CHAPTER 5 Preliminary Auditing Planning: Understanding the Auditee’s Business SOLUTIOS !OR RE"IE# CHEC$POITS 5-1
The thre three e main main steps steps are are ris risk k assess assessmen ment, t, resp respons onse e to asses assessed sed risk risks, s, and and conclu concluding ding by forming the audit opinion and issuing an appropriate audit report.
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The ongoin ongoing g activi activitie ties s that that are are requi require red d by C! C! through throughout out the the engag engagemen ementt includ include" e" Communications among audit team members throughout the process, #ocumentation of the audit decisions and $ndings, %evisions %evisions to risk assessments and planned responses i f appropriate due to kno&ledge obtained during audit process, and Communications &ith those charged &ith the auditee's governance and its management. other valid activities may be noted • • •
•
•
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)ubli )ublicly cly liste listed d compani companies es need need to be audit audited ed accor according ding to the the secur securiti ities es regul regulati ations ons that that apply to them. )rivate companies often don't need audits, depending on the *urisdiction, because in some cases shareholders of smaller corporations can &aive a statutory audit requirement. +n some cases, the company's stakeholders, such as ma*or shareholders or lenders, may require an audit of the $nancial statements even if it could be &aived.
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udit udit clien clients ts are are the the people people &ho &ho engag engaged ed the audi auditor tor and and pay pay his or or her fees. fees. The The audite auditee e is the actual entity &hose $nancial statements are being audited. /ften in practice the auditor is engaged by the those charged &ith governance 0usually the board of directors as part of their responsibilities to the shareholders, in &hich case the client' and auditee' are one in the same.
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Those Those char charged ged &ith &ith gover governan nance ce of an an entity entity are are the the peopl people e &ho are are resp responsi onsible ble for for its operations and accountable to its stakeholders.
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n audit auditor or can can use the the follo& follo&ing ing sour sources ces of of inform informati ation on to help help decide decide &heth &hether er to to accep acceptt a ne& audit auditee. 4inancial information prepared prepared by the prospective auditee" nnual reports to shareholders +nterim $nancial statements !ecurities registration statements %eports %eports to regulatory agencies +nquiries directed to the prospects business associates" 6anker 7egal counsel 8nder&riter /ther persons, e.g., customers, suppliers )redecessor )redecessor auditor, if any, communication, re" +ntegrity of management, #isagreements &ith management
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nalysis" !pecial or unusual risk related to the prospect @eed for special skills 0e.g., computer or industry eApertise +nternal search for relationships that &ould compromise independence 5-B
udite uditee e consen consentt is requ requir ired ed becau because se the the rules rules of profe professi ssiona onall conduct conduct code code of ethi ethics cs applicable to the practice of public accounting 0as issued by various professional accounting bodies prohibit the predecessor auditor from revealing con$dential information to the successor &ithout the consent of the auditee. Con$dentiality remains even &hen the auditor-auditee relationship ends.
5-D
n audit auditor or may may decide decide to to take take on lo&, lo&, moder moderate ate,, or even even a high high risk risk enga engageme gement, nt, as as long long as the auditor is con$dent that the risk can be managed do&n to an acceptable level through careful performance of the audit &ork. This decision depends on the *udgment of each auditor, &hich is based on their capacity to manage the risks, and their personal tolerance for risk. uditor 's *udgment in this case is that the engagement engagemen t is too risky, but uditor 6's *udgment is that the risk can be reduced to an acceptable level by performing the audit &ork.
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:ng :ngageme ement let letter be bene$t e$ts" F
F
F
?elps establish an understanding bet&een auditee and auditor of the terms of the engagement and the nature of the &ork. ?elps avoid quarrels and misunderstandings bet&een auditee and auditor. ?elps avoid disputes over the audit fee. ?elps avoid legal liability assertions based on failure to do &ork that the ) may not have contemplated or agreed to do.
5-1=
time time budget budget sho&s sho&s the the diGeren diGerentt audit audit team team members members assigne assigned d to the the various various segmen segments ts of the audit &ork, the time eApected to be needed to perform procedures for each segment, and other information useful for planning such as &hether the &ork is to be done at a interim date or at year year end. The actual time spent on the assigned audit &ork is recorded recorded so that 01 there is a record for billing the auditee, 02 the eHciency of the audit team members can be evaluated, and 0( there is a record for planning the neAt audit.
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+nterim +nterim audit audit &ork refers refers to procedur procedures es performed performed severa severall &eeks or months months before before the balance sheet date. Iear-end ear-end audit &ork refers to procedures performed shortly before and after the balance sheet date. udit $rms typically spread the &orkload o ut during the year by scheduling interim audit &ork so they &ill have enough time and people available &hen several audits have year-ends on the same date 0#ecember (1 is common.
5-12 5-12
udi u ditor tors s mus mustt under underst stan and d the the"" • • • • • • •
6road economic environment in &hich the auditee operates :Gects of national economic policies >eographic location and its economy #evelopments in taAation and regulatory areas +ndustry characteristics that are important !igni$cant +T applications in the companys that produce accounting information The business strategy, the business risks the the strategy addresses, addresses, and the business processes used to operate the business
The auditor's ob*ective in obtaining an understanding of the auditee's business, its !mieliauskas 9 6e&ley, Auditing: 6e&ley, Auditing: An International Appro Approach ach , 3th :dition )age 5-2 !olutions ;anual < 2=1(, ;c>ra&- ?ill %yerson 7td. ll %ights %eserved
environment and its risks is to design an eGective audit program that addresses all the signi$cant risks of $nancial statement misstatements. udit standards require a discussion among the engagement team about the susceptibility of the auditee's $nancial statements to material misstatement. 6ased on this shared understanding, the audit team can identify &hat can go &rong at the $nancial statement level, determine the signi$cance of the risks and assess ho& likely it is that these risks occurred. The standards further require the auditor to perform this risk assessment at the $nancial statement level by considering classes of transactions, account balances and disclosures in the $nancial statements. The auditor also assesses risks at the assertion levelJ assertions are discussed later in this chapter. ccounting is supposed to reKect the economic substance of transactions and this usually requires asking the right business questions of management. :Gective questioning requires strong understanding of the auditee's business, its environment and risks. 5-1(
The broad economic environment includes eAternal factors that can aGect the auditee's success but over &hich it may have little control. These present risks that the auditee's management needs to take into account in developing its strategy. These factors include" international trade restrictions, duties and tariGsJ foreign eAchange rates, global commodity prices 0&hich can be aGected by &eather or political unrest, or other unpredictable eAternal eventsJ taAation and regulatory changes.
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The broad economic factors &ill aGect diGerent industries diGerently. 4or eAample global commodity prices aGect companies that supply or use each particular commodity. The auditee's industry may be targeted by foreign governments for punitive anti-dumping duties 0e.g. soft&ood lumber or steel, or may be particularly vulnerable to lo& cost foreign suppliers 0e.g. clothing or furniture. :nergy shortages and price increases &ill aGect energy intensive industries more signi$cantly than other industries. ;arket demand Kuctuations in the auditee's market need to be considered by the audito r as they &ill aGect its $nancial condition and performance. lso, speci$c taA regulations may aGect the auditee's industry.
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The %+; eAample in the chapter highlights risks in high-tech companies related to protecting intellectual property rights and eGective patent $ling and searching processes to avoid infringement by others, and la&suits for infringement. >oing beyond the chapter section, high tech businesses also face risk of obsolescence, competition, failure to generate cash Ko&s from users of their technology, failure to set pricing to cover costs, etc. +n the forestry industry, companies face risks of commodity price or currency Kuctuations that are hard to plan for, and changes in eAport duties to countries they eAport to, and competition &ith other countries that produce forest products &ith lo&er costs.. The bitibi6o&ater case in the chapter illustrates an eAample o f the risks in the forestry industry.
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The purpose of performing preliminary analytical procedures in the audit planning stage is to direct attention to potential problem areas so the audit &ork can be planned to reduce the risk of missing something important.
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The auditor's understanding the business and risks is highly integrated &ith planning and eAecuting the rest of the audit &ork. The auditor needs to understand the business in order to recogniLe &hat analytical procedures are telling him or her. The fact that something is diGerent from last year may or may not be something that needs to investigatedJ kno&ing the business helps the auditor make that *udgment. The $nal set of audit procedures eAecuted to complete the audit must take into account all the relevant kno&ledge that the audit team gains during the audit engagement, including internal control and risks.
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4ive types of general analytical revie& procedures" 1.
Compare $nancial information &ith prior period0s.
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2. (. . 5.
Compare $nancial information &ith budgets or forecasts. !tudy predictable $nancial information patterns based on the entitys eAperience. Compare $nancial information to industry statistics. !tudy $nancial information relationships to non$nancial information.
5.1E
/Hcial documents and authoriLations that can be read as part of a preliminary analytical revie&" Corporate charter Corporate byla&s rticles of partnership #irectors minutes :Aecutive committee minutes udit committee minutes 4inance committee minutes @e& contracts and leases
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/Hcers Compensation uthoriLation of oHcers salaries. uthoriLation of stock options and other MperkM compensation. 6usiness /perations mount of dividends declared. cceptance of contracts, agreements, la&suit settlements. pproval of ma*or purchases of property and investments. #iscussions of merger and divestiture progress. Corporate 4inance mount of dividends declared. #iscussions of merger and divestiture progress. uthoriLation of $nancing by stock issues, long-term debt, and leases. pproval to pledge assets as security for debts. #iscussion of negotiations on bank loans and payment &aivers. ccounting )olicies and Control pproval of accounting policies and accounting for estimates and unusual transactions. uthoriLations of individuals to sign bank cheques.
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The auditor's understanding of the business risks is important in identifying &hat kinds of changes and relations are eApected based on ho& the business performed during the audited period and &hat kinds might indicate the $nancial information is misstated. 6usiness risk is the auditee risk that the entity &ill be unable to achieve its business ob*ectives or eAecute its strategies. 8nderstanding management's risk assessment process helps to assess the risk that the $nancial statements could be materially misstated. uditing standards 0e.g., ?andbook C! (15 emphasiLe the auditor's need to understand business risk and the Mentitys risk assessment process in order to plan and eAecute appropriate audit procedures. This is referred to in the teAt as the business risk approach to planning and eAecuting the audit. The auditor may identify risks of material misstatement that management's risk assessment process failed to identify and if the auditor believes there is a material &eakness in the entitys risk assessment process, the auditor needs to
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communicate this to the audit committee or equivalent. >enerally, the business risk approach requires the auditor to take a broader vie& of the &hole organiLation and assess the risks of material misstatements that arise from a variety of aspects of the business.
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They are the $nancial statements management has prepared for the current year that &ill be, but have not yet been, audited. They are the starting point for the audit planning.
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The steps auditors can use to apply comparison and ratio analysis to unaudited $nancial statements are" 01 obtain or prepare comparative common-siLe $nancial statements and calculate ratios, 02 study the data and describe the companys $nancial activities, 0( ask relevant questions about questionable relationships, and 0 obtain or prepare a cash Ko& statement to begin the analysis of the going-concern status of the company.
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Nertical analysis refers to $nancial statement amounts eApressed each year as proportions of a base, such as sales for the income statement accounts and total assets for the balance sheet accounts. These common-siLe' statements sho& ho& the various components related to each other - this analysis provides a starting point for further evaluation and enquiry by the auditor. They can be further analyLed horiLontally, to see ho& the relations have changed over time.
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?oriLontal analysis refers to changes of $nancial statement numbers and ratios across t&o or more years. This basic analytical data can indicate unusual or uneApected Kuctuations that suggest further evaluation and enquiry that the auditor should perform.
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The ratios in ppendiA 5- are" current ratio, days sales in receivables, doubtful accounts ratio, days sales in inventory, receivables turnover, inventory turnover, cost of goods sold ratio, return on equity, and ltmans $nancial distress ratios and discriminant score. !tudents may be able to name other relevant ratios.
5-2B
#ecrease in accounts receivable turnover ratio can indicate slo& collections, that may indicate more uncollectible accounts should be provided for in the allo&ance for bad debts, i.e. net % balance is overstated. +t can also indicate the % balance is overstated because it has been manipulated fraudulently.
5-2D
+ncrease in number of day's sales in inventory can indicate slo& moving inventory that is more likely to be obsolete or other&ise hard to sell, that may indicate a bigger provision should be made for inventory obsolescence, i.e. net inventory balance is overstated. +t can also indicate the inventory balance is overstated because it has been manipulated fraudulently.
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The prior year retained earnings 0OE==,=== plus current year income 0O(B=,=== does not add up to the current year ending retained earnings 0O1,23=,===. %etained earnings has been reduced by O1=,===, probably dividends declared and paid. The balance sheet does not sho& dividends payable, and no other information is given.
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@et cash Ko& is negative O==,=== @et cash Ko& P @et income Q- changes in &orking capital and non-cash items, Q$nancing and investing cash Ko&s P change in cash balance (B=,===-(E====-1=====-1=====-2====Q(=====QB5====-2=====-1====-1======P=====
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nalysis directs attention to areas that look unusual, &here misstatements may have occurred. This indicates questions auditors should raise &ith management. ;anagement may provide valid business reasons for the Kuctuations, but the analysis alone does not
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con$rm or refute these eAplanations. ;ore tangible evidence is required to form a conclusion about &hether a particular $nancial statement amount is fairly stated or not. 5-(2
;ateriality is one of the $rst important *udgments the auditor must make since it aGects every other planning, eAamination and reporting decision.
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M;aterial informationM in accounting and auditing is information that should be disclosed if it is likely to inKuence the economic decisions of $nancial statement users. M/verall materialityM in an audit conteAt is the largest amount of uncorrected dollar misstatement that could eAist in published $nancial statements, yet they &ould still fairly present the companys $nancial position and results of operations in conformity &ith >).
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!ome amount of inaccuracy al&ays eAists in $nancial statements because inaccuracies do not aGect users' decisions and hence are not material, the cost of $nding and correcting small errors is too great, and the time taken to $nd them &ould delay issuance of $nancial statements. lso, accounting numbers involve estimates and predictions about future events that may not turn out as eApected.
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The audit of an estimate involves the auditors producing their o&n estimate and comparing it to management's estimate. /ften a range for an estimated amount is generated. 4or eAample, management may estimate an allo&ance for doubtful accounts to be O5=,===, and the auditors may estimate that the allo&ance could be O=,=== to O55,===. +n this case management's estimate is &ithin the auditors' range of reasonableness. ?o&ever, the auditors should take note that the management estimate leans to&ard the conservative side 0more than the auditors' O=,=== lo&er estimate, but not much less than the auditors' higher O55,=== estimate. +f other estimates eAhibit the same conservatism, and the eGect is material, the auditors &ill need to evaluate the overall reasonableness of the eGect of all estimates taken together. +f the auditors develop an estimate that diGers 0e.g., a range of O55,=== to OB=,=== for the allo&ance that management estimated at O5=,===, the preferred treatment is to consider the diGerence bet&een management's estimate and the closest end of the auditors' range as an error 0in this case, error P O5,=== P auditors' O55,=== minus management's O5=,===. The remaining diGerence to the farthest end of the range 0O15,=== P OB=,=== R O55,=== is noted and reconsidered in combination &ith the $ndings on all management's estimates.
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The best ob*ective evidence of the reasonableness of an estimate 0for eAample, the allo&ance for doubtful accounts receivable is the actual events that occur later 0for eAample, the &rite-oG of accounts that eAisted at the time the allo&ance &as estimated. The comparison of estimates &ith subsequent actual eAperience can often be used as a hindsight test of the ob*ective reasonableness of accounting estimates. ?o&ever, some estimates 0for eAample, pension eApense may have such long time horiLons that actual eAperience may not be available before ne& estimates must be made.
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/verall ;ateriality is set for the $nancial statements as a &holeJ it applies to the largest amount of misstatement that in the auditors vie& &ould not aGect user decisions. /verall )erformance ;ateriality is an amount less than the overall materiality levelJ it allo&s a cushion since there are likely misstatements that the auditors procedures &on't detect, even in a competent audit. The cushion is to lo&er the risk of giving a clean opinion on $nancial statements that are materially misstated.
5-(D
+f the auditor decides the materiality should be revised to a smaller amount, the auditor &ill probably have to eAtend any testing that &as done based on the larger materiality level. s
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the audit materiality level gets smaller, the auditor must do more &ork to $nd any material misstatements. +f materiality is lo&ered after test eAtents have been determined and procedures conducted, the auditor &ould need to consider &hether these eAtents are adequate &ith a lo&er materiality level. +f not, it may be necessary to increase the eAtent of testing. +f some accounts had been sub*ect to minimal audit &ork because they &ere much less material, this also &ould need to be reconsidered based on the ne& lo&er materiality. lso, any trivial' misstatements discovered &ould also need to be reconsidered, as &ell as the overall decision on &hat level of misstatements &ill be treated as trivial' since this may be lo&er if materiality is lo&er. 5-(E
Sualitative aspects of materiality are important because even quantitatively small misstatements resulting from intentional misstatement, intentional violation of the la&, or intentional earnings manipulation must be considered material because of their potential impact on users. Sualitative criteria allo& the auditor to stand back to take a broad perspective and consider other factors that may be informative about the consequences of the materiality level used. The qualitative aspects of materiality are equally important as comparison to an arbitrary $Aed dollar amount that may be chosen to some eAtent on the basis of an auditor's costbene$t decision 0i.e., a business decision of the auditor or audit $rm.
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uditing standards do not require auditors to use any speci$c quantitative benchmarks for setting materiality levels.
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ny fraud committed against eAternal stakeholders for the company's bene$t is material no matter ho& small. ?o&ever, in frauds against the company materiality is determined by the usual qualitative and quantitative guidelines discussed in the chapter. +n the case of controls in place to prevent fraud, if the risk of a theft or misstatement is more than remote, then this is considered a material' internal control de$ciency must be reported to the audit committee or 6oard.
5-2
8sing one /verall ;ateriality level is the simplest approach, in comparison to various methods that might be used to allocate the amount to diGerent accounts 0i.e., !peci$c ;ateriality' levels. This approach also results in the least testing and is the approach implied by the ?andbook audit guidance.
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4ive principal assertions in $nancial statements" 1.
:Aistence assertion" The practical ob*ective is to establish &ith evidence that assets, liabilities and equities actually eAist and that sales and eApense transactions actually occurred. Cut-oG can be considered an aspect of the eAistence assertion 0:Aistence in a speci$ed time period. C! (15 uses the term occurrence &hen eAistence is applied to transactions.
2.
Completeness assertion" The practical ob*ective is to establish &ith evidence that all transactions of the period are in the $nancial statements and all transactions that properly belong in the preceding or follo&ing accounting periods are eAcluded. nother term for these aspects of completeness is cut-oG. Completeness also refers to proper inclusion in $nancial statements of all assets, liabilities, revenue, eApense and related disclosures.
(.
/&nership 0or %ights and /bligations assertion" The practical ob*ectives related to rights and obligations are to establish &ith evidence that assets are o&ned 0or rights such as capitaliLed leases are sho&n and
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liabilities are o&ed. .
Naluation 0or llocation, ;easurement assertion" The practical ob*ective is to establish &ith evidence that proper values have been assigned to things 0assets, liabilities, equities and related disclosures and events 0revenues, eApenses and related disclosures. llocation' refers to the practical ob*ective of obtaining evidence about MvaluationsM achieved by cost allocations such as depreciation and inventory costing methods. ;easurement' is the term used to refer to application of an appropriate generally accepted method to determine the dollar amount to include in a $nancial statement, as in C+C s.1=== or other conceptual accounting frame&orks.
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)resentation and #isclosure assertion" The practical ob*ective is to establish &ith evidence that accounting principles used by management are appropriate in the circumstances and are applied properly, and that disclosures contain all information required by generally accepted accounting principles.
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ssertions are the focal points for all audit procedures because they are the fundamental management claims that are being audited. udit procedures produce evidence that relates to one or more speci$c assertions. s &ill be eAplained in detail later in Chapter D, auditors use audit ob*ectives that are derived from the $ve principal assertions to design speci$c evidence gathering procedures.
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uditing completeness involves getting evidence about &hat is not there. uditors have to depend on management's representations to some eAtent, and corroborate these &ith evidence from a variety of sources, including internal controls. There is rarely a slam dunk' type of procedure that provides strong conclusive evidence that everything that should have been included has been included.
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uditors should think about a Mcompliance assertionM even though it is not eAplicitly listed in the auditing standards because auditors have responsibilities regarding these compliance-type events" 01 company employees observing the companys internal control policies and procedures 0see Chapter E, 02 irregularities and illegal acts 0see Chapter B, and 0( compliance &ith la&s and regulations in government-standard audits 0see Chapter 21. The practical ob*ective of the compliance assertion, though not listed in the C+C ?andbook, can be stated as" to establish &ith evidence that the entity has complied &ith applicable public la&s and regulations and &ith the terms of private contracts and agreements. The compliance assertions are particularly important &hen auditing governmental agencies 0most uditor >eneral audits as &ell as ones done by )s. +nternal audits eAtend the concept to compliance &ith managerial policies.
5-B
+f you are given a list of audit procedures 0this is called an audit program' and are using them to plan this year's audit, you need to consider" hat are the assertions management is making by reporting this $nancial informationU hich assertion0s does this procedure produce evidence aboutU #oes the list of procedures 0the audit program cover all the assertionsU /ne aspect that may be missing in many standard audit programs is to consider the compliance assertion, as discussed in the chapter.
5-D The overall audit strategy is outlined in C! (==. The components suggested in the standard include documents information about 01 investigation or revie& of the prospective or continuing engagement and client relationshipJ 02 staG, technical, or industry eApertise !mieliauskas 9 6e&ley, Auditing: An International Approach , 3th :dition )age 5-D !olutions ;anual < 2=1(, ;c>ra&-?ill %yerson 7td. ll %ights %eserved
requiredJ 0( preliminary materiality levelsJ 0 assessment of signi$cant industry or company risks and related audit issuesJ 05 identi$cation of unusual accounting principlesJ 03 use of substantive or combined audit approachJ 0B nature and eAtent of resources requiredJ 0D staG assignment and scheduling of team communications and $eld &orkJ and 0E special considerations for initial or group audit engagements. 5-E
The overall audit strategy guides development of the detailed audit plan, &hich contains the audit program details. The audit programs include speci$c audit ob*ectives and procedures for determining inherent and control risk, obtaining the suHcient competent evidence that is the basis for the audit report, and producing the required documentation.
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SOLUTIOS !OR E%ERCISES A& PROBLE'S :)5-1 nalytical %evie& %atio %elationships a.
The current ratio &as made larger than it should have been. The current asset numerator &as made larger 0$ctitious accounts receivable larger than the inventory removed &hile the current liability denominator did not change. 0?o&ever, if the income taA eGect of the error is included, the current liabilities change by a greater proportion that the current assets change, and it turns out that the current ratio &as made smallerV
b.
+n this case the relative rate of change is important, because both the numerator and denominator of the current ratio are changed by the same amount. 1.
Current ratio 0before &as greater than 1"1--the incorrect accounting makes the ratio larger than it should be. :Aample"
2.
Current ratio 0before &as equal to 1"1--the incorrect accounting does not change the ratio. :Aample"
(.
6efore O1==,=== O1==,=== P 1"1 fter O E=,=== O E=,=== P 1"1
Current ratio 0before &as less than 1"1--the incorrect accounting makes the ratio smaller than it should be. :Aample"
c.
6efore O1==,=== O2=,=== P 5.="1 fter O E=,=== O1=,=== P E.="1
6efore O 2=,=== O1==,=== P =.2"1 fter O 1=,=== O E=,=== P =.11"1
:Gect of unrecorded purchase counted in physical inventory, assuming the accounts are ad*usted to include the inventory on hand. +nventory is not misstated. Cost of goods sold is understated. >ross pro$t is overstated. @et income is overstated. The question asks for the eGect on the ratios compared to &hat they &ould have been &ithout the error. Current ratio" >reater than 1"1 before. :qual to 1"1 before. 7ess than 1"1 before.
The error of recording the inventory and not the current payable makes the ratio larger. The error makes the ratio larger. The error makes the ratio larger.
>ross margin ratio" The error makes it larger. Cost of goods sold ratio" The error makes it smaller. %eceivables turnover"
The error does not aGect either the sales numerator or the receivables denominator, so the ratio is not aGected.
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d.
+n this case the net receivables amount is correct. The proper ad*ustment should be to reduce gross receivables and the allo&ance for doubtful accounts by an equal amount. Current ratio"
@ot aGected because the current asset and current liability totals are not aGected.
#ays sales in receivables"
#oubtful account ratio"
%eceivables turnover"
@ot aGected &hen the net receivables is used to calculate the ratio. The improper accounting causes the ratio to be larger than it should be. 0)roper accounting &ould cause the allo&ance numerator to be reduced to a greater eAtent, by a faster rate, than the receivables denominator. @ot aGected &hen the net receivables is used to calculate the ratio.
%eturn on beginning equity"
@ot aGected because the income is measured properly &ith adequate allo&ance for doubtful accounts.
orking capitalTotal assets"
e.
@ot aGected because both terms are measured properly.
The eGect on the ltman 01E3D discriminate W score is a larger score because of the directional eGect of all the changes mentioned" orking capitalTotal assets"
The ratio is larger because C is greater and T is smaller.
%etained earningsTotal assets"
The ratio is larger because retained earnings remained the same &hile T is smaller.
:arnings 6+TTotal assets"
The ratio is larger, because :6+T is about the same as last year, and T is smaller.
;arket equityTotal debt"
The ratio is larger because market equity is the same, &hile total debt is lo&er.
@et salesTotal assets" The ratio is larger because net sales have decreased less 05X than the total assets have decreased 01=X. :)5-2 8nderstand the 6usiness--Transactions and ccounts ccounting systems may diGer, so the solution belo& accommodates most possibilities. Yformatting request from revie&er" can this be converted to a table format &ith grid linesUZ #ebits
Credits
Cash receipts
Cash
!ales revenue ccounts receivable +nvestment income
Cash disbursements
ccounts payable
Cash
!mieliauskas 9 6e&ley, Auditing: An International Approach , 3th :dition )age 5-11 !olutions ;anual < 2=1(, ;c>ra&-?ill %yerson 7td. ll %ights %eserved
+nventory 4iAed assets 7ong term debt :Apenses Credit sales
ccounts receivable
!ales revenue
!ales returns and allo&ances
!ales revenue 0contra return account
ccounts receivable Cash 0cash refunds
)urchases on credit
+nventory 4iAed assets :Apenses
ccounts payable
)urchase returns
Cash 0cash refund ccounts payable
+nventory 0contra return acct.
8ncollectible account rite-oGs
llo&ance for doubtful accounts
ccounts receivable
:)5-( uditing an ccounting :stimate The audit problem is to develop a range of valuation of the inventory in order to evaluate managements estimate.
!elling price dvertising and shipping eApenses uditors estimate of the range for the inventory valuation a.
7o&
?igh
O BD,===
O E2,===
B,===
5,===
O B1,===
O DB,===
Ies, an ad*ustment can be proposed. 7oss 0or Cost of >oods !old +nventory rite do&n the inventory to the nearest end of the auditors range.
b.
O 12,=== O12,===
@o ad*ustment is necessary. The management estimate of OD=,=== is &ithin the auditors range estimate.
:)5- %isk of ;isstatement in Narious ccounts a. 6ased on information you have available in Chapter 5, &hich accounts may be most susceptible to overstatementU 8nderstatementU +nventory understatements may occur from counting and pricing errors. 4iAed asset understatements may result from failure to capitaliLe costs 0eApensing them instead or from erroneous depreciation calculations. !mieliauskas 9 6e&ley, Auditing: An International Approach , 3th :dition )age 5-12 !olutions ;anual < 2=1(, ;c>ra&-?ill %yerson 7td. ll %ights %eserved
7iability understatement and eApense understatement appear to be quite common. b.
hy do you think a company might permit asset accounts to be understatedU sset understatements can result from accounting errors, misapplication of accounting principles, and measurement errors 0such as undercounting the inventory. company might be motivated by taA evasion to understated assets and income.
c.
hy do you think a company might permit liability accounts to be overstatedU :stimated liabilities might be measured large for conservatism. The company might over accrue eApenses in order to reduce taAable income. fraud might be imbedded in false payables to false vendors.
d.
hich direction of misstatement is most likely" income overstatement or income understatementU %esearch studies indicate that income overstatement occurs most frequentlyJ the cause is often understatement of eApenses 0e.g. accrued eApenses, or overstatement of revenues 0e.g. inappropriate revenue recognition policy choice or interpretation.
:)5-5 udit planning a
alter should" [ \no& the business and industry [ %evie& [ prior years' $les [ auditee correspondence [ engagement letter or obtain one [ Coordinate staG [ ?old a planning meeting &ith the staG [ )repare risk and materiality assessments [ /btain draft statements for analytical revie& [ #evelop a preliminary audit strategy [ +dentify key dates, i.e., inventory count [ Consider need for specialists or other auditors [ Consider role of internal auditors [ :stimate fees and time [ #evelop audit programs [ )repare $les and supplies [ ?ave plan approved by partner.
b
Nalidity :Aistence Completeness /&nership Naluation Cut-oG
[ [ [ [ [ [
#isclosure [
all information required in the 4! has been disclosed either in the body of the statements or in notes [ %evenues and eApenses are recorded in the proper amounts
;easurement
all amounts in the 4! should be there all assets and liabilities eAist at a given date everything that should have been included in the 4! is there assetsliabilities are o&nedo&ed by the entity all 4! items are properly valued all transactions are included in the correct period
!mieliauskas 9 6e&ley, Auditing: An International Approach , 3th :dition )age 5-1( !olutions ;anual < 2=1(, ;c>ra&-?ill %yerson 7td. ll %ights %eserved
and in the proper period.
:)5-3 ssertions ssertions used by the auditor fall into the follo&ing categories" 0a
0b
0c
assertions about classes of transactions and events for the period under audit" 0i occurrence ] transactions and events that have been recorded have occurred and pertain to the entityJ 0ii completeness ] all transactions and events that should have been recorded have been recordedJ 0iii accuracy ] amounts and other data relating to recorded transactions and events have been recorded appropriatelyJ 0iv cut-oG ] transactions and events have been recorded in the correct accounting periodJ and 0v classi$cation ] transactions and events have been recorded in the proper accountsJ assertions about account balances at the period end" 0i eAistence ] assets, liabilities and equity interests eAistJ 0ii rights and obligations ] the entity holds or controls the rights to assets, and liabilities are the obligations of the entityJ 0iii completeness ] all assets, liabilities and equity interests that should have been recorded have been recordedJ and 0iv valuation and allocation ] assets, liabilities and equity interests are included in the $nancial statements at appropriate amounts and any resulting valuation or allocation ad*ustments are appropriately recordedJ and assertions about presentation and disclosure" 0i occurrence and rights and obligations ] disclosed events, transactions and other matters have occurred and pertain to the entityJ 0ii completeness ] all disclosures that should have been included in the $nancial statements have been includedJ 0iii classi$cation and understandability ] $nancial information is appropriately presented and described, and disclosures are clearly eApressedJ and 0iv accuracy and valuation ] $nancial and other information are disclosed fairly and at appropriate amounts.
:Aistence
Completeness
Naluation
:Aistence and completeness )resentation
:Aistence /&nership
Completeness
Naluation
:Aistence and /&nership
Completeness
)resentation
!mieliauskas 9 6e&ley, Auditing: An International Approach , 3th :dition )age 5-1 !olutions ;anual < 2=1(, ;c>ra&-?ill %yerson 7td. ll %ights %eserved
The auditor may use the assertions as described above or may eApress them diGerently provided all aspects described above have been covered. 4or eAample, the auditor may choose to combine the assertions about transactions and events &ith the assertions about account balances. s another eAample, there may not be a separate assertion related to cut-oG of transactions and events &hen the occurrence and completeness assertions include appropriate consideration of recording transactions in the correct accounting period.
Naluation
!ource" C+C ssurance ?andbook, C! (15 #iGerent terms are used to provide $ner de$nitions. The $ner de$nitions can be helpful for developing more speci$c statements of the auditing ob*ectives, that relate speci$c $nancial statement components and to auditing procedures. 4or eAample, to describe the eAistence assertion as it relates to a transaction stream some people $nd it easier to think about &hether transactions really occurred' rather than &hether the transactions really eAist'. nother term used for eAistence is validity, i.e., are the balances valid, are the transactions validU Narious alternate terms have been used historically and so they are retained, but they can be vie&ed as synonyms. /verall, suHcient appropriate audit evidence must be obtained to address the $ve principle assertions discussed in the teAt, &ith regard to the level of risk of misstatement in each assertion, for each account balance, class of transactions, and disclosure.
:)5-B :Aperts' ork as audit evidence hen eApertsspecialists are engaged, auditors must ensure they have appropriate professional quali$cations and good reputations. n eApert should be unrelated to the company under audit, if possible. uditors must obtain an understanding of the eApert's methods and assumptions. The auditor also must verify all signi$cant information that the eApert's conclusions are based on if the eApert's &ork &ill be a signi$cant piece of evidence used to form the audit opinion 0C! 32=. 4or eAample, if the eApert is providing an opinion on mineral reserves valuation, the auditor should tie the reports used by the eApert into other documentation to verify the properties evaluated are o&ned by the auditee, and check commodity price assumptions to eAternal data such as published commodity trading statistics.
:)5-5-D The professional standards ^ack is applying in the end of chapter pplication Case and nalysis include" C!SC-1 Suality control for $rms that perform audits and revie&s of $nancial statements, and other assurance engagementsJ C! 2== /verall ob*ectives of the independent auditor and the conduct of an audit in accordance &ith Canadian auditing standardsJ C! 21= greeing the terms of audit engagementsJ C! (== )lanning an audit of $nancial statementsJ and C! (15 +dentifying and assessing the risks of material misstatement through understanding the entity and its environment. !elected eAcerpts of relevant sections of these standards are given belo& for each of the seven steps in the Case nalysis. !tudents can also be assigned to revie& the standards to identify these and other requirements that call for the acceptance considerations set out in the case. !mieliauskas 9 6e&ley, Auditing: An International Approach , 3th :dition )age 5-15 !olutions ;anual < 2=1(, ;c>ra&-?ill %yerson 7td. ll %ights %eserved
/verall, the ob*ective set out in C!SC-1 is being applied by ^ack's $rm's procedures in this case. e.g., C!SC-1 /b*ective 11. The ob*ective of the $rm is to establish and maintain a system of quality control to provide it &ith reasonable assurance that" 0a The $rm and its personnel comply &ith professional standards and applicable legal and regulatory requirementsJ and 0b %eports issued by the $rm or engagement partners are appropriate in the circumstances. %eferring to the standards more speci$cally, note the follo&ing professional requirements being met by the seven steps ^ack is taking. 1.
/btaining and revie&ing $nancial information about the prospective auditee organiLation to determine purpose, main users, and basis of accounting. _ This step allo&s the $rm to comply &ith C!SC-1, paragraphs 23 and 2B, e.g., cceptance and Continuance of Client %elationships and !peci$c :ngagements 23. The $rm shall establish policies and procedures for the acceptance and continuance of client relationships and speci$c engagements, designed to provide the $rm &ith reasonable assurance that it &ill only undertake or continue relationships and engagements &here the $rm" 0a +s competent to perform the engagement and has the capabilities, including time and resources, to do soJ 0%ef" )ara. 1D, 2( 0b Can comply &ith relevant ethical requirementsJ and 0c ?as considered the integrity of the client, and does not have information that &ould lead it to conclude that the client lacks integrity. 0%ef" )ara. 1E-2=, 2( 2B. 0a
0b
0c
!uch policies and procedures shall require" The $rm to obtain such information as it considers necessary in the circumstances before accepting an engagement &ith a ne& client, &hen deciding &hether to continue an eAisting engagement, and &hen considering acceptance of a ne& engagement &ith an eAisting client. 0%ef" )ara. 21, 2( +f a potential conKict of interest is identi$ed in accepting an engagement from a ne& or an eAisting client, the $rm to determine &hether it is appropriate to accept the engagement. +f issues have been identi$ed, and the $rm decides to accept or continue the client relationship or a speci$c engagement, the $rm to document ho& the issues &ere resolved.
_ +t also meets C! 22=, paragraph 12 in regards to the speci$c audit engagements ^ack $rm is considering accepting. e.g., C! 22= 12.
The engagement partner shall be satis$ed that appropriate procedures regarding the acceptance and continuance of client relationships and audit engagements have been follo&ed, and shall determine that conclusions reached in this regard are appropriate. 0%ef" )ara. D-E
!mieliauskas 9 6e&ley, Auditing: An International Approach , 3th :dition )age 5-13 !olutions ;anual < 2=1(, ;c>ra&-?ill %yerson 7td. ll %ights %eserved
2.
:valuating the public accounting $rm's and individual auditors' independence from the prospect _ This step meets requirements of C!SC-1 and C! 22=, paragraphs 11 and C! 2==, paragraph 1. e.g., C!SC-1, paragraphs 21 and .2 +ndependence 21. The $rm shall establish policies and procedures designed to provide it &ith reasonable assurance that the $rm, its personnel and, &here applicable, others sub*ect to independence requirements 0including net&ork $rm personnel maintain independence &here required by relevant ethical requirements. !uch policies and procedures shall enable the $rm to" 0%ef" )ara. 1= 0a Communicate its independence requirements to its personnel and, &here applicable, others sub*ect to themJ and 0b +dentify and evaluate circumstances and relationships that create threats to independence, and to take appropriate action to eliminate those threats or reduce them to an acceptable level by applying safeguards, or, if considered appropriate, to &ithdra& from the engagement, &here &ithdra&al is possible under applicable la& or regulation. 2. t least annually, the $rm shall obtain &ritten con$rmation of compliance &ith its policies and procedures on independence from all $rm personnel required to be independent by relevant ethical requirements. 0%ef" )ara. 1=-11 e.g., C! 2== :thical %equirements %elating to an udit of 4inancial !tatements 1. The auditor shall comply &ith relevant ethical requirements, including those pertaining to independence, relating to $nancial statement audit engagements. 0%ef" )ara. C1-1B
(.
Considering &hether the public accounting $rm has competency, resources, any special skills required _This step applies C!SC-1, paragraph 2E, C! 22=, paragraphs 12-1 0see above, and C! (==, paragraph D, e.g., C!SC-1 ?uman %esources 2E. The $rm shall establish policies and procedures designed to provide it &ith reasonable assurance that it has suHcient personnel &ith the competence, capabilities, and commitment to ethical principles necessary to" 0a )erform engagements in accordance &ith professional standards and applicable legal and regulatory requirementsJ and 0b :nable the $rm or engagement partners to issue reports that are appropriate in the circumstances. 0%ef" )ara. 2-2E C! D. 0a 0b 0c
(== +n establishing the overall audit strategy, the auditor shall" +dentify the characteristics of the engagement that de$ne its scopeJ scertain the reporting ob*ectives of the engagement to plan the timing of the audit and the nature of the communications requiredJ Consider the factors that, in the auditors professional *udgment, are signi$cant in directing the engagement teams eGortsJ
!mieliauskas 9 6e&ley, Auditing: An International Approach , 3th :dition )age 5-1B !olutions ;anual < 2=1(, ;c>ra&-?ill %yerson 7td. ll %ights %eserved
0d
0e
.
Consider the results of preliminary engagement activities and, &here applicable, &hether kno&ledge gained on other engagements performed by the engagement partner for the entity is relevantJ and scertain the nature, timing and eAtent of resources necessary to perform the engagement. 0%ef" )ara. D-11
/btaining information from management as to &hether the prospect's management accepts responsibility for the $nancial statement preparation and implementing adequate controls to reduce risk of errors and fraud _ This step complies &ith C! 21=, paragraph 3 allo&ing ^ack's $rm to determine &hether pre-conditions for the audits are present. This kno&ledge &ill also be useful in complying &ith C! (==, paragraph 3, and C! (15, paragraphs 3-B
e.g., C! (15 3. The risk assessment procedures shall include the follo&ing" 0a +nquiries of management, and of others &ithin the entity &ho in the auditors *udgment may have information that is likely to assist in identifying risks of material misstatement due to fraud or error. 0%ef" )ara. 3 0b nalytical procedures. 0%ef" )ara. B-1= 0c /bservation and inspection. 0%ef" )ara. 11 B.
5.
The auditor shall consider &hether information obtained from the auditors client acceptance or continuance process is relevant to identifying risks of material misstatement.
Considering &hether the engagement &ould require special attention or involve unusual risks _This step also allo&s ^ack's $rm to comply &ith C! 22= and the other standards concerning audit engagement continuance and acceptance
3.
!earching for ne&s reports and, &hen possible, asking business associates about the organiLation _This step can provide information related to the acceptance standards noted above in C! 22=, as &ell as kno&ledge relevant in identifying and assessing risks of misstatement that are set out in C! (15.
B.
4or ne& audits, communicating &ith the previous auditor _This step arises in the C! from the requirements to comply &ith relevant ethical requirement for public accountants. These include the rules of conduct or ethics codes of the various provincial accounting bodies.e.g., C! 22=, paragraph CB0n C0n %elevant ethical requirements R :thical requirements to &hich the engagement team and engagement quality control revie&er are sub*ect, &hich comprise relevant independence and other ethical requirements set out in rules of professional conduct code of ethics applicable to the practice of public accounting issued by the various professional accounting bodies. Y+n +! 22=, this paragraph states" %elevant ethical
!mieliauskas 9 6e&ley, Auditing: An International Approach , 3th :dition )age 5-1D !olutions ;anual < 2=1(, ;c>ra&-?ill %yerson 7td. ll %ights %eserved
requirements R :thical requirements to &hich the engagement team and engagement quality control revie&er are sub*ect, &hich ordinarily comprise )arts and 6 of the +nternational :thics !tandards 6oard for ccountants Code of :thics for )rofessional ccountants 0+:!6 Code related to an audit of $nancial statements together &ith national requirements that are more restrictive.Z
!mieliauskas 9 6e&ley, Auditing: An International Approach , 3th :dition )age 5-1E !olutions ;anual < 2=1(, ;c>ra&-?ill %yerson 7td. ll %ights %eserved
SOLUTIOS !OR &ISCUSSIO CASES #C5-1 Communications bet&een predecessor and successor auditors The procedures you should follo& prior to accepting the engagement include the follo&ing" 1.
2.
(. .
5. 3.
B.
D.
E.
Iou should eAplain to your prospective auditee your $rm's need to inquire of #iggs and should request permission to make such inquiries. 0This means that the )resident of 7yrac &ill need to contact #iggs to inform him that he is no longer the company's auditor, even though the )resident does not &ant to. !ince the auditor must be engaged, and dismissed, by those charged &ith governance of 7yrac, it &ould not be appropriate for your $rm to do this. Iou should ask your prospective auditee to authoriLe #iggs to respond fully to all inquiries since #iggs &ould be prohibited from disclosing con$dential information &ithout its former auditee's permission. ith permission, you should contact #iggs about your prospective auditee's decision to change auditors, as an act of professional courtesy. Iou should make reasonable inquiries of #iggs regarding matters that &ill aid in deciding &hether to accept the 7yrac audit engagement. 0Iour inquiries should ask about facts &hich might bear on the integrity of management, disagreements &ith management about accounting and auditing matters, and #iggs understanding of the reason0s for the change of auditors. +f #iggs does not respond fully to your questions, you should consider the implications of the limited response in deciding &hether to accept the engagement. fter &eighing all information received from #iggs, you should inform your auditee that a $rst-time audit is more time-consuming than a recurring audit because the ne& auditor is generally unfamiliar &ith the auditees operations and does not have the bene$t of past kno&ledge of company aGairs to use as a guide. discussion &ith your auditee of the estimated required audit time and fee arrangement should be coordinated &ith a clear eAplanation of the purpose and scope of the audit. ny &ork that can be done by auditee personnel should also be discussed so that eAcess audit time might be eliminated and proposed report deadlines can be reasonably met. To satisfy your quality control ob*ective, you should use procedures such as revie&ing the $nancial statements of the auditeeJ inquiring of third parties such as its banks, legal counsel, investment bankers, and others in the business community as to its reputationJ and evaluating his ability to serve this auditee properly &ith reference to industry eApertise, siLe of engagement, and available staG. +f you have no reservations, after all signi$cant factors have been considered, discussed, and agreed to, you should accept the engagement and con$rm the understandings in an engagement letter.
#C5-2 udit engagement acceptance a.
The sources of information and inquiries include" +nquiry, +ncluding )rior orking )apers--prior audit &orking papers, personnel &ho &orked on the audit in prior years are available to convey their understanding of the business, inquiry and intervie&s &ith the companys management, directors, and audit committee. /bservation--take a tour of the companys physical facilities, keeping eyes open for activities and things that should be reKected in the accounting records. The tour is the time to see company personnel in their normal &orkplaces.
!mieliauskas 9 6e&ley, Auditing: An International Approach , 3th :dition )age 5-2= !olutions ;anual < 2=1(, ;c>ra&-?ill %yerson 7td. ll %ights %eserved
!tudy. @umerous sources--C+C and +C) industry accounting and auditing guides, specialiLed trade magaLines and *ournals, registration statements and nnual %eports $led &ith the securities market regulators, general business magaLines and ne&spapers 04inancial )ost, %eport on 6usiness, 6usiness eek, 4orbes, 4ortune, ?arvard 6usiness %evie&, 6arrons, and the all street ^ournal. b. c.
#C5-(
b
c
@o, but Suality Control !tandards require $rms to investigate prospective auditees. !tudents can decide this acceptance question either &ay, although the brief facts may pre*udice the conclusion to&ard nonacceptance. The )s o&n $rm decided to resign 1= years ago, presumably over matters of o&ner-manager integrity. Iet, ;r. !hine appears to be a respected member of his ne& commun ity. ;aybe his Mfast and looseM accounting past is behind him. ;aybe not. !tudent should use the facts available, and madke reasonable assumptions, to provide arguments that suppo rt the choice they make.
a
4actors to consider before accepting the audit engagement include"
-
+s the ) $rm independentU #oes the ) $rm have the eApertise to conduct the auditU ill the auditee be able to pay the audit feeU +s the auditee a going concernU +s management highly questionableU #o they need an auditU +s the risk arising from kno&n users of the $nancial statements reasonably determinable and acceptableU
%isk assessment procedures include the follo&ing activities. +dentify users of $nancial statements Ro&nerma*or shareholder &ho has asked for audit for $rst time this year, and potential lenders she &ill likely give the audited $nancial statements to, and &ho likely &ill use the fs to evaluate the risk of the company not paying back its loan and interest. /ther qualitative factors could be relevant, like contracts or covenants based on fs balances, transaction volumes, pledges of assets as collateral, etc. 4or quantitative assessment, apply appropriate benchmarks, e.g. 5-1=X normal income, =.5 - 1X revenues or assets, ?ere there is no @ormal income' as it is a ne&, start-up company. /ther bases suggested can be considered, such as" ssets" O25=== to 5==== %evenues" O=== to D=== Then also consider qualitative factors, to generate reasonable range. ssets is probably most appropriate since the start up stage also means revenues are not good performance indicators yet, and user decisions not likely to depend on revenue information. s the auditor, you must select one amount from the range to provide a materiality level for planning the audit. Iour choice needs to be *usti$ed based on qualitative factors. 4or eAample, in this case it &ould be appropriate and prudent go to the lo&er end of asset-based range, O25,===, since it is a $rst time audit, users are kno&n to be relying at least partly on $nancial statements for important $nancial decisions, but the best information in the $nancial statements at this stage of the business's life is the asset values. ;ateriality is the most important *udgment and is made early in the audit because the
!mieliauskas 9 6e&ley, Auditing: An International Approach , 3th :dition )age 5-21 !olutions ;anual < 2=1(, ;c>ra&-?ill %yerson 7td. ll %ights %eserved
auditor's assessment of risk of material misstatement requires a preliminary benchmark of &hat it material' - this then aGects every other planning decision. d
!ome possible ratios" Current ratioquick ratio R may indicate liquidity problem, $nancial condition is poor, risk of business failure. /perating cash Ko&s over payables indicates cash burn for start up stage business indicates &orking capital requirements to fund operating shortfall and risk if not likely to be met. >ross margin percentR may suggest performance of operation is ineHcient as costs not covered by revenues, or price competition aGecting viability other valid ratios, implications are also acceptable for this case :Aample of additional information - 4or more meaningful ratio analysis, further information is needed for more diGerent comparisons, e.g. more operating periods to compute turnover, eHciency ratios, industry averages,
#C5- )redecessor and !uccessor uditors ells 9 %atley need to initiate communications &ith both predecessor auditors. The situation is unusual, but 9% need to obtain complete information from all the predecessors involved since the last audit 02=12 $nancial statements. 6oth Canby 9 Co. and lbrecht 9 ?ubbard are predecessors. 0+f Canby 9 Co. had completed the 2=1( audit, and 9% had been hired to perform the 2=1 audit, then Canby 9 Co. &ould be the only )redecessor. 9? &ould be history. +nquiry of only one of the predecessors &ould not result in complete information because the circumstances surrounding each auditor change may be diGerent. The t&o predecessors, having served at diGerent times and for diGerent lengths of time, may have diGerent kno&ledge about llpurpose 7oan Company and its president. +f the company is public and sub*ect to securities market reporting requirements, reports for both changes should have been $led &ith the regulator.
#C5-5 Calculate a )lanning ;ateriality mount This solution provides a stock price-based method of determining &hat is material to users based on the impact of an income misstatement is eApected to have on the share price, as indicated by the multiple' that market participants are using to price this com pany's shares. This approach provides an alternative &ay of thinking about the materiality concept, though simpler methods based on $nancial statement amounts 0usually pre-taA income are more commonly used in practice. 3X )rice :Gect !tock price 013 A O=.3DB )rice materiality *udgment d*usted stock price
O O O
11.==
0slightly rounded
.33 1=.(
!mieliauskas 9 6e&ley, Auditing: An International Approach , 3th :dition )age 5-22 !olutions ;anual < 2=1(, ;c>ra&-?ill %yerson 7td. ll %ights %eserved
d*usted earnings per share 0divide by 13 multiple
O
.3325
+ndicated net income 0multiply by B5=,=== shares
O D,3DD
0rounded
dd pre-taA accounts that can be audited completely" +nterest eApense +ncome taA eApense 0(5X
O -=O 23=,ED3
0rounded
+ndicated pre-taA income
O B5,3B
8naudited pre-taA income 0O515,====.35
O BE2,(=D
+ndicated planning materiality based on pre-taA income
O
0rounded
3,3(
#C5-3 )reliminary nalysis, ;ateriality, ssertions. a
To assess the risk of material misstatement, the auditor must understand the nature of the business on &hat needs to be accounted for, because it &ill aGect &hat inherent risks eAist in the business and thus its accounts. This illustrates the importance to the auditor of understanding ho& a business creates value and earns pro$ts. The case requires one to apply one's kno&ledge of the business, given the facts provided in the case and other reasonable assumptions, to *udge the relevant inherent risks for diGerent $nancial statement components in relation to the $ve principle assertions" eAistence, completeness, o&nership, valuation and presentation Y:C/N)Z
b
To make a decision on materiality, &e $rst identify the main users of $nancial statements R these are the minority shareholders &ho have asked for an audit for the $rst time this year. lso, the bank holding the long term loan sho&n in the trial balance likely &ill use the fs to evaluate the risk of the company not paying back its loan. /ther qualitative factors could be relevant, like contracts or covenants based on fs balances, transaction volumes, indicators of fraud, etc. 4or quantitative assessment, apply appropriate benchmarks, e.g. 5-1=X pre-taA normal income, =.51X revenues or assets, and then also consider qualitative factors, to generate reasonable range. !elect one level from range and *ustify the quantitative choice based on qualitative factors.
c
T&o possible ratios that could be calculated for analysis are" i current ratioquick ratio R may indicate liquidity problem, $nancial condition is poor, risk of business failure. ii gross margin percent R may suggest performance of operation is ineHcient, or price competition aGecting viability - for more meaningful ratios and analysis, further information is needed, e.g. past periods to compute turnover, eHciency ratios, industry average, to allo& for more diGerent comparisons. /ther valid ratios, implications, and related further investigation are also acceptable if clearly eAplained and supported
!mieliauskas 9 6e&ley, Auditing: An International Approach , 3th :dition )age 5-2( !olutions ;anual < 2=1(, ;c>ra&-?ill %yerson 7td. ll %ights %eserved
d
ssessment of the risk of material misstatement 0%;; takes into consideration both the inherent and control risks, at the assertion level. The inherent risk assessments are based on the nature of the item and the risk that an error can have occurred in accounting for that item in the $rst place, regardless of controls. The general tendency is for high value items that are attractive to steal, like TNs, to have higher inherent risks related to the eAistence assertion. 4or #a&ood, it is manufacturing the TN and monitors, so the valuation may be sub*ect to errors in compleA cost allocations, and the net realiLable value may fall due to technological obsolescence, so the valuation assertion has high risk of misstatement. !everal other accounts could also be noted as high risk, such as &arranty provision 0high valuation assertion risk as this is an estimate or )): because it is highly material and may become obsolete or ineHcient over time, aGecting its valuation. nother item that may have high inherent risk in #a&ood is the accounts receivable balance if there is a concern about collectibility, as the valuation assertion &ould have a high risk of misstatement. T&o items that may have lo& inherent risk assessments are the bank loan - it is straightfor&ard to value it and con$rm its eAistence and completeness. !hare capital might also be noted as a lo& risk account, since its o&nership is &ell documented and since it is not compleA to account for, its eAistence, valuation and completeness &ould not have high inherent risk. >enerally, assessing high inherent risk leads the auditor to eApect management to have strong risk assessment processes, and strong controls in place to oGsetreduce these risks. +f this is the case, &hen inherent risk and control risk are combined as %;;, the assessed risk could be lo&er than the inherent risk alone. ?o&ever, to rely on this assessment the auditor must test the relevant controls. +n #a&ood's case it may be feasible and eHcient for the auditor to test these controls and get some assurance from them, and that &ill lo&er the amount of assurance required from substantive tests. /n the other hand, if the controls are not very strong the %;; &ill be very high for high inherent risk items and the auditor &ill need a lot of substantive evidence to be able to get reasonable assurance to form an opinion about &hether the fss are fairly stated.
e
+nventory in manufacturing business &ill have ra& material, +) and $nished goods ssertions" 0note - assessments of %;; belo& are for $nished goods, +) risk assessments may diGer :Aistence" moderate - The question is &hether all the TNs and monitors recorded really are on hand. !ince these items could be easily stolen, the risk is raised, but veri$cation by physical inspection can provide very reliable evidence. 4urther, if controls in place appear strong over recording the purchases, it &ould be diHcult to make an entry for an inventory purchase that doesn't eAist. Thus the risk is moderated. Completeness" moderate - The question is &hether all the inventory the company actually o&ns has been recorded. This depends on good controls over recording all purchases, and moving costs of +) through the production accounting process properly. !ince it is possible to miss recording unless controls are good, and inventory is key to the company's success, &e can assume the controls over this are good and the risk is moderated. Naluation" high - The question is &hether the dollar amount allocated to the $nished goods is correctly calculated and complies &ith >) 0i.e., the $nancial reporting frame&ork selected by management, including the relevant inventory valuation policies and methods. There are a number of factors that can lead to risk of misstatement of the valuation assertions, such as" the TNs might not be able to be sold at eApected pricesJ the ra& materials and componement used may not be of suitable qualityJ the costs of
!mieliauskas 9 6e&ley, Auditing: An International Approach , 3th :dition )age 5-2 !olutions ;anual < 2=1(, ;c>ra&-?ill %yerson 7td. ll %ights %eserved
the components may not be correctly recordedJ all production costs incurred in the process may not be captured accurately such o verhead allocations. /&nership" lo& - The question is &hether #a&ood has proper title to the invento ry. The risk is assessed as lo& since it is unlikely that #a&ood &ill record inventory that is has not purchased and taken title to upon delivery, or &ill include inventory once it is sold 0under an assumption that the terms of sale for this type of business are not compleA to follo&, and title transfers &hen goods are delivered &ith little uncertainty about completing the sale )resentation" lo& - The question is &hether the inventory is properly classi$ed in the $nancial statements and all disclosures required by >) are complied &ith. This is assessed as a lo& risk assertion since the classi$cation not compleA 0as long as there are reasonable systems controls in place to measure the diGerent classes of inventory" %;, +) and 4>, accounting policies for inventory valuation 9 disclosure are clear to apply, management is assume to have the required accounting skills. /ther valid risk assessments could be made based on diGerent assumptions, or on diGerent interpretations of the facts provided since these are fairly limited in the case.
#C5-B ;ateriality 7evel %educed The case requires consideration of the factors that determine the materiality level for audit purposes, in particular a decision to reduce the materiality level. a
The magnitude of net income, other $nancial statement items, the users and the potential impact of errors on their decisions, and other qualitative factors can be discussed.
b
7o&er materiality &ill tend to require more audit procedures, e.g. higher sample eAtents &hen representative samples are tested, and this &ill apply &hether eAtents are determined statistically or *udgmentally - if a smaller error matters, more has to be looked at to get the same assurance that a material error is unlikely to have occurred.
c
+n this case the auditors need to consider the impact of a lo&er materiality level on the unad*usted errors 0and the potentially undetected errors in the opening balances. +t may be that at the lo&er materiality level these errors &ould have needed to be ad*usted. !ince they &ere not, and they aGected a current asset, they &ill reverse in this year, and &hich in turn materially aGects the current year-end balances. +t &ill be important for the auditor to take the reversal of this prior period error into account
#C5-D ;ateriality pproaches in udit )ractice. ;ateriality decisions are highly *udgmental, so a lot of variability in practice is inevitable. :ven the same auditor may &ant to use a diGerent approach in diGerent audits, since the decision is based on many qualitative factors that &ill be conteAt-speci$c. C! (2= provides a lot of options so that auditors are not constrained from applying their *udgment. C! (2= also highlights the diGerent considerations and requires the auditor to consider diGerent factors and *ustify the decision on each $nancial statement audit. llo&ing for these diGerent approaches in the standards can prevent auditors in practice from starting to take too much of a literal, cookbook' attitude about &hat the standards require.
#C5-E ;ateriality and ;isstatements in :stimates !mieliauskas 9 6e&ley, Auditing: An International Approach , 3th :dition )age 5-25 !olutions ;anual < 2=1(, ;c>ra&-?ill %yerson 7td. ll %ights %eserved
The case is based on the !:C's la&suit against the @ortel eAecutives, alleging they used cookie *ar' reserves to make their 2==( bonus. The data provided can be analyLed to sho& management may be using measurement uncertainty strategically, to bias the estimate. 8sing large reservesprovisions to understate income in one year can allo& a higher income to reported in a later period, &hen the result &ill push the company into pro$t and make the eAecutives eligible for bonuses. The auditor &ould need to assess the reasonable range of these estimates in each year, and compare the company management's suggested estimate to see if it is outside the range. The direction of any diGerence bet&een the auditor' and management's estimates is i mportant to track across all the company's estimates in a period - do they tend to go in the same direction in terms of impact on earningsU This could suggest a conscious attempt to over or understate the reserves to have control over the reported results in the follo&ing periods. The analysis of auditor ranges to management's in subsequent periods should also take into account the reversal of provisions in previous periods, to assess potential for bias.
#C5-1= Suantitative and qualitative materiality criteria a The follo&ing accounts &ill be overstated" ccounts receivable Current assets and total assets !ales revenue +ncome and retained earnings This cut-oG error most clearly aGects the :`+!T:@C: 0or /CC8%%:@C: assertion since it results in the year's sales and year-end % balance being overstated. b Current ratio calculations" including error
P 1,1==,===D3=,=== P 1.2D
&ith error corrected P 011=====-25==== 0D3=,=== P =.EE +mpact is to lo&er the ratio from 1.2D to =.EE This brings the ratio belo& the level required by the bank covenant. c 6ased on quantitative criteria only, an auditor might conclude it is not material since it is less than 5X of @+6T. ?o&ever, another auditor might * udge it to be close enough to quantitative thresholds for it to be considered material, since it is X of @+6T, 2.(X current assets, etc. +n any case, since correcting the error &ill push ratio belo& the minimum level set in the bank covenant of 1.2 to 1, the error aGects a key $nancial ratio that the bankuser is monitoring and &ill aGect banks decision to continue loan or call it back. This is a qualitative factor that makes it a material misstatement. +n conclusion, it should be considered material based on qualitative considerations. #C5-11 /verall udit !trategy, %etail +ndustry This case involves $nding t&o real companies in the same industry and applying the chapter planning concepts in this conteAt. The /verall udit !trategy checklist in :Ahibit 5-E can be used as a guide. !ome other guiding questions that students can consider include" - hat business are the companies in. ?o& does each make moneyU hat are its main strategic ob*ectivesU hat business risks does it face that could prevent it from meeting its strategyU 0%efer to the relevant risk factors listed in C! ( 15 ppendiA #iscuss t&o business processes that are likely to be important in this business considering its strategy !mieliauskas 9 6e&ley, Auditing: An International Approach , 3th :dition )age 5-23 !olutions ;anual < 2=1(, ;c>ra&-?ill %yerson 7td. ll %ights %eserved
and risks, and &hy these &ould be most important. - /utline the company's corporate governance structure 0e.g., 6oard of #irectors composition and quali$cation and independence, udit or other board committees, as indicated or implied in their nnual %eport. -#etermine the audit risk level the audit team &ould be &illing to accept for this engagement, and the materiality level for planning purposes. ^ustify your choices. -%evie& the companys main accounting policies, including those for revenue, inventory, capital assets, and any other that seem relevant in this business and comment on their appropriateness 0i.e., are the policies chosen by management conservative, aggressive, etcU. -)resent the result of key analytical revie& procedures and eAplain the impact of these $nding on your audit approach. !ummariLe your $ndings in the report and provide details in an :Ahibit. Comment on the impact of accounting policy choices on the results of the analytical procedures. -6ased on your research and business risk assessment above, identify t&o or three key audit issues, and their impact on your audit approach. key audit issue is an area &here you think there is a particularly high risk that the companys $nancial statements are materially misstated. !upport your selection of these key audit issues by eAplaining speci$cally ho& the business risks and other company factors you identi$ed might lead to higher risk of material misstatement in this companys $nancial statements.
!mieliauskas 9 6e&ley, Auditing: An International Approach , 3th :dition )age 5-2B !olutions ;anual < 2=1(, ;c>ra&-?ill %yerson 7td. ll %ights %eserved
