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SULTHAN HAKIM/ 145020308121003

International Undergraduate Program in Accounting of Brawijaya University

Course: Auditing Laboratory

AUDITING CASES: 3. AUDIT RISK AND ANALYTICAL PROCEDURE

DISCUSSION QUESTIONS

1. Although this question can be answered by a simple reading of Exhibit 3-1, it does force the
student to consider the contractual obligations being assumed by both parties. One portion of this
letter that might warrant discussion is the CPA firm's declaration that absolute assurance is not
being given in regard to major misstatements. The students can be queried as to the reasons for
including this statement. In addition, the students can be asked to discuss the method by which
the client company can draw the distinction between reasonable assurance and absolute
assurance. As a different line of questioning, the students can discuss other responsibilities that
could have been accepted by either party.

The engagement letter is required. Responsibilities of the CPA firm found in the engagement
letter:

To perform an audit in order to express an opinion on the client's financial statements


To make a search for material misstatements
To report any internal control weaknesses
To report any potential fee changes
To provide the final audit report by February 22, 2010.

Responsibilities of the client:


To pay the audit fee,
To provide a year-end trial balance by January 17, 2010, and an interim trial balance by
October 17, 2009,
To provide audit documents to the CPA firm as specified.

2. In performing analytical procedures, auditor expectations should be derived from a wide variety
of sources. For cost of goods sold, Abernethy and Chapman should consider each of the
following in arriving at an anticipated total:
- Past figures. If cost of goods sold has always been a certain percentage of Lakeside's sales,
that same relationship would be expected to continue unless other factors have changed. Had
Lakeside, for example, switched from cheaper products to more expensive ones, the
relationship between cost of goods sold and sales would possibly be affected. Or, if Lakeside
has dropped the Cypress line in order to sell the products of some other manufacturer, a
similar change might have been anticipated. However, without an adjustment of this type,
cost of goods sold as a percentage of sales would be expected to remain stable.
- Industry averages. By studying trade publications, Abernethy and Chapman can determine an
industry average for cost of goods sold as a percentage of sales. Although Lakeside's results
could not be expected to be exactly the same as this average, the auditors should not anticipate
a significant variation to occur without some adequate explanation.
- Competitors. If available, the financial statements of competing companies can be used to
determine the normal relationship of cost of goods sold to sales. Although no two companies
are ever alike, important comparisons such as this one should be made between similar
companies.
- Budgeted figures. If Lakeside has an annual budget, the numbers estimated by the company
at the beginning of the period can be used by the auditor in establishing an expected cost of
goods sold

3. The potential problem areas that be inherent in auditing a business like a Lakeside Company,
such as:
Lakeside holds an inventory of high technology items: consumer electronic equipment.
Obsolescence of a portion of this merchandise is an ever- present danger because of new
innovations. The inventory can also be easily damaged, a problem that is not always
visually obvious.
Lakeside distributes merchandise to retail stores. A generous return policy is provided;
thus, an estimate must be made of the sales returns that will be received by the company
after the audit is concluded.
Lakeside sells on credit throughout two states. Hence, estimating collections from
accounts receivable may be difficult.
Lakeside rents a number of its stores. The auditor must determine whether capitalization
of these leases is required.
Lakeside has a large amount of debt. The auditor has to ensure that all debt is being
properly reported and disclosed. The interest expense associated with these liabilities
must also be correctly calculated and recognized. In addition, the auditors need to verify
that all loan covenants are being met.
Lakeside is considering going public. A company attempting to raise significant capital
may be tempted to over-estimate assets and revenues. The auditor needs to be particularly
careful on accounts that lend themselves to significant estimate.

4. The auditor must be satisfied that sufficient, competent evidence has been obtained to substantiate
an opinion concerning the fair presentation of the client's financial statements. The decision as to
the sufficiency of this evidence is left solely to the judgment of the auditor. Only through years
of experience can the auditor develop the ability to make this determination. Although specific
guidelines for this decision are not available, all significant problems must be resolved and all
suspicious occurrences should be investigated. Evidence needs to be accumulated for each
significant area of the financial statements to substantiate the assertions made by the client about
its reported balances. Where inherent risk and control risk are judged to be high, the auditor must
take steps to reduce detection risk to an acceptable level. In such cases, several steps are possible:
performing additional substantive testing, using more experienced staff personnel, performing
testing procedures closer to the balance sheet date, or relying on more effective testing
procedures.

Another factor that influences the auditor's decision is the quality of evidence being accumulated.
Some information may come directly to the auditors from outside parties, data that is usually
considered to be of a higher quality than evidence prepared by the client company. Less evidence
is required if it is judged by the auditor to be of a high quality.

Although each of these factors is considered, the ultimate decision still must rest with the auditor's
judgment. This individual is taking responsibility for the audit opinion as well as accepting the
risks involved in circulating this report. Thus, the auditor must be satisfied that, based upon the
wisdom gained through years of audit experience, sufficient evidence has been obtained.

5. Any discussion as to the "quality" of evidence being gathered by analytical procedures must be
based on the objective of the testing. Analytical procedures performed in the planning stage are
not primarily designed for the purpose of indicating the fair presentation of financial information.
Instead, they are used in the assessment of risk, to alert the auditor to potential problem areas that
may require additional substantive testing. In that respect, analytical procedures serve a vital
audit purpose. Students should always be reminded, though, that this testing is only one
component of the overall substantive testing being performed by the independent auditor.
Furthermore, analytical procedures provide circumstantial evidence which, taken alone, is not a
high quality type of evidence.

6. Knowledge of the consumer electronics business is just one aspect of Cline's expertise that will
allow him to evaluate the fair presentation of Lakeside's financial statements. Overall knowledge
of the client company and the industry in which it operates should also allow the auditor to:

- identify areas that may need special consideration;


- assess conditions under which accounting data are produced, processed, reviewed, and
accumulated within the organization;
- evaluate the reasonableness of estimates;
- evaluate the accuracy of management representations;
- make judgments about the appropriateness of the accounting principles applied and the
adequacy of disclosures.

Knowledge of a business and the industry in which it operates may be obtained from examining
the client company's accounting records and inquiry of the client personnel. This information
can be supplemented through review of the prior years' audit documents, AICPA Accounting
and Audit Guides, industry publications, financial statements from other companies in the same
industry, college textbooks, magazines, and other trade periodicals.

Since the students may not be familiar with the AICPA Industry Audit Guides, the instructor
may want to bring an example or two to class for this discussion. Examples of the industries
covered by these audit guides include:
- Airlines
- Finance Companies
- Investment Companies
- Providers of Health Care Services

7. A number of the current concerns faced by auditing firms as well as the auditing profession as a
whole relate either directly or indirectly to increased price competition. Through class discussion
of this particular question, students should be able to ascertain at least three of these problems:

- Price competition forces narrow time constraints on the work of the independent auditor.
In order to finish an audit engagement in a short enough time so that a reasonable profit
can be made, a danger exists that the auditor will 1) accept less than sufficient evidence,
2) fail to recognize critical audit areas, or 3) not be able to acquire the depth of knowledge
necessary for essential audit judgments. Thus, the argument is frequently raised that price
competition leads to a decrease in overall audit quality.
- Because the initial year of an audit will often require significantly more time than
examinations of subsequent years, price competition can lead a firm to actually lose
money in the first year of an engagement. Therefore, the CPA firm must work to keep a
client for several years to offset this initial loss and produce a reasonable profit. The
necessity of retaining an engagement for a number of years may force the firm to be
subservient to management's demands to avoid being fired. This argument has lost much
of its impact over the last few years as client companies have established audit committees
comprised of outside members of the board of directors to ensure the independence of the
auditing firm
- Many auditors also feel that price competition is generally detrimental to the public
accounting profession. The main thrust of this argument is that price competition
encourages companies to select their independent auditors based primarily on cost rather
than on the quality of audit work. This type of selection process would favor firms
offering cheap rates over auditing firms offering quality services.

After the students have been allowed to discuss the problems associated with price competition,
the instructor may want to ask whether these problems outweigh the advantages of having the
auditing profession participate in the free market system. Since most business students in the
United States appear to advocate free markets within the country, some interesting discussion can
be stimulated as to whether the auditing profession should be exempt from price competition.
8. According to the audit risk model, planned detection risk (PDR) equals acceptable audit risk
(AAR) divided by the product of inherent risk (IR) and control risk (CR). Holding inherent risk
and acceptable audit risk constant, there is an inverse relationship between control risk and
planned detection risk. Thus, an increase (decrease) in control risk leads to a decrease (increase)
in planned detection risk. Also, as planned detection risk decreases (increases), the amount of
substantive tests and other audit procedures increases (decreases). That is, if the auditor
determines the level of detection risk to be low, he or she wants the chance of not detecting an
error too small. In order to have a small chance of not detecting an error, the auditor must do
more testing. For example, given AAR=10% and IR=80%, and assuming an 80% CR (high), then
using the audit risk model, planned detection risk is a relatively low 15.6% [.10/(.80x.80)], but
assuming a 20% CR (low), then planned detection risk is a relatively high 62.5% [.10/(.80x.20)].

9. According to SAS 99 the assessment of the risk of fraud begins with a meeting of the entire team
for such purpose. This brainstorming session needs to encourage the involvement of all team
members and cannot be just a staff training session. The objective is to solicit the ideas from all
team members and to sensitize the entire team to the particular problem areas that this client
presents. The process begins with such a session, but does not end there. During the audit the
entire team needs to consider how the information being developed relates to the areas already
identified, noting new areas that need attention, or adjusting expectations on the areas already
identified. The areas identified by fraud risk are primarily in the areas of inherent risk and control
risk. Increased fraud risk represents an increase in inherent risk (the risk that errors exist) or will
also increase the control risk (the risk that the clients internal control system will not detect the
error or irregularity).

10. The registration process is not difficult. Maintaining the status of a registered CPA firm is more
difficult and requires that the firm be willing to adjust its operations including independence and
staffing quality control standards to meet the higher expectations of the PCAOB. They may also
be required to change the nature of their practice, at least as far as publicly traded clients because
of the list of proscribed activities. Abernathy and Chapman have sufficient time to become
registered and therefore need only be concerned about accepting Lakeside as a client if there is
some obstacle to their registration. If Lakeside asks if they are currently registered, then the
answer has to be, no, but we are pursing registration.

EXERCISES

1. Performing analytical procedures is one aspect of an auditing course that traditionally


generates a lot of student interest and enthusiasm. One method of approaching this question is
to have the class list the potential problems that were discovered and then discuss the relative
severity of each. The students can be asked to consider the appropriate response that should
be made by the audit team to each of the elements listed. By discussing the various possible
responses, students are better able to recognize the attest function as a fluid process that must
be flexible enough to adapt to a specific set of circumstances. It should be noted to students
that, in practice, several years (rather than two) would be analyzed for trends:

a) Ratio analysis from 2007 to 2008.

Ratio 2007 2008 Significance


Current 1.35 1.36 No significant change
# Days inventory on 93 101 Increase may indicate obsolete or slow
hand moving inventory on hand
Receivable collection 21 25 Slight increase may indicate relaxing of
period (days) credit policies and/or possible
understatement of allowance
Debt-to-total-assets 74.4% 74.5% No significant change; however, the high
ratio indicates significant leverage and
potential solvency problems if additional
debt is needed
Times interest earned 3.6 times 2.8 times Decline indicates reduced ability to meet
interest payments through operations

Profit Margin 2.79% 2.27% No significant change


Return on Assets 8.47% 6.73% Declining return results from a combination
of declining net income and increasing total
asset base.
Return on Equity 33.2% 26.4% Decline in return results from a
combination of declining net income and
increasing equity base.

Conclusion: Lakeside had no significant changes in its liquidity or solvency levels;


however, the company appears to be experiencing a decline in its profitability level. The
audit staff should pay particular attention to revenue- enhancing or expense-reducing areas,
such as fictitious sales or improper capitalization of expenses to halt this downward trend.

b) Ratio analysis: comparison to industry.

Ratio Industry Ave. Lakeside 2008 Significance


Current 1.73 1.36 Lakeside is below the industry average.
This may indicate short-term solvency
(liquidity) problems.
Days inventory on 65 101 Lakeside is well above the industry
hand average. This may indicate short-term
solvency problems.
Receivables collection 11 25 Lakeside is well above the industry
period average. This may indicate short-term
solvency problems.
Debt-to-total-assets 13% 74.5% Lakeside is significantly above the industry
average; this may indicate long-term
solvency problems.
Times interest earned 30 times 2.8 times Lakeside is significantly below the industry
average; this may indicate solvency
problems.
Profit Margin 2.93% 2.27% Lakeside is only slightly below the
industry average.
Return on Assets 6.09% 6.73% Lakeside is only slightly above the
industry average.
Return on Equity 13.27% 26.4% Lakeside is significantly above the
Ratio Industry Ave. Lakeside 2008 Significance
industry average.

Conclusion: Lakeside is well below the liquidity level of the industry, and the company is in a significantly
worse solvency level than the industry. Auditors should be aware of methods to enhance the liquidity and
solvency levels, such as unrecorded liabilities. Lakeside profitability is about the same as the industry average,
except for return on equity, in which it is more than double that of the industry (primarily due to the high level
of leverage).

c. Scan the financial statements and the trial balances.

Procedure Results Significance


Scan the income statement [Note: The company's stores continue to These losses suggest the possibility
instructors may want to suggest that report an overall loss which is that the stores will eventually be
students prepare a common size increasing in amount. discontinued by Lakeside or
income statement] drastically altered in some manner.

Scan the balance sheet [Note: Nothing unusual


instructors may want to suggest that
students prepare a common size
balance sheet]
Scan the cash flow statement Cash flow from operations The cash flow problems, combined
declined significantly in 2008. with the solvency problems may
indicate a problem with the
company's ability to continue as a
going concern.
Scan the trial balance Something appears to be wrong with These fluctuations could indicate
the information generated by Store recording errors or an employee
Three. The sales for that store have attempting to inflate the earnings
increased by approximately 94% being reported for Store Three. This
since the previous year. At the same problem is more germane than might
time, the cost of the goods sold has be encountered normally because of
dropped from 58.5% of sales (which the profit- sharing bonus system that
is consistent with the other stores) to rewards employees for reporting high
only 50.3% of sales. Also, the income figures.
inventory held by this store has risen
by over 50%.

Scan the trial balance Sales Commissions for District D in Although not necessarily a material
2009 appear to be slightly out of line. figure, the potential error should be
All of the other commissions are investigated so that Lakeside can
approximately 5.7% of sales, while make the appropriate corrections if
this account is nearly 7% of the needed.
applicable sales figure.

Scan the trial balance Rent expense on vehicles and Such a decrease often serves to
equipment has decreased in 2009. indicate that the company has
acquired new property.
Scan the trial balance The Repairs and Maintenance This significant increment may
account has increased by over 150% indicate a posting error that will
since 2008. require correction. Conversely,
Procedure Results Significance
actual repairs may have been made by
Lakeside. In that situation, the auditor
needs to verify that all capitalized
costs have been segregated and
properly accounted for within the
company records.

Scan the trial balance The "Gain on Disposition of Fixed Often a company will fail to remove
Asset" balance of $14,000 warrants the appropriate cost and related
investigation. accumulated depreciation when a
plant asset is sold. The auditor should
also ascertain that the current year
depreciation expense has been
properly recognized. Finally, the sale
of an asset can lead to the acquisition
of a new asset as a replacement. The
independent auditor should follow up
on this possibility to assure that any
replacement is appropriately
capitalized.

Scan the trial balance The Allowance for Doubtful The auditor should determine if the
Accounts balance shows a debit client has written off an especially
balance on September 30, 2009, large group of accounts. Perhaps bad
compared to a credit balance one year debt experience is changing and a
earlier. larger allowance is required.

Scan the trial balance The company's two bank credit lines The auditor should verify that no loan
now have a total balance that exceeds covenants have been broken. In
the $750,000 maximum that was addition, because of disclosure
indicated in an earlier case. requirements as well as the effects on
the interest expense account, the
auditors will need to review any new
borrowing agreement.

Scan the trial balance The long-term notes payable have The auditor should determine the
increased by $50,000. The auditor application of those funds as well as
would certainly be interested in the the loan agreement signed by the
application of those funds as well as company.
the loan agreement signed by the
company.

Scan the trial balance Sales returns have increased The auditors need to ascertain the
significantly for both the company reasons for such an increase. Any
stores and the distributorship. change in the trend for sales returns
would lead the auditors to reevaluate
year-end accruals.
Scan the trial balance The equipment account shows an If the company has acquired
increase from the previous year. additional equipment during the year,
the auditor needs to verify that
capitalization and depreciation were
given proper treatment.
Procedure Results Significance

Scan the trial balance The estimated bonus expense has That increase is probably due to the
increased. profit-sharing plan having been in
effect for all nine months of 2009, but
the increase should be investigated.