Q1:Discuss how the SEC has influence (if any) over the audit of Smackey Dog Foods, Inc. Solution:
The SEC assists in providing investors with reliable information upon which to make investment decision. The Securities Act of 1933 requires most companies planning to issue new securities to the public to submit a registration statement to the SEC for approval. The Securities Exchange Act of 1934 provides additional protection by requiring public companies and others to file detailed annual reports with the commission. Smackey Dog Food, need to file next forms: Form S-1. “S” forms apply to the Securities Act of 1933 and must be completed and registered with the SEC when a company plans to issue new securities to the public. The S-1 form is the general form used when there is no specifically prescribed form. Form 10-Q. This report must be filed quarterly for all publicly held companies. It contains certain financial information and requires timely auditor reviews of the financial statements before filing with the commission. Q2: Discuss the essential activities involved in the initial planning of an audit. How do these all specifically to the Smackey Dog Food client? Solution:
Audit Planning consist of the following:
1. The auditor decides whether to accept a new client or continue serving an existing one. This determination is typically made by an experienced auditor who is in a position to make a important decisions. The auditor wants to make this decision early, before incurring any significant cost that cannot be recovered. With Smackey Dog Food, Keller CPA had time to devote to the audit and therefore accepted the job. 2. The auditor identifies why the client wants or needs an audit. This information is likely to affect the remaining parts of the planning process.
3. To avoid misunderstandings, the auditor obtains an understanding with the client about the terms of the engagement. With Smackey Dog Food, the auditors sent over the audit staffers to assess the client and plan the audit. 4. The auditor develops an overall strategy for the audit, including engagement staffing and any required audit specialist. Q3:Discuss the 4 stages of the audit and the major activities performed by the auditor in each phase. Give an example of how each of these specifically applies to the Smackey Dog Food, Inc audit. For instance, examine the apparent internal control weaknesses and possible negative outcome of each. Solution:
Plan and Design an Audit Approach (Phase I)
For any given audit, there are many ways in which an auditor can accumulate evidence to meet the overall audit objective of providing an opinion on the financial statements. Two overriding considerations affect the approach the auditor selects: 1.Sufficient appropriate evidence must be accumulated to meet the auditor’s professional responsibility. 2.The cost of accumulating the evidence should be minimized. The first consideration is the most important, but cost minimization is necessary if CPA firms are to be competitive and profitable. If there were no concern for controlling costs, evidence decision making would be easy. Auditors would keep adding evidence, without concern for efficiency, until they were sufficiently certain that there were no material misstatements. Concern for sufficient appropriate evidence and cost control necessitates planning the engagement.
The plan should result in an effective audit approach at a reasonable cost. Perform Tests of Controls and Substantive Tests of Transactions (Phase II) Before auditors can justify reducing planned assessed control risk when internal controls are believed to be effective, they must first test the effectiveness of the controls. The procedures for this type of testing are commonly referred to as tests of controls. For example, assume a client’s internal controls require the verification by an independent clerk of all unit selling prices on sales before sales invoices are mailed to customers. This control is directly related to the accuracy transaction-related audit objective for sales. The auditor might test the effectiveness of this control by examining a sample of duplicate sales invoices for the clerk’s initials indicating that the unit selling price was verified. Auditors also evaluate the client’s recording of transactions by verifying the monetary amounts of transactions, a process called substantive tests of transactions.
For example, the auditor might compare the unit selling price on a duplicate sales invoice with the approved price list as a test of the accuracy objective for sales transactions. Like the test of control in the preceding paragraph, this test satisfies the accuracy transaction-related audit objective for sales. For the sake of efficiency, auditors often perform tests of controls and substantive tests of transactions at the same time. Perform Analytical Procedures and Tests of Details of Balances (Phase III) There are two general categories of phase III procedures.
Analytical procedures use comparisons and relationships to assess whether account balances or other data appear reasonable. For example, to provide some assurance for the accuracy objective for both sales transactions (transaction-related audit objective) and accounts receivable (balance-related audit objective), the auditor might examine sales transactions in the sales journal for unusually large amounts and also compare total monthly sales with prior years. If a company is consistently using incorrect sales prices or improperly recording sales, significant differences are likely. Tests of details of balances are specific procedures intended to test for monetary misstatements in the balances in the financial statements Complete the Audit and Issue an Audit Report (Phase IV)
After the auditor has completed all procedures for each audit objective and for each financial statement account and related disclosures, it is necessary to combine the information obtained to reach an overall conclusion as to whether the financial statements are fairly presented. This highly subjective process relies heavily on the auditor’s professional judgment. When the audit is completed, the CPA must issue an audit report to accompany the client’s published financial statements.
Q4:Describe Keller CPAs’ responsibilities related to communications regarding internal control matters. What internal controls issues do you identify? Solution:
1. Recorded transactions exist (occurrence).
2. Existing transactions are recorded (completeness)
3. Recorded transactions are correctly included in the master files and are correctly summarized (posting and summarization)
4. Recorded transactions
are stated at the correct amounts (accuracy)
5. Transactions are correctly classified (classification)
6. Transactions are recorded on the correct dates (timing)
There are several internal control issues for Smackey Dog Food: a. Lack of Internal Control
b. Segregation of Duties
c. Lack of control on main production for the company
d. Lack of control in accounting records procedure
e. Lack of control in handling and recording accounts receivable
Q5:You decide that you will address Smackey Dog Food, Inc.’s accounts receivables through confirmations. Discuss the various types of confirmations and what forms you will implement and why. Solution:
A positive confirmation is a communication addressed to the debtor requesting the recipient to confirm directly whether the balance as stated on the confirmation request is correct or incorrect. A blank confirmation form is a type of positive confirmation that does not state the amount on the confirmation but requests the recipient to fill in the balance or furnish other information. Because blank forms require the recipient to determine the information requested, they are considered more reliable than confirmations that include balance information. Blank forms are rarely used in practice because they often result in lower response rates. An invoice confirmation is another type of positive confirmation in which an individual invoice is confirmed, rather than the customer’s entire accounts receivable balance. A negative confirmation is also addressed to the debtor but requests a response only when the debtor disagrees with the stated amount. In Smackey Dog Food case I will implement positive confirmation. A positive confirmation is more reliable evidence because the auditor can perform follow-up procedures if a response is not received from the debtor.
Q6:What are the major factors affecting sample size for confirming accounts receivable? Solution:
When practical and reasonable, the confirmation of a sample of accounts
receivable is required. This requirement exists because A/R usually represents a significant balance on the financial statement, and confirmations are a highly reliable type of evidence. Confirmation of accounts selected from the trial balance is the most common test of details of balances for the accuracy of accounts receivable. Auditors perform test of the debits and credits to individual customer’s balances by examining supporting documentation for shipments and cash receipts. Auditors will determine whether receivables from related parties have been separated on the aged trial balance.
Q7:A major issue in verifying the ending balance in property, plant and equipment is the possibility of legal encumbrances. Discuss what specific concern do you have. Describe the procedures your firm will perform to obtain evidence about existing legal encumbrances. Solution:
It is common practice to do so part of the audit of the property, plant and equipment accounts. It is possible the client has incorrectly capitalized repairs, rents or similar expenses. Clients commonly include transactions that should be recorded as assets in repairs and maintenance expense, lease expense, supplies, small tools, and similar accounts. If I was to conclude this type of material misstatement is likely, they may need to do larger amounts of debited to the expense accounts? In addition to performing procedures to obtain evidence related to balance-related audit objectives for fixed assets, auditors also perform audit procedures related to the four presentation and disclosure objectives for fixed assets.
A major consideration in verifying disclosures related to fixed assets is the possibility of legal encumbrances. Auditors may use several methods to determine whether manufacturing equipment is encumbered, including: Read the terms of loan and credit agreements; Mail loan confirmation requests to banks and other lending institutions and Have discussions with the client or send letters to legal counsel. Q8:The client wants to know if you will be present at the year-end inventory. What is your decision and why? What role or actions will you take at the inventory if you decide to attend the inventory. Why? Solution:
I would be present at the year-end inventory because the inventory count is done by in-house personnel. SAS 1 now requires auditors to satisfy themselves about the effectiveness of the client’s methods of counting inventory and the reliance they can place on the client’s representation about the quantities and physical condition of the inventory. As an auditor, I will: Be prepared at the time the client counts their inventory for determining year-end balances; Observe the client’s counting procedures; Make inquires of client personnel about their counting procedures and Make my own independent tests of the physical count I would be responsible for evaluating and observing the client’s procedures, including doing test counts of the inventory and drawing conclusions about the adequacy of the physical inventory. An auditor doesn’t need to a physical examination if the inventory is housed in a public warehouse or overseen by outside custodians.
Q9:Considering the general six functions that make up the inventory and warehousing cycle for Smackey Dog Foods, Inc., identify the related documents and/or records that would be used. From your analysis of the internal controls related to the inventory and warehousing cycle of Smackey Dog Foods, Inc., what internal control weaknesses exist? Solution:
An adequate cost accounting system is an important part of the processing of goods function for all manufacturing companies. The Smackey Dog Food Inc, has so much waste that they should consider a job cost system. They should begin with acquisition of raw materials for production. Adequate controls over purchasing must be maintained whether inventory purchases are for raw material for a manufacturer or finished goods for a retailer. Receipt of the ordered materials for productions its part of the acquisition and payment cycle, involves the inspection of material received for quantity and quality. The receiving department should prepare a receiving report that becomes a part of the documentation before payment is made. After inspection, the material is sent to the storeroom and copies of the receiving documents are sent to purchasing, the storeroom and A/P.
Once received, materials should be stored in a stockroom. If another department needs materials for production, personnel submit a properly approved materials requisition, work order, or similar document. This requisition document is used to update the perpetual inventory master files and record transfers from raw materials to work-in-process accounts. These updates occur automatically in organizations with integrated inventory management and accounting software systems. They could consider determining the finished goods items and quantities they will produce based on specific orders from customers, sales forecasts, predetermined finished goods inventory levels, and economical production runs. Production department should make provisions to account for the quantities produced, control of scrap, quality controls, and physical protection of material in process. There are many internal weaknesses and to correct them it may take replacing some individuals on the management team. One good internal control would be for finished goods in that they are should be kept under physical control in a separate, limited-access area.
Knowledge about a client’s internal control is included in a separated generally accepted auditing standard. The auditor must obtain a sufficient understanding of the entity and its environment, including its internal controls, to assess the risk of material misstatement of the financial statements whether due to error or fraud and to design the nature, timing, and extent of further audit procedures. The auditor obtains the understanding of internal control to assess control risk in every audit. Auditors are primarily concerned about controls over the reliability of financial reporting and controls over classes of transactions. Q10:Discuss if Keller CPAs or its auditors are breaching any Professional Rules of Conduct and why or why not? Solution:
A disclaimer of opinion must be issued if the auditor is determined to lack independence under the rules of the Code of Professional Conduct. This strict requirement reflects the importance of independence to auditors. In return for the faith that the public reposes in them, members should seek continually to demonstrate their dedication to professional excellence. Pete was out of compliance to discuss Smackey Dog Food Inc with his friend Alan. Members have a continuing responsibility to cooperate with each other to improve the art of accounting, maintain the public’s confidence, and carry out the profession’s special responsibilities for self-governance. The collective efforts of all members are required to maintain and enhance the traditions of the profession. Rule # 101-No violation
Rule # 102- Yes, volition; because Pete’s (Pete is auditing manager) new best friend, Alan, was married to Smackey Dog Food, Inc.’s owner, Kim, 4 years ago
201General standards-No violation
202Compliance with standards- No violation
203Accounting principles- No violation
301Confidential client information-Yes, violation; because Pete has talked 302Contingent fees- No violation
501Acts discreditable- No violation
502Advertising and other forms of solicitation- No violation 503Commissions and referral fees- No violation
505Form of organization and name- No violation
Q11:Discuss the CPA firm’s legal liability concerns for this audit if they make a material unintentional or intentional mistake. Include any other legal liability concerns regarding possible Professional Rule violations.
The inclusion of the word material conveys that auditors are responsible only to search for significant, not minor misstatements that do not affect users’ decisions. An audit provides a high level of assurance, but it is not a guarantee. When an audit has failed to uncover material misstatements and the wrong type of audit opinion is issued, it is appropriate to question whether the auditor exercised due care in performing the audit. The law often allows parties who suffered losses to recover some or all of the losses caused by the audit failure. It is difficult to determine when the auditor has failed to use due care. Legal precedent makes it difficult to determine who has the right to expect the benefit of an audit. An auditor’s failure to follow due care often results in liability and damages against the CPA firm. Four sources of auditors’ legal liability consist:
1. Liability to clients
2. Liability to third parties under common law
3. Civil liability under the federal securities laws
4. Criminal liability