Chapter 5 Homework Miller Seems Exhibit Lax Attitude Several His

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CASE 5

SUGGESTED ANSWERS TO DISCUSSION QUESTIONS

(1)

SAS 31, “Evidential Matter,” states that: “The measure of the validity of

[evidential matter] for audit purposes lies in the judgment of the auditor….” (para.

.02) Thus, the quality of oral evidence is an evaluation made by the auditor that

would be influenced by a number of factors: the perception of management’s

(2)

Accounts receivable generate a constant flow of cash into a company, offering a

temptation to any employee who might be inclined to steal. Over the years,

ingenious individuals have devised a multitude of plans for diverting this

monetary inflow to themselves. Some of the more common schemes include the

following:

* Money that comes to the company from a customer is stolen by an

employee with the balance then being written off the records as an

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(3)

A company’s net income can always be inflated by creating fictitious credit sales.

For example, an invoice is prepared for a fake customer with the amount being

recorded as an increase in both accounts receivable and sales. In the Lakeside

audit, the client company wants to grow. Bank loans or new equity investments

(4)

In talking with client personnel, an auditor must be constantly alert for any

indication of potential problems. “Red flags” are often encountered in these

discussions that need to be investigated to ensure that material misstatements

do not exist. During Mitchell’s conversation with Miller, a number of comments

are made that should concern the auditors:

* Access to the accounts receivable subsidiary ledger is available to all

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claims that he can monitor the age of individual accounts, the company

needs to be aware of changes that occur over time. For example, the

* Miller controls the accounts receivable subsidiary ledger with virtually no

company oversight or control. For example, no reconciliation with the

problems.

* No formal system exists for setting credit limits and granting credit. Rogers

* Credit is based solely on reports that are filed by the sales representatives.

These individuals have a direct interest in getting additional sales since

* The credit files are never updated. Therefore, the company learns that a

customer is no longer a good credit risk only by incurring a loss, the writing

* Miller indicates that the company might have previously been holding

accounts rather than writing them off as bad on a timely basis. The auditor

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* The company waits until an account is 15 days old before a second invoice

is mailed. This delay is, perhaps, one of the reasons that the age of the

(5)

First, because of weaknesses found during the preliminary evaluation of the

internal control, control risk may be assessed at the maximum level. Since

maximum control risk is being assumed, the auditor has no reason to test the

operating efficiency of the control procedures.

(6)

Inherent risk is the susceptibility of an account balance or class of transactions to

a material misstatement. A number of factors affect this assessment: the

quantity and size of transactions occurring over time, the past history of the

company in this area, the likelihood of theft, the necessity of performing

complicated calculations in order to generate reported figures, problems inherent

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to a particular industry, the need for making estimations, the results of analytical

procedures, and the possibility of obsolescence. For example, in the Lakeside

(7)

In positive confirmations, debtors are asked to respond in all cases whether or

not they are in agreement with the information given. When using the negative

form of request, debtors are asked to respond only if they disagree with the

information.

Since positive confirmations require a response in every case, they provide

(8)

The selection of a specific account for confirmation is an indication that the

auditor desires additional evidence or assurance about that particular balance. A

number of situations exist that would suggest the need for confirmation of a

specific account:

a) The balance appears to be with a related party;

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(9)

The debit entries made to Lakeside’s Accounts Receivable control account

produce an audit trail made up of the following documents or records:

* Sales Journal – indicates the original journal entry recorded for each sales

transaction. An auditor matches the debits in the general ledger account to

these journal entries to ascertain that no posting errors have been made.

* Bill of Lading – records the quantity and description of the items being

shipped. The auditor compares it with the sales invoice to make certain that

the items ordered and billed are in agreement with the items that were

shipped.

* Accounts Receivable Subsidiary Ledger – indicates the receivable balance

from each individual customer. An auditor compares individual entries

Although the following documents are not part of the audit trail leading to the

recording of the Accounts Receivable debits, they are certainly relevant to any

testing made in connection with the fair presentation of those debits:

Invoice Slips, Cash Remittance Lists, Validated Bank Deposit Slips – some

This question also asks about the reliability of the evidence gathered from this

(10)

Miller is uncertain how the 0.7% figure was determined. He says that the

(11)

Mitchell probably should not recommend that Accounts Receivable be confirmed

(12)

Consistent with our answer in #11 above, Miller has not designed an effective

system. It is not unusual for a company to grow, and what worked before can no

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SUGGESTED ANSWERS TO EXERCISES

Note: Although no specific question relates to the following matter, students may

detect that a contradiction exists between a statement made by Miller in Case 5

and the system memorandum presented in Exhibit 4-3. Miller indicates that he

verifies the prices and extensions reported on sales invoices. Exhibit 4-3 states

Case 5 – Exercise 1

Abernethy and Chapman

Internal Control Questionnaire – Accounts Receivable

Client: The Lakeside Company

Prepared by:

Date:

Questions Comments on

Current System

Significance Suggestions

1 Does an independent

party on a regular

basis reconcile the

subsidiary ledger?

The subsidiary

ledger is reconciled

annually by the

independent

During the year,

virtually no control is

maintained over

Miller’s handling of

On a periodic basis,

a member of the

administrative staff

should verify that the

2 Are appropriate,

established criteria in

The criteria for

writing off accounts

For the auditor, a

problem exists as to

Establish a formal

system for writing off

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Questions Comments on

Current System

Significance Suggestions

place for writing off

doubtful accounts?

are nebulous and

seemingly based

the consistency of

removing bad debts

bad accounts. This

system need be no

accounts.

3 Are accounts to be

written off properly

reviewed and

No independent

party authorizes the

write-off of bad

The removal of bad

accounts can be

used to cover cash

Once a system has

been established for

the write-off

4 Is an appropriate

follow up made on

accounts that are

written off?

Follow-up of bad

debts is not

addressed in the

case; Mitchell does

If no follow-up is

made, the company

reduces the

possibility of making

The receivable can

be turned over to an

outside collection

agency or, as an

5 Does the company

periodically re-

evaluate the method

in use for estimating

No reevaluation of

the method for

estimating bad

accounts has been

No proof exists that

the bad debt

expense and the

allowance for

Client should

schedule recent bad

accounts to arrive at

a new estimation of

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Questions Comments on

Current System

Significance Suggestions

6 Are customers billed

regularly by a party

separate from the

subsidiary ledger?

The first three

invoices are maile

d

by the sal

es division;

any further billing is

made by Miller, who

is in charge of the

By having Miller

send the last

invoices, the

opportunity for

Control can be

established by

allowing Miller to

continue the billing,

7 Is an independent

verification made of

complaints from

customers

make certain that the

The responsibility for

looking into

complaints is vested

in Miller.

Again, all of the

responsibilities are in

the hands of one

person with no

Lakeside should

have complaints

sent to an employee

who can then

8

policy of granting

credit changed over

the past year?

According to the

client, no formal

change in the policy

of granting credit has

been made.

However, the

Any shift in credit

policy requires

auditor attention as

to the effect on the

allowance account

and bad debt

Lakeside should

adopt a policy to

guide Rogers in his

credit decisions. In

addition, outside

verification of credit

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Questions Comments on

Current System

Significance Suggestions

modification has

occurred. Because

Lakeside audit since

credit reports are

9 Can a credit sale

possibly be made

without prior credit

approval?

No indication is

given in the case as

to whether sales

invoices are verified

after the shipment to

necessary before the

To the auditor, the

possibility of a sale

being made without

credit approval casts

further doubts on the

At the point in the

accounting system

at which the

extensions and

prices are verified,

10 Are credit files

complete and

periodically

reviewed?

Credit files contain

only the sales

representative’s

credit reports and do

correspondence, etc.

As indicated above,

the credit granting

policy is informal an

d

based almost solely

As a part of the

design of a

comprehensive

credit system,

Questions Comments on

Current System

Significance Suggestions

11 Are invoices verified

as to agreement with

having Miller perform

Verification of goods

and prices is made

Verifying extensions

and prices after the

All verifications

should be made

12 Are extensions and

footing recalculated?

See answers for

question 11.

13 Are cash discounts

recomputed and

verified as to actual

days?

Cash discounts are

verified by the sales

division.

System appears

adequate. Financial

information should

be fairly presented.

None.

14 Can a sale possibly

be made and goods

shipped without an

invoice being

recorded or mailed?

Using prenumbered

sales invoices and

bills of lading along

with the periodic

verification of all

If the possibility

exists that the

company can make

sales without

recording them, the

Since the documents

are already

prenumbered, the

auditor needs to

make certain that

(2)

Case 5 – Exercise 2

Abernethy and Chapman

Internal Control Evaluation

Client: The Lakeside Company

Prepared by:

Date:

Exhibit 5-2 is a portion of the audit program that Mitchell designed to test the

operating efficiency of controls in the revenue and cash receipts cycle. For each

Step Anticipated Results Potential Problem(s)

1-A The total listed on the sales

invoice should agree with the total

on the sales invoice slip. In

addition, evidence should be

If the invoices do not agree, the

possibility is raised that fictitious

or misstated sales are being

recorded. Lack of tangible

the requirements of the system.

1-B Anticipated Results – The

quantity and description of the

items sold should be the same

Potential Problem – Differences

warn the auditor that sales have

been both billed and recorded

1-C Anticipated Results – Cash

received as per the remittance

list should be consistent with the

invoice and the invoice slip.

Customers should be

Potential Problem – The cash

may have been stolen, or

someone in the company may

be engaged in lapping.

Step Anticipated Results Potential Problem(s)

1-D Anticipated Results – Calculated

cash discounts should be

identical with the amounts

Potential Problem – Discounts

may be incorrectly recorded to

hide cash shortages or as a step

1-E Anticipated Results – All prices

on the invoices should agree

with the prices being shown on

the approved price list.

Potential Problems – Wrong

amounts may be paid by

customers. Improper pricing,

either intentionally or

1-F Anticipated Results – The

extensions and footings on the

Potential Problems – Wrong

amounts may be paid by

1-G Anticipated Results – The

amount received according to

Potential Problems – A

discrepancy could indicate the

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Step Anticipated Results Potential Problem(s)

being deposited. In addition, the

the possibility of lapping.

1-H Anticipated Results – All cash

remittances should be recorded

promptly as credits to the

Potential Problems – Since the

subsidiary ledger is not well

controlled in the Lakeside

1-I Anticipated Results – Each

Potential Problems – Because

2-A Anticipated Results – Each debit

entry should be corroborated by

an appropriate sales invoice

Potential Problems – This test

has major significance in that it

can alert the auditor to any

2-B Anticipated Results – Each credit

Potential Problems – This tracing

2-C Anticipated Results – Each credit Potential Problems – Again,

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Step Anticipated Results Potential Problem(s)

to a specific account should

lapping or attempts by

3 Anticipated Results – For each of

Potential Problems – The use of

4 Anticipated Results – Each list

Potential Problems – Cash

SUGGESTED ANSWERS TO SARBANES-OXLEY QUESTION

(1)

This question is similar to the SOX question in Case 4. The emphasis is on the

difference between public and privately held companies. The difference involves