Review Questions:

2. How can an auditor introduce unpredictability into audit procedures?

Answer: Unpredictability in audit procedures may occur if the risk gets higher as times pass by and
substantive test is needed. When an auditors perform audit procedure, they should incorporate the
element of unpredictability in selection of nature, timing and extent of audit procedures. If an auditor
encounter unpredictability in audit procedures, auditor must perform procedures such as but not
limited to, examine payment less than your normal threshold in your search for unrecorded liabilities,
perform surprise unannounced review of teller cash, make physical visit to the inventory location one
month after the end of the year and review inventory records, review payroll salary authorization sheets
for ten employees and agree to amounts in the payroll master table, test a bank reconciliation for the
seventh month in the year being audited, confirm an immaterial bank account that you haven’t
confirmed in the past and pick ten vendors at random and perform procedures to verify their existence.
To sum it up, auditor must perform test of controls, substantive tests of transactions, analytical
procedures and tests of details of balances in response of auditor’s assessment of risk of material
misstatement.

6. Distinguish between a test of controls and a substantive test of transactions. Give two examples of
each.

Answer: Test of controls and substantive test of transactions are both audit procedures, test of controls
is an audit procedures to test the effectiveness of controls in support of reduce assessed control risk
while substantive test of transactions is an audit procedure to determine whether all six transaction-
related audit objective which are consists of Occurrence that deals with recorded transactions exist,
Completeness that deals with existing transactions are recorded, Accuracy that deals with recorded
transactions stated are correct amounts, Posting and Summarization that deals with recorded
transactions are properly recorded in master files and correctly summarized, Classification that deals
with transactions included in client’s journals are properly classified and Timing that deals with
transaction recorded are on correct dates. Wherein all this six transaction-related audit objective have
been satisfied for each class of transactions. Examples of Test of Controls are Examination of a sample
sales invoice and compare customer order to authorized credit limit and Account for sequence of
shipping documents and trace each to the sales journal. Examples of Substantive Test of Transactions
are Recalculation of gross pay for selected entries in payroll journal entries and Recalculation of
amounts on selected sales invoices and tracing of amounts to the sales journal.

10. The following are three decision factors related to assess control risk: effectiveness of internal
controls, cost-effectiveness of a reduced assessed control risk, and results of test of controls. Identify
the combination of conditions for these three factors that is required before reduced substantive testing
is permitted.

Answer: When an auditor assessing risk of control, auditor must consider the effectiveness of the
entity’s internal controls wherein auditor must consider the reliability of financial reporting used by the
entity, effectivity and effectiveness of entity’s operations and whether the entity is complying with laws
and regulations during conducting the audit. Auditor also must consider cost-effectiveness of reducing
assessed control risk in order to test entity’s internal control with minimum cost. After auditor assess
entity’s risk of internal control, auditor must understand the result whether it is effective or not.
Exercise 1:

For each of the following controls, identify whether the control leaves an audit trail. Also identify a test
of control audit procedure the auditor can use to test the effectiveness of the control.

A. An accounting clerk accounts for all shipping documents on a monthly basis and initials the
monthly shipping log.
B. Bank reconciliations are prepared by the controller, who does not have access to cash
receipts.
C. As employees check in daily by using time clocks, a supervisor observes to make certain that
no individual “punches in” more than one time card.
D. Vendors’ invoices are approved by the controller after she examines the purchase order and
receiving report attached to each invoice.
E. The cashier, who has no access to accounting records, prepares the deposit slip and delivers
the deposit directly to the daily.
F. An accounting clerk verifies the price, extensions and footing of all sales invoices in excess of
P300 and initials the duplicate sales invoice when he has completed the procedure.
G. All mail is opened and cash is prelisted daily by the president’s secretary who has no other
responsibility for handling assets or recording accounting data.

Answers:

A. Audit Trail: Y
Test of Control: Auditor can perform inspection by means of examining duplicate of
purchase invoice to determine that each one is supported by authorized shipping
document. Also, auditor can account for numbers included in the sequence to
determine that all documents are there.

B. Audit Trail: Y
Test of Control: Auditor can perform inspection and re-performance by means of
examining evidence of reconciliation for test month and test accuracy of reconciliation.
Also, auditor can examine a sample of bank reconciliation for indication that the
controller prepared each one.

C. Audit Trail: N
Test of Control: Auditor can perform observation by means of observing whether time
cards are forwarded daily to payroll and observed when they are rated. Also, auditor
can observe whether supervisor is present and performing his responsibilities at time
employees check in.

D. Audit Trail: Y
Test of Control: Auditor can perform observation and inquiry by means of observing
whether vendor’s invoices are approved and inquire about who is responsible for
approving the vendor’s invoices. Also, auditor can examine invoices for controller’s
approval
 E. Audit Trail: N
Test of Control: Auditor can perform inspection by means of examining documents for
internal verification. Also, auditor can observe the cashier preparing the deposit slip and
delivering the deposit to the bank.

F. Audit Trail: Y
Test of Control: Auditor can perform re-performance and inspection by means of
examining sample of sales invoices and agree prices to authorized price list. Review
changes to price throughout the year for proper approval. Also, auditor can examine
sales invoice for initials.

G. Audit Trail: N
Test of Control: Auditor can perform observation and inquiry by means of observing
whether personnel responsible for handling cash have no accounting responsibilities
and inquire as to their duties. Also auditor can observe president’s secretary opening
mail and prelisting cash receipts and examine existence of prelisting.

Exercise 2:

Maria Cabrera, CPA, follows the philosophy of performing interim tests of controls and substantive tests
of transactions on every December 31 audit as a means of keeping overtime to a minimum. Typically,
the interim tests are performed sometime between August and November.

Required:
a. Evaluate her decisions to perform interim tests of controls and substantive tests of
transactions.
Answer: When an auditor perform interim audit, it is a preliminary audit work conducted
prior to fiscal year-end of client. It is conducted in order to compress period needed to
complete final audit. There are advantages of interim audit in perspective of the client and
the auditor. When it comes to the client, he/she can issue its audited financial statements
sooner under interim audit. When it comes to the auditor, he/she can have more time
available during their peak audit season to engage in activities for more client. So if there
are advantages, there are also disadvantages. When performing interim audit, figures may
be altered in the accounts which have already been audited by a dishonest employee that
leads to confusion in the minds of audit staff at time of final audit. It is an additional work
for auditors because final audit must be conducted after conducting this type of audit,
wherein auditors make this type of audit in order to prevent accounting staff from changing
the facts and figures. By this statements, we therefor conclude that when performing this
type of audit, it will just increase the expenses of an entity because this type of an audit is
not required by the law, it’s just an optional for the client and it will result to workload of an
auditor because he/she needs to prepare notes after completion of this type of an audit.
Lack of audit evidence may occur and reliability of it may be affected under this kind of
audit. So, Ms. Maria Cabrera should practice Final Audit rather than Interim Audit in order to
 give a more reliable assertions towards audit.

b. Under what circumstances is it acceptable for her to perform no additional tests of controls
and substantive tests of transactions work as a part of the year-end audit tests?
Answer: It is acceptable for Ms. Maria Cabrera to perform no additional tests of controls
and substantive test of transactions as long as all of his accumulated audit evidence is
reliable and up to date. Also, if there is no confusion in the audit procedure conducted by
the auditor and client’s internal control is operating effectively.

c. If she decides to perform no additional testing, what is the effect on other tests she
performs during the remainder of the engagement?
Answer: If Ms. Cabrera decides to perform no additional testing, other tests she performs
during the remainder of engagement may not be reliable if it has high risk of material
misstatement because audit evidence may insufficient and needs more testing in order to
be reliable. Assertions she conducted also may not be reliable due to lack of testing and
ineffective internal control if occurred and her issued audit report may not be confidently
enough to give it to the client she audited.

Exercise 3:

Following are several decisions that the auditor must make in an audit. Letters indicate alternative
conclusions that could be made:

Decisions Alternative Conclusions

1. Determine whether it is cost-effective A. It is cost-effective
to perform tests of controls. B. It is not cost-effective
2. Perform substantive tests of details C. Perform reduced tests
of balances. D. Perform expanded tests
3. Complete initial assessment of E. Controls are effective
control risk. F. Controls are ineffective
4. Perform tests of controls. G. Controls are effective
H. Controls are ineffective
Requirement:
a. Identify the sequence in which the auditor should make decisions 1-4 above.
b. For the auditor of the sales and collection cycle and accounts receivable, an auditor reached
the following conclusions: A, D, E, H. Put the letters in the appropriate sequence and
evaluate whether the auditor’s logic was reasonable. Explain your answer.
c. For the audit of inventory and related inventory cost records, an auditor reached the
following conclusions: B, C, E, G. Put the letters in the appropriate sequence and evaluate
whether the auditor used good professional judgment. Explain your answer.
d. For the audit of property, plant and equipment and related acquisition records, an auditor
reached the following conclusions: A, C, F, G. Put the letters in the appropriate sequence
and evaluate whether the auditor used good professional judgment. Explain your answer.
e. For the audit of payroll expenses and related liabilities, an auditor recorded the following
conclusions: D, F. Put the letters in the appropriate sequence and evaluate whether the
auditor used good professional judgment. Explain your answer.
Answer:

A. Auditor should follow this sequence when making decisions; First, complete initial assessment of
control risk. Second, determine whether it is cost effective to perform tests of controls. Third,
perform test of controls. Lastly, perform substantive test of details of balances.
B. The sequence is E, A, H and D. The logic was reasonable wherein if we are the one conducting
audit, we believed that the internal controls would be effective and it would be cost effective to
perform tests of controls. If our conclusion about the controls were not effective, we need to
expand substantive test of details of balances.
C. The sequence is E, B, G and C. The logic was not reasonable wherein if we are the one
conducting audit, we believed that the internal controls may be effective but it was not cost
effective to reduce assessed control risk. We don’t need to perform tests of controls and it will
be more cost effective if we will skip performing tests and follow this sequence E, B and D.
D. The sequence is F, A, G and C. The logic was not reasonable wherein if we are the one
conducting audit we believed that the controls were not effective and we will proceed to D and
perform expanded substantive test of details of balances.
E. The sequence is F and D. The logic was reasonable wherein if we are the one conducting the
audit, we believed that the internal controls were not effective and proceed to substantive tests
of details of balances and perform expanded tests.

Exercise 4:

Hazel Jess, a new staff auditor, is confused by the inconsistency of the three audit partners she has been
assigned to on her first three audit engagements. On the first engagement, she spent a considerable
amount of time in the audit of cash disbursements by examining cancelled checks and supporting
documentations, but almost no testing was spent in the verification of fixed assets. On the second
engagement, a different partner had her do less intensive tests in the cash disbursements area and take
smaller sample sizes than in the first audit, even though the company was much larger. On her most
recent engagement under a third audit partner, there was a thorough test of cash disbursement
transactions far beyond that of the other two audits, and an extensive verification of fixed assets. In fact,
this partner insisted on a complete physical examination of all fixed assets recorded on the books. The
total audit time on the most recent audit was longer than that of either of the first two audits despite
the smaller size of the company. Hazel’s conclusion is that the amount of evidence to accumulate
depends on the audit partner in charge of the engagement.

Requirement:

a. State several factors that could explain the difference in the amount of evidence accumulated in
each of the three audit engagements as well as the total time spent.
Answer: For the first engagement, together with her partner, they focused all of their allocated
time for auditing cash disbursement of their client. Because of this, internal control of the client
was not operating effectively and there is lapses and also there is a material misstatement occur
that’s why they focus too much on this. But they only examined cancelled checks and its
supporting documents, their chosen audit evidence was not good enough to examine the cash
disbursement of their client and maybe there are too much cancelled check and too many
supporting documents related to this and they scrutinize all of this information and didn’t use
the criteria under PSA 530 when it comes to audit sampling. Because of this, their allocated time
 of auditing their client was not followed and resulted to lack of testing to other accounts which
is fixed assets. For their second engagement, they perform audit on cash disbursement with a
little amount of audit evidence even though the client is a large company. Because of this
situation, their client maybe has lack of audit trail such as but not limited to, accounts payable
and purchases. Because of the size of the company, it needed more audit sampling to be used in
accordance with PSA 530 and need more time to audit this client because this is a large
company rather than the first engagement and third they conducted. For their most recent
engagement which is her third engagement, together with her partner, they perform their job
perfectly and in sync maybe because all of audit trail needed was there, audit evidence they
used was appropriate and there chosen audit sampling was good enough to lower the risk of
material misstatement on cash disbursement and fixed assets. Because of this, time allocated to
this engagement was far longer than their prior audit and if the allocated time needed in this
engagement was not met, it is reasonable to add an additional charges because they used this
time for further audit the cash disbursement and fixed assets of the client.

b. What could the audit partners have done to help Hazel understand the difference in the audit
emphasis on the three audits?
Answer: For all the three engagement they conducted, only the third engagement for us was
successful because Hazel and her partner emphasis all their needed audit sampling they will
used, audit evidence they need to gather and audit trail they need to find when they accepted
this engagement and after evaluating their internal control and financial statements. For the
first and second engagement they didn’t emphasis well there audit procedure prior conducting
audit. They didn’t emphasis the audit sampling they needed to use resulted to large amount of
audit evidence they need to examine and audit trail to find. They didn’t emphasis well the
allocated time they needed for all the engagement they engaged with but for their most recent
engagement, it is reasonable enough if their allocated time exceeded for what is they expected.

c. Explain how these three audits are useful in developing Hazel’s professional judgment. How
could the quality of her judgment have been improved on the audits?
Answer: Hazel was a new auditing staff to the firm she apply with and because of lack of
experience she can get tips and lessons that she needed to emphasis for her next engagement.
Because of this, she can now determine for her next engagement what are the things she needs
to consider and what are the things she needs to avoid with. She can also understand that audit
procedure and audit plan they emphasis prior audit may altered depends on the level of risks
they encounter that’s why she has now the idea that their audit plan and audit procedure may
change throughout the audit process. Because of this instances, Hazel could improve her
judgments towards her next engagement or audit to her new client.
Exercise 5:

The following are three situations in which the auditor is required to develop an audit strategy:

1. The client has inventory at approximately 50 locations in the Philippines. The inventory is
difficult to count and can be observed only by travelling by automobile. The internal controls
over acquisitions, cash disbursements and perpetual records are considered effective. This is the
fifth year that you have done the audit, and audit results in past years have always been
excellent. The client is in excellent financial condition and is privately held.
2. This is the first year of an audit of a medium-sized company that is considering selling its
business because of severe underfinancing. A review of the acquisition and payment cycle
indicates that controls over cash disbursements are excellent, but controls over acquisitions
cannot be considered effective. The client lacks receiving reports and a policy as to the proper
timing to record acquisitions. When you review the general ledger, you observe that there are
many large adjusting entries to correct accounts payable.
3. You are doing the audit of a small loan company with extensive receivables from customers.
Controls over granting loans, collections and loans outstanding are considered effective and
there is extensive follow-up of all outstanding loans weekly. You have recommended a
computer system for the past 2 years, but management believes the cost is too great, given
their low profitability. Collections are an ongoing problem because many of the customers have
severe financial problems. Because of adverse economic conditions, loans receivable have
significantly increased and collections are less than normal. In previous years, you have had
relatively few adjusting entries.
Requirement:
a. For audit 1, recommend an evidence mix for the five types of tests for the audit of inventory
and cost of goods sold. Justify your answer. Include in your recommendations both tests of
controls and substantive tests.
Answer: When conducting an audit, you need to conduct the five types of testing namely
the Risk Assessment Procedure, Test of Controls, Substantive Test of Transactions, Analytical
Procedures and Test of Details of Balances. For this situation, auditor need to conduct audit
on their inventory and cost of goods sold and need to follow this five types of testing.
Because this is the fifth time auditing this client, auditor already know about all the things
he/she need to know about the entity and its internal control, so the other three type of
test are the tests that we need to consider. Because of effectivity of acquisition, cash
disbursement and its perpetual records of inventory, internal control are also effective. Test
of controls and Substantive test of transactions about inventory and cost of goods sold are
already been performed due to its effectivity. Analytical procedures should be perform in
order to identify the occurrence and existence of inventory recorded. Test of details of
balances should be done by re-computing the accounts affected by the cost of goods sold
such as but not limited to inventory, purchases and other contra account of purchases if any
also the inventory account. We highly recommend to re-count the amount of inventory
recorded in their records, check also the cash disbursement and all the related document
that supporting all disbursement of the entity and check all the acquisition acquired by the
entity together with the related documents supporting all of their acquisition. We also
recommend to recalculate the amount of goods sold by the entity and use footing to tally
 the total amount of goods sold computed by the entity and the amount computed in our
audit.

b. For audit 2, recommend an evidence mix for the audit of the acquisition and payment cycle,
including accounts payable. Justify your answer.
Answer: Because this is the first time auditing this entity, we need to understand its
environment and the entity itself. Because of lack of effectivity of acquisition by the entity,
internal control also are not effective. So we need to conduct an audit of entity’s acquisition
and payment cycle including their accounts payable. After assessing the entity internal
control and the entity itself, cash disbursement was effective but their acquisition was not
effective the way we think. After testing their internal control, there are high material
misstatement towards their records about acquisitions and also towards their accounts
payable because there are large amount of adjusting entries occurred. Also, they lack of
recording their receiving report and acquisitions and this leads to high material
misstatement of acquisition and accounts payable. Substantive test of controls will be
conducted with extensive amount of testing together with testing internal control due to
the aforementioned information stated from previous statements. Analytical procedure
under this type of situation is usually performed to reduce other substantive tests because
acquisition and accounts payable provide evidence about the material misstatements. If the
auditor already expect to find material misstatement to acquisition and accounts payable,
additional analytical procedures are not cost effective. Test of details of balances should be
tested extensively towards acquisition and accounts payable. Re-calculate all the balances
recorded and inspect all the adjusting entries made by the entity towards accounts payable.
Also, entity was doing underfinancing and this may indicate that there are malicious activity
conducted by the entity

c. For audit 3, recommend an evidence mix for the audit of outstanding loans. Justify your
answer.
Answer: Maybe the auditor already conducted audit to this entity because auditor already
recommended computer software for them, this signifies that auditor already know about
all the things he/she need to know about the entity and its internal control. So from this
situation, testing of internal control and substantive test of controls are already been done.
Controls about granting the loans and loans outstanding was effective but collection
towards their customer was not effective due to financial problem of their customers. So
from this, analytical procedure to be conducted should be re-assessment of credit limit of all
the customers and assess whether they are capable to pay and collect the loan granted. Test
of details of balances was not effective to do because all things are effective towards the
entity except the collection. Collection towards customer could be effective if they will
assess the credit limit of each of their customers and consider all their financial capabilities.