Ch3 checkpoints by b9Wd4w


									Important Note re: Chapter Review Checkpoint questions:

      As you read and study each of chapter content thoroughly, please try to answer the
      review checkpoint questions (within chapter content) on your own prior to
      reading the following notes.
Answers to Chapter Reading Review Checkpoints-ch.3

3.1   White collar crimes are frauds perpetrated by people who work in offices and steal with a pencil or a
      computer terminal. The contrast is violent street crime.

      Employee fraud is the use of fraudulent means to take money or other property from an employer. It
      consists of three phases: (1) the fraudulent act, (2) the conversion of the money or property to the
      fraudster’s use and (3) the cover-up.

      Embezzlement is a type of fraud involving employees or nonemployees wrongfully taking funds or
      property entrusted to their care, custody, and control, often accompanied by false accounting entries and
      other forms of lying and cover-up.

      Larceny is simple theft of an employer’s property that is not entrusted to an employee’s care, custody or

      Defalcation is another name for employee fraud and embezzlement.

      Errors are unintentional misstatements or omissions of amounts or disclosures in financial statements.

      Direct-effect illegal acts are violations of laws or government regulations by the company or its
      management or employees that produce direct and material effects on dollar amounts in financial
      statements. “Illegal acts” (far-removed) are violations of laws and regulations that are far removed from
      financial statement effects (for example, violations relating to insider securities trading, occupational health
      and safety, food and drug administration, environmental protection, and equal employment opportunity).

3.2   AICPA auditing standards require that:

      a.       audit team members have an understanding and awareness of signs of errors, frauds (including
               direct-effect illegal acts), and indirect-effect illegal acts.

      b.       the audit be designed to respond to knowledge of fraud risks and provide reasonable assurance of
               detecting material errors and frauds (including direct-effect illegal acts).

      c.       audit team members should have the proper degree of professional skepticism, assuming neither
               dishonesty nor unquestioned honesty of management.

      d.       for reporting, the materiality concept is different for errors, fraud, and illegal acts. For errors, the
               usual idea of materiality prevails; for frauds (including direct-effect and far-removed illegal acts)
               immateriality is expressed in terms of “clearly inconsequential.” Matters that fall below the
               threshold apparently can be reported to levels of management below the board of directors and
               audit committee. More significant matters are reported to the director level, and management
               involvement in frauds and illegal acts is never considered inconsequential.
3.3   The seven steps specified by SAS 99: Consideration of Fraud in a Financial Statement Audit are:

      Step 1:   Engagement Team Discussion (“Brain Storming”)
      Step 2:   Identify Information Necessary to Assess Fraud Risk Factors
      Step 3:   (a) Identify Risk Factors Related to Fraudulent Financial Reporting and (b) Assess Fraud Risks
      Step 4:   Respond to Assessed Risks
      Step 5:   Evaluate Audit Evidence
      Step 6:   Communicate Fraud Matters
      Step 7:   Document Fraud Matters

3.4   Below are some other conditions and circumstances that have existed along with frauds in the past:
      Fraud Risk Factors

         Management’s Characteristics and                    Industry                  Operating Characteristics and
                      Influence                             Conditions                       Financial Stability
          Management has a motivation              Company profits lag the           A weak internal control
           (bonus compensation, stock                industry.                          environment prevails.
           options, etc.) to engage in              New requirements are              The company is not able to
           fraudulent reporting.                     passed that could impair           generate sufficient cash flows to
          Management decisions are                  stability or profitability.        ensure that it is a going concern.
           dominated by an individual or a          The company’s market is           There is pressure to obtain
           small group.                              saturated due to fierce            capital.
          Management fails to display an            competition.                      The company operates in a tax
           appropriate attitude about internal      The company’s industry is          haven jurisdiction.
           control and financial reporting.          declining.                        The company has many difficult
          Managers’ attitudes are very             The company’s industry is          accounting measurement and
           aggressive toward financial               changing rapidly.                  presentation issues.
           reporting.                                                                  The company has significant
          Managers place too much                                                      transactions or balances that are
           emphasis on earnings projections.                                            difficult to audit.
          Nonfinancial management                                                     The company has significant and
           participates excessively in the                                              unusual related-party
           selection of accounting principles                                           transactions.
           or determination of estimates.                                              Company accounting personnel
          The company has a high turnover                                              are lax or inexperienced in their
           of senior management.                                                        duties.
          The company has a known history
           of violations.
          Managers and employees tend to
           be evasive when responding to
           auditors’ inquiries.
          Managers engage in frequent
           disputes with auditors.

3.5   Auditors should know how to preserve the chain of custody of evidence. The chain of custody is the crucial
      link of the evidence to the suspect, called the “relevance” of evidence by attorneys and judges. If
      documents are lost, mutilated, coffee-soaked, compromised (so a defense attorney can argue that they were
      altered to frame the suspect), they can lose their effectiveness for the prosecution.
3.6   a.       There is no difference among the categories at the awareness level.

      b.       The expectation is lower for far-removed illegal acts, where audit procedures (other than inquiry
               and familiarity) are performed only when specific information indicates that possible illegal acts
               may have a material indirect effect on financial statements.

      c.       About the same degree of skepticism with respect to all the categories; in connection with errors
               and frauds (including direct-effect illegal acts) auditors should have the proper degree of
               professional skepticism, assuming neither dishonesty nor unquestioned honesty of management; in
               connection with far-removed illegal acts, auditors should make inquiries about management’s
               policies and procedures for compliance with laws and regulations and obtain written management
               representations concerning the absence of violations of laws and regulations.

      d.       For reporting, the materiality concept is different: (1) for errors, the usual idea of materiality
               prevails, (2) for frauds (including direct-effect and far-removed illegal acts), immateriality is
               expressed in terms of “clearly inconsequential.” Matters that fall below the threshold can be
               reported to levels of management below the board of directors and audit committee. More
               important matters go to the director level, and management involvement in frauds and illegal acts
               is never considered inconsequential.

3.7   Audit risk is a concept applied both to the probability of issuing an inappropriate opinion and to the
      probability of failing to detect material errors and frauds in a particular disclosure or account balance.
      Audit risk is a conceptual combination of the other risks: Audit Risk = Inherent Risk x Internal Control
      Risk x Detection Risk.

      “Audit risk in an overall sense” refers to the audit taken as a whole and the probability that the auditors will
      issue an inappropriate opinion on financial statements. Generally, this is the risk of giving the standard
      unqualified report when the financial statements contain material misstatements or the report should be
      qualified or modified in some manner.

      “Audit risk applied to individual account balances” refers to the probability that auditors will fail to
      discover misstatement in a particular account balance at least equal to the tolerable misstatement assigned
      to the audit of that balance. This version of audit risk is applied in concept at the individual account
      balance level.

3.8   The three components of audit risk are:

      Inherent risk--the probability that material errors or frauds have entered the data processing system.

      Internal control risk--the probability that the client’s system of internal control will fail to detect material
      errors and frauds, provided any enter the accounting system in the first place.

      Detection risk--the probability that audit procedures will fail to find material errors and frauds, provided
      any have entered the system and have not been detected or corrected by the client’s internal control system.

3.9   From the Audit Risk Alert

      Some of the effects of bad economic times auditors should be alert to detect in clients’ financial statements:

              Asset valuations--recoverability and bases of accounting.
              Inappropriate offsetting of assets and liabilities.
              Changes in cost-deferral policies and the reasonableness of amortization periods.
              Allowances for doubtful accounts, in general, and loan-loss allowances for financial institutions,
               in particular.
                Compliance with financial covenants and the necessity to obtain waivers from lending institutions
                 to meet current requirements.
                Changes in sales practices or terms that may require a change in accounting.

3.10   The nature of audit procedures refers to their effectiveness in detecting errors and fraud. Confirmation
       with third parties is more effective in detecting errors and fraud than verbal inquiry.

       The timing of audit procedures refers to when they are performed, usually at (1) interim, or at (2) year-end.
       However, timing may have other aspects such as surprise procedures (unannounced to client personnel) or
       procedures performed after the year-end.

       The extent of the application of procedures usually refers to the sample sizes of data examined, such as the
       number of customer accounts receivable to confirm, or the number of inventory types to count.

3.11   “Material information” in accounting and auditing is “information that should be disclosed if it is likely to
       influence the economic decisions of financial statement users.

3.12   On an audit engagement, the audit team uses materiality three ways:

            a.   As a guide to planning substantive procedures (collectively referred to as the audit plan)—
                 directing attention and audit work to those items or accounts that are important, uncertain, or
                 susceptible to errors or frauds.

            b.   As a guide to evaluation of the evidence. Auditors use performance materiality (an amount less
                 than materiality for the financial statements as a whole) to make sure that the aggregate of
                 uncorrected and undetected immaterial misstatements does not exceed materiality for the financial
                 statements as a whole. For example, auditors may use an amount smaller than overall financial
                 statement materiality when auditing particular classes of transactions, account balances, or

            c.   As a guide for making decisions about the audit report. An account such as inventory can be
                 material in an audit context because of its size or its place in the financial statements. Additionally,
                 inventory’s importance can result from the potential for misstatement or the effect that a
                 misstatement can have on the financial statements.

3.13   “Vouching” relates to the examination of documents. Generally, items of financial information are selected
       from an account, and auditors then go backward through the bookkeeping-filing system to find the source
       documentation which supports the item selected.

       “Tracing” essentially is the opposite direction compared to “vouching”. In the process of tracing, auditors
       select sample items of basic source documents and proceeds forward through the bookkeeping process to
       find the final recording of the accounting transactions.

       “Scanning” refers to the auditors scrutinizing documentation for unusual items and events.
3.14    Auditors use eight general audit procedures to gather evidence: (1) inspection of records and
documents (vouching, tracing, scanning), (2) inspection of tangible assets, (3) observation, (4) inquiry,
(5) confirmation, (6) recalculation, (7) reperformance, and (8) analytical procedures. One or more of these
procedures may be used no matter what account balance, control procedure, class of transactions, or other
information is under audit.

3.15   Five types of general analytical procedures and their sources:

         Analytical Procedures                                  Sources of Information
         1. Comparison of current-year account balances         Financial account information for
             to balances of one or more comparable              comparable period(s)
             periods                                            Example: Current year’s Cost of Goods
                                                                Sold compared to last year’s balance
         2.   Comparison of the current-year account            Company budgets and forecasts
              balances to anticipated results found in the      Example: Current year’s Cost of Goods
              company’s budgets and forecasts                   Sold compared to the company’s budgeted
         3.   Evaluation of the relationships of current-       Financial relationships among accounts in
              year account balances to other current-year       the current period
              balances for conformity with predictable          Example: Days’ Sales in Inventory
              patterns based on the company’s experience
         4.   Comparison of current-year account balances       Industry statistics
              and financial relationships (e.g., ratios) with   Example: Days’ Sales in Inventory
              similar information for the industry in which     compared to industry averages
              the company operates
         5.   Study of the relationships of current-year        Nonfinancial information such as physical
              account balances with relevant nonfinancial       production statistics
              information (e.g., physical production            Example: Days’ Sales in Inventory
              statistics)                                       compared to unfilled orders

3.16   Professional standards require that analytic procedures be used during planning and during final evaluation
       stages of the audit; they are optional for use as substantive audit procedures.

3.17   An audit plan is a list of the audit procedures the auditors need to perform to gather sufficient appropriate
       evidence on which to base their opinion on the financial statements. Auditors indicate when they have
       performed each procedure, and where the evidence is documented. Thus, audit plans are used not only for
       quality control and supervision, but also as documentation that the audit team is following generally
       accepted auditing standards.

3.18   An internal control plan contains the specification of procedures for obtaining an understanding of the
       client’s business and internal control and for assessing the inherent risk and the control risk related to the
       financial account balances and classes of transactions. A substantive audit plan contains the specification of
       substantive procedures for gathering direct evidence on management’s assertions (i.e., existence,
       occurrence, completeness, cutoff, rights and obligations, valuation and allocation, accuracy, classification,
       and understandability) about amounts and disclosures in the financial statements.
3.19   Four “cycles” and accounts in them:

       Revenue and collection cycle
             Acquisition and expenditure cycle
                    Production and conversion cycle
                            Financing and investment cycle

        X      X      X      X     Cash
        X                          Accounts receivable
        X                          Allowance for doubtful accounts
        X                          Sales
        X                          Sales returns
        X                          Bad debt expense

               X      X            Inventory
               X                   Fixed assets
               X                   Accumulated depreciation
               X                   Accounts payable
               X                   Accrued expenses
               X                   General expense

                      X            Cost of goods sold
               X      X            Depreciation expense

                             X     Marketable securities
                             X     Bank loans
                             X     Long term notes
                             X     Accrued interest
                             X     Capital stock
                             X     Retained earnings
                             X     Dividends declared
                             X     Interest expense
                             X     Income tax expense

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