AUDIT RISK AND ANALYTICAL PROCEDURES Case 3 On June 28, 2006, Richard Abernethy, managing partner of Abernethy and

Chapman, met with the firms three-member engagement review committee to discuss the Lakeside Company audit. Although Abernethy admitted that the job had some problems, he strongly recommended seeking Lakeside as an audit client. He described Lakeside as an established Richomd company with an almost unlimited growth potential through the distributorship side of its business. Furthermore, he believed that the engagement offered an excellent opportunity for Abernethy and Chapman to gain entry into a new audit area: consumer electronics. Abernethy indicated that he had talked with King and Company, the predecessor auditors. Abernethy not only described the controversy that had arisen over the auditors 2005 qualified opinion but also indicated that King and Company appeared to have no reservations about the integrity of Lakesides management. In addition, if retained, Abernethy and Chapman would be allowed to review the prior years audit documentation. Wallace Andrews, an audit manager with Abernethy and Chapman, then described to the committee his visit to the Lakeside Company headquarters. He had found many elements of the companys accounting system to be more appropriate to a smaller business but still judged that the financial records were capable of being audited. After reviewing all of the pertinent information, the review committee unanimously recommended that the firm accept this engagement. Consequently, Abernethy met with Benjamin Rogers, president of Lakeside, during the subsequent week and a final oral agreement was reached. Several days later, Abernethy forwaded two copies of an engagement letter (see Exhibit 3-1) to Rogers, who signed one copy and returned it to the CPA firm. Rogers also contacted the previous auditors, King and Company, and gave them formal permission to show the Lakeside audit documentation to Abernethy and Chapman. Three members of the organization were assigned to the engagement team: Dan Cline, partner; Wallace Andrews, manager; and Carole Mitchell, senior auditor. In addition, several staff auditors were available to assist this group whenever necessary. There was also a consulting partner assigned. Although each of these auditors was involved in completing other engagements, a number of preliminary audit procedures were started during the months that followed. As the partner, Cline was responsible for the final review of all audit documentation produced during the Lakeside examination. To acquire the industry expertise needed to evaluate the clients financial reporting, he set out to learn as much as possible about the selling and distribution of consumer electronics. Meanwhile, Cline and the other members of the engagement team began to consider the various risks involved with this audit. As with all accounting firms performing audits, for each separate account or group of accounts, Abernethy and Chapman determines an amount of risk called acceptable audit risk. An independent auditor provides reasonable, not absolute, assurance; therefore, risk is not entirely eliminated. Acceptable Audit Risk (AAR) is measure of how wiling the auditor is to accept that the financial statements may be materially misstated even after the audit is completed and an

unqualified opinion is given. If the firm desires a low level of risk, then they have to be more certain that the financial statements are not materially misstated. For example, if the AAR is 10%, then the auditor has to be 90% confident that the financial statements are fairly stated, and if the AAR is 5%, then the auditor has to be 95% confident. Thus, there is an inverse relationship between the AAR and the firms confidence in the fair presentation of the financial statements. AAR is said to have three components: inherent risk, control risk, and planned detection risk. Inherent risk is a measure of the firms assessment of the susceptibility of material misstatement before considering the effectiveness of the internal control. The evaluation of inherent risk is based upon the nature of the clients business and the susceptibility to misstatement in particular accounts. For example, due to the possibility of theft and the large number of transactions affecting the account, cash is normally considered to have a higher level of inherent risk than prepaid expenses. The auditor does not effect inherent risk, rather he or she seeks to assess the level within the client. Control risk is a measure of the firms assessment of the likehood that if a material misstatement occurs it will not be prevented or detected by the clients internal control. The evaluation of control risk is based upon the effectiveness of Lakesides internal control. Fro example, if the engagement team concludes that Lakesides internal control is poor, then control risk will be set at the maximum level. Like inherent risk, the auditor does not affect control risk, rather he or she seeks to assess the level within the client. Planned detection risk is a measure of the firms assessment of the likelihood that material misstatements that occur and go undetected by the clients internal control will not be detected by the firms own audit procedures. The acceptable level of planned detection risk for an audit is inversely related to the firms assessment of inherent risk and control risk. If the inherent risk are judged to be high for a particular account or the company as a whole, then the acceptable level of planned detection risk is low. With planned detection risk at a low level, the auditor must plan to do more (or a higher quality of) substantive testing. In the planning stage of the audit, Andrews began to assess inherent risk by gaining an indepth knowledge of Lakeside. He reviewed the audit documentation of the predecessor auditor and spent a number of days at Lakesides headquarters studying various aspects of the business while also talking with key employees. In addition, he toured three of the retail stores and, at another time, questioned two of the regional sales representatives about the organization of teh companys distributorship business. Mitchell, the senior auditor is in charge of making a preliminary assessment of control risk. In the initial stages of the engagement, she and staff auditor Art Heyman are evaluating the five components of internal control. Based on the assessments of inherent and control risks, Mitchell will determine the acceptable level of planned detection risk, which will allow her to recommend substantive auditing procedures for the Lakeside engagement. These substantive procedures will be capable (according to her judgement) of generating the sufficient, competent evidence needed to render a decision as to the fair presentation of the financial statements. However, before Mitchells program is put into action, a review by both Cline and Andrews will be required. In most audits, the partner and

manager are likely to feel that additional testing is needed in cerain audit areas whereas less evidence may be adequate in others. The partner of Abernethy and Chapman stress that risk levels must be constantly monitored throughout an engagemnet. Hence, before the final audit program is prepared, a thorough investigation is made to identify all critical audit areas within the clients financial records. A critical area is defined by the firm as any account balance, any procedure within a system, or any potential problem where either the materiality or the risk of material misstatement is so great as to threaten the fairness of the reported data. Although Mitchell understands that the determination of critical areas will influence the spesific testing procedures to be included within the audit program, she also realizes that her firm has submitted a relatively low bid to get this engagement. Thus, she is aware that wasted time has to be avoided in order to complete the examination within the budgeted time period. By pinpointing any critical areas,Mitchell hopes to maximize audit efficiency. One of the principal techniques used during the assessment of inherent risk to identify critical audit areas is in an analytical review. Analytical procedures are considered so important that they are required to be performed during the initial planning stage and again at the final stage of the audit. According to Statement on Auditing Standard Number 56 (Paragraph 6), the objective of analytical procedures is to identify such things as the existence of unusual transactions and events, and amounts, ratios, and trends that might indicate matters that have financial statement and audit planning ramifications. Analytical procedures do not necessarily indicate that a balance is correctly or incorrectly reported. However, if a recorded amount differs significantly from the expectations, additional investigation is warranted. There are five types of analytical procedures-those that compare the clients data with: Industry data (such as industry average financial ratios) Similar prior period data (such as account balances in the previous year) Client-determined expected results (such as budgeted amounts) Expected results using non-financial information (such as square footage and shelf space in a warehouse to estimate maximum inventory quantities), and 5. Auditor determined expected results (such as estimates from historical trends in accounts or financial ratios) One of the most commonly applied analytical review procedures is called financial ratios analysis. Using this method allows an auditor to identify relationships among accounts that help to measure a companys liquidity, solvency, and profitability. A summary of some typical financial ratios is included in Exhibit 3-2. An auditor can use these ratios to identify trends from prior periods or to compare with other companies in the same industry. Exhibit 3-3 includes average ratios of companies in Lakesides industry: consumer electronics. Mitchell visited the Lakeside headquarters on October 17, 2006, to begin performing analytical procedures on that companys financial information for the first nine months of the current year. Prior to this date, she had carefully reviewed the Lakeside financial statements for the past two years (Exhibit 3-4, 3-5, and 3-6). She also studied industry data developed for her by the audit partner, Dan Cline (Exhibit 3-3) When Mitchell arrived at the clients headquarters, she obtained a trial balance from the controllers office (Exhibit 3-7) . before beginning her analysis, she discussed general ledger and trial balance procedures with Mark Hayes, the controller for Lakeside. He indicated that a trial balance is 1. 2. 3. 4.

prepared every two weeks to provide company officials with current data. Copies of this trial balance are distributed to Mr. Rogers, Mr. Miller, Ms. Howell, Mr. Davis, and Mr. Thomas for their review (Exhibit 4-1 for an organization chart). All ledger entries, except for inventory and cost of good solds, come from weekly posting of the companys journals. The various inventory figures are generated from a weekly summary sheet provided by the computer center that maintains Lakesides perpetual inventory records. At the end of each quarter, estimated figures for depreciation and bonuses are included to present a more realistic net income figure for the period. Income taxes are also estimated by Hayes and paid quarterly to the goverment. In addition, to promote comparability in evaluating the stores, a monthly rental charge is included for store 6. This figure, which is based on square footage and store location, is eliminated orior to preperation of external financial statements. However, company management believes that this expense is necessary for internal comparisons and decision making.