Solutions for Chapter 4 Audit Risk, Business Risk, and Audit Planning

Review Questions: 4-1. Business Risk - Those risks that affect the operations and potential outcomes of organizational activities. Engagement Risk - The risk auditors encounter by being associated with a particular client: loss of reputation, inability of the client to pay the auditor, or financial loss because management is not honest and inhibits the audit process. Financial Reporting Risk - Those risks that relate directly to the recording of transactions and the presentation of financial data in an organization s financial statements. Audit Risk ! The risk that the auditor e"presses an inappropriate audit opinion when the financial statements are materially misstated, i.e., the financial statements are not presented fairly in conformity with the applicable financial reporting framework. 4.#. $usiness risk management is defined as: %&rocess, effected by an entity s board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risks to within its risk appetite, to provide reasonable assurance regarding the achievement of entity ob'ectives.( )*+,+, #--4. The organization itself bears the responsibility for effective implementation of /01. 2t is important for all organizations to implement an effective /01 so that risks are understood and properly controlled by members of the organization, particularly management and the board of directors. 4-3. *orporate losses are tied to risk management because companies simply fail to identify and manage the risks associated with business operations or strategic initiatives. These failures to manage risk often have significant financial implications as seen in the $& oil spill case. 2n addition, failures occur because the organization does not fully appreciate the risks associated with dysfunctional compensation schemes. The financial crisis that began in #--4 clearly demonstrated that financial institutions that did not understand, or manage, their risks failed. *ontrols e"ist to address risks. Therefore, it would be impossible to evaluate the effectiveness of controls without first knowing the risks, or bad outcomes, that the controls are designed to address.

4.4.

5 #-1# *engage 6earning. 7ll 0ights 0eserved. 1ay not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

4-1

4.8.

9hen a company decides to develop a new product, it faces the risk of being unsuccessful, the risk of not fully understanding the technological aspects of their design, or the risk of potential lawsuits. The company also faces a risk if it does not have a comprehensive marketing plan or if it fails to obtain proper regulatory approval for a product. The auditor must consider all of these elements in evaluating the capitalization of research and development costs and the valuation of company products. To identify the risks associated with a client, the auditor should utilize a number of sources and arrive at a decision considering each of them. The ma'or procedures the auditor will utilize to identify fraud risks include: 2n;uiry of predecessor auditor 2n;uiries of other professionals in the business community <iscussions with other auditors within the audit firm that may have had interaction with management or the client in other capacities. 0eview of news media and web searches 0eview of public databases for information about the company, its operations, or any pending legal cases or federal rulings for or against the company. &reliminary interviews with management 2nterviews with audit committee members 2n;uiries of federal regulatory agencies &otential use of private investigation firms. Management integrit refers to the trustworthiness of management in such things as acting in the organization>s best interest, e"hibiting high standards of ethical behavior, providing full access to information needed by the auditor, and acting in an honest and trustworthy manner, not hiding or manipulating information or transactions for personal benefit. The auditor assesses management integrity by making a systematic in;uiry of other professionals and reviewing previous interactions with management. 7ssessment includes 7n in;uiry of professionals in the community in which the client operates, such as bankers and lawyers. 7 review of recent regulatory or court cases against the client, including recent ,/* filings. 7 review of the financial press, including a comprehensive review of 2nternet databases, for information or articles about the company and its management. 7n in;uiry of predecessor auditors as to management integrity, e"istence of disagreements about the audit, and management>s motivation to manipulate accounting principles. 7 thorough review of previous financial reports to uncover financial problems and the ;uality of financial reporting utilized.

4-:.

4-=.

4-#

The auditor s assessment of management integrity is usually considered the most important factor in continuing a client relationship or accepting a new client because management integrity is inversely related to financial reporting risk. ,tated another way: the higher management integrity, the lower is the risk of financial reporting fraud or other misstatements. 4-4. The primary factors a public accounting firm ought to consider before accepting a new client include 1. #. 3. 4. 8. :. =. 1anagement>s integrity and reputation. 6egal proceedings involving the company. The overall financial position of the company and its financial health. The e"istence of related-party transactions. ,tatus and ;uality of previous regulatory filings. ?uality of the company s internal control over financial reporting. 0easons that the client is looking for a new auditor.

+ther factors the firm may consider include 1. #. 3. 4. 8. :. =. @uture growth prospects of the client. /"pertise in providing services to the client )industry knowledge.. &restige gained by being associated with the client. &rospects for future business with the client. &rospects for future business in the industry by being associated with the client. Timing of audit engagement and ability to better utilize e"isting staff personnel. The e"istence of disputes )either fees or accounting issues. with the previous auditors.

4-A.

!inan"ial Reporting Risk is defined as those risks that relate directly to the recording of transactions and the presentation of financial data in an organization s financial statements. The e"istence of financial reporting risks implies that the auditor should specifically identify audit procedures that address the risk that a misstatement would occur in a specific account balance or relevant assertion. The ma'or factors that lead to high financial reporting risk include, but are not limited to: ,ub'ectivity of 'udgments affecting the account balance, e.g. estimates or impairments, *omple"ity of transactions or contracts, e.g. comple"ity of financial instruments, or comple"ity of contracts. 1anagement motivation to misstate the financial statements, e.g. pressure to meet reported earnings. ?uality of the company s internal control system, including the risk of management override and the controls developed to mitigate management override.

4-3

4-1-. 7 %high risk( audit client is one in which the auditor believes that )a. association with the client will have a higher than average potential of material loss to the audit firmB or )b. the company operates in an industry that is considered high riskB or )c. the company s financial results are such that financial failure is a possibility. Cigh risk audit clients are generally characterized by: 1anagement with ;uestionable integrity 2nade;uate capital 6ack of long-run strategic and operational plans 6ow cost of entry into the market <ependence on a limited product range <ependence on technologies that may ;uickly become obsolete 2nstability of future cash flows Cistory of ;uestionable accounting practices &revious in;uiries by the ,/* or other regulatory agencies &oor financial condition 6arge market value stock fluctuations 7n industry characterized by rapid volatility

1any companies that were found to have fraudulent financial statements had been identified by their auditors as high riskB /nron is a prime e"ample. 4.11. 0elated party transactions represent special risk to the auditor because they are transactions that are controlled by related entities so that the facts of the transaction may not represent the substance of the transaction. Cowever, the auditor might not be aware of the nature of the related party transactions and must therefore institute special procedures to determine if related party transactions e"isted. 2f related party transactions are not discovered and properly disclosed, then the financial statements ! which are purported to represent the results of transactions with outside parties ! would be misstated. There are two ma'or alternatives to identify related parties. 1anagement in;uiry would be a good starting point. 0eview of vendor lists to attempt to match names or addresses might also turn up potential conflicts of interest. 7 review of board minutes or other sources for loans granted would be a source as well. 7 second approach is to identify unusual transactions, or transactions that seem to be designed to accomplish a particular financial purpose, and then investigate those transactions to determine if they are related party transactions. 0elated party transactions are especially concerning because they represent a potential breakdown of corporate governance, conflicts of interest, and opportunities to influence the financial reporting process. The transactions represent risks to the auditor because they are often covered up by management.

4-4

4.1#.

The main sources of information that the auditor will look at in determining whether or not to accept a new audit client are: &redecessor auditor +ther professionals in the business community +ther auditors within the audit firm Dews media and web searches &ublic databases &reliminary interviews with management 7udit committee members 2n;uiries of federal regulatory agencies &rivate investigation firms

2t is important to systematically make the accept decision to ensure that all sources are considered, and a %;uick decision( is not made for financial reasons. @or e"ample, if a systematic decision was made for the /nron audit by 7ndersen, they would have been much less likely to retain /nron as a client. 2t is generally believed that the firm was reluctant to give up the total profitability from all services that /nron was providing. 4-13. The auditor should seek information from the predecessor auditor that will assist in deciding whether to accept the new client and that will help plan the audit. ,pecifically, they should ask of their beliefs for why an auditor change was made, how management works with auditors, and the general ;uality of the firms controls. The predecessor auditor should be ;uizzed on any ma'or disagreements with the audit client, especially those dealing with accounting issues or the payment of fees. The auditor also wants to understand if the previous auditor believes there are any problems with management integrity or competencies as weaknesses in both areas create higher engagement risk. They should find out if there were any communications with the management andEor the audit committee concerning internal control issues, illegal acts, or fraud. 4-14. The engagement letter clarifies the responsibilities and e"pectations of the auditor and the client. 2t is formally acknowledged by the client and, in the absence of a formal contract, serves as a contract for an engagement. The engagement letter is referred to if there is a breach of contract suit brought against the auditor. The engagement letter should cover the nature of the audit services to be performed, their timing, the e"pected fees and the basis on which they will be billed, the responsibilities of the auditor in searching for fraud, the client>s responsibilities for preparing information for the audit, and the need for other services to be performed by the *&7 firm. 4-18. &otential successor auditors are re;uired to contact the predecessor auditor to gain information from the predecessor auditor that might have led to the dismissal of the predecessor auditor. The successor auditor must first obtain the client s permission to talk with the predecessor auditor because of confidentiality issues. The in;uiries should include the disagreements with management as to accounting principles, auditing

4-8

procedures, or other similarly significant matters. The auditor should also make in;uiries of company management and the audit committee regarding the reasons for changing auditors and whether there were any disputes regarding accounting principles. 2f the potential audit client is a public company, the previous auditor and management are re;uired to file a report with the ,/* detailing all the substantive reasons for the change. 2f the potential audit client is not a public company, the ma'or source of information is the predecessor auditor. 4-1:. 7udit risk is the risk that the auditor e"presses an inappropriate audit opinion when the financial statements are materially misstated, i.e., the financial statements are not presented fairly in conformity with the applicable financial reporting framework. The auditor sets their level of audit risk based on a number of factors. 7 detailed diagram of those factors is included in /"hibit 4.1. $usiness risk, engagement risk, and financial reporting risk are directly considered when setting audit risk. +nce audit risk is set, the auditor will assess control risk, inherent risk, and then determine the level of detection risk, and therefore will, in turn, determine the nature, timing, and e"tent of substantive audit procedures performed. The important thing to emphasize is that audit risk should be minimized and is determined by the auditor in response to the auditors assessment of engagement risk. 4-1=. Audit risk and materiality are intertwined concepts. 7udit risk is defined in materiality terms, i.e. it is the likelihood that the financial statements are materially misstated. The auditor must design and conduct the audit to gain assurance that all material misstatements will be detected. The lower the level of materiality, the more audit work must be done. 2n summary, materiality must first be set in order to implement the audit risk model. 4-14. The critical dimensions of materiality are )1. the dollar magnitude of the item, )#. the nature of the item under consideration, )3. the perspective of a particular user. These items can be based on either individual auditor 'udgment or can be ;uantified in tables or computer programs that can be used by auditors. The advantage of the more ;uantitative approach is that it )a. promotes consistency across audit engagementsB )b. ensures that important items are addressed in the audit engagementB and )c. presents an initial basis from which an auditor can ad'ust the preliminary materiality assessment. The advantage of the individual auditor approach is that the auditor is in the best position to understand the uses of the financial statements, the ma'or users, and pertinent other factors that may affect the overall presentation of the financials statements. @or e"ample, the auditor may be aware of debt covenants or other restrictions that may affect the assessment of materiality on specific accounts. There is no one correct approach. *learly, there is need for individual auditor ad'ustment to any preliminary assessment of planning materiality. The ,/* has been very adamant that materiality is not a 8F cut-off point, i.e. there are many items that are material that may be much less than 8F of net income.

4-:

4-1A. 7n accounting estimate could not be materially misstated for two consecutive years, but because of the %swing( in the estimate, net income could be misstated because the total change in estimate from a best estimate could have a material effect on the financial statements. To illustrate, assume that the auditor has determined that G8-,--- is material. 2n making an estimate of a liability account, let s assume that last year the auditor believed the estimate was too high by G48,---, but did not re;uire an ad'ustment because it was less than materiality. 2n the current year, the auditor has concluded that the estimate of the same account is understated by G4-,--- ! again an amount less than materiality. Cowever, the swing in the estimates results in an G48,--- additional increment to the income statement this year ! an amount that is clearly material. Thus, the auditor has to e"amine swings in estimates in comparison with the auditor s assessment of the best estimate. 4-#-. The ;ualitative aspect of materiality recognizes that some items, because of their very nature, may be ;uite significant to users ! even if the dollar magnitude is less than most ;uantitative measures of materiality. 7s an e"ample, a company may be developing a new line of business with very high e"pected growth. 7 decline in the rate of growth may be very significant to the stock market even if the dollar amounts are not material to the overall financial statements. 7uditors understand this concept and will increasingly be called upon to implement it in the preparation of financial statement audits. Thus, the auditor s planning materiality has to incorporate these ;ualitative factors which may cause planning materiality to be lower than if it were based solely on ;uantitative factors. The ,/* provides guidance on situations in which a quantitatively small misstatement may still be considered material because of qualitative reasons. These include the following:

the misstatement hides a failure to meet analysts> consensus e"pectations for the company the misstatement changes a loss into income or vice versa the misstatement concerns a segment or other portion of the company s business that plays a significant role in the company s operations or profitability the misstatement affects the company s compliance with regulatory re;uirements the misstatement affects the company s compliance with loan covenants or other contractual re;uirements the misstatement has the effect of increasing management>s compensation ! for e"ample, by satisfying re;uirements for the award of bonuses or other forms of incentive compensation the misstatement involves concealment of an unlawful transaction.

4-=

4-#1. 7 literal interpretation of setting audit risk at 8F is that if a client>s financial statements are materially misstated, the auditor, on average, would fail to detect the misstatement on appro"imately 8 of every 1-- engagements. +bviously, an audit firm could not stay in business if it failed to detect 8 of every 1-- material misstatements. To set audit risk at the 8F level, the auditor makes two assumptions. @irst, not every client>s financial statements contain material misstatements. Thus, setting audit risk at 8F does not mean that 8 of 1-- audited financial statements issued contain material errors. ,econd, and more important, the auditor often assumes that inherent risk is 1--F, that is, there is a 1-- percent probability that the financial statements would have a material misstatement if there were no internal control policies or procedures to prevent or detect and correct the misstatement. $ecause this is not likely, the auditor>s actual level of risk is substantially less than 8F. 4-##. 2nherent risk is the susceptibility of transactions to be recorded in error. 1ore formally, it is defined as the susceptibility of an account balance to a material misstatement, assuming that there are no related internal control structure policies or procedures. 2nherent risk is difficult to measure and assess. The auditor does know, however, that some transactions are inherently more risky or more susceptible to error in the recording process than are others. Dormal sales transactions are less susceptible to error than a comple" sale transaction negotiated at the end of the year with shipment to take place early in the ne"t period. $ecause inherent risk is difficult to measure, auditors tend not to measure it and to assess it at 1--F to compensate for setting audit risk at some high level such as 8F. 9hen choosing to assess inherent risk at less than !!", the auditor must be aware that actual level of audit risk incurred on the audit engagement may increase unless the auditor also chooses to establish audit risk at less than 8F. The rationale is that the auditor uses 8F because he or she knows that inherent risk is less than 1--F. Cowever, if inherent risk is correctly assessed inherent risk at #8F and audit risk is left at 8F and an audit program is built on these parameters, the auditor will incur an actual audit risk of 8F. 2f, however, inherent risk is #8F and the auditor assesses it at 1--F, then actual audit risk will be at 1.#8F, significantly less than the nominal 8F level. Thus, auditors ought to be very careful about changing assessed levels of inherent risk without considering the effect on overall audit risk. 4-#3. The four primary limitations of the audit risk model are 2ts difficulty to formally assess. 2ts sub'ective determination. 2ts treatment of each risk component as separate and independent when in fact the components are not independent The lack of precision of audit technology to assess accurately each component of the model. 7uditing is based on testing, and precise estimates of the model>s components are not possible. 4-4

@urther, the audit risk model is useful for helping the auditor determine substantive procedures to perform in the financial statement audit. Cowever, for an auditor performing an integrated audit, the model is not particularly useful in helping the auditor determine the nature, timing, and e"tent of control procedures to perform in order to opine on the effectiveness of internal controls. The audit risk model is a conceptual guideline, not a ;uantitative guideline. 7n understanding of the risks will allow the auditor to develop an audit within the overall framework. The limitations, if understood, will minimize e"cess reliance on components of the audit risk model when such reliance is not 'ustified. 4-#4. The analysis of the audits of the 6incoln @ederal ,avings H 6oan demonstrates the importance of fully understanding an audit client s business, including the economics of the company, economic trends affecting the client, and the risks inherent in the client s transactions. Cad they understood the housing market in the &hoeni" area, they could have better assessed the actual substance of the loan transactions. @or e"ample, although many of the transactions met the literal interpretation of a specific accounting standard, the substance of the transactions was such that 6incoln was making a loan to an undercapitalized business to purchase real estate from 6incoln ,avings H 6oan at inflated prices. The auditor could have learned about the nature of the real estate market by utilizing 2nternet software designed to gather information about businesses, knowledge management systems established by accounting firms, on-line searches, ,/* filings, financial press, or broker analyses. 2t is important for an auditor to know such information about a savings and loan organization because )a. the real economics of a transaction, not the form of the transaction should drive the accounting treatmentsB )b. the knowledge alerts the auditor to situations where the company is engaging in uneconomic decisions and allows the auditor to ask penetrating ;uestions and to investigate problemsB )c. the knowledge helps the auditor determine if there are violations of regulatory re;uirements that may affect the clientB and )d. the knowledge puts the auditor in a better position to evaluate the collectability of loans as loans represent the ma'or asset of the company. 4-#8. 9hen business is declining, the company is likely to see a decline in sales and a conse;uent build up in inventory, resulting in lower inventory turnover. 7lso, in a declining business environment, there will likely be downward pressure on the company s products, for e"ample, many automobile companies have had to cut prices in order to move inventory. @urther, it is possible that other competitors could still be introducing new products that would make some of the client s older inventory obsolete and a further decline in the value of the inventory. 9hen auditing for those risks, the auditor would: <etermine the decrease in inventory, usually by product line, <etermine the rate of sales at current sales prices, <etermine the decline in market prices for goods sold.

4-A

&erform a detailed analysis of slowly moving products to determine if they are obsolete, or if they need to be ad'usted downward to market value.

4-#:. Risks that may be present in a company, and that may be associated with material misstatements in the companys financial statements include: +perations in regions that are economically unstable, for e"ample, countries with significant currency devaluation or highly inflationary economies. +perations e"posed to volatile markets, for e"ample, futures trading. +perations that are sub'ect to a high degree of comple" regulation. Ioing concern and li;uidity issues including loss of significant customers, or constraints on the availability of capital or credit. +ffering new products, or moving into new lines of business. *hanges in the entity such as ac;uisitions or reorganizations. /ntities or business segments likely to be sold. The e"istence of comple" alliances and 'oint ventures. Jse of off balance sheet finance, special-purpose entities, and other comple" financing arrangements. ,ignificant transactions with related parties. 6ack of personnel with appropriate accounting and financial reporting skills. *hanges in key personnel including departure of key e"ecutives. <eficiencies in internal control, especially those not addressed by management. *hanges in the 2T system or environment, and inconsistencies between the entity s 2T strategy and its business strategies. 2n;uiries into the entity s operations or financial results by regulatory bodies. &ast misstatements, history of errors or significant ad'ustments at period end. ,ignificant amount of non-routine or non-systematic transactions including intercompany transactions and large revenue transactions at period end. Transactions that are recorded based on management s intent, for e"ample, debt refinancing, assets to be sold and classification of marketable securities. 7ccounting measurements that involve comple" processes. &ending litigation and contingent liabilities, for e"ample, sales warranties, financial guarantees and environmental remediation.

The existence of one or more of these risk factors does not necessarily mean that there is a material misstatement present. The presence of one or more of these risk implies increased planned audit work, that should be specifically targeted to address the identified risks.

4-1-

4-#=. The ,/* and auditing standard setters emphasize that the auditor should utilize a riskbased approach to the conduct of an audit. The main point is that a risk-based approach should consider )a. the business risk affecting the company, and )b. the ade;uacy of internal controls over account balances in determining the e"tent of audit testing to perform. @or e"ample, if the market for the company s products is deteriorating because of the introduction of superior products by a competitor, then there is a high risk that some of the inventory will be obsolete. This should cause the auditor to e"pect a decrease in the client s inventory account. 7nother e"ample is the sub-prime lending failure and the likelihood of an increase in failure rates. These factors signal a slow-down in the economy, as well as higher risks with receivables and loans. 7ccordingly, the auditor would e"pect that the client s allowance account to increase. The auditor should focus on the valuation of the receivables and loans. The development of independent e"pectations about the client s performance allows the auditor to plan the audit more effectively and to identify areas needing more audit work. The risk analysis allows for a more efficient audit because the auditor will be able to concentrate on areas where there is a greater likelihood of misstatements. 4-#4. The background information that will assist the auditor in determining the e"istence of a problem with inventory obsolescence or accounts receivable problems include: *omparison of client ratios with industry data. @or e"ample, the number of days> sales in receivables or inventory in comparison with industry norms may indicate a potential problem. 0eview of industry prospects for new products or new competitors. This information is found in industry trade 'ournals and in current business publications such as The 9all ,treet Kournal, $usiness 9eek, @orbes, or @ortune, or through review of ma'or information sources on the 2nternet. *ompany product reviews in consumer magazines such as *onsumer 0eports. 0eview of industry database or data analysis maintained by the public accounting firm. 1any public accounting firms have industry specialists who keep tabs on an industry and prepare periodic analyses of the industry. 0eview of brokerage firm reports on the industry and on the client. ,ome brokerage houses develop specialized e"pertise on certain industries. @or e"ample, one may follow the paper industry in detailB another may focus on the retailing industry. 1ost of them will make their reports available.

2n addition to these above sources, the auditor can perform a computerized data search utilizing such traditional services as D/L2, or other 2nternet services such as Coovers +n 6ine to find information about the company or its products. 1ost audit firms will develop 2ntelligent ,ystems and related database systems to gather data about clients, company products, and industry trends. 4-11

4-#A. The auditor can identify a number of important factors simply by touring a plant that will assist in planning and conducting the audit. These include: 4-3-. Misualization of cost centers and the flow of goods into and out of the production process that should be helpful in identifying overhead allocations and in analyzing material variances. +bservation of shipping and receiving procedures, inventory controls, potentially obsolete production, and possible operational inefficiencies. *lient>s use of e;uipment, as well as observation of idle e;uipment. Dew construction and use of new e;uipment. /"tent of scrap and apparent controls over it. &otential obsolete inventory and the general procedures for handling inventory which is useful in making plans to observe inventory. 2ntroduction to key management and production personnel who may need to be contacted later about inventory or cost control procedures. The condition of the company s facilities. The auditor can form a general impression about competitiveness and efficiency.

0atio and industry trend analysis can be useful in pointing out significant trends in the industry or changes in individual account balances. 0atio analysis can indicate whether the client is lagging behind the industry in important aspects, such as credit collection or in amounts of inventory carried. This analysis re;uires the auditor to first develop e"pectations about account balances and trends. $oth types of analysis may point out areas that need to be given special audit attention. 2t forces the auditor to understand the Nbigger picture of the operation of the client, and helps put into conte"t other audit findings.

4-31. 2nventory turnover, number of day s sales in inventory, and number of day s sales in receivables would be very useful in this situation. @or e"act formulas, see e"hibit 4.1-. 4-3#. 0isk analysis affects the account balances as follows: allo#ance for loan losses: if the account is considered high risk, the auditor would want to gather more data than normal, both internal data and industry data. @or e"ample, if competitors in the industry were all seeing increasing loan losses, it is likely that the client would be as well. inventory: if the account was considered high risk, the auditor would probably want to take more physical counts than usual. They would also want to make a greater effort to check for obsolescence )maybe through physical inspections..

4-1#

sales commissions: if the account was considered high risk, the auditor would probably want to perform walk-through procedures to ensure that the proper amount of commission is taken on each type of sale. accounts receivable: if the account was considered high risk, the auditor would probably want to seek more confirmations of account balances, check more subse;uent collections, review credit policies, and check the allowance account assumptions.

@or each of these account balances, an auditor who is more skeptical about the client would collect even more evidence, and would evaluate it more critically. Multiple Choi"e Questions: 4-33. 4-34. 4-38. 4-3:. 4-3=. 4-34. 4-3A. 4-4-. 4-41. 4-4#. 4-43. c. d. d. d. c. b. c. d. e d. d

#is"ussion and Resear"h Questions: 4-44. Business Risk #efinition: Those risks that affect the operations and potential outcomes of organizational activities. $mportan"e to Audit: The auditor must understand the comple"ity of the business and its risks as a basis for determining )a. whether the auditor has sufficient knowledge to audit the client, )b. whether the auditor understands the approaches taken by management to manage risks, and )c. the measurement of the risks that affect the financial statements. Assessed or Controlled: 7ssessed %ngagement Risk #efinition: The risk auditors encounter by being associated with a particular client: loss of reputation, inability of the client to pay the auditor, or financial loss because management is not honest and inhibits the audit process.

4-13

$mportan"e to Audit: 1any firms now have strict client acceptance and client retention procedures in place that are used yearly. 2f the decision is to maintain a relationship with the client, audit procedures should reflect the riskiness that was determined during the acceptance and retention stages. Assessed or Controlled: 7ssessed and controlled. The auditor can choose not to accept the client. !inan"ial Reporting Risk #efinition: Those risks that relate directly to the recording of transactions and the presentation of financial data in an organization s financial statements. $mportan"e to Audit: The overall audit approach and the e"tent of the procedures performed are ad'usted following the assessment of financial reporting risk. Assessed or Controlled: 7ssessed. Audit Risk #efinition: The risk that the auditor e"presses an inappropriate audit opinion when the financial statements are materially misstated, i.e., the financial statements are not presented fairly in conformity with the applicable financial reporting framework. $mportan"e to Audit: The auditor sets the level of audit risk. The level that it is set at determines the amount and type of substantive procedures to be performed. Assessed or Controlled: *ontrolled. $nherent Risk #efinition: 0isk of material misstatement that is higher in certain processes merely because of their natureB assumes that controls are not e"istent. $mportan"e to Audit: &rocesses that have a high inherent risk should re;uire a greater focus of attention. Assessed or Controlled: 7ssessed. Control Risk #efinition: The likelihood that a material misstatement could occur in a transaction or ad'usting entry that will not be detected by the entity s internal controls.

4-14

$mportan"e to Audit: *ontrol risk e"hibits the need for internal control assessments in every audit engagement. The assessment of control risk will then determine the amount and type of audit procedures performed. Assessed or Controlled: 7ssessed. #ete"tion Risk #efinition: The risk that the auditor will not detect a material misstatement that e"ists in an account balance. $mportan"e to Audit: The determination of detection risk directly determines the nature, amount, and timing of audit procedures to ensure that the audit achieves no more than the desired audit risk. Assessed or Controlled: *ontrolled. 4-48. a. 7 company with good risk management will have implemented procedures such that they are aware of their risks, including financial reporting risks, and have taken appropriate steps to mitigate those risks, or to control them at a level consistent with the organization s strategy and risk appetite. 7s it relates to specific account balances, a company that has good risk management will have a lower likelihood of encountering high levels of obsolete inventory, or high levels of uncollectible receivables. 0isk management is more than financial reporting risk and the auditor would find that the company takes calculated risks in introducing new products or ac;uiring new companies. Typical risks in developing and introducing a new product are: 0isk that 0H< activities may not produce a viable product 0isk that the new product might not meet government standards 0isk that the new product might be a deviation from previous products, and thus deteriorate brand e;uity 0isk that the new products sales will be less than e"pected 0isk that new product could cause lawsuits or other liabilities

b.

*ontrols that would be applicable to address these risks might include: capital budgeting process that lays out the cost of development and e"pected return, a comprehensive /01 process that includes the development of a risk appetite and a portfolio of risks, i.e. the company will develop many different products at a time.

4-18

a thorough ;uality review process to ensure that all new products meet the company s and the government s standards, a culture that the company will meet high consumer e"pectations. a comprehensive strategy for product development that considers a portfolio of products. ;uality testing to ensure that the product meets the company s ;uality e"pectations as well as user e"pectations. continuous market testing to determine consumer interest and needs. a research and development strategy that invests in ;uality personnel and research to bring out high ;uality products.

&ossible effect on the organization if controls are not in place: economic effects, including significant losses due to product not meeting market e"pectations, ;uality e"pectations, or sub'ecting the company to lawsuits. long$term effects% if a company does not have a long-term strategy or does not have a process to develop high ;uality products, it may not be able to survive in the marketplace.

c.

There is a direct relationship between risks and controls. All controls are designed to mitigate or control specific risks. Thus, as auditors evaluate controls, it is always in the conte"t of mitigating specific risks. 2n financial reporting, those risks related to misstated account balances and assertions.

4-4:. There are a number of risks associated with the payment of a unionized factory worker. a.,ome risks that should be addressed include: &ayment made for hours not worked, ,omeone else punching the employee s time card when the employee is not present. &ayment made for incorrect amounts, 2mproper computation of fringe benefits and recording of the associated liabilities, 2ncorrect allocation of labor to the proper products, &aying a fictitious person.

b.,ome of the controls that a company may consider include:

4-1:

,upervisory review and sign-off of time worked for each employee in each area )either by the day or by the week., 0e;uired data capture of the specific 'obs or products worked on )either on the time card, or re;uired punch in at data stations in the factory., 7uthorized pay rates put into a computer table by the C0 department and limited access to change the rates, &roper testing of all computer programs. &eriodic review by payroll department and then by internal audit of the calculation of liabilities associated with payroll. separation of management of long-term assets, e.g. pensions, to meet employee obligations. independent internal audits of the payroll process. segregation of duties in payroll such that any complaints about pay rates or benefit administration could be directed to someone other than the person making out or approving the payroll checks or benefits payments.

4-4=. aHb. The debate is a meaningful one. /ventually, every audit gets involved in direct testing of account balances to determine whether there is a material misstatement in the account balance or the financial statements as a whole. Cowever, as the research pointed out in the chapter, the ma'or audit failures of the last decade tended to occur because auditors had developed a habit of testing the accounts and looking for technical compliance with I77& while not understanding the underlying economics of the company and its transactions. The auditor must not only analyze technical re;uirements, but is called upon increasingly to comment on the overall fairness of presentation ! at least to the audit committee. @inally, we need to emphasize that there are many areas of financial statement audits where simply technical auditing will not work. @or e"ample, the auditor needs to understand strategies, the economy, competition, and so forth to make estimates of inventory obsolescence, collectibility of receivables, or product warranty liabilities. 1any audit firms have determined that auditor # s analysis is the better analysis. 7nalytical review and a business risk analysis are not designed to replace %old fashioned audit testing(, but it brings a fuller perspective to the audit tests. 2t also allows the auditor to focus on accounts most likely to contain a material misstatement. 2n this way, both auditors approaches are complementary, not conflicting. 0egarding 7uditor 3, the essence of this chapter is that the auditor is more than an accountant. The auditor must understand a business and its risks in order to perform an efficient and effective audit.

4-1=

@urther, the ,/* and auditing standard setters have been pushing the profession to perform risk-based audits in order to achieve greater efficiency in the audit while maintaining audit effectiveness. c. The ,/* concerns are well-founded. &t should be noted that the 'E(s concerns apply to the improper implementation of a risk$based approach to an audit) not to the applicability of a risk$based approach to auditing. 0ather, the ,/* has e"pressed concern that some firms )especially in the period of time leading up to the issuance of the ,arbanes-+"ley 7ct of #--#. that auditors were substituting pseudo-risk analysis for real risk analysis and real auditing. 9henever auditors fall into the trap of %mindlessly( following procedures and not analyzing the implications of their findings, they can fall into an audit approach that will likely miss material misstatements. 7nalytical review is not the only procedure performed, nor is analytical review only compared with previous company results. The full business risk approach will analyze company results and compare it to industry trends and current economic trends affecting the company. Thus, while the current results may be consistent with previous years, they might not be consistent with other economic trends or with competitor trends. The auditor needs to investigate both and reach a 'udgment about material misstatement. @or e"ample, if the company results were consistent with previous years, but there have been ma'or changes in the economy such as a ma'or interest rate change, a downturn in the economy, a slowdown in housing, new competitors, and so forth, it should heighten the auditor s skepticism towards the correctness of the client s account balance. The key is that business risk analysis is much more than analytical review. d. The results should be une"pected, although most clients will regularly argue that due to their superior management, it should be e"pected that their revenue will increase faster than that of the industry as a whole. That may be the case. Cowever, it is usually difficult for a company to have both )a. increased revenue above industry averages, and )b. an increase in gross margin. The e"ception to this generalization would be when 7pple introduced the i&hone or the i&od. Thus, the auditor would need to e"plore potential e"planations of the ratio changes, which might include: 2ntroduction of a new product such as the i&hone that has great market acceptance, @ictitious sales, +verstatement of year-end inventory )causing a reduction in *+I,. Dew production approaches and efficiencies 7pplication of the risk-based approach to auditing would re;uire the auditor to assess which of the above e"planations seem most plausible. Then, the auditor will ad'ust the audit procedures to focus on the most plausible e"planation, thus hopefully developing an efficient audit approach that focuses on the important risks.

4-14

4-44. a. 1anagement integrity is defined as the general honesty of management and its motivation for truthfulness )or lack thereof. in financial reporting. 2t is a reflection of the e"tent to which management shows good business practice and to which the auditor believes that management>s representations are likely to be honest. 2f the auditor ;uestions management>s integrity, the nature of the audit evidence to be gathered will be affected as follows: The auditor will not be able to rely on management>s representations without significant corroboration. The audit evidence generated from internal documents must be evaluated with a great deal of skepticism. The auditor will seek more e"ternal audit evidence and corroboration from outside parties, including vendors and customers. The auditor must consider the possibility that management would be motivated to misstate the financial statements to accomplish personal ob'ectives. Thus, the auditor should investigate any significant changes in account balances or ratios that may indicate management misstatement. b. ,ources of evidence pertaining to management integrity might include 2n;uiry of members of the professional community in which the client operates, such as bankers and lawyers. 0eview of recent regulatory or court cases against the client, including recent ,/* filings. 0eview of the financial press, or 2nternet $usiness or database providers, for articles about the company and its management. 2n;uiry of predecessor auditors as to management integrity, e"istence of disagreements on the audit, and management>s motivation to manipulate accounting principles. 0eview of previous financial reports to uncover financial problems and the ;uality of financial reporting utilized. Jse of private investigators to gather information on management>s integrity if the situation merits. c. 7nalysis of ,cenarios: a. This is a fre;uent business practice and is not considered to reflect negatively on management>s integrity. 1any members of management believe that it is their obligation to minimize their overall ta" burden. The e"istence of related-party transactions, however, should alert the auditor to plan the audit to ensure that the economic substance of related-party

4-1A

transactions are discovered and described in the annual financial statements. The auditor should also be alert to ta" planning strategies that *ongress and the general public consider Nover the edge because it is likely that such strategies will be challenged ! if not in court, then at least in the court of public opinion. @inally, the mere e"istence of related parties creates an opportunity to use transactions with the parties to inappropriately portray the real economics of the business. The auditor should plan a thorough investigation to ensure that all related party transactions are fairly disclosed. b. This is a common business trait and seems to be widely accepted. Cowever, it is also an indication of a potential problem when a member of management is so domineering that he or she can intimidate other members of the organization to achieve their ob'ectives, no matter how achieved. There have been many instances of ma'or management fraud by intimidating managers. The auditor must be alert to the potential effect on the overall control structure of the organization. 2f employees are punished for not achieving a specific ob'ective or are highly rewarded for achieving a specific ob'ective, there may be motivation to accomplish the ob'ective by manipulating the financial reporting process. c. 7s in the previous scenarios, this is not an uncommon trait. 2n the author>s view, this is an unfortunate statement about the status of accounting principles in the Jnited ,tates. Two factors in this scenario should raise the auditor>s skepticism: the manager )1. has a very short-term orientation and )#. has shown a tendency to change 'obs after achieving the short-run ob'ectives. The scenario is one of high risk and should raise the auditor>s awareness of significant accounting manipulations resulting in the substance of the transaction not being reflected in the financial statements. The auditor should be critical of the accounting for estimates, the use of reserves, or other changes where sub'ective accounting 'udgments are made. d. This should be a good scenario for discussion. +stensibly the manager is a pillar of the business community. Cowever, two factors are unsettling: )1. the previous conviction on ta" evasion and )#. the current manipulation among controlled corporations to avoid ta". 7lthough this latter practice is common, the auditor must determine whether such manipulation does not violate the federal income ta" provisions. Cowever, most auditors would consider this to be a high risk situation. The auditor should determine if there are any issues still outstanding from the previous ta" return and whether there are potential constraints on the president s activities resulted from the ta" conviction.

4-#-

The auditor should have management list all controlled or partially controlled organizations and all related-party transactions during the period under audit. e. The scenario reflects poorly on management>s integrity. The attitude is that it will do something only after being Ocaught.O ,uch an attitude raises ;uestions about management>s openness with the auditor in disclosing transactions or ;uestionable accounting. This situation raises some interesting ;uestions for the auditor. @irst, there is a ;uestion about whether the auditor wishes to be associated with such a client. The engagement risk may be too high. ,econd, the auditor will probably have to e"pand the audit to determine whether any unrecorded liabilities are associated with environmental protection. The auditor must consider whether an audit can be performed within the planned audit time frame without substantial client cooperation. 2t is doubtful that such cooperation will be forthcoming. f. *harles obviously has charisma. 7gain, there may be nothing wrong, but there have been a number of situations in which management has e"hibited an e"travagant life-style that would be difficult to 'ustify by the earnings of the company. The scenario should serve to heighten the auditor>s skepticism. The situation would cause the auditor to carefully e"amine transactions with company management to ensure that they are all legitimate. 2n other words, if there is any impropriety, the nature of transactions with management becomes material - almost regardless of the dollar amount. $ecause the company has grown ;uickly, the auditor must be alert to pressures e"erted by management to sustain such growth. That pressure could result in inflated transactions. d. I0+J& <2,*J,,2+D. The purpose of this ;uestion is to have students focus on the reality of practice that it is often difficult to distinguish between an individual that is a strategic genius versus one that also ma'or ethical failings. ,ome of the characteristics that the group might identify are: <ominance by management over all activities, &ressure to meet economic goals, @ocus on earnings per share and meeting analysts e"pectation, &ays lip service to risk management, 7pproves loans to lower levels of management, thus making them somewhat indebted to him or her, ,urrounded by an ineffective board or audit committee, *heats on e"pense accounts, $lurs the lines between corporate e"penses and personal e"penses, e.g. use of a corporate airplane, ,trong focus on ac;uisitions that boost current profits, but little attention paid to integrating the operations.

4-#1

4-4A. The client is a continuing audit clientB thus, the firm>s audit file on the client and reports to the ,/* or other users should serve as a ma'or source of information to be used in planning the audit. The primary sources of information the auditor should consult include: 1. &rior year working papers, including the permanent file, to obtain information about &lanning materiality. 7udit ad'ustments and difficulties encountered during the audit, 7udit budget and actual time on various parts of the audit. 1atters of continuing audit importance, such as loan agreements and key personnel. /ngagement letter and constraints affecting current years audit. 7udit staff personnel assigned 2ndustry accounting or auditing pronouncements as they may affect the client and any actions the client took in previous years to implement the pronouncements. 2dentification of risk factors. &revious reports. &artner and supervisory memos assessing important audit areas. 7ccount assessments of continuing importance such as allowance accounts, warranty estimates, or loan loss reserves. *omments by the prior year auditors about changes they recommend for the current year audit. 0eports to regulatory agencies or other special purpose reports: 2dentification of important reporting items. *urrent reporting re;uirements. 0eview of regulatory correspondence: &otential risks for client. &otential implications for current year reports. 0eview of business periodicals: *urrent business news about the client. 2ntroduction of new products. +verview of current economic developments, competitor actions, and other competitive developments affecting the client. 0eview of industry databases: *omparison of company developments and financial results with industry averages and trends.

#.

3.

4.

8.

4-##

:.

2nterview with top management: +perating plans such as new construction, new product developments, or ma'or financial plans such as mergers, ac;uisitions, or new plant developments. 1anagement>s assessment of the company>s prospects, risks and so on. The concerns management wishes to have addressed during the audit. 0eview of internal audit reports: &roblem areas identified during their audits. 7ctions taken by the auditees, management, and audit committees. &otential planning for cooperation with e"ternal auditor in performing the yearend audit. *ompetence and coverage of audit work. 0eview of audit committee meetings: ,pecial concerns. &revious topics and disposition. <iscussion with audit partner: Time budget and personnel assignment preferences. &reliminary assessment of risk factors. Timing for the audit. <ue date and type of audit reports or other reports to be issued.

=.

4.

A.

4-8-. a. There is an inverse relationship between client riskiness and materiality thresholds. Thus, a riskier client will re;uire a smaller threshold. 2n this case, the materiality threshold for *lient 7 should be less than that for *lient $. @urther, the auditor will need to collect more audit evidence to obtain the same level of assurance for *lient 7 compared to *lient $. b. /ach individual auditor will make different professional 'udgments compared to other auditors. ,ome of the individual characteristics that may affect an auditor s professional 'udgments include their level of e"perience, their training, whether or not they have encountered a client that has engaged in fraud, and their professional skepticism, among others. c. 2f one auditor is more professionally skeptical than another auditor, they would likely set the materiality threshold even lower than another auditor in the scenario described in part )a. of this problem. Thus, if a less skeptical auditor set materiality at G4,---, a more skeptical auditor might set it at G3,--- and would accordingly collect even more evidence in support of their 'udgment about whether accounts receivable was or was not materially misstated. 4-81. 4-#3

a. &ther $nformation 2ntegrity of 1anagement Sour"e of &ther $nformation 2n;uiries of other business professionals. 2n;uiries of previous auditors. 2nterviews with management ,/* filings. &rivate investigation. 2n;uiries of others in firms. &ublic databases. 2nterview with management 2nterview of the $oard of <irectors 2nterview with management and the board of directors. 0eview of annual reports to the public as well as ,/* filings. 1ake in;uiries of lawyers regarding knowledge of legal actions against the company. 2nterview with management 2nterviews with operating personnel Misit to operations. 2nterview with management +verall analysis of the industry *omparison of company with competitors 0eview of company in industry magazines, including company prospects 2nterview with management Misits to locations. $ackground information on the client by searching the 2nternet or other sources of information about the potential client.

/"pectations of 1anagement *ompany ,trategy

&otential 6egal 7ctions Taken 7gainst *ompany

/"tent of computerization of operations

Irowth /"pectations

6ocations and general nature of operations.

7nalysis of $usiness 0isk

b.

7uditors often bid low on the audit fee because of the anticipation of greater consulting work with a potential client. The positive aspects of such behavior are: lower audit fee for the client. increased emphasis on audit efficiency. 4-#4

 potentially lower cost for the client enabling them to pass on cost savings to consumers. The potential negative aspects of the behavior are: audit function becomes non-profitable, thus 'eopardizing its ability to attract and retain the type of employees needed for the demanding work. too much emphasis is placed on obtaining other workB possibly at the risk of compromising on audit issues to retain the client. if the audit is not profitable, it may lead to )1. short-cuts in audit procedures resulting in a less effective auditB and )#. lack of investment in new technology to make the audit effective. c. 7n intelligent agent could be programmed to search all meaningful databases and newspaper articles for information about the client or its management. The agent could bring relevant items to the auditor s attention so that the firm could address potential problems in a timely fashion and to understand emerging risk areas. @or e"ample, the intelligent agent may bring information about a new competitive product that may cause obsolescence for some of the client s products. The auditor could then meet with management to determine what plans management has to deal with the potential valuation problem. +ther options of using the internet include: 0eview on-line chat about the company using such databases as finance.yahoo.com 0eview industry analysis on a company through a website such as Coovers online. &erform a Ioogle search on the company and its products. &erform a product review by search relevant industry trade magazines on the company s products. d. $ob would want an engagement letter to ensure that both he and the client understand both the client s and management s responsibilities and e"pectations regarding the audit. 2n addition, the engagement letter sets forth information such as the timing of the audit, e"pected client preparation for the audit, and the tentative fees for the audit.

4-8#. 7greement or <isagreement with each of the statements:

4-#8

1. 7gree. 1ateriality can be applied both ;uantitatively and ;ualitatively. 2t is a concept that helps guide the auditor in determining the amount of evidence to be gathered and making 'udgments on the correctness of a company s financial statements. #. 7gree. ,etting audit risk at a low level such as 8F is acceptable as long as the auditor uses conservatism elsewhere in the audit engagement. ,etting audit risk at .-8 implies that 8F of audits would end with an incorrect audit opinion. ,uch a failure rate would be unacceptable to the profession. 7s a compensation for audit risk in the model, many firms assume inherent risk is 1.- )1--F.. This ensures that the audit risk is significantly below the nominal .-8 level. 3. 7gree. 2nherent risk may be so low that the auditor may not need to perform direct tests of an account balance. Cowever, the auditor should perform some indirect tests of the account balance, such as substantive analytical review procedures, to determine if the account balances appear to be stated at amounts other than e"pected. 2f the amounts differ significantly from e"pectations, the auditor would need to perform additional direct tests. 4. 7gree. The auditor must gather evidence that not only are controls appropriately designed, but also they are working as designed. 8. 7gree. 7 <etection 0isk of 8-F implies that it is not a strong audit test and it should be used only as assistance in corroborating other audit evidence. :. 7gree. 7s engagement risk increases, audit risk should decrease in order to protect the auditor from potential litigation or other problems caused by being associated with the client. =. 7gree. 7lthough the audit model looks like a very ;uantitative approach it is based on a significant amount of auditor 'udgments. 4-83.
a. The FASB defines materiality as the magnitude of an omission or misstatement of

accounting information that, in light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement. The ,upreme *ourt of the Jnited ,tates offers a somewhat different definition and states that %a fact is material if there is a substantial likelihood that the Pfact would have been viewed by the reasonable investor as having significantly altered the >total mi"> of information made available )see discussion in &*7+$ &roposed 7uditing ,tandard %*onsideration of 1ateriality in &lanning and &erforming an 7udit )<ecember #--A.. Regardless of how it is specifically defined, materiality includes both the nature of the misstatement as well as the dollar amount of misstatement and must be judged in relation to importance placed on the amount by financial statement users. Thus,

4-#:

auditors need to understand the users of financial statements and their likely needs and expectations in order to make appropriate materiality judgments. b. The three ma'or dimensions of materiality are )1. the dollar magnitude of the item, )#. the nature of the item under consideration, )3. the perspective of a particular user. The three dimensions interact to determine whether a misstatement or omission would be material to important users of a company>s financial statements. /"amples of items for each dimension might be these: <ollar 1agnitude: ,omething that is over 8F of net income or a 8F misstatement of an account balance. Dature of 2tem under *onsideration: 7 misstatement of an account that significantly changes a trend in earnings or reflects on the integrity of management. &erspective of a &articular Jser: 1anagement of an outside entity that is considering ac;uiring the company and is relying on audited financial statements as an important part of its decision. c. Qes, the auditor>s assessment of materiality can, and likely will, change during the course of the audit. 7s the auditor ac;uires additional information about the client and the likely audited net income, the auditor>s assessment of any further undetected misstatement may change and the auditor s assessment of materiality for the client may change as more ;ualitative factors are considered. 7n auditor>s assessment of materiality that changes during the audit to a smaller amount implies that some of the work performed early in the audit may have been performed with larger planning materiality than the auditor now believes appropriate. Therefore, the auditor should review the previous audit work to determine whether the amount of work was sufficient to detect a material misstatement as defined by the revised assessment of materiality. 2f the auditor believes the work was not sufficient to detect a material misstatement, the auditor should consider performing additional audit work in the areas already performed to gather satisfaction that any )now-defined. material misstatement would be detected. 4-84. a. <ealing with the uncertainty of an account balance. Jncertainty is always a part of auditing. The auditor needs to reduce the uncertainty to an amount in which the auditor is comfortable in dealing with the client on the nature of a proposed 4-#=

ad'ustment. @or accounts that are ob'ectively determined, e.g. the gross amount of accounts receivable, the auditor can increase precision by doing more sampling and e"amining more audit evidence. +n the other hand, there are other accounts such as the allowance for uncollectible accounts or a warranty liability where there is not a %known( correct answer. The auditor and the client may simply disagree on the estimates. Cowever, the e"istence of uncertainty does not mean the auditor should simply defer to the client s estimate. The auditor should determine that the client has a good information system to identify the correct amount of the estimate. The auditor should be able to test the information system or independently develop an estimate of the account balance to be used in making 'udgments about the correctness of the account balance. The auditor should always work with a %best estimate( of the account balance, but must also consider the changes in estimates in relationship to the best estimate each year. The %best estimate( provides a basis for the auditor to assess the %swings( in account balances over years and to determine whether management may be manipulating reported earnings by using discretion in the individual account estimates. Thus, while the auditor may work with the client s estimate as being correct within a range in any given year, the auditor should always compare the client s estimates with the auditor s best estimates over a # or more year period. b. The answer below assumes that the auditor only looks at the effect of this year s misstatements on net income. $ased on the differences between the booked income and the auditor s best estimate, the current year income is misstated as follows: 7ssets 6iabilities 7ccounts 0eceivable )asset. 8-,--- +ver &repaid 2nsurance )asset. #-,--- +ver &repaid 0evenue )liability account. 18-,--- Jnder 2ncome 8-,--- +ver #-,--- +ver 18-,--- +ver

The net effect of these items is an overstatement of assets of G=-,---, an understatement of liabilities by 18-,---, and an overstatement of net income of G##-,---. )The assumption is that if prepaid revenue is understated, the client has recognized the amount of the understatement as revenue during the period.. The G##-,--- is more than the G1--,--- set as materiality by the auditor. The reported income is misstated by a material amount. 2t can be concluded that the financial statements are materially misstated for the year and the minimum correction, before considering the effect of previous year s misstatement, is to ad'ust the accounts by at least G1#-,---. The preferred approach is to ad'ust all the accounts to the %best estimate( value. 7s an alternative, the auditor could suggest the client ad'ust the &repaid 0evenue to its best estimate and reduce the recorded revenue by G18-,--- and increase the liability by that amount.

4-#4

c.

2n considering the minimum amount of ad'ustment needed this year, the auditor needs to also consider the effect of previous year s misstatements that were not recorded. The effect of the two year s misstatements are as follows: *urrent Qear 2ncome /ffect 7fter *onsidering &revious Qear G3-,--- Jnder G#8,--- +ver G#4-,--- +ver G#38,--- +ver

*urrent Qear $alance ,heet 7ccounts 0eceivable G8-,--&repaid 2nsurance G#-,--- )+. &repaid 0evenue G18-,--- )J. Total /ffect on 2ncome

6ast year $alance ,heet )+. G4-,--- )+. G 8,---)J. GA-,---)+.

The net effect of not making any ad'ustments is that net income will be overstated this year by an amount that is material. There are some offsetting effects between the two years that raises the misstatement from the previous G##-,--- to the new estimate of G#38,---. 1ore importantly, the balance sheet accounts continue to be misstated and there will be carry-over effects for the following year. 2n addition, the &repaid 0evenue account is misstated by a material amount. The minimum ad'ustment is one that decreases the amount of income misstatement and reduces &repaid 0evenue to an amount where it is misstated by less than materiality. 2n other words, the minimum ad'ustment is to reduce &repaid 0evenue by an amount greater than G138,---. Cowever, the best approach is to ad'ust all the accounts to their best estimate so there are no carry-over effects for the ne"t year. Ienerally management will want fle"ibility on these accounts because they are estimates. Cowever, as can be seen, they can easily be manipulated to manage reported income ! especially if the auditor does not evaluate all the %swings in the account estimates each year. d. 2n looking at the problem, it should be clear that it is always best to make all ad'ustments. @urther, even if the auditor believes that any ad'ustment within the range of reasonableness is acceptable, there is clear evidence that the &repaid 0evenue account should be ad'usted from G1.4 million to at least G1.A# million, or a G11#,--- ad'ustment. ,imilarly, the prepaid insurance should be ad'usted to the G1--,---. 7ccounts receivable can remain as recorded. The rationale for not booking immaterial ad'ustments typically includes the following: The amounts are not material, ergo they are not significant enough to affect any user and therefore there is no need to book any ad'ustments. 2t is costly and time consuming to book the ad'ustments.

e.

4-#A

There may be legitimate differences of opinion, especially on account balances that re;uire significant 'udgment, as to the correctness of the account balance. Thus, if the differences are minor and there is a good chance the client is correct, there should be no need to ad'ust the balances 'ust because the auditor believes he or she has a better estimate in an area in which everyone admits there is considerable uncertainty. Jnbooked estimates can be carried forward to the ne"t year for further analysis. /verything evens out in the end.

These arguments are pretty powerful, especially on the accounts in which a definable clear-cut answer is not apparent. Cowever, as one former @7,$ member put it, %if it is not material, why would management ob'ect to making the 'udgmentR( The fact that management ob'ects to the ad'ustment tends to reiterate that the estimate is material. @urther if ad'ustments are made each year, it takes away the possibility that management can manipulate reported income in any given year by using management discretion to ad'ust the %swings( in account balances re;uiring estimates. f. /stimates are indeed estimates. Cowever, prepaid insurance is not an estimate. The amounts of prepaid revenue can be further tested because receipt of a payment from a client must either be classified as revenue or as prepaid revenue. The auditor should be able to use statistical sampling to increase the testing on prepaid revenue to even further refine the estimate. Dote that the auditor already has a fairly tight estimate of prepaid revenue, i.e. a range from 1.A# to 1.A4 indicating that the auditor has already performed a significant amount of testing and has a fairly tight estimate of the account balance. Thus, it can be argued that the auditor has tight estimates on both prepaid insurance and prepaid revenue and there should be very little negotiation on the account balance. The accounts receivable balance is more difficult. $oth management and the auditor should e"amine previous estimates and compare those estimates with realized collectibility to determine the best model for making the estimates. There is room to negotiate regarding accounts receivable, but not on the other two account balances.

4-88. a. 2tems that may be covered in the memo: &otential advantages: 1. #. 3. 4. 8. The company appears to be in a high growth area. Dew management appears to have a track record of success. There is great potential for additional profitable consulting business. There is opportunity for significant practice growth as the client grows. The company is e"citing.

4-3-

:. The company may go public in the ne"t 3 - 8 years. There may be opportunities for additional work, e.g. 2nitial &ublic +ffering work which is generally ;uite profitable for our firm. =. The new work would e"pand our e"pertise into new areas. &otential disadvantages: 1. There are significant valuation problems associated with the client, particularly the 43F of assets in the form of goodwill. #. 1anagement has a reputation for %slashing and burning(, rather than building shareholder value through the underlying assets. 3. The company has pushed legal limits in almost all phases of its business. There could be potential problems associated with governmental investigations. ,uch investigations could harm the reputation of our firm and may have a negative impact on our other business opportunities. 4. The opportunities for other work may cause either )a. actual, or )b. perceived independence problems as company management might leverage our overall relationship with them to achieve favorable financial accounting presentations. 8. The company has become very aggressive in its choice of accounting principles. That aggressiveness may cause our auditing opinion to be ;uestioned. :. The casino business is high risk and company management does not appear to have any e"pertise in controlling such a business. =. %$ringing the e"citement of 6as Megas( to the 2nternet may also be a )a. very costlyB and )b. very risky endeavor for the client. 4. 1anagement will likely take the company public in the ne"t 3 - 8 years thus increasing our potential e"posure. A. There are control problems in the e"isting lines of business. 1-. +ur firm may not have industry e"pertise. b. @actors to consider in deciding how much to bid for the work include: 1. #. 3. 4. 8. :. 6ength of audit contract. 6ikelihood of additional consulting work. /"perience of staff personnel needed on the audit engagement. 0isk associated with public offering of stock in the 3 - 8 year range. @uture growth prospects of the firm. 2ntegrity of management and any e"perience others in the firm may have had with new management. =. /"tent that computerization could be used to gain audit efficiency. 4. <esire to be in this particular industry, i.e. the ability to develop industry specialization that could be e"panded to potential other clients. A. 6ikely reaction of other competing firms. 1-. &erceived risk of being associated with the client.

4-31

c.

+ther information that should be obtained before bidding on the audit include: 1. #. 3. 4. 8. :. =. 1ore information on management. <etail on government investigations. 7ccounting treatment for goodwill in the past. Dature of computer problems with the e"isting company. @inancial information on both companies. /"isting business relations, i.e. who are their bankers, investment bankers, etc. 9hat is the perceived integrity of managementR /"istence of a strategic plan by management.

d.

&rofessional skepticism may play an important role in the decision about whether or not to accept this potential audit client. 7n auditor that is more skeptical might view the facts concerning the companyEmanagement financial accounting and legal aggressiveness as more concerning than an auditor that is less skeptical. 7 less skeptical auditor may place more emphasis on the potential consulting services, and may assume that they can %audit away( any perceived risk factors that the client presents.

4-8:. Tour of &lant +bservations: 1. The Oanti;ueO production line raises ;uestions about product costing and overhead allocations. The two other lines are mostly automated, which may suggest that traditional approaches to allocating overhead based on direct labor hours may be inappropriate. The older production line may also result in problems with scrap. The auditor needs to determine whether the overhead allocation techni;ues are appropriate to the production methods. 7 number of potential risks are associated with this observation: The accounting for idle machines: ,hould the idle machines be written down to net realizable or disposal valueR The idling of the second production line: <oes this have implications for inventory reduction or the future production of a productR <oes it indicate management>s plans to replace or modernize the lineR 2f the company is operating below planned capacity, will the methods used for allocating overhead to products be sufficient to absorb current overheadR The auditor will want to be sure to perform procedures related to the valuation of machinery and the obsolescence of inventory, possibly through obtaining relevant information outside of the organization on these valuation issues. 7nytime the client is dealing with hazardous chemicals or similar products, there is a ;uestion about compliance with environmental regulations and potential liabilities associated with such disposal. The auditor must consider the need to gather information on the client>s compliance with e"isting environmental regulations and

#.

3.

4-3#

potential legal implications for non-compliance in order to assess the financial statement implications. 4. This represents a weakness in the client>s overall control structure. 7 messy distribution center in which the employees OcatchO up on items during non-peak times is prone to error. The auditor considers e"panding audit tests to gain assurance that goods are shipped on time, are billed in the correct time period, are properly identified, and are billed at the correct price. This indicates potential obsolescence of the items as well as problems with inventory management that may reflect on other areas of inventory. 2t also represents an opportunity to make constructive recommendations to the client. The company should have formal procedures to inspect goods as they are received. The lack of such procedures could result in paying for goods that cannot be used, or alternatively, the company might be using goods that are defective subse;uently causing the products to be returned for warranty. There is no indication of ;uality control or inspection )at least on a sampling basis. for goods that are contained in cartons, which could result in the company paying for goods not received or using goods that do not meet ;uality specifications. This does not necessarily represent a problem if the client has a contract for payment of goods that is clear and is based on goods actually utilized. The other impact is that the auditor has to develop a different approach to auditing the receipt of and payment for these goods. The lack of security signals a potential problem with inventory shrinkage. $ecause of the weaknesses in control procedures, the auditor should observe and test the taking of a physical inventory at year-end.

8.

:.

=.

4.

A.

'ote: 7ll of these situations represent opportunities for the auditor to make constructive comments to the client on areas for which significant improvements in inventory control could be made most without significant cost. These comments might lead to opportunities for management advisory services )within the constraints of the auditor independence rules, and possibly sub'ect to audit committee approval. but may also represent areas in which the auditor with control e"pertise might assist the client by pointing out controls that would improve inventory control and cut overall costs.

4-33

4-8=. a. 7dvantages 2dentify significant divergences in trends, earnings components, asset and liability structure, and so on. 2dentify the effect of management policy decisions on the company in comparison with industry average )may be good or bad or simply may raise ;uestions.. 2dentify potential problem areas )e.g., why this company is so much different than the industry as a whole.. 9hat assumptions would be re;uired to 'ustify such differencesR

6imitations The client may have operations that are significantly different )at least in some portion. than the industry as a whole. The client may have a different operating philosophy )e.g., financing or operating leverage, which may distort all important ratios and other comparisons.. +n the other hand, the potential downside of such policies may also be identified through comparison with industry data.

The client may use accounting principles that are different from those of other companies in the industry. @or e"ample, the client may use 62@+ and many of the other companies may use @2@+. ,uch differences will cause company and industry data to lack comparability. b. 2dentification of risk areas for Kones 1anufacturing: &otential 0isk 2ndicator 2nventory increase 0isk 7nalysis There is a substantial increase in inventory, both in dollar terms and as a percentage of sales, which could indicate potential problems with new products, with obsolescence, or with competitiveness with other products. 2t may indicate an increase of inventory 'ust before year-end in anticipation of rise in cost, a strike, or unusually heavy demand. 2nventory may be overstated due to misstatements of ;uantities or prices. This could also affect the following change. *+I, has decreased to 88 percent of sales at the same time inventory has increased. +ne e"planation 4-34

*ost of goods sold decrease

is that *+I, has not been booked for some significant sales. There may also be a change in product mi". 2n any event, audit attention should be directed to these areas. 7ccounts payable increase The 7E& increase could reflect credit problems or other financing problems. ,uch problems could make it difficult for the company to carry out its ongoing activities. 2t may simply reflect the purchase of an unusual amount of inventory 'ust before yearend. 2nventory turnover has decreased by 33 percent. This points to and confirms the problems identified by the increase in inventory and decrease in cost of goods sold. /ither there are substantial obsolescence problems, material items are not correctly recorded, or the inventory has been increased in anticipation of some unusual event early ne"t year, such as a raw material shortage, strike, or unusual demand. This ratio has increased by #3 percent over the previous year and is 33 percent above the industry average. The increase in the ratio could represent a number of problems: o 6ess stringent credit standards. o 9arranty problems )i.e., the customers may not be paying because of problems with the products.. This would be consistent with the interpretations associated with inventory turnover, o Jnrecorded returned items or a significant lag in issuing credit memos associated with returned items. o &otential accounting recording problems. /mployee turnover This is more difficult to interpret, but there is a :percent increase over previous years to a rate that is double that of the industry. This might indicate problems with morale, ;uality control, or other

2nventory turnover

7verage number of days to collect

4-38

dissatisfaction with the manner in which the company is being run. 0eturn on investments This ratio does not indicate a problem. 2n fact, the company e"ceeds the industry average. 7n alert auditor should wonder however, how the company is able to maintain a superior return when there are problems with inventory and receivables. This ratio has increased substantially and is double the industry average. The company has become highly leveraged. The increased leverage has three implications the auditor ought to address: o The e"istence of new debt covenants that ought to be addressed as part of the audit. o 7 potential problem of remaining a going concern should there be a downturn in operations or a significant increase in interest rates )on how the debt is structured.. o There may be concern with how the debt proceeds have been utilized by the company. <oes it represent additional capital, or is it being used for current operating purposesR The auditor should seek an answer to this ;uestion and consider the implications of the answer to the audit. +ne important use of analytical procedures is to point to potential problem areas that may affect the audit. The implication is that the auditor should consider specifically how the identified risk areas might reflect material misstatements in the financial statements. The risk areas identified above should lead the auditor to plan specific audit tests including, but not limited to, the following: /"panded tests of inventory, pricing, returns, warranties, and the accounting procedures for recognizing product returns. /"panded tests for potential inventory obsolescence include a detailed analysis of industry trends, competitor products, current sales level, and so on. 7n e"panded scope of receivables testing to determine the validity and collectibility of receivables that are increasingly older.

<ebtE/;uity ratio

4-3:

 7 heightened awareness of any factors that might indicate fraud or material misrepresentations on the part of management. The inconsistency reflected in some of the economic data may indicate that management is deliberately overstating inventory and understating cost of goods sold. There should be a specific analysis of going concern issues. The e"panded debt, the employee turnover, and the inventory and receivable problems all point to significant operating issues. 2n comparison with most standard audits, there should be a greater emphasis on year-end testing and very little reliance on management representations. The risk of error should point to a very skeptical audit. c. The one ratio above that might cause the auditor to increase professional skepticism is the 0eturn on 2nvestments. This ratio is better than e"pected and better than industry. 9hen the client s numbers look almost too good to be true, the auditor s professional skepticism should be increased. @urther, as indicated above, the inconsistency reflected in some of the economic data may indicate that management is deliberately overstating inventory and understating cost of goods sold, thereby causing the auditor to have increased skepticism about these accounts. 4-84. a. *onclusions regarding financial reporting risk: There is a significant trend toward a declining current and ;uick ratio which would indicate li;uidity problems for the company, often relating to operating problems. 2nterest coverage has decreased significantly and is substantially below the industry average, indicating that the company is vulnerable to any downturn in operations or changes in interest rates. 7lthough it may not immediately signal problems as to remaining a going concern, it could indicate that such problems could surface in the near future. There is a significant increase in the number of day>s sales in receivables, which is one of the key danger signals for any company of this nature. The increase could reflect potential problems from product ;uality, less stringent credit policies, governmental concerns with the product, fictitious sales, or unrecorded product returns. 2nventory turnover is steadily decreasing, reflecting a deterioration of the company>s ma'or product and the inability to introduce new products in the market. There may be realizability problems related to inventory as well as future operating problems.

4-3=

The number of day>s sales in inventory has been steadily increasing. This is the same problem as the decreasing inventory turnover identified above. ,ome people find that this ratio better visualizes the problem. 2ndianola has steadily decreased its investment in 0H<, to a current level that is less than 33 percent of the industry average. This signals potential long-run problems with the company, because unless successful research and development is the key to success in the pharmaceutical industry, the company develops and successfully introduces new products, it has potential goingconcern problems.

*ost of goods sold as a percentage of sales appears to be a positive development. +n further analysis, however, there may be clouds in this silver lining as well: )1. the primary production of older products rather than the introduction of newer products andEor )#. accounting errors in recording inventory, sales, or receivables. The debtEe;uity ratio has increased significantly. There is less interest coverage. 2n addition, there may be concerns with debt covenants that may have been violated. The significant decrease in earnings per share hampers the company>s ability to raise new capital. 7lso, the significant decrease that has taken place in the past three years may cause investors to ;uestion current management>s ability. &otential suits may be brought against management if there are signs of mismanagement. The amount and e"tent of personal bonuses or potential misuse of corporate funds become important and heighten the auditor>s awareness of potential abuses and lower the ;ualitative materiality for investigating corporate e"penditures that reimburse or provide benefits to management. The salesEtangible asset ratio indicates that the company is not generating an industry normal volume for assets. This may indicate that there is substantial idle capacity or that new capacity has not yet gone on line. )The inference of new capacity is brought about by the increase in the debtEe;uity ratio.. There may be problems with interest capitalization or write-offs of e"cess capacity. The salesEtotal assets ratio is well below industry average. $ut more significant is the fact that it is markedly lower than the salesEtangible assets average. This would indicate that the company has substantial capitalized intangible assets. Iiven the declining profitability and operations of the company, there may be substantial valuation problems associated with these intangible assets. ,ales growth has increased but less than the industry average. 2t is also evident that the increase has come with poorer credit.

4-34

The preceding analysis points out a number of areas on which audit attention ought to be focused. The company is publicly traded and ,/* reports are re;uired. The dependence on one ma'or product with a patent about to e"pire, decreased research and development, and decreased operating performance all point to potential realization problems. The audit work will likely be modified as follows: 7udit risk will be set at a level below the industry norm, reflecting the increased engagement risk associated with the client. 9ork on specific audit areas more likely to contain misstatements )e.g., receivables and inventory. will be e"panded. There will be greater concentration on realizability problems, especially in the area of intangibles. The audit approach will e"hibit a great deal of skepticism and will need to corroborate all important management representations. b. +ther information that might be gathered as part of this audit engagement would include 7nalysis of industry product trends including the identification of competitor products and other new product developments )obtained from industry 'ournals..

The status of client>s drugs submitted for approval by the @ood and <rug 7dministration, as well as the status of competitor products )obtained initially from company but verified by either reviewing @<7 correspondence or confirming status with the @<7.. *lient plans for new products and use of new capacity )management.. 1anagement>s budget, operating plans, and strategy for dealing with current problems )management. *orrespondence with financial advisers regarding debt structuring, loan covenants, and so on )review of company files, confirmation with financial advisers if applicable..

c.

7ctions that took place in the preceding year would likely have included 7 ma'or issuance of debt reflected in the debtEe;uity ratio. The ac;uisition of another company or of other intangible assets reflected in the decrease in the salesEtotal assets ratio, which has decreased more than the salesEtangible assets ratio. This possibility is also evidenced by the 18 percent

4-3A

growth in sales over the previous year, an increase significantly higher than the previous best year growth of 4 percent. 7 ma'or sales problem may e"ist with significant increases in number of day>s sales in inventory increasing reflecting some panic thinking on the part of the company.

4-4-

4-8A. a. The audit firm was too casual in its process of accepting the new client, perhaps because it was a private company, perhaps because it was a well-known retailer in the state. Therefore, there were numerous deficiencies in the auditor s approach to both accepting the client and planning the audit. ,ome of the deficiencies included: 6ack of an engagement letter, @ailure to communicate with the predecessor auditor, @ailure to investigate the company s business practice and its current relationship with the ,/*, @ailure to identify the e"istence of related party transactions )these would have been somewhat apparent because of the race car promotions., @ailure to talk with the board of directors and to understand their role in the audit, 6ack of assessment regarding the competence and independence of the board and the audit committee. @ailure to fully interview the *@+ and *@+ staff regarding approaches to accounting. The company should have investigated to determine if there is any public debt and therefore public reporting responsibilities, The nature of the audit procedures should not be dictated by managementB it should be dictated by the auditor who has assessed various financial reporting risks.

There should not be a different standard in accepting private companies than would be used for accepting public companies, especially when the private company is large and has some responsibility to operate in the public interest. b. )1. The auditor has three choices: a.. 0esign from the audit engagement, b.. *ontinue on the audit as planned, c. 0evise the audit for the risk factors that the auditor knows about. The auditor should write an engagement letter that identifies the nature of the audit and the cost of the audit to respond to risk factors ! if the auditor decides to stay on the audit engagement. This might be the best choice because the auditor might be sued for a breach of contract if the auditor were to resign from the engagement as it is not necessarily the company s fault that the auditor firm did not do its due diligence. Cowever, given the nature of the company s operations, many )including the authors. would recommend resigning from the audit engagement because of the risk and lack of transparency that took place in the client acceptance process.

4-41

)#. The engagement letter is a critical piece of information that should have been included in this audit. The engagement letter would lay out e"pectations of management, including those related to internal control and disclosure of related party-transactions, as well as the need to change audit fees if additional risks become known to the auditor. The engagement letter would clearly have helped the auditor because it would have been the client that had violated the terms of the engagement and it would make it much more difficult for the client to sue the auditor for breach of contract should the auditor resign. )3. The audit would be e"panded in a number of ways: 2ncreased search for related party transactions, Ireater skepticism related to accounting estimates, and the need to establish a 'ustifiable basis for accounting estimates, 1ore complete analysis of internal controls with a specific audit plan linkage from deficiencies in controls to identification of additional audit procedures, /mphasis on gathering higher ;uality audit evidence, including evidence from outside sources. $etter understanding the materiality threshold of significant outside parties, e.g. bankers or other lenders, 7nalyzing key performance data for anomalies ! either in relationship to prior years or in relationship to others in the industry. ,urprise audits of stores inventories.

&rofessional skepticism has important implications for the planning of the audit. 7s the auditor has increased skepticism about the veracity of the account balances and assertions, the nature, timing and e"tent of work should be increased to specifically address the auditor s concerns. )4. The auditor has ;uoted a fi"ed-fee based on what was represented to the audit firm as the state of the company and its policies. 2t seems that there is a difference in reality and then what was portrayed to the auditor. Thus, it would seem reasonable that if the auditor stays on there will be a need to ad'ust fees. 2f the client does not agree, that would constitute a good rationale for resigning. c. Step () The ethical issue is whether or not to resign. Step *) The affected parties are the audit firm )the right to have a client they can trust and that will not present undue audit risk. and company management )the right to receive audit services when promised.. Step +) $oth parties have valid rights, although management s actions and decisions probably make the auditor s rights more prominent. Step 4. +ne course of action is to resignB the other course of action is to stay with the client. Step ,) 2f the auditor resigns, there may be legal implications. Cowever, since there is no engagement letter management may not have a strong case. 2f the auditor remains, they will clearly have to do a much more substantive audit and professional skepticism will have to be increased markedly. Step -) 7ny of these conse;uences seems reasonable, and the decision about which conse;uence to accept will depend on the auditor s risk tolerance. The %greatest good for the greatest number( is not particularly relevant in this scenario since there are 4-4#

'ust two well-defined parties to the situation. Step .) The rights framework would imply that the auditor s rights have been violated more than the other way around. ,tep 4. The answer will depend on students beliefs and opinions articulated in the preceding steps, and assumptions about the auditor s tolerance for proactively dealing with a high risk client. 4-:-. a. The accounting decisions that the company and the auditor must make are as follows: *ood#ill. 2s there an impairment of goodwill, and if so, how do we measure the amount of the impairmentR 9hat is the likely future operations of the companies ac;uired to which the goodwill is applicableR +lant Assets. Cow do we account for discontinued operationsR 2s the lay-offs permanentR 2s there an impairment of the plant assets, and if so, how is the impairment measuredR 'ales. 9ith sales being down, is there an effect on the level of inventory and the potential obsolescence of inventoryR Cow do we measure the obsolescence of inventory, or the current market value of the inventoryR Accounts Receivable. 9ith customers paying more slowly, there is evidence that more of the receivables will be uncollectible. Cowever, with the downturn in the economy, we must ask whether the procedures that were used to estimate uncollectible accounts in previous years )years of increasing sales and a good economy., are still applicable. Cow do we estimate the amount of uncollectible receivablesR Return on (ompany +ension +lans. 9hat kind of investments do we have for the pension plansR <o we e"pect a lower return over the life of the pension planR 2f yes, how does that affect our plan assets and needed contributions to the planR 9hat is the appropriate value of the pension plan assetsR

b. +roperty% +lant% and Equipment. The audit will focus on management s plans for closing plants and alternative uses of the plant assets ! buildings, land, and e;uipment. The auditor will need to determine the Nbest in use value for the plants that have been closed, as well as those that are e"pected to be closed in the near future. The audit changes from testing depreciation to determining impaired value of the asset. *ood#ill. The auditor needs to determine the lines of business to which the goodwill was associated. The auditor will need to look at: *urrent level of economic activity for that line of business, 4-43

@uture profitability of that line of business, /"pected *ash flows from the business, &lanned cash flows, /conomic changes on that line of business as a whole.

The auditor then needs to compare e"pected cash flows and the newly pro'ected cash flows in order to measure the impairment of the goodwill. Receivables, 1ost of the audit emphasis will be on the valuation of the receivables. The auditor will focus on: 7ging of receivables, /conomic climate affecting the business, @inancial health of ma'or customers, *hanges in interest rate in the economy, @uture prospects for an upturn in the industry. &revious approaches to estimating the allowance for doubtful accounts.

The changed economic conditions dictates that the previous approaches to measuring uncollectable accounts will not work. The focus must be on developing a realistic estimate of the allowance for uncollectible accounts. &nventory, The downturn in the economy presents two ma'or valuation problems for the auditor: 1arket value may be changing downward as companies struggle to sell e"isting inventory, *ompetitors may continue to introduce new products that will make some of the company s products obsolete.

The auditor will be looking at current sales data, current selling prices, inventory turnover, changing market conditions, and so forth in order to estimate the amount of inventory that should be written down. c. 9e must recognize that management s optimistic approach may very well be correct. Cowever, the auditor must take a realistic look at economic trends and the impact on the company and the industry to deal with the asset valuations identified above. The lack of a current vibrant economy does not mean that the auditor should ignore that many of the assets may be impaired. 4-:1 Daturally, each student s response will be somewhat different. The purpose of this problem is to get the students comfortable with reading auditing standards and considering what the standard is re;uiring and why. The risk assessment procedures, and relevant paragraphs in 7, Do. 1# include:

4-44

a. +btaining an understanding of the company and its environment )paragraphs =-1=.B b. +btaining an understanding of internal control over financial reporting )paragraphs 14-4-.B c. *onsidering information from the client acceptance and retention evaluation, audit planning activities, past audits, and other engagements performed for the company )paragraphs 41-48.B d. &erforming analytical procedures )paragraphs 4:-44.B e. *onducting a discussion among engagement team members regarding the risks of material misstatement )paragraphs 4A-83.B and f. 2n;uiring of the audit committee, management, and others within the company about the risks of material misstatement )paragraphs 84-84.. Cases: 4-:#. a. There are a number of potential hypotheses that may e"plain the changes in the financial data that has taken place. The task for the auditor is to determine which of the potential e"planations either )a. best e"plains all the changes, or )b. best reflects the economic reality of the situation. 2n previous classroom situations, the students have offered the following potential hypotheses: 1. The company is more efficient because of its computerized processing. #. The company has embarked on a program that has led to better customer relations, but it has come at the cost of deferred receivables. 3. The line of credit has led management to put on e"tra sales efforts during the last ;uarter of the year in order to keep from violating the debt covenant. 4. The rebilled invoices are either )a. fictitious, or )b. were real, but were not accompanied by the corresponding credit memos going to the same customers. 8. The company has more efficient warehousing techni;ues due to the new computerization. :. 7 change in customer mi" has allowed the company to raise its margins. b. The intent of this ;uestion is to get the students to e"ercise professional skepticism in analyzing the hypotheses without being unduly influenced by management. 9hen the analysis is performed, the only hypothesis that e"plains all the ratios is no. 4 above )either fictitious sales or the failure to grant credit to offset the new invoices.. The reason this is the best e"planation is that it e"plains the following changes: 2ncrease in Dovember and <ecember billings, 2ncrease in 7ccounts 0eceivable, 2ncrease in the Iross 1argin &ercentage ! both for the client and in comparison with the industry.

4-48

c. $ased on the analysis in part b, the auditor should concentrate audit efforts on the possibility of either fictitious billings or the failure to issue credit memos. Done of the other hypotheses e"plain all the changes. @urther, it is naSve to think that a competitor could improve the gross margin significantly higher than the industry in one year when it is selling to ma'or customers who have considerable pricing power. The risks relate to fictitious sales or the failure to issue credit memos. 2nterestingly, the client had issued the rebilling invoices only on clients that management knew would not return accounts receivable confirmations. ,ome of the audit procedures the auditor should consider include: 1atch the total of credit memos issued to the total of %rebilled invoices( to determine that the totals are the same. Take a sample of credit memos and trace them into the original 'ournal of entry, and further trace into the general ledger )these two procedures would have detected the fraud. *onsider confirming individual %line-items( of accounts receivable with customers instead of total balance. &erform a detailed review of subse;uent payments. Telephone ma'or customers to determine if they are aware of the %rebilling( agreements. &erform a count of inventory and reconcile with the Ieneral 6edger. <etermine if some inventory is held on consignment. 2f it is held on consignment, make arrangements to observe the inventory. TDote: given the high risk of fraud associated with this account, observing the inventory is better than sending out a confirmation to the warehouse or customer holding the inventory.U

4-:3. The purpose of this problem is to introduce the student to the process of using public information to identify risks associated with a company. The student should analyze publicly available information and consider setting up an intelligent agent such as a personalized Ioogle page that sends all information about the company directly to the student s desk top. 4-:4. The authors have used this approach very successfully, although primarily at the graduate level. 2t can be scaled back at the undergraduate level to provide an opportunity for 4-4:

students to learn about the vast amounts of information available on companies. 2t also forces them to utilize that information to perform a risk analysis for the company. 4-:8. aHb. 7 number of risk areas should be identified based on the reading of the case

7 ma'or change in the nature of the operations of the thrift industry opened the doors to new types of highly risky investments. 2t also allowed a greater concentration of investments into high-risk areas, e"panded lending authorities beyond traditional boundaries, and allowed a new type of management to obtain control of many of the institutions. The industry was suffering financial hardships even before the legislation was enacted. 2t had a classic financing problem: long-term fi"ed assets and short-term variable liabilities. 9hen interest rates soared during the latter part of the =-s, many of the ,H6s would have been considered bankrupt had they been forced to value their assets at current market value, but regulatory accounting procedures tended to hide the problem. There was a need to go beyond such accounting to understand the economic significance of the industry>s problems. 6incoln @ederal was purchased by a real estate development entity, was run as a subsidiary of it, and was used to support the land developments of 7merican *ontinental *orporation. 2t was no longer functioning as a separate, independent entity with the responsibility to make conservative investments to support family homes. /arnings from 6incoln could assist 7merican *ontinental and its stock price. The compensation arrangements for many Veating relatives was clearly e"cessive considering )1. 6incoln>s size, )#. the nature of their duties, and )3. thrift institutions of similar size. There seemed to be little support, or documentation, for the collateral )and the value of the collateral. for many of the new investments. The company was operating in a section of the country where the myth that Ogrowth was foreverO was perpetuated. This is not a criticism of the ,outhwest but of business mentality that operates on an assumption that above average growth levels can be sustained forever. 1any of the investments, when sub'ected to financial analysis, simply did not hold up. /"amples include the &hoenician and other ma'or real estate developments in the &hoeni" area.

4-4=

 c.

/mployees were compensated on a commission basis for selling bonds. This is unusual practice for an ,H6.

The use of appraisals as evidence is a difficult audit ;uestion. 9hen assessing the persuasiveness of appraisals as audit evidence, the auditor normally considers the following: The ;ualifications of the appraiser. @or e"ample, if a significant number of appraisals are from one appraiser, the auditor needs to know whether the appraiser is certified )certification process is similar to accounting certification.. The recency of the appraisals. The relationship of the appraisal firm to the client. 2s there a specific relationship, or might there be a relationship so that the appraisal firm gets the company>s business because the appraisals come out the way management wants them to come outR The economic assumptions behind the appraisals. The auditor may want to review these assumptions to determine )1. their correspondence with economic assumptions that seem to fit the region, and )#. their sensitivity to the appraised value. @or e"ample, if the appraisal assumes a 1- percent growth rate in population for the ne"t several years, but the auditor>s best estimate is that the growth rate will be 8F at best, the auditor should perform a sensitivity analysis to determine the impact of such an assumption on the appraised value. The policy of the company in rotating appraisals for significant real estate over time.

+f course, the appraisal is only one aspect of the company>s determination of the valuation of a loan receivable. The appraisal is important in the case of default. Thus, the auditor will not be evaluating every appraisal, but will want to )1. determine the client>s procedures for obtaining independent appraisals before a loan is granted and then grant the loan if the appraisal indicates substantial collateral for the loan, and )#. perform a detailed review of appraisals on a sample basis for all loans outstanding, and on a 'udgment basis for all loans in default or likely to go in default. The first analysis is the key to company operations, that is, it determines that ade;uate collateral is obtained before issuing loans. &t may be important% ho#ever% to point out to students that many loan officers in the past have been compensated on the amounts of loans made% not the quality of the loans. 6oan officers were essentially compensated on a commission basis. 2t was in the loan officer>s best interest to get appraisals that would help a proposed loan get approval from a loan policy committee.

4-44

!&R# M&/&R C&MPA'0 A'# /&0&/A M&/&R C&RP&RA/$&': (-.+ARA/&0E R&'1 A2A34'&' (a) #es"ri1e the primar risks fa"ing !ord) 7 return to elevated gasoline prices, as well as the potential for volatile prices or reduced availability *ontinued or increased price competition resulting from industry overcapacity, currency fluctuations, or other factors. 7dverse effects from the bankruptcy, insolvency, or government-funded restructuring of, change in ownership or control of, or alliances entered into by a ma'or competitor. 7 prolonged disruption of the debt and securitization markets. @luctuations in foreign currency e"change rates, commodity prices, and interest rates. /conomic distress of suppliers that may re;uire us to provide substantial financial support or take other measures to ensure supplies of components or materials and could increase our costs, affect our li;uidity, or cause production disruptions. ,ingle-source supply of components or materials. 6abor or other constraints on our ability to restructure our business. 9ork stoppages at @ord or supplier facilities or other interruptions of production. ,ubstantial pension and postretirement health care and life insurance liabilities impairing our li;uidity or financial condition. 9orse-than-assumed economic and demographic e"perience for our postretirement benefit plans )e.g. discount rates or investment returns.. 0estriction on use of ta" attributes from ta" law Oownership change. The discovery of defects in vehicles resulting in delays in new model launches, recall campaigns, or increased warranty costs. 2ncreased safety, emissions, fuel economy, or other regulation resulting in higher costs, cash e"penditures, andEor sales restrictions. Jnusual or significant litigation or governmental investigations arising out of alleged defects in our products, perceived environmental impacts, or otherwise.

4-4A

7 change in our re;uirements for parts or materials where we have long-term supply arrangements that commit us to purchase minimum or fi"ed ;uantities of certain parts or materials, or to pay a minimum amount to the seller )Otake-or-payO contracts.. 7dverse effects on our results from a decrease in or cessation of government incentives related to capital investments. 7dverse effects on our operations resulting from certain geo-political or other events. ,ubstantial levels of 7utomotive indebtedness adversely affecting our financial condition or preventing us from fulfilling our debt obligations )which may grow because we are able to incur substantially more debt, including additional secured debt.. @ailure of financial institutions to fulfill commitments under committed credit facilities. 2nability of @ord *redit to obtain competitive funding. 2nability of @ord *redit to access debt, securitization, or derivative markets around the world at competitive rates or in sufficient amounts due to credit rating downgrades, market volatility, market disruption, or other factors. Cigher-than-e"pected credit losses. 2ncreased competition from banks or other financial institutions seeking to increase their share of financing @ord vehicles. *ollection and servicing problems related to finance receivables and net investment in operating leases. 6ower-than-anticipated residual values or higher-than-e"pected return volumes for leased vehicles. Dew or increased credit, consumer, or data protection or other regulations resulting in higher costs andEor additional financing restrictions. 2nability to implement our +ne @ord plan.

(1) #es"ri1e the primar risks fa"ing /o ota) $ndustr and Business Risks The worldwide automotive market is highly competitive. The worldwide automotive industry is highly volatile.

4-8-

Toyota s future success depends on its ability to offer new innovative competitively priced products that meet customer demand on a timely basis. Toyota s ability to market and distribute effectively is an integral part of Toyota s successful sales. Toyota s success is significantly impacted by its ability to maintain and develop its brand image. The worldwide financial services industry is highly competitive.

!inan"ial Market and %"onomi" Risks Toyota s operations are sub'ect to currency and interest rate fluctuations. Cigh prices of raw materials and strong pressure on Toyota s suppliers could negatively impact Toyota s profitability. The downturn in the financial markets could adversely affect Toyota s ability to raise capital.

Politi"al, Regulator and 2egal Risks The automotive industry is sub'ect to various governmental regulations. Toyota may become sub'ect to various legal proceedings. Toyota may be adversely affected by political instabilities, fuel shortages or interruptions in transportation systems, natural calamities, wars, terrorism and labor strikes.

(") Compare the risks of !ord and /o ota) The two companies report the same general types of risks )e.g., related to competition, industry volatility, product demand, etc... Cowever, @ord provides risk factor information in much greater detail than Toyota. The biggest substantive differences between the two involve @ord s e"pressed concerns about the demand for their products )their declining market share., product warranties, cash flow concerns, and the resolution of issues involving retirement benefits for employees. @urther, given Toyota s massive product recalls and safety concerns in late #--A, the fact that they provide little discussion of this issue is surprising. 1d. 3h would auditors want to know a1out their "lients4 1usiness5related risks6 7n auditor who understands the risks that its client faces will be in a better position to understand where there might be risks in the financial statements, and thus where the auditor should focus more effort. @or e"ample, risks related to product defects might have implications for inventory valuation and warranty e"pense. *a) 3hat are related part transa"tions6 0elated party transactions are those in which one business, or the e"ecutivesEowners of one business, conduct business with other businesses with the same e"ecutivesEowners. *1) 3h do related part transa"tions pose a risk to audit firms6

4-81

These transactions pose a risk to audit firms because the transactions do not occur at %arm s length(, i.e., the terms of the transactions may not reflect pricing that is consistent with market based measures. To the e"tent that these transactions are not %normal(, and to the e"tent that they are controlled by e"ecutive management, they can be used to manipulate financial results. ,uch financial manipulation poses a risk to audit firms. $ecause related party transactions can and do occur with regularity, auditors need to determine their e"tent, and conduct tests to understand whether and how the transactions affect the financial results. *") Read a1out the related parties at !ord and /o ota) #oes one firm have more related5 part transa"tions than the other6 $f so, what might 1e the rationale6 Are there an situations that "ause ou parti"ular "on"ern6 Toyota has no related party transactions, other than those conducted in the normal course of business. @or @ord, most of the related party transactions described are conducted in the normal course of business, and therefore do not seem to present any unusual conflicts of interest. +f course, the auditors will need to be sure this is actually the case. The transactions that involve senior e"ecutives at @ord, particularly with individuals from the founding @ord family, seem to present the most concern. @or e"ample, it is unclear the e"tent to which @ord 1otor *ompany truly benefits from its affiliation with the <etroit 6ions. @urther, it is unclear the e"tent to which @ord 1otor *ompany truly benefits from the yearly consulting agreement with 9illiam *lay @ord. ,hareholders may be concerned that this spending is unnecessary.

4-8#

ACA#%M$C R%S%ARC7 CAS% Kohnstone, V. )#---.. *lient-7cceptance <ecisions: ,imultaneous /ffects of *lient $usiness 0isk, 7udit 0isk, 7uditor $usiness 0isk, and 0isk 7daptation. Auditing% A 5ournal of +ractice 6 /heory. 'arasota, 78 9, $:;. 1. 3hat is the issue 1eing addressed in the paper6 The issue being addressed is how client acceptance decisions are made by audit partners. 7uditors evaluate the business risk and audit risk of a potential audit client when making the client- acceptance decision. This study developed a model to test the evaluation of client risk and how it is related to the auditor business risk as well as how auditors handle risk adaptation to retain the riskier clients. The model was developed using two stagesB a risk evaluation stage and a risk adaptation stage. The risk evaluation stage evaluates the following: partners assessments of client business risk as related to the client s audit risk and visa versa, partners assessment of audit risk and the client s business risk as related to the auditor s business risk. The risk adaptation stage included three potential strategies that might be used by the audit partner to mitigate previously noted risks. The first strategy was based on the assumption that the partner s assessment of audit risk and client s business risk will negatively affect the likelihood of accepting the client. ,trategy two was based on the assumption that the relationship between the partner s assessment of the client s business risk and audit risk and the likelihood of accepting the client can be mitigated by the partner s assessment of the auditor s business risk. ,trategy three was based on the assumption that the partner s assessment of the client s business risk and audit risk as well as the assessment of the auditor s business risk will relate in a positive manner to the use of proactive risk-adaptation strategies. The final assumption is that the relationship between the partner s assessment of the client s business risk, audit risk, and the auditor s business risk and the likelihood of accepting the client will be mediated by use of proactive risk- adaptation strategies. *) 3h is this issue important to pra"ti"ing auditors6 There are professional standards that state an audit firm should implement procedures to help determine the acceptability of audit clients. Cowever, the standards do not give any guidance as to what those procedures should be. 9ith the increase in litigation against audit firms for audit failures and the increase in competition for audit clients, procedures for client acceptance are becoming more and more important to auditors. +) 3hat are the findings of the paper6 The results relating to the risk-evaluation stage of the model showed that partners assessment of audit risk affects their assessment of a client s business risk and both client related risk assessments affect the auditor s assessment of the auditor business risk. Therefore, it was determined that audit partners do consider the comple" relationship between audit risk, client business risk and audit business risk. The relationship between

4-83

audit risk and auditor business risk is much stronger than the relationship between the client business risk and the auditor business risk. The results relating to the risk adaptation stage showed that the partners directly linked their assessment of a client s business risk with the client-acceptance decision. The partner s assessment of the auditor s business risk was also considered as a means of mediating the affect of the client s business and audit risk. Cowever, additional results from this research also indicated that partners did not use proactive risk-adaptation strategies to mediate the effects of the client s business risk, audit risk, and auditor s business risk assessments on the client-acceptance decision. The synopsis for this result is that auditors have difficulty shifting auditor s business risk back to the client due to competition within the industry and high costs of litigation. 4) 3hat are the impli"ations of these findings for audit 8ualit 9or audit pra"ti"e: on the audit profession6 The results of this research may help to e"plain why similar audit firms may reach different client-acceptance decisions about the same prospective audit client. The audit industry has been known to apply proactive risk-adaptation strategies to determine audit plans and should maybe consider the usefulness of possibly using the proactive riskadaptation strategies to help mediate the effects of audit risk and client business risk on the client-acceptance decisions that are made. ,) #es"ri1e the resear"h methodolog used as a 1asis for the "on"lusions) There were 13= participants from a $ig 8 accounting firm. The partners had an average of 1A years e"perience and had made an average of nine client-acceptance decisions in the last year. /ach partner completed two cases. The cases provided company specific information about financials and company management. The level of industry competition was also included. The partners were also provided with information about the company s internal controls. 7fter reading each case, the partners evaluated the client-acceptance risks, planned their risk-adaptation strategies from available alternatives and then provided their client-acceptance decisions. /ach case was assigned independent variables related to the client s business risk )high, low., audit risk )high, low., and auditor s business risk )high, low.. <ependent variables included the client s business risk evaluation, audit risk evaluation, auditor s business risk evaluation, proactive risk-adaptation strategies, and the client- acceptance decision. ,tructural e;uation modeling, which is a statistical method that simultaneously estimates both the association between observed indicators and the measurement model, was used to determine the actual results. -) #es"ri1e an limitations of the resear"h that the student 9and pra"ti"e: should 1e aware of) The student )and practice. should be aware that the research for this paper was based on responses from only one audit firm and therefore the conclusions may not apply to other firms. Ieneralization of the results regarding the evaluated risks and proactive riskadaption strategies is limited to the indicators in the study. 4-84

0esearch is not an e"act science. 9e look for the soundness of the research to uncover patterns of behavior that is demonstrated within the audit profession. Then we have to look for indications of how the audit practice should be influenced by the results.

4-88