PRACTICAL AUDITING (TEXTBOOK AND IFRS-BASED EXERCISES) 2019 Edition Patricia M. Empleo Certified Public Accountant Ph.D, MBA, BSC Professor and pe Velayo Colk f . ity of Santo Tomas ~ Alfredo M. Velayo College 0! University 0! Accountancy Scanned with CamScannerAudit Planning ~ Leader Interna Control — NMembers | BASIC CONCEPTS OF FINANCIAL STATEMENT AUDIT | JESU BI OID IOS OGIO DIODE IO IDOI IO IIIT TITAS TAIT EXPECTED LEARNING OUTCOMES After reading this chapter, you should be able to (a) recall the nature of a financial statement audit by stating its purpose; (b) identify the management's assertions when presenting the financial statements; (c) describe each major phase in financial statement audit; (d) identify and discuss the most common procedures applied in financial statement audit; (e) explain the purpose of audit documentation; ( state the type appropriate type of audit report for each conclusion drawn based on assessment of audit documentation; (g) formulate appropriate audit adjusting entries; and (h) complete a working trial balance. THE PURPOSE OF FINANCIAL STATEMENT AUDIT AND MANAGEMENT'S: ASSERTIONS — Financial statements are primarily the responsibility of the entity's management who makes the following assertions: existence or of transactions that result to reported assets, liabilities and equity at the reporting date and income and expenses for the reporting period. com| information presented in the financial statements that are the results of the transactions and other events that actually occurred during the reporting period. (ei or control over all reported assets, and adligations for reported liabilities at the reporting date, appropriate use of measurement bases for assets, liabilities and equity and recognition of income and expenses In accordance with the revenue and expense recognition principles applicable; and Scanned with CamScannerChapter 1 - Basic Concepts o ancial Statement Audit i ic ji of all financial statement *' appropriate presentation and disclosure 0 . components od accompanying notes to the financial Sees to the effect that the substance and not merely the legal form of the recordeg , transactions is communicated to the users. External users, mainly investors and other ; stakeholders, use the information. contained in the financial statements in making judgments about the enterprise to formulate decisions. There may be instances, however, that a SPECific Concern of the entity's management may be in conflict with the information needs of the users. Thus, an external audit is necessary to determine whether the financial statements issued by the management are free of biases and are prepared in accordance with the appropriate financial reporting framework. This reporting framework aims to present information that is relevant and reliable for the decision needs of the external users. The external auditor conducts an independent examination of the financial statements to address each of the foregoing assertions of the management. THE AUDIT PROCESS The audit process starts when a reporting entity engages the services of an independent auditor for an independent examination of its financial statements and concludes when an auditor issues an audit opinion based on the assessment of the evidence gathered in the course of the conduct of audit procedures and assessment of evidence gathered therefrom. The following are the major phases in a financial statement audit: | { (a) _ pre-engagement activities; (b) audit planning and evaluation of internal control; (c) _ evidence gathering; and (d) reporting. 16 j (a) Pre-Engagement Activities Pre-engagement activities are procedures conducted to determine whether or not to accept a new engagement or retai r t or reject a prospective client, the auditor should consider the client’s business ae Client, nt’s Putation, the changes in client’s ownership or management and the client’s reporting Practices, . P Likewise, the auditor should determine whether he or she and his or her audit team possess the necessary skills, resources and competence to complete the audit within the period specified by the engagement. The pre-engagement activities are designed to manage conflicts and threats to the auditor. The auditor should not accept an engagement, when based on his or her assessment, his or her independence would be compromised. In Scanned with CamScannerChapter 1 - Basic Concepts of Financial Statement Audit repeat engagements, subsequent relationships established shall be assessed to ‘determine whether independence has not been compromised. If the engagement is accepted or retained, the terms shall be documented in an engagement letter. ((b) Audit Planning & e - 5 Audit planning involves evaluation of internal control to determine the extent of audit procedures necessary to be performed. The audit planning phase requires active involvement of the whole audit team, from the partner in charge down to the audit staff. It includes the following tasks: (1) obtaining an understanding of the client, its business, industry and accounting policies; ¥ (2) obtaining an understanding of the client's internal control system; (3) a8S62Slig MatShAlity Sitd audit risk;--cricion (4) identifying audit objectives; (5) determining whether reliance can be placed on certain controls in the system; (6) determining the nature, extent and timing of substantive tests to be performed; and (7) designing and finalizing the audit program. (c) Evidence-Gathering or Audit Documentation The evidence-gathering (audit documentation) phase must accomplish the objective of documenting the fact that the audit was adequately planned and sufficient, competent evidential matter is obtained that serves as the basis for the audit opinion reached (International Standards on Auditing 230 Audit Documentation par. 5). The evidence gathered must both be sufficient and competent. Sufficiency Tefers to the quantity of evidence an auditor acquires and competence refers to the relevance, validity and reliability of the evidence acquired. Audit evidence consists of both accounting data (business documents, journals and ledgers) and corroborating information (cancelled checks, invoices, contracts, promissory notes, written representations from customers and vendors, etc.) that supports accounting data. Because of the time element involved in completing the audit, the examination of evidence is made on a test basis. The auditors test samples of transactions and generalize the results to the population from which the ‘samples were drawn. This requires that the evidence gathered be persuasive rather than merely convincing. ! The audit procedures applied by. the auditor are selected based on the audit objectives, the quantity and types of evidence available, materiality and the assessed level of audit risk. An audit evidence acquired may address one or more Scanned with CamScannerChapter 1 - Basic Concepts of Financial Statement Audit audit objectives, and in some instances, a series of audit and may be Necessary to address one audit objective. The following are Ly ‘audit procedures applied by the auditor: ‘aining written statements from a third party; obtaining written and oral information from management, employees and others; = obtaining internal evidence and external evidence (for example: contracts, minutes of meetings, vouchers, bank statements, ete.); lishing trends and valid relationships of information; establishing correctness of account balances; and verifying mathematical accuracy of account sg data (tracings, footings and cross-footings). The foregoing and other audit procedures are carried out to perform ty of controls and substantive tests. Tests of controls are conducted to assess ability of the company’s internal controls to prevent or detect meters) misstatements. Substantive tests, on the other hand, are tests of details and analytical procedures performed to detect material misstatements in aC balance, transaction class or financial statement Presentation and di Substantive tests may be classified into tests of details or anal ‘Tests of detai's are intended to detect material misstatement a to test aggregated data. Analytical procedures are evaluations of finance information made by a study of plausible felationships among both financial anc non-financial data. Analytical procedures allow the auditor to test aggregated cata to reach @ condusion, Josure. lytical procedures. ind allow an auc Audit evidence must both be sufficient and competent. The documentation ‘Shall contain the source of the document, the clear Purpose of the audit procedure Performed, and the conclusions reached based on the procedure performed anc evidence gathered. The extent of the documentations should be Sufficient for an ith 0 previous connection with the engagement. to understand the nature, timing, extent and fesults of procedures performed evidence obtained, and conclusions reached, Documentation must be made immedi ately after completing an auxiit procedure. Typical examples of audt documents are Ing to the prospective client's industry, members of the Board of Directors, products manufactured, ete ): Scanned with CamScannerpapter 1 - Basic Concepts of Financial Statement Audit (b) information that enables the auditor to determine the audit approach (information relating to the effectiveness of internal control Procedures and whether or not such procedures are being complied with); () information as to whether a particular financial statement account balance is complete, valid and accurate and (d) information relating to’the completeness, validity and accuracy of the financial statements taken as a whole including information relating to the consistency of the financial statements with the auditor's knowledge of the business The form, content and extent of audit documentation depend on factors, ‘such as (ISA 230 A2) b the size and complexity of the entity; the nature of the audit procedures to be performed; the identified risks of material misstatements; * the significance of the audit evidence obtained; * the nature and extent of exceptions identified; * the need to document a conclusion or the basis for a conclusion not readily determinable from the documentation of the work performed or evidence obtained; + the audit methodology and tools used. h Specifically, the audit file documentation serves to: (a) organize and coordinate all phases of the audit engagement; (b) provide evidence to demonstrate that the planned audit procedures were in fact performed; (c) aid partners in reviewing the work performed by audit staff members; (d) provide evidence that the auditors complied with the auditing standards; (e) document the judgments involved in forming the audit opinion; (f) aid in planning and conducting future audits of the client; and (g) provide information in rendering additional services to the audit client (say, in preparing income tax returns and in making recommendations for improvement of the client’s internal control procedures.) is i it i includes In the risk response phase, typical audit documentation normally incl the following fists on audit plan that addresses all material financial statement Scanned with CamScannerChapter 1 - Basic Concepts of Financial Statement Audit areas, the assessed risk of material misstatement at the financial statement and assertion levels, the Nature, timing and extent of the further audit procedures Performed that respond to the assessed audit tisks, and significant risks identified, Also documented are the nature and extent of consultation with others, significance and nature of the evidence obtained at the assertion being tested, a clear explanation of the results obtained from the test and the exceptions followed Up, actions taken as a result of auditing procedures, changes if any to the overall audit strategy, use of significant judgments applied in performing work and evaluating results, discussions with Management on significant matters, memoranda and details of assumptions used, establishment of validity of assumptions established, Cross references to supporting documentation and evidence that the financial statements agree with the underlying accounting records. The auditors usually maintain two files of audit documentation for each client: (1) current files for each year's engagement and pertain to documentation relating to that year’s examination and (2) the permanent file of telatively unchanging data (for example, articles of incorporation). ‘The following are examples of current files in the audit documentation: * — working trial balance; * a-summary of audit adjusting and classifying entries; * — lead schedule; * bank reconciliation; * aged accounts receivable; * minutes of meetings during the reporting period; and * narrative documentation summarizing ‘bases for resolutions involving uncertainties, Examples of permanent file in audit documentation ate as follows: articles of incorporation; corporate by laws; copy of pension contract with funding agency; copy of trust indentures for long-term debt; and copy of the effective collective bargaining agreement. The audit documentation, which generally is in the form of audit working Papers, must be organized in a logical manner using an indexing system so that the working papers and other documents can be easily located and shared among audit team members. The working papers and other documents should be organized in a manner that facilitates file review and quality control Monitoring by the manager, engagement partner, quality control reviewer/monitor, Audit documents are the property of the audit firm. However, much of the information in working papers is confidential, and generally must not be made available to outsiders without the consent of the client. Scanned with CamScannerChapter 1 - Basic Concepts of Financial Statement Audit Under no circumstances should the workin 1d papers be destroyed after the have been subpoenaed or after an announcement has been imade for itigation involving an engagement. If the auditors are charged with negligence, their audit working papers serve as a major basis to refute or substantiate such a charge. The major types of audit working Papers include administrative working papers, supporting schedules, adjusting journal entries and reclassification entries, supporting schedules, analyses, reconciliations and other computational working papers, and corroborating documents. : rs Administrative working papers aid the auditors in the planning and administration of engagements, and include the audit plans ahd audit programs, time budgets, internal control questionnaires and flowcharts and engagement letter. They may take the form of a narrative documentation that summarizes the phases of audit work performed on the engagement. In the risk assessment phase, the documentation relates to preengagement procedures, independence and ethics assessment, terms of engagement, materiality consideration, overall audit strategy, audit team discussions which may include possible causes of material misstatements in the financial statements, risk assessment procedures performed and the results, assessed risk of material misstatement identified based on the understanding of the entity and related internal control, significant risks, and communication with management and those charged with governance. (Guide to Using ISAs in the Audits of SMEs) (d) Reporting The auditor should review and assess the.conclusions drawn from the audit evidence obtained as the basis for the expression of an opinion on the financial statements. The auditor’s report should contain a clear written expression of an opinion on the financial statements taken as a whole. Based on the results of the evaluations made, the auditor would determine what form of audit report is appropriate in the circumstances. “Types of Audit Reports e The auditor should evaluate the conclusions drawn from the audit evidence obtained as the basis for forming an opinion on the financial statements. (ISA 700, The Independent Auditor’s Report on the Financial Statements, par. 4). There are two general types of audit report: unmodified and modified. (1) Unmodified opinion it its are presented When the auditor concludes that the financial statement fairly, in all material respects, with the applicable financial reporting framework (at Scanned with CamScannerChapter I - Basic Concepts of Financial Statement Audit the present time, the International Financial Reporting ‘Standards oF the International Financial Reporting Standards for Small and Medium Sized Entities), an unmodified (or unqualified) opinion would be appropriate. An unqualifieg opinion should be expressed when the auditor concludes that the financia| statements give a true and fair view (or are presented fairly, in all materiaj respects) in accordance with the applicable financial reporting framework (par. 35 ISA 700). 2)” Modified opinion When based on the audit evidence obtained, the financial statements as a whole are not free from material misstatement or when sufficient appropriate audit evidence could not be obtained to conclude that the financial statements as a whole are free from material misstatement, a modified opinion is expressed. A modified opinion may take the form of a qualified opinion, adverse opinion or disclaimer of opinion, A qualified opinion should be expressed when either (1) sufficient appropriate audit evidence was obtained, but the auditor concludes that misstatements exist, individually or in the aggregate, that are material but not Pervasive to the financial statements or (2) the auditor is unable to obtain sufficient appropriate audit evidence on which to base the opinion and that the possible effects on the financial statements of undetected misstatements, if any, could be material but not pervasive. A qualified opinion should be worded as being “except for the effects (or the possible effects) of the matter to which the qualification relates. An adverse opinion should be expressed when the effects of misstatements are both material and pervasive. -This opinion applies where sufficient appropriate evidence was obtained, but the auditor concludes that misstatements, individually or in the aggregate, are both material and Pervasive to the financial statements. An adverse opinion states that the financial statements do not Present fairly the financial position, financial performance, and cash flows of the entity audited. A disclaimer of opinion (which basically means giving no opinion) should be expressed when-the possible effects of undetected misstatements, if any, could be both material and pervasive. This opinion is expressed when the auditor is unable to obtain sufficient appropriate audit evidence on which to base the opinion, and concludes that the possible effects of undetected misstatements, if any, could be both material and pervasive. This opinion also applies to extremely rare circumstances where in conditions of major uncertainties and their possible effects on the financial statements, it is not possible to form an opinion. Scanned with CamScannerChapter 1 - Basic Concepts of Financial Statement Audit ‘The Working Trial Balance and the Audit Adjusting Entries _ The working trial balance is a schedule listing the balances of accounts in ~ the general ledger for the current and previous year, with columns for adjusting entries, reclassification entries, and the financial statement amounts. The working trial balance is of two types: (1) one-section trial balance, which looks like an ordinary worksheet and lists all ledger accounts. A pair of columns is maintained for each of the following: trial balance, adjustments and reclassifications, adjusted ‘profit or loss accounts and adjusted financial position accounts. « (2) two-section trial balance, which is divided into two components: the working comprehensive income and the working financial position. Each section provides a separate column for unadjusted balances, adjustments and reclassifications and adjusted balances. The working trial balance shows the results of all adjustments and reclassifications made as a result of detailed audit of account balances. Thus, audit adjusting entries developed from a cash count of petty cash, bank reconciliation statement, confirmation and analysis of accounts receivable, analysis of property, plant and equipment, etc. are summarized in the working trial balance. Adjusting and reclassifying entries are a list of auditors’ adjustments in the client prepared financial statements to bring the account balances to correct balances. When the auditors discover errors or irregularities in the accounting records of a client, they propose adjusting entries to correct the accounting records. Also, the auditors develop reclassification entries for items that, although correctly recorded in the accounting records, must be reclassified for fair presentation of the financial statements. A lead schedule is used to combine several amounts which total to a line item in the financial statements. For example a lead schedule is prepared to list the different cash on hand and cash in bank that is shown as a single line item “Cash” on the face of the statement of financial position. Scanned with CamScannerChapter 1 - Basic Concepts of Financial Statement Audit Illustrative Working Trial Balance Below is the trial balance as of December 31, 2018 of Clarity Company, as prepareq by its accountant. Clarity Company Trial Balance December 31, 2018 Cash Accounts receivable Allowance for doubtful accounts Inventory, December 31, 2017 Prepaid expenses Investments Furniture and Equipment Miscellaneous Equipment Accumulated Depreciation Accounts Payable Accrued Expenses Unearned Rent Income Ordinary Share Capital Retained Earnings Sales Rent Income Purchases Salaries Expenses Advertising Expense Commission Expense Utilities Expense Supplies Expense Transportation Expense Repairs and Maintenance Miscellaneous Expenses P Debit Credit 191,000 615,000 P 21,000 584,000 8,000 110,000 312,000 90,000 76,400 543,000 y 51,000 12,800 600,000 182,800 3,500,000 48,000 2,424,000 400,000 124,000 80,000 32,000 12,000 14,000 16,000 23,000 5,035,000 P 5,035,000 You have gathered the following information for adjustment: 1, 60,000. 2. costing P600,000. The Cash account included equipment acquisition fund amounting to A physical Inventory taken on December 31, 2018 revealed goods Goods purchased under FOB shipping point and verified to have been shipped by the supplier on December 28, 2018 were received and recorded by Clarity on January 4, 2019, PS0,000, 10 Scanned with CamScannerChapter. L- Basic Concepts of. Financial, Statement allt 4 The allowance for doubtful accounts should ile acini recaivable: Id bo adjusted to 5% of 5 The company purchased 100 shares of Its P100 par value ordinary share capital for P30,000, the amount having been charged to the Investment account. 6 Except for equipment purchased on June 30, 2018 for P20,000 cash, all equipment were acquired at the Inception of the company three years ago. Depreciation for 2018 has not been recorded, ‘ a Prepaid expenses Include P4,800 Insurance premlum on a one-year Insurance policy taken on October 1, 2018. 8 Unearned rent income on December 31, 2018 amounted to P10,000. 9. Accrued expenses on December 31, 2018 amounted to 54,000. REQUIRED: (a) Prepare audit adjusting entries. (b) Prepare a working trial balance to facilitate the preparation of the financial statements for the year ended December 31, 2018. ’ Solutions: (a) Audit Adjusting Entries: i 1 Acquisition Fund 60,000 elec era n a Purchases 50,000 Accounts Payable 50,000 Doubiful Accounts Expense 9,750 Allowance fr Doubtful Accounts 9,75 lB1000 X B= 40350 ~ Moss = FO Treasury Shares 30,000 aod) Investments , Depreciation Expense 39,200 35.200 ‘Accumulated Depreciation WW Scanned with CamScannerChapter ic Concepts of Financial Statement Audit a: Total Furniture and Equipment 402,000 Acquired June 30, 2018 (20, 00) Acquired at inception P382, Annual depreciation =. P eagoan Annual depreciation rate = 38,200/382,000 = 10% 2018 Depreciation: on beginning balance P38,200 on new (10% x 20,000 x 6/12) =__1,000 Total P39,200 Insurance Expense , 1,200 . Prepaid Expenses e 1,200 Unearned Rent Income 2,800 Rent Income 2,800 12,800 — 10,000 = 2,800 decrease Miscellaneous Expenses 3,000 Accrued Expenses 3,000 54,000 - 51,000 = 3,000 increase Inventory, end 650,000 Cost of Goods Sold 2,408,000 Purchases 2,474,000 Inventory, beg. 584,000 The audit adjusting and reclassification entries are not necessarily posted in the books of the client. Audit adjustments and reclassifications are still effected through the nominal accounts and real accounts of the client, regardless as to whether the client’s books have been closed or are still open, because as previously stated, because their purpose is to correct the client-prepared financial statements. The trial balance shown overleaf is a one-section trial balance, listing in one-section both the profit or loss accounts and the balance sheet accounts. A working trial balance may also be prepared in a two-section format, separating the profit or loss accounts from the balance sheet accounts. Notice that the audit adjustments and reclassifications listed on pages 10 and 11 are a a ppropriately posted to the adjustment columns of the working trial balance. . 12 a —_ Scanned with CamScannerChapter 1 Basic Concepts of Financial Statement Audit CLARITY COMPANY WORKING TRIAL BALANCE FOR THE YEAR ENDED DECEMBER 31, 2018 i Balan Adjustments Profit or Loss Finandal Position Debt Credit Debit Credit Debit Credit Debit Credit Cash 491,000 60,000 731,000 recounts rece 615,000 615,000 ‘Alowance for doubtful 21000 3750 sae accounts : inventory, Dee. 31,2017 584000 $4000 Prepaid expenses 8,000 1,200 5800 Investments 110,000 30,000 80,000 Furniture and equipment 312,000 i 312000 ‘Miscellaneous equipment 90,000, 90,000, ‘Accumulated depreciation 76400 3.200 715 600 ‘Accounts payable 543,000 50,000. 593,000 ‘Accrued expenses 51,000 3.000 54,000 ‘neared rent income 42,800 | 2.800 10,000 ‘Ordinary share capital 500,000 00,000, Relained earings 182,800 162,800 Saks 3,500,000 350000 Rentinoome 48,000 2.800 50,800) Purchases 2.424,000, 50,000 | 474,000 Salaries expense 400,000 400,000 ‘Adverising expense 124,000 124,000 Commission expense 80,000 80,000. Unites expense: 32,000) 32,000, Supplies expense 12,000. 12,000 “Transporation expense 14,000. 14,000 Repairs and maintenance 16,000 = 6,000 Miscelaneous expenses 23,000. 3000 |X 26,000. 3,035,000 | 5,035,000 Equipment aoquiston fund 60,000 60,000 Doubiul accounts expense. 9,750, 9750 Tnveniory, Dec. 31,2018, 50,000 350000 Cost of goods sold 7,408,000 708,000 Treasury shares 30,000 30,000) Depreciation expense 39,200 33200 Insurance expense 1200 1,200. 363.950 | 5258960 | 3162,150 | 3550,800 roi before ncome tax 388 650 3,550,800 | 9550,800 Profit before income tax 2 388,650 Thcome ax expense T6585 Income lax payable T6585 Prof 212,055 3ea50 | 1.974800 | 7,974,800 13 Scanned with CamScanner10. 11% 12. DISCUSSION QUESTIONS What Is a financial statement audit? What Is its basic purpose? What are the management's assertions addressed by an auditor in financial statement audit? What are the major phases In financial statement audit? Briefly describe the types of activities undertaken by the auditor/audit team in each phase, What types of evidence does the auditor in financial statement audit gather? Give typical examples of such evidence. What factors are considered in the selection of audit procedures to be performed in an audit engagement? Describe the purposes of audit documentation. Identify example of matters that must be included in audit documentation in the (a) risk assessment phase; (b) risk response phase; and (c) reporting phase. What are the two basic types of audit report? Under what circumstances is the expression of a qualified opinion appropriate? Under what circumstances is the expression of the unmodified opinion appropriate? What factor is considered by the auditor in making a decision as to whether to issue a qualified opinion or a disclaimer of opinion? What does the working trial balance contain? Scanned with CamScannerChapter 1 - Basic Concepts of Financial Statement Au Que MULTIPLE CHOICE A financial statement audit aims to AY present financial information about an enti Pe entity for use by external 3B determine whether financial statements presented by the management are prepared in accordance with an applicable financial reporting framework. C ccernne whether the entity appropriately pays its income tax jue. D. determine whether the entity is able to pay its maturing obligations. What management's assertion does the auditor address when he/she obtains evidential matter on the appropriate balance of “Trade and Other Payables” that will be shown in the statement of financial position? Existence or occurrence Completeness Rights and obligations Measurement and allocation Jpoe> What management's assertion does the auditor address when he/she reviews the classification of a tract of land acquired exclusively for capital appreciation? A Existence or occurrence B. Rights and obligations c Measurement and allocation -D. Presentation and disclosure What management's assertion does the auditor address when he/she obtains evidence on the shipping terms of inventories in transit shipped by a vendor? Existence or occurrence Completeness Rights and obligations Measurement and allocation Scanned with CamScanner5. Which of the following Is the main objective of the conduct of pre- engagement actlvitles? A B, G Dd. to determine whether or not to accept a new client or retain an existing client, to set the amount of the audit fee to be charged to the client. to be familiar with the working staff of the audit client. to assess the likellhood of Issuing an unqualified opinion. What Is the main purpose of an auditor In his/her evaluation of the client's Internal control system? to properly distribute the different tasks to the members of the audit team. to make a decision whether or not to accept a new engagement or retaln an existing cllent. to determine the extent of audit procedures necessary to be performed. to gather sufficient evidential matter as basis for audit opinion. Which of the following pairs of accounts would an auditor most likely analyze on the same working paper? pp a> Notes receivable and accounts payable. Notes recelvable and interest payable. Notes receivable and interest income. Interest income and interest expense. The current file of an audit documentation most likely would include \boe> Bond indenture of 20-year bonds payable. Articles of incorporation. Pension plan contract Analysis of accounts receivable An audit documentation should A Be Ci D. not contain comments concerning management, _ show that the accounting records agree or reconcile with the management. be destroyed after an announcement has been made for litigation involving an audit engagement. be made available to others even without the consent of the audit client. 16 Scanned with CamScannerChapter 10. il. 12. 13. 14, - Basic Concepts of Financial Statement Audit In which of the following circumstances wot it issuil i uld an auditc issuing a qualified opinion and issuing a disclaimer of rer choose pepe financial statements? pI a client's A Departure from reporting framework. Inadequate disclosure of accounting policies. Inability to obtain sufficient appropriate evidence. Unreasonable justification for a change in accounting policy. Which of the following factors are considered in the selection of audit procedures to be performed in an engagement? lL composition of the audit team audit objectives TIL. level of audit risk IV. _ type of audit evidence available Il, I and IV I, I, and IV J, I, and IIT III and IV only sop All of the following are normally included in the auditor’s current file of audit documentation, except A copy of prior year’s financial statements. ah minutes of meetings of the board of directors during the reporting period. G working trial balance. D. A copy of the entity's organizational chart. 7 ‘A working paper that gives the components of a line item to be presented on the face of the financial statements Is called A. working trial balance. B. supporting schedule. ee lead schedule. . D. draft of financial statements. An auditor gathers audit documentation mainly to detect fraud and misstatements. evaluate management effectiveness. evaluate internal control, ; form an opinion on the fairness of the financial statements. a \poe> 17 Scanned with CamScannerChapter 1 - Basic Concepts of Financlal Statement Audit 15. Which of the following Is classified as a substantive test? Review of payroll checks Reconcile disbursements per books with checks appearing In the bank statement. * GQ Scanning of employment contracts D, Accounting for a sequence of Issued credit memoranda. 16. Which of the following Is a list of activities to be undertaken by the auditor to gather audit evidence? A Audit documentation B. Audit plan C. Audit program D. Audit strategy Scanned with CamScannerEXERCISES problem 1 (Récignment’) The trial balance of Cielo Corporation prior to the closing of its accounts for the fiscal year ended September 30, 2018 is as follows: Cash Accounts receivable Allowance for doubtful accounts Notes receivable Merchandise inventory Furniture and equipment Accumulated depreciation Goodwill Accounts payable Notes payable Ordinary Share Capital Retained earnings Sales Sales returns and allowances Purchases Purchase returns and allowances Advertising expense Sales salaries Commission expense Miscellaneous selling expense Rent expense Office salaries Light and water Insurance expense Taxes and licenses General expenses. Interest expense Interest income Debit Credit P 225,000 P 936,000 31,900 155,000 568,900 618,000 187,500 300,000 536,000 100,000 1,000,000 "552,500 3,728,200 47,600 2,159,300 36,500 96,100 288,500 152,000 29,900 130,000 197,200 15,000 10,800 47,800 163,400 41.200 : 9,100, 6,181,700 6,181,700 Your examination of the company’s accounts has indicated the need for adjustments based on the following information: L The Cash account includes a customer's check for P15,000 deposited on September 25, 2018 but returned by the bank on September 29, 2018 for lack of countersignature. No entry was made by the company for the return of the check or its redeposit on October 5, 2018. 19 Scanned with CamScannerChapter asic Concepts of Financial Statement Audit i btful accounts should b, 2, Based on an aging schedule, the allowance for doul : “adjusted to stb of the customers’ outstanding balance as of September 30, 2018. 3. A physical inventory taken of the merchandise stock as of the close of the fiscal year amounted to P601,200. A purchase of merchandise, FOB shipping point, for which goods Costing P50,000 were in transit on September 30, 2018, was neither taken as a liability nor included in the inventory on that date. VS 5. Goods received on consignment, still unsold, were included in the inventory at the agreed selling price of P30,000. The merchandise inventory at September 30, 2017 was correctly stated. 7,, On July 1, 2018, equipment acquired on October 1, 2013 with a carrying value of P32,000 on September 30, 2017, was sold for P35,000 cash. The sales proceeds were credited to the furniture and equipment account. ¥ 8.- Depreciation for the fiscal year 2017-2018 has not yet been recorded. Depreciation rate is 10%. 9.,An insurance policy was renewed on the inventory and equipment on April 1, 2018 with the annual premium of P8,400 paid on that date. 10./The rent expense account consisted of rent paid for store and office space for thirteen months ending October 31, 2018. - 11. The one-year Note Payable of P100,000 was discounted at the bank at 12% on August 31, 2018, . 12. The Goodwill account was set up by a credit to Retained Earnings under a resolution of the board of directors. REQUIRED: Prepare a one-section trial balance, Providing. columns for trial balance, adjustments, profit or loss, and financial position. The com} is subject to income tax rate of 30%. Ignore the deferred portion of the income tax, aie i | 20 Scanned with CamScannerChapter 1 Ba ic Concepts of Financial Statement Audit problem 2 Selected account balances (before adjustments) Retained Earnings, January 1, 2018 taken from th Inc. for the year ended December 31, 2018 are as follows: ears of ewes: Sales Salaries and Commissions y ae Advertising Expense 32,180 Legal Services 4) ‘450 Insurance and Licenses 17,000 Salesmen’s Traveling Expense 7120 Depreciation Expense — Delivery Equipment 12200 Depreciation Expense — Office Equipment 9,600 Interest Revenue 1,400 Utilities 12/800 Telephone and Postage 2,950 Supplies Inventory 4,360 Miscellaneous Selling Expenses 4,400 Dividends 66,000 Dividend revenue 14,300 Interest expense 9,040 Allowance for doubtful accounts (credit balance) 740 Officers’ salaries 73,200 Sales 990,400 Sales returns and allowances 22,400 Sales discounts ~ 1,760 Gain on Sale of Equipment 37,000 Inventory, January 1, 2018 179,400 Inventory, December 31, 2018 41,100 Purchases 346,000 Freight in 11,050 Accounts receivable 522,000 Extraordinary loss, before income tax 145,200 Ordinary Share Capital 78,000 Data for adjustment: 1 Cost of inventory in the possession of consignees as of December 31, 2018 was not included in the ending inventory balance, P67,200. 2 After aging the accounts receivable, a decision was made to increase the allowance for doub' receivable- balance. tful accounts to 3% of the ending accounts 3.’ Sales conimission for the last day of the year had not been accrued. Total sales on December 31 were P27,200. Sales commission averages to 3% of sales. a Scanned with CamScannerChapter I - Basic Concepts of Financial Statement Audit 4. No accrual had been made for a freight bill received on January 5, 2018, for goods received on December 29, 2018, P1,500. 5. An advertising campaign was initiated November 1, 2018. The cost of P4,200 incurred in November and December was debited to prepaid advertising. . 6. Freight charges of P18,400 paid on sold merchandise and not passed on to the buyers were netted against sales. 7. Depreciation on a new equipment purchased on March 1, 2018 had not been recognized. Equipment are depreciated on a straight-line basis, salvage value being ignored. This equipment was purchased for P15,600 and is estimated to be useful for 10 years. 8. The Extraordinary Loss represents loss from supplies lost and unsalable inventories heavily damaged by flood in August. 9. Income tax rate is 30%. REQUIRED: a. Prepare adjusting entries. b. Prepare a statement of comprehensive income following the function of expense method. Prepare a statement of comprehensive income following the nature of expense method. Prepare a statement of retained earnings for the year ended December 31, 2018. : : c 22 Scanned with CamScannerChapter 1 - Basic Concepts vj ©inanctat Statement Audit MULTIPLE CHOICE ertinent to the audit of the account it aaa | The fed hola the year ended December 3, 218 Corporation, a close or of Go and Associates, CPAs. Shown below are the unaudited werent by the certain additional information pertaining thereto appearing in the Wout rece Unadited Balances, 12/31/18 Debit Credit Petty Cash Fund P 15,000 Cash in Bank 243,600 Trading Securities 330,000 ‘Accounts Receivable 3,544,000 ‘Allowance for Uncollectible Accounts 120,000 ‘Advances to Officers and Employees o 7 Inventories 4,398,900 Prepaid Insurance 29,400 Property, Plant, and Equipment, at cost 10,945,000 Accumulated Depreciation 703,500 Franchises 500,000 Licensing Agreement 216,000 Accounts Payable 2,141,550 Interest Payable 0 Accrued Expenses 598,020 Unearned Revenues 0 Income Taxes Payable 193,365 Dividends Payable . 1,250,000 Current Portion of Long-Term Debt 0 Mortgage Payable : 2,000,000 Bonds Payable 2,000,000 Discount on Bonds Payable 122,000 Ordinary Share Capital 5,000,000 Additional Paid in Capital 1,350,000 Retained Earnings, January 1, 2018 : 2,867,840 Sales 32,250,000 Cost of Goods Sold ano Marketing and Administrative Expenses 8,900,4 Other icerie . 180,000 Interest Expense 404,320 Income Tax Expense 1,585,705 1,250,000 Dividends Dectared P 50,654,275 ___P 50,654,275 P.50,654,275___P 90,654,275 23 Scanned with CamScannerChapter 1 - Basic Concepts of Financial Statement Audit Additional Information: 1. A count of the petty cash fund on January 2, 2019 showed its composition as follows Currency and coins P 6,000 Petty cash vouchers, all dated 2018, except for P1,500 which pertains to 2019 6,000 Employee's postdated check 3,000 Total : , P15,000 2. The following are some of the December 31, 2018 reconciling items noted for cash in bank: a. Customers’ checks returned by the bank marked “DAIF” in December 2018, redeposited in January 2019, P35,000. b. A bank credit memo representing collection by bank from one of the company’s major customers, P40;000. c. A check drawn by another company for P25,000 incorrectly charged by bank in December 2018. d. Checks issued by the company in 2018 and not yet cleared by bank as of December 31, 2018, P105,000. e. The company wrote several checks at the end of 2018 for accounts payable that were held and not mailed until January 15, 2019. These totaled P48,300 and were included in the outstanding checks of December 31, 2018. 3. The trading securities portfolio for Karkits Corporation contained the securities listed below: Fair Value Cost Dec. 31,2017 Dec. 31, 2018 Smart Co. ordinary shares P 70,000 P 30,000 P 40,000 Globe Corp. ordinary shares 100,000 120,000 150,000 Nokia Company ordinary shares 210,000 180,000 160,000 P380,000 P330,000 350,000 The above securities are listed in the stock exchanges. 4. The audit revealed that Accounts Receivable was composed of the following items: Customers’ accounts P2,799,000 Advances to officers and employees 120,000 Selling price of merchandise sent to Mobiline Corp. on consignment at 125% of cost and not yet sold by Mobiline Corp. 625,000 P3,544,000 24 Scanned with CamScannerapter 1 - Basie Conce rancial Statement Audit ch t of the receivab ased on the assessmen ceivables, an pecounts equal to 5% of the outstanding customers’ pone sapere riate, hysical inventory of merchandise as of Decem| 5. 489.800, The following information has bean toc} 7iA8 amounted to inventory transactions: lating to certain a. A P35,000 shipment of goods to a customer on De terms FOB destination, was not included in the year-end’ Wena atte goods cost P26,000 and were received by See the cust 3019. The sale was properly recorded in 2019.) Ce" OM January 8, b. _ An invoice’ for goods costing P35,000 was received and recorded as a purchase on December 31, 2018. The related goods, shi destination, were received on January 2, 2019 aa thus, ee pd included in the physical inventory. ’ d c. Goods costing P27,000 were received from a vendor on January 5, 2019. The related invoice was received and recorded on January 12, 2019. The goods were shipped on December 31, 2018, terms FOB shipping point. d. Inventory cut-off tests indicate that P22,350 of inventory received on December 30, 2018 was recorded as purchases and accounts payable in 2019. These items were included in the inventory count at year end e. — Inventory cut-off tests also indicate several sales invoices recorded in 2018 for goods that were shipped in early 2019. The goods were not included in inventory, but were set aside in a separate shipping area. The total amount of these shipments was P36,000. Cost is P25,000. 6. The prepaid insurance account contains the premium costs of two policies: Policy A. cost of P13,200, two-year term taken on September 1, 2018 Policy B. cost of P16,200, three-year term taken on April 1, 2018. 7. The Property, Plant, and Equipment account of the company is composed of the following: . Land and Building P 8,600,000 Furniture’ and Fixtures 2,177,000 Leasehold Improvements 168,000 Total . P10,945,000 At the beginning of 2018, the company purchased land and building for P8,600,000, which included P180,000 of realty tax in artears for prior years. A Mortgage of P2,000,000 was assumed by the company on the purchase. Twenty percent of the purchase price should be allocated to the land, and the 25 Scanned with CamScannerChapter 1 - Basic Concepts of Ft inancial Statement Audit balance to the building. In order to make the building suitable for the use of the company, remodeling costs in the amount of 900,000 were incurred and this was charged to Repairs and Maintenance Expense. such remodeling necessitates demolition of a portion of the bullding which resulted in recovery of salvage materials, sold for P30,000 cash and recorded as Scrap Income. No depreciation has been recognized on the building for 2018 which has an estimated useful life of 50.years and salvage value ‘of P250,000. On May 1, 2018, costs of P168,000 were incurred to improve leased office premises. The leasehold improvements have a useful life of 8 years. The related lease, which terminates on December 31, 2024 is renewable for an additional 6 year term. The decision to renew will be made in 2019 based on office space needs at that time. No depreciation has been recorded yet on the leasehold improvements for 2018. 8. A franchise agreement was acquired at the beginning of 2018 for P500,000. No amortization has been recorded for 2018. A ten-year amortization period is to be used. 9. The company’s Licensing Agreement account has a balance of P216,000. Original amount was P360,000 and is being amortized on a five-year basis starting in January 2016. As of year end, amortization has not been recorded. 10. You were furnished with the schedule of Accounts Payable and Accrued Expenses as of December 31, 2018. Your verification disclosed the following: a. Payment to Delon Company, a supplier, amounting to. P126,000 was erroneously debited to the account of De Leon Corporation, another supplier. 7 b. The following unpaid vouchers have not been recorded as of year-end: Light, telephone, and water bills for December totaling P22,800. Property taxes for the last quarter of 2018 due on the first week of January, 2019, P10,000. Various payroll taxes, P18,000. 11. Rent was received from a tenant in December 2018. The amount of 130,000, was recorded as income at that time even though the rental pertains to 2019. 12. The mortgage on land and building assumed by the com} is 7 pany is payable in installment of P500,000 every January 1, starting on January 1, a1. Yaterest of 20% per annum Is payable semiannually every January 1 and July 1, 13. The bonds payable represented a 9%, P2,000,000 face value bond: D | is which were issued on January 1, 2014 to yield 10%. Interest Is payable annually ” 26 Scanned with CamScannerChaptel Basic Concepts of Financiat Statement Audit i january 4, No interest accrual nor bond discount amortization was recorded during 2018. 44. The company is subject to 30% income tax rate. (Disregard any difference between accounting profit and taxable profit.) Instructions: (a) Prepare a list of audit adjusting entries, (b) Prepare a one-section trial balance, with the columnar headings as exemplified on page 13. (c) Compute the correct balances of the following 1G Petty Cash Fund A. 15,000 B. P9,500 Cc P7,500 Dd. P6,000 2. Cash in Bank A 296,000 B, P326,900 c. P353,600 D. P401,900 3. Trading Securities A 380,000 B. P350,000 G 330,000 D. P300.000 4. Accounts Receivable A 3,198,000 B. P2,798,500 ic P2,794,000 D. 2,758,000 5. Allowance for Doubtful Accounts A P1S59,900 B. P139,925 CG P139,700 D. 137,900 27 Scanned with CamScannerChapter 1 - Basic Concepts of Fi nancial Statement Audit 6. Advances from Officers and Employees A. PO B. 3,000 CG P120,000 D. P123,000 7. Inventories A. 4,451,900 CON B. P4,476,900 : GQ P4,964,250 D. 4,976,900 8. Prepaid Insurance A P12,850 B. 21,125 CG P23,150 D. 23,700 ' 9. Land A P1,864,000 B. P 1,720,000 ‘ c P1,690,000 D. P 1,684,000 10. Building \ A P7,780,000 B. P7,750,000 Cc 7,636,000 D. P7,606,000 11. Accumulated Depreciation — Building A. P155,000 B. P150,000 C.. P150,600 Dd. 147,120 12. Carrying amount of Leasehold Improvements A P168,000 B. P154,000 cG P151,200 D. P150,600 13. Franchise A P500,000 B. P450,000 c. P400,000 ' D P350,000 28 Scanned with CamScannerChapter 1 Basic Concepts of Finan Statement Audit Carrying amount of Licensing Agreement 4 P72,000 . p. _—-P144,000 c.__P288,000 Dp. __-P428,000 15. Accounts Payable A. 2,239,200 B. 2,212,200 ‘ & P2,204,200 “D. P2,155,900 46. Accrued Operating Expenses A P547,220 B. —-P598,020 Cc. —-P648,820 Dd. P848,820 17, Unearned Revenues A PO B, P21,667 Cc) P65,000 D. P130,000 18. Interest Payable A P180,000 B. P200,000 c. P380,000 D. P580,000 19. Income Tax Payable “A P66,239 B. P163,477 C. — P320,491 Dd. P759,620 20. Dividends Payable A PO B. P250,000 c 625,000 D. P1,250,000 21. Current Portion of Long-term Debt PO P500,000 P1,000,000 P1,500,000 gOg>r 29 Scanned with CamScanner22. 23. 24. 25. +26. 27. 28. 29. Discount on Bonds Payable A. P129,800 B. P122,000 CG P114,200 D. 109,800 Ordinary Share Capital A. 5,000,000 B P4,000,000 Cc. 3,500,000 D. 3,000,000 Retained Earnings A. P7,192,630 B. P7,091,630 C 5,021,191 D. 4,240,165 Sales A 32,214,000 B. P31,625,000 G 31,600,000 D. 31,560,000 Cost of Goods Sold A. P17,659,300 B. P17,631,300 c P17,606,300 D. P17,579,300 Marketing and Administrative Expenses A. P8,386,800 B. P8,372,470 a P8,368,650 D. P8,220,450 Other Income A. P40,000 B. 45,000 Cc P50,000 D. P70,000 Interest Expense A. P1,392,120 B. P792,120 Cc. P624,620 D. P504,320 30 Scanned with CamScanner arer 1 Basic Concepts of Financial Statement Audit Cha 30, PROM 5 306,113 “5,015,459 4,777,410 bp. __P3,007,770 .e that the entity made an early adopti - 2 aa of these statements are caret option of IFRS 19 Leases How r Karkits shall recognize’ Rights-of-Use : value of the required periodic lease eee lo ae IL. Karkits shall recognize lease liability equal to the feriiis ee payments payable up to the end of the lease term. 9 mL. Karkits has the option of recording the lease Payments in the Rent Expense account over the remaining term of the lease. IV. Karkits will have an increase in the recognized interest expense. A All of the above statements are correct. B. Two statements are correct. c Two statements are correct. D. Only one statement is correct. 31 Scanned with CamScanner