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In planning an audit, the auditor's knowledge about the design of relevant internal control activities should be used to

A. Identify the types of potential misstatements that could occur.
B. Assess the operational efficiency of internal control.
C. Determine whether controls have been circumvented by collusion.
D. Document the assessed level of control risk.

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During the planning phase, an auditor obtains an understanding of the entity and its environment through the performance of risk assessment procedures. These procedures enable the auditor to effectively assess the types of potential misstatements that could occur and the controls that should be in place to mitigate the risk of a material misstatement (RMM).

Required risk assessment procedures include AIIO:

Analytical procedures (study of data comparisons and relationships) using high-level data
Inquiries of management and others within the entity, including internal auditors
Inspection of documents and records, such as authorization forms and procedures manuals
Observation (watching the application of manual controls)

Understanding the design of relevant internal control activities is used to:

Identify the types of potential misstatements (eg, errors, fraud)
Consider factors that affect the RMM
Design tests of controls and substantive procedures

(Choices B and D) Assessing and documenting the operational efficiency of internal control occur after the auditor obtains an understanding of the entity. The potential misstatements must be identified before conclusions can be drawn.

(Choice C) Auditors are expected to be alert for the possibility of fraud. They are not expected to determine whether controls have been circumvented by collusion. If it appears that controls were not effective, further testing would be designed to determine whether collusion occurred.

Things to remember:

An auditor obtains an understanding of an entity through the performance of risk assessment procedures. These procedures are designed to gather information to enable the auditor to effectively assess the types of potential misstatements that could occur and the controls that should be in place to mitigate such risks.

Which of the following reports most likely would provide assurance on internal controls over the confidentiality of client data at a service organization?

A. SOC 1 Type 1
B. SOC 1 Type 2
C. SOC 2 Type 1
D. SOC 2 Type 2

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System and organization controls (SOC) reports provide assurance about a service organization's internal controls. SOC 1 reports provide assurance about a service organization's controls relevant to the user entity's financial reporting.

SOC 2 reports, in contrast, provide assurance on the service organization's controls over security, availability, processing integrity, confidentiality, and privacy of the user entity's data. Generally, these reports are provided by the service organization to its clients.

The emphasis of SOC 2 reports is on the operational fitness of IT systems. These reports can play an important role in:

Oversight of the organization
Vendor management programs
Internal corporate governance and risk management processes
Regulatory oversight

Both SOC 1 and SOC 2 reports come in two types: Type 1 reports address only the accuracy of management's description of the controls and whether those controls are suitably designed. Type 2 reports provide assurance about whether the controls are operating effectively.

Things to remember:

System and organization controls (SOC) 1 reports provide assurance about a service organization's controls relevant to a user entity's financial reporting. SOC 2 reports provide assurance about the controls over security, availability, processing integrity, confidentiality, and privacy of the user entity's data. Type 1 reports address the accuracy of management's description of controls and whether those controls are suitably designed. Type 2 reports provide assurance about whether the controls are operating effectively.

Rein, Inc. reported $40,000 as deferred tax assets and $53,000 as deferred tax liabilities at the beginning of Year 2. At the end of Year 2, Rein reported $58,000 as deferred tax assets and $65,000 as deferred tax liabilities. What should Rein report as deferred income tax expense or benefit at the end of Year 2?

A. $6,000 tax expense.
B. $6,000 tax benefit.
C. $7,000 tax expense.
D. $7,000 tax benefit.

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The deferred income tax expense or benefit represents temporary differences between accounting and taxable income resulting from certain items being taxable or deductible on a tax return in a different period than reported on the income statement.

Some differences result in future taxable amounts, which require the recording of deferred tax liabilities (DTL) and create a deferred tax expense because future taxes will be owed. Others are future deductible amounts, resulting in deferred tax assets (DTA) that create deferred tax benefits because future taxes will be saved. The DTA and DTL are netted at year end and are reported either as a noncurrent asset or liability.

The deferred tax expense (or benefit) is the change in the net DTA or net DTL for the reporting period as follows:

If net DTL increased or net DTA decreased, record an expense.
If net DTA increased or net DTL decreased, record a benefit.

In this scenario, Rein, Inc.'s net DTL decreased during the year, which creates a deferred tax benefit of $6,000, as shown below (Choice A).

(Choices C and D) The $7,000 is the net DTL at the year end. The change in the net amount of DTA and DTL equals the deferred expense or benefit.

Things to remember:

The deferred tax expense (benefit) is the change in the net deferred tax asset (DTA) or net deferred tax liability (DTL) for the reporting period. Deferred tax expense results when there is a net DTL increase or net DTA decrease. A deferred tax benefit results when there is a net DTA increase or net DTL decrease.

For year 1, a taxpayer reported its taxable income using the accrual method of accounting. For year 2, the taxpayer will change its accounting method from the accrual method to the cash method of accounting. At December 31, year 1, the taxpayer had $1,100,000 of accounts receivable and $750,000 of accounts payable and accrued expenses. What is the amount of the adjustment required to effect the change in accounting method and over what period will the change be recognized?

A. The adjustment results in an increase to taxable income of $350,000, and it will be recognized over four years, beginning in the year of change.
B. The adjustment results in a reduction to taxable income of $350,000, and it will be recognized over four years, beginning in the year of change.
C. The adjustment results in a reduction to taxable income of $350,000, and all of it will be recognized in the year of change.
D. The adjustment results in an increase to taxable income of $350,000, and all of it will be recognized in the year of change.

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Choice C (Correct): IRC Section 481(a) requires adjustments to be made in the event of a change in accounting method. The purpose of such adjustments is to avoid duplication of amounts previously recognized as expense or income under the previous accounting method. Since the taxpayer would have previously reported $1,100,000 of income as the receivables were accrued, that amount must be backed out to get to cash basis. Similarly, since the taxpayer would have reported $750,000 of expenses for the payables accrued, such expenses must be added back to get to cash basis. Thus, to switch to cash basis, the taxpayer has a net reduction in taxable income of $350,000 (i.e., -$1,100,000 income not actually received + $750,000 expenses not actually paid). The adjustment is generally taken into account in the year of change; however, since it is more onerous on a taxpayer to take a net positive adjustment into account all in one year, IRC Section 481(b) allows the amount to be spread over four years (i.e., the year of change and next three taxable years) if the amount is greater than $3,000.

Choices A, B (Incorrect): IRC Section 481(a) requires adjustments to be made in the event of a change in accounting method. The purpose of such adjustments is to avoid duplication of amounts previously recognized as expense or income under the previous accounting method. IRC Section 481(b) allows such adjustments that result in an increase in taxable income of more than $3,000 to be allocated over 4 years (i.e., the current year and the next three years). However, the taxpayer’s required adjustment does not fit this description.

Choice D (Incorrect): IRC Section 481(a) requires adjustments to be made in the event of a change in accounting method. The purpose of such adjustments is to avoid duplication of amounts previously recognized as expense or income under the previous accounting method. The adjustment is generally taken into account in the year of change; however, since it is more onerous on a taxpayer to take a net positive adjustment into account all in one year, IRC Section 481(b) allows the amount to be spread over four years (i.e., the year of change and next three taxable years) if the amount is greater than $3,000.

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