review the results of confir matio ns of select ed accou nts payabl e balanc es. 3. Compare payabl es turnov er or days payabl es to previo us year's data. 4. Obtain select ed vendo r's statem ents and reconc ile to vendo r accou nts in 5 the accou nts payabl e subsid iary ledger . 5. Compare purch ase return s and allowa nces as a percen tage of reven ue or cost of sales to indust rial data. 6. Test a sampl e of check reques t vouch ers for suppo rting docu ments (i.e., purch ase order, receiv ing report, and invoic e) 3) You are auditing XYZ company for the year ended 12/31/2014 and will be expressing an opinion on their financial statements as of that date. You have not completed your audit report when these facts come to your attention. For each of the following, independent 6 scenarios, describe how they should affect the financial statements for 12/31/2014, if at all. Assume all the items are material. a) A large accounts receivable from ABC to XYZ (material to the financial statements) was considered fully collectible at 12/31/14. However, ABC suffered a plant explosion on 1/25/15. Because ABC was uninsured, it is not likely that the account will be paid. b) The tax court ruled in favor of XYZ on 1/26/15. The case involved deductions XYZ claimed on their 2012 and 2013 tax returns. In accruing taxes payable, XYZ provided for the full amount of the potential disallowances. The IRS has indicated it will not appeal the court's decision. c) XYZ's manufacturing division, whose assets constituted 45% of XYZ's total assets, was sold on 2/1/15. The new owner assumed the bonded indebtedness associated with the division. d) On 1/15/15, a major investment advisor issued a negative report on XYZ's future prospects. The market price of XYZ's common stock subsequently fell by 40%. 4) Why do auditors obtain management representation letters from their audit clients at the end of every audit? Your answer should include a general statement of the overall purpose of management representation letters as well as two examples of the representations auditors ask the auditee client's management to make in a management representation letter. 5) You are auditing a firm's ending inventory balance. You obtained a complete listing of every item that made up the ending inventory balance from the client's subsidiary inventory ledger. At the same time that the client took its physical count of the items in ending inventory, you selected a sample of items from the listing and performed you own count of the number of that item in ending inventory. You then compared your count to the client's count and noted any differences in your working papers. Then you obtained a listing of the costs assigned to each item of inventory in your sample and verified the cost to purchase invoices from the vendors. Finally, you multiplied the number in your count by your costs and compared the resulting amount to client's inventory subsidiary ledger. You traced the total of their subsidiary ledger to their general ledger account. a) For each of the following tests you performed, describe the purpose of the test to include all the audit objectives involved. i) ii) Verifying the costs per item iii) b) Counting the items in inventory Tracing the subsidiary ledger total to the general ledger The total amount shown on the client's subsidiary ledger did match their general ledger balance, but you found differences in the subsidiary ledger and your audit tests in both the number of items in inventory and costs per items. These errors 7 totaled more than your tolerable misstatement. Discuss what alternatives you have to address this difference. 8 Report of Independent Registered Public Accounting Firm To the Board of Directors and Shareholders of XYZ, Inc.: We have audited management's assessment, included in the accompanying Management's Report, on Internal Control over Financial Reporting, that XYZ, Inc. has not maintained effective internal control over financial reporting as of December 31, 2014, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO criteria). XYZ's management is responsible for assessing the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the company's internal control over financial reporting based on our audit. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the auditor obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Two material weaknesses were identified in the design and operation of internal controls over the accounting for sales commissions and separation of duties related to purchases of inventory. Given the nature of the transactions and processes involved and the potential for a misstatement to occur as a result of the internal control deficiencies existing on December 31,2014, we have concluded that there is more than a remote likelihood that a material misstatement in the annual or interim financial statements would not have been prevented or detected by internal controls. These material weaknesses were considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2014 financial statements. 9 In addition to the materiel weaknesses noted above, we identified several deficiencies in internal control over financial reporting that we deemed to be less significant than a material weakness. These deficiencies have been separately communicated to XYZ's management. In our opinion, because XYZ has not maintained an effective internal control over financial reporting, we are unable to evaluate management's assessment that XYZ did not maintain effective internal control over financial reporting as of December 31, 2014. Also in our opinion, because of the effect of the material weaknesses described above on the achievement of the 'objectives of the control criteria, XYZ has not maintained. in all material respects, effective internal control over financial reporting as of December 31, 2014, based on the COSO criteria. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) the balance sheets of XYZ as of December 31,2014 and 2011, and related statements of income, shareholders' equity, and cash flow for each of the three years in the period ended December 31, 2014. James M. Peters, CPA. December 31, 2014 10