Deck 4: Quality and Standards of Assurance Engagements

Question 1

What are errors and fraud

Answer 1

Financial statement:
The financial statement of a company is the record of past year activities. There are many financial statements like cash flow statement, balance sheet, income statement, profit and loss account, etc.
Audit:
The audit is the process of checking the financial statements of a company `to ensure that it is 100% authentic and free from any kind of bias or fraud.
Functions of audit:
• To verify the financial statements
• To give an opinion on the financial statement after the audit
• To inform the management of the company about the fraud, if any.
Fraud:
Fraud means the willingly wrong representation of something, to hide some material facts from outsiders or mislead them about some facts.
Example: Misrepresentation of cash balance in the balance sheet, Misrepresentation of profit in the income statement to mislead the shareholders, Using wrong accounting standards, etc.
Error:
An error means mistakes. Error in auditing means that representation of wrong facts about the company by mistake. This happens when the accountant used the wrong accounting standard or assumption in the recording process of accounting transactions.
Example: Recording fixed assets on market value, recording inventory on acquiring value, etc.

Question 2

What are positive confirmations

Answer 2

Accounts receivable:
It is the amount due to customers on the sale of goods or services but not received yet (Credit sales).
Bad debt:
It the amount in accounts receivable that the company is not able to collect.
Allowance for doubtful debt:
It an allowance maintain by the company against the probable loss of bad debt.
Positive confirmation:
The auditor sends a confirmation letter to a sample bunch of accounts receivable of the company. The auditor sends this letter to confirm the amount it owes at the year-end.
Positive confirmation means that accounts receivable is expected to reply whether the balance is correct or incorrect. The customer needs to reply about the amount it owes.

Question 3

Analyzing the results from analytical procedures. The auditor performs preliminary analytical procedures to plan the audit. Results from the analytical procedures for the revenue process follow. In addition to the below questions, for each result, indicate how the auditor adjusts the audit program to gather evidence regarding the potential misstatements in the financial statements that could be suggested by the results from the analytical procedures.
a. The auditor compares the accounts receivable balance with the previous year's balance and finds that it has decreased. What questions should the auditor ask What misstatement could the auditor anticipate in the financial statements
b. The auditor calculates the accounts receivable turnover for the current year and the previous year and finds that it decreased for the current year. What questions should the auditor ask What misstatement could the auditor anticipate in the financial statements
c. The auditor compares the balance in the Allowance for Doubtful Accounts for the current year and the previous year and finds that it has declined in the current year. What questions should the auditor ask What misstatement could the auditor anticipate in the financial statements
d. The auditor compares the balance in the Sales Returns account for the current and previous year and finds that it has increased. What questions should the auditor ask What misstatement could the auditor anticipate in the financial statements

Answer 3

Financial statement:
The financial statement of a company is the record of past year activities. There are many financial statements like cash flow statement, balance sheet, income statement, profit and loss account, etc.
Accounts receivable:
It is the amount due to customers on the sale of goods or services but not received yet (Credit sales).
Bad debt:
It the amount in accounts receivable that the company is not able to collect.
Allowance for doubtful debt:
It an allowance maintain by the company against the probable loss of bad debt.
Sales return:
It is a part of the sold goods that returned by the buyer. There are many reasons to do so. Following are some reasons for sales return:
• The quality of the received product is not the same as expected,
• There is some defect in the product,
• The buyer wants some changes in the product, like another color or size, etc.
a.
Questions the auditor will ask:
• Why the balance of account receivable decreased
• Is there is any change in the balance of bad debt expense or allowance for doubtful debt
• Is the company now conducting sales on a cash basis
Misstatement in the financial statement could be anticipated by the auditor:
• The company overstates its bad debt expenses to reduce the net profit and tax burden.
• The company overstated its account receivable last year to show high profit and to mislead the stakeholders of the company.
b.
Questions the auditor will ask:
• Why the balance decreased
• Is there is any change in bad debt expense or allowance for doubtful debt
• If the accounts receivable turnover decreased because of a decrease in the net sales then why the net sales decreased
Misstatement in the financial statement could be anticipated by the auditor:
• The company understates its net sales to reduce the net profit and tax burden.
• The company overstated its account receivable to show high profit and to mislead the stakeholders of the company.
c.
Questions the auditor will ask:
• Why the balance decreased
• Is there is any change in the balance of bad debt expenses
• Is there is any change in the company policy regarding allowance for doubtful debts
Misstatement in the financial statement could be anticipated by the auditor:
• The company understates its bad debt expenses to increase the profit this misleads the stakeholders of the company.
d.
Questions the auditor will ask:
• Why the balance increased
• Is there any change in the quality of the products
Misstatement in the financial statement could be anticipated by the auditor:
• The company overstates its sales return to reduce the net profit and tax burden.

Question 4

Bristol-Myers Squibb
Bristol-Myers produces and distributes medicines and health care products. In 2002, the company experienced one of its worst years in its 100-year history. Three of its top- selling drugs lost patent protection, and sales dramatically declined due to their generic substitutes produced by other companies. The share price of Bristol-Myers stock declined by nearly two-thirds, from about $75 in September 1999 to $25 in September 2002.
In April 2002, the company disclosed that it had used sales incentives to encourage wholesalers to buy more drugs and health care products than necessary. In July 2002, Bristol-Myers was notified that the SEC was opening a formal inquiry to determine whether the company had inflated revenue by as much as $1 billion in 2001 through the use of sales incentives. The company restated its earnings to remove the amount of excessive sales. a. Evaluate Bristol-Myers Squibb's revenue recognition policy. Why did the SEC object to it
b. If you had been Bristol-Myers Squibb's auditor, what questions would you have asked the client about the sales incentives How would you modify the audit risk model to account for them
c. Identify an internal control procedure that could have prevented the revenue misstatement that occurred.

Question 5

What do the auditing standards say about the auditor's presumption relating to the possibility of revenue fraud in the financial statements

Question 6

What are negative confirmations

Question 7

Performing substantive tests of transactions. The auditor performs substantive tests of transactions for sales revenue to determine that the sales revenue reported on the income statements is not materially misstated. For each procedure performed in the audit of the revenue process in the following list, indicate the management assertion that is tested during the audit procedure.
a. The auditor selects a sample of shipping documents and traces the documents to the sales invoices.
b. The auditor selects a sample of sales invoices and traces the documents to the shipping notices.
c. The auditor selects a sample of recorded sales from the sales journal and determines whether credit was approved for the sale.
d. The auditor selects a sample of recorded sales from the sales journal and vouches the prices on the sales invoices to an approved price list.
e. The auditor selects a sample of recorded sales from the sales journal and determines whether the amount billed equals the amount shipped.

Question 8

Time Warner
In July 2002, the SEC reviewed revenue transactions by the America Online (AOL) unit of Time Warner to determine whether the company used "unconventional" ad deals to increase revenue to meet expectations of Wall Street analysts. An article appearing in The Washington Post on July 18, 2002, alleged that AOL had manipulated its ad revenue when it was waiting for approval of its merger with Time Warner, which owns CNN cable news, HBO, Warner Brothers, and Time magazine. The new company known as AOL Time Warner was created on January 11, 2001. As a result of the merger, American Online and Time Warner each became a wholly owned subsidiary of AOL Time Warner. In 2003, the name of the company was changed to Time Warner.
A Washington Post reporter reviewed a number of AOL's revenue transactions from July 2000 to March 2002. Without the unconventional deals described in the article, quarterly earnings per share would not have met analysts' forecasts for two quarters in 2000. According to the Post, during this time, "Investors punished companies whose earnings were off by even a cent." 12 AOL employees interviewed for the article said that the company was under tremendous pressure to meet its revenue targets due to the $112 billion merger pending with Time Warner. Ad revenue became very important to the Internet division as competition from other Internet service providers hurt AOL's monthly subscriber fees. Unfortunately, the contracts for the advertising services were with dot-com companies, which also were suffering from declining sales and many of which did not have the cash to pay for the ads they had agreed to buy from AOL.
The unconventional deals include a variety of methods to increase revenue. AOL's business affairs department contacted companies that were unable to pay for their long-term ad contracts and renegotiated the terms, requiring the companies to make one-time payments to renegotiate or get out of the contracts. AOL recognized all revenue for the renegotiated contracts immediately as ad revenue. Earlier, in September 2000, AOL had used another unconventional ad deal to generate revenue. It recorded ad revenue based on a lawsuit settlement. AOL purchased Movie Fone in 1999, which had won a $26.8 million settlement from Wembley PLC, a British entertainment company, but had not yet collected the claim. Instead of collecting the settlement, AOL offered Wembley the opportunity to buy $23.8 million in online ads (a good deal for Wembley because it saved $3 million). Because AOL was short of advertising revenue for the quarter ending on September 30, 2000, it had to create the Wembley ads and air them before the end of the quarter. Wembley considered the proposal for some time, but AOL could not wait for its decision because this revenue had to be booked in September 2000. Without Wembley's knowledge, AOL took artwork from Wembley's British website (24 Dogs.com, an online greyhound racing website) and created banner and button ads using the artwork and started running them on various AOL sites. Within an hour of posting the greyhound ads, the Wembley website crashed, due to the traffic generated by the AOL ads.
Despite AOL's action, Wembley reached an ad agreement with it that generated $16.4 million in ad revenue for the September 30, 2000, quarter, effectively taking a nonoperating gain on a lawsuit settlement and converting it to a more valuable operating revenue number.
a. Evaluate the revenue recognition policies used by AOL. Are the policies consistent with the applicable financial reporting framework
b. How would the auditor discover the misstatements in the financial statements
c. Describe how the audit risk model could be used in the AOL audit to consider the pending acquisition and the decline in sales revenue.

Question 9

Describe two ways that a client could misstate revenue. Which of these two methods could be harder for the auditor to catch

Question 10

Explain how the auditor uses accounts receivable confirmations to gather evidence regarding the account balance.

Question 11

Internal control procedures. The auditor has documented the following internal control procedures used by the client. For each procedure, explain the test you would perform to determine whether the control was working and the assertion that you would be testing.
a. The warehouse clerk is required to have an approved sales order before goods are released from the warehouse to be sent to the shipping department.
b. Shipping clerks compare goods received from the warehouse with approved sales orders and initial the sales order indicating their agreement.
c. The accounting department compares the sales invoice price with the master price file and initials the sales invoice indicating agreement.
d. Control amounts posted to the accounts receivable ledger are compared with control totals of invoices. A daily reconciliation report is prepared by the accounting clerk and initialed at the end of each day.
e. Sales invoices are compared with shipping documents and approved customer orders before invoices are mailed. The accounts receivable clerk initials the shipping document indicating the agreement.
f. Goods returned for credit are approved by the supervisor of the sales department. The credit memo is initialed by the supervisor indicating approval.
g. The total cash payments posted to the accounts receivable ledger from remittance advices is compared to the bank deposit slip by the treasury department. The clerk in the treasury department indicates that the two agree by initialing the reconciliation report.

Question 12

Xerox Corporation
Xerox Corporation, a company based in Stamford, Connecticut, is involved in the production and management of documents in the form of copy machines, fax machines, and commercial printing equipment. In the late 1990s, competition had a negative impact on Xerox sales (among others things, computer printers were replacing copiers to generate print copies). A poorly organized business restructuring also caused administrative problems and billing and sales slowdowns for Xerox. The accounting department at Xerox began being pressured to compensate for the poor sales results with accounting measures. Xerox "assigned accountants numerical goals to produce profits through accounting actions. It just became standard operating procedure that, you know, you look to the accountants to find income."
In April 2002, Xerox settled a case with the SEC, agreeing to pay a $10 million fine and restating its results back to 1997. The restatement showed that it had recorded $6.4 billion of revenue early and had overstated its pretax income by $1.41 billion over the five years, a 36% overstatement. Paul R. Berger, Associate Director of Enforcement at the SEC, described the actions of Xerox executives in the SEC enforcement notice: "Xerox's senior management orchestrated a fouryear scheme to disguise the company's true operating performance. Such conduct calls for stiff sanctions, including in this case, the imposition of the largest fine ever obtained by the SEC against a public company in a financial fraud case. The penalty also reflects, in part, a sanction for the company's lack of full cooperation in the investigation."
The SEC enforcement notice reported that the company had recorded longterm leasing agreements for copiers over shorter periods than the leases ran in order to record more revenue during the early years of the leases. The company also had made a one-time sale of accounts receivable to increase operating results but failed to disclose this fact to outsiders. Xerox established a "cookie jar" reserve account that was set up to cover merger costs but instead was used to meet analysts' quarterly earnings forecasts. From 1997 to 2000, the SEC alleged that senior managers at Xerox were paid more than $5 million on performance-based compensation and made more than $30 million from the sale of company stock.
In a related SEC inquiry, notices of possible civil action for fraud were sent to KPMG, Xerox's former auditor (that had been fired in 2001), and a number of Xerox executives (both current and former). KPMG responded that it did nothing wrong in its work for Xerox and had, in fact, been fired for forcing Xerox to conduct an independent accounting exam that resulted in an earlier Xerox restatement. The restatement in 2001 prompted the SEC investigation in 2002. Xerox executives argued that they had relied on the accounting guidance provided by KPMG.
a. Evaluate the revenue recognition policies used by Xerox. As an auditor, would you have approved them
b. Describe how the audit risk model could have been used in the Xerox audit to consider the performance-based compensation and the decline in sales revenue.
c. How would the auditor evaluate management in this company Would the auditor be aware of management's position to "look to the accountants to find income"

Question 13

What role does professional skepticism play in the audit of the revenue process

Question 14

How does the auditor evaluate the allowance for doubtful accounts

Question 15

Performing substantive tests of transactions. The following audit steps are part of the audit program for the revenue process. Indicate the assertion supported by the evidence gathered in performing each procedure.
a. Select a sample of sales invoices from the sales journal.
(1) Vouch to the supporting shipping document.
(2) Determine whether credit was approved.
(3) Vouch prices on the invoice to the approved price list.
(4) Compare the amount billed to the amount shipped.
(5) Recalculate the invoice.
(6) Compare the shipping date with the invoice date.
(7) Trace the invoice to the posting in the control account for accounts receivable and the general ledger control account.
b. Select a sample of shipping documents from the shipping department file and trace the shipments to the recorded sales invoices.
c. Scan the sales invoices and the shipping documents for missing numbers in sequence.

Question 16

Gemstar-TV Guide International, Inc.
KPMG and Gemstar, publisher of TV Guide magazine, agreed to pay the SEC a $10 million fine as a penalty for overstating revenue from 1999 to 2002. The overstatements involved improperly reporting licensing and advertising revenue. The SEC said that the auditors should have known that the company improperly recognized revenue. The SEC stated that KPMG auditors substituted "management representations for competent evidence."
The revenue recognition problems were described in an accounting and auditing enforcement notice disclosing the earnings misstatement. According to the report, the revenue recognition problems were in two areas of revenue: licensing and advertising.
Licensing Revenue and Disclosure in the Footnotes
Gemstar recognized $23.5 million in licensing revenue from AOL in 2000. This revenue represented an upfront fee that should have been recognized over the eightyear time period in which the services were to be provided. Gemstar recognized $113.5 million in licensing revenue from Scientific-Atlanta for 2000-2002 and $18.1 million in licensing revenue from Time Warner Cable (TWC) for 2001-2002. According to the report, the KPMG auditors should have known that the Scientific- Atlanta and TWC revenue recognition did not conform to a financial reporting framework because the contract terms did not meet the requirements. The company did not have a contract with Scientific-Atlanta or TWC, Gemstar had not received any of the revenue, the companies disputed the revenue recognized by Gemstar, and the revenue payments were contingent on then-current contract negotiations.
According to the enforcement notice, KPMG auditors should have known that Gemstar's revenue recognition disclosure in the footnotes did not comply with disclosure requirements consistent with the financial reporting framework. Accounting Principles Board (APB) Opinion No. 22 requires disclosure of all significant accounting policies. Under generally accepted auditing procedures, auditors should read the company's annual report. The disclosure related to the AOL revenue was inadequate because the company disclosed that it recognized revenue over the life of the contract and described the AOL contract as long term but failed to recognize revenue in accordance with the disclosure (it recognized all revenue in the first year of the eight-year contract).
The disclosure for the Scientific-Atlanta and TWC revenue indicated that Gemstar had recognized revenue when it received notification that a manufacturer had shipped units using Gemstar technology. According to the SEC, the auditors should have known that Gemstar's disclosure regarding revenue recognition based on licensing revenue was inadequate to describe the actual revenue recognition for this contingent revenue.
Advertising Revenue and Disclosure in the Footnotes
Gemstar recognized $60.1 million of advertising revenue in 2001 and 2002 from Motorola, (Chicago) Tribune Company, Fantasy Sports, and various print advertisers that did not conform to the financial reporting framework. The revenue came from noncash arrangements with customers as part of various business transactions. For example, the Motorola revenue originated with an arrangement by which it paid $188 million to use Genstar's IPG technology, to settle a litigation award, and to purchase $17.5 million of prepaid advertising. The Tribune revenue originated with an arrangement between it and Gemstar in which the Tribune agreed to purchase the WGN distribution business from Gemstar in exchange for $106 million in cash and $100 million in advertising. According to the SEC, KPMG auditors should have known that the Motorola and Tribune revenue were not recognized in accordance with the financial reporting framework. According to the SEC, Gemstar could not "reliably, verifiably, and objectively" determine the fair value of the advertising portion of the arrangement because it had not sold IPG advertising that was not part of a related-party or nonmonetary transaction.
The SEC also determined that the auditors should have known that Gemstar's disclosure in its 10-K was inconsistent with the company's method of accounting for the transaction. For example, the company described its substantial growth in the Interactive Sector revenue and attributed the growth to the "successful launch of IPG advertising." However, the company did not disclose that the revenue came from the Motorola and Tribune transactions. The auditor also should have known that the company disclosed the sale of WGN but not the $100 million of advertising revenue associated with the sale.
The SEC censured KPMG, which paid a fine of $10 million to settle the charges of improper conduct. KPMG partners involved in the audit were prohibited from working for public companies for a period of one to three years. At the time, the KPMG fine was the largest ever obtained by the SEC from an accounting firm. Cash from the settlement went to the Gemstar shareholders.
a. Evaluate Gemstar's revenue recognition decisions related to the licensing and advertising revenue. Explain why the SEC disagreed with the decisions made by management.
b. Why did the SEC determine that the disclosure made by Gemstar was not consistent with the financial reporting framework Explain the proper disclosure relating to the licensing and advertising revenue.
c. What does the SEC mean that the auditors substituted "management representations for evidence" What should the auditors have done to verify the revenue

Question 17

Describe the assertions made by management regarding the accounts in the revenue process.

Question 18

How does the auditor test the presentation and disclosure assertions for the revenue process

Question 19

Performing substantive tests of balances. The following audit steps are part of the revenue process audit program. Indicate the assertion supported by the evidence gathered in performing each procedure.
a. Select a sample of customers' accounts.
(1) Vouch debits in the accounts to sales invoices.
(2) Vouch credits in the accounts to cash receipts documentation and approved credit memos.
b. Select a sample of credit memos.
(1) Review for proper approval.
(2) Trace to posting in customers' accounts.
c. Scan the accounts receivable control account for postings from sources other than the sales and cash receipts journals. Vouch a sample of such entries to supporting documents.

Question 20

Go to the website for a company of your choice and determine how it recognizes revenue, estimates sales returns, and determines the amount of uncollectible accounts. List the revenue reported for the last two years as well as the balance in Accounts Receivable and the Allowance for Doubtful Accounts for each year. Does the change in the allowance account appear reasonable Explain your answer.

Question 21

What are the most important assertions for the revenue process Explain your answer.

Question 22

A key internal control in the revenue process is the separation of duties between cash handling and record keeping. The objective most directly associated with this control is to verify that a. Cash receipts recorded in the cash receipts journal are reasonable
B) Cash receipts are properly classified
C) Recorded cash receipts result from legitimate transactions
D) Existing cash receipts are recorded

Question 23

Testing internal control procedures in computerized and manual accounting systems. Accounting systems typically implement controls to prevent misstatements in processing transactions. For each of the following controls described, (1) indicate the misstatement that could occur if the control is not implemented and (2) identify an audit procedure to test the control's effectiveness.
a. Sales transactions less than $25,000 are approved by the accounting system automatically (without involvement of the credit manager). Sales transactions higher than $25,000 require written approval by the credit manager.
b. All sales invoices are priced according to an authorized price list. Any exceptions to this pricing must be approved by the sales manager.
c. All shipping document are prenumbered and accounted for. Shipping document numbers are noted on all sales invoices.
d. A report of exceptions noting the failure of the invoice amount and the shipping amount to match is sent to the sales manager.

Question 24

Go to the SEC website ( www.sec.gov ) and identify a company that it has cited for revenue recognition problems. Describe the problem and identify the accounting principle that the company violated.

Question 25

What is inherent risk in the revenue process Explain when it would be high for an audit client. Explain when it could be low for an audit client.

Question 26

An auditor tests a company's policy of obtaining credit approval before shipping goods to customers in support of management's financial statement assertion of a. Valuation or allocation
B) Completeness
C) Existence or occurrence
D) Rights and obligations

Question 27

Substantive tests of transactions. Two auditors are discussing the audit procedures for sales revenue. Stacy Mendoza believes that the best way to test sales revenue is to select a random sample of recorded sales and to trace these sales back through the system to the supporting documents, noting that all items billed were shipped and that the sales were invoiced at the correct prices. Takai Wong disagrees. He believes that it is better to gather evidence for the sales process by starting with the prenumbered shipping documents and then tracing them forward through the system to the invoice, noting the existence of control procedures and the correctness of the invoice processing.
a. If you follow Stacy's audit approach, identify the assertion supported by your evidence.
b. If you follow Takai's audit approach, identify the assertion supported by your evidence.
c. Which auditor is correct

Question 28

Prepare the journal entries to record the transactions in the revenue process. Identify the balance sheet and income statements accounts included in the process.

Question 29

What is control risk

Question 30

Which of the following internal controls would most likely reduce write-offs of uncollectible accounts receivable a. Employees responsible for authorizing sales and charge-offs of uncollectible accounts receivable are denied access to cash.
B) Shipping documents and sales invoices are matched by an employee who does not have the authority to charge off uncollectible accounts receivable.
C) Employees involved in the credit-granting function are separated from the sales function.
D) Accounts receivable master file records are reconciled to the control account by an employee who is not involved in the credit-granting function.

Question 31

Cutoff tests. While performing a sales cutoff test for your audit client, you review all shipping documents for five days before and five days after year-end. All sales are on credit and are sent FOB shipping point. Cost of goods sold is 75% of sales revenue. You are using the shipping log for the ten-day time period of the test. Test results follow.

a. Identify by shipping number the sales that the company has recorded as sales revenue at December 31, 2010.
b. Identify by shipping number the sales that should have been recorded as sales revenue at December 31, 2010.
c. Prepare the adjusting entry needed to correct the sales revenue and inventory at December 31, 2010.
d. Prepare the journal entries needed to record the sale represented by shipping document 450784, including the cash collection and the revenue recognition.
e. What accounting rule should the company use to recognize revenue
f. How is the company currently recognizing revenue
g. What questions should you ask the client to clarify the evidence you have gathered during this audit test

Question 32

Why is the revenue process important to the overall audit process

Question 33

What is the auditor's responsibility for internal controls

Question 34

A manufacturing company received a substantial sales return in the last month of the year, but the credit memorandum for the return was not prepared until after the auditors had completed the field work. The returned merchandise was included in the physical inventory. What control should have prevented the misstatement a. Aged trial balance of accounts receivable is prepared.
B) Credit memoranda are prenumbered and all numbers are accounted for.
C) A reconciliation of the trial balance of customer's accounts with the general ledger control is prepared periodically.
D) Receiving reports are prepared for all materials received and such reports are accounted for on a regular basis.

Question 35

Analytical procedures. You have been asked to audit the revenue from membership fees for the Orange County Master Gardeners Club. Your spouse is a member of the club.
a. What questions would you ask the club treasurer to verify the revenue
b. Let's assume that we have the following information: the club had approximately 200 members at the end of last year. Each year the club loses 15% of its members and gains 20% in new members. The dues are $50 per year, but members over 65 have a life-time membership where they do not pay dues. Approximately 20% of our membership is over 65 at any time. Describe some analytical procedures that you might use to determine that the membership revenue reported on the club's financial statements is not materially misstated.
c. Assume that membership revenue reported by the treasurer is $6,000. What would you conclude about the revenue

Question 36

Describe the business process approach to auditing. Why is it useful

Question 37

When does the auditor test internal controls

Question 38

The sales manager credited a salesperson, Jack Smith, with sales that were actually "house account" sales. Later Smith divided his excess sales commissions with the sales manager. What control should have prevented the misstatement a. The summary sales entries are checked periodically by persons independent of sales functions.
B) Sales orders are reviewed and approved by persons independent of the sales department.
C) The internal auditor compares the sales commission statements with the cash disbursements records.
D) Sales orders are prenumbered, and all are accounted for.

Question 39

Sales cutoff tests. Sales cutoff tests are performed to determine that sales are recorded in the correct time period according to the revenue recognition rules of the applicable financial reporting framework.
a. What is the revenue recognition rule for recording revenue when your audit client sells a product that it ships to the customer
b. What is the accounting rule for recognizing revenue when your client performs a service such as one a dentist could perform
c. How would you perform cutoff tests for a product that is shipped to the customer if your primary audit concern is gathering evidence to support the existence of the sales What conditions could be present in an audit client resulting in a risk that sales recorded at year-end do not exist
d. How would you perform cutoff tests for a service that your client performs (for example, a dentist's office) if your primary audit concern is completeness of sales
e. What conditions could be present in an audit client leading to a risk that sales recorded at year-end are incomplete

Question 40

What is the auditor's responsibility in gathering evidence for the balance sheet and income statement accounts in the revenue process

Question 41

How is audit testing linked to management's assertions

Question 42

A sales invoice for $5,200 was computed correctly, but, by mistake, was entered as $2,500 to the sales journal and to the accounts receivable master file. The customer remitted only $2,500, the amount on his monthly statement. What control should have prevented the misstatement a. Prelisting and predetermined totals are used to control posting.
B) Sales invoice numbers, prices, discounts, extensions, and footing are independently checked.
C) The customer's monthly statements are verified and mailed by a responsible person other than the bookkeeper who prepared them.
D) Unauthorized remittance deductions made by customers or other matters in dispute are investigated promptly by a person independent of the accounts receivable function.

Question 43

Substantive test of balances. Refer to Appendix A for five replies from customers of BCS Inc. in response to the receivables confirmation conducted by Stuart Cram, the BCS auditor and a copy of two letters for which replies have not yet been received.
a. For each reply, explain what you think has happened, how you would verify your explanation, and whether the reply represents a misstatement in the BCS accounts. If so, prepare the adjusting entry.
b. For the two nonreplies, explain what other method the auditor could use to obtain some assurance on the balances involved.

Question 44

How does the auditor's responsibility for gathering evidence differ between the balance sheet and income statement accounts

Question 45

What are dual-purpose tests How does an auditor use them

Question 46

Copies of sales invoices show different unit prices for apparently identical items. What control should have prevented the misstatement a. All sales invoices are checked as to all details after their preparation.
B) Differences reported by customers are satisfactorily investigated.
C) Statistical sales data are compiled and reconciled with recorded sales.
D) All sales invoices are compared with the customer's purchase orders.

Question 47

Evaluating the allowance for doubtful accounts. See Appendix B for the aged receivables trial balance for BCS. Review it and explain what the information in each column represents.
a. Use this information to calculate a bad debt provision for BCS at December 31, 2010 Last year BCS used the following percentages to calculate the bad debt provision: current accounts, .05%; 30 day accounts, 2%; 60 day accounts, 10%; 90 day accounts, 40%. First calculate the allowance using the percentages applicable in the previous year. Then, if you determine that actual write-offs last year were $20,000 more than the provision and that the economic conditions for BCS customers has worsened in the current year, explain how you could adjust the allowance.
b. Why is it necessary for BCS to estimate bad debt expense at year-end What accounting principle does BCS violate if it does not estimate bad debt

Question 48

Identify the most important document in the revenue process and explain why it is important.

Question 49

What are substantive tests of transactions

Question 50

The following sales procedures were encountered during the annual audit of Marvel Wholesale Distributing Company. Use this information to answer questions 38, 39, and 40. Customer orders are received by the sales order department. A clerk computes the approximate dollar amount of the order and sends it to the credit department for approval. Credit approval is stamped on the order and sent to the accounting department. A computer is then used to generate two copies of a sales invoice. The order is filed in the customer order file.
The customer copy of the sales invoice is routed through the warehouse, and the shipping department has authority for the respective departments to release and ship the merchandise. Shipping department personnel pack the order and manually prepare a three-copy bill of lading: the original copy is mailed to the customer, the second copy is sent with shipment, and then the other is filed in sequence in the bill of lading file. The sales invoice shipping copy is sent to the accounting department with any changes resulting from lack of available merchandise.
A clerk in accounting matches the received sales invoice shipping copy with the sales invoice customer copy from the pending file. Quantities on the two invoices are compared and prices are compared to an approved price list. The customer copy is then mailed to the customer, and the shipping copy is sent to the data processing department.
The data processing clerk in accounting enters the sales invoice data into the computer, which is used to prepare the sales journal and update the accounts receivable master file. She files the shipping copy in the sales invoice file in numerical sequence.
To determine whether the internal controls operate effectively to minimize instance of failure to post invoices to customers accounts receivable master file, the auditor would select a sample of transactions from the population represented by the:

A) Customer order file.
B) Bill of lading file.
C) Customer s accounts receivable master file.
D) Sales invoice file.

Question 51

Evaluating management's assertions. An auditor could use the procedures listed after the following lettered items to evaluate management's assertions for the revenue process.
a. Identify the procedure as a test of controls or substantive test of transactions or balances and indicate the assertion it tests.
b. Describe how you would design a test to determine whether the control is effective or the account balance or transaction has been recorded correctly.
c. What misstatement is the client trying to prevent by using the control What misstatement does the auditor attempt to prevent by using the substantive test
Audit Procedures
(1) Trace a sample of shipping documents to sales invoices and sales journals to make sure that the shipment was billed.
(2) Examine a sample of sales invoices to determine whether each one has a shipping document attached.
(3) Trace a sample of debit entries in the accounts receivable subsidiary ledger to the sales journal to determine whether the date, customer name, and amount are the same.
(4) Perform cutoff tests by reviewing the shipping documents for five days before and five days after year-end to determine that the sales revenue was recorded in the correct time period.
(5) Review the allowance for doubtful accounts at year-end to determine that it is correctly stated.
(6) Confirm accounts receivable at year-end.

Question 52

What is the aged trial balance for accounts receivable How could the auditor use it in the audit process

Question 53

What are substantive tests of balances

Question 54

The following sales procedures were encountered during the annual audit of Marvel Wholesale Distributing Company. Use this information to answer questions 38, 39, and 40. Customer orders are received by the sales order department. A clerk computes the approximate dollar amount of the order and sends it to the credit department for approval. Credit approval is stamped on the order and sent to the accounting department. A computer is then used to generate two copies of a sales invoice. The order is filed in the customer order file.
The customer copy of the sales invoice is routed through the warehouse, and the shipping department has authority for the respective departments to release and ship the merchandise. Shipping department personnel pack the order and manually prepare a three-copy bill of lading: the original copy is mailed to the customer, the second copy is sent with shipment, and then the other is filed in sequence in the bill of lading file. The sales invoice shipping copy is sent to the accounting department with any changes resulting from lack of available merchandise.
A clerk in accounting matches the received sales invoice shipping copy with the sales invoice customer copy from the pending file. Quantities on the two invoices are compared and prices are compared to an approved price list. The customer copy is then mailed to the customer, and the shipping copy is sent to the data processing department.
The data processing clerk in accounting enters the sales invoice data into the computer, which is used to prepare the sales journal and update the accounts receivable master file. She files the shipping copy in the sales invoice file in numerical sequence.
To determine whether the internal controls operated effectively to minimize instances of failure to invoice shipment, the auditor would select a sample of transactions from the population represented by the:

A) Customer order file.
B) Bill of lading file.
C) Customers' accounts receivable master file.
D) Sales invoice file.

Question 55

Evaluating misstatements found during an audit. The misstatements that you found during your audit of the year-end accounts receivable balance are listed after the following lettered items.
a. For each item, indicate the audit procedures that could evaluate the potential misstatement in the financial statements and the management assertion addressed by the audit procedure.
b. How would you determine whether the misstatements were caused by errors on the part of the audit client or fraud Does it matter
Misstatements
(1) Sales totaling $1,254,721 were shipped on January 3, 2012, and recorded on December 31, 2011.
(2) Balances in individual customer accounts do not agree with the supporting documents (invoices, shipping documents, cash receipts).
(3) Some sales transactions were not recorded.
(4) A customer account in the 0-30 days category in the aged trial balance is actually more than 120 days old.
(5) Actual accounts receivable written off in 2011 were higher than the December 31, 2010, allowance for uncollectible accounts balance.

Question 56

What is the purpose of prelisting cash receipts Do you think it is worth the extra time it takes

Question 57

Describe one substantive test of transactions that could be used to test the existence assertion.

Question 58

The following sales procedures were encountered during the annual audit of Marvel Wholesale Distributing Company. Use this information to answer questions 38, 39, and 40. Customer orders are received by the sales order department. A clerk computes the approximate dollar amount of the order and sends it to the credit department for approval. Credit approval is stamped on the order and sent to the accounting department. A computer is then used to generate two copies of a sales invoice. The order is filed in the customer order file.
The customer copy of the sales invoice is routed through the warehouse, and the shipping department has authority for the respective departments to release and ship the merchandise. Shipping department personnel pack the order and manually prepare a three-copy bill of lading: the original copy is mailed to the customer, the second copy is sent with shipment, and then the other is filed in sequence in the bill of lading file. The sales invoice shipping copy is sent to the accounting department with any changes resulting from lack of available merchandise.
A clerk in accounting matches the received sales invoice shipping copy with the sales invoice customer copy from the pending file. Quantities on the two invoices are compared and prices are compared to an approved price list. The customer copy is then mailed to the customer, and the shipping copy is sent to the data processing department.
The data processing clerk in accounting enters the sales invoice data into the computer, which is used to prepare the sales journal and update the accounts receivable master file. She files the shipping copy in the sales invoice file in numerical sequence.
To gather audit evidence that uncollected items in customers' accounts represented existing trade receivables, the auditor would select a sample of items from the population represented by the:

A) Customer order file.
B) Bill of lading file.
C) Customers' accounts receivable master file.
D) Sales invoice file.

Question 59

Audit assertions. Auditing has been defined as a process of determining the degree to which assertions correspond to the rules. Explain this statement by discussing the assertions and the rules for the revenue process.

Question 60

Describe the rules of the applicable financial accounting framework for recognizing revenue. Are these rules easy for the client to apply

Question 61

Describe one substantive test of balances that could be used to test the existence assertion.

Question 62

Performing tests of controls for the revenue process. Review the list of controls that could be present in the revenue process and determine the audit procedures that could be performed to test the control. For each procedure, indicate the management assertion that the auditor gathers evidence to evaluate while performing the test.
a. Prenumbered shipping documents are completed in the shipping department.
b. Sales invoices are prenumbered.
c. Customer credit is approved before orders are shipped.
d. Credit memos are prenumbered and the sequence is checked for missing documents.
e. Customer statements are mailed monthly by the accounts receivable department.

Question 63

Qwest Communications International, Inc.
In July 2002, Qwest, a telecommunications company based in Denver, Colorado, acknowledged that it had improperly recorded revenue for 2000, 2001, and 2002. The company restated its financial results for 2000 and 2001 and reduced its estimate of earnings for 2002. With 61,000 employees and yearly sales revenue of $19.7 billion in 2001, Qwest provides telecommunication services to residential, business, and government customers. Its revenue misstatements originated from its handling of revenue from transactions in which it sold long-term capacity on its network and bought similar capacity from its trading partners (referred to as swap transactions or round-trip trades ).
Arthur Andersen, LLP, advised several telecommunications clients how to structure swap transactions in a 48-page document referred to as the "white paper." According to the document, swap transactions are not barter arrangements, which would prevent the two firms from recognizing revenue. The document suggests that two given companies structure their transactions so the capacity sold is an operating asset and the capacity bought is a capital asset. This practice allows the seller to recognize revenue and to record the cost of providing the capacity as a capitalized cost rather than an expense, moving the cost off the income statement and putting it in a capital asset account on the balance sheet. From Andersen's point of view, because the risks and rewards of buying capital leases were different than those of operating leases, the companies involved in the swaps were no longer exchanging similar assets. If the assets exchanged were not similar, it was possible to recognize revenue on the capacity swapped in the transaction.
Companies in the telecommunications industry relied heavily on the use of swap transaction accounting to inflate revenue, which was commonly believed to be the most reliable measure of a company's health. These companies included Qwest, Global Crossing, and WorldCom. Arthur Andersen was the auditor for many telecommunications firms. Officials of the Securities and Exchange Commission (SEC) were concerned that such revenue-increasing tactics were widely used by these companies to "give the appearance of economic activity and growth when there was none."These companies, in effect, were following advice similar to that given in the Andersen "white paper." SEC officials believed that telecommunications companies' swap transactions had no business purpose other than to increase revenue.
In August 2002, the SEC formally concluded that the telecommunications companies improperly booked revenue from capacity swaps with other companies. This SEC decision officially put an end to the widely used industry practice that had inflated revenue for many telecommunications companies. 6 The ruling resulted in earnings restatements by several companies and prompted shareholder lawsuits alleging accounting fraud.
Joseph Nacchio, the chief executive officer of Qwest, resigned under pressure in June 2002. He and other top Qwest executives had sold Qwest stock during the years the swap accounting was used. His stock sales alone netted $130 million in profit. Qwest insiders sold stock worth $530 million between January 2000 and July 2001, raising questions about their interest in keeping the stock price as high as possible by reporting growth in sales revenue.
a. Evaluate the revenue recognition principle used by Qwest to record revenue based on swap transactions.
b. What is the role of the auditor in evaluating the audit client's revenue recognition policy Would you have approved it What is wrong with the policy
c. Do you believe that company executives engaged in fraudulent activity by their use of swap transactions to increase revenue Do you think the executives should be shielded from liability for swap transactions that occurred before the SEC issued a formal statement prohibiting these companies from recognizing revenue using these transactions
d. If company executives received stock options based on performance, how could this have influenced their choice of accounting method for revenue recognition How should the auditor evaluate the audit client's use of stock options for executives How would you include stock options in the audit risk model