Balance Sheet and Relatively Reliable Documentation
Chapter 7 # 30 a. Give three examples of relatively reliable documentation and three examples of less reliable documentation. What characteristics distinguish the two? Examples of relatively reliable documentation are: vendor statements, bank statements. And signed lease agreements. Examples of relatively unreliable documentation are: copies of customer invoices, internal memoranda and other communications, and a listing of fixed asset additions.
The difference between the two is whether they were originated from outside or inside the client’s organization. External information is considered more reliable than internal documentation. b. Explain why confirmations are normally more reliable evidence than inquiries of the client. Confirmations are normally more reliable evidence than inquiries of the client because of the independence of the outside party confirming the information. c. Explain why recalculation tests are highly reliable but of relatively limited use.
Recalculation tests are highly reliable because the auditor is able to gain 100% assurance of the accuracy, but the tests only verify whether the recorded amounts are accurately totaled.
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There tests do not uncover omissions or fictitious amounts. d. Explain why analytical procedures are important evidence even though they are relatively unreliable by themselves. Analytical procedures are evidence of the likelihood of misstatements in the financial statements, but they are rarely sufficient by themselves to conclude that the statements are misstated.
Other supportive evidence is needed to determine whether apparent misstatements are actually material. e. Describe a situation in which confirmation will be considered highly reliable and another in which it will not be reliable. Confirmation of bank balances is considered highly reliable whereas confirmation of a department store charge account is often not considered reliable. Banks are accustomed to confirmations from auditors and normally maintain excellent accounting records, whereas most customers of department store have neither characteristic.
f. Under what circumstances is the physical observation of inventory considered relatively unreliable evidence? If an auditor is not qualified to distinguish between valuable inventory and worthless inventory, the physical examination of inventory would not be considered to be reliable evidence. g. Give several examples in which the qualifications of the respondent or the qualifications of the auditor affect the reliability of the evidence. Attorney’s letter – General counsel compared to an attorney involved only with patents.
Examination of the corporate minutes – Experienced partner compared to a new assistant. Confirmation of accounts receivable – Corporation accustomed to confirmations compared to a member of the general public. Physical observation of inventory – auditor knowledgeable in the client’s inventory compared to one who is not. Chapter 8 # 29 a. Define what constitutes a “related party. ” A related party transaction occurs when one party to a transaction has the ability to impose contract terms that would not have occurred if the parties had been unrelated.
Accounting standards conclude that related parties consist of all affiliates of an enterprise, including (1) its management and their immediate families, (2) its principal owners and their immediate families, (3) investments accounted for by the equity method, (4) beneficial employee trusts that are managed by the management of the enterprise, and (5) any party that may, or does, deal with the enterprise and has ownership, control, or significant influence over the management or operating policies of another party to the extent that an arm’s-length transaction may not be achieved.
b. Which of the preceding transactions would most likely be considered to be a related party transaction? (1) Related party transaction. Canyon Outdoor has entered into an operating lease with a company owned by one of the directors on Canyon’s board. Because the board has control and significant influence over management of Canyon, the lease transaction may not be at arm’s-length. (2) Not a related party transaction. The fact that Canyon Outdoor has purchased inventory items for many years from Hessel Boating Company is a normal business transaction between two independent parties.
Neither party has an ownership interest in the other party, nor neither has an ability to exercise control or significance influence over the other. (3) Related party transaction. The financing provided by Cameron Bank and Trust through the assistance of Suzanne may not be at arm’s length given Suzanne’s husband has control and significant influence over Canyon Outdoors and may have be able to influence the transaction through his wife’s employment at the bank or through his influence over Canyon’s management.
(4) Not a related party transaction. Just because the two owners are neighbors does not mean that either has significant influence or control over the other. Mere acquaintance does not suggest the transactions would not be at arm’s length. (5) Not a related party transaction. The declaration and approval of dividends payable to shareholders is a normal board function. c. What financial statement implications, if any, would each of the above transactions have for Canyon Outdoor?
When related party transactions or balances are material, the following disclosures are required: 1. The nature of the relationship or relationships. 2. A description of the transaction for the period reported on, including amounts if any, and such other information deemed necessary to obtain an understanding of the effect on the financial statements. 3. The dollar volume of transactions and the effects of any change in the method of establishing terms from those used in the preceding period.
4. Amounts due from or to related parties, and if not otherwise apparent, the terms and manner of settlement. d. What procedures might auditor consider to help them identify potential related party transactions for clients like Canyon Outdoor? Auditors can determine the existence of material transactions with related parties by performing the following procedures: 1. Obtain background information about the client to enhance understanding of the client’s industry and business. 2.
Perform analytical procedures of the nature to evaluate the possibility of business failure and assess areas where fraudulent financial reporting is likely. 3. Review and understand the client’s legal obligations to become familiar with the legal environment in which the client operates. 4. Review the information available in the audit files, such as permanent files, audit programs, and the preceding year’s audit documentation for the existence of material non-arm’s length transactions.
Also discuss with tax and management personnel assigned to the client their knowledge of management involvement in material transactions. 5. Discuss the possibility of fraudulent financial reporting with company counsel after obtaining permission to do so from management. 6. When more than one CPA firm is involved in the audit, exchange information with them about the nature of material transactions and the possibility of fraudulent financial reporting. 7.
Investigate whether material transactions occur close to year-end. 8. In all material transactions, evaluate whether parties are economically independent and have negotiated the transaction on an arm’s-length basis, and if each transaction was transacted for the valid business purpose. 9. Whenever there are material non-arm’s-length transactions, each one should be evaluated to determine its nature and the possibility of its being recorded at the improper amount. 10.
When management is indebted to the company in a material amount, evaluate whether management has the financial ability to settle the obligation. 11. Inspect entries in public records concerning the proper recording of real property transactions. 12. Make inquiries with related parties to determine the possibility of inconsistencies between the clients’s and related parties. 13. Inspect the records of the related party to a material transaction. 14. Ascertain from them their understanding of the nature and purpose of the transaction.