CHAPTER 9
OVERVIEW OF RISK-BASED AUDIT PROCESS
Questions 1.
In thei theirr inve invest stig igat atio ion n of a pros prospe pect ctiv ivee clie client nt,, the the CPAs CPAs shou should ld assess assess the the backgr backgroun ounds ds and reput reputati ations ons of the prospe prospect ct and its major major shareh sharehold olders ers,, directors, and officers. officers. Thus, inquiries are made of underriters, underriters, bankers, and attorne!s that conduct business business ith the prospective prospective client. Also, the CPAs are required required to make inquiries inquiries of the prospect"s prospect"s predecesso predecessorr auditors auditors to obtain obtain information that might enter into the acceptance decision, such as information regarding the integrit! of management. The prospect"s financial reports, #$C fili filing ngs, s, cred credit it repo report rts, s, and and ta% ta% retu return rnss are are used used as sour source cess of fina financ ncia iall background information.
&.
An engagem engagement ent lette letterr is sent to the client client b! the audit auditors ors to make make clear clear the nature of the engagement, an! limitations on the scope of the audit, ork to be performed b! the client"s staff, and the basis for computing the auditors" fee. The engagement letter represents the ritten contract for the engagement, and its primar! objective is to prevent possible misunderstandings beteen the client and the auditors. It constitutes constitutes an executory contract beteen the auditors and the client.
'.
(#ho (#hoppi pping ng for for acco accoun unti ting ng prin princi cipl ples es)) is a prac practi tice ce here hereb! b! mana manage geme ment nt changes auditors to a CPA firm that is more likel! to allo an accounting principle that has been the subject of dispute ith the compan!*s prior auditors. A number of mechanisms serve serve to discourage the practice, including+ including+ 1- the requireme requirements nts under PAS No. 84 84 for the successor auditors to inquire of the predecessors about the reasons for the change in auditors, &- the #$C /0 requirements for management to report the reasons for a change in auditors hich also require the auditors to e%press their agreement ith the details, and '- the requirements under PAS No. 97 that that require accountants ho are being asked to provide a report on the accounting treatment of an prospective or completed transaction to consult ith the client*s auditors to ensure that the! have a complete understanding of the form form and substance of the transaction. transaction. In additi addition, on, the #arban #arbanes/ es/%l %le! e! Act of &22& &22& requir requires es the audit audit commit committee tee to assume responsibilit! for engaging, compensating, and overseeing the auditors.
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9-2
Solutions Manual – Public Accountancy Profession 3.
The approac approach h describe described d in the the statemen statementt is not not appropri appropriate. ate. 4ateriali 4aterialit! t! depends depends on both the dollar dollar amount and the nature nature of the item. 5or e%ample, e%ample, auditors auditors appl! a more rigorous standard of materialit! in evaluating transactions beteen related parties and potentiall! illegal acts than the! appl! to misstatements in accounts.
6.
The to t!pes t!pes of missta misstatemen tements ts due to fraud fraud are are 1- misstat misstatement ementss arising arising from frau fraudu dule lent nt fina financ ncia iall repo report rtin ing, g, and and &&- miss missta tate teme ment ntss aris arisin ing g from from misappropriation of assets sometimes referred to as defalcation-. defalcation-. 5raudulent financial reporting is of more concern to the auditors because it t!picall! results in effects that are much more material material to the financial financial statements. 7efalcations often are not material to the financial statements.
management*s objectives. There are man! 8. A business risk is a treat to achieving management*s e%amples of business risks that ma! result in a risk of material misstatement of the financial statements. To are shon belo+ Business Risk
Risk of Material Material Misstatement Misstatement
9apidl! 9apidl! changing changing technolog! technolog! in the clie client nt*s *s indu indust str! r! ma! thre threat aten en to cause the client*s products to become obsolete.
Inventor! ma! be overvalued because it is not valued at net reali:able value.
$conomic conditions in the industr! ma! result in significant uncollectible accounts receivable.
Accounts receivable ma! be overvalued because the alloance for uncollectible accounts is not adequate.
;.
The audit audit proced procedure uress to be folloed folloed in a given given engageme engagement nt depend depend upon upon such factors as the risks of material misstatement of the financial statements, the assumption about the effectiveness of internal control, the auditors" estimates of materiali materialit!, t!, the nature of the accounting accounting records, records, the caliber caliber of accounting accounting personnel, personnel, and an! special special objectives objectives of the engagement. engagement. Consequent Consequentl!, l!, a sepa separa rate te,, tail tailor or/m /mad adee audi auditt prog progra ram m shou should ld be prep prepar ared ed for for each each audi auditt engagement.
.
The quotation quotation is is misleadin misleading g because because it implie impliess that an audit progr program am is no more more than a checklist checklist of instruction instructionss for ine%peri ine%perienced enced auditors. auditors. Actuall!, Actuall!, audit programs are essential to assessing that all ork is performed and are used on virtuall! all audit engagements regardless of the amount of e%perience of the auditor. Also, a ritten audit program is is required for all audits. audits.
<.
The risk risk of materi material al misstat misstateme ement nt is the probabil probabilit it! ! that that an accoun account, t, class class of transactions, or disclosure disclosure is materiall! materiall! misstated. It consists of inherent inherent risk the risk of ial misst ith consideri consideri internal internal control- and
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Overview of Ris!"ase# Au#it Process
9-3
control risk the risk that internal control ill fail to prevent or detect and correct the material misstatement-. 12. 12. #ign #ignif ific ican antt risk riskss ofte often n rela relate te to nonr nonrou outi tine ne tran transa sact ctio ions ns and and esti estima mati tion on transactions. #uch transactions t!picall! involve more subjective subjective judgment than routine transactions and, therefore, the! often have a higher risk of material misstatement. #ignificant risks risks ma! also be fraud risks. 11. 5actor 5actorss hich hich ma! cause cause an audit audit engageme engagement nt to e%ceed e%ceed the original original time estimate include the folloing+ 1- Accounting Accounting records records ma! ma! not be up to date and complet complete. e. &- Inadequacies in internal internal control ma! be discovered necessitating a more detailed audit than anticipated. '- A significant significant risk, risk, such as a fraud risk, risk, ma! be discovered discovered requiring requiring an e%tension of audit procedures. 33- 5rau 5raud d ma! ma! be disc discov over ered ed,, and and an e%te e%tend nded ed inve invest stig igat atio ion n ma! ma! be authori:ed b! the client to clarif! the situation. 6- Inadequat Inadequatee supervision supervision of audit audit staff ma! permit permit unnecessa unnecessar! r! or mis/ directed ork to be performed. 8- 5indings 5indings during during the course of the audit audit ma! cause the client client to request request e%tension of the scope of the ork. In some engagements, clients are charged at agreed dail! or hourl! rates for the time used to perform the audit. The difficult! of forecasting forecasting time requirements is a principal reason for the use of per diem rates rather than quoting a fee for the entire engagement. engagement. 5or man! engagements, a ma%imum ma%imum fee is agreed upon= upon= this plan ma!, of course, force the auditing firm to absorb part of the cost of une%pected amounts of ork. A decision as to charging charging the client for unusual unusual amounts of time ill involve consideration of all aspects of the engagement and prior relation relationss ith the client. client. >enerall!, >enerall!, hoever, hoever, the client should not be billed for e%cessive time attributed to audit inefficiencies e.g. item 6- above-. 1&. ?nderreporting of time results in the CPA firm not billing the client client for all of the time actuall! involved involved in rendering rendering the professional professional services. Thus, the firm"s revenue is being restricted. restricted. In addition, the underreporting underreporting ill cause the firm to underestim underestimate ate the amount of time require required d for future engagements engagements.. Thus, auditors on future engagements ill be e%pected to perform audit procedures in an unrealisticall! unrealisticall! short period of time. This interferes ith ith the performance of an effective audit as ell as the realistic evaluation of firm personnel.
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9-4
Solutions Manual – Public Accountancy Profession
Cases 1.
a.
Prior rior to acce accept ptan ance ce of the the engag ngageement ment,, Arga Argant ntee @ Tan shou shoulld have ave communicated ith the predecessor auditor regarding+
b.
The The form form and conte content nt of enga engage geme ment nt lette letters rs ma! var!, var!, but the! the! oul ould d generall! contain information regarding+
&.
a.
5acts that might bear on the integrit! of management. 7isa 7isagr gree eeme ment ntss ith ith mana manage geme ment nt conc concer erni ning ng acco accoun unti ting ng principles, auditing procedures, or other significant matters. The predecessor*s understanding about the reason for the change. An! other information that ma! be of assistance in determining hether to accept the engagement.
The objective of the audit. The estimated completion date. 4anagement*s responsibilit! for the financial statements. The scope of the audit. ther communication of the results of the engagement. The The fact fact that that beca becaus usee of the the test test natu nature re and and othe otherr inhe inhere rent nt limi limita tati tion onss of an! an! s!st s!stem em of inte intern rnal al cont contro rol, l, ther theree is an unavoidable risk that even some material misstatement ma! remain undiscovered. Access to hatever records, documentation, and other information ma! be requested in connection ith the audit. Arrangements ith respect to client assistance in the performance of the audit engagement. $%pectation of receiving from management ritten confirmation concerning representations made in connection ith the audit. otification of an! changes in the original arrangements that might be necessitated b! unknon or unforeseen factors. 9equest for the client to confirm the terms of the engagement b! acknoledging receipt of the engagement letter. The The basi basiss on hi hich fees ees are are comp compu uted ted and an! bil billing ing arrangements.
T!pical T!pical engagement engagement letter letter generall! generall! includes includes the folloing folloing++ The name and address of the person or persons ho retained the auditor to perform the auditing services. An openin opening g paragr paragraph aph that that confir confirms ms the under understa standi nding ng of the
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Overview of Ris!"ase# Au#it Process
b.
9-5
A summar! of significant events that lead to the retention of the services of the auditor. A genera generall descri descripti ption on of the CPA firm firm that that ill ill conduc conductt the e%amination. A statement that the e%amination ill be performed in accordance ith auditing standards. A description of the scope of the services to be rendered, hich should establish the nature of the engagement. An! scope restrictions or special limitations and their effect on the auditor*s report. A statement regarding the auditor*s responsibilit! for the detection of fraud. An indication of the possible use of client personnel in connection ith the audit ork to be performed. A statement that the auditor ill provide a management letter if required in the circumstances. The method and timing of billings as ell as billing rates and fee arrangements. #pace for the client client represent representative ative*s *s signature signature,, hich indicates indicates (acceptance) of the letter and the understandings, therein.
The benefi benefits ts of prepari preparing ng an engageme engagement nt letter letter inclu include de the avoidan avoidance ce of possible problems beteen the CPA and the client concerning 1- the scope of the ork, ork, &- the service service to be rende rendered red,, and '- the audit audit fee. fee. In addition, addition, the (in/charge (in/charge)) auditor auditor conductin conducting g the e%amination e%amination can avoid misu misund nder erst stan andi ding ng the the natu nature re and and scop scopee of the the enga engage geme ment nt if the the engagement letter is included in the permanent section of the audit orking papers. The letter should eliminate eliminate misunderstandings misunderstandings and confusion about the t!pe of financial statements to be e%amined, the estimated report date, and the t!pe of opinio opinion n e%pect e%pected. ed. In additio addition n to avoidin avoiding g possib possible le misunderstandings, an! legal problems relating to the auditor*s failure to perf perfor orm m cert certai ain n proc proced edur ures es can can be revi revie eed ed ith ith refe refere renc ncee to the the contractua contractuall commitment commitment assumed. assumed. 5or e%ample, e%ample, if scope limitation limitationss prevent the auditor from performing normal audit procedures, the auditor cannot be legall! responsible if an irregularit! is not detected hen clearl! it ould have been detected if such procedures ere performed.The engage engagemen mentt letter letter is also also useful useful as a refere reference nce docume document nt hen hen preparing for future engagements.
c.
The CPA CPA usuall! usuall! prepare preparess the engage engagement ment letter letter as a follo/ follo/up up to a verbal verbal understand understanding ing that he and his client client have reached. reached. It is desirable desirable that the client endorse and return an approved cop! of the engagement letter to the
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9-6
Solutions Manual – Public Accountancy Profession CPA. CPA. It also is acce accept ptab able le for the the clie client nt to prep prepar aree his his on on lett letter er summari:ing his understanding of the nature of the engagement.
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d.
Prefer Preferabl abl! ! the engagem engagement ent lette letterr should should be sent at the beginn beginning ing of the engagement so that misunderstandings, if an!, can be remedied.
e.
bvi bviou ousl sl!, !, the the enga engage geme ment nt lett letter er ill ill be most most usef useful ul in clar clarif if!i !ing ng misunderstandings on a first engagement. But it is desirable desirable that the letter letter be reneed periodicall!. periodicall!. Client personnel or the nature nature of the engagement ma! change change,, and the resubmis resubmissio sion n of the letter letter gives gives both both partie partiess an opportunit opportunit! ! to revie the circumstance circumstances. s. Accordingl Accordingl!, !, for recurring recurring e%amin e%aminati ations ons of financ financial ial statem statement ents, s, it is approp appropri riate ate to prepar preparee an engagement engagement letter letter at the start of each e%amination e%amination.. 5or other continuing continuing engagements, the engagement letter also should be updated periodicall! probabl! on a !earl! basis.
a.
The procedures that 5rancis should follo prior to accepting the engagement include the folloing+ 1- 5rancis 5rancis should should e%plain e%plain to ikolai ikolai the need to inquire inquire of Do and should should request permission to make such inquiries. &- 5rancis 5rancis should request request that that ikolai authori authori:e :e Do to respond full! full! to all of 5rancis* 5rancis* inquiries inquiries since Do ould be prohibite prohibited d from disclosing disclosing confidenti confidential al informatio information n obtained obtained in the course course of his profession professional al engagement ith ikolai. '- 5rancis 5rancis should advise advise Do of ikolai*s ikolai*s decision decision to change change auditors auditors as an act of professional p rofessional courtes!. 3- 5rancis 5rancis should make reasonab reasonable le inquiries inquiries of Do regarding regarding matters matters that ill aid in deciding deciding hether hether to accept the engagemen engagement. t. 5rancis* 5rancis* inquiries should include questions regarding facts hich might bear on the integrit! of management, disagreements ith management as to accounting principles, auditing procedures or other significant matters, and Do*s understanding of the reasons- for the change of auditors.6- 5rancis 5rancis should should eigh eigh all the informa information tion recei received ved from from Do. If Do does does not respond full! to 5rancis* questions, 5rancis should consider the implications of the limited response in deciding hether to accept the engagement. 8- After eighing eighing all informati information on received received from Do, 5rancis should should inform ikolai that a first/time audit is more time/consuming than a recurring audit because the ne auditor auditor is generall! generall! unfamiliar unfamiliar ith client*s client*s operations and does not have the b enefit of past knoledge of compan! affairs to use a guide.
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Overview of Ris!"ase# Au#it Process
9-7
;- A discussion discussion ith ikolai ikolai of the estimat estimated ed required required audit time time and fee arrangemen arrangementt should should be coordinat coordinated ed ith a clear e%planatio e%planation n of the purpose purpose and scope of the audit. audit. An! ork that can can be done b! client personnel should also be discussed so that e%cess audit time might be eliminated and proposed report deadlines can be reasonabl! met. - To satisf satisf! ! 5ranc 5rancis* is* qualit! qualit! contro controll object objective ives, s, 5ranci 5ranciss should should use procedure proceduress such as revieing revieing the financial financial statements statements of ikolai= ikolai= inquir inquiring ing of third third partie partiess such such as ikola ikolai*s i*s banks, banks, legal legal couns counsel, el, invest investmen mentt banker bankers, s, and others others in the busine business ss commun communit! it! as to ikola ikolai*s i*s reputa reputatio tion= n= and evalua evaluatin ting g his abili abilit! t! to serve serve ikola ikolaii properl! ith reference to industr! e%pertise, si:e of engagement, and available staff. <- If 5rancis 5rancis has no reservations reservations,, after all signific significant ant factors factors have been consid consider ered, ed, discus discussed sed,, and agreed agreed to, 5ranci 5ranciss should should accept accept the engagement and confirm the understanding in an engagement letter. b.
5rancis* 5rancis* procedu procedures res on this this first/t first/time ime audit audit should should include include the the folloing folloing++ 1- 5rancis 5rancis should should revie the orkpaper orkpaperss of Do to obtain informatio information n that ill help plan the audit ork. &- 5rancis 5rancis should make make arrangements arrangements as earl! earl! as possible possible for the initial initial meet meetin ing g ith ith (ke! (ke!)) comp compan an! ! pers person onne nell ho ho ill ill be cont contac acte ted d throughout the engagement. '- #ince basic basic informatio information n about the compan! compan! is not readil! availabl availablee to 5rancis on this first/time audit, information of a general nature should be obta obtain ined ed as earl earl! ! in the the plan planni ning ng stag stagee as possi possibl ble. e. #uc #uch h information should include compan! histor!, nature of the business, credit policies, financing methods, sales methods and terms, seasonal busi busine ness ss patt patter erns ns,, prod produc ucts ts,, serv servic ices es,, plan plantt loca locati tion ons, s, inte intern rnal al procedure procedures, s, accounting accounting policies, policies, ta% status, etc. Client Client procedures procedures manual manualss and manuals manuals of accoun accounts ts shoul should d be read read to obtain obtain such information.-
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9-8
Solutions Manual – Public Accountancy Profession should consider disclaiming an opinion on the earnings statement and statement of changes in financial position. 8- The compositi composition on of all importa important nt accounts accounts should should be reviee revieed. d. 5rancis 5rancis should limit his e%amination of prior period accounts to a revie or surve! of such accounts, ithout a detailed e%amination, unless the results of 5rancis* surve! and anal!ses indicate the need for further investigation of accounting methods in the prior !ears. ;- 5rancis 5rancis must consider consider hether the financia financiall statements statements are prepared prepared using financial reporting standards standards that ere ere consistentl! applied. applied. If, after performing necessar! audit procedures, 5rancis cannot be satisfied as to consi consiste stenc! nc!,, consid considera eratio tions ns must must be given given to qualif qualif!in !ing g the auditor*s report as to consistenc!. 5rancis should use professional judgment to determine the e%tent of reliance that should be placed placed on the ork of Do. The scope of 5rancis* 5rancis* ork ma! be reduced as a result of 5rancis* consultation ith Do and a revie of the prior/!ear orkpapers of Do. 3.
a.
A CPA CPA can can use use the the foll folloi oing ng source sourcess of of infor informat mation ion to help help decide decide hethe hetherr to accept a ne audit client. $inancial infor%ation infor%ation prepared prepared b! the prospective client+ Annual reports to shareholders Interim financial statements #ecurities registration statements Annual report on #$C 9eports to regulator! agencies &n'uiries directed &n'uiries directed to the prospect*s business associates+ Banker Eegal counsel ?nderriter
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Overview of Ris!"ase# Au#it Process
9-9
b.
6.
#tudents #tudents can decide decide this this acceptanc acceptancee question question either either a!, althoug although h the brief brief facts prejudice the the conclusion toard nonacceptance. nonacceptance. The CPA*s on firm decided to resign onl! 12 !ears ago, presumabl! over matters of oner/ manager integrit!. integrit!. Fet, 4r. #ello appears to to be a respected member of his ne communit!. 4a!be his (fast and loose) accounting accounting past is behind him. 4a!be not. Benefits of engagement letters are+
Gelps establish an understanding beteen client and auditor of the terms of the engagement and the nature of the ork.
Gelps avoid quarrels and misunderstandings beteen client and auditor.
Gelps avoid disputes over the audit fee.
Gelps avoid legal liabilit! assertions based on failure to do ork that the CPA ma! not have contemplated or agreed to do.