LO 10-6, 10 10-36 Based on an assessment of audit risk, the auditors are concerned with the following two risks: 1. The risk that that the client might be making duplicate payments to vendors. 2. The risk that the client's accounting clerk might be making unauthorized payments to himself. a. Assuming that the client has a manual accounting system, describe how the auditors can design a test to identify the duplicate payments and unauthorized payments. b. Assuming that the client has an IT accounting system, describe how the anditors might use data analytic software to design a test to identify the duplicate payments and the unauthor ized payments c. Describe the advantages of using data analytics software to identify unusual transactions or entries Required 10-37. You are the auditor in charge of the audit of Steffens Corporation. In the audit of invest- ments, you have just been given the following list of securities held by Steffens Corporation at December 31, 20x3. LO 10-8, 10 STEFFENS CORPORATION Schedule of Marketable Securities December 31, 20x3 Market Value December 31 $599,100 216.500 10,000 shares of Microsoft Corp. 6,000 shares of General Motors Corp. 8,000 shares of Beta Corporation 400 Holloway Lodging Corp. 7.5% Convertible Bonds (not publicly traded) 555,000 Identify the potential audit problems that may be indicated by the schedule. Tovalue the shares of Beta Corporation, management has employed a securities valuation firm Explain the audit considerations involved in auditing the value developed by the valuation firm Required: a b Objective Questions 10-38 Multiple Choice Questions Select the best answer for each of the following situations and give reasons for your choice. a Which of the following controls would most likely reduce the risk of diversion of cus- tomer receipts by a client's employees? LO 10-3 ) A bank lockbox system. (2) Prenumbered remittance advices. (3) Monthly bank reconciliations. (4) Daily deposit of cash receipts. b. To provide assurance that each voucher is submitted and paid only once, the auditors most likely would examine a sample of paid vouchers and determine whether each voucher is: () Supported by a vendor's invoice. LO 10-3 (2) Stamped "paid" by the check signer. (3) Prenumbered and accounted for. (4) Approved for authorized purchases. In testing controls over cash disbursements, the auditors most likely would determine that the person who signs checks also: LO 10-5 c. () Reviews the monthly bank reconciliation. (2) Returns the checks to accounts payable. (3) Is denied access to the supporting documents (4) Is responsible for mailing the checks LO 10-6 d. To gather evidence regarding the balance per bank in a bank reconciliation, the auditors wOuld examine any of the following except: () Cutoff bank statement. Year-end bank statement. (2) (3) Bank confirmation (4) General ledger hapter Ten e. You have been assigned to the year-end audit of a financial institution and are planning the timing of audit procedures relating to cash. You decide that it would be preferable to LO 10-7, 10 () Count the cash in advance of the balance sheet date in order to disclose any kiting operations at year-end. (2) Coordinate the count of cash with the cutoff of accounts payable. (3) Coordinate the count of cash with the count of marketable securities and other nego- tiable assets (4) Count the cash immediately upon the return of the confirmation letters from the finan- cial institution. Which of the following procedures would the auditors most likely perform to test controls relating to management's assertion about the completeness of cash receipts for cash sales at a retail outlet? LO 10-5 () Observe the consistency of the employees' use of cash registers and tapes. (2) Inquire about employees' access to recorded but undeposited cash. (3) Trace deposits in the cash receipts journal to the cash balance in the general ledger. (4) Compare the cash balance in the general ledger with the bank confirmation request. LO 10-3 Reconciliation of the bank account should not be performed by an individual who also: (I) Processes cash disbursements (2) Has custody of securities. &. (3) Prepares the cash budget. (4) Reviews inventory reports. h. The auditors suspect that a client's cashier is misappropriating cash receipes for personal use by lapping customer checks received in the mail. In attempting to uncover this embez- zlement scheme, the auditors most likely would compare the LO 10-4, 6 () Details of bank deposit slips with details of credits to customer accounts. Daily cash summaries with the sums of the cash receipes journal entries. (2) (3) Individual bank deposit slips with the details of the monthly bank statements. (4) Dates uncollectible accounts are authorized to be written off with the dates the write- offs are actually recorded. iIn order to guard against the misappropriation of company-owned marketable securities, which of the following is the best course of action that can be taken by a company with a large portfolio of marketable securities? () Require that one trustworthy and bonded employee be responsible for access to the safekeeping area where securities are kept. (2) Require that employees who enter and leave the safekeeping area sign and record in a log the exact reason for their access LO 10-9 (3) Require that employees involved in the safekeeping function maintain a subsidiary control ledger for securities on a current basis. (4) Require that the safekeeping function for securities be assigned to a bank or stock broker that will act as a custodial agent. Hall Company had large amounts of funds to invest on a temporary basis. The board of directors decided to parchase securities and derivatives and assigned the future purchase and sale decisions to a responsible financial executive. The best person or persons to make periodic reviews of the investment activity would be: LO 10-9 () An investment committee of the board of directors (2) The chief operating officer. (3) The corporate controller. (4) The treasarer . The auditors who physically examine securities should insist that a client representative be present in order to: (I) Detect fraudulent securities (2) Lend authority to the auditors' directives. (3) Acknowledge the receipt of securities returned. (4) Coordinate the return of securities to the proper locations LO 10-10 Cash and Financial Imvesteents 441 LThe best way to verify the amounts of dividend revenue received during the year is: LO 10-7, 10 (I) Recomputation. (2) Verification by reference to dividend record books. (3) Confirmation with dividend-paying companies (4) Examination of cash disbursements records 10-39 Simulation -1, 2,3, 4, 6 You are working on your firm's fifth audit of SSC. The previous audits have all resulted in standard unqualified audit reports. Read the following write-up from your audit files concern- ing SSC and its industry, and then reply to the questions that follow Company Information In 20X1, Gary Sherwood founded Sherwood Stone Company (SSC). In the middle of its second year of existence, the company completed development of a large extraction pit area and constructed an aggregate processing plant that is equipped to crush, screen, and wash aggregate products. By 20X4, the sand and gravel operation was profitable and growing market conditions justified modifications and expansion. Currently. SSC produces a wide range of sand and stone products from its pit near Bisbee, Arizona. The materials it devel ops are composed of sand and stone materials for commercial construction and highway projects SSC sells to a wide variety of commercial and governmental customers, with only one of its numerous customers-Wingo Corporation-accounting for more than 5 percent of total sales. In total, Wingo has represented approximately 30 percent of sales (and receivables) for the past few years. Wingo Corporation is by far Arizona's largest street and road contractor and seems solid financially. Virtually all of SSC's sales are on credit, althouugh all but the smallest contracts require "progress" billings that result in payment being received by SSC on a pro rata basis with delivery of materials to the customer. Payments from customers are made directly to the company's lockbox system with SSC's local bank. All transactions occur in U.S. dollars, and SSC maintains both a general checking account and a payroll account sSC has worked closely with Wingo Corporation in developing a superior road paving product (QuietRide"). Not only is the car ride relatively quiet on QuietRide roads, but it is also relatively cool (thus lengthening the life of automobile tires) and less likely to lead to cars sliding in rainy conditions. Although Wingo Corporation holds the overall patent, SSC has patented a critical component that is used in the product (the component is "QSand"). The product now accounts for approximately 25 percent of the company's sales (all to Wingo Corporation) and 33 percent of its profits. The success of QSand has led SSC to start developing another product, QDeck. QDeck will be a final finishing coat over the pool deck-the concrete walking and lounging area that surrounds a swimming pool. QDeck is intended to address two problems: () individuals slipping and falling on pool decks while walking with wet feet and (2) individuals burning their feet on the deck on particularly hot days. Gary indicates that the current compound seems to allow good traction and decks remain much cooler than with products of other companies. The problem being addressed at this point is that the current compound seems to crack easily and has a relatively short useful life. Indeed, in one test of the product on the deck at Gary's home, Gary's wife Madonna cut her foot on one of the cracks and required several stitches to close the wound. Gary laughed and said that at least she didn't slip or burn her feet on that hot day when it happened. More seriously, he suggested that this deficiency is currently being worked on and must be solved before the product goes to market. The product is being independently developed and is intended for both residential and commer- cial markets In 20X8, the company experienced a level of profitability just slightly above that of 20X7-but this was well below the net incomes of the preceding few years. Gary suggested to you that, surprisingly, intense price competition from several smaller competitors in the Bisbee area caused the somewhat low level of profitability. But, he added, he didn't expect the problem to last for long because he doubted that those companies could continue to operate selling at those lower prices. Gary had hoped for a more profitalble year in 20X8, as a signifi- cant amount of the company's long-term debt is payable in 20X9. SSC is currently involved in discussions with the bank on refinancing. 442 Chapter Ten sSC added significant additional crushing and washing plant and equipment during 20X8 to increase production in the future by more than 100 percent while expanding capabilities to prodace custom specification materials No dividends have been paid during the past two years, although previcusly most of the carmings were distributed through dividends to SSC's five sharcholders-CEO and Chair of the Boand of Directors Gary Sherwood, his wife Madonna Sherwood, CFO Jane Zhan, and two college friends of Gary's who invested in the company, Cindy Stone and Kelly Higgins These five individuals make up the company's board of directors The Bank of Arizona is the financial institution with which SSC maintaims its two cash accounts (general and payroll cash accounts) and from which it obtains a significant portion of its financing: the inventories are pledged on the Bank of Arizona loan. This year, in reac tion to pressure from the bank, SSC established an audit commitee composed of Madonna Sherwood, Cindy Stone, and Kelly Higgins. Industry Information The industry activities consist of the extraction and preparation of sand and rock products These activities include the cleaning, separating. and sorting of quamried sand and the process of crushing rocks. The products are in the form of sand used in making concrete; sand used in laying bricks (which contains little soil); sand used for fill (which contains a large amount of seil); and quarte sand. It excludes the products of gravel quarying (sandstone, gravel stone. and iron sand) While sales within the industry are relatively unaffected by changes in technology or obso- lescence, industry sales rely heavily upon both the residential and commercial constraction markets as well as government spending. During the past five years, construction has per- formed well and that trend is expected to continue for at least the next several years. Sand and gravel peoduction has increased at approximately 4 percent per year during this time period, as has construction within the central Arizona area. Questions Which of the following represents a corect statement conceming the risk of misappropria tion of cash for SsC a. () This is not a major concerm because sales are made on credit. (2) Deposit of cash into a lockbox system decrcases the risk of misappropeiation. (3) Misappeopriation of cash is not a significant problem in a commercial company. (4) The success of QSand increases the risk that cash will be misappropriated. b. Which of the following corectly identifies a risk facing SSC that might adversely affect cash receipts during the coming years? (I) Establishment of the audit commitee (2) Increase in the popularity of home swimming peols (3) Sales to many different customers (4) Sales to Wingo c. Which of the following correctly identifies a risk facing SSC that might adverscly affect sales during the coming years? () A general slowdown in the economy. (2) Sales to many smaller customers other than Wingo Corporation (3) Increased attcntion to developing new products. (4) A board of directors dominated by management. d Which of the following corectly identifies a risk facing SSC that might affect its ability to continue as a going concem over the long run? ) Competition from several competitors. (2) Your CPA firm's decisicn to issue standard unmodified andit reports not mentioning the going-concern status during the past five years. (3) Obsolescence of all products doe to rapid changes in technology in the industry. (4) The nature of inventory items-small in size, high in value. 444 Chapter Ten d. The auditor discovered an unusually large receivable from one the entity's new cus tomers. The auditor suspects that the receivable may be fictitious because the auditor has never heard of the customer and because the auditor's initial attempt to confirm the receiv able has been ignored by the customer. (Select only 2 procedures.) e. The aaditor suspects that fictitious employees have been placed on the payroll by the entity's payroll supervisor, who has access to payroll records and to the paychecks. (Select only 1 procedure.) The auditor suspects that selected employees of the emity received unauthorized raises from the entity's payroll supervisor, who has access to payroll records. (Select only I procedure.) The entity's cash receipts of the first few days of the subsequent year wese properly depos- ited in its general operating account after the year-end. However, the auditor suspects that the entity secorded the cash receipts in its books during the last week of the year under audit. (Select only I procedure.) h The auditor suspects that vouchers were prepared and processed by an accounting depart- meat employee for merchandise that was neither ordered nor received by the entity. (Select only I procedure.) LThe details of invoices for equipment repairs were not clearly idenified or explained to the accounting department employees. The auditor suspects that the bookkeeper incor- rectly recorded the repairs as fixed assets. (Select only 1 procedure) The auditor suspects that a lapping scheme exists because an accounting department employee who has access to cash receipts also maintains the accounts receivable ledger and refuses to take any vacation or sick days. (Select only 2 procedares.) k. The auditor suspects that the entity is inappropriately increasing the cash reported on its balance sheet by drawing a check on one account and not reconding it as an outstanding check on that acccunt and simultancously recoeding it as a deposit in a second account (Select only I procedure.) The auditor suspects that the entity's controller has overstated sales and accounts receiv able by recording fictitious sales to regular customers in the entity's books. (Select only 2 procedures.) 10-41 LO 10-6 Simulation Items a throughfrepresent the items that an aaditor ordinarily would find on a client-prepared bank reconciliation. The accompanying List of Auditing Procedures represents substantive auditing procedures. For cach item, select one or mose procedures, as indicated, that the audi- tor most likely woald perform to gather evidence in support of that item. The procedures on the list may be selected once, moee than once, or not at all. Assume The client prepared the bank reconciliation on 10/2/X5. 1 The bank reconciliation is mathematically accurate. The auditor received a cutoff bank statement daned 10/7/X5 directly from the bank on 10/11/X5 The /30/X5 deposit in transit-outstanding checks #1281, #1285, #1289, and W1292-and the ceerection of the error regarding check #1282 appeared on the cutoff bank staement The audisor assessed control risk concerning the financial statement assertions related to cash at the maximum List of Auditing Procedures A Trace to cash receipts journal. B. Trace to cash disbursements journal H Inspect supporting documents for reconciling item not appearing on cutoff statement L Trace items on the bank reconciliation to cutoff C. Compare to 9/30/X5 general ledger D. Confirm directly with bank E. Inspect bank credit memo. statement. J Trace items on the cutoff statement to bank F. Inspect bank debit memo reconciliation Ascertain reason for unusual delay G