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CASE 3 

 SUGGESTED ANSWERS TO DISCUSSION QUESTIONS

(1)

 Although this question can be answered by a simple reading of Exhibit 3-1, itdoes force the student to consider the contractual obligations being assumed byboth parties !ne portion of this letter that might warrant discussion is the "#Afirm$s declaration that absolute assurance is not being gi%en in regard to ma&or misstatements 'he students can be queried as to the reasons for including thisstatement n addition, the students can be ased to discuss the method bywhich the client company can draw the distinction between reasonableassurance and absolute assurance As a different line of questioning, the

students can discuss other responsibilities that could ha%e been accepted byeither party

'he engagement letter is required *esponsibilities of the "#A firm found in theengagement letter+

'o perform an audit in order to express an opinion on the client$s financialstatements,

'o mae a search for material misstatements,

'o report any internal control weanesses,

'o report any potential fee changes,

'o pro%ide the final audit report by ebruary .., ./1/

*esponsibilities of the client+

'o pay the audit fee,

'o pro%ide a year-end trial balance by 0anuary 1, ./1/, and an interimtrial balance by !ctober 1, .//2,

'o pro%ide audit documents to the "#A firm as specified

(.)

n performing analytical procedures, auditor expectations should be deri%ed froma wide %ariety of sources or cost of goods sold, Abernethy and "hapman

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should consider each of the following in arri%ing at an anticipated total+

- #ast figures f cost of goods sold has always been a certain percentageof aeside$s sales, that same relationship would be expected to continueunless other factors ha%e changed 4ad aeside, for example, switched

from cheaper products to more expensi%e ones, the relationship betweencost of goods sold and sales would possibly be affected !r, if aesidehas dropped the "ypress line in order to sell the products of some other manufacturer, a similar change might ha%e been anticipated 4owe%er,without an ad&ustment of this type, cost of goods sold as a percentage of sales would be expected to remain stable

- ndustry a%erages 5y studying trade publications, Abernethy and"hapman can determine an industry a%erage for cost of goods sold as apercentage of sales Although aeside$s results could not be expected tobe exactly the same as this a%erage, the auditors should not anticipate asignificant %ariation to occur without some adequate explanation

- "ompetitors f a%ailable, the financial statements of competingcompanies can be used to determine the normal relationship of cost of goods sold to sales Although no two companies are e%er alie, importantcomparisons such as this one should be made between similar companies

- 5udgeted figures f aeside has an annual budget, the numbersestimated by the company at the beginning of the period can be used bythe auditor in establishing an expected cost of goods sold

(3)

- aeside holds an in%entory of high technology items+ consumer electronicequipment !bsolescence of a portion of this merchandise is an e%er-present danger because of new inno%ations 'he in%entory can also beeasily damaged, a problem that is not always %isually ob%ious

- aeside distributes merchandise to retail stores A generous return policyis pro%ided6 thus, an estimate must be made of the sales returns that willbe recei%ed by the company after the audit is concluded

- aeside sells on credit throughout two states 4ence, estimatingcollections from accounts recei%able may be difficult

- aeside rents a number of its stores 'he auditor must determinewhether capitali7ation of these leases is required

- aeside has a large amount of debt 'he auditor has to ensure that alldebt is being properly reported and disclosed 'he interest expenseassociated with these liabilities must also be correctly calculated andrecogni7ed n addition, the auditors need to %erify that all loan co%enants

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are being met

- aeside is considering going public A company attempting to raisesignificant capital may be tempted to o%er-estimate assets and re%enues'he auditor needs to be particularly careful on accounts that lend

themsel%es to significant estimate

(8)

'he auditor must be satisfied that sufficient, competent e%idence has beenobtained to substantiate an opinion concerning the fair presentation of the client$sfinancial statements 'he decision as to the sufficiency of this e%idence is leftsolely to the &udgment of the auditor !nly through years of experience can theauditor de%elop the ability to mae this determination Although specificguidelines for this decision are not a%ailable, all significant problems must beresol%ed and all suspicious occurrences should be in%estigated E%idence needs

to be accumulated for each significant area of the financial statements tosubstantiate the assertions made by the client about its reported balances9here inherent ris and control ris are &udged to be high, the auditor must taesteps to reduce detection ris to an acceptable le%el n such cases, se%eralsteps are possible+ performing additional substanti%e testing, using moreexperienced staff personnel, performing testing procedures closer to the balancesheet date, or relying on more effecti%e testing procedures

 Another factor that influences the auditor$s decision is the quality of e%idencebeing accumulated :ome information may come directly to the auditors fromoutside parties, data that is usually considered to be of a higher quality thane%idence prepared by the client company ess e%idence is required if it is

 &udged by the auditor to be of a high quality

 Although each of these factors is considered, the ultimate decision still must restwith the auditor$s &udgment 'his indi%idual is taing responsibility for the auditopinion as well as accepting the riss in%ol%ed in circulating this report 'hus, theauditor must be satisfied that, based upon the wisdom gained through years of audit experience, sufficient e%idence has been obtained

(;)

 Any discussion as to the

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performed by the independent auditor urthermore, analytical procedurespro%ide circumstantial e%idence which, taen alone, is not a high quality type of e%idence

(=)

>nowledge of the consumer electronics business is &ust one aspect of "line$sexpertise that will allow him to e%aluate the fair presentation of aeside$sfinancial statements !%erall nowledge of the client company and the industry inwhich it operates should also allow the auditor to

- identify areas that may need special consideration6- assess conditions under which accounting data are produced, processed,

re%iewed, and accumulated within the organi7ation6- e%aluate the reasonableness of estimates6

- e%aluate the accuracy of management representations6- mae &udgments about the appropriateness of the accounting principlesapplied and the adequacy of disclosures

>nowledge of a business and the industry in which it operates may be obtainedfrom examining the client company$s accounting records and inquiry of the clientpersonnel 'his information can be supplemented through re%iew of the prior years$ audit documents, A"#A Accounting and Audit ?uides, industrypublications, financial statements from other companies in the same industry,college textboos, maga7ines, and other trade periodicals

:ince the students may not be familiar with the A"#A ndustry Audit ?uides, theinstructor may want to bring an example or two to class for this discussionExamples of the industries co%ered by these audit guides include+

- Airlines- inance "ompanies- n%estment "ompanies- #ro%iders of 4ealth "are :er%ices

()

 A number of the current concerns faced by auditing firms as well as the auditingprofession as a whole relate either directly or indirectly to increased pricecompetition 'hrough class discussion of this particular question, students shouldbe able to ascertain at least three of these problems+

#rice competition forces narrow time constraints on the wor of theindependent auditor n order to finish an audit engagement in a shortenough time so that a reasonable profit can be made, a danger exists that

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the auditor will 1) accept less than sufficient e%idence, .) fail to recogni7ecritical audit areas, or 3) not be able to acquire the depth of nowledgenecessary for essential audit &udgments 'hus, the argument is frequentlyraised that price competition leads to a decrease in o%erall audit quality

5ecause the initial year of an audit will often require significantly more timethan examinations of subsequent years, price competition can lead a firmto actually lose money in the first year of an engagement 'herefore, the"#A firm must wor to eep a client for se%eral years to offset this initialloss and produce a reasonable profit 'he necessity of retaining anengagement for a number of years may force the firm to be subser%ient tomanagement$s demands to a%oid being fired 'his argument has lost muchof its impact o%er the last few years as client companies ha%e establishedaudit committees comprised of outside members of the board of directorsto ensure the independence of the auditing firm

@any auditors also feel that price competition is generally detrimental to thepublic accounting profession 'he main thrust of this argument is that pricecompetition encourages companies to select their independent auditorsbased primarily on cost rather than on the quality of audit wor 'his typeof selection process would fa%or firms offering cheap rates o%er auditingfirms offering quality ser%ices

 After the students ha%e been allowed to discuss the problems associated withprice competition, the instructor may want to as whether these problemsoutweigh the ad%antages of ha%ing the auditing profession participate in the freemaret system :ince most business students in the nited :tates appear toad%ocate free marets within the country, some interesting discussion can bestimulated as to whether the auditing profession should be exempt from pricecompetition

(B)

 According to the audit ris model, planned detection ris (#C*) equalsacceptable audit ris (AA*) di%ided by the product of inherent ris (*) andcontrol ris ("*) 4olding inherent ris and acceptable audit ris constant, thereis an in%erse relationship between control ris and planned detection ris 'hus,an increase (decrease) in control ris leads to a decrease (increase) in planneddetection ris Also, as planned detection ris decreases (increases), the amountof substanti%e tests and other audit procedures increases (decreases) 'hat is, if the auditor determines the le%el of detection ris to be low, he or she wants thechance of not detecting an error too small n order to ha%e a small chance of notdetecting an error, the auditor must do more testing or example, gi%en

 AA*D1/ and *DB/, and assuming an B/ "* (high), then using the auditris model, planned detection ris is a relati%ely low 1;= F1/G(B/xB/)H, butassuming a ./ "* (low), then planned detection ris is a relati%ely high =.;

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F1/G(B/x./)H

(2)

 According to :A: 22 the assessment of the ris of fraud begins with a meeting of 

the entire team for such purpose 'his brainstorming session needs toencourage the in%ol%ement of all team members and cannot be &ust a staff training session 'he ob&ecti%e is to solicit the ideas from all team members andto sensiti7e the entire team to the particular problem areas that this clientpresents 'he process begins with such a session, but does not end thereCuring the audit the entire team needs to consider how the information beingde%eloped relates to the areas already identified, noting new areas that needattention, or ad&usting expectations on the areas already identified 'he areasidentified by fraud ris are primarily in the areas of inherent ris and control risncreased fraud ris represents an increase in inherent ris (the ris that errorsexist) or will also increase the control ris (the ris that the clientIs internal control

system will not detect the error or irregularity)

(1/)

'he registration process is not difficult @aintaining the status of a registered "#Afirm is more difficult and requires that the firm be willing to ad&ust its operationsincluding independence and staffing quality control standards to meet the higher expectations of the #"A!5 'hey may also be required to change the nature of their practice, at least as far as publicly traded clients because of the list of proscribed acti%ities Abernathy and "hapman ha%e sufficient time to becomeregistered and therefore need only be concerned about accepting aeside as aclient if there is some obstacle to their registration f aeside ass if they arecurrently registered, then the answer has to be, Jno, but we are pursingregistrationK

SUGGESTED ANSWERS TO EXERCISE

(1)

#erforming analytical procedures is one aspect of an auditing course thattraditionally generates a lot of student interest and enthusiasm !ne method of approaching this question is to ha%e the class list the potential problems thatwere disco%ered and then discuss the relati%e se%erity of each 'he studentscan be ased to consider the appropriate response that should be made by theaudit team to each of the elements listed 5y discussing the %arious possibleresponses, students are better able to recogni7e the attest function as a fluidprocess that must be flexible enough to adapt to a specific set of circumstancest should be noted to students that, in practice, se%eral years (rather than two)would be analy7ed for trends

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a) *atio analysis from .// to .//B

Ratio 2007 2008 Significance

"urrent 13; 13= Lo significant changeM Cays in%entory onhand

23 1/1 ncrease may indicate obsolete or  slow mo%ing in%entory on hand

*ecei%able collectionperiod (days)

.1 .; :light increase may indicate relaxingof credit policies andGor possibleunderstatement of allowance

Cebt-to-total-assets 88 8; Lo significant change6 howe%er, thehigh ratio indicates significant le%erageand potential sol%ency problems if additional debt is needed

'imes interest earned 3= times .B times Cecline indicates reduced ability tomeet interest payments throughoperations

#rofit @argin .2 .. Lo significant change*eturn on Assets B8 =3 Ceclining return results from a

combination of declining net income

and increasing total asset base*eturn on Equity 33. .=8 Cecline in return results from a

combination of declining net incomeand increasing equity base

"onclusion+ aeside had no significant changes in its liquidity or sol%encyle%els6 howe%er, the company appears to be experiencing a decline in itsprofitability le%el 'he audit staff should pay particular attention to re%enue-enhancing or expense-reducing areas, such as fictitious sales or improper capitali7ation of expenses to halt this downward trend

b) *atio analysis+ comparison to industry

Ratio Industry Ave. Lakeside 2008 Significance

"urrent 13 13= aeside is below the industrya%erage 'his may indicate short-termsol%ency (liquidity) problems

Cays in%entory onhand

=; 1/1 aeside is well abo%e the industrya%erage 'his may indicate short-termsol%ency problems

*ecei%ables collectionperiod

11 .; aeside is well abo%e the industrya%erage 'his may indicate short-termsol%ency problems

Cebt-to-total-assets 13 8; aeside is significantly abo%e the

industry a%erage6 this may indicatelong-term sol%ency problems'imes interest earned 3/ times .B times aeside is significantly below the

industry a%erage6 this may indicatesol%ency problems

#rofit @argin .23 .. aeside is only slightly below theindustry a%erage

*eturn on Assets =/2 =3 aeside is only slightly abo%e theindustry a%erage

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Ratio Industry Ave. Lakeside 2008 Significance

*eturn on Equity 13. .=8 aeside is significantly abo%e theindustry a%erage

"onclusion+ aeside is well below the liquidity le%el of the industry, and thecompany is in a significantly worse sol%ency le%el than the industry Auditorsshould be aware of methods to enhance the liquidity and sol%ency le%els, suchas unrecorded liabilities aeside profitability is about the same as the industrya%erage, except for return on equity, in which it is more than double that of theindustry (primarily due to the high le%el of le%erage)

c :can the financial statements and the trial balances

Procedure Results Significance

:can the income statementFLote+ instructors may want tosuggest that students prepare a

common si7e income statementH

'he company$s stores continueto report an o%erall loss which isincreasing in amount

'hese losses suggest thepossibility that the stores wille%entually be discontinued by

aeside or drastically altered insome manner:can the balance sheet FLote+instructors may want to suggestthat students prepare a commonsi7e balance sheetH

Lothing unusual

:can the cash flow statement "ash flow from operationsdeclined significantly in .//B

'he cash flow problems,combined with the sol%encyproblems may indicate a problemwith the company$s ability tocontinue as a going concern

:can the trial balance :omething appears to be wrongwith the information generated by:tore 'hree 'he sales for thatstore ha%e increased byapproximately 28 since thepre%ious year At the same time,the cost of the goods sold hasdropped from ;B; of sales(which is consistent with theother stores) to only ;/3 of sales Also, the in%entory held bythis store has risen by o%er ;/

'hese fluctuations could indicaterecording errors or an employeeattempting to inflate the earningsbeing reported for :tore 'hree'his problem is more germanethan might be encounterednormally because of the profit-sharing bonus system thatrewards employees for reportinghigh income figures

:can the trial balance :ales "ommissions for Cistrict Cin .//2 appear to be slightly outof line All of the other  commissions are approximately

; of sales, while this accountis nearly of the applicablesales figure

 Although not necessarily amaterial figure, the potential error should be in%estigated so thataeside can mae the

appropriate corrections if needed

:can the trial balance *ent expense on %ehicles andequipment has decreased in.//2

:uch a decrease often ser%es toindicate that the company hasacquired new property

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Procedure Results Significance

:can the trial balance 'he *epairs and @aintenanceaccount has increased by o%er 1;/ since .//B

'his significant increment mayindicate a posting error that willrequire correction "on%ersely,actual repairs may ha%e beenmade by aeside n that

situation, the auditor needs to%erify that all capitali7ed costsha%e been segregated andproperly accounted for within thecompany records

:can the trial balance 'he

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Procedure Results Significance

:can the trial balance 'he equipment account showsan increase from the pre%iousyear

f the company has acquiredadditional equipment during theyear, the auditor needs to %erifythat capitali7ation anddepreciation were gi%en proper 

treatment:can the trial balance 'he estimated bonus expensehas increased

'hat increase is probably due tothe profit-sharing plan ha%ingbeen in effect for all nine monthsof .//2, but the increase shouldbe in%estigated

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CASE 4 

 SUGGESTED ANSWERS TO DISCUSSION QUESTIONS

(1)

Statement on Auditing Standards 78 ,

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of this should also be a%ailable for inspection *ogers seems to understandthat better systems are needed but has in%ested neither the time nor themoney to de%elop such policies and procedures 'his lac of support mayindicate that the management is not serious about establishing adequatecontrol within the company 5ecause of the company$s growth, impro%ements

in the future may be forthcoming, but at the present time the managementappears (from what has been said) to ha%e let the company outgrow itscontrol policies and procedures

• !rgani7ational structure f aeside has a chart presenting the %ariousofficials and their &obs, the auditors can assess whether control policies wouldbe easy to circum%ent Although Exhibit 3-. shows the company di%ided intoclearly distinct areas, the Assistant to the #resident does seem to be in aposition to operate without proper control super%ision n addition, the#resident seems to hold a significant amount of power in this company, with%ery little control ha%ing been established

•  Assignment of authority and responsibility 'his factor includes how authority

and responsibility for operating acti%ities are assigned and how reportingrelationships and authori7ation hierarchies are established :ince aeside isnot a huge organi7ation, *ogers tends to inter%ene in many of the operatingacti%ities 4owe%er, as aeside continues to grow, this may become a ma&or concern to the auditors

• 4uman resource policies and practices 'hese policies and practices relateto hiring, orientation, training, e%aluating, counseling, promoting,compensating, and remedial actions 'he auditors should inquire andobser%e aeside$s policies, including any standards for hiring the mostqualified indi%iduals, training, and performance appraisals

*is assessment is the second component of internal control 'he auditors willdetermine and e%aluate how aeside identifies, analy7es, and manages rissrele%ant to the preparation of the financial statements 'he auditors will want topay particular attention to se%eral changes occurring at aeside and how themanagement deals with these changes 'hese changes include the expansionof the company$s stores, the concentration on the "ypress product line, and therelati%ely new bonus system

Lext, the auditors will loo at the actual control acti%ities in place to see thatspecific control ob&ecti%es are being met 9ithin this testing, the auditors shouldloo at the following as goals of the company$s internal control+

• #erformance re%iews ndependent checs on both performance and proper %aluation of recorded amounts should be conducted 'he auditors will wantto %erify that reconciliations and other comparisons are made at important

 &unctures in the %arious systems

• nformation processing 'he auditors will want to %erify that aeside hasboth general controls and application controls 'hey will especially %erify thatproper authori7ation of transactions exist 'he auditors can examine the

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documentation produced for a %ariety of transactions to ensure that each wasauthori7ed by the appropriate indi%idual within the company urther, theauditors will %erify that aeside properly designs and uses adequatedocuments 5y waling through the %arious systems, the auditors candetermine if adequate documentation is required at each point and if those

documents are preprinted and prenumbered to ensure that the proper information is gathered and retained

• #hysical controls 5y physical obser%ation of the warehouse, the stores, andother assets, the auditor can determine if aeside has adequate safeguardso%er its assets

• :egregation of duties 5y looing at the organi7ation of a company, theauditors can determine if the necessary separation of responsibilities is inplace to facilitate adequate control or example, since aeside has a chartshowing the %arious officials and their &obs, the auditors can assess whether atrue system of checs and balances has been established Although Exhibit8-1 shows the company di%ided into clearly distinct areas, information in

Exhibits 8-3 and 8-8 indicates, for example, that the Assistant to the #residenthas a great many responsibilities, some of which raise the possibility of control problems

Lext, the auditors will ha%e to examine any information that helps toascertain the efficiency of the company$s information and communication systemn the case presented, little data is pro%ided to e%aluate the information systemexcept that *ogers feels the systems are outdated for a company of this si7e'herefore, the auditors should assess the design of the system and the peoplewho operate the accounting system or example, the auditors might want toselect a number of transactions and trace them from the point of origination

through the accounting system to see that the recording process is performedproperly 'his testing is designed to determine if the system is capable of performing the following tass in an effecti%e manner+

• dentify and record all %alid transactions

• Cescribe on a timely basis the transactions in sufficient detail to permitproper classification

• @easure the %alue of transactions

• Cetermine the time period in which transactions occurred

• #resent the transactions appropriately in the financial statements

'he final component of internal control is monitoring @onitoring is the processthat assesses the quality of internal control performance o%er time aesidedoes not appear to ha%e an extensi%e monitoring system, such as an internalaudit function 9ithout an internal auditor, no independent party within thecompany ser%es to monitor and o%ersee the company$s internal controls 'heinternal audit function can be extremely important in a company, especially wherestores and sales representati%es operate at a geographic distance from the homeoffice

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(.)

 An e%aluation of the o%erall control en%ironment is not possible from Exhibits 8-3and 8-8 4owe%er, the auditors can see that responsibilities ha%e been

de%eloped and di%ided within the company Each indi%idual or departmentseems to ha%e a well-defined &ob within the two systems 'hus, some e%idenceexists to indicate that management is aware of the importance of internal control:uch systems simply cannot be created without adequate support by thecompany$s management

n terms of ris assessment, aeside does not appear (from "ases . through 8)to ha%e a formal method of systematically assessing riss (9eaness) 'heauditors should recommend a system of identifying riss, their significance, their lielihood of occurrence, and how they might be managed 'his is especially truewith aeside$s growth of stores, concentration of suppliers ("ypress only), and

installation of a bonus system

n addressing control acti%ities, the auditors can see, as indicated in the answer to Exercise (.), that the company seems to use adequate documents andauthori7ation procedures (:trength) n addition, although the Assistant to the#resident has many different duties (9eaness), the company seems to ha%emade an attempt to segregate responsibilities in an appropriate manner

5oth of the information systems that are presented also seem well designedespecially for a small but growing company 4owe%er, the company still usessome manual systems that can be slow and offer the opportunity for manyhuman mistaes to be made (9eaness) 'he answer to Exercise (.) goes intomore detail concerning control strengths and weanesses in this area

'he monitoring acti%ities seem to be somewhat lax 4owe%er, with aeside stillbeing relati%ely small, *ogers$ o%ersight somewhat compensates for the lac of monitoring 9ith the growth of aeside, this is becoming less true

(3)

 After a preliminary assessment of control ris, the auditors ha%e three possibleactions+

a) 5ecause of potential strengths found within internal control, the auditor may feel that control ris can be assessed at below the maximum le%elf so, the auditors must then be able to identify specific controlprocedures that will liely pre%ent or detect material misstatements'he auditors must perform tests of these controls to e%aluate their effecti%eness to determine if a reduction in the assessment of controlris is &ustified

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b) 5ecause of weanesses found within internal control, the control rismay ha%e to be assessed at the maximum le%el 'his e%aluation willprobably force the auditor to reduce detection ris by such means asperforming additional substanti%e testing, using more experienced staff personnel, carrying out procedures closer to the balance sheet data, or 

relying on more effecti%e testing proceduresc) Although potential strengths may be identified within internal control,the auditors may still opt to assess control ris at the maximum le%el'his decision would be made if additional substanti%e tests appear tobe easier and cheaper to mae than performing the necessary tests of specific control policies and procedures

:arbanes !xley requires expanded internal control auditing because the@anagement Assessment of nternal "ontrol needs to be separately audited by aregistered "#A firm, regardless of its effect on the audit of the financialstatements

(8)

'he auditor will normally begin %erifying control policies and procedures bymaing inquiries of the employees as to the performance of their duties 'heanswers pro%ided indicate to the auditor whether each indi%idual understands theduties that ha%e been assigned as well as their purpose A proper nowledge of a &ob usually means that employees are more liely to comply with the systemand fulfill their responsibilities n addition, the auditor is often able to obser%ethe wor of these indi%iduals during the audit fieldwor rom theseobser%ations, an e%aluation can also be made as to the quality of the wor beingperformed

 Although inquiry and obser%ation are important steps in testing controlprocedures, the auditor needs to obtain more substantial e%idence A well-de%ised system of controls should require each employee to lea%e physical proof whene%er a tas has been completed+ a ticmar must be used, the person mustsign a form, a code number must be entered, etc 'hus, the auditor should beable to trace this physical e%idence through an entire system noting whether thepolicies and procedures are operating efficiently or important measures thatmight reduce the assessment of control ris, the auditor may want to %erifyeffecti%eness by examining a large number of documents requently, anauditor e%aluates control procedures within an entire system through a

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'his new information pro%ides an increased ris on the moti%ationGincenti%e for fraud to occur, in terms of the fraud triangle t does not mean that fraud hasoccurred and does not affect the opportunity or rationali7ation necessary for fraud to occur 'he auditor faced with this information should document thediscussion, and mae sure the audit team is aware of the con%ersation t is not

the &ob of the staff auditor to initiate an in%estigation at this early point in theaudit

SUGGESTED ANSWERS TO EXERCISES

(1)

a)

'he following page presents a flowchart for the re%enue recognition system

Lumerous acceptable %ariations of this flowchart may be created 'his problemis not intended to suggest a rigid format for the flowchart but rather to gi%e thestudent experience in constructing and reading one 9hen e%aluating astudent$s wor, se%eral questions should be ased+

• Coes the flowchart truly mirror the systemP

• s the flowchart understandableP

• s the flowchart o%erly complex, containing too many symbols andexplanationsP

!ne technique that might be used with this assignment is to di%ide the class into

teams of three or four students each 'hen select a flowchart at random fromeach team and as the team members to critique it 'his process, which can bedone inside or outside of class, will compel the students to %iew the flowchart asan instrument intended to communicate the design of a system

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(1)

b)

Revenue and Cash Receipts Cycle

Cistributorship "ash *eceipts

"hecs arri%e from customers along with the copy of the in%oice slip 'he checs arerecei%ed by the 'reasurer$s !ffice where each chec is immediately stamped

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'he checs and the ban deposit slips are taen by the 'reasurer$s !ffice to the ban'he second copy of the ban deposit slip is %alidated and returned to the 'reasurer$s!ffice where it is placed in a permanent file by date along with the fourth copy of thecash remittance list 'he ban returns the first copy of the %alidated ban deposit slip

directly to the Assistant to the #resident where it is placed in a temporary file by date

'he in%oice slips and the first three copies of the cash remittance list are sent by the'reasurer$s !ffice to the :ales Ci%ision 'he second copy of the sales in%oice and thefourth copy of the bill of lading had originally been filed by that department when thegoods were shipped Each in%oice slip is matched with the corresponding sales in%oiceand bill of lading 'he appropriate discount is calculated and recorded on each copy of the cash remittance list Each in%oice slip is then attached to the appropriate salesin%oice and bill of lading and placed in a permanent file by in%oice number 'he thirdcopy of the cash remittance list is placed in a permanent file by date

'he second copy of the cash remittance list is sent to the "ontroller$s !ffice where thecash receipts and the sales discounts are refooted rom this information, a daily &ournal entry is made in the cash receipts &ournal :ubsequently, the second copy of thecash remittance list is filed permanently by date

'he sales di%ision sends the first copy of the cash remittance list to the Assistant to the#resident 4e compares the ban deposit slip that he has recei%ed from the banagainst the total of the cash remittance list for that same date with a spot chec of indi%idual items 'he list of collections is then used to update the Accounts *ecei%able:ubsidiary edger before being placed in a temporary file by date pon receipt of themonthly ban statement, the cash remittance lists and the %alidated ban deposits areremo%ed and used to prepare the monthly ban reconciliation 'he reconciliation, theban statement, the %alidated deposit slips, and the cash remittance lists are thenplaced in a permanent file by date

(.)

'he student is ased to complete Exhibit 8-;, a preliminary analysis of the controlprocedures in the cash receipts system

Cocuments ound in 'his :ystem+

• n%oice :lips (one copy per payment) - prepared internally but returneddirectly by outside party t is the bottom portion of the number 8 copy of thesales in%oice

• Qalidated 5an Ceposit :lips (two copies per day) - prepared internally but%alidated by outside ban and mailed directly to the Assistant to the #resident

• "ash *emittance ist (four copies per day) - prepared internally

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• :ales n%oice (second copy) - prepared internally

• 5ill of ading (only fourth copy is a part of this system) - prepared internally,two copies sent to customer

• 5an :tatement (one copy per month) - prepared externally

• 5an *econciliation (one copy per month) - prepared internally

 Answers to :pecific Ouestions on the Analysis orm, Exhibit 8-;+

1 #renumbering of forms - Exhibits 8-3 and 8-8 indicate that the sales in%oices(including the sales in%oice slip) and the bills of lading are prenumbered Lone of theother documents shown in this system would normally be pre-numbered

. Authority for completing each document - Exhibit 8-8 indicates that all documentswithin this system are clearly assigned to a specific department

3 *e%iew of documents - a number of the documents are re%iewed prior to thebeginning of this system such as the sales in%oice and the bill of lading 'he%alidated ban deposit slips are re%iewed by the Assistant to the #resident while thecash remittance list is re%iewed by the "ontroller$s !ffice 'he ban statement isre%iewed by the Assistant to the #resident inally, the ban reconciliation isprepared by the Assistant to the #resident but does not appear to be re%iewed 'hefailure to re%iew this document would constitute an internal control weaness

8 #rocedures for completing each document and for re%iewing each document - allinstructions on the worsheet appear to be reasonably complete, although any set of written instructions could be put into more detail !ne problem does exist+ none of the instructions gi%e guidance when discrepancies are found or example,according to the flowchart, a ma&or problem exists in the sales di%ision at point 5

 According to the explanation, no instructions exist when the collection is less thanthe amount of the in%oice *ather than rebilling the additional amount, the in%oiceinformation is placed in a permanent file Although this rebilling process may behandled through the Assistant to the #resident or some other party, this procedure isnot indicated by the flowchart

; :eparation of record-eeping function and custody function--the 'reasurer$s !fficewhich ser%es the custodial function for the cash funds also records the initial receiptof cash 'hat type of organi7ation is typical of small companies but does offer theopportunity for theft or cash manipulation n addition, the Assistant to the #residentmaintains the Accounts *ecei%able :ubsidiary edger and reconciles the banstatements Although not specifically a control weaness because this indi%idualdoes not ha%e access to the cash account, these combined responsibilities do offer the opportunity for successful theft through collusion

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= Qerification of mathematical computations - all computations are independently%erified except for the cash discounts 'he flowchart is unclear as to the procedureto be applied when the sales di%ision calculation does not agree with the customer$spayment

mmediate record-eeping--the record-eeping function appears to beginimmediately upon the receipt of the cash

B 'ransactions authori7ed -- all transactions seemed to be appropriately authori7ed

2 !ther control procedures that might be mentioned by the students+

- checs are immediately stamped

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• Establish a separate billing department to prepare the sales in%oices and ensuretheir accuracy

• 9hen goods are shipped, a signed receipt should be recei%ed as proof of thetransfer

SUGGESTED ANSWERS TO SARBANES OX!E" QUESTIONS

(1)

'he board of directors needs to be organi7ed so that it can fulfill its purpose 'heprimary impro%ement is to increase its independence and operation 'he #resident of the "orporation should need be the "hairman of the 5oard of Cirectors and thereshould be sufficient independent board members to manage create a truly independent

audit committee nder :arbanes-!xley the audit committee is the primary interfacewith the registered "#A firm

!ther structural changes may in%ol%e management and their duties nlie thepre%ious non-public audits, %iolations of segregation of duties, or lac of audit trail mighttrigger a significant deficiency or material weaness notification 'herefore, while inthe past expanded substanti%e testing was possible in the e%ent of internal controldeficiencies, :A: 11. requires the communication of all such problems in the contextof the audit or the management report on the internal control system

(.)

'he audit or internal control is still rele%ant in the determination of the audit ris modeland the determination of detection ris relati%e to the audit of the financial statements,howe%er :arbanes-!xley requires that public company management report separatelyon the internal control system o%er which they are responsible urther, the registered"#A firm must audit that management report

'he result is that Abernathy and "hapman must e%aluate the effecti%eness, and testthe effecti%eness of the internal control system regardless of its impact on the financialstatement audit n most cases this would in%ol%e increased auditing and thereforehigher fees