Stephanie is auditing a major consumer products manufacturer. She is building her audit plan and trying to determine her approach to auditing their ending inventory balance as well as the long-term debt balance. Their inventory consists of a large number of items that are similar in value. For a variety of reasons, she has assessed the inherent risk of the inventory account as moderate to high. Her assessment of the design of internal controls over inventory recording and valuation is that these controls are well designed and haven't changed since she audited them last year and found they were working properly. However, she has not retested the controls yet for this year.

Stephanie's auditee only has three major bond issues that make up the long-term debt account balance. Each bond issue contains complex provisions like conversion features and debt covenants. The three bonds differ in size and one of them alone makes up 50% of the total balance.

The following questions cover all possible alternatives for testing the inventory and long-term debt balances and I have asked you to makes assumptions in them. Some of these assumptions may be extreme and I realize that. I just want you to apply the basic principles for testing to each question even if the assumptions involved are extreme.

Should Stephanie use a sampling technique to test their inventory balance? Why or why not?

Assuming she decided to sample the inventory, should she use statistical or non-statistical sampling? Explain your answer.

Assuming she decided to use statistical sampling to test the inventory, should she use Monetary Unit Sampling or Variables Sampling?. Explain your answer.

Should she use a sampling technique to test their long-term balance? Why or why not?

Assuming she decided to sample the long-term debt account, should she use statistical or non-statistical sampling? Explain your answer.

Assuming she decided to use statistical sampling for the long-term debt account, would she use Monetary Unit Sampling or Variables Sampling? Explain your answers.

Jake Jones is auditing an ending inventory balance. He obtained a complete listing of every item that made up the ending inventory balance from the auditee's subsidiary inventory ledger. The listing included the number of items is inventory, the cost per unit assigned to each item, and the extended cost (cost times quantity). At the same time that the auditee took its physical count of the items in ending inventory, he selected a sample of items from the listing and performed his own count of the number of that item in ending inventory. He then compared his count to the auditee's count and noted any differences in his working papers.

Then he obtained he used the costs in the listing and verified those cost to purchase invoices from the vendors. Finally, he multiplied the number in his count by the invoice costs and compared the resulting amount to a listing that the client had provided that included their totals for each item. He traced the total of their listing to their general ledger account.

For each of the following tests he performed, describe the purpose of the test to include all the audit objective(s) involved. Be sure to explain how the test supports each objective.

Counting the items in inventory

Verifying the costs per item

Tracing the total to the general ledger

When Jake ran his inventory tests as described above using a statistical sampling technique, he found differences in the inventory recorded cost that totaled to more than your tolerable misstatement. Discuss what alternatives he has to address this difference and how each alternative might compensate for or correct the sample results he found.

Alternative 1

Alternative 2

Alternative 3

Alternative 4

Discuss which how Jake should order these alternatives and why. That is, which alternative should he try first, second, third, and fourth and why?

The following is a list of misstatements that might be found in a year-end account balance. For each:

state the audit objective(s) that was violated because of the error and why;

describe one control activity that might have detected or prevented the misstatement;

and describe a test of balance audit procedure that auditors might use to find it.

Make sure you answers are sufficiently detailed to be clear about how the error violated the audit objective and how each internal control or testing procedure would detect the error. Assume in all cases that the auditee's controller prepares regular bank reconditions.

An accounting clerk omitted a check from the outstanding checklist on the year-end bank reconciliation. The check cleared a week after year-end.

Audit objective(s) violated -

Internal control -

Test of balance -

The auditee's bank credited the auditee's bank account four days before year-end with cash received from a loan the auditee had secured. However, the loan was not shown as outstanding on the year-end financial statements and the cash proceeds from the loan were not included firm's ending cash balance.

Audit Objective(s) violated -

Internal control -

Test of balance -

The auditee had factored without recourse a little over 50% of their ending accounts year-end accounts receivable balance. "Factoring" is when a firm sells its accounts receivable to another firm, usually a financial institution. "Without recourse" means that the purchasing firm cannot return the receivables to the selling firm if they can't collect them. Thus, full title to the receivables has passed to the purchasing firm. However, these accounts still showed in the auditee's ending accounts receivable balance. Note that auditee does not notify the customer who owed the account to the auditee that their account has been factored and the selling firm merely forwards receipts on factored accounts to the purchasing company.

Audit Objective(s) violated -

Internal control -

Test of balance -

The auditee's ending accounts payable balance excluded a significant number of amounts due vendors that created a materially understated in accounts payable.

Audit Objective(s) violated -

Internal control -

Test of balance -

Your audit of AJAX, Inc., a public company registered with the SEC, followed the following timeline of events. Assume that all events are material to the financial statements taken as a whole.

AJAX's fiscal year ended 12/31/2013.

Event 1 - On 1/15/14 AJAX's management informed you that a major competitor had just introduced a new product that made a substantial portion of their inventory obsolete and only resalable for a fraction of the cost shown on the balance sheet as of 12/31/13.

Event 2 - On 2/25/14 AJAX sold the line of business that produced that obsolete inventory items to another firm. The sale represented approximately 25% of AJAX's product line.

You completed your fieldwork and dated you audit report as of 3/1/14.

AJAX distributed their financial statements and your report on 3/15/14.

Event 3 - On 4/1/14 AJAX's internal audit department contacted you to tell you that they had discovered massive fraud that their CFO had perpetrated during 2013 that led to a material overstatement of the firm's accounts receivable and sales as of 12/31/2013. These errors were clearly material to the financial statements taken as a whole.

Describe what actions you would need to take, if any, based on each of the three labeled events. Be complete and describe any changes you would require in AJAX's financial statements for 2013, your audit report for 2013, and any additional actions, if any, required by GAAS. Also, justify your selections by stating why you would take them based on the type of each event.

Event 1 -

Event 2 -

Event 3 -

One of the final audit procedures for any audit is to obtain letters from the auditee's attorneys.

Why do auditors require attorney's letters? What potential financial reporting issue are they testing?

Who requests the letters from the attorney and why?

Why might attorneys resist providing the information needed by the auditor?

Final Exam Fall 2015 ACCT 612 - Auditing Instructions Name: After you have downloaded this document from the Final Exam item in the Course Content section, please save a copy of this document and rename it using your own name as the file name so that I can keep them separate on my machine (i.e., "Jim Peters Final.doc"). Type all your answers in this document. Once you have completed the exam, submit your completed Word files by midnight Saturday, 8/6. The exam is worth 20% of your final grade. If you need clarification on the wording of any question on the exam, you can e-mail me or call me at (505) 425-9999. I will deduct percentage points for not following these instructions. For example, I will deduct percentage points if you do not type your answers in this document and submit some other type of file or if you do not attached your file to the assignment. I have attached a spreadsheet file to the Final Exam assignment, which I refer to as a grading checklist, with this exam. That spreadsheet file shows you how I have allocated percentage points to questions. When grading your exams, I will fill in a copy of this file for each student and return it with your graded exam. When I grade exams, I embed comments in the Word documents to explain why I am deducting points, which is why I need you to submit your exams as Word document. Course Policy on Collaboration and Individual Work This is an individual assignment and you are not to seek help from anyone else other than me. I have engineered the test around the text and so you should not need to do any outside research. However, if you chose use any outside sources, cite them to avoid a charge of plagiarism. By cite, I mean be clear about exactly what material you took from what source and don't just include a "Works Cited" section at the end of the test. This is inadequate. The text doesn't qualify as an outside source and so you don't need to cite it nor do you need to cite any of my solutions. Finally, I want all your answer to be stated in your own words. You are not allowed to quote the text, my solutions, or any outside sources. Paraphrasing in your own words is fine, but direct quoting is not allowed. Also, direct quoting even the text or my solutions without citation is plagiarism. Questions 1) Joe Zebrowski was an internal auditor for a retail drug chain. He detected a computer programmer who worked on the firm's accounts payable system stealing from the firm. 1 The programmer had miss-programmed the portion of the program to truncate all cash discounts instead of rounding them. That is, when the firm paid a bill within the vendor's cash discount period, the program calculated the amount of the discount and then deducted that amount from the amount of the check written to the vendor. These calculations rarely came out to an even penny and the program should have rounded any amount for a half a penny up to the next highest penny and dropped any amounts less than a half a penny from the discount amount to round down to the next lowest penny. Instead, the programmer programmed the system to always drop any partial penny from the amount and always lower the discount amount to lower full penny. Instead of being discarded, the programmer also had the program put them is a secret storage location and let them accumulate. Once the amounts in the secret location reached a certain level, the programmer would have the program write him an expense reimbursement check for the accumulated amounts. He was able to access the program to write himself a check because when he developed the program, he left a secret back door into the program that bypass the account/password access control of the program. Programmers worked in the home office and rarely had any reason to travel or incur significant reimbursable expenses. a) b) 1) Describe two internal control(s) that should have prevented this fraud and how each control should have worked. Also discuss how the programmer might have been able to circumvent the control even if it were in place and working properly. You answer needs to be specific to the case. For example, if you believe segregation of duties should have prevented the theft, you need to describe the segregation of specific duties and how segregating those specific duties should have prevented the fraud. i) Control #1 - ii) Control #2 - Describe an audit test that the internal audit department might have used to detect the fraud and explain how it would have detected the fraud. Stephanie is auditing a major consumer products manufacturer. She is building her audit plan and trying to determine her approach to auditing their ending inventory balance as well as the long-term debt balance. Their inventory consists of a large number of items that are similar in value. For a variety of reasons, she has assessed the inherent risk of the inventory account as moderate to high. Her assessment of the design of internal controls over inventory recording and valuation is that these controls are well designed and haven't changed since she audited them last year and found they were working properly. However, she has not retested the controls yet for this year. 2 Stephanie's auditee only has three major bond issues that make up the long-term debt account balance. Each bond issue contains complex provisions like conversion features and debt covenants. The three bonds differ in size and one of them alone makes up 50% of the total balance. The following questions cover all possible alternatives for testing the inventory and longterm debt balances and I have asked you to makes assumptions in them. Some of these assumptions may be extreme and I realize that. I just want you to apply the basic principles for testing to each question even if the assumptions involved are extreme. 2) a) Should Stephanie use a sampling technique to test their inventory balance? Why or why not? b) Assuming she decided to sample the inventory, should she use statistical or nonstatistical sampling? Explain your answer. c) Assuming she decided to use statistical sampling to test the inventory, should she use Monetary Unit Sampling or Variables Sampling?. Explain your answer. d) Should she use a sampling technique to test their long-term balance? Why or why not? e) Assuming she decided to sample the long-term debt account, should she use statistical or non-statistical sampling? Explain your answer. f) Assuming she decided to use statistical sampling for the long-term debt account, would she use Monetary Unit Sampling or Variables Sampling? Explain your answers. Jake Jones is auditing an ending inventory balance. He obtained a complete listing of every item that made up the ending inventory balance from the auditee's subsidiary inventory ledger. The listing included the number of items is inventory, the cost per unit assigned to each item, and the extended cost (cost times quantity). At the same time that the auditee took its physical count of the items in ending inventory, he selected a sample of items from the listing and performed his own count of the number of that item in ending inventory. He then compared his count to the auditee's count and noted any differences in his working papers. 3 Then he obtained he used the costs in the listing and verified those cost to purchase invoices from the vendors. Finally, he multiplied the number in his count by the invoice costs and compared the resulting amount to a listing that the client had provided that included their totals for each item. He traced the total of their listing to their general ledger account. a) b) c) For each of the following tests he performed, describe the purpose of the test to include all the audit objective(s) involved. Be sure to explain how the test supports each objective. i) Counting the items in inventory ii) Verifying the costs per item iii) Tracing the total to the general ledger When Jake ran his inventory tests as described above using a statistical sampling technique, he found differences in the inventory recorded cost that totaled to more than your tolerable misstatement. Discuss what alternatives he has to address this difference and how each alternative might compensate for or correct the sample results he found. i) Alternative 1 ii) Alternative 2 iii) Alternative 3 iv) Alternative 4 Discuss which how Jake should order these alternatives and why. That is, which alternative should he try first, second, third, and fourth and why? 3) The following is a list of misstatements that might be found in a year-end account balance. For each: state the audit objective(s) that was violated because of the error and why; 4 describe one control activity that might have detected or prevented the misstatement; and describe a test of balance audit procedure that auditors might use to find it. Make sure you answers are sufficiently detailed to be clear about how the error violated the audit objective and how each internal control or testing procedure would detect the error. Assume in all cases that the auditee's controller prepares regular bank reconditions. a) b) c) An accounting clerk omitted a check from the outstanding checklist on the year-end bank reconciliation. The check cleared a week after year-end. i) Audit objective(s) violated - ii) Internal control - iii) Test of balance - The auditee's bank credited the auditee's bank account four days before year-end with cash received from a loan the auditee had secured. However, the loan was not shown as outstanding on the year-end financial statements and the cash proceeds from the loan were not included firm's ending cash balance. i) Audit Objective(s) violated - ii) Internal control - iii) Test of balance - The auditee had factored without recourse a little over 50% of their ending accounts year-end accounts receivable balance. "Factoring" is when a firm sells its accounts receivable to another firm, usually a financial institution. "Without recourse" means that the purchasing firm cannot return the receivables to the selling firm if they can't collect them. Thus, full title to the receivables has passed to the purchasing firm. However, these accounts still showed in the auditee's ending accounts receivable balance. Note that auditee does not notify the customer who owed the account to the auditee that their account has been factored and the selling firm merely forwards receipts on factored accounts to the purchasing company. i) Audit Objective(s) violated - 5 d) ii) Internal control - iii) Test of balance - The auditee's ending accounts payable balance excluded a significant number of amounts due vendors that created a materially understated in accounts payable. i) Audit Objective(s) violated - ii) Internal control - iii) Test of balance - 4) Your audit of AJAX, Inc., a public company registered with the SEC, followed the following timeline of events. Assume that all events are material to the financial statements taken as a whole. AJAX's fiscal year ended 12/31/2013. Event 1 - On 1/15/14 AJAX's management informed you that a major competitor had just introduced a new product that made a substantial portion of their inventory obsolete and only resalable for a fraction of the cost shown on the balance sheet as of 12/31/13. Event 2 - On 2/25/14 AJAX sold the line of business that produced that obsolete inventory items to another firm. The sale represented approximately 25% of AJAX's product line. You completed your fieldwork and dated you audit report as of 3/1/14. AJAX distributed their financial statements and your report on 3/15/14. Event 3 - On 4/1/14 AJAX's internal audit department contacted you to tell you that they had discovered massive fraud that their CFO had perpetrated during 2013 that led to a material overstatement of the firm's accounts receivable and sales as of 12/31/2013. These errors were clearly material to the financial statements taken as a whole. Describe what actions you would need to take, if any, based on each of the three labeled events. Be complete and describe any changes you would require in AJAX's financial statements for 2013, your audit report for 2013, and any additional actions, if any, required by GAAS. Also, justify your selections by stating why you would take them based on the type of each event. a) Event 1 6 5) b) Event 2 - c) Event 3 - One of the final audit procedures for any audit is to obtain letters from the auditee's attorneys. a) Why do auditors require attorney's letters? What potential financial reporting issue are they testing? b) Who requests the letters from the attorney and why? c) Why might attorneys resist providing the information needed by the auditor? 7 Final Exam Fall 2015 ACCT 612 - Auditing Instructions Name: Jim Peters Final .doc. After you have downloaded this document from the Final Exam item in the Course Content section, please save a copy of this document and rename it using your own name as the file name so that I can keep them separate on my machine (i.e., "Jim Peters Final.doc"). Type all your answers in this document. Once you have completed the exam, submit your completed Word files by midnight Saturday, 8/6. The exam is worth 20% of your final grade. If you need clarification on the wording of any question on the exam, you can e-mail me or call me at (505) 425-9999. I will deduct percentage points for not following these instructions. For example, I will deduct percentage points if you do not type your answers in this document and submit some other type of file or if you do not attached your file to the assignment. I have attached a spreadsheet file to the Final Exam assignment, which I refer to as a grading checklist, with this exam. That spreadsheet file shows you how I have allocated percentage points to questions. When grading your exams, I will fill in a copy of this file for each student and return it with your graded exam. When I grade exams, I embed comments in the Word documents to explain why I am deducting points, which is why I need you to submit your exams as Word document. Course Policy on Collaboration and Individual Work This is an individual assignment and you are not to seek help from anyone else other than me. I have engineered the test around the text and so you should not need to do any outside research. However, if you chose use any outside sources, cite them to avoid a charge of plagiarism. By cite, I mean be clear about exactly what material you took from what source and don't just include a "Works Cited" section at the end of the test. This is inadequate. The text doesn't qualify as an outside source and so you don't need to cite it nor do you need to cite any of my solutions. Finally, I want all your answer to be stated in your own words. You are not allowed to quote the text, my solutions, or any outside sources. Paraphrasing in your own words is fine, but direct quoting is not allowed. Also, direct quoting even the text or my solutions without citation is plagiarism. Questions 1 1) Joe Zebrowski was an internal auditor for a retail drug chain. He detected a computer programmer who worked on the firm's accounts payable system stealing from the firm. The programmer had miss-programmed the portion of the program to truncate all cash discounts instead of rounding them. That is, when the firm paid a bill within the vendor's cash discount period, the program calculated the amount of the discount and then deducted that amount from the amount of the check written to the vendor. These calculations rarely came out to an even penny and the program should have rounded any amount for a half a penny up to the next highest penny and dropped any amounts less than a half a penny from the discount amount to round down to the next lowest penny. Instead, the programmer programmed the system to always drop any partial penny from the amount and always lower the discount amount to lower full penny. Instead of being discarded, the programmer also had the program put them is a secret storage location and let them accumulate. Once the amounts in the secret location reached a certain level, the programmer would have the program write him an expense reimbursement check for the accumulated amounts. He was able to access the program to write himself a check because when he developed the program, he left a secret back door into the program that bypass the account/password access control of the program. Programmers worked in the home office and rarely had any reason to travel or incur significant reimbursable expenses. a) Describe two internal control(s) that should have prevented this fraud and how each control should have worked. Also discuss how the programmer might have been able to circumvent the control even if it were in place and working properly. You answer needs to be specific to the case. For example, if you believe segregation of duties should have prevented the theft, you need to describe the segregation of specific duties and how segregating those specific duties should have prevented the fraud. i) Control #1 - Reconciliation of inventory records with the general ledger. Comparisons should be made between the amounts recorded in the inventory and those in the general ledger relating to the cash discounts received by the firm and any discrepancies identified. The programmer however can be cunning and collude with the other staff maintaining the ledger and they can cook the accounts and make sure that they tally. ii) Control #2 - Segregation of duties and continuous review of the work of the programmers. The management employs the services of many programmers to investigate the work done by the programmer. This will enable the management to identify any malicious programs that have been fixed in the system. Segregation of duties will also enable the management to identify and question the sources of the programmer's reimbursement expenses because they work in their home offices and rarely incur these expenses. However the programmer can avoid this by colluding with other employees to assist him in this fraud and therefore the management should be vigilant in their investigations. 2 b) Describe an audit test that the internal audit department might have used to detect the fraud and explain how it would have detected the fraud. Review security system and policies in place. Reviewing the security system by another programmer who is an expert in the system will help the management identify this malicious plans of the programmer to steal from the firm and eliminate them by changing the settings of the system. 1) Stephanie is auditing a major consumer products manufacturer. She is building her audit plan and trying to determine her approach to auditing their ending inventory balance as well as the long-term debt balance. Their inventory consists of a large number of items that are similar in value. For a variety of reasons, she has assessed the inherent risk of the inventory account as moderate to high. Her assessment of the design of internal controls over inventory recording and valuation is that these controls are well designed and haven't changed since she audited them last year and found they were working properly. However, she has not retested the controls yet for this year. Stephanie's auditee only has three major bond issues that make up the long-term debt account balance. Each bond issue contains complex provisions like conversion features and debt covenants. The three bonds differ in size and one of them alone makes up 50% of the total balance. The following questions cover all possible alternatives for testing the inventory and longterm debt balances and I have asked you to makes assumptions in them. Some of these assumptions may be extreme and I realize that. I just want you to apply the basic principles for testing to each question even if the assumptions involved are extreme. a) Should Stephanie use a sampling technique to test their inventory balance? Why or why not? Stephanie should use a sampling technique to test the inventory considering the fact that a large number of items that are similar are involved. The large target population of the many items involved will can all be analyzed because they are time consuming. b) Assuming she decided to sample the inventory, should she use statistical or nonstatistical sampling? Explain your answer. Stephanie should use statistical sampling because this will ensure objectivity and that she is not subjective in identifying the items to be investigated. She should use stratified sampling techniques because of the large amounts of that are similar and homogeneous. 3 c) Assuming she decided to use statistical sampling to test the inventory, should she use Monetary Unit Sampling or Variables Sampling?. Explain your answer. Variable sampling will be recommended. Variable sampling will enable the auditor to make comparisons of the original items recorded in the inventory and either reject or accept if the average sample goes behold the expectations. She should compare the discrepancies with the original items recorded. d) Should she use a sampling technique to test their long-term balance? Why or why not? Stephanie should not use a sampling technique considering the inherent risk and only three bonds are to be investigated in determining the long term balance. Sampling is convenient where the population of the study is large and testing all the variables is not possible. In this case there are only three variables that are required to be tested and sampling is not very significant because all the three bonds can be investigated by the auditor. e) Assuming she decided to sample the long-term debt account, should she use statistical or non-statistical sampling? Explain your answer. Stephanie should use non statistical sampling methods like convenience and judgmental sampling techniques. She will use her experience to identify risk areas where the errors and variations can have occurred, instead of using statistical techniques which will be time consuming and they do not promise accurate results due to sampling errors. Statistical techniques can however be used where the auditors are more concerned with the objectivity of the researchers. f) Assuming she decided to use statistical sampling for the long-term debt account, would she use Monetary Unit Sampling or Variables Sampling? Explain your answers. She should use monetary sampling where every dollar in each of the three transactions will be a separate sampling unit and be capable of identifying any error that may have occurred. Every dollar in each of the three bonds should be traced from the beginning amounts through the transactions to the ending balances and any errors and omissions identified and reported. 2) Jake Jones is auditing an ending inventory balance. He obtained a complete listing of every item that made up the ending inventory balance from the auditee's subsidiary inventory ledger. The listing included the number of items is inventory, the cost per unit assigned to each item, and the extended cost (cost times quantity). At the same time that the auditee took its physical count of the items in ending inventory, he selected a sample of items from the listing and performed his own count of the number of that item in ending inventory. He then compared his count to the auditee's count and noted any differences in his working papers. 4 Then he obtained he used the costs in the listing and verified those cost to purchase invoices from the vendors. Finally, he multiplied the number in his count by the invoice costs and compared the resulting amount to a listing that the client had provided that included their totals for each item. He traced the total of their listing to their general ledger account. a) b) For each of the following tests he performed, describe the purpose of the test to include all the audit objective(s) involved. Be sure to explain how the test supports each objective. i) Counting the items in inventory. This was crucial to ascertain the actual occurrence and existence of the inventory. The records could include certain items that had meet recorded but they did not actually exist in the firm's current stock. Counting the items in the inventory helps to confirm that the items recorded are actually in possession in their correct amounts. ii) Verifying the costs per item. The costs per item is significant and needs to be verified to ensure that inventory quantities have been correctly valued and recorded with high levels of accuracy. iii) Tracing the total to the general ledger. The totals of the ledger should agree with the amounts recorded in the inventory accounts and there should not be issues of variations. This will ensure that all the necessary disclosures concerning the inventory have been made and in the correct period to which they relate to. When Jake ran his inventory tests as described above using a statistical sampling technique, he found differences in the inventory recorded cost that totaled to more than your tolerable misstatement. Discuss what alternatives he has to address this difference and how each alternative might compensate for or correct the sample results he found. i) Alternative 1 -Specific identification method. This is where by a firm maintains inventory accounts for all the items of the firm and when inventory is sold the firm the inventory is reduced and the cost of goods sold increased. This method works well when the company has limited and unique items that can be easily identified. ii) Alternative 2-Fiirst in, first out (FIFO) method. This is a method of valuing inventory that uses the old inventory first. According to this method the end of year inventory would consist of the most recent placed inventory. 5 c) iii) Alternative 3- Last in, first out method. This is a strategy of valuing inventory that assumes that the last items placed in inventory are the first to be sold during the accounting year. iv) Alternative 4- Average Cost method. This method of valuing inventory takes the average of all the units available for sale during the accounting period. It makes use of the average cost to assess the cost of goods sold and the ending inventory. Discuss which how Jake should order these alternatives and why. That is, which alternative should he try first, second, third, and fourth and why? Jake should try these methods as follows; specific identification method, first in ,first out method, Last in, first out method and average cost method respectively ,considering the complexity and the amount of efforts and time required in each method. For instance Specific identification method does not require a lot of computations unlike the average cost method. 3) The following is a list of misstatements that might be found in a year-end account balance. For each: state the audit objective(s) that was violated because of the error and why; describe one control activity that might have detected or prevented the misstatement; and describe a test of balance audit procedure that auditors might use to find it. Make sure you answers are sufficiently detailed to be clear about how the error violated the audit objective and how each internal control or testing procedure would detect the error. Assume in all cases that the auditee's controller prepares regular bank reconditions. a) An accounting clerk omitted a check from the outstanding checklist on the year-end bank reconciliation. The check cleared a week after year-end. i) Audit objective(s) violated - Cut off objective was violated because the transaction was not recorded in the correct accounting period. ii) Internal control -Reconciliation of inventory account with the general ledger and therefore identify omissions that were not recorded and corrective action taken immediately. 6 iii) b) c) Test of balance - Inspect all the daily transactions to confirm daily processing and ensure that all daily transactions are accounted for ,to prevent omissions and errors from occurring. The auditee's bank credited the auditee's bank account four days before year-end with cash received from a loan the auditee had secured. However, the loan was not shown as outstanding on the year-end financial statements and the cash proceeds from the loan were not included firm's ending cash balance. i) Audit Objective(s) violated - Completeness. The firm did not include the loan awarded in the final year's cash balances and the accounts were not adjusted to show the outstanding loan amount. ii) Internal control - Procedures and policies in place to ensure that the financial statements are adjusted and include all transactions when they occur. iii) Test of balance - Review the firm's procedures relating to recoding transactions and the policies set to effect the same. The auditee had factored without recourse a little over 50% of their ending accounts year-end accounts receivable balance. "Factoring" is when a firm sells its accounts receivable to another firm, usually a financial institution. "Without recourse" means that the purchasing firm cannot return the receivables to the selling firm if they can't collect them. Thus, full title to the receivables has passed to the purchasing firm. However, these accounts still showed in the auditee's ending accounts receivable balance. Note that auditee does not notify the customer who owed the account to the auditee that their account has been factored and the selling firm merely forwards receipts on factored accounts to the purchasing company. i) Audit Objective(s) violated - Rights and obligations. The ownership of the accounts receivable changed hands and this was not factored in. This is violation of the objective of rights and obligations. ii) Internal control - Procedures and policies in place to indicate transfer of the right to ownership, property held at third parties and exclude those held on behalf of the third party. iii) Test of balance - Review of the entity's activities relating to consignment for third parties. 7 d) The auditee's ending accounts payable balance excluded a significant number of amounts due vendors that created a materially understated in accounts payable. i) Audit Objective(s) violated - Presentation and disclosure objectives were violated because the accounts payable did not indicate the amounts due to vendors. The objective of accuracy was also violated because the accounts omitted the amounts due to suppliers. ii) Internal control - All accounts payable processed daily to record the amounts due to vendors. iii) Test of balance - Inspect the daily transactions and documentations to ensure daily processing. 4) Your audit of AJAX, Inc., a public company registered with the SEC, followed the following timeline of events. Assume that all events are material to the financial statements taken as a whole. AJAX's fiscal year ended 12/31/2013. Event 1 - On 1/15/14 AJAX's management informed you that a major competitor had just introduced a new product that made a substantial portion of their inventory obsolete and only resalable for a fraction of the cost shown on the balance sheet as of 12/31/13. Event 2 - On 2/25/14 AJAX sold the line of business that produced that obsolete inventory items to another firm. The sale represented approximately 25% of AJAX's product line. You completed your fieldwork and dated you audit report as of 3/1/14. AJAX distributed their financial statements and your report on 3/15/14. Event 3 - On 4/1/14 AJAX's internal audit department contacted you to tell you that they had discovered massive fraud that their CFO had perpetrated during 2013 that led to a material overstatement of the firm's accounts receivable and sales as of 12/31/2013. These errors were clearly material to the financial statements taken as a whole. Describe what actions you would need to take, if any, based on each of the three labeled events. Be complete and describe any changes you would require in AJAX's financial statements for 2013, your audit report for 2013, and any additional actions, if any, required by GAAS. Also, justify your selections by stating why you would take them based on the type of each event. a) Event 1 - The event occurred after the final accounting period. The introduction of the competitor product that made the company's inventory obsolete and only saleable 8 at a loss effect should be assessed and measured and the necessary adjustments made in the financial statements. 5) b) Event 2 - The loss on the disposal of the product line of business that was affected by the introduction of the competitor product. The loss on disposal should be properly accounted for and all the adjustments made in the financial statements. c) Event 3 - These event occurred after the accounting period and after the audit report had being issued. The events are material because the event indicate massive fraud that led to misstatement of the financial statements. The auditor should therefore update the disclosures to include these conditions One of the final audit procedures for any audit is to obtain letters from the auditee's attorneys. a) Why do auditors require attorney's letters? What potential financial reporting issue are they testing? Auditors request the attorney's letter if they have any doubt that the management of the company they are auditing have unresolved suits against them that have not being disclosed to the auditors. They are usually testing the firm's disclosure and presentation disclosures as required by international auditing standards. b) Who requests the letters from the attorney and why? The letters from the attorney are requested by Auditors auditing a firm if there are any doubts that the management is facing litigations that have not being disclosed to them. c) Why might attorneys resist providing the information needed by the auditor? The attorneys may resist providing to provide sensitive information that is confidential to the management to protect their rights. The auditors requesting such information may have to obtain a subpoena and present it in order to get the details they need. 9