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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

cost of goods sold as a percentage of sales would be expected to remain stable. Although specific guidelines for this decision are not available. without an adjustment of this type. In addition.  Lakeside is considering going public. Competitors. A company attempting to raise significant capital may be tempted to over-estimate assets and revenues. the auditors should not anticipate a significant variation to occur without some adequate explanation. Although no two companies are ever alike. the financial statements of competing companies can be used to determine the normal relationship of cost of goods sold to sales. The decision as to the sufficiency of this evidence is left solely to the judgment of the auditor.present danger because of new innovations. Evidence needs to be accumulated for each . Abernethy and Chapman can determine an industry average for cost of goods sold as a percentage of sales. Only through years of experience can the auditor develop the ability to make this determination. Industry averages. 4. has dropped the Cypress line in order to sell the products of some other manufacturer.  Lakeside has a large amount of debt. such as:  Lakeside holds an inventory of high technology items: consumer electronic equipment. 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. If Lakeside has an annual budget.  Lakeside sells on credit throughout two states. competent evidence has been obtained to substantiate an opinion concerning the fair presentation of the client's financial statements. . A generous return policy is provided. Hence. thus. The auditor must be satisfied that sufficient.  Lakeside distributes merchandise to retail stores. If available. Budgeted figures. . all significant problems must be resolved and all suspicious occurrences should be investigated. Although Lakeside's results could not be expected to be exactly the same as this average.  Lakeside rents a number of its stores. estimating collections from accounts receivable may be difficult. . However. The inventory can also be easily damaged. By studying trade publications. the auditors need to verify that all loan covenants are being met. The auditor has to ensure that all debt is being properly reported and disclosed. The auditor must determine whether capitalization of these leases is required. an estimate must be made of the sales returns that will be received by the company after the audit is concluded. Obsolescence of a portion of this merchandise is an ever. The interest expense associated with these liabilities must also be correctly calculated and recognized. a similar change might have been anticipated. important comparisons such as this one should be made between similar companies. The potential problem areas that be inherent in auditing a business like a Lakeside Company. The auditor needs to be particularly careful on accounts that lend themselves to significant estimate. a problem that is not always visually obvious.

Some information may come directly to the auditors from outside parties. Analytical procedures performed in the planning stage are not primarily designed for the purpose of indicating the fair presentation of financial information. This information can be supplemented through review of the prior years' audit documents. Students should always be reminded. that this testing is only one component of the overall substantive testing being performed by the independent auditor. 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. analytical procedures serve a vital audit purpose. sufficient evidence has been obtained. is not a high quality type of evidence. significant area of the financial statements to substantiate the assertions made by the client about its reported balances. assess conditions under which accounting data are produced. Another factor that influences the auditor's decision is the quality of evidence being accumulated. Instead. 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. using more experienced staff personnel. analytical procedures provide circumstantial evidence which. or relying on more effective testing procedures. the auditor must be satisfied that. 6. Any discussion as to the "quality" of evidence being gathered by analytical procedures must be based on the objective of the testing. In that respect. identify areas that may need special consideration. performing testing procedures closer to the balance sheet date. . based upon the wisdom gained through years of audit experience. the auditor must take steps to reduce detection risk to an acceptable level. . evaluate the accuracy of management representations. 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: . . they are used in the assessment of risk. 5. reviewed. AICPA Accounting . In such cases. and accumulated within the organization. processed. to alert the auditor to potential problem areas that may require additional substantive testing. Furthermore. Less evidence is required if it is judged by the auditor to be of a high quality. several steps are possible: performing additional substantive testing. . data that is usually considered to be of a higher quality than evidence prepared by the client company. Thus. Although each of these factors is considered. though. taken alone. Where inherent risk and control risk are judged to be high. evaluate the reasonableness of estimates. make judgments about the appropriateness of the accounting principles applied and the adequacy of disclosures.

price competition can lead a firm to actually lose money in the first year of an engagement. the instructor may want to bring an example or two to class for this discussion. This type of selection process would favor firms offering cheap rates over auditing firms offering quality services. or 3) not be able to acquire the depth of knowledge necessary for essential audit judgments. Since the students may not be familiar with the AICPA Industry Audit Guides. 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 . In order to finish an audit engagement in a short enough time so that a reasonable profit can be made. some interesting discussion can be stimulated as to whether the auditing profession should be exempt from price competition. the CPA firm must work to keep a client for several years to offset this initial loss and produce a reasonable profit. Many auditors also feel that price competition is generally detrimental to the public accounting profession. Providers of Health Care Services 7. Examples of the industries covered by these audit guides include: . Investment Companies . 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. industry publications. and Audit Guides. Finance Companies . and other trade periodicals. Thus. Airlines . 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. . the argument is frequently raised that price competition leads to a decrease in overall audit quality. magazines. a danger exists that the auditor will 1) accept less than sufficient evidence. 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. financial statements from other companies in the same industry. college textbooks. . Therefore. Because the initial year of an audit will often require significantly more time than examinations of subsequent years. 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. After the students have been allowed to discuss the problems associated with price competition. students should be able to ascertain at least three of these problems: . 2) fail to recognize critical audit areas. Price competition forces narrow time constraints on the work of the independent auditor.

80x.”  EXERCISES 1. the amount of substantive tests and other audit procedures increases (decreases). This brainstorming session needs to encourage the involvement of all team members and cannot be just a staff training session. there is an inverse relationship between control risk and planned detection risk. but we are pursing registration. Also. The process begins with such a session. They may also be required to change the nature of their practice.10/(. an increase (decrease) in control risk leads to a decrease (increase) in planned detection risk. but does not end there. In order to have a small chance of not detecting an error. noting new areas that need attention. 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. then using the audit risk model. Thus. The areas identified by fraud risk are primarily in the areas of inherent risk and control risk. The students can be asked to consider the appropriate response that should be made by the audit team to each of the elements listed. 8. the auditor must do more testing. and assuming an 80% CR (high). 10. During the audit the entire team needs to consider how the information being developed relates to the areas already identified. 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. at least as far as publicly traded clients because of the list of proscribed activities. If Lakeside asks if they are currently registered. Holding inherent risk and acceptable audit risk constant. For example. 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. students are better able to recognize the attest function as a fluid process that must . planned detection risk (PDR) equals acceptable audit risk (AAR) divided by the product of inherent risk (IR) and control risk (CR). or adjusting expectations on the areas already identified.10/(. given AAR=10% and IR=80%. as planned detection risk decreases (increases).6% [. he or she wants the chance of not detecting an error too small. “no. 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. but assuming a 20% CR (low). That is. According to SAS 99 the assessment of the risk of fraud begins with a meeting of the entire team for such purpose. By discussing the various possible responses.20)]. 9.80x. if the auditor determines the level of detection risk to be low. Performing analytical procedures is one aspect of an auditing course that traditionally generates a lot of student interest and enthusiasm. then planned detection risk is a relatively high 62. 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 client’s internal control system will not detect the error or irregularity).5% [. According to the audit risk model. then the answer has to be.80)]. planned detection risk is a relatively low 15. The registration process is not difficult.

73 1. This may indicate short-term solvency problems. Lakeside 2008 Significance Current 1.73% Declining return results from a combination of declining net income and increasing total asset base.93% 2. Return on Equity 33. Times interest earned 30 times 2. this may indicate solvency problems.4% 74. This may indicate short-term solvency (liquidity) problems.27% No significant change Return on Assets 8. however. Receivables collection 11 25 Lakeside is well above the industry period average.6 times 2.73% Lakeside is only slightly above the industry average.4% Decline in return results from a combination of declining net income and increasing equity base.09% 6.5% Lakeside is significantly above the industry average. . The audit staff should pay particular attention to revenue.8 times Decline indicates reduced ability to meet interest payments through operations Profit Margin 2.8 times Lakeside is significantly below the industry average. several years (rather than two) would be analyzed for trends: a) Ratio analysis from 2007 to 2008. however. the high ratio indicates significant leverage and potential solvency problems if additional debt is needed Times interest earned 3. in practice.35 1. b) Ratio analysis: comparison to industry.2% 26. Profit Margin 2.enhancing or expense-reducing areas. Ratio 2007 2008 Significance Current 1.5% No significant change. Conclusion: Lakeside had no significant changes in its liquidity or solvency levels. this may indicate long-term solvency problems. Ratio Industry Ave. be flexible enough to adapt to a specific set of circumstances. It should be noted to students that. Return on Assets 6. This may indicate short-term solvency problems. Debt-to-total-assets 13% 74.27% Lakeside is only slightly below the industry average. Days inventory on 65 101 Lakeside is well above the industry hand average.79% 2. such as fictitious sales or improper capitalization of expenses to halt this downward trend. the company appears to be experiencing a decline in its profitability level.47% 6.36 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 74.36 Lakeside is below the industry average.

. 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. 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.3% of sales. and the company is in a significantly worse solvency level than the industry. with the solvency problems may indicate a problem with the company's ability to continue as a going concern.5% of sales (which the profit. figure. 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. in which it is more than double that of the industry (primarily due to the high level of leverage). discontinued by Lakeside or income statement] drastically altered in some manner. inventory held by this store has risen by over 50%. 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. Auditors should be aware of methods to enhance the liquidity and solvency levels. Return on Equity 13. Also. the potential error should be All of the other commissions are investigated so that Lakeside can approximately 5. the cost of the goods sold has be encountered normally because of dropped from 58. Scan the trial balance Sales Commissions for District D in Although not necessarily a material 2009 appear to be slightly out of line. the income figures. Lakeside profitability is about the same as the industry average.sharing bonus system that is consistent with the other stores) to rewards employees for reporting high only 50. Scan the financial statements and the trial balances. This since the previous year. such as unrecorded liabilities.7% of sales. 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. applicable sales figure. Conclusion: Lakeside is well below the liquidity level of the industry.27% 26. At the same problem is more germane than might time. The sales for that store have attempting to inflate the earnings increased by approximately 94% being reported for Store Three. require correction. Lakeside 2008 Significance industry average. combined declined significantly in 2008. c. Conversely. while make the appropriate corrections if this account is nearly 7% of the needed. except for return on equity.4% Lakeside is significantly above the Ratio Industry Ave.

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accumulated depreciation when a plant asset is sold. Any stores and the distributorship. 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. Scan the trial balance Sales returns have increased The auditors need to ascertain the significantly for both the company reasons for such an increase. Perhaps bad compared to a credit balance one year debt experience is changing and a earlier. the auditor needs to verify that all capitalized costs have been segregated and properly accounted for within the company records. In the $750. . change in the trend for sales returns would lead the auditors to reevaluate year-end accruals. The auditor should also ascertain that the current year depreciation expense has been properly recognized. 2009. Scan the trial balance The long-term notes payable have The auditor should determine the increased by $50. additional equipment during the year. 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. requirements as well as the effects on the interest expense account. The independent auditor should follow up on this possibility to assure that any replacement is appropriately capitalized.000 maximum that was addition. Scan the trial balance The "Gain on Disposition of Fixed Often a company will fail to remove Asset" balance of $14. because of disclosure indicated in an earlier case. 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.000. the sale of an asset can lead to the acquisition of a new asset as a replacement. the auditor needs to verify that capitalization and depreciation were given proper treatment. large group of accounts. In that situation.000 warrants the appropriate cost and related investigation. Finally.Procedure Results Significance actual repairs may have been made by Lakeside. the auditors will need to review any new borrowing agreement. the loan agreement signed by the company. larger allowance is required. Scan the trial balance The equipment account shows an If the company has acquired increase from the previous year.

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.