Auditing a risk based approach to conducting a quality audit johnstone 10th edition solutions manual

Auditing A Risk Based-Approach to Conducting a Quality Audit Johnstone 10th Edition Solutions Manual

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Solutions for Chapter 7

True/False Questions

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Multiple Choice Questions 7-15 D

Review and Short Case Questions

7-29

A misstatement is an error, either intentional or unintentional, that exists in a transaction or financial statement account balance. Characteristics that would make a misstatement material include the following:

• The misstatement makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.

• The misstatement would have been viewed by a reasonable investor to have significantly altered the total mix of information available.

• The relative size of the misstatement.

7-30

The advantage of the more quantitative approach is that it (a) promotes consistency across audit engagements; (b) ensures that important items are addressed in the audit engagement; and (c) presents an initial basis from which an auditor can adjust the preliminary materiality assessment. The advantage of the individual auditor approach is that the auditor is in the best position to understand the uses of the financial statements, the major users, and pertinent other factors that may affect the overall presentation of the financials statements. For example, the auditor may be aware of debt covenants or other restrictions that may affect the assessment of materiality on specific accounts. There is no one correct approach. Clearly, there is need for individual auditor adjustment to any preliminary assessment of planning materiality. The SEC has been very adamant that materiality is not a 5% cut-off point, i.e. there are many items that are material that may be much less than 5% of net income.

7-31

(a) Performance materiality refers to the amount or amounts set by the auditor at less than the materiality level for the financial statements as a whole or for particular classes of transactions, account balances, or disclosures. (b) Tolerable misstatement is the amount of misstatement in an account balance that the auditor could tolerate and still not judge the underlying account balance to be materially misstated. Tolerable misstatement is the application of performance materiality to a particular sampling procedure. (c) Clearly trivial means that a misstatement is clearly inconsequential, whether taken individually or in the aggregate and whether judged by any criteria of size, nature, or circumstances

7-32

The qualitative aspect of materiality recognizes that some items, because of their very nature, may be quite significant to users – even if the dollar magnitude is less than most quantitative measures of materiality. As an example, a company may be developing a new line of business with very high expected growth. A decline in the rate of growth may be very significant to the stock market even if the dollar amounts are not material to the overall financial statements. Auditors understand this concept and will increasingly be called upon to implement it in the preparation of financial statement audits. Thus, when planning the audit, the auditor’s materiality assessment has to incorporate these qualitative factors which may cause the materiality amount to be lower than if it were based solely on quantitative factors.

The SEC provides guidance on situations in which a quantitatively small misstatement may still be considered material because of qualitative reasons. These include the following:

• the misstatement hides a failure to meet analysts' consensus expectations for the company

• the misstatement changes a loss into income or vice versa

• the misstatement concerns a segment or other portion of the company’s business that plays a significant role in the company’s operations or profitability

• the misstatement affects the company’s compliance with regulatory requirements

• the misstatement affects the company’s compliance with loan covenants or other contractual requirements

• the misstatement has the effect of increasing management's compensation – for example, by satisfying requirements for the award of bonuses or other forms of incentive compensation

• the misstatement involves concealment of an unlawful transaction.

7-33

An accounting estimate could not be materially misstated for two consecutive years, but because of the swing in the estimate, net income could be misstated because the total change in estimate from a best estimate could have a material effect on the financial statements. To illustrate, assume that the auditor has determined that $50,000 is material. In making an estimate of a liability account, let’s assume that last year the auditor believed the estimate was too high by $45,000, but did not require an adjustment because it was less than materiality. In the current year, the auditor has concluded that the estimate of the same account is understated by $40,000 –again an amount less than materiality. However, the swing in the estimates results in an $85,000 additional increment to the income statement this year – an amount that is clearly material. Thus, the auditor has to examine swings in estimates in comparison with the auditor’s assessment of the best estimate.

7-34

a. There is an inverse relationship between client riskiness and materiality thresholds. Thus, a riskier client will require a smaller threshold. In this case, the materiality threshold for Client A should be less than that for Client B. Further, the auditor will need to collect more audit evidence to obtain the same level of assurance for Client A compared to Client B.

b. Each individual auditor will make different professional judgments compared to other auditors. Some of the individual characteristics that may affect an auditor’s professional judgments include their level of experience, their training, whether or not they have encountered a client that has engaged in fraud, and their professional skepticism, among others.

c. If one auditor is more professionally skeptical than another auditor, that auditor would likely set the materiality threshold even lower than another auditor in the scenario described in part (a) of this problem. Thus, if a less skeptical auditor set materiality at $4,000, a more skeptical

auditor might set it at $3,000 and would accordingly collect even more evidence in support of the judgment about whether accounts receivable was materially misstated.

7-35

a. The FASB defines materiality as the “magnitude of an omission or misstatement of accounting information that, in light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.” The Supreme Court of the United States offers a somewhat different definition and states that “a fact is material if there is a substantial likelihood that the …fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available. Regardless of how it is specifically defined, materiality includes both the nature of the misstatement as well as the dollar amount of misstatement and must be judged in relation to importance placed on the amount by financial statement users. Thus, auditors need to understand the users of financial statements and their likely needs and expectations in order to make appropriate materiality judgments.

b. Examples of items for each dimension might be these:

Dollar Magnitude:

Something that is over 5% of net income or a 5% misstatement of an account balance.

Nature of Item under Consideration:

A misstatement of an account that significantly changes a trend in earnings or reflects on the integrity of management.

Perspective of a Particular User:

Management of an outside entity that is considering acquiring the company and is relying on audited financial statements as an important part of its decision.

c. Yes, the auditor's assessment of materiality can, and likely will, change during the course of the audit. As the auditor acquires additional information about the client and the likely audited net income, the auditor's assessment of any further undetected misstatement may change and the auditor’s assessment of materiality for the client may change as more qualitative factors are considered.

An auditor's assessment of materiality that changes during the audit to a smaller amount implies that some of the work performed early in the audit may have been performed with a larger planning materiality than the auditor now believes appropriate. Therefore, the auditor should review the previous audit work to determine whether the amount of work was sufficient to detect a material misstatement as defined by the revised assessment of materiality. If the auditor believes the work was not sufficient to detect a material misstatement, the auditor should consider performing additional audit work in the areas already performed to gather satisfaction that any (now-defined) material misstatement would be detected.

7-36

• Inherent Risk the susceptibility of an assertion about a class of transaction, account balance, or disclosure to a misstatement that could be material, either individually or when aggregated with other misstatements, before consideration of any related controls.

• Control Risk the risk that a misstatement that could occur in an assertion about a class of transaction, account balance, or disclosure and that could be material, either individually or when aggregated with other misstatements, will not be prevented, or detected and corrected, on a timely basis by the entity’s internal control.

• Audit Risk the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated.

• Detection Risk the risk that the procedures performed by the auditor to reduce audit risk to an acceptably low level will not detect a misstatement that exists and that could be material, either individually or when aggregated with other misstatements.

See Exhibit 7.1 for a graphical depiction of how these risks relate to each other.

7-37

Controls exist to address the inherent risks of material misstatement. Therefore, it would be impossible to evaluate the effectiveness of controls without first knowing the risks, or bad outcomes, that the controls are designed to mitigate.

7-38

As the risks of material misstatement increase, the auditor will accept less audit risk and detection risk will be decreased. As the risks of material misstatement decrease, the auditor can accept greater audit risk and detection risk will increase.

7-39

Audit risk and materiality are intertwined concepts. Audit risk is defined in materiality terms, i.e. it is the likelihood that the financial statements are materially misstated. The auditor must design and conduct the audit to gain reasonable assurance that all material misstatements will be detected. The lower the level of materiality, the more audit work must be done (the lower the detection risk). In summary, materiality must first be set in order to determine the appropriate level of audit risk.

7-40

The following is a list of factors that would lead the auditor to assess inherent risk at the assertion level at a higher level:

• the account balance represents an asset that is relatively easily stolen, e.g., cash

• the account balance is made up of complex transactions

• the account balance requires a high level of judgment or estimation to value

• the account balance is subject to adjustments that are not in the ordinary processing routine, e.g., year-end adjustments

• the account balance is composed of a high volume of transactions

7-41

• Operations in regions that are economically unstable, e.g., countries with significant currency devaluation or highly inflationary economies (a)

• Operations exposed to volatile markets, e.g., futures trading (a)

• Operations that are subject to a high degree of complex regulation (a)

• Going concern and liquidity issues including loss of significant customers, or constraints on the availability of capital or credit (a)

• Offering new products, or moving into new lines of business (a)

• Changes in the organization such as acquisitions or reorganizations (a)

• Entities or business segments likely to be sold (a)

• The existence of complex alliances and joint ventures (a)

• Use of off balance sheet financing, special-purpose entities, and other complex financing arrangements (b)

• Significant transactions with related parties (b)

• Lack of personnel with appropriate accounting and financial reporting skills (c, control risk)

• Changes in key personnel, including departure of key executives (b)

• Deficiencies in internal control, especially those not addressed by management (c, control risk)

• Changes in the IT system or environment, and inconsistencies between the entity’s IT strategy and its business strategies (a)

• Inquiries into the entity’s operations or financial results by regulatory bodies (a & b)

• Past misstatements, history of errors or significant adjustments at period end (b)

• Significant amount of non-routine or non-systematic transactions, including intercompany transactions and large revenue transactions at period end (b)

• Transactions that are recorded based on management’s intent, e.g., debt refinancing, assets to be sold and classification of marketable securities (b)

• Accounting measurements that involve complex processes (b)

• Pending litigation and contingent liabilities, e.g., sales warranties, financial guarantees and environmental remediation (b)

7-42

Pfizer discloses a variety of interesting risks relating to inherent risk at the financial statement level. These include:

• Increasing pricing pressures related to governmental regulations

• The Company’s growing reliance on selling specialty pharmaceuticals, and the pricing pressure that governments are making as those governments seek cost-containment strategies

• The drug discovery and development process is inherently risky in terms of whether research and development expenditures will result in profitable products

• The regulatory approval process is uncertain and unpredictable, so even if a new drug is discovered and developed, there is uncertainty about whether the government will allow Pfizer to sell it.

The auditor would be concerned about these risks because if these negative outcomes happen, it could threaten the fundamental financial viability of the company, and could provide incentives for management to misstate various accounts so that the company will appear to be in better financial position than it really is.

7-43

• Management inquiries

• Review of client’s budget

• Tour of client’s plant and operations

• Review relevant government regulations and the client’s legal obligations

• Access the audit firm’s knowledge management systems for relevant information

• Online searches

• Review of SEC filings

• Review of company websites

• Economic statistics, including industry data

• Professional practice bulletins

• Stock analysts’ reports

• Listen to company earnings calls

7-44

a. Management integrity is defined as the general honesty of management and its motivation for truthfulness (or lack thereof) in financial reporting. It is a reflection of the extent to which management shows good business practice and to which the auditor believes that management's representations are likely to be honest.

If the auditor questions management's integrity, the nature of the audit evidence to be gathered and the evaluation of that evidence will be affected as follows:

• The auditor will not be able to rely on management's representations without significant corroboration.

• The audit evidence generated from internal documents must be evaluated with a great deal of skepticism.

• The auditor will seek more external audit evidence and corroboration from outside parties, including vendors and customers.

• The auditor must consider the possibility that management would be motivated to misstate the financial statements to accomplish personal objectives. Thus, the auditor should

investigate any significant changes in account balances or ratios that may indicate management misstatement.

b. Sources of evidence pertaining to management integrity might include

• The predecessor auditor, if applicable

• Other professionals in the business community

• Other auditors within the audit firm

• News media and Web searches

• Public databases

• Preliminary interviews with management

• Audit committee members

• Inquiries of federal regulatory agencies

• Private investigation firms

c. Analysis of Management Scenarios:

i. This is a frequent business practice and is not considered to reflect negatively on management's integrity. Many members of management believe that it is their obligation to minimize their overall tax burden.

The existence of related-party transactions, however, should alert the auditor to plan the audit to ensure that the economic substance of related-party transactions are discovered and described in the annual financial statements. The auditor should also be alert to tax planning strategies that Congress and the general public consider ‘over the edge’ because it is likely that such strategies will be challenged – if not in court, then at least in the court of public opinion.

Finally, the mere existence of related parties creates an opportunity to use transactions with the parties to inappropriately portray the real economics of the business. The auditor should plan a thorough investigation to ensure that all related party transactions are fairly disclosed.

ii. This is a common business trait and seems to be widely accepted. However, it is also an indication of a potential problem when a member of management is so domineering that he or she can intimidate other members of the organization to achieve their objectives, no matter how achieved. There have been many instances of major financial statement fraud by top management who intimidated lower level managers.

The auditor must be alert to the potential effect on the overall control environment of the organization. If employees are punished for not achieving a specific objective or are highly rewarded for achieving a specific objective, there may be motivation to accomplish the objective by manipulating the financial reporting process and results

iii As in the previous scenarios, this is not an uncommon trait. In the author's view, this is an unfortunate statement about the status of accounting principles in the United States. Two factors

in this scenario should raise the auditor's skepticism: the manager (1) has a very short-term orientation and (2) has shown a tendency to change jobs after achieving the short-run objectives.

The scenario is one of high risk and should raise the auditor's awareness of significant accounting manipulations resulting in the substance of the transaction not being reflected in the financial statements. The auditor should be critical of the accounting for estimates, the use of reserves, or other changes where subjective accounting judgments are made.

iv. Ostensibly the manager is a pillar of the business community. However, two factors are unsettling: (1) the previous conviction on tax evasion and (2) the current manipulation among controlled corporations to avoid tax. Although this latter practice is common, the auditor must determine whether such manipulation violates the federal income tax provisions. However, most auditors would consider this to be a high risk situation.

The auditor should determine if there are any issues still outstanding from the previous tax returns and whether there are potential constraints on the president’s activities that resulted from the tax conviction.

The auditor should have management list all controlled or partially controlled organizations and all related-party transactions during the period under audit.

v. The scenario reflects poorly on management's integrity. The attitude is that it will do something only after being "caught." Such an attitude raises questions about management's openness with the auditor in disclosing transactions or questionable accounting.

This situation raises some interesting questions for the auditor. First, there is a question about whether the auditor wishes to be associated with such a client. The engagement risk may be too high. Second, the auditor will probably have to expand the audit to determine whether any unrecorded liabilities are associated with environmental protection. The auditor must consider whether an audit can be performed within the planned audit time frame without substantial client cooperation. It is doubtful that such cooperation will be forthcoming.

7-45

The following is a list of factors that would lead the auditor to assess control risk at a higher level:

• poor controls in specific countries or locations

• it is difficult for the auditor to determine or gain access to the organization or individuals who own and/or control the entity

• little interaction between senior management and operating staff

• weak tone at the top leading to a poor control environment

• inadequate accounting staff, or staff lacking requisite expertise

• inadequate information systems

• growth of the organization exceeds the accounting system infrastructure

• disregard for regulations or controls designed to prevent illegal acts

• no internal audit function, a weak internal audit function, or lack of respect for internal audit by management

• weak design, implementation, and monitoring of internal controls

• lack of supervision of accounting personnel

To understand the management’s risk assessment and other internal control components, the auditor will typically use some or all of the following techniques:

• Develop an understanding of the processes used by the board of directors and management to evaluate and manage risks.

• Review the risk-based approach used by internal auditing with the director of internal auditing and the audit committee.

• Interview management about its risk approach, risk preferences, risk appetite, and the relationship of risk analysis to strategic planning.

• Review outside regulatory reports, where applicable, that address the company’s policies and procedures toward risk.

• Review company policies and procedures for addressing risk.

• Gain a knowledge of company compensation schemes to determine if they are consistent with the risk policies adopted by the company.

• Review prior years’ work to determine if current actions are consistent with risk approaches discussed with management.

• Review risk management documents.

• Determine how management and the board monitor risk, identify changes in risk, and react to mitigate, manage, or control the risk.

7-46

Ratio and industry trend analysis can be useful in pointing out significant trends in the industry or changes in individual account balances. Ratio analysis can indicate whether the client is lagging behind the industry in important aspects, such as credit collection or in amounts of inventory carried. Additionally, this analysis can also help the auditor identify areas where a client seems to be doing much better than industry, without a valid reason for this difference. This analysis requires the auditor to first develop expectations about account balances and trends.

Both types of analyses may point out areas that need to be given special audit attention. This information then helps the auditor determine the nature, timing, and extent of planned audit procedures. This analysis forces the auditor to understand the ‘bigger picture’ of the operation of the client, and helps put into context other audit findings.

7-47

Inventory turnover, number of day’s sales in inventory, and number of day’s sales in receivables would be very useful in this situation. For exact formulas, see Exhibit 7.3

7-10

7-48

a. Brainstorming usually occurs during the planning phase of the audit, but on occasion sessions are repeated if actual fraud is detected or at the end of the audit to ensure that all ideas generated during brainstorming have been addressed during the conduct of the audit.

b. All members of the engagement team; the session is preferably led by the partner or manager

c. To transfer knowledge from top-level auditors to less senior members of the audit team via interactive and constructive group dialogue and idea exchange.

d. The guidelines are:

• Suspension of criticism. Participants are requested to refrain from criticizing or making value judgments during the session.

• Freedom of expression. Participants are encouraged to try to overcome their inhibitions about expressing creative ideas, and every idea is noted and accepted as a possibility.

• Quantity of idea generation. Participants are encouraged to provide more ideas rather than fewer, with the intent to generate a variety of possible risk assessment scenarios that can then be explored during the conduct of the audit.

• Respectful communication. Participants are encouraged to exchange ideas, further develop those ideas during the session, and to respect the opinions of others.

e. The steps are:

(1) review prior year client information, (2) consider client information, particularly with respect to the fraud triangle, i.e., incentive, opportunity, and rationalization, (3) integrate information from steps 1 and 2 into an assessment of the likelihood of fraud in the engagement, and (4) identify audit responses to fraud risks.

7-49

a. Identification of risk areas for Jones Manufacturing:

Potential Risk Indicator

Inventory increase

Risk Analysis

There is a substantial increase in inventory, both in dollar terms and as a percentage of sales, which could indicate potential problems with new products, with obsolescence, or with competitiveness with other products. It may indicate an increase of inventory just before year-end in anticipation of rise in cost, a strike, or unusually heavy demand. Inventory may be overstated due to misstatements of quantities or prices. This could also affect the following change.

7-11

Cost of goods sold decrease

Accounts payable increase

COGS has decreased to 55 percent of sales at the same time inventory has increased. One explanation is that COGS has not been booked for some significant sales. There may also be a change in product mix. In any event, audit attention should be directed to these areas.

The A/P increase could reflect credit problems or other financing problems. Such problems could make it difficult for the company to carry out its ongoing activities. It may simply reflect the purchase of an unusual amount of inventory just before yearend.

Inventory turnover

Average number of days to collect

Inventory turnover has decreased by 33 percent. This points to and confirms the problems identified by the increase in inventory and decrease in cost of goods sold. There are substantial obsolescence problems, material items are not correctly recorded, or the inventory has been increased in anticipation of some unusual event early next year, such as a raw material shortage, strike, or unusual demand.

This ratio has increased by 23 percent over the previous year and is 33 percent above the industry average. The increase in the ratio could represent a number of problems:

o Less stringent credit standards.

o Warranty problems (i.e., the customers may not be paying because of problems with the products.) This would be consistent with the interpretations associated with inventory turnover,

o Unrecorded returned items or a significant lag in issuing credit memos associated with returned items.

o Potential accounting recording problems.