Problem DC 10-1, Page 547 When Marge Simpson, PA, audited the Candle Company inventory, a random sample of inventory types was chosen for physical observation and price testing. The sample size was 80 different types of candles and candle-making inventory. The entire inventory contained 1,740 types, and the amount in the inventory control account was $166,000. Simpson had already decided that a misstatement of as much as $6,000 in the account would not be material. The audit work revealed the following eight errors in the sample of 80. Book Value (a) Audit value Error Amount (b) % Misstatement b/a $600.00 $622.00 $(22.00) (0.037) 15.50 14.50 1.00 0.065 65.25 31.50 33.75 0.517 83.44 53.45 29.99 0.359 16.78 15.63 1.15 0.069 78.33 12.50 65.83 0.840 13.33 14.22 (0.89) (0.067) 93.87 39.87 54.00 0.575 $966.50 $803.67 $162.83

Assume the sample was chosen using Monetary Unit Sampling, and the sampling risk is 10%. Simpson also assumes that the Misstatement Assumption for zero misstatements is 50% for both over and under misstatements. Is the inventory materially misstated? Total Population = 166,000.00 Sample Size = 80 ARACR = 10.00% Upper Misstatement Unit Error Assumption 50.00% Lower Misstatement Unit Error Assumption Materiality 6,000

ACTUAL NUMBER OF DEVIATIONS FOUND Sample size ACTUAL NUMBER OF DEVIATIONS FOUND 1 2 3 4 5 6 7 8 9 10 10 PERCENT RISK OF OVER RELIANCE (RIA or Beta Risk) 20 10.9 18.1 24.5 30.5 36.1 41.5 46.8 51.9 56.8 61.6 66.2 25 8.8 14.7 20.0 24.9 29.5 34.0 38.4 42.6 50.8 54.8 30 7.4 12.4 16.8 21.0 28.8 32.5 36.2 39.7 43.2 46.7 35 6.4 10.7 14.5 18.2 21.6 28.2 31.4 34.5 37.6 40.6 40 5.6 9.4 12.8 16.0 19.0 22.0 27.7 33.2 35.9 45 5.0 8.4 11.4 14.3 17.0 19.7 22.3 24.8 27.3 29.8 32.2 50 4.6 7.6 10.3 12.9 15.4 17.8 20.2 22.5 24.7 27.0 29.2 55 4.2 6.9 11.8 14.1 16.3 18.4 20.5 22.6 24.6 26.7 60 3.8 8.7 10.8 15.0 16.9 18.9 20.8 22.7 65 3.5 5.9 8.0 10.0 12.0 13.9 15.7 17.5 19.3 22.8 70 3.3 5.5 7.5 9.3 11.1 14.6 18.0 19.6 21.2 75 3.1 5.1 7.0 10.4 12.1 13.7 15.2 18.3 19.8 80 2.9 4.8 6.6 8.2 9.8 11.3 15.8 17.2 18.7 90 2.6 4.3 7.3 10.1 11.5 16.7 100 2.3 3.9 5.3 7.9 9.1 12.7 125 1.9 6.3 8.3 10.2 11.2 150 1.6 3.6 4.4 6.1 7.8 8.6 200 1.2 2.0 2.7 3.4 4.0 6.5 7.1 300 0.8 1.3 1.8 4.7 400 0.6 1.0 1.4 1.7 2.4 3.0 500 0.5 1.1 2.1 1.9 1.8 1.6 1.6 1.5 1.9 The Upper and Lower Bounds must be determined. What do these mean? Obtain the Precision Limits from this table – 10% RIA

Overstatements Number of Misstatements (1) Upper Precision Limit Portion (2) Recorded Value (3) Misstatement Unit Error Assumption (4) Bound Portion 2x3x4 Overstatements 0.029 166,000 0.500 $2,407 1 0.019 0.840 2649 2 0.018 0.575 1718 3 0.016 0.517 1373 4 0.359 954 5 0.015 0.069 172 6 0.065 162 Upper Precision Limit 0.128 Initial Misstatement Bound $9,435

Understatements Number of Misstatements (1) Upper Precision Limit Portion (2) Recorded Value (3) Misstatement Unit Error Assumption (4) Bound Portion 2x3x4 Understatements 0.029 166,000 0.500 $2,407 1 0.019 0.067 211 2 0.018 0.037 111 Upper Precision Limit 0.066 Initial Misstatement Bound $2,729

Offsetting Adjustments Number of Misstatements Misstatement Unit Error Assumption (a) Sample Size (b) Recorded Population (c) Point Estimate a(c/b) Bounds Initial Overstatement Bound $9,435 Understatement Misstatements 1 0.067 80 166,000 139 (139) 2 0.037 77 (77) Total 0.104 216 (216) Adjusted Overstatement Bound 9,219 Initial Understatement Bound 2,729 Overstatement Misstatements 0.840 1743 (1743) 0.575 1193 (1193) 3 0.517 1073 (1073) 4 0.359 745 (745) 5 0.069 143 (143) 6 0.065 135 (135) 2.425 5032 (5032) Adjusted Understatement Bound -2303 As the Upper Bound is greater than the materiality of $6,000, there may be a material misstatement

Tolerable misstatement The Decision Rule Reject Tolerable misstatement ($6,000) $6,000 $2,303 LMB $9,219 UMB Problem Since materiality is $6,000, there may be material misstatement.

Problem EP 11-4, Page 609 Several accounts receivable confirmations have been returned with the notation “verification of supplier statements is no longer possible because our data processing system does not accumulate each supplier’s invoice”. Required: What alternative auditing procedures could be used to audit these accounts receivable? (© 2000, American Institute of CPAs. All rights reserved. Adapted by permission.)

Solution to Problem EP 11-4 The auditor can consider alternative confirmation methods to test the accounts receivable balance, such as confirming individual invoices in the balance. Auditing procedures other than confirmation which may be used to verify an account receivable include: Examination of evidence of subsequent payment of the account including: The customer’s remittance advice accompanied by the payment. The cheque sent in by the customer. An authenticated bank deposit ticket listing a deposited cheque for the outstanding account. An entry in the cash receipts book. A credit posted to the customer’s account. Examination of other evidence including: Shipping department’s notice of shipment, accompanied possibly by a receipted copy of the bill of lading, the customer’s purchase order, sales invoices, and any correspondence referring to the shipment of the goods. Entries removing the goods from inventory. Time records and work orders, if appropriate. External inquiries as to the existence and credit rating of the debtor. Discussion of the account with the auditee’s credit manager, examination of credit department records, and records of merchandise returned, and such other investigation as may lead to better understanding of the nature of the account and its collectability.

Problem EP 11-5, Page 609 During the audit of the December 31, 20X5, financial statements, the auditor identifies cash amounts received after December 31, 20X5, and traces these amounts to the cash account in the general ledger and to the accounts receivable subledger balances at December 31, 20X5. Required: What kind of procedure is this? Which financial statement assertion does it provide evidence for? What records or documents would the auditor need to look at to identify cash amounts received after year-end?

Solution to Problem EP 11-5 The type of audit procedure is document inspection - vouching. The type of evidence created by testing in this direction is support for the existence of the related account receivable balance at the year end.  Knowledge of accounting system components, such as the names of books and records used by the auditee to record cash receipts would be applied to answer this part. The auditor would need to examine the cash receipts journal and post-year-end bank statements and deposit records to verify cash received after year end.

Problem DC 11-6, Page 613 The ABC Appliance Company, a manufacturer of small electrical appliances, deals exclusively with 20 distributors situated throughout the country. At December 31 (the balance sheet date), receivables from these distributors aggregated $875,000. Total current assets were 1.3 million. With respect to receivables, the auditors followed the procedures outlined below in the course of the annual audit of the financial statements. Reviewed the system of internal control and found it to be exceptionally good. Reconciled the subsidiary ledger and control accounts at year-end. Aged the accounts – none were overdue. Examined detailed sales and collection transactions for February, July, and November. Received positive confirmations of year-end balances. Required: Criticize the completeness or incompleteness of the above program, giving reasons for your recommendations concerning the addition or omission of any procedures.

Solution to Problem DC 11-6 Receivables audit procedures   The procedure followed appears to be appropriate except that the examination of detail transactions for three months might be considered to be excessive in view of the exceptionally good internal control. A lighter test of such transactions, designed to test the effectiveness of the control procedures, might be devised. The procedures followed should be supplemented by the following: Review the company's method of sales cutoff at year-end and test billings and shipments (including returns) for an adequate period before and after year-end to establish that cut-off procedures have been adhered to. Examine collections in early part of subsequent period to determine if a substantial portion of the receivables has been collected. Examine agreements entered into with the distributors. If price protection clauses are included, review the current price position and distributor inventory positions to determine whether a reserve for such protection is needed. When a company deals with a limited number of customers, it is dependent upon the continued solvency of all such customers. Obtain a representation letter from appropriate company officials covering the receivables.

Problem DC 11-9, Page 615 The auditor of a stock exchange brokerage company, Roller Securities Inc., sends out negative confirmations of account details for a sample of about 50% of the stock brokerage’s customers, selected at random. Historically, 2-5% of the confirmations have been returned, and the majority of the discrepancies reported have been understatements. Investigation of those discrepancies rarely indicates an error on Roller Securities Inc.’s part. Usually, they are explained by transactions that are in progress or pending over the year-end, by late payments on the customer’s part, or by other mistakes in the customer’s own records. Required: Describe the inherent risks and the internal control risks that exist for customer accounts at Roller Securities Inc. Discuss the advantages and disadvantages of using negative confirmations to provide audit evidence about the assertions in this case. Comment on the persuasiveness of the evidence the negative confirmations provide. Do you think it can be sufficient to support the auditor’s opinion?

Solution to Problem DC 11-9 The case requires one to consider risks in a stock brokerage business and evaluate the appropriateness of negative confirmations as audit evidence. One suggested approach to the analysis is as follows: (a) The main inherent risk is failing to record a customer stock transaction correctly, or omitting recording it. This would result in invalid or incomplete information in the customer’s account. Given that marketable securities are involved, there is also a fairly high risk of fraud by misappropriation of customer funds or investments. Regulatory non-compliance is another consideration. Given the types of inherent risks to be controlled, strong controls are required over authorization, ownership, completeness and validity of customer trades and account balances. There is also the risk that customers will provide incorrect information and the need to keep records of customer telephone orders and instructions, issue confirmations, and verify customer account details regularly. The external audit in this situation can complement internal controls by providing a further check on validity, completeness and authorization/ownership.

Solution to Problem DC 11-9, continued Negative confirmations are relatively inexpensive and a large percentage of the customer population can be queried. A weakness is the low response rate, and the inability to know if non-responses would have indicated errors. They do get at the key concern that customer assets have been misappropriated by the stock brokerage firm since customers are more likely to respond when their accounts are incomplete.

Problem DC 11-10, Page 615 Parts Inc. sells electrical components to large department stores and also has a few cash sales to electricians. Sales invoices are prepared for all sales. Cash sales are recorded in the cash receipts journal, and cash is deposited to the bank each day. All sales to large stores are credit sales and are handled by sales clerks by telephone or email. The sales clerk takes the customer’s request, checks the authorized customer list for credit limits (if it is a credit sale), prepares the sales invoice, and sends one copy to the inventory control department, which sends the ordered goods to the shipping department. For cash sales, the inventory control clerk brings the items sold to the sales counter and the goods are given to the purchaser at the time of sale. For credit sales, the shipping clerk signs the inventory control copy of the sales invoice and then prepares a shipping invoice. A third copy of the sales invoice is forwarded to the accounting department so that a clerk can enter the sale into the sales journal. The shipping invoices are maintained in the shipping department in case a shipment needs to be checked. All goods are shipped FOB shipping point. Required: Design two audit procedures, in addition to sample selection, that will provide evidence of he occurrence/existence of sales. Identify the procedure (trace, compare, vouch, and so on) and the documents you are using, and explain why these procedures will show whether recorded sales are valid. Design two audit procedures that will provide evidence of the completeness of sales. Identify the procedure (trace compare, vouch, and so on) and the documents you are using, and explain why these procedures will show whether recorded sales are complete. (Adapted from External Auditing (AU1), June 2011, with permission of Chartered Professional Accountants of Canada, Toronto, Canada)

Solution to problem DC11-10 Procedures that would be appropriate include: (a) Select a sample of sales from the sales journal and vouch to the sales invoice and then to the shipping document. Any credit sale not shipped is not a valid sale. Trace cash sale invoices to cash receipts journal or bank deposit. Any sale recorded as a cash sale but not paid for would likely not be a valid sale. (b) Select a sample of shipping invoices and trace to sales invoice and then to sales journal, to find any sales shipped but not recorded in the sales journal. Trace cash deposits for last week before year end to sales journal to find unrecorded sales.