Ch04-Audit Evidence and Audit Programs

Audit Evidence and Audit Programs

MULTIPLE CHOICE:

1. The permanent file section of the working papers that is kept for each audit client most likely contains

a. Review notes pertaining to questions and comments regarding the audit work performed.

b. A schedule of time spent on the engagement by each individual auditor.

c. Correspondence with the client's legal counsel concerning pending litigation.

d. Narrative descriptions of the client's internal control policies and procedures

ANSWER: D

2. Of the following procedures, which is not considered part of “obtaining an understanding of the client’s environment?”a. Examining trade publications to gain a better

understanding of the client's industry.b. Confirming customer accounts receivable for existence

and valuation.c. Touring the client's manufacturing and warehousing

facilities to gain a clearer understanding ofoperations.

d. Studying the internal controls over cash receipts and disbursements.

ANSWER: B

3. If working papers are to have the characteristics that will ensure that they achieve their primary purposes, which of

the following is the most important? a. Working papers must be of standard format and standard

content. b. Working papers must be properly indexed and cross-

referenced to the draft audit report. c. Working papers must provide sufficient, competent, and

useful information to support the audit report. d. Working papers must be arranged in logical order

following the audit program sequence.

ANSWER: C

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Chapter 4 Audit Evidence and Audit Programs

4. Which of the following is not an example of analytical evidence?a. Compared inventory turnover by major class with the

prior year on a monthly and quarterly basis.b. Compared gross profit percentages by major product

classes with the prior year.c. Examined invoices for plant asset additions to

determine whether the client had erroneously recorded ordinary repairs as plant assets.

d. Examined monthly performance reports and investigated significant variations from budgeted amounts.

ANSWER: C

5. Choose the best illustration of objective audit evidence from the following

a. The paid invoice file containing invoices matched with receiving reports and purchase orders.

b. Management's assertion that payment procedures require matching of invoice with receiving report and purchase order.

c. Clerical staff assurances that management policy regarding payment of invoices--matching of invoice with receiving report and purchase order--is always

followed. d. The treasurer's statement of not remembering any

exceptions in which an invoice was submitted for payment that was not accompanied by a matching receiving report and purchase order.

ANSWER: A

6. An initial (first-time) audit requires more audit time to complete than a recurring audit. One of the reasons for this is thata. New auditors are usually assigned to an initial audit.b. Predecessor auditors need to be consulted.c. The client's business, industry, and internal control

are unfamiliar to the auditor and need to be carefully studied.

d. A larger proportion of customer accounts receivable need to be confirmed on an initial audit.

ANSWER: C

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7. Which of the following is a basic tool used by the auditor to control the audit work and review the progress of the audit? a. Time and expense summary.b. Engagement letter.c. Progress flowchart.d. Audit program.

ANSWER: D

8. An auditor wants to develop an audit test to evaluate the reasonableness of the quantity of scrap material resulting

from a certain production process compared to industry standards. Which would be the most competent type of evidence available to satisfy this objective?

a. Documentary. b. Hearsay. c. Physical. d. Analytical.

ANSWER: D

9. As part of audit planning, CPAs should design audit programs for each individual audit and should include audit steps and procedures to a. Detect and eliminate fraud.b. Increase the amount of management information

available. c. Provide assurances that the objectives of the audit are

met. d. Ensure that only material items are audited.

ANSWER: C

10. Of the following audit procedures, which best supports the valuation objective?a. Performing a lower of cost or market test of the

client's inventories.b. Reviewing a contingent liability footnote for proper wording.c. Searching for unrecorded liabilities.d. Observing the client's year-end physical inventory

taking.

ANSWER: A

11. An assumption underlying analytical procedures is that

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a. These procedures cannot replace tests of balances and transactions.

b. Statistical tests of financial information may lead to the discovery of material errors in the financial statements.

c. The study of financial ratios is an acceptable alternative to the investigation of unusual

fluctuations. d. Relationships among data may reasonably be expected to

exist and continue in the absence of known conditions to the contrary.

ANSWER: D

12. An auditor is examining accounts receivable. What is the most competent type of evidence in this situation?

a. Interviewing the personnel who record accounts receivable.

b. Verifying that postings to the receivable account from journals have been made.

c. Receipt by the auditor of a positive confirmation. d. No response received for a request for a negative

confirmation.

ANSWER: C

13. With respect to the auditor's planning of a year-end examination, which of the following statements is always true? a. An engagement should not be accepted after the fiscal

year-end. b. An inventory count must be observed at the balance

sheet date. c. The client's audit committee should not be told of the

specific audit procedures that will be performed. d. It is an acceptable practice to carry out substantial

parts of the examination at interim dates.

ANSWER: D

14. A letter to the auditor in response to an inquiry is an example of a. Physical evidence.b. Confirmation evidence.c. Documentary evidence.d. Analytical evidence.

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ANSWER: B

15. Which of the following statements about working papers is correct? a. Working papers are not permitted to be used as a

reference source by the client. b. The auditor should document the understanding of the

client's internal control obtained to plan the audit c. Working papers may be regarded as a substitute for

the client's accounting records.d. When reporting on comparative financial statements,

the independent auditor may discard working papers after two years.

ANSWER: B

16. Which of the following factors is most important in determining the competence of audit evidence?

a. The reliability of the evidence in meeting the audit objective.

b. The objectivity of the auditor gathering the evidence. c. The quantity of the evidence obtained.

d. The independence of the source of evidence.

ANSWER: A

17. The procedures specifically outlined in an audit program are primarily designed to a. Protect the auditor in the event of litigation. b. Detect errors or fraud.c. Test internal evidence.d. Gather evidence.

ANSWER: D

18. When reviewing audit working papers, the primary responsibility of an audit supervisor is to determine

that: a. Each worksheet is properly identified with a

descriptive heading.b. Working papers are properly referenced and kept in

logical groupings.c. Standard departmental procedures are adhered to with

regard to work paper preparation and technique. d. Working papers adequately support the audit findings,

conclusions, and report.

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ANSWER: D

19. Auditors apply analytical procedures to the client's operations in order to identify a. Improper separation of accounting and other financial

duties. b. Weaknesses of a material nature in the client's

internal control. c. Unusual transactions.

d. Noncompliance with prescribed control procedures.

ANSWER: C

20. Which of the following workpapers would one normally expect to find in the permanent file?a. A copy of a long-term bond indenture.b. The working trial balance.c. An analysis of additions and disposals relating to

marketable securities.d. A workpaper analyzing customer replies to confirmation

requests.

ANSWER: A

21. The in-charge auditor decides that work papers are complete a. When satisfied that the audit objectives have been met

and the working papers support the conclusions. b. When working papers make reference to the steps

outlined in the audit program.c. Only after the auditor who prepared the working papers

has signed and dated them.d. When proper cross-references to other working papers

are noted.

ANSWER: A

22. Of the following procedures, which does not produce analytical evidence?a. Compare revenue, cost of sales, and gross profit with

the prior year and investigate significant variations.b. Examine monthly performance reports and investigate

significant revenue and expense variances.c. Confirm customers' accounts receivable and clear all

material exceptions.d. Compare sales trends and profit margins with industry

averages and investigate significant differences.

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ANSWER: C

23. Audit evidence can come in different forms with different degrees of persuasiveness. Which of the following is the least persuasive type of evidence? a. Documents mailed by outsiders to the auditor. b. Correspondence between the auditor and vendors. c. Sales invoices inspected by the auditor.

d. Computations made by the auditor.

ANSWER: C

24. Analytical procedures are a. Substantive tests designed to evaluate a system of

internal control.b. Tests of control procedures designed to evaluate the

validity of management's representation letter. c. Substantive tests designed to evaluate the

reasonableness of financial information.d. Tests of control procedures designed to detect errors

in reported financial information.

ANSWER: C

25. Which of the following statements relating to the competence of evidential matter is always true?

a. Evidential matter gathered by an auditor fromoutside an enterprise is reliable.

b. Accounting data developed under satisfactory conditions of internal control are more relevant than data developed under unsatisfactory internal control conditions.

c. Oral representations made by management are not valid evidence.

d. Evidence gathered by auditors must be both valid and relevant to be considered competent.

ANSWER: D

26. An auditor test counted a batch of inventory. This is an example of what kind of evidence?

a. Analytical. b. Documentary. c. Physical. d. Hearsay.

ANSWER: C

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27. In evaluating the reasonableness of advertising expense, which of the following would be the best evidence?

a. Oral evidence obtained through discussions with company marketing executives and representatives of the advertising agency retained.

b. Documentary evidence obtained by vouching charges to the account and by retracing charges from source

documents to the account.c. Analytical evidence developed by comparing the ratio of advertising expenses to sales with historical data for the company and industry.d. Arithmetical evidence developed by re-computing charges

submitted by the advertising agency and paid by the company.

ANSWER: C

28. Which of the following is not a consideration in the development of audit programs?a. Internal control over the recording of plant asset

additions and repairs and maintenance expenditures is found to be weak.

b. The client constructed a major addition to its central manufacturing facility during the year under audit.

c. The client is a private university located in the Midwest.

d. The client's board or directors is elected by the stockholders at the annual meeting.

ANSWER: D

29. Audit working papers are used to record the results of the auditor's evidence-gathering procedures. When preparing working papers, the auditor should remember that working papers should be a. Kept on the client's premises so that the client can

have access to them for reference purposes.b. The primary support for the financial statements

being examined.c. Considered as a part of the client's accounting records

that are retained by the auditor.d. Designed to meet the circumstances and the auditor's

needs on each engagement.

ANSWER: D

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30. The main advantage of properly indexed working papers is to a. Reduce the size of the file.b. Better organize the working papers.c. Allow division of labor within the audit team. d. Facilitate the efficient use of audit staff.

ANSWER: B

31. Which of the following is not a typical analytical procedure?

a. Study of relationships of financial information with relevant nonfinancial information.

b. Comparison of financial information with similar information regarding the industry in which the entity operates.

c. Comparison of recorded amounts of major disbursements with appropriate invoices.

d. Comparison of recorded amounts of major disbursements with budgeted amounts.

ANSWER: C

32. Which of the following is an example of inferential evidence?a. The auditor observes the taking of the client's

physical inventory and performs test counts.b. The auditor inspects marketable securities for

existence.c. An auditor, who notes that customer accounts receivable

have increased significantly in the current year as a percentage of sales, suspects that a larger proportion of the accounts will prove uncollectible.

d. The auditor counts cash on hand at year-end.

ANSWER: C

33. Which of the following would be least likely to be comparable between similar corporations in the same

industry line of business? a. Earnings per share.b. Return on total assets before interest and taxes. c. Accounts receivable turnover.d. Operating cycle.

ANSWER: A

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34. Which of the following is not an example of confirmation evidence?a. Requesting the client's outside legal counsel to

evaluate the possible outcome of pending litigation.b. Questioning the client's employees about existing

internal control policies and procedures.c. Requesting the client's customers to verify year-end

accounts receivable balances.d. Requesting payees to respond in writing to the terms

contained in notes payable appearing in the client's ledger.

ANSWER: B

35. A CPA, in performing an independent audit, would most likely use recalculation as a substantive test for which of the following expense-related accounts? a. Purchases of supplies.b. Interest expense.c. Advertising expense.d. Repairs and maintenance expense.

ANSWER: B

36. During the course of an audit engagement, an auditor prepares and accumulates audit working papers. The

primarypurpose of the audit working papers is to a. Aid the auditor in adequately planning his work. b. Provide a point of reference for future audit

engagements. c. Support the underlying concepts included in the

preparation of the basic financial statements. d. Support the auditor's opinion.

ANSWER: D

37. Which of the following is not an appropriate auditing procedure supporting fairness of financial presentation?a. Inspecting plant asset additions for existence.b. Recalculating accrued interest on notes payable.c. Examining invoices in support of legal fees recorded

during the fiscal year.d. Reviewing the client's production quality control

program.

ANSWER: D

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38. Sales commissions as a percentage of sales declinedsignificantly during the year under audit. Of the following possible causes, the most likely isa. Sales increased during the year.b. The sales force was reduced at the end of the year.c. Sales commission rates were increased at the beginning

of the year.d. Fictitious sales were recorded at year-end to inflate

earnings. Commissions were not recorded on thesesales.

ANSWER: D

39. Which of the following is responsible for the fairness of the representations made in financial statements? a. Client's management.b. Independent auditor.c. Audit committee.d. AICPA.

ANSWER: A

40. An audit program provides proof that a. Sufficient competent evidential matter was obtained. b. The work was adequately planned.c. There was compliance with generally accepted standards of reporting.d. There was a proper study and evaluation of internal

control.

ANSWER: B

41. Which of the following ultimately determines the specific audit procedures necessary to provide an independent

auditor with a reasonable basis for the expression of an opinion? a. The audit program.b. The auditor's judgment.c. Generally accepted auditing standards.d. The auditor's working papers.

ANSWER: B

42. During the working paper review, an audit supervisor finds that the auditor's reported findings are not adequately cross-referenced to supporting documentation. The

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supervisor will most likely instruct the auditor to

a. Prepare a working paper to indicate that the full scope of the audit was carried out.

b. Familiarize him/herself with the sequence of working papers so that he(she) will be able to answer questions about the conclusions stated in the report.

c. Eliminate any cross-references to other working papers since the system is unclear.d. Provide a workpaper indexing system that shows the

relationship between findings, conclusions, and the related facts.

ANSWER: D

43. Which of the following would be the most relevant form of evidence to evaluate the reasonableness of account balances? a. Analytical. b. Documentary. c. Physical. d. Hearsay.

ANSWER: A

44. Generally, what source of evidence should most impact audit conclusions? a. External b. Inquiry. c. Oral. d. Informal.

ANSWER: A

45. Most of the independent auditor's work in formulating an opinion on the financial statements consists of a. Studying and evaluating internal control.b. Obtaining and examining evidential matter.c. Examining cash transactions.d. Comparing recorded accountability with assets.

ANSWER: B

46. During an audit of the accounts receivable function, you found that the accounts receivable turnover rate had

fallen from 7.3 to 4.3 over the last three years. What is the most likely cause of the decrease in the turnover rate?

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a. An increase in the discount offered for early payment. b. A more liberal credit policy.c. A change from net 30 to net 25.d. Greater cash sales. ANSWER: B

47. Which of the following is generally included or shown in the auditor's working papers? a. The procedures used by the auditor to verify the

personal financial status of members of the client's management team.

b. Analyses that are designed to be a part of, or a substitute for, the client's accounting records.

c. Excerpts from authoritative pronouncements that support the underlying generally accepted accounting principles used in preparing the financial statements.

d. The manner in which exceptions and unusual matters disclosed by the auditor's procedures were resolved or treated.

ANSWER: D

48. To test for unsupported entries in the ledger, the direction of audit testing should be from the a. Ledger entries. b. Journal entries. c. Externally generated documents. d. Original source documents.

ANSWER: A

49. Which of the following does not describe one of the functions of audit workpapers?

a. Facilitates third-party reviews.b. Aids in the planning, performance, and review of

audits.c. Provides the principal evidential support for the

auditor's report.d. Aids in the professional development of the operating

staff.

ANSWER: D

50. The principal reason for developing a written audit program is to help assure that the

a. Audit work is properly supervised.

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b. Audit work is properly planned and documented. c. Audit report contains only significant findings. d. Work of different auditors is properly coordinated.

ANSWER: B

51. One of the primary roles of an audit program is to: a. Serve as a tool for planning, directing, and

controlling audit work.b. Document an auditor's understanding of the internal

control. c. Provide for a standardized approach to the audit

engagement. d. Delineate the audit risk accepted by the auditor.

ANSWER: A

52. The principal purpose for cross-indexing audit working papers is to a. Give the working papers a professional appearance. b. Explain the use of tick marks.

c. Provide explanation of the audit steps performed. d. Provide a trail for the auditor and the reviewer.

ANSWER: D

53. Audit information is generally considered relevant when itis: a. Derived through valid statistical sampling.b. Objective and unbiased.c. Factual, adequate, and convincing.d. Consistent with the audit objectives.

ANSWER: D

54. External auditors often confirm assertions contained in the organization's financial statements and accounting records

with third parties. Which of the following best explains why confirmation produces evidence of high quality?

a. Written assertions from knowledgeable third parties provide sufficient evidence to achieve most audit objectives.

b. Confirmation by knowledgeable third parties is usually the most relevant evidence available.

c. Confirmation by knowledgeable third parties is usually the least costly evidence available.

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d. Confirmation by knowledgeable third parties is highly competent because of its independent source.

ANSWER: D

55. As a category of evidence, documents may be external or internal. As an auditor reviewing your client's

accounts receivable, which of the following is an example of internal documentary evidence? a. The carrier's bill of lading.b. Sales invoice copies.c. A customer's purchase order.d. A vendor's month-end statement.

ANSWER: B

COMPLETION:

56. Audit programs can be developed only after the auditor has completed the audit _______________ process.

ANSWER: PLANNING

57. An auditor who gathers increased quantities of evidence for larger account balances is observing the standard relating to of audit evidence.

ANSWER: SUFFICIENCY

58. An auditor who gathers increased amounts of external evidence under conditions of weak internal control is observing the standard of of audit evidence.

ANSWER: COMPETENCE (VALIDITY) 59. In performing substantive audit tests, focusing on the

existence or occurrence objective helps locate misstatements due to while the completeness objective directs audit attention to misstatements due to .

ANSWER: COMMISSION, OMISSION

60. Evidence consisting of everything that can be counted, examined, observed, or inspected is referred to as _____________ evidence.

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ANSWER: PHYSICAL

61. The audit trail consists of that stream of evidence that enables the auditor to trace a transaction or event forward from its inception to the appropriate ledger account, or conversely, vouch a transaction backward from the ledger

account to the inception of the transaction or event. For the audit trail to exist, transactions must be .

ANSWER: DOCUMENTED

62. Analytical evidence may be the best form of evidence supporting the objective, in that auditors' suspicions concerning errors of omission are often first aroused by the application of analytical procedures.

ANSWER: COMPLETENESS

63. An auditor-prepared bank reconciliation is an example of _______________ evidence.

ANSWER: MATHEMATICAL

64. A group of related transactions affecting essentially the same set of general ledger accounts is referred to as a _________________ .

ANSWER: TRANSACTION CYCLE

65. The focal point of the current file is the ____________ _______________ ______________ often referred to as a table of contents.

ANSWER: WORKING TRIAL BALANCE

MATCHING:

66. For each of the listed auditing procedures, indicate, by letter, the type of evidence it represents.

a. Physical evidenceb. Confirmation evidencec. Documentary evidenced. Analytical evidencee. Mathematical evidencef. Hearsay evidence

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____ 1. Audited client-prepared bank reconciliation (mathematical

____ 2. Vouched debits to repairs accounts by examining vendors’ invoices documentary

____ 3. Observed the client’s year-end physical inventory physical

____ 4. Compared accounts receivable turnover with industry Averaage

____ 5. Prepared ten-year income summary expressing all components as a percentage of sales

____ 6. Obtained letter from client’s outside legal counsel regarding pending litigation

____ 7. Inquired of corporate treasurer as to reason(s) for acquiring marketable securities

____ 8. Calculated year-end interest accrual and compared with general ledger balance

____ 9. Obtained replies directly from customers concerning the correctness of client’s recorded year-end accounts

receivable balances

____ 10.Examined securities purportedly owned by the client and held by local brokers

____ 11.Compared operating cash flows with net income and identified causes of significant disparities.

SOLUTION:

1. e2. c3. a4. d5. d6. b7. f8. e9. b10. a 11. d

67. For each of the listed procedures, indicate, by letter, the

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assertion(s) being tested.

a. Existence or occurrenceb. Completenessc. Rights and obligationsd. Valuation or allocatione. Presentation and disclosure

____ 1. Confirmed customer accounts receivable A,D

____ 2. Vouched property additions to underlying Documentation consisting of vendors’ invoices and work orders D-VALUATION

____ 3. Inquired of corporate treasurer as to reasons for buying and holding securities E-PRESENTATION

____ 4. Selected a sample of bills of lading representing shipments to customers and traced to sales invoices to determine that all shipments have been billed to customers B-COMPLETENESS

____ 5. Examined vendors’ invoices recorded after year-end to determine whether any of these invoices represent liabilities of the client as of year-end B,C –

COMPLETENESS…RIGHTS…

____ 6. Obtained confirmation of marketable securities from client’s brokers A,C,D – EXISTENCE…RIGHTS…VALUATION

____ 7. Evaluated the reasonableness of the client’s depreciation policy D – VALUATION …

____ 8. Obtained letter from client’s outside legal counsel regarding pending litigation E – PRESENTATION …

____ 9. Inspected recorded addition to client materials handling facilities A - EXISTENCE

____ 10. Investigated decrease in revenue from scrap sales as revealed by the application of analytical procedures B – COMPLETENESS

SOLUTION:

1. a,d2. d

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3. e4. b5. b,c6. a,c,d7. d8. e9. a10. b

PROBLEM/ESSAY

68. For each of the following ledger accounts, give an example of substance underlying the account balance:

1. Cash in bank2. Sales revenue3. Inventories4. Accounts payable5. Notes payable6. Capital stock7. Marketable securities8. Operating expenses9. Wages and salaries expense10. Property, plant, and equipment

SOLUTION:

1. Bank statement, canceled checks, deposit tickets2. Sales invoices, shipping documents, cash register tapes 3. Goods in warehouses, goods out on consignment4. Vendors’ records of accounts receivable, vendors’

invoices5. Payees’ confirmation of amounts owed to them, copy of

note in client’s files6. Records maintained by registrar and transfer agent7. Securities in vault or in safekeeping, brokers’

advices, brokers’ confirmations8. Vendors’ invoices, canceled checks, client’s

workpapers supporting such charges as depreciation,amortization, and product warranty

9. Payroll summaries, time cards, clock cards, canceledchecks, human resources records

10. Plant assets at various locations, vendors’ invoices

69. Audit evidence must be sufficient and competent. To be competent, the evidence must be both valid and relevant.

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Required:

a. What is meant by “sufficient audit evidence?”b. Define the concepts of validity and relevance as they relate to audit evidence.

SOLUTION:a. Sufficient audit evidence is evidence that is adequate

to support the auditor’s opinion on the financial statements. A matter of audit judgment, sufficiency is usually based on materiality and the adequacy of existing internal control.

b. Validity of audit evidence is a function of three qualities:

1) The independence and competence of the source of the evidence (e.g., external evidence possesses greater validity than internal evidence);2) The conditions under which the evidence was

obtained (e.g., evidence produced by stronginternal control possesses greater validitythan evidence gathered under weak internalcontrol); and

3) The manner in which the evidence was obtained (e.g., evidence obtained directly by the auditor possesses greater validity than evidence obtained indirectly).

Relevance means that the evidence pertains to specific auditobjectives. Observing the taking of the inventory, for example, provides evidence concerning existence of the inventory, but is not relevant to determining ownership.

70. The following operating data has been provided to Erica Chavez by her audit client, Grimes Hardware. Sales commissionsaverage 6 percent of sales:

2002 % 2003 % Change (%) Sales $18,000 100% 22,000 100% 22%Cost of sales 10,000 11,000Sales commissions 1,080 1 100 Gross profit 6,920 9,900Operating expenses 3,200 3,600Income before taxes 3,720 6,300Income taxes 1,200 2,000Net income $2,520 4,300 ===== =====

Required:

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a. Complete the vertical and horizontal analysis by calculating the correct percentages.

b. Why are both vertical and horizontal analysis important inputs to analytical procedures?

c. Assuming sales commissions have been accuratelycomputed based on 2003 sales, what are the possible explanations for any abnormalities produced by your percentage calculations?

SOLUTION:

a.

2002 % 2003 % Change (%) Sales $18,000 100% 22,000 100% 22%Cost of sales 10,000 56 11,000 50 10Sales commissions 1,080 6 1,100 5 2 Gross profit 6,920 38 9,900 45 43Operating expenses 3,200 17 3,600 16 13Income before taxes 3,720 21 6,300 29 69Income taxes 1,200 7 2,000 9 67Net income $2,520 14 4,300 20 71 ===== == ===== ==

b. Trend analysis (the “Change” column) examines changes in data over time. Given the assumption that past trends may be expected to continue into the future, significant changes warrant further investigation. Vertical analysis (the first two percentage columns), by expressing all components as percentages of a common base (sales in this case), permits the auditors to compare percentages with previously developed auditor expectations. If, for example, the auditor has previously determined that commissions average 6% of sales, he/she may wish to investigate the lower rate reflected in 2003 results.

c. If sales commissions are accurate and represent 6 percent of sales, the sales base must be overstated in order to produce a commission rate of only 5 percent. Sales may have been fabricated, or 2004 sales may have been recorded in 2003. The

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material decline in cost of sales as a percentage of sales suggests that recorded sales transactions were not accompanied by cost of sales entries.

71. The following financial data have been extracted from the records of Blackwell Wholesale Tires:

2003 2002

Sales $15,660 14,980Cost of sales 7,800 7,400Ending inventory 6,200 4,300Accounts receivable-trade 2,200 1,300Total current assets 12,300 10,100Total current liabilities 7,300 4,980Customer payment terms: 2/10;n/30Industry averages:

Gross margin 51%Current ratio 2:1Inventory turnover 2.5Accounts receivable turnover 11.0

Required:

Based on the above data, in which areas do you recommend concentrating audit resources for the 2003 audit? Support your answer by citing the relevant data.

SOLUTION:

2003 2002

Sales $15,660 14,980Cost of sales 7,800 7,400Gross margin 7,860 50% 5,580 49%

Inventory and accounts receivable appear to warrant emphasis for Blackwell Wholesale Tires. Although the gross margin has not changed materially in 2003 relative to 2002 and approximates the industry average for both years, inventory turnover has declined significantly and is well below the industry average (1.25 v. 2.5). This suggests the possibility of inflated inventory quantities, incorrect inventory prices, obsolete inventory, or

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some combination of these. Accounts receivable turnover for 2002 was approximately equal to the industry average; but for 2003 turnover has declined to approximately 7 times versus 11 times for the industry. Given payment terms of 2/10;n/30, one would expect a turnover between 11 and 12 times, or approximately 30 days sales in accounts receivable. A turnover of 7 times equates with approximately 50 days sales in accounts receivable. Failure to properly investigate customer credit, or weak collection procedures, or inflated accounts receivable are possible explanations for the decline in turnover. Although the current ratio appears adequate when compared with the preceding year and with the industry average, the quick ratio (current assets minus inventory divided by current liabilities) has declined from 1.16 in 2002 to .84 in 2003. This suggests a short-term liquidity problem, especially if inventories are overstated and/or customer accounts receivable are delinquent.

71. Identify the deficiencies in the following audit workpaper:

TRAMWAY ENTERPRISESBank Reconciliation12/31/2003

Balance per bank $5,774 *Add deposit in transit 1,223 & 6,997Deduct outstanding checks:

4455 $67 &

4477 180 & 4478 1,023 & 4479 33 &

1,303

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Adjusted balance $5,594 =====Balance per ledger $6,300Adjustment to correct (706)Adjusted balance as above $5,594 ====== SOLUTION:

1. Initials of preparer and reviewer and dates of preparation and review are missing.

2. Name of bank account being reconciled is omitted.3. Subtraction error. Adjusted balance should be $5,694

rather than $5,594.4. Audit adjustment of $706 not explained.5. Audit legends not explained.

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