Assignemnt Questions
Rename your file with your first name, last name, and "HW3." Reminder - I do not allow direct quotes in student's work in this class. You need to paraphrase and cite your outside sources. "Outside sources" do not include the text and so you don't need to cite it. Type your answers into this document, rename it, and upload it to the Homework assignment for Week 3.
1) The following questions are based on the same scenario I used for question 3 in your week 1 homework. That question addressed violations of the Code of Conduct. I want to apply the same scenario to legal liability issues raised in Chapter 3. Here is a copy of the scenario:
John Smith owns a small, privately held firm. He hired you to audit its financial statements. You are a licensed CPA with 10 years of audit experience. He told you that the audit was to be completed in time to submit audited financial statements to a bank as part of a loan application. You immediately accepted the engagement and agreed to provide an auditor's report within three weeks. John agreed to pay you a fixed fee plus a bonus if the loan was granted. You hired two accounting students to conduct the audit and spent several hours telling them exactly what to do. You told the students not to spend time reviewing John's internal controls but instead to concentrate on proving the mathematical accuracy of the ledger accounts and on summarizing the data in the accounting records that support John's financial statements. The students followed your instructions and, after two weeks, gave you the financial statements, which did not include footnotes. You studied the statements and prepared an unqualified auditor's report. The report, however, did not refer to generally accepted accounting principles or to the fact that John had changed to the accounting standard for capitalized interest.
Hint - This question is about legal liability. The connection to the Code is that the Code sets standards that, if violated, might determine the level of negligence of the auditor. However, that is only one issue in determining the auditor's level of legal liability. For both these questions, you need to address duty to perform, level of negligence, causal connection, and level of liability (e.g., proportionate, joint and several, or some other measure). These issues are common to what plaintiffs need to prove and what defenses an auditor can mount. The auditor has one additional defense for client lawsuits - contributory negligence. Make sure you answers are complete in that the address all these issues for each question. Also, since there are areas where jurisdictions differ, you also need mention if the issue would depend on which jurisdiction the case was in and how. As always, make sure your answer refers to the specifics of the scenario.
Here are the new questions:
a) After the audit was completed, John used the financial statements to secure a loan from a bank. Within a year, John was unable to make payments on the loan. In the process of investigating the reason why, the bank determined that the financial statements were material misstated. John, however, was near bankruptcy and could not pay off the loan. The bank sued you for the balance due on the loan. Given the violations I discussed in my solution to the week 1 homework, do you think the bank will prevail? You answer should provide an analysis of the legal issues involved to include the auditor's duty to perform, what level of negligence is involved, what you level of liability would be (proportionate or joint and several), and a clear statement of why you do or don't think the bank would prevail to include how effective your defenses might be.
b) Now assume that instead of applying for a bank loan, you knew that John was planning to use the financial statements as part of a prospectus for an initial public stock offering (IPO), i.e., John's firm sold stock directly to the public. John did and a potential investor read the prospectus and did a comprehensive analysis of the financial statements as a basis for his decision to buy a significant portion of stock in the new corporation. A year later, the firm was doing so badly that its stock price was down to 10% of what it was after the IPO. The investor sued both the John's new corporation and you for his investment losses. During the trial, the investor was able to show that the financial statements were materially misstated in key areas that affect firm value. Given the violations I discussed in my solution to the week 1 homework, do you think the investor will prevail? You answer should provide an analysis of the legal issues involved to include what bases (cover all that apply) the investor would have to sue, what your level of liability would be (proportionate or joint and several), and a clear statement of why or why not you think the investor would prevail to include how effective your defenses might be.
2) The text lists 18 audit objectives - 8 for balances, 6 for transactions, and 4 for presentation and disclosure. For each of the following audit procedures, list the category and specific objective each tests and provide an explanation of why you selected the category and object. Some of these audit procedures test more than one objective and I want you to list and explain all that apply. Assume all procedures were executed on the audit for a fiscal year ending December 31, 2015. Fill in the following table to answer the question. I have filled in the first item as an example.
Hint - This is a complex, technical question designed to reinforce your understanding of audit objectives. We will be referring to audit objectives frequently for the balance of the term and so you need to learn them. Your first step is to determine whether the procedure tests an attribute of an individual transaction, an item in an account balance, or a disclosure issue. Then you can move on to selecting the correct objective for that category. I have included some additional discussion of objectives at the end of the assignment where I provide some discussion that focuses on common errors students make in applying audit objectives to cases. Another common problem with this question is reading things into the procedure given. You need to be precise in interpreting the description of the test and not add procedures to it that are not explicitly mentioned in the test no matter how logical the assumption might be.
Audit Procedure Category Objective Explanation
1. Examine sales invoices for the last five sales transactions recorded in the sales journal in 2015 and examine shipping documents to determine they are recorded in the correct period. Balance
Transaction Cutoff
Timing The cutoff object is to determine that transactions recorded near the end of an accounting period are included in the correct period. The text is unclear here because it states that balance-related objectives are applied to balance sheet accounts and sales is an income statement account. However, I believe the procedure still fits the cutoff objective.
This procedure would also test whether the transaction was recorded on the correct date. Since transactions that are recorded at the end of the year also are recorded during the year, this objective also would apply.
2. Add all customer balances in the accounts receivable trail balance and agree the amount to the general ledger.
3. Determine whether long-term receivables and related party receivables are reported separately in the financial statements.
4. For a sample of shipping documents selected from shipping records, trace each shipping document to a transaction recorded in the sales journal.
Audit Procedure Category Objective Explanation
5. Determine whether all risks related to accounts receivable are adequately disclosed.
6. Examine a sample of duplicate sales invoices to determine whether each one has a shipping document attached.
7. Inquire of the client whether any accounts receivable balances have been pledged as collateral on long- term debt and determine whether all required information is included in the footnote description for long-term debt.
8. Send letters to a sample of accounts receivable customers to verify whether they have an outstanding balance at December 31, 2015 Audit Procedure Category Objective Explanation
9. For a sample of sales transactions selected from the sales journal, verify that the amount of the transaction has been recorded in the correct customer account in the accounts receivable ledger.
10. Foot the sales journal for the month of July and trace posting to the general ledger.
11. For a sample of customer accounts receivable balances at December 31, 2015, examine subsequent cash receipts in January 2015 to determine whether the customer paid the balance due.
12. Discuss with the credit department personnel the likelihood of collection of all accounts as of December 31, 2015 with a balance greater than $100,000 and greater than 90 days old.
3) Professional skepticism is a critical issue in auditing and also an area where PCAOB inspections found that big four firms are deficient.
Hint: Threats to professional skepticism come from a variety of sources. A threat to professional skepticism is a feature of either the auditor or the audit environment that creates an auditor bias towards accepting whatever client's management says without adequate confirmation. Many threats are subconscious and hard for auditors to detect and prevent. You can refer to Table 6-1 for examples of these. The purpose of this question is to reinforce your knowledge of professional skepticism and develop an understanding of how to protect it on an audit.
a) Define in your own words what professional skepticism means.
b) We have discussed the issue of whether auditors can be independent of their client when the client is paying their fees. This arrangement also adds to threats to professional skepticism on audits. Discuss three threats to professional skepticism mentioned in the chapter and how the auditor might mitigate each threat. Also discuss whether the treat is increased because the auditor is being paid by the client.
Summary of Audit Objective Definitions
I am providing this summary to help clarify the definitions of the audit objectives covered in the text. These objectives are very precisely defined and applied. The following cover some of the major misunderstandings that students have exhibited in the past when applying audit objectives.
• Transaction objectives only apply to tests of individual transactions and provide no support for balance objectives even though balances normally result from transactions. They are designed to insure that original transactions are recorded properly in books of original entry (i.e., journals) and do not apply to balances or disclosure issues. For example, posting and summarization only applies to insuring the proper recording of transactions in journals and not to whether those postings were correctly carried forward to ledgers and the financial statements.
• Balance objectives only apply to tests of balances and items in balances. Items in balances are things like the individual accounts receivable balances that make up the overall accounts receivable balance or individual inventory items that make up the inventory balance. While balances result from transactions, tests of transactions do not cover balance objectives only transaction objectives.
• Presentation and disclosure objectives only apply to financial statements; mainly footnote disclosures. They apply to the basic financial statements only to the point that those statements include the proper categories like segregating current assets from fixed assets. However, they do not cover whether balances were categorized properly in the first place. That is the classification balance objective.
• Detail tie-in tests the transfer of information from the journals to the general ledger and financial statements. Detail tie in cannot provide evidence that the original transactions were recorded properly. Those issues are covered by transaction objectives.
• Completeness as a transaction or balance objective applies to an entire transaction or items in a balance and not whether the original recording of the transaction contained all the necessary information. Insuring that all necessary information is captured is accuracy.
• Completeness as a transaction or balance objective can only be tested if you start from a source document and trace it to the accounting records. Any test that starts by selecting items from the accounting records cannot test whether those records are complete in the first place.
• Existence/occurrence as a transaction or balance objective can only be tested if you start from the accounting records and vouch the item or transaction to source documents since these objects test whether items that have been recorded should have been recorded. When applied to transactions of balances, it also only applies to complete transactions or items.
• Sales and expense accounts do not have items in them and are only sums of transactions. This creates a gray area when applying balance objectives to sales. As my answers state, I tend to accept balance objectives for tests of sales and expenses because of this ambiguity, but it isn't standard practice.