Question
Suzie Pickering has experience in the clothing and retail industry, which is why she was assigned to the Cloud 9 audit. Suzie is mentoring Ian
Suzie Pickering has experience in the clothing and retail industry, which is why she was assigned to the Cloud 9 audit. Suzie is mentoring Ian Harper, a first-year staff on the audit team, and they are working together on the detailed substantive test program. Ian remembers that Suzie used analytical procedures in the risk assessment phase and she explained to Ian how useful they could also be in the risk response phase. Ian suggests that they plan to rely extensively on analytical procedures for Cloud 9s substantive tests. He is very enthusiastic and wants to put analytical procedures in the plan for all transaction processes and major balances because he believes analytical procedures are very efficient for the audit team to perform. Suzie is more cautious. Although she will definitely plan to use some analytical procedures, she knows they will also need other types of tests. Why? asks Ian. How do I know when to only use analytical procedures? What other tests do we need? Ian is starting to realize that the standards and professional practice would not allow him to rely exclusively on analytical procedures. Cloud 9 has significant inventory balances (around 25% of total assets) and receivables (around 28% of total assets), so the auditors will need to gather persuasive evidence about the existence, valuation and allocation, and rights and obligations assertions for these accounts. Procedures such as confirming receivables balances and observing inventory counts are definitely going to be included in the detailed audit program. Suzie warns Ian that it is not always the size of the account that determines the use of analytical procedures or other procedures. For example, in Cloud 9s trial balance there is a derivatives investment account that is around 5% of total assets. It is a smaller portion of total assets, but since accounting for derivative investments is complex, they probably cannot rely solely on analytical procedures, particularly regarding the valuation and allocation assertion. an and Suzie continue their discussion about using analytical procedures. Ian is starting to feel more confident and suggests that there are some factors to consider about the Cloud 9 audit that would affect the use of the various procedures. We could use all of the usual techniques in the Cloud 9 audit, although we have to be careful in making comparisons across years for a couple of reasons. We have only just taken over the audit, so although prior-year data was audited, we are still building up our level of familiarity with the data and dont really understand all the conditions that applied to the previous years. Also, the changes at Cloud 9, in particular the opening of the retail store and the additional borrowing to finance the purchase of the delivery trucks that we discovered during our preliminary work, will impact the data. Ian and Suzie have decided that analytical procedures will not be sufficient for all accounts. For each major transaction process and account balance they will also conduct tests of details of transactions. For vouching tests, the auditors will sample transactions and balances in the accounting records and go to the underlying documentation (or physical assets) to confirm the recorded details. For example, for sales recorded as being made prior to the fiscal year-end, they will examine the invoices and shipping documents to gather evidence on the date, amount, and other details of the transactions. If they find a sales invoice with a February date has been included in the sales for the year ended January 31, they have evidence of a misstatement in the occurrence and cutoff assertions for sales. They will also trace the details in a sample of documents through to Cloud 9s accounting records. This means that they will start with the documents and then test how that transaction (or asset or liability) is recorded in the clients accounts. For example, if they find a sales invoice with a January date that is not included in the sales for the year, they will have evidence of a misstatement in the completeness and cutoff assertions for sales. Suzie advises Ian that the sample sizes and approach to sampling are determined by the results of the controls testing and the resulting expectations for errors. Suzie also asks Ian to include tests of details of accounts, such as accounts receivables and property, plant, and equipment (PPE), in the detailed audit program. Where the risk is low, such as PPE, they will perform these tests at an interim date. Finally, Suzie informs Ian that the IT audit manager, Mark Batten, is writing the ADA program. Suzie asks Ian to consider Cloud 9s estimated warranty liability. The estimated warranty liability is included in accrued liabilities on the balance sheet and trial balance. Included in accrued liabilities on the October 31, 2022 trial balance is an estimated warranty liability of $832,015, which is slightly higher than the liability on the prior years October 31, 2021 trial balance of $808,326. Suzie asks, What is the likelihood that the liability is understated? Are there any reasons to believe there are unidentified claims, and how would auditors detect such claims? Ian does not know of any change in manufacturing conditions that would affect the quality of Cloud 9s product, and thus the obligation under the warranty program. However, a new product was introduced at the start of the previous year. Because sales of the new Heavenly 456 walking shoe are now 20% of total sales, we should consider any possible effects on the warranty liability. I recommend specific work be done to assess the claims from this new product. However, if we remove this product from the analysis, the relationship between the warranty liability and sales is likely to be similar to past years. Because warranties apply to products, the amount of the warranty liability is determined by sales volume and product quality. Therefore, if conditions affecting product quality have not changed, and there is no change to the warranty program, substantive analytical procedures are a useful way of testing the reasonableness of the warranty liability. Finally, Ian concludes, relying on substantive analytical procedures to test the warranty liability is more justified if control testing suggests that Cloud 9 has effective controls over warranty claim estimation and identification of pending claims. During their conversation about Cloud 9s warranty liability, Suzie asks Ian about how they would use other substantive procedures to obtain evidence about the completeness assertion for the liability balance. For example, Suzie asks, would inspecting documents using vouching and tracing be useful and, if so, how would you use them? Ian is still keen on using substantive analytical procedures but considers the question carefully. I think we would use vouching to get evidence about transactions or balances that are recorded as warranty claims by Cloud 9. We could do this by selecting transactions or items in the account balance and obtaining the documentary evidence to support each one. However, it might be more useful to consider tracing because this would allow us to start with the documents and get evidence about how and whether the transactions are recorded in the accounts. If we find a document relevant to a warranty claim has not been recorded in the accounting system, we would be concerned that the liability is understated, or not complete. Additionally, we would like to examine transactions around the balance sheet date and make sure they are recorded in the correct accounting period. This evidence relates to the cutoff assertion and is part of considering completeness. Suzie asks Ian to set up the working papers for the tests they will perform. W&S Partners uses electronic working papers and there are examples available for Ian to use as a base for the Cloud 9 working papers. The priorities for Ian are to ensure that each test is described in sufficient detail in the audit program so the audit staff can perform the test correctly and identify any misstatements. The working papers also have to provide for comments to be included as the work is completed and reviewed by senior staff. Scan the line items on the prior-year financial statements and the current-year trial balance for Cloud 9. Using your knowledge of financial accounting, identify line items that require estimates or fair value measurements. For each item, state whether estimation uncertainty is low or high and briefly explain why.
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