CHAPTER 10 A RISK-BASED AUDIT APPROACH PART I

I. Review Questions 1. Holding a belief that a potential conflict of interests always exists causes auditors to perform procedures to search for errors or irregularities that would have a material effect on financial statements. This tends to make audits more extensive for the auditor and more expensive for the client. The situation is not a desirable one in the vast majority of audits where no errors or irregularities exist. Errors and irregularities !uditors are re"uired to plan the audit to detect errors and irregularities that would have a material effect on the financial statements. Clients illegal acts !uditors are not re"uired to search for illegal acts# but they are warned to be alert to any that might be detected in the ordinary course of an audit. $. %even major assertions in financial statements a. Existence assertion The practical objective is to establish with evidence that assets# liabilities and e"uities actually exist and that sales and expense transactions actually occurred. &ut'off can be considered an aspect of the existence assertion. b. Occurrence assertion The practical objective is to establish with evidence that recorded transactions or events that occurred during a given accounting period pertained to the entity. c. Completeness assertion The practical objective is to establish with evidence that all transactions of the period are in the financial statements and all transactions that properly belong in the preceding or following accounting periods are excluded. !nother term for these aspects of completeness is cut-off. &ompleteness also refers to proper inclusion in financial statements of all assets# liabilities# revenue# expense# and related disclosures.

2.

10-2
Services

Solutions Manual - Principles of Auditing and Other Assurance

d.

Rights and Obligations assertion The practical objectives related to rights and obligations are to establish with evidence that assets are o ned (or rights such as capitali)ed leases are shown* and liabilities are o ed.

e.

Measurement assertion The practical objective is to establish with evidence that a transaction or event is recorded at the proper amount and revenue or expense is allocated to the proper period.

f.

!aluation assertion The practical objective is to establish with evidence that proper values have been assigned to things (assets# liabilities# e"uities and related disclosures* and events (revenues# expenses and related disclosures*. !uditing %tandards refer to the practical objective of obtaining evidence about +valuations, achieved by cost allocations such as depreciation and inventory costing methods.

g.

Presentation and "isclosure assertion The practical objective is to establish with evidence that accounting principles used by management are appropriate in the circumstances and are applied properly# and that disclosures contain all information re"uired by generally accepted accounting principles.

-.

.enefits of preliminary assessment of materiality /ine'tune the audit for effectiveness and efficiency. Help auditors avoid surprises related to /inding out too late about not auditing enough. /inding out later about auditing too much. Is 0122#222 material3 4aybe. Absolute si#e. If you think so# it5s material just because it5s a large number. Relative si#e. 6o. If 0122#222 is less than 17 of a relevant base. 4aybe. If 0122#222 is between 17 and 127 of a relevant base. 8es. If 0122#222 is 127 or more of a relevant base. $ature of the item. 8es# 0122#222 is material if it arises from an illegal act.

A Ris%-based Audit Approach & Part '

1.

10-3

8es# auditors have credited discovery of errors and irregularities to analytical review procedures in 29.17 of the cases in a set of audits# and another 1:.17 discovery rate was attributed to +prior expectations, and +discussions., In assessing inherent risk and control risk# the auditor must consider the types of errors or irregularities that might occur and their impact on the financial statements (materiality.* In evaluating materiality# the auditor should consider the impact of errors and irregularities both individually and in the aggregate. !uditing %tandards re"uire that the auditor design the audit to provide reasonable assurance of detecting errors and irregularities that are material to the financial statements. !uditing %tandards re"uire that audit risk and materiality be considered both in planning the audit and in evaluating audit results. &ontrol risk and inherent risk are also directly related to the setting of materiality thresholds. If# for example# application of analytical procedures (inherent risk analysis* leads the auditor to suspect earnings inflation# individual item materiality thresholds should be reduced accordingly (i.e.# either the materiality percentage or the amount of unaudited income should be decreased.* %imilarly# if control risk analysis leads the auditor to suspect numerous errors# aggregate materiality thresholds need to be lowered accordingly.

;.

9.

!n auditor5s reaction to an immaterial error may differ from his or her reaction to an immaterial irregularity. !uditors generally accumulate the amount of individual immaterial errors to be sure that the aggregate of all errors is not material. In addition# the auditor is concerned about whether an error came from a misunderstanding or other cause that would have resulted in yet more errors during the period. !n auditor is expected to report all irregularities to the audit committee or the board of directors and senior management. <efer to pages -12 to -11 of the textbook. <efer to pages -1$ to -1- of the textbook.

:. =.

12. <efer to page -2$ of the textbook. 11. Inventory is included in the ac"uisitions and payments# payroll and personnel (for manufacturing concerns*# and production and warehousing cycles. 12. (olerable misstatement is the amount of materiality allocated to an account or class of transactions. Tolerable misstatement is a portion of planning materiality allocated to the audit of an account or class of transactions and is directly related to materiality. 1$. The factors that should be considered are the peso amount of the account# the likelihood of error# and the cost of auditing the account.

10-4
Services

Solutions Manual - Principles of Auditing and Other Assurance

1-. In evaluating audit risk for an engagement# auditing standards indicate that an auditor should consider (1* management characteristics# (2* operating and industry characteristics# and ($* engagement characteristics. II. Multiple Choice Questions 1. 2. $. -. 1. d c c b d ;. 9. :. =. 12. a c d c d 11. 12. 1$. 1-. 11. d a c c a 1;. 19. 1:. 1=. 22. a a d b d 21. b

III. Comprehensive Cases Case 1. a. !ntonio5s activity is an irregularity (intentional distortion of financial statements* rather than error (unintentional mistake*. It is also an illegal act on !ntonio5s individual part. The problem does not describe the kind of related party transactions discussed in 0%! 112. 8es# a weakness in internal control exists. It may be considered a material weakness because the compensating control (internal auditors5 work on slow'moving inventory* did not operate in a timely enough manner to detect the irregularity before it had gotten large. If a material weakness in internal control exists# .rava > &ampos are obligated to report it to management and?or the board of directors. d. The problem description indicates that this element of the audit was conducted in a negligent manner. There5s nothing wrong about auditing a sample of the transactions# but &ampos5 follow'up and explanation of the missing receiving reports leaves much to be desired. !t the very least he could have reviewed the reports produced by !ntonio at a later date# and he could have traced the purchases to the inventory records and perhaps noticed an over'stocking condition. The auditors had some evidence that an irregularity might exist# but they failed to apply extended audit procedures properly. 8es. 6icolas was a party to the issuance of false financial statements and as such is a joint tortfeasor. The elements necessary to establish an action for common law fraud are present. There was a material misstatement of fact# knowledge of falsity (scienter*# intent that the plaintiff bank rely on the false statement# actual reliance and damage to the bank as a result thereof. If action is based upon fraud there is no re"uirement that the bank establish

b. c.

Case 2. a.

A Ris%-based Audit Approach & Part '

10-5

privity of contract with the &0!. 4oreover# if the action by the bank is based upon ordinary negligence# which does not re"uire a showing of scienter# the bank may recover as a third'party beneficiary (an exception to the strict privity re"uirement*. Thus# the bank will be able to recover its loss from 6icolas under either theory. b. 6o. The lessor was a party to the secret agreement. !s such# the lessor cannot claim reliance on the financial statements and cannot recover uncollected rents. @ven if he was damaged indirectly# his own fraudulent actions led to his loss# and the e"uitable principle of +unclean hands, precludes him from obtaining relief. 6icolas was not independent. His report is improper and he is probably subject to disciplinary action by the professional organi)ation or regulatory body. !ccording to the ethics interpretation on actual or threatened litigation +!n expressed intention by the present management to commence litigation against the auditor alleging deficiencies in audit work for the client is considered to impair independence if the auditor concludes that there is a strong possibility that such a claim will be filed., Case 3. 1. 2. $. Case 4. 1. 2. $. -. 1. ;. a. b. a. b. a. b. a. b. a. b. a. b. h k g -. 1. ;. j f a 9. :. =. o l c 12. b 11. n 12. p 1$. i 1-. d

c.

%ales and collections cycle 0resentation and disclosure 0roduction and warehousing Aaluation !c"uisitions and payments @xistence Investing and financing @xistence !c"uisitions and payments @xistence Investing and financing Aaluation

10-6
Services

Solutions Manual - Principles of Auditing and Other Assurance

9. a. b. Investing and financing <ights and obligations

Case 5. a.

!udit <isk B Inherent <isk x &ontrol <isk x Cetection <isk Cetection <isk B !udit <isk ? (Inherent <isk x &ontrol <isk* Cetection <isk B $7 ? (1227 x 127* Cetection <isk B ;7 Cetection <isk B !udit <isk ? (Inherent <isk x &ontrol <isk* Cetection <isk B 17 ? (1227 x 127* Cetection <isk B 12 7

b.

Case 6. (1* !djustment is not necessary for two reasons (a* The amount involved is not material. (b* The present classification is an acceptable one. (2* <eclassification of the credit balances is not warranted because the amounts are not material. ($* 4aking direct entries in the general ledger without use of journals is not an acceptable practice. It prevents proper authori)ation# is conducive to errors# and may be used to conceal fraud. Dournal entries should be developed by the client for the transactions in "uestion regardless of the amounts involved. (-* &redit memoranda should be controlled by serial numbers and should bear the approval signature of an executive in all cases. !ny violation of these rules is a virtual invitation to the concealment of irregular transactions. The client should be so advised in the report on internal control. (1* @xplanations should be re"uired for all general journal entries. ! transaction regarded as usual by one employee might be considered as unusual by another# and the practice now in effect will surely lead to journal entries not readily understandable. The client should be so advised. (;* 4issing posting references should be determined and inserted in the ledger by the client5s employees. (9* 6o adjustment is re"uired because the amount is not material. @ven if the amount were material# no adjustment would be re"uired for the purpose of calendar year financial statements. (:* This insignificant shortage should be called to the attention of the petty cash custodian and any paper work thereby avoidedE the amount involved does

A Ris%-based Audit Approach & Part '

not warrant any action by the auditors.

10-7

(=* !n adjusting entry should be proposed as follows !dvertising @xpense ....................... $#222 4iscellaneous @xpense............ $#222 To correct erroneous classification for expenditures for advertising. (12* !n adjusting entry is probably warranted in the case although the amount is relatively small. !s a means of assuring that all notes payable outstanding are reflected in the accounts# it is helpful to compute each period5s interest expense exactly and to reconcile this amount with the notes shown as outstanding. 0repaid Interest................................ 1#222 Interest @xpense ...................... 1#222 To defer interest expense applicable to the succeeding period. (012#222 x 12?122.* Case 7. The purposes of obtaining the representation letter are to have management acknowledge their primary responsibility for the financial statements# and to get in writing the important oral representations that have been obtained from management during the course of the audit. 0%! 122# Audit Evidence# re"uires that the auditors obtain written representations from management on every audit engagement. /ailure to do so is a +scope limitation#, which precludes the auditors from issuing an un"ualified opinion. The representation letter should be signed by members of management that are responsible for and knowledgeable about the matters covered by the representations and that# normally# they should be signed by the chief executive officer and the chief financial officer. The auditors should consider the effects of management5s refusal to furnish written representations on their ability to rely on other of their representations. 0%! 922# (he Auditors Report on )inancial Statements* states that when the client imposes restrictions that significantly limit the scope of the audit# the auditors generally should issue a disclaimer of opinion. (a* The following are alternative courses of action that are available to you# and supporting arguments. (1* 8ou could accept !ngeles5 suggestion and issue an un"ualified opinion. Celos %antos is no longer part of management of the company. Therefore# there is no reason to re"uire his signature on the

10-8
Services

Solutions Manual - Principles of Auditing and Other Assurance

representation letter. 8our firm can still adhere to the letter of the standard by having Famboa sign the letter. (2* 8ou could issue a "ualified opinion because of the scope limitation. delos %antos was an important part of management during the period under audit. He is knowledgeable of and responsible for many of the matters covered by the representations. /ailure to obtain his signature would be a significant scope limitation. %ince delos %antos is no longer part of management# this is not a scope limitation imposed by the client that would generally result in a disclaimer of opinion. ($* 8ou could issue a disclaimer of opinion# using the arguments from (2*# but concluding that the refusal to sign is a scope limitation imposed by management. The mysterious circumstances surrounding the resignation of delos %antos might also support this conclusion. (-* 8ou could withdraw from the engagement. This course of action may be justified if delos %antos5 refusal to sign the letter causes you to "uestion the integrity of management. The unanswered "uestions regarding the reasons for delos %antos5 resignation also provide some support for this course of action. (b* Gur opinion The mysterious circumstances surrounding the resignation of delos %antos should be of as much concern as delos %antos5 failure to sign the representation letter. 0erhaps delos %antos5 was being forced by other members of management to misstate the financial statements. !ssuming that the auditors could resolve their concerns about that matter# it probably would not be necessary to obtain delos %antos5 signature on the letter# and an un"ualified opinion could be issued. Gbtaining the signature of Famboa on the letter also is probably not important# because he is neither knowledgeable of nor responsible for the matters contained in the representation letter.