Guided Readings for Financial Accounting, Lesson 6.2 – Mastery Level

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1

SUGGESTION: Read the third section of Chapter Six (“Performing an Audit”). This section is intended to help you attain an understanding of how an audit examination is performed.

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(6Q19) – Ace Company reports that it has accounts receivable of $329,400. Jane Doe works for the independent CPA firm that is auditing Ace’s financial statements. She has been assigned to examine this specific account. In general, what is Jane Doe supposed to do?

(6A19) – The independent auditor examines both the transactions reported in this account and its current balance. The auditor looks for sufficient evidence so that reasonable assurance can be provided that the reported balance contains no material misstatements. The auditor’s role is one of exploration. The auditor seeks all possible evidence to support the account balance. Only after enough evidence has been obtained can the auditor provide reasonable assurance that the account is presented fairly according to U.S. GAAP.

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(6Q20) – Ace Company reports that it has accounts receivable of $329,400. Jim Doe works for the independent CPA firm auditing Ace’s financial statements. He has been assigned to examine this account. What are some of the actual tests that an auditor might perform to gather evidence that this balance contains no material misstatements and is, therefore, presented fairly according to U.S. GAAP?

(6A20) – An auditor might perform dozens of tests in examining accounts receivable. The balance goes up when a credit sale is made and down when cash is collected (or when an account is judged to be bad). Thus, the auditor examines sales documents to make sure increases are valid. The auditor looks at cash receipts to see if reductions in accounts receivable were real. The auditor looks at documentation for evidence as to why an account was written off. The auditor can also contact the customer to confirm the balance.

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(6Q21) – Many people believe that the role of the independent auditor is to guarantee that the financial statements are perfect. That is not the case. Why not?

(6A21) – An independent auditor provides reasonable (not perfect) assurance that financial statements contain no material misstatements. One reason for this distinction is that financial statements contain many estimates and virtually all of them will prove to be somewhat inaccurate. The company accountant is not a fortune teller. In addition, large companies have billions of transactions. No auditor can examine each one with absolute, total care. Also, the reporting company might hide issues from the auditor that could not be found in a normal audit examination. Perfect assurance is not possible.

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(6Q22) – In an audit report, the independent auditor provides “reasonable assurance” that the balances and disclosures are presented fairly in all material respects according to U.S. GAAP (they contain no material misstatements). Are decision makers not expecting more assurance than that? Does that report bother decision makers who are using those financial statements to make important decisions—often involving thousands if not millions of dollars?

(6A22) – Hopefully, decision makers are not naïve. They are receiving reasonable assurance from an audit report rather than perfect assurance. Perfect assurance is not feasible because of all the estimates and the quantity of transactions. Auditors are only able to provide reasonable assurance that the statements contain no material misstatements. Perfect assurance is not humanly possible and decision makers need to be aware of that inherent limitation. That level of risk (although slight) should be taken into consideration when decisions are made.

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SUGGESTION: Work the second Test Yourself question in Section 6.3 of Chapter Six (“The Osgood Company released its Year One financial statements …”). As always, there are four possible answers. Which one of those is most likely to be judged a material misstatement that should have been uncovered by the auditor? In other words, which answer is least likely to have been missed by the independent auditor in a normal audit.

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SUGGESTION: Read the fourth section of Chapter Six (“The Need for Internal Controls”). The purpose of internal controls is often misunderstood. Every organization needs to have strong internal controls for a number of reasons but primarily to help ensure that employees perform every action and activity as intended by the management and board of directors. Internal controls are the policies and procedures that enable a company to operate effectively and efficiently.

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(6Q23) – What are internal controls?

(6A23) – Internal controls are all of the policies and procedures that are added to various business systems to make sure they operate effectively and efficiently as designed. Internal controls are included in the various systems within a company (payroll, cash receipts, inventory procurement, and the like) to prevent or discover incorrect actions so that the system will work effectively in carrying out its intended function.

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(6Q24) – A sales person who works for Ace Company is making a large sale to a customer. The customer wants to make the purchase on account so that payment can be delayed for several weeks. Before the sale can proceed, Ace’s credit department must review the customer’s credit application and decide whether to approve it. Why are these steps an example of internal control?

(6A24) – Internal control often involves a separation of responsibilities within a company as a way of establishing a system of checks and balances. The sales person has responsibility for making sales whereas the credit department investigates and decides on credit approval. The sales person cannot be tempted to make sales to poor credit risks to inflate the results. The credit department does not benefit from the outcome and will, therefore, make a considered decision. Operations are more efficient with this structure.

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(6Q25) – As part of an audit examination, an independent auditor examines and evaluates the reporting company’s internal control (both the efficiency of the design and the implementation of the design). Why is that an important step in an audit? How does internal control connect to an independent audit?

(6A25) – Early in an audit, the quality of the reporting company’s internal control system is evaluated (both the design and the implementation). If the internal controls that address the financial reporting function are strong, the chance of a material misstatement is reduced. Thus, the independent auditor does not need to accumulate as much supporting evidence about the pertinent account balance. The strong quality of the internal control has reduced the risk. Less evidence is needed (the audit work is easier). If the reporting company has poor internal controls, the risk of a material misstatement is greater and the independent auditor will have to gather more evidence.

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SUGGESTION: Work the Test Yourself question in Section 6.4 of Chapter Six (“Tomlinson and Partners is a local CPA firm…”). This is an interesting question because the independent auditing firm is currently examining both accounts receivable and inventory. The audit of inventory takes twice as much time. If the two accounts are approximately the same size, why would the auditor focus more time on inventory? Make sure to read and think about the explanation.

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SUGGESTION: Read the fifth section of Chapter Six (“The Purpose and Content of an Independent Auditor’s Report”). At the end of an audit examination, the independent auditor provides a report (sometimes referred to as an opinion) that is attached to the audited set of financial statements to help add credibility. Read this section of the textbook so you will know what information is contained in the audit report.

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Near the beginning of the section of the textbook titled “The Purpose and Content of an Independent Auditor’s Report,” there is a link for a video titled “Why You Should Trust Financial Statements.” Watch that video. It is not too long and it should reinforce much of what you have learned in this chapter.

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(6Q26) – What is an unqualified audit opinion? What is a qualified audit opinion?

(6A26) – An unqualified audit opinion is one in which the independent auditor provides reasonable assurance that financial statements are presented fairly in all material respects according to U.S. GAAP. In other words, the auditor believes that the financial statements contain no material misstatements. A qualified audit opinion is one in which the independent auditor is not able to provide reasonable assurance that financial statements are presented fairly in all material respects according to U.S. GAAP.

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(6Q27) – What are the most likely reasons why an independent auditor provides a qualified audit opinion on a set of financial statements rather than an unqualified audit opinion?

(6A27) – A qualified opinion on a set of financial statements is usually provided by an independent auditor for one of two reasons. (1) – The auditor is unable to obtain sufficient evidence to support important account balances and disclosures. The financial statements are not necessarily wrong. The auditor has not gained enough evidence to be sure. (2) – The auditor uncovers a material error or fraud. Unless the reported information is fixed, the financial statements are not presented fairly according to U.S. GAAP.

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(6Q28) – In the first paragraph of a standard independent auditor’s report, the financial statements are identified. Moreover, the responsibilities of the reporting company’s management and the independent auditor are identified. What are those responsibilities?

(6A28) – Read the report of the auditors of The Procter & Gamble Company in Section 6.5. According to the first paragraph of this standard audit report, the financial statements are the responsibility of the company’s management. In contrast, the independent auditor is responsible for expressing an opinion on those financial statements based on the findings of the audit examination.

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(6Q29) – In the first paragraph of The Procter & Gamble Company audit report, the independent auditors clearly state, “These financial statements are the responsibility of the Company’s management.” Why is that sentence so important?

(6A29) – Many people might erroneously believe that the independent auditor prepared the financial statements and, therefore, is responsible for them. That is not true. The company prepares the financial statements. Management is responsible for them. The auditor gathers sufficient evidence to form an opinion as to whether these statements are presented fairly according to U.S. GAAP.

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(6Q30) – In the second paragraph of The Procter & Gamble audit report, the independent auditor (Deloitte & Touche) spells out that, “An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.” Why does the auditor specifically say that the work is only done on a “test basis?”

(6A30) – Many companies have millions, and sometimes billions, of transactions each year. No audit team could possibly examine them all. Many are small and inconsequential. Therefore, the audit report mentions “test basis” to indicate that reasonable assurance can be conveyed without having to study and analyze every single transaction. Auditors examine enough transactions so that they feel able to provide reasonable assurance without looking at them all.

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(6Q31) – In an examination of financial statements, the independent auditor has to identify areas where the risk of misstatement is especially high. How does the quality of a reporting company’s internal controls over financial reporting affect the work of the independent auditor?

(6A31) – If a company has excellent internal controls built into its financial reporting and other related systems, the chance of a material misstatement occurring and getting into the financial statements is reduced. With less risk of material misstatement, the independent auditor can (a) choose to do less testing of balances and disclosures or (b) can do testing that is less costly and complicated. Less evidence is needed because of the high quality of the company’s internal controls. That saves time and money.