Auditing Case #3 Audit Risk and Analytical Procedures Kenneth Mulvenna

Review Comments

Table of Contents
Discussion Question 1................................................................................................................................... 3 Discussion Question 2................................................................................................................................... 3 Discussion Question 3................................................................................................................................... 4 Discussion Question 4................................................................................................................................... 4 Discussion Question 5................................................................................................................................... 4 Discussion Question 6................................................................................................................................... 5 Discussion Question 7................................................................................................................................... 6 Discussion Question 8................................................................................................................................... 6 Discussion Question 9................................................................................................................................... 6 Discussion Question 10................................................................................................................................. 7 Exercise 1 ...................................................................................................................................................... 8

Discussion Question 1 An independent auditor must document that an understanding of the audit engagement has been established with the client. An engagement letter is one method that can be used for this documentation. Why is this documentation required, and what should be included? Analyze the engagement letter prepared by Abernathy and Chapman (Exhibit 3-1). What specific responsibilities is the CPA firm accepting? What responsibilities are assigned to the client company? The engagement letter may include an agreement to provide other services such as tax returns or management consulting allowed under the Code of Professional Conduct. It should also state any restrictions to be provided by the clients personnel in obtaining records and documents, and schedules to be prepared for the auditor. It often includes an agreement on fees. The engagement letter also serves the purpose of informing the client that the auditor cannot guarantee that all acts of fraud will be found. The engagement letter is required to ensure that the auditor and the client have come to agreement on terms and conditions and too inform both parties of their respective responsibilities. Without both parties coming to agreement with the terms and conditions in the engagement letter, the auditor cannot move forward with the audit. Abernathy and Chapman are agreeing to audit Lakesides financial statements for the year ending December 31, 2012. They also agree to express an opinion on the fairness of the financial statements. Abernathy and Chapman mention that if they cannot complete the audit or are unable to form an opinion, they may decline to express an opinion or decline to issue a report as a result of the engagement. Another responsibility of Abernathy and Chapman is to prepare the federal and state income tax returns for Lakeside. The responsibilities of Lakeside include: establishing and maintaining effective internal control over financial reports, identifying and ensuring the company complies with the laws and regulations applicable to its activities, making all financial records and related information available to Abernathy and Chapman, and providing a representation letter to Abernathy and Chapman at the end of the engagement. In addition to the responsibilities mentioned earlier, Lakeside Company will provide a year-end trial balance by January 17, 2013, and an interim trial balance for the first three quarters of the year by October 17, 2012. Also, Lakeside will provide Abernathy and Chapman audit documentation. If Lakeside agrees to everything in the engagement letter presented by Abernathy and Chapman, they are too sign and return a duplicate copy to Abernathy and Chapman.

Discussion Question 2 A client company will report balances for accounts such as Cost of Goods Sold. In order to perform analytical procedures, the auditor must develop expectations from as many sources as possible. The expected balance is then compared with the actual balance and any significant fluctuations are examined further. In the Lakeside case, what sources would be available to the auditor in arriving at an expected figure for Cost of Goods Sold? The auditor should look at previous years Cost of Goods Sold figures to obtain an estimate for the current year. If previous years COGS were a percentage of total sales, then the
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expected COGS should be approximately of the same percentage. Industry averages of COGS could be a great indicator in determining an expected figure. If Lakeside has an annual budget, the numbers estimated for sales would help with the estimation of COGS. And lastly, the auditor should look at Lakesides competition to see where the competitors COGS are roughly around what number.

Discussion Question 3 What potential problem areas would be inherent in auditing a business such as the Lakeside Company? In other words, what accounts or transactions would typically have a high level of inherent risk? There are many accounts and transactions of Lakeside that would have a high level of inherent risk. One might deal with inventory. Obsolescence of a certain inventory items may require a great deal of testing by the auditor. Lakesides large amount of debt and the leasing of their stores increase the inherent risk of Lakeside. A transaction that would have a high level of inherent risk is Lakeside considering going public. Lakeside may be tempted to over-estimate assets and revenues as a source to look good for potential investors.

Discussion Question 4 An audit program is designed to generate sufficient evidence on which the auditor can base an opinion. How does the auditor know when sufficient evidence has been accumulated? To make a final evaluation as to whether sufficient evidence has been accumulated, the auditor reviews the audit documentation for the entire audit to determine whether all material classes of transactions, accounts, and disclosures have been adequately tested. The review is to make sure that all parts of the audit program have been accurately completed and documented and that all audit objectives have been met. As an aid in deciding whether the audit evidence is adequate, auditors often use a completing the audit checklist which is a reminder of the items that may have been overlooked. If auditors conclude that sufficient evidence has not been obtained, auditors are presented with two choices: accumulate additional evidence or issue either a qualified opinion or a disclaimer of opinion.

Discussion Question 5 Mitchell is going to perform analytical procedures on Lakesides trial balance and other accounting data. What is the quality of the evidence that is gathered by this substantive testing procedure? That is, how competent is evidence provided by analytical procedures compared with other types of evidence? Analytical procedures use comparisons and relationships to assess whether account balances or other data appear reasonable compared to the auditors expectations. The usefulness
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of analytical procedures as audit evidence depends on the auditor developing an expectation of what a recorded account balance or ratio should be. Auditors develop an expectation of an account balance or ratio by considering information from prior periods, industry trends, clientprepared budgeted expectations, and nonfinancial information. The auditor considers the level of assurance, if any; he/she wants from substantive testing for a particular audit objective and decides which procedure can provide that level of assurance. Analytical procedures may be effective and efficient tests for assertions in which potential misstatements would not be apparent from an examination of the detailed evidence. It is important for the auditor to understand the reasons that make relationships plausible because data can appear to be related when data is actually not related. There are five types of analytical procedures that auditors compare client data with: (1) industry data, (2) similar prior-period data, (3) client-determined results, (4) auditor-determined results, and (5) expected results using nonfinancial data. The quality of these substantive tests depend on many factors, some include: whether data was obtained from independent sources outside the client, whether sources under the client were independent, whether the data was developed under a reliable system with proper controls, whether the data was subjected to audit testing in the current or prior years, and whether the expectations were developed using data from a variety of sources. Analytical procedures, especially tests involving the trial balance, are of greater quality to the audit because these tests compare current years data to previous years data. By doing, these tests, an auditor can easily see if any material misstatements appear.

Discussion Question 6 How extensive should an auditors knowledge of a clients industry be, and how does the auditor go about getting this type of information? A thorough understanding of the clients business and industry and knowledge about the companys operations is essential for the auditor to conduct an adequate audit. In recent years, several factors have increased the importance of understanding the clients business and industry. Recent declines in economic conditions around the world, information technology, clients have expanded operations globally, and many clients have invested in complex financial instruments. The three primary reasons for obtaining a good understanding of the clients industry and external environment are: (1) risks associated with specific industries may affect the audit, (2) many inherent risks are common to all clients in certain industries, and (3) many industries have unique requirements that the auditor must understand to evaluate financial statements. Many auditor litigation cases result from the auditors failure to fully understand the nature of transactions in the clients industry. This is why understanding the clients business and industry are very important. An auditor can get obtain this information by reading the industrys profile on many business sites. Interviewing business owners of the specific industry is always helpful. Magazines and newspapers can offer insight on industry trends, ratios, major businesses, and the outlook of the near future.

Discussion Question 7 This case suggests that price competition with other CPA firms was an important factor in securing this audit engagement. What are the potential problems for a CPA firm that can arise from acquiring clients through price competition? Price competition forces narrow time constraints on the work of the independent auditor. In order to finish an audit engagement in a short enough time so that a reasonable profit can be made, a danger exists that the auditor will: (1) accept less than sufficient evidence, (2) fail to recognize critical audit areas, or (3) not be able to acquire the depth of knowledge necessary for essential audit judgments. Thus, the argument is frequently raised that price competition leads to a decrease in overall audit quality.

Discussion Question 8 What is the relationship between control risk and planned detection risk? Also discuss the relationship between the level of detection risk and relative amount of substantive tests (e.g., high, moderate, low) to be performed by the auditors. For example, if the detection risk is high, does that mean the auditor should perform more or less substantive tests than otherwise? Control risk is a measure of the firms assessment of the likelihood that a material misstatement will not be prevented or detected by the clients internal control. The evaluation of control risk is based upon the effectiveness of the clients internal control. Thus, if Abernathy and Chapman decide that Lakesides internal controls are poor and need revision, then the control risk will be set at the maximum level. Auditors do not affect control risk. Planned detection risk is a measure of the firms assessment of the likelihood that material misstatements that go undetected by the clients internal control will also go undetected by the firms own audit procedures. The relationship between control risk and planned detection risk is inversely related. If the inherent risk and the control risk are judged to be high for a particular account then the acceptable level of planned detection risk is low; and vice versa. When planned detection risk is at a low level, the auditor must plan to do a higher quality of substantive testing. For instance, if the planned detection risk is high, then the auditor should perform less substantive tests than normal.

Discussion Question 9 How does a CPA firm assess the risk of fraud? How is this assessment related to other elements of audit risk assessment? SAS 99 provides guidance to auditors in assessing the risk of fraud. Auditors must maintain a level of professional skepticism as they consider a broad set of information, including fraud risk factors, to identify and respond to fraud risk. SAS 99 also requires the auditor to make specific inquiries about fraud in every audit. Inquiries of management and others within the company provide employees with an opportunity to tell the auditor information that otherwise
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might not be communicated. SAS 99 requires the audit team to discuss where they might think financial statements could be susceptible to fraud, how management could perpetrate fraud, etc. Auditors should also use many analytical procedures to help identify unusual transactions or events that might indicate a hint of fraud. To sum up, there are five important areas where auditors should focus on to assess the risk of fraud: (1) communications among audit team, (2) inquiries of management, (3) identify fraud risk factors, (4) perform analytical procedures, and (5) execute professional skepticism. When the auditor determines that fraud may be present, SAS 99 requires the auditor to discuss the matter and audit approach for further investigation with an appropriate level of management, even if the matter might be considered inconsequential. The areas identified by fraud risk are primarily in the areas of inherent risk and control risk. Increased fraud risk represents an increase in inherent risk (the risk that errors exist) or will also increase the control risk (the risk that the clients internal control system will not detect the error or irregularity).

Discussion Question 10 Is it reasonable for Abernathy and Chapman to consider accepting Lakeside as a client when the firm is not currently registered with the PCAOB? The registration process is not difficult. Maintaining the status of a registered CPA firm is more difficult and requires that the firm be willing to adjust its operations including independence and staffing quality control standards to meet the higher expectations of the PCAOB. Abernathy and Chapman have sufficient time to become registered with the PCAOB. By being a member of the PCAOB, CPA firms look more appealing to clients because the PCAOB is similar to a big brother of CPA firms. The PCAOB holds CPAs accountable for the audit work that CPAs perform. And the PCAOB requires CPAs every year to increase their knowledge by attending free seminars and classes to stay updated on current laws and regulations. Clients will have more confidence and trust for a CPA firm completing their audit if the CPA is a member of the PCAOB.

Exercise 1 The Lakeside Company Analytical Review Procedures December 31, 2012 Prepared by: Kenneth Mulvenna Date: March 25, 2013 (a) Compute the financial ratios listed in Exhibit 3-2 for Lakeside for the years ended December 31, 2010 and December 31, 2011. Comment on any large fluctuations, unusual fluctuations, or lack of expected fluctuations. Also, give an overall conclusion as to the significance of the change in Lakesides liquidity, solvency, and profitability positions from 2010 to 2011. Use the following format. [Use Case3.xls for a spreadsheet to compute the ratios]. Ratio Current (liquidity) 2010 1.36 2011 1.36 Significance of Change No significant fluctuation, indicating a stable liquidity position (based on this measure of liquidity) Increase may indicate obsolete or slow moving inventory on hand Slight increase may indicate relaxing of credit policies and/or possible understatement of allowance No significant change Decrease indicates less ability to meet interest payments Not enough of a significant change

Average Days Inventory on Hand (liquidity) Average Days to Collect Receivables (liquidity Debt-to-Total Assets Ratio (solvency) Times Interest Earned (solvency) Profit Margin (profitability) Return on Assets (profitability) Return on Equity (profitability)

93.03

100.52

20.63

24.71

74% 3.57 times 3%

75% 2.79 times 2%

8%

7%

33%

26%

Declining return results from a combination of declining net income and increasing total asset base Major decline in return results from a combination of declining net income and increasing equity base

Overall Conclusion: The liquidity measures show no significant change from 2010 to 2011. Lakeside has shown a tougher time meeting interest payments in 2011 compared to 2010. The slight decrease in profit margin could be a result from average days inventory on hand increasing.

(b) Compare the year 2011 financial ratios computed for Lakeside above to the industry average ratios included in Exhibit 3-3. Comment on any large fluctuations, unusual fluctuations, or lack of expected fluctuations. Also, give an overall conclusion as to the significance of the difference between Lakesides liquidity, solvency, and profitability positions in 2011 and the industry average positions. Use the following format. Ratio Current Industry Ave. 2.16 Lakeside 2011 1.36 Significance of Change Lakeside is below the industry average. This may indicate shortterm solvency problems Lakeside is well above the industry average. This may indicate shortterm solvency problems. Lakeside is below the industry average. This will help liquidity. Lakeside is significantly above the industry average; this may indicate long-term solvency problems. Lakeside is significantly below the industry average; this may indicate solvency problems. Lakeside is well below the industry average. This may hurt profitability for future years. Lakeside is only slightly below the industry average. Lakeside is significantly above the industry average.

Average Days Inventory on Hand Average Days to Collect Receivables Debt-to-Total Assets Ratio Times Interest Earned

15 days

101 days

69 days 52%

25 days 75%

9.16 times

2.79 times

Profit Margin

4.2%

2%

Return on Assets Return on Equity

8.1% 19.3%

7% 26%

Overall Conclusion: Lakeside Companys profitability measures seem to be on average with the industry. Lakeside is earning interest per year a lot slower than the industry and their competition. Where Lakeside lacks is within the liquidity ratios, i.e. operations. They have a tough time getting inventory sold.

(c) Scan each of the financial statements and the trial balances included in Exhibits 3-4 through 3-7. Comment on any unusual accounts, account balances, or large, unusual, or lack of expected fluctuations from the previous year. You should find at least 10 items. [Note: you may have more than one finding for each procedure]. Use the following format: Procedure Scan the trial balance. Findings 1. A debit balance appears in the Allowance for Doubtful Accounts account. 2. Inventory Warehouse 3. Accounts Payable Cypress 4. Estimated bonus liability 5. Something appears to be wrong with the information generated by Store Three. The sales for that store have increased by approximately 94% since the previous year. At the same time, the cost of the goods sold has dropped from 58.5% of sales (which is consistent with the other stores) to only 50.3% of sales. Also, the inventory held by this store has risen by over 50%. 6. Repairs and Maintenance Significance 1. Bad accounts may be increasing or a debit entry may have been miss-posted. 2. Over-purchasing of inventory could be a factor. 3. Becoming the sole distributor. 4. Increased mainly because of bonus-sharing plan. 5. These fluctuations could indicate recording errors or an employee attempting to inflate the earnings being reported for Store Three.

7. Sales returns have increased both for the stores and the distributorship.

Scan the income statement. Scan the balance sheet.

Nothing unusual or substantial stands out. 8. Note Payable Trade increase by $296,000. Nothing unusual or substantial stands out.
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6. From 2011 to 2012, this account tripled in balance. The auditor should look into whether new equipment was purchased. 7. This is due to the increase in sales, however; management should look into the quality of their inventory being sold. N/A 8. Becoming the sole distributor of Cypress products should be the result of this increase. N/A

Scan the statement of cash flows.

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