CASE 1: ANALYSIS OF POTENTIAL AUDIT CLIENT

DISCUSSION QUESTIONS

1. Why would the owners of Lakeside, as well as the company’s banks, require that an
annual audit be made by an independent CPA firm?
Outside parties are aware that the financial information produced by a company and its
management may not always be reliable and to add creditability to this reporting process.
Under the PSA 200 par. 2 states that the audit of financial statements to enable the auditor to
express opinion whether the financial statements are prepared, in all materials respect, in
accordance with an identified financial reporting framework. The management of the firm and
the users of financial information have different objectives when it comes to financial a
statement, that’s why there is a need to be an independent auditor so that they can remain
unbiased. Independent experts are retained to audit the financial statements and to test the
underlying accounting records. Then auditors issue an opinion for the benefit of outside parties.
The added degree of assuredness allows decisions makers to rely on reported financial
information. And because the owner wants to show the public a “good-look” of its financial
statements; since he would like to receive more capital by making his company public. In
addition, good-looking financial statements of the company could provide good credit from the
bank. To the lakeside company, the owner would like to provide audited financial statement to
the bank to obtain the loan and receive the best possible interest rate. On the other hand, a
decision by a bank loan officer about whether to make a loan to Lakeside Company and what
rate of interest adequately compensates the bank for the level of risk assumed depends on an
independent auditing report about lakeside’s financial reports. An auditing report about the
company is reliable for the bank; it can significantly reduce the level of information risk. If the
loan officer has assurance from the auditors that the company’s financial statements are
prepared in accordance with GAAP, he or she will have more confidence in his or her
assessment of business risk. By reducing information risk, the audit reduces the overall risk to
the bank.

2. Can an accounting firm hope to accrue any real benefits from a marketing campaign
such as the one carried out by Abernethy and Chapman? Should the management of a
company select its auditors based on advertisements?
An accounting firm is a business like any other, and its management must recognize that
a marketing strategy is probably necessary to generate a continual flow of sufficient operating
revenues. However, in the accounting profession, disagreement exists as to the extent that
such marketing should take. In the past, overt marketing was not permitted since it was
considered to be unprofessional. This position was supported based on the reasoning that a
firm should be selected based solely on the quality of its service. No reliable system existed,
though, for conveying such information to potential clients. Hence, firms with many clients
tended to remain large, while smaller firms often found growth to be nearly impossible. In the
free market system espoused by the United States, restrictions on such practices as advertising
and solicitation were inevitably overturned. Over the past three decades, attitudes toward
marketing have changed dramatically as competition has become much more intense.
Advertisements by CPA firms in newspapers and magazines are now common. Newsletters
such as that distributed by Abernethy and Chapman are also frequently used to increase a
firm's name recognition in the business community.
In the current world of business, some type of marketing strategy seems imperative if
an accounting firm is to compete. Whether that marketing should extend to formal advertising
is often a question of firm policy. Most importantly, the firm must ensure that potential clients
know of its presence and the services that it offers. A client will probably not select a CPA firm
based on advertising. However, the client may initially become aware of the firm only through
some type of marketing.
Interestingly, some members of the accounting profession view marketing as having had
a negative impact on the profession as a whole. Price competition for new clients is often
associated with the marketing of a firm. These critics assert that lowered fees result in sloppy
and hurried audit work that can decrease the overall reputation of the profession. (Additional
resources discussing this issue can be found in the "Suggested Readings" at the end of this
case.)

 The Abernethy and Chapman can advertise their work through advertisements or any
marketing campaign as long as they are not bringing the profession into disrepute when
marketing professional services (Code of Ethics, Section 250.2)
 It means that they should be honest and truthful and should not make exaggerated claims for
services offered.
 Regarding if the firm can hope to accrue any real benefits from such marketing campaign, the
Abernethy and Chapman should not claim that the increased in revenue is caused by
advertisements alone. There are other factors that may contribute to this growth. As they
have said, continuing emphasis on high-quality auditing and accounting services have also
generated to this increased revenue. The management should be prudent in selecting its
auditor who can competently provide the professional services they needed.

3. This case implies that no auditor with the firm of Abernethy and Chapman has as in-
depth understanding of the audio equipment business. Is a CPA firm allowed to accept
an engagement without having established the necessary expertise to oversee the audit?
Would the knowledge required to audit an audio equipment company differ
significantly from that needed in the examination of a car dealership?
 CPA firm could not be expected to maintain expertise in every potential industry that it
might audit. When reviewing potential new clients, the firm should evaluate the ability to gain
the necessary industry expertise prior to the audit. Industries may have its own specific
accounting practices; these industries could offer unique auditing problems. So without a
thorough investigation auditors cannot ascertain the knowledge that is needed to examine the
potential client. In consumer electronics business distribution and credit policies would be very
different then what you would find at the car dealership. Auditing standards only require that
the auditor have the expertise by the completion of the audit. It would be unethical to
misrepresent a firm’s experience.

4. Many businesses encounter significant uncertainties yet most opinions do not include
an extra paragraph. Why did lakeside’s problem with its store number six lead the
auditors to provide the additional warning?

“A paragraph included in the auditor’s report that refers to a matter appropriately presented or
disclosed in the financial statements that, in the auditor’s judgment, is of such importance that it
is fundamental to user’s understanding of the financial statements.”
Additional paragraph added by the auditors of king and company:
“King and Company were not satisfied that the company would be able to recover the $186,000
investment in its latest store.”
“Lakeside store had, consequently, never been able to generate the customer traffic necessary to
even come to a break-even point.”
“The continuing failure of the shopping center made the fate of the lakeside store to appear quite
uncertain to King and Company.
 The profits generated by Lakeside Store may not be enough if compared with the costs it
incurs for its operations.
 The sixth store was constructed with the funds provided by loans entailing interest
payments plus its loans from the two Richmond banks to meet its payment terms for their
audio equipment inventory.
 The failure of the shopping center to be successful also affected the company.
These uncertainties lead the audit firm to provide an additional paragraph in its audit report
regarding the potential impact on the stability, profitability and solvency of the company, to be
used by the users of information. These facts must be objectively disclosed if considered material
upon the professional judgment of the auditor.
5. Lakeside has recently created a profit-sharing bonus plan. Why might such an
incentive be a special concern to an auditor?
Auditors must assess the possibility of fraud risk factors. Fraud risk factors are events or
situations that would indicate an increases possibility that fraud has occurred. Lakeside has
recently created a profit-sharing bonus plan. Profit-sharing bonus plans gives the employees an
incentive to seek increases in company income, however the employees could be tempted to
inflate income. The employees could do this a few ways by creating nonexistent sales, or
holding off on recording expenses to another quarter or year. Fraud could become a problem at
Lakeside Companying the near future because the profit-sharing bonus plan is new and the
stores are not close to the home office.
A profit-sharing bonus plan gives employees an added incentive to seek increases in
company income; a larger profit figure will lead to a larger bonus at the end of the year.
Consequently, employees may be tempted to inflate income artificially by creating false sales or
deferring the recording of expenses. An auditor must always be alert for situations that can
promote the possibility of such irregularities. A profit-sharing bonus plan may well have only
positive effects on company employees. However, the auditor should not be so naive as to fail
to recognize that some individuals may take advantage of such plans by manipulating the
financial records.
This problem may be especially significant in the Lakeside Company because the bonus
plan is new and the stores are geographically located at a distance from the home office. New
plans require adaptation by company controls and such separation always increases potential
control concerns. In addition, Rogers has already mentioned that some of the internal control
systems are no longer adequate. Thus, the possibility of inflated income figures is even more of
a possibility.

6. Rogers wants Abernethy and Chapman to assist his company in developing new
accounting systems. Does a CPA firm face an independence problem in auditing the
output of systems that its own employees have designed and installed?

 Auditor should plan and perform the audit with Professional Competence and Due Care
(PSA 200, par. 4). In this regards, professional accountants are obliged to maintain
professional knowledge and skill at the level required to ensure that clients or employers
receive competent professional services and to act diligently in accordance with applicable
technical and professional standards ( Code of Ethics, Sec.130, par1)
 It is therefore presumed that a CPA firm has established the necessary expertise and has
sufficient personnel with enough capabilities and competence on the time it accepted such
engagement. Moreover, before accepting as new client relationship, a professional
accountant in public practice should consider whether acceptance would create any threats in
 compliance with the fundamentals principles. He/she must provide only those services within
the professional bounds.
 Information produced by an audio equipment company is not significantly different from that
acquired from a car dealership because they are of the same industry, in this case,
merchandising industry. And, any information lags may be consulted to an expert.

7. In recent years, many CPA firms have been acquired by larger (often national or
international) firms. Why might a large organization consider purchasing an
accounting firm such as Abernethy and Chapman? Why might Abernethy and
Chapman agree to be acquired? Is this “merger mania” good for the accounting
profession?

The major reasons merger mania is alive and well now and for the foreseeable future is that
merging accounting firms, at a minimum, expect to:
 Establish internal and external plans for their short term and long-term succession
 Establish competitive advantage
 Eliminate competitive disadvantage
 Expand their geographic footprint for better client acquisition opportunity
 Expand current services portfolios
 Stabilize revenue streams

However, both the acquirer and the acquiree (in this case the CPA firm of Abernethy and
Chapman), should consider their clients before doing a merger. They might want to consult their
clients first or finish their auditing engagements with them before doing a merger with a larger
company. With this, they might not encounter further conflicts or problems that might arise in
accordance to Philippine Standard on Auditing and Code of Ethics

Further, other limitations may affect the persuasiveness of evidence available to draw
conclusions on particular financial statement assertions (for example, transactions between
related parties). In these cases, certain PSAs identify specified procedures which will, because of
the nature of the particular assertions, provide sufficient appropriate audit evidence in the
absence in the absence of:
A. Unusual circumstances which increase the risk of material misstatements beyond that
which would ordinarily be expected.
B. Any indication that a materials misstatement has occurred (PSA 200, par. 11)
 WRITTEN QUESTIONS
1. Following the above conference with Rogers, Abernethy asks Andrews to produce a memo
listing the potential problems that the firm might encounter in this audit. Prepare this memo
for the lakeside engagement. Include all accounts and transactions that seem to require
special attention. Evaluate the possible severity of each of these concerns.

Area that Should be Reviewed Purpose of Review

Proposed Adjusting Entries To determine the type and materiality of the proposed
adjustments
Opening Balances in Accounts Ensure that the opening balances were audited and that enough
evidence was collected
Look Through Work Papers Regarding Evaluate if internal controls have any weaknesses or if there are
Internal Controls any areas that do not have controls in place, as well as strong
controls that are in place
Understand accounting principles that Understand how Lakeside has consistently recorded their
Lakeside previously used accounts
Audit Results Understand what previous auditors found and be wary of that
information while moving forward with the client.
For example, the “impairment of value”
from the case

Documentation of Audit Planning Decide if the predecessor’s planning

steps of the audit were efficient or not, and then compare their
planning steps to those of Abernethy and Chapman. This could
save time in the future while going through the audit and make
the audit more thorough

Contingencies Understand what King Company’s thoughts and concerns of

Lakeside’s
contingency plan were and use them for further insight when
Abernethy and Chapman look into the contingency plan

Significant and Unusual Transactions Determine if Lakeside Company has any unique transactions that
could
2. Andrews was also assigned to visit the headquarters/warehouse of lakeside to tour the
facility. What should Andrews observe, and what factors should he be especially aware of
during this visit?
3. Prepare the auditor’s report that king and company rendered at the end of the 1990
engagement. How does this qualified opinion differ from a standard auditor’s report?

INDEPENDENT AUDITOR'S REPORT

To the Board of Directors:

We have audited the accompanying balance sheet of the Lakeside Company as

of December 31, 2011, and the related statements of income, retained earnings, and
cash flows for the year then ended. These financial statements are the responsibility
of the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audit.

We conducted our audit in accordance with auditing standards generally

accepted in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial statements.
An audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audit provides a reasonable basis for
our opinion.

During 2010, the Lakeside Company made a large investment in a retail store
located in the eastern sector of Richmond, Virginia. This store has failed to reach a
break-even sales point to date, and total recovery of the Company's investment is
highly uncertain. In our opinion, the chances are reasonably possible that the asset's
value has been permanently impaired and should be reduced to the net realizable
value in conformity with generally accepted accounting principles. Management of
the company has refused to recognize this impairment loss.

In our opinion, except for the effects of not recording or disclosing the impairment
of value of the asset, as discussed in the preceding paragraph, the aforementioned
financial statements present fairly, in all material respects, the financial position of
the Lakeside Company at December 31, 2011, and the results of its operations and
its cash flows for the year then ended in conformity with accounting principles
generally accepted in the United States of America.

King and Company (signed), Certified Public Accountants

Date: (last day of audit fieldwork)
CASE 2: NEW CLIENTS AND AN AUDITOR’S LEGAL LIABILITY

DISCUSSION QUESTIONS

1. King and Company faced a materiality question in forming its 1990 audit opinion. How do
auditors evaluate the materiality of an item in a specific engagement? Do you believe that the
investment in the sixth store was actually material to the Lakeside Company?

A materiality uncertainty exists when the impact of going concern problem is significant such
that, in the auditor's judgement, clear disclosures of the nature and implications of
uncertainties is necessary for the fair presentation of the financial statements.

Auditors evaluate materiality of an item in a specific engagement by determining its materiality

level or amount of misstatement/omission that could be material to the financial statements
taken as a whole. The measurement of materiality is based on its effect, eg. materiality is set
too high if its misstatement could significantly influence the economic decision of users taken
on the basis of financial statements. This will guide the judgement of the auditor when first
detecting and evaluating the risk of material misstatement.

Materiality of uncertainty can be determined by having a proper basis of comparison, which in

this case is the net income (write-off effect) or another consideration is which of the
statements are affected? (Balance sheet and income statement) looking at the case and judging
it based on comparison of potential loss to total assets, investment in stores and owner's
equity, it is assumed that there's a reasonable basis of materiality.

Possible closing of the 6th store due to continuous financial losses plus the potential loss of
186,000 against client's net worth of 500,000 would certainly appear to be material. Other
comparisons based on total assets or net income would yield to same result.

2. When a major uncertainly exists, the reporting entity must fully disclose all relevant
information within its financial statements. Some auditors believe that this disclosure fulfills
the reporting requirements; thus, an extra paragraph within the audit report provides no
additional information to the reader and is neither beneficial nor needed. Why uncertainty
disclosure is still considered necessary by the auditing profession? Should this requirement
be dropped or changed?
Auditors are most likely to require adjustments under conditions of highest uncertainty,
that is, when fair values are both more subjectively-determined and more imprecise in
outcomes; however this tendency disappears when clients supplement recognized fair values
with additional disclosure. My finding suggests that the SEC’s preference for supplemental
disclosure has the unintended consequence of impacting fair values recognized in the body of
the financial statements. Finally, although imprecision sometimes makes it more likely that
auditors will require an adjustment, the dollar amount of adjustment is smaller.
3. If Rogers had not consented in having Abernethy talk with the predecessor auditor, what
actions would have been open to Abernethy?
The action that would have been open to abernethy is that there will be a further investigation
if he cannot get a info to the predecessor auditor also there are alternative ways like checking
the regulatory bodies or SEC so that abernethy can conclude what he will do.

4. If Abernethy had learned from King that Rogers or his staff lacked integrity, what action
should have then been followed and why?

. If Abernathy discovered that Rogers and/or his staff lacked integrity through its predecessor
auditing firm, before rejecting or disassociating to client, there shall be proofs or evidences to
support the claim or perform an investigation considering the following to test the integrity of
client:

a. Identify and business reputation of the client's principal owners, key management, related
parties and those charged with its governance.

b. The nature of the client's operations, including its business practices.

c. Information concerning the attitude of the client's principal owners, key management and
those charged with its governance towards such matters as aggressive interpretation of
accounting standards and the internal control environment.

d. Whether the client is aggressively concerned with maintaining the firm's fees as low as
possible.

e. Indications of an inappropriate limitation in the scope of work.

f. Indications that the client might be involved in money laundering or other criminal activities.

g. The reasons for the proposed appointment of the firm and non-reappointment of the
previous firm.
Perform additional investigation to ensure the integrity of client through inquiry of other firm
personnel or third parties such as bankers, legal counsel and industry peers or do background
searches of relevant databases.

This discovery though doesn't give rise to an impulsive or reckless rejection, the firm should
also consider the quality/ internal control of the client and its course of action.

5. What is the purpose of a peer review? Why have peer reviews become necessary? What does
the peer review team examine?

The peer review helps to monitor a CPA firm’s accounting and auditing practice (practice
monitoring). The goal of the practice monitoring, and the program itself, is to promote and
enhance quality in the accounting and auditing services provided by the CPA firms subject to
these standards. This goal serves the public interest and enhances the significance of AICPA
membership and accounting and audit quality.

There are two types of peer reviews: System Reviews and Engagement Reviews. System
Reviews focus on a firm’s system of quality control and Engagement Reviews focus on work
performed on particular selected engagements. While a System Review is a type of peer review
that is a study and appraisal by an independent evaluator(s), known as a peer reviewer, of a
CPA firm’s system of quality control to perform accounting and auditing work. The system
represents the policies and procedures that the CPA firm has designed, and is expected to
follow, when performing its work. The peer reviewer’s objective is to determine whether the
system is designed to ensure conformity with professional standards and whether the firm is
complying with its system appropriately.

To plan a System Review, a peer reviewer obtains an understanding of (1) the firm’s accounting
and auditing practice, such as the industries of its clients, and (2) the design of the firm’s
system, including its policies and procedures and how the firm checks itself that it is complying
with them. The reviewer assesses the risk levels implicit within different aspects of the firm’s
practice and its system. The reviewer obtains this understanding through inquiry of firm
personnel and review of documentation on the system, such as firm manuals.

The reviewer examines engagement working paper files and reports, interviews selected firm
personnel, reviews representations from the firm, and examines selected administrative and
personnel files. The objectives of obtaining an understanding of the system and then testing the
system forms the basis for the reviewer’s conclusions in the peer review report.
 6. What is the purpose of working papers and what general data should be found in (1) a
permanent file and (2) an annual working paper file?

Audit working papers are used to document the information gathered during an audit. These
working papers provide evidence that sufficient information was obtained by an auditor to
support his or her opinion regarding the underlying financial statement through the following
functions:

 are necessary for audit quality control purposes

 provide assurance that the work delegated by the audit partner has been properly completed
 provide evidence that an effective audit has been carried out
 increase the economy, efficiency, and effectiveness of the audit
 contain sufficiently detailed and
 up-to-date facts which justify the reasonableness of the auditor’s conclusions
 retain a record of matters of continuing significance to future audits.

A permanent file is a set of records that serves as an ongoing reference for an organization's
external auditors. The information in the file is intended to be accessed repeatedly in successive
audits to assist the audit team in the conduct of their tasks. The file may contain the following
documents:

 Accounting policies
 Articles of incorporation
 Bylaws
 Chart of accounts
 Director list
 History of the client organization
 Internal controls documentation
 Organization chart
 Prior year's audit report

Annual working paper files

Typically each audit working paper must be headed with the following information:

 The name of the client

 The period covered by the audit
 The subject matter
 The file reference (3)
 The initials (signature) of the member of staff who prepared the working paper, and the
date on which it was prepared
 In the case of audit papers prepared by client staff, the date the working papers were
received, and the initials of the audit team member who carried out the audit work
 The initials of the member of staff who reviewed the working papers and the date on
which the review was carried out

7. King mentioned that Rogers did not fully comprehend the purpose of an audit. What
obligation does a CPA firm to ensure that a client understands the audit function?

The AICPA defines the accounting profession’s public as consisting of clients, credit
grantors, governments, employers, investors, the business and financial community, and others
who rely on the objectivity and integrity of CPAs to maintain the orderly function of commerce.
Every action taken by the CPA should work towards serving the public interest.
The commitment to serve the public interest in accounting has eroded, as personal and
business relationships with clients and client management increasingly create conflicts of
interest. Many such relationships have created barriers to objective and impartial decision
making and threatened the independence of the audit function. The 2014 recodification of the
AICPA Code of Professional Conduct attempts to deal with a conflict of interests when providing
attest services through a threats-and-safeguards approach

8. Rogers apparently does not like paying for an audit. Should Abernethy suggest that a review
rather than an audit be made of lakeside’s financial statements? What is the difference
between a review and an audit?

There are several key differences between an audit, a review, and compilation. Essentially,
a compilation requires the auditor to simply present financial statements based on the
representations made by management, with no effort to verify this information. In a review
engagement, the auditor conducts analytical procedures and makes inquiries to ascertain
whether the information contained within the financial statements is correct. The result is a
limited level of assurance that the financial statements being presented do not require any
material modifications. In an audit engagement, the auditor must corroborate the ending
balances in the client's accounts and disclosures. This calls for the examination of source
documents, third party confirmations, physical inspections, tests of internal controls, and
 other procedures as needed. Thus, the differences between an audit, a review, and a
compilation are as follows:

 Level of assurance. The level of assurance that the financial statements of a client are fairly
presented is at its highest for an audit and at its lowest (none at all) for a compilation, with
a review somewhere in between.
 Reliance on management. In all three cases, the auditor begins with the account
balances provided by management, but an audit requires in a significant amount of
corroboration of this information. A review requires some testing of the information,
while a compilation almost entirely relies on the presented information.
 Understanding of internal control. The auditor only tests the internal controls of the
client in an audit; no testing is conducted for a review or a compilation.
 Work performed. An audit requires a significant number of hours to complete, since
there are many audit procedures to be performed. A review requires substantially
fewer hours, while the effort associated with a compilation is relatively minor.
 Price. It requires vastly more effort for an auditor to complete an audit, so audits are
much more expensive than a review, which in turn is more expensive than a
compilation.

9. Richard Abernethy has to make a recommendation to the partner review committee as to

whether the firm should seek the audit engagement of the lakeside company. If you were
Abernethy, what would you recommend?

I would recommend audit engagement; an audit engagement very loosely refers to

an audit that an auditor performs. More specifically, it refers only to the initial stage of
an audit during which the auditor notifies the client he has accepted the audit work and
clarifies his understanding of the audit's purpose and scope.
WRITTEN QUESTIONS

1. Exhibits 2-1 and 2-2 are attached. From the information that has been presented in the first
two cases, complete these forms.

2. If the firm of Abernethy and Chapman does seek and receive this audit engagement, a review
will be made of the working papers produced by the predecessor auditor. Prepare a list of the
specific contents that should be examined. Indicate each area that should be reviewed and the
purpose of studying these particular working papers.

3. Assume that Abernethy and Chapman audit’s Lakeside’s 1991 financial statements and
gathers sufficient, competent evidence to render an unqualified opinion without any mention
of the uncertainty. Assume further that lakeside opts to issue comparative statements
showing figures for 1990 and 1991. Write a single audit report that will inform the render of
both opinions, as well as the examination made by the previous auditors.

Independent Auditor's Report

To the shareholder of Lakeside Company

Opinion
We have audited the financial statements of Lakeside Company which comprise the statements
of financial position as at December 31 1990 and 1991, and the statements of comprehensive
income, statements of changes equity and statement of cash flows for the years then ended,
and notes to financial statement, including a summary of significant accounting policies.

In our opinion, the accompanying financial statements present fairly, in all material respects,
the financial position of the company as at December 31 1990 and 1991, and its financial
performance and its cash flows for the year ended in accordance with Philippines Financial
Reporting Standards (PFRSs).

Basis for Opinion

We conducted our audit in accordance with Philippine standards on auditing (PSAs). Our
responsibilities under those standards are further described in the Auditor's Responsibilities for
the audit of the financial statements section of our report. We are independent of the company
in accordance with the code of ethics for Professional accountants in the Philippines (Code of
Ethics) together with the ethical requirements that are relevant to our audit of the financial
statements in the Philippines, and we have fulfilled our ethical responsibilities in accordance
with these requirements and the code of ethics. We believe that the audit evidence we have
obtained is sufficient and appropriate to provide a basis for our opinion.

Other Matter

The financial statements of Lakeside Company for the year ended December 31 1990 were
audited by King and Company (another auditor) who expressed a going concern uncertainty
opinion on those statements.

Responsibilities of Management and Those Charged with Governance for the financial
statements

Management is responsible for the preparation and fair presentation of the financial
statements in accordance with PFRSs, and for such internal control as management determines
is necessary to enable the preparation of financial statements that are free from material
misstatement, whether due to fraud or error.

In preparing the financial statements, management is responsible for assessing the company’s
ability yo continue as going concern, disclosing, as applicable, matters related to going concern
and using the going concern basis of accounting unless management either intends to liquidate
the company or to cease operations or has no realistic alternative but to do so.

Those charged with Governance are responsible for overseeing the company's financial
reporting process.

Auditor's Responsibilities for the Audit of the Financial Statements

Our objectives are to obtain reasonable assurance about whether the financial statements as a
whole are free from material misstatement, whether due to fraud or error, and to issue an
auditor's report that includes our opinion. Reasonable assurance is a high level of assurance but
is not a guarantee that an audit conducted in accordance with PSAs will detect a material
misstatement when it exists. Misstatement can arise from fraud or error and are considered
material if, individually or in the aggregate, they could reasonably be expected to influence the
economic decisions of users taken on the basis of these financial statements.

As part of an audit in accordance with PSAs, we exercise professional judgment and maintain
professional skepticism throughout the audit. We also:

* identify and assess the risks of material misstatement of the financial statements, whether
due to fraud or error, design and perform audit procedures responsive to those risks, and
obtain audit evidence that is sufficient and appropriate to provide a basis for our opinion. The
risk of not detecting s material misstatement resulting from fraud may involve collusion,
forgery, intentional omissions, misrepresentation or the override of internal control.

* Obtain an understanding of internal control relevant to the audit in order to design audit
procedures that are appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Company's internal control.

* Evaluate the appropriateness of accounting policies used and reasonableness of accounting

estimates and related disclosures made by the management.

* Conclude on the appropriateness of management's use of going concern basis of accounting

and based on the audit evidence obtained, whether a material uncertainty exists related to
events or conditions that may cast significant doubt on the company's ability to continue as
going concern. If we conclude that a material uncertainty exists, we are required to draw
attention in our auditor's report to the related disclosures in the financial statements or, if such
disclosures are inadequate, to modify our opinion. Our conclusion are based in the audit
evidence obtained up to the date our auditor's report. However, future events or conditions
may cause the company to cease to continue as going concern.
* Evaluate the overall presentation, structure and content of the financial statements, including
the disclosures, and whether the financial statements represent the underlying transactions
and events in a manner that achieves fair presentation.

We communicate with those charged with governance regarding, among other matters, the
planned scope and timing of the audit and significant audit findings, including any significant
deficiencies in internal control that we identify during our audit.

Report on other legal and regulatory requirements

Our audits were conducted for the purpose of forming an opinion on the basic financial
statements taken as a whole. The supplementary information for the year ended December 31
1991 required by the Bureau of internal revenue is presented for the purpose of additional
analysis and is not required part of the basic financial statements prepared in accordance with
PFRS. Such supplementary information has been subjected to the auditing procedures applied
in the audit of the basic financial statements and in our opinion is fairly stated in all material
respects in relation to the basic financial statements taken as a whole.

(Auditor name, signature above)

Abernethy and Chapman
(Office place)

January 11 1992
 Exhibit 2-1
Abernethy and Chapman

Analysis of Potential Legal Liability

Potential Client:
Type of Engagement:
Form Completed by: Date:

1) Is the potential client privately-held or publicly held?

2) Evaluate the possible liability to the client that Abernethy and Chapman might incur if the
engagement is accepted.

3) List the third parties that presently have a financial association with the potential client and
could be expected to see the financial association with the potential client and could be
expected to see the financial statements.

4) Discuss the possibility that other third parties will be brought into a position where they
would be expected to see the financial statements of the potential client.

5) Evaluate the possible liability to third parties, both present and potential, that Abernethy and
Chapman might incur if the engagement is accepted.
 Exhibit 2-1
Abernethy and Chapman

Information from Predecessor Auditor

Potential Client:
Form Completed By:
Predecessor Auditor:
Date of Interview:

1) Discuss the predecessor auditor’s evaluation of the integrity of the management of the
potential client.

2.) Did the predecessor audit reveal any disagreements with management as to accounting
principles, auditing procedures, or other similarly significant matter? If so, fully describe these
disagreements.

3.) What was the predecessor auditor’s understanding as to the reasons for the change in
auditors?

4.) Did the predecessor auditor give any indication of other significant audit problems associated
with the potential client?

5.) Did the predecessor auditor indicate any problem in allowing Abernethy and Chapman to
review prior years’ working papers for the potential client? If “yes”, explain.

6.) Was the predecessor auditor’s response limited in any way?

 CASE 3: INTERNAL CONTROL STRUCTURE

DISCUSSION QUESTIONS

1. Analyze the engagement letter prepared by Abernethy and Chapman. What Specific
responsibilities are being accepted by the CPA firm? What responsibilities are assigned to the
client company?

2. As one testing procedure used in establishing the validity of reported amounts, the auditor
will take a figure found in the financial statements and trace its components back through the
various accounting records to the source documents created at the time of the original
transactions. This of forms, records, and documents leading through the accounting system is
often referred to as an “audit trail.”
What items make up the audit trail for this amount and what information could be gathered from
each? Indicate the degree of reliance the auditor should place on the data derived from these
individual sources?
3. What kinds of information should Andrews have gathered during the preliminary stage of
this audit in order to answer Cline’s Questions? What sources are available to the auditors to
help understand and assess the client’s internal control structure?
4. From the information provided to this point, what answers can be given to cline’s questions?
Mention the strengths as well as any weaknesses that have been found that will have a
bearing on the auditor’s assessment of control risk.
5. After a preliminary assessment has been made of lakeside’s control risk, what possible
actions can be taken by auditors?
6. In the preliminary phases of an examination, the auditors must also assess the inherent risk,
the possibility that a materials misstatement will occur. What factors would be most likely to
influence this evaluation? What impact does the inherent risk have on substantive auditing
procedures?
WRITTEN QUESTIONS
1. To gain an understanding of the client’s present accounting systems, the firm of Abernethy
and Chapman has a policy that all systems must be recorded in a memo and a flowcharting
format. By using both, staff members are able to achieve a better and a quicker understanding
of the design of each system.

Bases on Exhibit 3-4, Prepare a flowchart to provide a graphic display of this system. Use
the flowchart symbols that appear in Exhibit 3-3

Next analyze Exhibit 3-5, a flowchart representation of the cash receipts procedures, and
prepare a written memorandum to accompany and explain this particular system.

2. At the firm of Abernethy and Chapman, after the memo and flowchart have been prepared, a
preliminary analysis is made of the internal control policies and procedures found in the
system. The auditor is searching for weaknesses within the structure of the system as well as
nay particularly strong features that would reduce control risk. To assist the auditor in
evaluating a system, Abernethy and Chapman utilizes the form presented in Exhibit 3-6.
Complete this document based on the flowchart in Exhibit 3-5 representing the Cash
Receipts section of the Revenue and Cash Receipts cycle. Be especially careful to note any
internal control weaknesses or strengths that may be indicated.

3. Rogers has stated that he wants the auditing firm to help improve Lakeside’s accounting
systems. Exhibit 3-4 identifies the revenue recognition procedures currently used in
connection with distributorship sales. List improvements that could be made in this system.