Question

Part II Short Answer (40 Points) A CPA is performing an audit of a client's financial statements for the year ended 12/31/18. The Company has significant inventories on hand. What is the key procedure that the Statements on Auditing Standards require the CPA to do re: the inventories? There is a presumption that the auditor will request the confirmation of accounts receivable during an audit unless one of three criteria are met; name 1 of these 3 criteria: What is the definition of fraud, as described in the Statement on Auditing Standards: Name the 3 Fraud Risk Factors:

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Answer 1

1. Key procedures that the statement on Auditing Standards require the CPA to do re: the inventories are as follows:-

• Cutoff analysis:- Examine procedures for halting any further receiving into the warehouse or shipments from it at the time of the physical inventory count, so that extraneous inventory items are excluded. To see whether inventory are properly accounted for.
• Observe the physical inventory count:- Discuss the counting procedure, observe counts as they are being done, test count some of the inventory yourself, and trace their counts to the amounts recorded by the company's counters, and verify that all inventory count tags were accounted for. In case of multiple inventory storage location, test the inventory in those locations where there are significant amounts of inventory. Ask for confirmations of inventory from the custodian of any public warehouse where the company is storing inventory.
• Reconcile the inventory count to the general ledger:- Trace the valuation compiled from the physical inventory count to the company's general ledger, to verify that the counted balance was carried forward into the company's accounting records.
• Test high-value items:- If there are items in the inventory that are of unusually high value. Spend extra time counting them in inventory, ensuring that they are valued correctly, and tracing them into the valuation report that carries forward into the inventory balance in the general ledger.
• Test inventory in transit:- There is a risk that inventory may be in transit from one storage location to another at the time of the physical count. Test for this by reviewing your transfer documentation.
• Test item costs:- Know where purchased costs in the accounting records come from, compare the amounts in recent supplier invoices to the costs listed in the inventory valuation.
• Test for lower of cost or market:- Follow the lower of cost or market rule, and do so by comparing a selection of market prices to the recorded costs.
• Finished goods cost analysis:- If a significant proportion of the inventory valuation is comprised of finished goods, review the bill of materials for a selection of finished goods items, and test them to see whether it shows an accurate compilation of the components in the finished goods items, as well as correct costs.

2. Criteria for presumption that the auditor will request for the confirmation of accounts receivable during an audit is:-

• Accounts receivable are immaterial to the financial statements.

3. SAS 99 defines fraud as an intentional act that results in a material misstatement in financial statements. There are two types of fraud considered: misstatements arising from fraudulent financial reporting (e.g. falsification of accounting records) and misstatements arising from misappropriation of assets (e.g. theft of assets or fraudulent expenditures). The standard describes the fraud triangle. Generally, the three 'fraud triangle' conditions are present when fraud occurs. First, there is an incentive or pressure that provides a reason to commit fraud. Second, there is an opportunity for fraud to be perpetrated (e.g. absence of controls, ineffective controls, or the ability of management to override controls.) Third, the individuals committing the fraud possess an attitude that enables them to rationalize the fraud.

4. Three Fraud Risk Factors are as follows:-

• Large amounts of cash or other valuable inventory items on hand, without adequate security measures in place.
• Heavy dependence on a few key employees, who have too much power and too few checks and balances. Employees with conflicts of interest, such as relationships with other employees and financial interests in vendors or customers.
• Weak internal controls.