68. For each of the following ledger accounts, give an example of substance underlying the account balance:
1. Cash in bank 2. Sales revenue 3. Inventories
4. Accounts payable 5. Notes payable 6. Capital stock
7. Marketable securities 8. Operating expenses
9. Wages and salaries expense 10. Property, plant, and equipment SOLUTION:
1. Bank statement, canceled checks, deposit tickets
2. Sales invoices, shipping documents, cash register tapes 3. Goods in warehouses, goods out on consignment
4. Vendors’ records of accounts receivable, vendors’
invoices
5. Payees’ confirmation of amounts owed to them, copy of note in client’s files
6. Records maintained by registrar and transfer agent 7. Securities in vault or in safekeeping, brokers’
advices, brokers’ confirmations
8. Vendors’ invoices, canceled checks, client’s
workpapers supporting such charges as depreciation, amortization, and product warranty
9. Payroll summaries, time cards, clock cards, canceled checks, 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.
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 strong internal control possesses greater validity than evidence gathered under weak internal control); 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 audit
objectives. 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 commissions
average 6 percent of sales:
2002 % 2003 % Change (%)
Sales $18,000 100% 22,000 100% 22%
Cost of sales 10,000 11,000 Sales commissions 1,080 1 100 Gross profit 6,920 9,900
Operating expenses 3,200 3,600 Income before taxes 3,720 6,300 Income taxes 1,200 2,000
Net income $2,520 4,300
===== =====
Required:
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 accurately
computed 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 10 Sales commissions 1,080 6 1,100 5 2 Gross profit 6,920 38 9,900 45 43
Operating expenses 3,200 17 3,600 16 13 Income before taxes 3,720 21 6,300 29 69 Income taxes 1,200 7 2,000 9 67
Net 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 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 14,980 Cost of sales 7,800 7,400 Ending inventory 6,200 4,300
Accounts receivable-trade 2,200 1,300 Total current assets 12,300 10,100 Total current liabilities 7,300 4,980 Customer payment terms:
2/10;n/30
Industry averages:
Gross margin 51%
Current ratio 2:1
Inventory turnover 2.5
Accounts 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 14,980 Cost of sales 7,800 7,400
Gross 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 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 ENTERPRISES Bank Reconciliation
12/31/2003
Balance per bank $5,774 * Add deposit in transit 1,223 &
6,997
Deduct outstanding checks:
4455 $67 &
4477 180 &
4478 1,023 &
4479 33 &
1,303
Adjusted balance $5,594
=====
Balance per ledger $6,300 Adjustment 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