Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
CHAPTER 6
Audit Planning, Understanding the Client, Assessing Risks, and Responding
Review Questions
6-1 6-1
In the their ir inv inves esti tiga gati tion on of a pro prosp spec ecti tive ve clie client nt,, the the CPA CPAs shou should ld asse assess ss the the back backgr grou ound ndss and and reputations of the prospect and its a!or a!or shareholders, directors, and officers" #hus, in$uiries are ade of under%riters, bankers, and attorne&s that conduct business %ith the prospective client" Also, the CPAs are re$uired to ake in$uiries of the prospect's predecessor auditors to obtain inforation that ight enter into the acceptance decision, such as inforation regarding the integrit& of anageent" #he prospect's financial reports, ()C filings, credit reports, and ta* returns are used as sources of financial background inforation"
6-+ 6-+
#he #he aud audit it co coi itt ttee ee of a boar board d of dire direct ctor orss us ustt be cop copos osed ed of at lea least st thr three ee inde indepe pend nden entt directors" Independent directors are those %ho %ho are outside directors not officers or eplo&ees eplo&ees %ho have no relationships that ight ipair their independence" #his %ould include relationships such as perforing consulting services for copan& anageent" In addition, the ebers ebers ust be financiall& financiall& literate, at least one one eber eber ust ust be a financial e*pert"
6-. 6-.
An enga engage ge ent ent let lette terr is sent sent to the the cli clien entt b& b& the the audi audito tors rs to to ak akee cle clear ar the the natu nature re of the the engageent, an& liitations on the scope of the audit, %ork to be perfored b& the client's staff, and the basis for coputing the auditors' fee" #he engageent engageent letter represents the %ritten contract contract for the engageent, and its priar& ob!ective is to prevent possible isunderstandings bet%een the client and the auditors" It constitutes an executory contract bet%een bet%een the the auditors auditors and the client" client"
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Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
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(ho (hopp ppin ing g for for acc accou ount ntin ing g pri princ ncip iple les s is a pra pract ctic icee %he %here reb& b& ana anage ge ent ent cha chang nges es audi audito tors rs to to a CPA fir that is ore likel& to allo% an accounting principle that has been the sub!ect of dispute %ith the copan&2s copan&2s prior auditors" A nuber of echaniss serve to discourage discourage the practice, practi ce, including3 1 the re$uireents of AICPA AICPA AU +10 PCA45 .1 . 1 for the successor auditors to in$uire of the predecessors about the reasons for the change in auditors, + the ()C 7-8 re$uireents for anageent to report the reasons for a change in auditors %hich also re$uire the auditors to e*press their agreeent %ith the details, and . the re$uireents under AICPA AU 7+ PCA45 6+ that re$uire accountants %ho are being asked to provide a report on the accounting treatent of an prospective or copleted transaction to consult %ith the client2s auditors to ensure that the& have a coplete understanding of the for and substance of the transaction" In addition, the (arbanes-4*le& Act of +00+ re$uires the audit coittee to assue responsibilit& for engaging, copensating, and overseeing the auditors"
6- 6-
#he #he aapp ppro roac ach h des descr crib ibed ed in the the sta state te ent ent is is n not ot appro appropr pria iate te"" 9ater 9ateria iali lit& t& depe depend ndss o on n bot both h the the dollar aount and the nature of the ite" ite" :or e*aple, auditors appl& a ore rigorous standard of aterialit& in evaluating transactions bet%een related parties and potentiall& illegal acts than the& appl& to isstateents in accounts"
6-6 6-6
#he #he t%o t%o t&pe t&pess o off is isst stat ate een ents ts due due to to frau fraud d are are 1 1 is isst stat ate een ents ts aris arisin ing g fro fro frau fraudu dule lent nt financial reporting, and + isstateents arising fro isappropriation of assets soeties referred to as defalcation" :raudulent :raud ulent financial reporting is of ore ore concern to the auditors because it t&picall& t&picall& results in effects effects that are uch ore ore aterial aterial to the financial financial stateents" stateents" ;efalcations often are not aterial to the financial stateents"
6-<
A bus busin iness ess risk risk is a trea treatt to to achie achievi ving ng anag anage een ent2 t2ss ob!e ob!ect ctiv ives es"" #here #here are an& an& e*ap e*aple less of business business risks that a& result result in a risk of aterial aterial isstate isstateent ent of the the financial financial stateents" stateents" #%o #%o are sho%n belo%3 Business Risk
6-7 6-7
Risk of aterial isstate!ent
Rap Rapidl& cha changing techn chnolog& in the client2s industr& a& threaten to cause the client2s products to becoe obsolete"
Inv Inventor& a& be ov overva rvalue lued becaus causee it is not valued at net reali=able value"
)cono )cono ic cond condit itio ions ns in the the indu indust str& r& a& a& result result in signif significan icantt uncoll uncollect ectibl iblee accoun accounts ts
Acco Accoun unts ts recei receiva vabl blee a& a& be overval overvalued ued because because the allo%an allo%ance ce for for receivable" uncollectible accounts is not ade$uate"
#he #he aud audit it pro proce cedu dure ress to be foll follo% o%ed ed in a give given n enga engage ge ent ent dep depen end d upo upon n suc such h fact factor orss as the the risks of aterial isstateent of the financial stateents, the assuption about the effectiveness of internal control, the auditors' estiates of aterialit&, the nature of the accounting records, the caliber of accounting personnel, and an& special ob!ectives of the engageent" engageent" Conse$uentl&, Conse$uentl&, a separate, tailor-ade audit progra should be prepared for each audit engageent"
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Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
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#he $uotation is isleading because it iplies that an audit progra is no ore than a checklist of instructions for ine*perienced auditors" Actuall&, audit progras are essential to assessing that all %ork is perfored and are used on virtuall& all audit engageents regardless of the aount of e*perience of the auditor" Also, a %ritten audit progra is re$uired for all audits"
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#he risk of aterial isstateent is the probabilit& that an account, class of transactions, or disclosure is ateriall& isstated" It consists of inherent risk the risk of aterial isstateent %ithout considering internal control and control risk the risk that internal control %ill fail to prevent or detect and correct the aterial isstateent"
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(ignificant risks often relate to nonroutine transactions and estiation transactions" (uch transactions t&picall& involve ore sub!ective !udgent than routine transactions and, therefore, the& often have a higher risk of aterial isstateent" (ignificant risks a& also be fraud risks"
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:actors %hich a& cause an audit engageent to e*ceed the original tie estiate include the follo%ing3 1 Accounting records a& not be up to date and coplete" + Inade$uacies in internal control a& be discovered necessitating a ore detailed audit than anticipated" . A significant risk, such as a fraud risk, a& be discovered re$uiring an e*tension of audit procedures" / :raud a& be discovered, and an e*tended investigation a& be authori=ed b& the client to clarif& the situation" Inade$uate supervision of audit staff a& perit unnecessar& or isdirected %ork to be perfored" 6 :indings during the course of the audit a& cause the client to re$uest e*tension of the scope of the %ork" In soe engageents, clients are charged at agreed dail& or hourl& rates for the tie used to perfor the audit" #he difficult& of forecasting tie re$uireents is a principal reason for the use of per die rates rather than $uoting a fee for the entire engageent" :or an& engageents, a a*iu fee is agreed upon? this plan a&, of course, force the auditing fir to absorb part of the cost of une*pected aounts of %ork" A decision as to charging the client for unusual aounts of tie %ill involve consideration of all aspects of the engageent and prior relations %ith the client" @enerall&, ho%ever, the client should not be billed for e*cessive tie attributed to audit inefficiencies e"g" ite above"
6-1.
Underreporting of tie results in the CPA fir not billing the client for all of the tie actuall& involved in rendering the professional services" #hus, the fir's revenue is being restricted" In addition, the underreporting %ill cause the fir to underestiate the aount of tie re$uired for future engageents" #hus, auditors on future engageents %ill be e*pected to perfor audit procedures in an unrealisticall& short period of tie" #his interferes %ith the perforance of an effective audit as %ell as the realistic evaluation of fir personnel"
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Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
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5alance sheet ites are ore easil& verified than are incoe stateent accounts" Assets and liabilities represent e*isting resources and obligations %hich a& be substantiated b& such procedures as ph&sical observation, confiration b& outside parties, and e*aination of e*ternall& created docuentar& evidence" Revenue and e*penses, on the other hand, have no tangible for" Rather, the& e*ist onl& as entries in accounting records, describing the effect of certain changes in assets and liabilities upon o%ners' e$uit&" #he best %a& to substantiate revenue or e*penses is usuall& to verif& the related change in an asset or liabilit& account"
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#he general ob!ectives of the auditor's substantive procedures %ith respect to assets are to3 1 + . / 6
6-16
)stablish the existence of the assets" )stablish the client's rights to the assets" )stablish the completeness of recorded assets" erif& cut-off of related transactions" ;eterine the proper valuation of the assets" ;eterine the proper financial stateent presentation and disclosure "
9aking a proper cutoff refers to the process of assigning transactions occurring near the balance sheet date to the proper accounting period" A cutoff error in recording sales transactions affects revenue in the incoe stateent, and accounts receivable or cash and retained earnings in the balance sheet" In addition, an offsetting error in revenue %ill occur in the incoe stateent of the follo%ing &ear" A cutoff error in recording sales also a& give rise to a related cutoff error in recording the cost of these sales" An iproper cutoff in recording the cost of sales affects cost of goods sold in the current incoe stateent, and inventor& and retained earnings in the current balance sheet" An offsetting error in the cost of goods sold %ill also occur in the follo%ing &ear's incoe stateent"
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a #he purpose of tracing !ournal entries for%ard into the ledgers is to verif& the completeness of the client's posting procedures" b #he purpose of vouching ledger entries to the !ournals is to provide the auditor %ith assurance that entries in the ledger are supported b& !ournal entries" #his procedure addresses the existence assertion"
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In all audits certain procedures a& be perfored during the interi period, including3 • • • • •
4btaining an understanding or updating the understanding of the client and its environent Assessing the risks of aterial isstateent of the financial stateents inherent risks 4btaining an understanding of internal control and perforing tests of controls Issuance of the anageent letter (ubstantive tests of transactions that have occurred prior to the end of the interi period
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Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
#he e*tent of the interi tests of financial stateent balances e"g", accounts receivable that a& be perfored during the interi period depends largel& on the effectiveness of the client2s internal control" Bhen the client has ver& strong internal control, an& of the substantive procedures a& be perfored before &ear-end" 6-1>
#ests of controls are designed to provide the auditors %ith assurance that prescribed internal control policies and procedures are in use and operating effectivel&" #his inforation is useful to the auditors in assessing the likelihood of aterial isstateents occurring in various financial stateent aounts" o%ever, tests of controls generall& do not indicate the aount of isstateent or %hether, in fact, an& aterial isstateent actuall& e*ists" (ubstantive procedures are designed to detect aterial isstateent in specific financial stateent aounts" #he aount of substantive procedures perfored b& the auditors depends in large part upon their assessent of the likelihood that aterial isstateents ight e*ist"
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#he audit plan, the audit progra, and the tie budget are developed to help insure copliance %ith the generall& accepted standard of field %ork %hich re$uires ade$uate planning of the audit %ork and proper supervision of assistants" It %ould be difficult, if not ipossible, to copl& %ith generall& accepted auditing standards if there %ere no detailed and broad planning as anifested in the audit plan, the audit progra, and the tie budget"
6-+1
#he purpose of the tea eeting on fraud risk is designed to a llo% the ore e*perienced tea
ebers to share insights and e*change ideas about ho% and %here the entit&2s financial stateents ight be susceptible to aterial isstateent due to fraud, to discuss ho% to design appropriate procedures to detect the isstateents, and to ephasi=e the iportance of aintaining the proper degree of professional skepticis regarding the possibilit& of fraud" 6-++
#he preceding &ear's audit %orking papers contain a great deal of inforation useful to the auditor in a recurring e*aination" #he audit plan provides background inforation about the client, significant risks, and identifies a!or proble areas encountered during the previous engageent" #he prior &ear's audit progra provides a foral list of the procedures perfored during the last engageent, an& of %hich should be applicable in the current audit, and the tie re$uired to coplete each procedure" #his inforation is ver& helpful in developing an audit progra and tie budget for the current engageent" 9an& of the previous audit %orking papers are helpful to ne% audit staff b& providing e*aples of %orking paper forat and organi=ation" Also, these %orking papers substantiate the beginning account balances for the &ear under audit"
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Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
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;uring the planning process, the auditors ake preliinar& estiates of both risk and aterialit& for the engageent" #he auditors ust plan their engageents to reduce the audit risk of issuing an un$ualified opinion on ateriall& isstated financial stateents to a relativel& lo% level" At the account balance level, audit risk actuall& has three coponents3 1 inherent risk, + control risk, and . detection risk" 4n audits %here the risk of isstateent is relativel& high, the auditors ust copensate b& increasing the effectiveness of their audit procedures" #he& a& design ore effective procedures, increase the nuber of ites selected for testing, or perfor ore procedures at the balance sheet date rather than at an interi date" #he& a& also add an eleent of unpredictabilit& to the procedures" #he auditors' preliinar& estiates of levels of aterialit& also affect the nature, tiing, and e*tent of their planned procedures" 9aterialit& levels deterine %hich accounts are significant enough to re$uire audit, affect the si=e of the test saples, and deterine the dollar aount of individual ites that %arrant e*aination"
Questions Re"uiring Anal#sis
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#he procedures that 9organ should appl& in deciding %hether to accept this prospective audit client %ould ordinaril& include the follo%ing3 1
)valuate the CPA fir's independence %ith respect to the prospective audit client"
+ )*plain to the prospective client the need to ake in$uiries of the predecessor auditor, re$uesting that the client authori=e the predecessor auditor to respond full& and to allo% a revie% of the predecessor's audit %orking papers" . 9ake in$uiries of the predecessor auditor concerning such atters as the integrit& of anageent, an& disagreeents %ith anageent as to accounting principles, the reason for the change in auditors, and an& other atters affecting the decision of %hether to accept the engageent" / 9ake in$uiries of other appropriate third parties regarding the histor& of the prospective client and the reputations of its anageent and directors" #hese third parties a& include the client's bankers, legal counsel, and under%riters" 4btain a kno%ledge of the client's business activities and business environent" (ources of this inforation include in$uiries of anageent and others %ithin the organi=ation, inspection of internal docuents and records, the client2s %ebsite, AICPA accounting and audit guides, registration stateents and Form 10-Ks filed %ith the ()C, interi financial stateents, incoe ta* returns, and credit reports"
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Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
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Consider an& special probles or uni$ue risks likel& to be associated %ith the engageent"
< old preliinar& eetings %ith anageent and the audit coittee to discuss such atters as the scope of the services to be perfored, tiing of the perforance and copletion of the audit, basis for the fee, and %ork that a& be done b& the client's staff in preparation for the audit" Upon acceptance of the engageent, 9organ should issue an engageent letter suari=ing the arrangeents reached %ith the client" 6-+
a Auditors ust obtain an understanding of the client and its environent in order to deterine %hether the client should be accepted and perfor risk assessent" #his understanding encopasses the follo%ing3 1
#he nature of the client, including the client2s application of accounting policiesD#he auditors2 understanding of this area %ill include the client2s copetitive position, organi=ational structure, accounting policies and procedures, o%nership, capital structure, and product lines" #he understanding %ill also encopass an understanding of the client2s business odel and its a!or business processes"
+
#he industr&, regulator&, and other e*ternal factorsD#he factors included here are industr& conditions, such as the copetitive environent, supplier and custoer relationships, and technological developents" #he& also include the regulator&, legal, and political environent, and general econoic conditions"
.
4b!ectives and strategies and related business risksD#he auditors obtain an understanding of the operating and financing strategies of anageent" #he& also obtain an understanding of anageent2s risk assessent process" #his assists the auditors in identif&ing significant business risks that a& create risks of aterial isstateent of the financial stateents"
/
9ethods of easuring and revie%ing perforanceD#he auditors obtain an understanding of the ethods anageent uses to easure and revie% perforance at various levels %ithin the organi=ation" #hese ethods are iportant to deterining incentives of anageent and other eplo&ees" #he easures a& also be used in designing effective anal&tical procedures"
Internal controlD#he auditors2 understanding of internal control assists the in planning the audit and assessing control risk"
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Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
b (ources of inforation on prospective clients include AICPA Audit and Accounting Guides and Industry Risk Alerts, trade publications, and governental agenc& publications" Previous audit reports, annual reports to stockholders, ()C filings, and prior &ears' ta* returns are e*cellent sources of financial background inforation" Inforal discussions bet%een the auditors and ke& officers can provide inforation about the histor&, si=e, operations, accounting records, and controls of the enterprise" In$uiries of others %ithin the organi=ation can provide inforation that confirs in$uiries of anageent, and provides ore detailed inforation about risks and business processes" Inspection of internal docuents and records can provide inforation about the nature of the client2s operations and internal control" #he predecessor auditor a& also provide inforation" c 8no%ledge of the client and its environent helps the auditors in3 1 Identif&ing significant business risks that a& result in risks of aterial isstateent of the financial stateents" + Identif& special risks that re$uire an audit response" . ;esign further audit procedures substantive procedures and tests of controls" / Assessing inherent risk and aking preliinar& assessents of control risk" 9aking !udgents about the appropriateness of accounting principles in use and the ade$uac& of disclosures" 6 )valuating the reasonableness of estiates, such as depreciation lives and the allo%ance for doubtful accounts" < )valuating the reasonableness of anageent representations" 7 ;eveloping an efficient audit strateg&" > ;eterining the staffing re$uireents of the engageent" 6-+6
a Assess the risk of aterial isstateent and design further audit procedures substantive procedures and tests of controls" b Possible responses to high risk audit engageents or high risk assertions include3 •
• • •
(taff the engageent audit area %ith ore e*perienced individuals or individuals %ith speciali=ed kno%ledge" Ad!ust the tiing of audit procedures to nearer to &ear end" Perfor ore effective audit procedures" Increase the e*tent of ites tested"
c :urther audit procedures include substantive procedures and also tests of controls %hen the audit plan assues that the controls are operating effectivel& or substantive procedures alone cannot provide sufficient evidence for a particular assertion"
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Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
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#he t&pical engageent letter includes the follo%ing3 1 + . / 6 < 7 > 10 11
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#he nae of the person %ho retained the auditors to perfor the auditing services" A description of the ob!ective and scope of the audit" A stateent that the audit %ill be conducted in accordance %ith auditing standards generall& accepted in the United (tates" An& scope restrictions or liitations and their effect upon the auditors' report" (tateents of auditor and anageent responsibilities" A stateent that anageent agrees to provide the auditors %ith access to all persons %ithin the entit& and all necessar& inforation" A stateent that the auditors %ill counicate significant deficiencies that the& discover" 9anageent %ill be re$uested to provide a %ritten confiration of representations ade" #he scheduled dates for perforance and copletion of the audit" #he fee and billing arrangeents" (pace for the appropriate client official to sign, indicating acceptance of the letter and agreeent %ith the arrangeents described therein" a 9isstateents due to fraudulent financial reporting are intentional isstateents or oissions of aounts or disclosures in the financial stateents to deceive financial stateent users" 9isstateents arising fro isappropriation of assets soeties referred to as defalcation involve the theft of an entit&2s assets %here the effect of the theft causes the financial stateent not to be presented in conforit& %ith generall& accepted accounting principles" b #he three conditions necessar& for the coission of fraud include3 1 soe t&pe of incentive or pressure, + an opportunit& to coit the fraud, and . an attitude that allo%s the individual to rationali=e the act" In a case of fraudulent financial reporting, ebers of top anageent a& have an incentive to coit the act relating to aintaining the value of their stock options" #he& a& have an opportunit& based on %eaknesses in the corporate governance of the organi=ation" :inall&, the& a& be able to rationali=e the act b& assuing that the copan& %ill ake enough incoe ne*t period to allo% the to correct the isstateent" c #he auditors a& respond to fraud risks b& 1 a odification in the approach having an overall effect on ho% the audit is conducted, + an alteration in the nature, tiing, and e*tent of the procedures perfored, and . perforance of procedures to further address the risk of anageent override of internal control"
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Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
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(tudents a& arrive at a variet& of estiates" #hose suggested in the te*t include3 a :ranklin Co"
b #&ler Co"
E
70,000 160,000
E /,00 >,000
1,00 ./>,000
1.,00 +<,000
Rules of #hub3 percent of net incoe before ta*es 10 percent of net incoe before ta*es 1F+ percent of total assets 1 percent of total assets 1F+ percent of total revenues 1 percent of total revenues
1/7,000 ++,00 +>6,000 /,000
1 percent of total e$uit&
1.7,000
(liding scale illustration
1>.,..<
10,000
/7,.0
If the auditors use the rule of thub guidelines the& %ill usuall& use the aounts for an& rule e"g", versus 10 percent of sales in such a anner as to function as a sliding scale in %hich the aterialit& easure increases at less than a pro-rata aount as entit& si=e increases" :or :ranklin Co" the larger copan&, the auditors %ould probabl& consider the follo%ing easures as being relevant3 percent of net incoe before ta*es E 70,000 1F+ percent of total assets 1,00 1F+ percent of total revenues 1/7,000 #herefore, bet%een E70,000 and E1,00 %ould be a reasonable range for aterialit& for the Copan&" :or #&ler Co" a ver& sall copan&, the auditors %ould probabl& use the higher percentage of the rules of thub" Also, the& %ould probabl& not use the net incoe or e$uit& easures because the copan&'s incoe is too lo%" #herefore the follo%ing easures %ould probabl& be considered relevant3 1 percent of total assets 1 percent of total revenues
E+<,000 E/,000
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Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
c
Characteristics of a sall isstateent that ight render it $ualitativel& aterial include isstateents of the financial stateents that re$uired3 • • • • • •
• • • •
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6-.1
Affect a copan&'s copliance %ith a contractual agreeent" Reverse a trend of earnings or other trends" Cause a copan& not to ake the consensus earnings per share" Arise fro an ite capable of precise easureent" Changes a loss into incoe, or vice versa" Concerns a segent or other portion of a copan&'s business that has been identified as significant to operations or profitabilit&" Affects copliance %ith regulator& re$uireents" Affects copliance %ith loan covenants" Increases anageent's copensation" Involves concealent of an unla%ful transaction"
a If auditors %ere to use the overall easure of planning aterialit& for all accounts, the& ight not discover relativel& large errors %hich, %hen cobined %ith other undiscovered errors, clearl& e*ceed the aterialit& easure" Auditors t&picall& allocate aterialit& %hen the& intend to use audit sapling for substantive testing of one or ore of the accounts" b
#he aount allocated to individual accounts a& e*ceed the overall aterialit& for several reasons" :irst, an& isstateents of various accounts tend to counterbalance each other" (econd, the double entr& bookkeeping s&ste allo%s detection of isstateents in an account b& auditing a related account e"g", %hile auditing receivables, an error ight be discovered in sales"
a
Bells a& respond to fraud risks in the follo%ing three %a&s3 1 A odification in the overall approach to the audit %hich ight involve3 a Appl&ing increased professional skepticis and designing procedures that provide ore reliable evidence" b Assigning additional staff %ith speciali=ed skill and kno%ledge or b& assigning ore e*perienced staff to the engageent" Also the e*tent of the supervision of the staff should be ad!usted to reflect the fraud risks" c @iving further consideration to the appropriateness of the accounting principles used b& the client" d Incorporating an added eleent of unpredictabilit& in the selection of auditing procedures" + An alteration in the nature, tiing and e*tent of the procedures perfored" :or e*aple, Bells ight appl& procedures the provide ore reliable evidence, shift ore audit tests to &ear-end, or increase saple si=es for certain substantive procedures"
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Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
. Perfor procedures to further address the possibilit& of anageent override of internal control, including 1 e*aining !ournal entries and other ad!ustents for evidence of fraud, + revie%ing accounting estiates for biases, and . evaluating the business rationale for significant unusual transactions" b Bhenever the auditors believe that there is evidence that fraud a& e*ist, the atter should be brought to the attention of an appropriate level of anageent" :raud involving senior anageent and fraud that causes a aterial isstateent of the financial stateents should be reported directl& to the audit coittee" In ver& serious situations the auditors should consider resigning the engageent" 6-.+
a 4bservation of the client2s ph&sical inventor& priaril& provides evidence related to the existence assertion" #o a lesser degree it establishes valuation in that daaged or slo%oving inventor& ites a& be identified for possible lo%er-of-cost-or-arket testing" It a& also provide evidence about cut-off of purchases and sales" b Ph&sical inspection of e$uipent ites listed in the plant ledger serves to establish the existence of the assets" It does not, ho%ever, establish rights to those assets" c 4btaining a listing of inventor& and reconciling the total to the general ledger establishes a population to be tested for valuation. d #racing shipping docuents to recorded sales is designed to establish the completeness of recorded accounts receivable" It also provides evidence about the cut-off of sales transactions" e Identif&ing related parties is perfored to deterine the appropriate financial stateent presentation and disclosure of the assets" f ouching selected purchases of securities establishes existence of, rights to, and valuation cost of the securities" It a& also provide soe evidence about the cut-off of securit& transactions"
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a #he general approach follo%ed during risk assessent is to use all the evidence obtained about the client and its environent to3 1 Identif& risks + Relate the identified risks to %hat can go %rong at the relevant assertion level . Consider %hether the risks are of a agnitude that could result in a aterial isstateent / Consider the likelihood that the risks could result in a aterial isstateent
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Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
b In responding to financial stateent level risks the auditors a&3 1 Assigning to the audit ore e*perienced staff or individuals %ith speciali=ed
skills
+ Providing ore supervision for the audit staff and ephasi=ing the need for the to aintain professional skepticis . Incorporating additional eleents of unpredictabilit& in the selection of further audit procedures to be perfored / Increasing the overall scope of audit procedures c A significant risk is a risk that re$uires special audit consideration" d In responding to significant risks, the auditors ust3 1 Carefull& consider the design and ipleentation of the related controls" + Got rel& on evidence gathered in prior periods about the operating effectiveness of the related internal controls" . Got rel& solel& on anal&tical procedures to obtain audit evidence about the related financial stateent assertions" 6-./
#he procedure perfored b& :oster is copletel& ineffective for testing sales cutoff" In a coputeri=ed accounting s&ste, the !ournals and ledgers generall& are prepared siultaneousl& b& the coputer" #he !ournal entr& date and the posting date are both deterined b& the date indicated b& the eplo&ee entering the transaction" #o test the effective cutoff of transactions in a coputeri=ed or anual accounting s&ste, the auditors ust trace entries before and after the balance sheet date to supporting docuentation, indicating the date the transaction actuall& occurred" :or sales transactions, the auditors are interested in e*aining shipping docuents, %hich indicate the date the sales took place"
6-.
#he solution to this $uestion %ill var& %ith the copan& selected b& the student" #&pical business risks include3 1 Rapid pace of technolog& change in the industr& + Copetition . Changes in regulator& re$uireents / International operations Internal product developent 6 Changes in foreign e*change rates < Changes in interest rates 7 ;efendant in la%suits" > Changes in securities prices 10 Changes is soft%are pirac& la%s 11 Changes in social, political, and econoic conditions
6-1.
Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
6-.6
1 a #here is an increased risk of fraudulent financial reporting b& subsidiar& anageent" 9ore specificall&, subsidiar& anageent %ould likel& attept to increase revenue or decrease e*penses" b #he auditors %ould probabl& respond b& perforing ore procedures at the subsidiar& location" Additional tests of revenue %ould be perfored and the auditors %ould likel& decide to observe inventor& at &ear-end" In addition, soe of the procedures a& be perfored on an unannounced basis" + a #here is an increased risk of fraudulent financial reporting b& anageent related to revenue" b #he auditors %ould likel& respond b& utili=ing ore e*perienced audit tea ebers" (pecificall&, audit staff that had e*perience %ith cople* revenue contracts in the telecounications industr&" #he& %ould also likel& increase the e*tent of the substantive procedures applied to revenue" . a #here is an increased risk that the futures traders %ill fraudulent overstate the value of the contracts to increase their copensation" b #he auditors %ould likel& respond to this situation b& bringing in a specialist to assist in valuing the contracts" In addition, the& %ould do e*tensive testing of the valuation of the contracts" / a #here is an increased risk that anageent a& be fraudulentl& overstating incoe at one or ore of the stores" b #he auditors %ould likel& respond b& doing increased testing of revenue and inventor& at the stores" #he auditors could use the results of the anal&tical procedures to identif& stores that are ore likel& to have fraudulent reported results e"g", those %ith unusuall& high profit argins" #he auditors also a& not disclose the locations that the& intend to visit for inventor& observation"
6-.<
(ection 1.b+ of the (ecurities and )*change Act of 1>./ indicates that ever& issuer %ith securities registered under (ection 1+ and ever& issuer %hich is re$uired to file reports under section 1d ust3 1 8eep records %hich accuratel& reflect the transactions and dispositions of the assets, and + ;evise and aintain a s&ste of internal control sufficient to provide reasonable assurance that3 a transactions are e*ecuted in accordance %ith anageent's authori=ation, b transactions are recorded as necessar& to perit preparation of financial stateents in accordance %ith appropriate accounting principles and aintain accountabilit& for assets, c access to assets is restricted to authori=ed individuals, and d the recorded accountabilit& for assets is copared %ith assets at reasonable intervals and appropriate action is taken %ith respect to differences" #his section is a re$uireent of the :oreign Corrupt Practices Act of 1><6Dsee Chapter <"
6-1/
Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
$%&e'tive Questions
6-.7
9ultiple Choice a . An unreliable accounting s&ste provides an opportunit& for an individual to isappropriate assets" #he other ites create risks of fraudulent financial reporting" b
/ 9ebers of the audit coittee should be independent of anageent" #herefore, the individuals should be board ebers %ho are not eplo&ees or officers, and %ho have not relationship %ith anageent that ight ipair their ob!ectivit&"
c
/ 9anageent should not be infored about %hich branches %ere selected for testing at all or at least not until !ust before testing is to be done"
d
. (ubstantive procedures substantiate the account balances as of the balance sheet date and therefore cannot be completed prior to that date" #he other ites pertain to the operation of the s&ste during the &ear under audit and could be copleted in the interi period"
e
/ Before accepting an engageent the possible successor should ask $uestions about the integrity of management , disagreeents %ith anageent, and the reasons for the change in auditors" All of the other replies are incorrect because the& represent inforation that the successor a& %ish to obtain after accepting the engageent"
f
/ 5ecause entries in the sales !ournal represent recorded sales, tracing entries fro it to debits in the accounts receivable ledger provides evidence on %hether recorded sales have been properl& posted to custoer accounts"
g
. #he ob!ective of tests of details of transactions perfored as substantive procedures is to detect aterial isstateents in the financial stateents as transactions are tested to deterine %hether the& have been properl& recorded"
h
/ ;etection risk is the risk that the auditor %ill conclude, based on substantive procedures, that a aterial isstateent does not e*ist in an account balance, %hen, in fact, such isstateent does e*ist"
i
. 9aterialit& and audit risk underl& the application of generall& accepted auditing standard in that so an& audit decisions are affected b& the aount used as a aterialit& easure and the level of audit risk assued on the engageent"
6-1
Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
!
+ :raud risk factors are factors that have been observed in circustances in %hich fraud has occurred" #he fraud risk factors %ere identified b& researchers and practitioners through anal&ses of an& past frauds" Het, none of the factors %as al%a&s present in the various individual cases included in the anal&ses" Ans%er 1 is incorrect because in an& particular circustance, the e*istence of a fraud risk factor a& or a& not indicate that in that circustance the risk of fraud is high" Ans%er . is incorrect because the e*istence of a fraud risk factor a& not re$uire odification of planned audit procedures e"g", the audit progra a& alread& have audit procedures that consider the factor" Ans%er / is incorrect because a fraud risk factor a& or a& not be a significant deficienc&"
k
. AICPA AU +/0 PCA45 .16 outlines the three functions generall& necessar& for fraud as 1 incentive or pressure, + opportunit&, and . attitude" 5eing in a supervisor& position is not one of those conditions, although it a& provide the individual an opportunit& to coit fraud"
l
+ ess predictable audit procedures are likel& to be used %hen fraud risks are high" (A( >> also suggest that the auditors have increased skepticis, assign ore skilled staff, and consider further anageent2s selection and application of accounting principles" Ans%er 1 is incorrect because supervision of ebers of the audit tea %ill be ore close, not less" Ans%er . is incorrect because tea ebers a& or a& not be CPAs e"g", a fraud specialist %ho is not a CPA ight be added to the tea" Ans%er d is incorrect because sub!ective, rather than ob!ective transactions a& often be ephasi=edD depending upon the nature of the fraud risks identified"
6-16
Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
6-.> (iulation (a'tor
a" b" c" d" e" f" g"
h"
i" !" k" l"
G:5 is a continuing audit client" #he banking industr& has been ver& health& during this and recent &ears" G:5 operates in a gro%ing, prosperous area and has reained profitable over the &ears" @overnent regulation and overvie% of the banking industr& is e*tensive and effective" G:5's board of directors is controlled b& (ith, the a!orit& stockholder, %ho also acts as the chief e*ecutive officer" Interest rates have been ver& volatile recentl&" 9anageent at the bank's branch offices has authorit& for directing and controlling G:5's operations and is copensated based on branch profitabilit&" #he internal auditor reports directl& to arris, a inorit& shareholder, %ho also acts as chairan of the board's audit coittee" #he accounting departent has e*perienced little turnover in personnel during the five &ears @reen has audited G:5" ;uring +0J1, G:5 increased the efficienc& of its accounting operations b& installing a ne%, sophisticated coputer s&ste" G:52s forula has consistentl& underestiated the allo%ance for loan losses in current &ears" 9anageent has been receptive to @reen2s suggestions relating to accounting ad!ustents"
Effe't on Risks of aterial isstate!ent )*n'rease or +e'rease ; ;
Create a Risk of (raud)#es or now
G G
;
G
;
G
I
H
I I
H H
;
G
;
G
I
H
I
H
;
G
6-/0 (iulation a"
; (ince #B; returned to profitable operation, its healthier financial condition leads to a decrease in the risk of aterial isstateent"
b" I #he risk of aterial isstateent increases %hen anageent is doinated b& a single person" (ince 9ead controls the 5oard of ;irectors, is a a!orit& stockholder, and is the C)4, it %ould appear that 9ead doinates anageent" c"
I #he risk of aterial isstateent increases %hen the internal auditor reports to top anageent rather than to the audit coittee because it is less likel& that the internal auditor %ill be able to ob!ectivel& perfor the function"
d" I #he risk of aterial isstateent increases %hen the ke& anageent positions particularl& senior accounting personnel encounter turnover" e"
; #he loan officer's continual onitoring of #B; decreases the risk of aterial isstateent"
f"
G #iing of pa&roll c&cles %ould norall& have no ipact on the risk of aterial isstateent"
6-1<
Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
g" I A strong financial presence or abilit& to doinate a certain industr& sector that allo%s a copan& to dictate ters or conditions to suppliers or custoers a& result in inappropriate or non-ar's-length transactions" h" I A change to generall& accepted accounting principles %ill increase the risk of aterial isstateent because the change in basis re$uires anageent to prepare a nuber of entries that have not been ade in the past? these entries a& be ade iproperl&" Also, difficulties in deterining beginning accrual basis balances increases the risk of isstateent" i"
I #he sale of one-half of the copan&'s controlling interest in United )$uipent easing is an entr& that is out of the ordinar& course of business, and accordingl&, increases the risk of aterial isstateent"
!"
; itigation results in contentious and difficult accounting valuation issues because an accountant ust attept to deterine the likelihood of loss and the aount"
k" I #he risk of aterial isstateent increases %hen significant related-part& transactions occur and anageent has an aggressive attitude to%ards reporting of the transactions" l"
I #he risk of aterial isstateent increases in situations %here there are unusual and difficult accounting issues present" It %ould appear that the barter transaction %ith a belo% arket purchase %ould be considered an unusual transaction"
" G #he aount of insurance coverage %ould have little ipact on the risk of aterial isstateent" n" I #he risk of aterial isstateent increases as it appears that anageent has taken an aggressive attitude to%ard reporting this transaction" In addition, this appears to be an unusual and difficult accounting issue involving revenue recognition" o" I )*perience has sho%n that a nuber of entities have intentionall& isstated reported financial condition and operating results in situations in %hich a public or private placeent of securities is planned" 6-/1 (iulation a . Consideration of fraud in a financial stateent audit" b + 9aterialit& in planning and perforing an audit" c < Related parties d 1 Anal&tical procedures e Consideration of la%s and regulations in a financial stateent audit f . Consideration of fraud in a financial stateent audit g / Understanding the entit& and its environent and assessing the risks of aterial isstateent h . Consideration of fraud in a financial stateent audit
6-17
Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
6-/+ a + b 1 c d 1 e +
ouch fro !ournals to source docuents" #race fro source docuents to !ournals" . )ither a or b" if transaction is recorded, testing in either direction %ill address recording for the proper aountDvaluation Copleteness understateents )*istence overstateents
6-/. a b c d e f g h
+ 1 11 < 7 . 10
Audit progra Audit plan #ie budget )ngageent letter Inherent risk Audit risk (ignificant risk 5usiness risk
Pro%le!s
6-//
(4U#I4G3 Cheviot Corporation )stiated tie3 .0 inutes 9r" Kohn 5ra& President Cheviot Corporation ;ear 9r" 5ra&3 4ur recent tour of Cheviot's plant %as a ost pleasant and interesting e*perience" #he inforation obtained on this tour and during the discussion of &our financial stateents and accounting records has enabled us to plan the scope of an audit especiall& suited to &our needs" 4ur fees are based on the tie spent on the engageent b& various ebers of our audit staff, and %ill be billed at our established rates" #he total tie re$uired for an initial engageent is usuall& soe%hat greater than in repeat e*ainations, since the latter do not re$uire anal&sis of past &ears' transactions" Considerable savings in the cost of the audit a& be ade b& utili=ing the services of &our accounting staff to help us in certain phases of the %ork" Be can arrange for &our eplo&ees to prepare for us a nuber of %orking papers" If &ou approve, %e shall indicate to &our chief accountant the e*act nature of the %orking papers to be prepared" 4ur audit %ill be perfored in accordance %ith auditing standards generall& accepted in the United (tates and %ill include all procedures %hich %e consider necessar& to provide a basis for e*pression of our opinion on the fairness of the financial stateents" #he audit %ill include3
6-1>
Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
1 4btain an understanding of the client and its environent, including internal control + Assessent of risks of aterial isstateent and design further audit procedures" . #ests of the financial stateent accounts and balances to the e*tent %e consider necessar&, based on our consideration of risks and internal control" / Preparation of the federal and state incoe ta* returns" Issuance of our auditor's report upon &our financial stateents" If our investigation indicates the desirabilit& of an& changes in internal control procedures, %e shall prepare a report on this sub!ect for &our consideration" o%ever, an audit cannot be relied upon to identif& all %eaknesses in internal control" #he purpose of our audit is to enable us to e*press an opinion on the fairness of the financial stateents? the audit is designed to provide reasonable, but not absolute, assurance of detecting aterial fraud and defalcations, and %e %ill notif& &ou if our audit does bring the to light" Although it is not possible to deterine in advance the e*act nuber of da&s re$uired for the engageent, our estiates indicate that the total fee %ill be bet%een E1+,00 and E1,000" #he audit %ill be copleted and our report subitted b& 9arch 1, +0LL " Be %ould like an opportunit& during the ne*t fe% da&s to discuss %ith &ou and &our chief accountant the nature of the preliinar& %ork to be done b& &our staff" Be shall also be pleased to ans%er an& further $uestions %hich &ou a& have concerning the deterination of audit fees" er& trul& &ours, Carson, Robinson and Copan&, CPAs 6-/
(4U#I4G3 alle& :inance Copan& )stiated tie3 +0 inutes a #he CPAs should deterine the scope of the audit %ork b& developing an audit progra %hich considers the risks of aterial isstateent of the financial stateents and controls in effect" #he CPAs ust e*tend the scope of the audit in areas of high risk or if essential controls are issing" Assessent of internal controls %ill include consideration of the operations at the loan offices as %ell as controls e*ercised b& 9r" Gorris and the fre$uenc& and effectiveness of supervisor& and internal audit visits to the loan offices" #he CPA's audit progra should concentrate on %eak spots %hich are evident fro the consideration of internal control" #hat is, %here the risk of aterial isstateent of an account is higher" #he auditors %ill perfor an assessent of fraud risks" If the CPAs identif& fraud risks, the auditors %ill decide on an appropriate response, %hich a& be an overall response or a change in the nature, tiing and e*tent of audit procedures" In all audits, the auditors ust design additional procedures to address the risk of anageent override of controls" If fraud is detected and deterined to be aterial in aount, the CPAs ust e*tend the scope of the audit to deterine the ad!ustent re$uired for fair presentation of the financial stateents" #he CPAs could then render an un$ualified opinion on the ad!usted financial stateents reporting the loss fro fraud"
6-+0
Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
b #he CPAs are responsible for their opinion on the fairness of the financial stateents" AICPA AU +/0 PCA45 .16 re$uires that the& assess the risk that fraud a& cause the financial stateents to contain a aterial isstateent" 5ased on that assessent, the auditors should design the audit to provide reasonable assurance of detecting fraud that is aterial to the financial stateents" Het, soe t&pes of fraudDparticularl& those involving forger& and collusionDa& not be detectible b& a properl& designed and e*ecuted audit" If the CPAs are satisfied that an& fraud %hich e*ists is not aterial in aount, their responsibilit& %ould be to refer the atter to the client for follo% up" If the client specificall& re$uests an e*tension of the CPAs' %ork because of suspicions of fraud, the CPAs a& perfor the re$uested %ork but the& usuall& %ould not guarantee that the& %ill discover all of the fraudulent acts" 6-/6
(4U#I4G3 (taff Auditor )stiated tie3 +0 inutes a A anaging partner is likel& to oppose the underreporting of tie b& audit staff ebers because the practice reduces the fir's revenue, underines the planning of future engageents, and lo%ers staff orale" #he billings of public accounting firs often are based on the nuber of hours %orked" If the staff underreports these hours, the fir %ill underbill its clients" In addition, the fir %ill use the understated hours as a basis for planning the follo%ing &ear's audit" Bhen the estiated hours in the tie budget are understated, ne*t &ear's audit staff %ill be under pressure to Meat tieM to avoid running over budget, and, again, the client %ill be underbilled for the services actuall& rendered" :inall&, %hile audit staff a& voluntaril& Meat tieM on a teporar& basis, this practice ultiatel& builds up resentent and lessens eplo&ee orale" #his a& contribute to high eplo&ee turnover and the loss of $ualified personnel" b (eniors are evaluated, in part, on their abilit& to bring an engageent in Mon budget"M #his is considered Mgood anageentM b& the senior" If the audit staff %ill underreport their hours, the senior's prospects for copleting the engageent %ithin the budgeted tie frae are increased" #herefore, the senior's self-interest conflicts %ith the long-run interests of the fir" c #he purpose of this third $uestion is to raise the $uestion of peer pressure" In the authors' e*perience, the pressure upon ne% audit staff to MconforM can be intense" Also, there is considerable copetition aong the audit staff to MoutperforM one another" #herefore, %e think that an& staff ebers %ould e*pect other staff ebers to cooperate %ith the senior's plan" #his e*pectation %ould, in turn, create ore pressure upon the individual staff eber to cooperate as %ell" Be cannot ans%er the $uestion of %hether an individual's response %ould differ fro that of his or her colleagues" #his response is dependent upon personal values and ob!ectives"
6-+1
Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
d 4ur ans%er to the underreporting proble is a personal one, and it a& differ significantl& fro that suggested b& students" Be feel that the $ualit& control procedures relating to underreporting ust be ipleented b& partners, as a conflict of interests e*ists at the senior or supervisor& level" Partners should ake clear to ne% staff auditors that the fir does not condone underreporting of tie" #he reasons should be ade clear to the audit staff, and partners should state that the& aintain an Mopen doorM polic& to discuss engageent-related pressures %ith staff assistants" Also, the partners ight point out that staff assistants %ho underreport their hours %ill not receive recognition for the hours e*pended" )ven in those firs that do not directl& copensate for overhead hours, the nuber of hours %orked reported is a factor sub!ectivel& considered in the prootion process" :inall&, engageent partners should criticall& revie% their audit staff's tie sheets" If a partner kno%s that an engageent is running under a tie pressure, &et the audit staff reports ver& little overtie, the partner should investigate" 6-/<
(4U#I4G3 Precision Industries, Inc" )stiated tie3 +0 inutes a #he auditors a& be on hand during the last business da& of the current period to note the serial nuber of the shipping advice for the last shipent" (ince all shipents are FOB shipping point , shipping advises through this last serial nuber should be recorded as sales of the current &ear? shipping advises bearing subse$uent nubers represent sales of the follo%ing &ear" #he auditors a& then deterine that a proper cutoff has been ade b& noting the serial nuber of the shipping advises relating to sales recorded for several da&s before and after the balance sheet date" :or the above procedures to be effective, the auditors ust deterine that the client issues the shipping advises in se$uential order" #his can usuall& be accoplished b& revie%ing a se$uential log of shipents aintained b& the shipping departent, or b& revie%ing bills of lading dated and signed b& the coon carrier" b #he overall effect of a cutoff error in recording future sales revenue in the current &ear depends upon %hether the client has also included the cost of these sales in the current &ear" If the cutoff error is liited to entries recording sales revenue, the current &ear's sales, net incoe, accounts receivable andFor cash, and retained earnings %ill be overstated b& the sales price of the preaturel& recorded shipents" o%ever, the recording of sales revenue is soeties accopanied b& entries charging cost of sales and reducing inventor&" If these entries are ade in the current &ear for goods shipped ne*t period, the current &ear's cost of good sold %ill be overstated and inventor& %ill be understated" Preaturel& recording the cost of these sales %ill partiall& offset the overstated revenue and liit the overstateent of the current &ear's incoe, total assets, and retained earnings to the e*cess of the selling price of the shipents over their cost"
6-++
Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
Ethi's Case
6-/7
(4U#I4G3 #o%er N #o%er )stiated tie3 . inutes #here is little guidance in authoritative pronounceents to aid auditors in aking a decision %hether or not to accept a client" Statement on Quality Control Standards, o! 1 states that3 Policies and procedures should be established for deciding %hether to accept or continue a client in order to inii=e the likelihood of association %ith a client %hose anageent lacks integrit&" (uggesting that there should be procedures for this purpose does not ipl& that a fir vouches for the integrit& or reliabilit& of a client, nor does it ipl& that a fir has a dut& to an&one but itself %ith respect to the acceptance, re!ection, or retention of clients" o%ever, prudence suggests that a fir be selective in deterining its professional relationships" #hus, it is clear that a CPA fir should avoid situations that involve association %ith anageent that lacks integrit&" o%ever, professional !udgent ust be used to evaluate the facts bearing on the integrit& of anageent" Auditing standards indicate that the auditors should respond to fraud risks b& changing the overall approach to the audit, altering audit procedures, or perforing procedures to address the risk of anageent override" a
#he follo%ing are arguents that support acceptance of the client3 •
•
•
Be are in the auditing business" (oe engageents involve ore risk than others, but %e can take the additional risk b& designing a ore thorough audit progra, for %hich %e %ill bill accordingl&" Hou do not gro% b& turning do%n the tough engageents" (oe fir %ill accept this clientD%h& not usO )dond probabl& has atured to a point %here he %ould not engage in $uestionable activities"
•
)ven though )dond lied to the IR(, he %ould probabl& not lie to his auditors"
•
All other inforation about )dond indicates that he is a an of integrit&"
6-+.
Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
b
#he follo%ing are arguents against acceptance of the client3 •
•
•
•
#he fact that the audit opinion %ill be used to obtain substantial additional financing akes this audit a high risk engageent" #he incident %ith the IR( clearl& indicates that )dond lacks sufficient integrit&" Be should not be associated %ith his corporation" 9anageent fraud is difficult to detect b& custoar& audit procedures" If )dond does elect to isstate the financial stateents, it is possible that our audit procedures %ould fail to detect the irregularities" #he onl& %a& to assure that the reputation of the fir is not $uestioned is to avoid such high risk audit engageents"
c 4ur opinion3 Be feel that the decision to accept this client depends on the degree of risk the fir is %illing to accept" (ince all other inforation indicates that )dond is an individual of integrit&, the acceptance of the client is appropriate, if the auditors recogni=e the high risk of the engageent and increase the e*tent of their auditing procedures accordingl&" At the first indication of inappropriate behavior on the part of )dond, the fir should resign fro the engageent" CHAPTER 6 APPE.+*/ AU+*T CA0E E/ERC*0E0
6C-1
(4U#I4G3 8CG Anal&sis of Audit Plan )stiated tie3 . inutes
(ection
Purpose
Content
45K)C#I)( 4: #) )G@A@)9)G#
#o describe the services that are to be rendered to the client"
#he ob!ectives are 1 audit of 8CG's financial stateents for the &ear ended 1+F.1FJ, and + issuance of a letter on copliance %ith covenants of the client's letter of credit agreeent"
5U(IG)(( AG; IG;U(#RH C4G;I#I4G(
#o describe the nature of 8CG's business and industr&"
8CG sells and services icrocoputers, net%orking hard%are and soft%are to business custoers" #he industr& is sensitive to econoic conditions and ver& copetitive, %ith 8CG copeting %ith copanies uch larger than itself" 8CG2s long-ter success depends on its abilit& to attract and retain $ualified inforation technolog& personnel" #he annual gro%th in spending for inforation technolog& products and services is e*pected to be . per &ear for the ne*t three &ears"
6-+/
Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
PAGGIG@ 9))#IG@( 4BG)R(IP AG; 9AGA@)9)G#
#o indicate eetings held %ith client and %ith CPA engageent tea" #o describe the o%ners and anageent of the copan&"
At this point, one eeting has been held %ith client personnel and one %ith the engageent tea" 8CG is privatel& o%ned b& #err& 8e&stone, 9ark 8e&stone, Kohn 8e&stone, 8eith Houng, and Rita Houng" #err& and 9ark 8e&stone participate in anageent" #he a!or ob!ective of 8GC is to increase revenues b& 6 and increase net incoe b& 7 for each of the ne*t . &ears" 9a!or strategies include3 1 aggressive advertising, + sales to custoers %ith higher risk profiles, and . ne% soft%are developent" #he priar& risks include 1 advertising a& not create the desired results, + credit losses a& e*ceed benefits of increased sales, and . soft%are developent activities a& not produce products" 9easures used to onitor perforance include3 1 inventor& and receivables turnover, + aging of accounts receivable, . sales and gross argins b& t&pe of revenue, / net incoe, and the total inventor& balance" #he procedures used include 1 revie% of inforation fro the prior-&ear2s audit, + In$uiries of anageent, . reading board inutes, / revie% of onthl& perforance reports, revie% of industr& reports, revie% of the copan&2s %ebsite, and 6 revie% of articles in the Ball (treet Kournal" #%o significant risks %ere identified3 1 8CG has engaged in a strateg& to sell to custoers %ith higher credit risk, and + the officers of the copan& receive significant bonuses based on $uarterl& results"
45K)C#I)(, (#RA#)@I)( AG; 5U(IG)(( RI(8(
#o describe 8CG2s business ob!ectives, a!or strategies and the risks related to achieving its ob!ectives"
9)A(UR)9)G# AG; R)I)B 4: :IGAGCIA P)R:4R9AGC)
;escribes the ethods used b& anageent to onitor perforance"
PR4C);UR)( #4 45#AIG AG UG;)R(#AG;IG@ 4: #) CI)G# AG; I#( )GIR4G9)G#
;escribes the procedures used b& the auditors to obtain an understanding of the client and its environent"
(I@GI:ICAG# RI(8(
#o describe the significant risks identified b& the auditors"
(I@GI:ICAG# ACC4UG#IG@ AG; AU;I#IG@ 9A##)R(
#o describe particular accounting and auditing atters of concern"
#hree particular concerns e*ist3 1 proper accounting for e*tended %arranties, + capitali=ation of soft%are costs, and . possible ipairent of soft%are"
PAGGIG@ 9A#)RIAI#H
#o identif& an aount to be used as a easure for planning aterialit&"
5ased on an anal&sis of sales, total assets, and preta* net incoe, an aount of E.00,000 %ill be used as a easure of planning aterialit&"
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Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
(C);UIG@ AG; (#A::IG@ PAG
6C-+
1"
#o provide the schedule for a!or portions of the audit, and the staffing re$uireents for the engageent"
#he section includes a!or dates beginning %ith interi audit %ork through the issuance of an updated anageent letter" A total of 1> hours are budgeted for the audit"
(4U#I4G3 8CG Risks )stiated tie3 +0 inutes Risk 8GC has engaged in a strateg& to sell to custoers %ith higher credit risk"
*!pli'ations and Response #he iplication of this factor is there a& be an increased risk of isstateent of bad debt e*pense and the allo%ance for bad debts" #he auditors a& decide to assign a ore e*perienced auditor to this audit area" In addition, the auditors %ill decide to increase the evidence related to the ade$uac& of the allo%ance b& perhaps e*aining the credit %orthiness of ore of the accounts" In addition, the auditors should not rel& on tests of related controls that %ere perfored in prior periods" #he iplication of this factor is an increased risk that anageent a& isstate $uarterl& results to a*ii=e bonuses" #he auditors a& respond b& ad!usting the staffing of the engageent, increasing the level of skepticis, adding ore unpredictabilit& to the audit procedures, or increasing the evidence collected" #he auditors a& also increase the e*tent of the procedures directed at $uarterl& results"
+"
#he officers of the copan& receive significant bonuses based on $uarterl& results"
6C-.
(4U#I4G3 8CG Capitali=ation of (oft%are ;evelopent Costs )stiated tie3 60 inutes a
8)H(#4G) C49PU#)R( N G)#B4R8(, IGC" ;eceber .1, +0J 9eorandu on Accounting IssuesDAccounting for )*tended Barranties In +0J/ 8CG began developing net%orking soft%are product for sale" #his &ear the copan& has started capitali=ing certain costs of developent" :A(5 (tateents :A( Gos" + and 76, and to a lesser e*tent, :A(5 Interpretation Go" 6 :IG 6 provide guidance in this area" :A( + akes clear that the nature of the activit& for %hich the soft%are is being developed should be considered in deterining %hether soft%are costs should be included or e*cluded in research and developent para" .1" :IG 6 indicates that to the e*tent that the ac$uisition, developent, or iproveent of a process b& an enterprise for use in its selling or adinistrative activities includes costs for coputer soft%are, those costs are not research and developent costs" )*aples of such costs include developent of a general anageent inforation s&ste and the coputeri=ed reservation s&ste of an airline" #his does not appear to be the t&pe of costs involved in this situation"
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Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
:A( 76 further clarifies the issue b& stating that all costs incurred to establish the technological feasibility of a coputer soft%are product to be sold, leased or other%ise arketed are research and developent costs para" ." #he technological feasibilit& of a product is established %hen the enterprise has completed all planning, designing, coding, and testing activities that are necessary to establish that the product can be produced to meet its design specifications including functions, features, and technological performance requirements" Paragraph / of :A( 76 provides a suar& of tests to indicate %hether technological feasibilit& has been established" Costs incurred subse$uent to establishing technological feasibilit& are to be capitali=ed" #he capitali=ation of coputer soft%are costs ceases %hen the product is available for general release to custoers" Costs of aintenance and custoer support should be charged to e*pense %hen related revenue is recogni=ed or %hen the costs are incurred, %hichever occurs first" Barren ove ;ate b
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#he a!or audit issue involved %ill be deterining that the client has properl& categori=ed costs bet%een research and developent those costs involved in establishing technological feasibilit& and those costs that should be capitali=ed" #he auditors %ill have to deterine at %hat point the soft%are product reached the point of technological feasibilit&"
8CG Ratio Anal&sis )stiated tie3 60 inutes 8e&stone Coputers N Get%orks, Inc" Anal&tical Revie% Ratios:or the Period )nded ;eceber .1, +0J
Current Ratio ;a&s' (ales in Accounts Receivable, Coputed %ith Average Accounts Receivable Allo%ance for ;oubtful Accounts F Accounts Receivable 5ad ;ebt )*pense F Get (ales #otal iabilities to Get Borth Return on #otal Assets Return on Get Borth Return on Get (ales @ross Profit F Get (ales (elling, 4perating and Adinistrative )*pense #ies Interest )arned
6-+<
1+F.1FJ 1"1// .<"0 1"0 0". ." 1"< <" 0"+ ++"1 +1"+ 1"<
1+F.1FJ/ 1"+1
Industr& 1".00
.."+ 1"1 0"+ +"< 7". .0" 1"0 +."+ +1"/ /"1
.<"000 ----------+">00 >"0 +>"0 +". +/"0 +."> "
Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
;etails of Coputations of +0J ratios
Current Ratio
Current Assets F Current iabilities E11,7/,7+ F E10,.+,6. Q 1"1//
;a&s (ales in AFR Coputed %ith Average AFR
(ales per da& Average AFR
;a&s sales
Q (ales F .6 Q E>+,76,01 F .6 Q E+.,660 Q 5eg" AFR )nd AFR F + Q E7,./,+/ E10,+.,/<F+ QE>,.7/,>>1 Q Average AFR F (ales per da& Q E>,.7/,>>1 F E+.,660 Q .6">>
Allo%ance for 5ad ;ebts F AFR
E10/,000 F E10,+.,/< Q "010
5ad ;ebts )*pense F Get (ales
E+6,6<7 F E>+,76,01 Q "00.
#otal iabilities to Get Borth
#otal iabilities F (tockholders' )$uit& E10,<<6,+/. F E.,0.,7 Q .".
Return on #otal Assets
Get Incoe F #otal Assets E++>,7<< F E1.,7.0,0>7 Q 0"01<
Return on Get Borth
Get Incoe F (tockholders' )$uit& E++>,7<< F E.,0.,7 Q 0"0<.
Return on Get (ales
Get Incoe F Get (ales E++>,7<< F E>+,76,01 Q 0"00+
@ross Profit F Get (ales
@ross Profit F Get (ales E+0,/1,/7 F E>+,76,01 Q 0"++1
(elling, 4perating and Adin" )*pense F Get (ales
(elling, 4perating and Adin" )*p" F Get (ales E1>,6,/> F E>+,76,01 Q 0"+1+
#ies Interest )arned
4perating Incoe F Interest )*pense E<>6,0+6 F E/<6,7>> Q 1"<
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Chapter 06 - Audit Planning, Understanding the Client, Assessing Risks, and Responding
b and c #his part of the proble reveals ho% difficult ratio anal&sis is %hen there are no a!or changes in ratios" o%ever, the follo%ing ight be considered3 ;a&s (ales in Accounts Receivable • • • • •
Changes in credit polic& 5etter econoic conditions Change in custoer i* 4verstateent of sales Understateent of receivables
Inventor& #urnover • • • •
Change in inventor& polic& Inventor& obsolescence 4verstateent of inventor& Understateent of purchases
;a&s Inventor& on and • • • •
Change in inventor& polic& Inventor& obsolescence 4verstateent of inventor& Understateent of purchases
@ross Profit F Get (ales • • • •
Change in sales i* Increase in sales pricing Reduction of costs Understateent of cost of goods sold and related overstateent of inventor&
A nuber of the other ratios sho% significant changes %hich see due priaril& to the increased level of profitabilit&"
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