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Auditing: A Risk Based Approach to Conducting a Quality Audit, 10e
Solutions for Chapter 6
True/False Questions
6-2 F
6-4 F
6-6 F
6-8 T
6-10 T
6-12 T
6-14 F
6-16 T
6-18 F
6-20 T
Multiple-Choice Questions
6-22 C
6-24 D
6-26 B
6-28 C
6-30 B
6-32 D
6-34 C
6-2
6-37 B
6-39 D
6-40 D
Review and Short Case Questions
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Sufficiency is defined as: “The measure of the quantity of audit evidence. The quantity of the
audit evidence needed is affected by the auditor’s assessment of the risks of material
misstatement and also by the quality of such audit evidence.” (ISA 500.5)
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What is determined to be appropriate and sufficient will be affected by the client’s risk of
material misstatement (i.e., inherent and control risks) or risk of material weakness, and will vary
across accounts and assertions. Both the U.S. and international auditing standards encourage
auditors to focus on accounts and assertions with the greatest likelihood of material
misstatement. There are cost implications associated with differences in appropriateness and
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The AICPA’s AU–C 500 defines the appropriateness of audit evidence as “The measure of the
quality of audit evidence (that is, its relevance and reliability in providing support for the
conclusions on which the auditor’s opinion is based)”. Appropriateness of audit evidence is a
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Directional testing is the design of audit tests to search primarily for either over-or
understatements for particular accounts (but not both). It takes advantage of the double entry
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Exhibit 6.2 compares testing related to the existence and completeness assertions. Panel A
illustrates the auditor’s work flow when testing for existence. This process is referred to as
vouching. Vouching involves taking a sample of recorded transactions and obtaining the original
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All things being equal, external documentary evidence is considered more reliable than internally
generated evidence. However, it is seldom that “all things are equal”. External documentary
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Procedure
How Used (examples)
Assertion(s) Tested
1. Observation
Observe client personnel taking a
physical inventory.
This is a test of control, but
can be used to provide
indirect evidence about the
following assertions:
Completeness, Existence,
Valuation
2. Reperformance
Recount selected inventory
Completeness
3. Inspection of
assets
Physically inspect selected
inventory items.
Existence, Valuation
4. Inquiry
1. in on consignment,
2. Completeness
3. that is obsolete or slow moving.
Ask whether there is any
inventory
2. out on consignment or stored in
public warehouses,
1. Rights
3. Valuation
consignment or in a public
warehouse.
Valuation, Rights
5. External
Confirm inventory out on
Existence, Completeness,
6. Inspection of
Documentation
Analyze sales/purchase contracts
for any special terms.
Valuation, Existence,
Completeness
7. Recalculation
Recalculate quantity times unit
cost and foot the file.
Valuation
inventory.
8. Analytical
Calculate inventory turnover and
Any of the five assertions
9. Scanning
Scanning inventory sub ledger for
unusual entries
Any of the five assertions
6-5
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Type of Audit Procedure
Assertions Tested
a. Analytical procedures
Any of the five assertions
b. Inspection of documentation
Completeness
c. Recalculation
Valuation
d. Inspection of documentation
Existence
e. Inspection of documentation
Existence, Valuation
f. Inspection of assets
Existence
g. Inspection of assets
Existence, Valuation
h. Inspection of documentation
Valuation, Completeness
i. External confirmation
Existence
j. Analytical Procedure
Valuation, completeness
k. Inquiry of Company Personnel
Completeness, Disclosure, Valuation
l. Inquiry of Company Personnel
Valuation
m. Reperformance
Completeness, Existence, Valuation
n. Inquiry of Company Personnel
Multiple assertions depending on the controls
o. Inspection of Documents
Completeness, Existence, Valuation
p. External confirmations
Completeness, Valuation, Disclosure
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1. Continued decline in market share, and a market shift (or an increase in or acceleration of
market shift) away from sales of trucks or sport utility vehicles, or from sales of other more
profitable vehicles in the United States.
Account: Sales revenue
2. Continued or increased price competition resulting from industry overcapacity, currency
fluctuations or other factors.
3. Lower-than-anticipated market acceptance of new or existing products.
Account: Inventory.
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4. Substantial pension and postretirement healthcare and life insurance liabilities impairing
our liquidity or financial condition.
5. Worse-than-assumed economic and demographic experience for our postretirement benefit
plans (e.g., discount rates, investment returns, and health care cost trends).
6. The discovery of defects in vehicles resulting in delays in new model launches, recall
campaigns or increased warranty costs.
Account: Inventory, warranty expense/liability.
7. Unusual or significant litigation or governmental investigations arising out of alleged
defects in our products or otherwise.
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a. Relevance means that the evidence addresses the assertion. For example, inspecting the
client’s inventory addresses the existence of the inventory, but does not address the
disclosure or rights assertions.
Reliability of evidence implies that the auditor can trust the evidence because the auditor
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b. The reliability of audit evidence is judged by its ability to provide convincing evidence
related to the audit objective being evaluated. In considering the reliability of audit
evidence, it is instructive to review the text of ISA 500 (A31), which states:
The reliability of information to be used as audit evidence, and therefore of the
audit evidence itself, is influenced by its source and its nature, and the
circumstances under which it is obtained, including the controls over its
This statement highlights the importance of considering the source of the evidence in
assessing its reliability. The IAASB, in ISA 500, has established the following
generalizations about the reliability of audit evidence:
More Reliable
Less Reliable
Directly obtained evidence (e.g.,
observation of a control)
Indirectly obtained evidence (e.g., an
inquiry about the working of a control)
system
Evidence from independent outside
sources
organization
Evidence that exists in documentary
form
Verbal evidence
on the quality of controls over their
preparation and maintenance)
Evidence derived from a well-
Evidence derived from a poorly controlled
c.
Judgment
Error
Yes or No
Nature of Error
Relevance, Reliability, or Both
Explanation
1. Yes
Both
Assuming the auditor exercised due care
in taking the sample, then all of the items
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This issue will be further addressed in
In this case, the auditor is simply
2. No
Reliability
The auditor will have to ensure that the
inventory exists and the warehouse has
The auditor needed to follow up to
determine the existence of the inventory.
3. Yes
Relevance
Tracing from recorded payables to source
The problem with this procedure is that
the auditor is primarily concerned with
4. Yes
Reliability
no matter what management says their
The problem is that management could
very well be biased. The auditor needs to
(a) determine if there is a ready market
5. No
Relevance
evidence.
The auditor has already chosen a reliable
source of evidence. Given the higher risk
should also be aware that the marketing
6. Yes
Reliability and Relevance
While it is good to review the inventory
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manager is most likely biased in
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In deciding to perform analytical procedures as a substantive audit procedure, the auditor
considers the following:
• Does the company have adequate internal controls over the account? The more effective a
client’s internal controls, the greater reliance an auditor can place on substantive analytical
procedures. Importantly, if a company does not have effective internal controls the auditor
will rely more heavily on tests of details than on substantive analytical procedures as the
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A client estimate should be based on information gathered by the client, and a model developed
by the client. The client takes full responsibility for the quality of the estimate, and should
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Given that inherent and control risks are high, then a substantive analytical procedure – as the
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a. Determine interest rate, discount rate or premium, and multiply it by the face of the bond
to determine interest expense. This would be the auditor’s expectation. The auditor would
also need to set an appropriate threshold and would then compare the expectation with
b. As an example, consider the audit of natural gas revenue at a utility company. The
auditor has tested controls over revenue recognition, including the processes of reading
gas meters and the proper pricing of gas sold to customer homes. The auditor has
concluded that internal controls are designed and operating effectively. Further, the
auditor has concluded that consumers tend to pay their bills and that the consumer does
not have independent knowledge of the amount that should have been billed. Given that
data, the auditor develops a regression model based on:
• Previous year’s gas billings
• Changes in housing developments
Based on these data, the auditor develops a regression model that predicts expected
revenue within a tolerable range of error with 95 percent accuracy. If the auditor finds
that the recorded revenue is within that range, there may be no need for further
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c. Compare supplies expense to production expense on a yearly basis to determine if the
expense is fairly stable. In this approach, the auditor’s implicit expectation is that the
expense balance will be the similar to the prior year. The auditor will use this expectation
in completing the analytical procedure.
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While substantive analytical procedures can provide useful audit evidence, the auditor might
become concerned if things look “too good” or are too much in line with prior periods. A client
who has incentives to fraudulently increase revenue can do it in manner that suggests that trends
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Exhibit 6.9 shows how the mix of tests may vary if the auditor performs substantive analytical
procedures. In both Box A and Box B, the auditor is taking a controls reliance approach for a
specific account or assertion, and part of the audit evidence is obtained from tests of controls. In
Box A, the auditor will obtain the remainder of the audit evidence through substantive tests of
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choose to rely more on direct tests of account balances. Another reason might relate to the
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Sufficiency is the measure of the quantity of audit evidence. The quantity of audit evidence
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When performing tests of controls, the amount of evidence the auditor needs to obtain depends
on whether the client has tested controls as a basis for its assertion on the effectiveness of
internal control. Further, the type of control being tested will affect the auditor’s sample size. If
the auditor is testing a manual control related to transaction processing, sample sizes will be
based on guidelines developed for attribute testing using statistical sampling techniques
(discussed in Chapter 8). For the most part, these sample sizes will vary between 30 and 100
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It may be a challenge for auditors to react negatively toward companies’ preferences to reduce
reserves because the components of those reserve accounts, and the estimates used to determine
an appropriate ending balance, are subjective and judgmental. It is also important to stress to
students that it can also be a challenge to stand up to management when they wish to increase
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Auditors need to understand the processes used by management in developing estimates,
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When obtaining audit evidence for certain accounts, auditors may need to rely on work
performed by an outside specialist/expert. (International auditing standards use the term expert
rather than specialist; for simplicity we use the term specialist but acknowledge that both terms
are appropriate.) It may be that for some accounts expertise in a field other than accounting or
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Auditing standards require the auditor to understand the role, knowledge, and objectivity of the
specialist and how the specialist’s work affects important financial accounts.
When using the work of a specialist, the auditor needs to evaluate the professional qualifications
of the individual. In making this evaluation, the auditor will consider:
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Some transactions that an auditor will be obtaining evidence about will be related-party
transactions. These are transactions that a client has with other companies or people that may be
related to either the client or to client’s senior management. Related-party transactions can occur
between:
• parents and subsidiaries
• an entity and its owners
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1. Inquire of the client about processes used to identify related-party transactions and the
client’s approach to accounting for related-party transactions.
2. Ask the client to prepare a list of all related parties. Supplement that list with disclosures that
3. Ask the client for a list of all related-party transactions, including those with SPEs or variable
interest entities, that occurred during the year.
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5. Inquire of the client and its lawyers as to whether the client is under any investigation by
regulatory agencies or law officials regarding related-party transactions.
7. Use generalized audit software to read the client’s files and prepare a list of all transactions
8. Identify all unusual transactions using information specific to the client including
9. Review the transactions and investigate whether or not the transactions occurred with related
10. Determine whether any of the transactions were fraudulent, or were prepared primarily to
11. Determine the appropriate accounting and footnote disclosure.
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Audit documentation is the record that forms the basis for the auditor’s representations and
conclusions.
Exhibit 6.13 provides an example of a workpaper related to an inventory price test. A review of
Exhibit 6.13 indicates that audit workpapers should contain the following:
• A heading that includes the name of the audit client, an explanatory title, and the balance
sheet date
• The initials or electronic signature of the auditor performing the audit test and the date
the test was completed
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• A section that identifies all significant issues that arose during the audit and how they
were resolved
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The concept is that audit documentation contains the evidence that the audit was conducted in
accordance with generally accepted auditing standards including documentation of the planning
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An audit program documents the procedures to be performed in gathering audit evidence and is
used to record the successful completion of each audit step. The audit program provides an
effective means for:
• Organizing and distributing audit work
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a. This is a good case for students to discuss in small groups in class. Individual answers to this
question will of course differ by individual. The purpose of this question is to get students
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c. Elizabeth did do some things right once her misrepresentation was discovered. She readily
confessed her actions, expressed remorse, and promised not to engage in ghost tick-marking
in the future. She could have become defensive, argumentative, and evasive about the
d. Do you agree with the outcome? Do you think the firm was too lenient? Too harsh? Answers
to these questions will of course differ by student. Instructors should encourage groups to
report out to the larger class in a discussion to highlight the rationale that individuals/groups
used to arrive at their conclusion. In prior use of these materials, groups were about evenly
split between whether the outcome was too lenient versus too harsh. As an example of one
way to answer this question by applying the ethical decision making framework from
Chapter 4, consider the following steps:
• Identify the ethical issue(s). The issue involves Elizabeth’s decision to engage in ghost
tick-marking.
• Determine who are the affected parties and identify their rights. The parties affected by
Elizabeth’s actions include:
(1) The audit firm as a whole. The firm has a right to demand and expect high
quality performance.
(2) Elizabeth’s supervisors. The auditors in charge of (and responsible for) the job
have the right to honesty and high quality work.
(3) The client and its stakeholders. The client hires auditors to help them be sure
that their financial records are accurate. If the audit firm does not catch an error, then the
financial statements may be misstated.
• Determine the most important rights. The most important rights are those held by the
client and its stakeholders. They are paying for high quality service, and if Elizabeth’s
actions had not been discovered, they would not have received such service.
• Develop alternative courses of action. Student groups that believe the audit firm was too
lenient generally argue that Elizabeth deserved to be fired outright for her actions, because of
her dishonesty and the costs that it imposed on the audit firm and her colleagues (e.g., extra
• Determine the likely consequences of each proposed course of action. Consequences will
depend on whether students believe the firm was too lenient or too harsh. Assume that
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• Assess the possible consequences, including an estimation of the greatest good for the
greatest number. Determine whether the rights framework would cause any course of action
• Decide on the appropriate course of action. Answers and ideas vary widely across
student groups. Answers generally include (1) immediately firing Elizabeth, (2) not firing
Elizabeth and simply counseling her and not noting the matter in her personnel record, (3)
Fraud Focus: Contemporary and Historical Cases
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a. The AICPA’s AU–C 500 defines the appropriateness of audit evidence as “The measure
of the quality of audit evidence (that is, its relevance and reliability in providing support
for the conclusions on which the auditor’s opinion is based)” and defines the sufficiency
of audit evidence as “The measure of the quantity of audit evidence. The quantity of the
audit evidence needed is affected by the auditor’s assessment of the risks of material
misstatement and also by the quality of such audit evidence.”
What is considered sufficient appropriate evidence will vary across clients depending on
the risk of material misstatement associated with the client. Thus, if there is a high level
of risk of material misstatement, the auditor will need more and higher quality evidence
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b. Substantive analytical procedures are a type of substantive test based on assessing
relationships or trends in accounts or ratios. A primary benefit of performing substantive
analytical procedures is that they can reduce the need to perform additional substantive
tests of details. Using these procedures is not required by auditing standards. These
procedures should primarily be used when the following conditions are present:
• The client should have effective internal controls over the data that will be used in
performing the analytical procedure so that the auditor will have more confidence
c. The allowance for doubtful accounts (PCAOB Release No. 104-2011-289) is an account
based on a management estimate. As such, auditors need to recognize that these estimates
are subject to management bias. The bias can occur in the assumptions that management
makes about such things as how likely it is that the accounts will be collected. It is
d. A standardized audit program is a guide that should be adjusted when conditions dictate
that there should be adjustments. The danger that most audit firms have is that too many
‘standardized’ audit programs are approached rotely by the auditor, and the critical
thinking that should take place on the audit is not present. For the cases identified in the
e. Auditors are expected to design an audit to identify any material misstatements – whether
from error or intentional misstatement (i.e., fraud). Evidence decisions that result in a