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CPA Certified Public Accountant AA : Audit & Insurance

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Question 5: The internal auditing department has been assigned to perform an audit of a division. Based on
background review, the auditor knows the following about management policies:
Company policy is to rapidly promote divisional managers who show significant success. Thus,
successful managers rarely stay at a division for more than three years.
A significant portion of division management's compensation comes in the form of bonuses based on
the division's profitability.
The division was identified by senior management as a turnaround opportunity. The division is
growing, but is not scheduled for a full audit by the external auditors this year. The division has been
growing about 7% per year for the past three years and uses a standard cost system.
During the preliminary review, the auditor notes the following changes in financial data compared to
the prior year:
Sales have increased by 10%.
Cost of goods sold has increased by 2%.
Inventory has increased by 15%.
Divisional net income has increased by 8%.
Assume the auditor found that there was a plan to overstate inventory and therefore increase
reported profits for the division. If reported correctly, the division would not have shown an increase
in net income. The auditor has substantial evidence that the divisional manager was aware of and
approved the plan to overstate inventory. There is also some evidence that the manager may have
been responsible for the implementation of the plan.
The appropriate audit action would be to
A. Continue to conduct interviews with subordinates until a clear-cut case is made and then report
the case to the audit committee.
B. Inform management and the audit committee of the findings and discuss proper follow-up action
and/or further investigation with them.
C. Inform the divisional manager of the audit suspicions and obtain the manager's explanation of the
findings before pursuing the matter further.
D. Document the case thoroughly and report the suspicions to the external auditor for further review
and external reporting.
Correct Answer: B