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-- ch;it*l

Learning objectives

Audit Planning,
Understanding the
CI ient, Assessi ng Risks,
and Responding

After studying this chapter,


you should be able to:

LOI

Describe the major


steps in the audit
process.

LO2

ldentifY the factors

that auditors consider


in accepting new
clients.
LO3

Explain the auditors'

responsibilities when
planning an audit.
LO4

In this chapter, we first provide an overview of the entire audit process. Then we
discuss obtaining a client, planning an audit, obtaining an understanding of the
client and its industry, assessing risks related to the client, and responding to those
risks. After describing the audit process, we address questions such as: How do
auditors determine whether a prospective client should be accepted as a client?
After accepting an audit client, how do auditors go about planning the engagement
and identifying the areas with a"high risk" of material misstatement? When one
considers the potential legal liability involved, it becomes obvious that auditors
do not merely accept a new audit client and then anive at the premises to "start
auditing."

Describe the nature

of the risk assessment


procedures that audi-

The Audit Process

tors use to obtain


an understanding
of the client and its

LO5

audit process.

Describe the man-

1. Plan the audit.

ner in which an audit

affected by the
auditors' assessment
of audit risk and
materiality.
is

Describe how the auditors address fraud risk.


LO7

LO8

Describe the major steps

environment.

Discuss how the auditors design further


audit procedures
in response to the
assessed risks of material misstatement.

Distinguish between

the systems and the


substantive procedures
portions of the audit
program.

in

the

Although specific audit procedures vary from one engagement to the next, the following stages are involved with
every engagement.

2. Obtain an understanding of the client and its environment, including intemal


control.

3. Assess the risks of misstatement and design further audit procedures.

4. Perform frrther audit procedures.


5. Complete the audit.
6. Form an opinion and issue the audit report.

l. Plan the audit. Audit planning begins with determining the requirements for the
engagement, including the financial statements to be audited, any other requirements
(e.g., regulatory filings), and the timing of the engagemen!. During this stage auditors
establish an understanding with their client as to the ndture of services to be provided
and the responsibilities ofeach party. In addition, they develop an overall audit strateW, aL audit plan, and an audit program.
While we describe the audit planning process as the first step in an audit, it should
be recognized that significant portions of the planning process cannot be completed
until the auditors have a sufficient understanding of the client and its environment,
including internal control. Therefore, in the first audit of a new client, much of the
planning process will be performed after the auditors have obtained this understanding, as described as stage two. In the audit of a continuing client, the auditors will have
gained the required understanding and, therefore, may do most of the planning at the
beginning of the audit.

Audit Planning, Onderstanding the Client, Assessing

Risks, and

Responding

85

It should be recognized that in audit planning auditors use a risk-based approach in


which they are continually considering the possibility of material financial statement
misstatements. As a result, the plan may need to be revised as a result of information on
risks as well as audit findings that are gathered throughout the audit. As an example, if
the auditors' procedures discover misstatements of an account, their finding may cause
them to plan additional procedures for a particular account.
2. Obtqin an understanding of the client and its environment. Auditors must gather sufficient background information to assess the risks of material misstatement of the financial statements and to design the nature, timing, and extent of further audit procedures.
Risk assessment procedures are used to gather this information and include inquiries
ofmanagement, analytical procedures, observation and inspection, and other procedures.
At this stage of the audit, the auditors are attempting to obtain an overall understanding of the client and its environment, including its objectives and strategies and related
business risks, the manner in which management measures and reviews financial performance, and the client's internal control. This understanding helps the auditors identiff
account balances, transactions, and disclosures with a high risk of material misstatement.
Obtaining an understanding of the nature of intemal control is an essential part of this
process because it allows auditors to identify accounts and classes of transactions that may
be misstated and to tailor audit procedures to the existing intemal control system. Information on intemal control comes from interviewing client personnel, observing the application of specific controls, inspecting documents and reports, and tracing transactions
through the information system, as well as reviewing prior years' audit working papers.
3.Zssess the risks of misstatement and designfurther audit proceduies. Auditors use
their understanding of the client and its environment to identify account balances, transactions, and disclosures that might be materially misstated. At the assertion level, the
auditors consider:

.
*
.

What could go wrong?

How likely is it that it will go wrong?


What are the likely amounts involved?

Information gathering procedures provide the auditors with evidence on inherent and
control risks for significant assertions. Remember that inherent risk is the risk of material misstatement of an assertion without considering internal control. Many inherent
risks arise because of business risks faced by management, including the possibility of
material misstatement due to fraud.
The auditors' consideration of control risk involves analyzing the design and implementation of internal control to decide whetherthe internal control system appears adequate
to prevent or detect and correct material misstatements. For example, if the auditors believe
thit inherent risk is higher for an important area arrd internal control is weak (i.e., control
risk is high), they will assess the risk of material misstatement as high. On the other hand,
ifinherent risk is assessed as low and controls seem capable ofpreventing or detecting and
correcting misstatements, the auditors may decide to perform tests of controls to support
an assessment that control risk is low. If those tests indicate that the controls are operating
effectively, the auditors may conclude that the risk of material.misstatement is low.
Based on the assessed risk of misstatement for various account balances, classes of
transactions, and disclosures, the auditors will design and perform further audit procedures.
4. Performfurther audit procedures. Further audit procedures include a combination
of additional tests of controls and substantive procedures relating to account balances, transactions, and disclosures. Tests of controls are performed to determine whether
key controls are properly designed and operating ffictively. To illustrate a test of a control, consider the control activity in which the accounting department accounts for the
serial sequence of all shipping documents before preparing the related journal entries.
The purpose of this control is to ensure that all shipments of merchandise are recorded in
the accounting records (i.e., to ensure the completeness ofrecorded sales and accounts
receivable). To test the operating effectiveness of the control, the auditors might review

ChaPter Six

't--t-="-*flTlil:T:"1"*

;"'x;

evidenceoftheclient,saccountingforthesequenceofshipping,documentsandselecta
yeal to inspect
uuriout times tirioughout the
shipping a".l]rr"rr, prJpared ut
sample of

for
ventingordetectingu-i*,.u..,,.nt;itdoes..notsubstantiatethedollaramountofanaccount
financial statement accounts' If'
may ur.O
balance. Also, a d;;;;;ntrol
depaft'"r..ul
the accounting

indicatelhat

d;;ib;J;

the precedinglu*g*p1,
example, the tests
of shrpping documents' the auditor:
forrh"
ment does not effectively account
accounts receivable
of misstaiements of sales revenue'
should be a1erl for the possibility
in Chapter 7'
further
discussed
frt"rnui .o"trol is
cost of goods sold, andinventorils.
the risk that auditorl
performed i" ,"u.1" detection risk,
Substantive procedures are
in detail in chapter 5

will not detect

,.;i;;il.;.e

rrr"*" pt"."aures, d.escribed


and disclosures' as well as substan
ofaccount balances, Oun.i.,lo"t,
examples and discus

*;;;i;;iui",r.nt.

include direct tests


t0 thr;;;; iO fto"ia" detailed
tive analyticrf p.".Ja*.r. 4"p,"^
accounts'
for the various financial statement
sions of thes" frfih;;;;Jit tests
near the tim
procedures
of
number
p;;;;;
5. Complete tn"- ouiit'The auditors
;;*"tt"a in detail in Chapter 16' includc
p,o"ta;;'
rt"t"
;;it'
;t
completio,
of
minutes
"f
fiuUifiti.., completing the review of
1o:
completing tfr" ,.ui"[*io, .rrr""oia.a
identify
to
search
the
pt;;;;;' to'rrpt"tl"g
managt
meetings, p.rto'-ing nnal analytical
from
Lrd obtaining a ripresentation letter
contingencie. ,rd:i?;.';;#;;;;,
as to whethr
conclusion
u"
ment. Finally, overall u'dit fi"di"g'
"*i1'-131a
"J"rll'Jil
gei"'atty accepted accou:t1lq rinciples'
the flnancial stateml"t" foffow
6.IssuetheaLtditreport.Thefinalstepintheprocessis,issuanceoftheauditrepo
Details on audit repofis are pr
reached in the pieceding steps.
based on tr,"
"on"trrioi,
sented in ChaPter l7'

ThesesixstagesintheauditprocessaresummarizedinFigure6.l.tnadditiontopreset
emphasizes the flrst fo
ciients, tf-,. ,"rruirrA.r of this chapter

ing informati",
steps of the

";;;;;ir*g
,*d,t;;;r;,^ii1pr*1"

i;j
""d",

;;tain

and
an understanding of the client

furlher audit procedur'


or mrrtutJr\-Jni-ura 1+1 perform
detailed
environment, (3) assess the risk
1rr.,"., ihupt"t' 7 and 8 provide
intemal
Because of the complexity of
the
and
audit
rypes of
"ontiofair"o., to-pieting the
to uri't'i
information on that topic. chaptem
(chapter 9); details on

irrr.i.-ii.

upir*'oir."rr
-uut*."r, *al, .u*pling
of iransactions' and disclosures
"1u""'
through 21)'
*Ju.tom otrr.r r"f"rting issues (chapters 18

,"maining
audit reporrs
"t
various u."orn
to
relating
audit evidence
(chapters t0

thr*;;i;i,

"*
,clen,irv

."n,ij.,

rac"rs
'1ha'[
'lhe
in u.'"pting new

audi"rs

cl

-"ili.lxTxT:iililfl::il:il::::'Jl:iffi1:
l;[;Tf,ih#iffxii;I3ffiA:t;,
obtained competitively through
by one CPA'fr;. ;;"tJ

"t.

the entire audit performed


sociar
ur.suLrd,
buslness or
partner's
partner s business

."","*,Il'll.f:3g$
""'::::':: l:'^:;,,"
Such prospectl\ re clienrs ntay range
it" to'puny's annual audit' l:31':i::::J1::,t*H'";,T'[:
considering
uroit io r-orrg-estauiisnea companies
.o*nur,|r'ri.i.i"J"'ri.r,
-whut
new client'l
plospective
with a

proposal tbr pertotmrng

from start-up
,irk, *. iouoiu..a
replacing their current-r"Jii"r.
new client? what
risk associated with a prospective
How does a cpA nrln "rui.rute the
client?
exist relating to acquiring a new
other professlonut ,",pJ"ilil*";
objectivity'
for u cPf Ii; to maiitain its integrity,
As a starting polnt,

iti,

.rrential

andreputationforprovidinghigh-quality,erui""s.Noauditorcanaffordtoberegularly
fraud or other misleading pracare engaging in management
associated with clients who
underscores the need for CPA
tices. The continuing

*""

prospective clients

"iii,,g"tl"ooL'ot'l"gLditot'
policies for tffiughry investigating
firms to develop quality conrrol
the historv of the proThe cpns ino'io investigate
before accepring,' ;;;;;;;en'r'
of the directors'
n,,r,r.r, as ttre identities and ieputations
spective client.

includi;";il;h

om.".r, and major stockholders'

Audit Plonning, Understanding the Client, Assessing Risks, and Responding

FIGURE 6.1
ofan Audit

Stages

+-

I
I
I
I
I

of client,
its environment, and internal control.

2. Obtain understanding

I
I
I
I
I
I
I
I
I
I

Perform risk assessment procedures, including:


* lnquiries of management and others within

entity.

. Analytical procedures.
n

Observation and inspection of activities,


operations, etc.
u lnquiries of others outside the company
(e.9., legal counsel, valuation experts).
e Review information from external sources.

3. Assess risks

of material misstatement

and design further audit procedures.

---t

ldentify and assess risks of material


misstatement for account balances. classes of
transactions, and disclosures. Consider:
, What can go wrong.
, The magnitude involved.
u The likelihood of a material misstatement.
Design further audit procedures.

4. Perform further audit procedures.

5. Complete the audit.

Audit procedures:
o Search for unrecorded liabilities.
o Review minutes of meetings.
* Perform final analytical procedures.
o Perform procedures to identify loss
contingencies.
" Perform review for subsequent events.
. Obtain representation letter.
u Evaluate audit findings.

6. Form an opinion and issue

the audit report.

* Public company reporting requires reporting


on internal control and on the financial
statements.

* Nonpublic company reporting ordinarily


involves only reporting on the financial
statements.

___t

Chapter Six

Even if the auditors perform an audit in accordance with generally accepted auditing
standards, they may be sued by stockholders or creditors that sustain a loss. Therefore,
auditors will ionsider the reputation of management and the financial strength and credit
rating of a prospective client to help assess the overall risk of association with the particular business. This overall risk is often referred to as engagement risk.
To help assess engagement risk, the auditors generally obtain management's permission
to make inquiries of other third parties about a prospective audit client. For example, the
client's banker can provide information regarding the client's financial history and credit
rating. The client's legal counsel can provide information about the client's legal environment, including such matters as pending litigation and disputes with regulatory agencies.
Engagemeni risk is increased when the client company is in a weak financial position
or ls greatly in need of additional capital. When an audit client goes bankrupt, the auditors
often are named as defendants in lengthy and costly lawsuits, with possible damage to their
professional reputation. For that reason, some CPAs choose to avoid engagements entailing a relativety trlgh engagement risk; others may accept such engagements, recognizing
the need to expand audit procedures to compensate for the unusually high levels ofrisk.
In additiorrto evaluating engagement risk, the auditors should consider whether they
can complete the audit in accordance with generally accepted auditing standards. As discussed in Chapter 3, the CPA flrm must be independent of the client to perform an audit.
Therefore, the auditors must determine whether there are any conditions that would prevent
them from performing anindependent a:uditof the client. Consideration also will be given
to whetherihe partneis and staffhave appropriate training and experience to competently
complete the engagement. If the auditors have no experience in a particilarly complex
industry, they may decide that a competent audit of a prospective client in that industry
cannot be peiformed unless the CPA flrm hires appropriately experienced personnel.

Submitting a
Proposal

To obtain the audit, the auditors may be asked to submit a competitive proposal that will
include information on the nature of services that the firm offers, the qualifications of the
firm's personnel, anticipated fees, and other information to convince the prospective client to select the firm. The CPA firm also may be asked to make an oral presentation to the
prospective client's audit committee and management to provide a basis for the selection.
As discussed in further detail later in this chapter, when the auditors replace other auditors, they must attempt to communicate with the predecessor auditors before making a
final decision to accept the new engagement.

Audit committees
Arrangements for the audit should be made through contact with the company's audit
Committee. Public companies must establish such a committee within the board of
directors to take an active role in overseeing the company's accounting and financial
reporting policies and practices. Audit committees are required by the New York Stock
Exchange, the American Stock Exchange, andNASDAQ.
en audit committee must be composed of at least three independent directors- that
is, those outside directors (neither officers nor employees) who have no other relationship that might impair their independence. Although audit-committee members are paid
foiserving on the board of directors, the Sarbanes-Oxley Act of 2002 provides that audit
committee members should not receive any consulting, advisory, or other compensatory
fee from the company, or be in any way affiliated with the company. Also, the members
of the audit committee must be financially literate, and at least one member (usually the
chairman) must be a financial expert. Finally, the audit committee must be responsible
for appointment, compensation, and oversight of the auditors.
Ouring the course of the audit, the auditors will discuss with the audit committee
matters zuch as weaknesses in internal control, proposed audit adjustments, disagreements with management as to accounting principles, the quality of accounting principles used by the co*puny, and indications of management fraud or other illegal acts by

Audit Planning, Understanding the Client, Assessing Risks, and Responding

dE'
=

lllustrative Case
a carpet
cleaning company started
in 1981 by Barry Minkow, a
16-year-old high school student. Although the company
experienced significant growth during the mid-1980s, it
ZZZZ Best Co. was

was not fast enough for Minkow. He hired several officers with criminal records and conceived a plan to restore
damaged buildings for insurance companies. A number
of multi-million-dollar restoration contracts were supposedly undertaken that later were found to be completely
fictitious. Minkow attempted to cover up the scheme by

Fraud at ZZZZ Best Co.

spending several million dollars to lease a building and


make it appear to be a legitimate restoration project when
the CPAs insisted upon visiting the site. Prior to the time
the fraud was uncovered, the company's stock had a market value in excess of $211 million. Shortly thereafter, the
stock was worthless. This case clearly illustrates the risks
involved in accepting young companies with rapid growth,
the need to investigate the background of key officers of a
company, and the need to have a thorough understanding
of the client's operations and industry.

corporate officers. Since these communications assist the audit committee in its oversight
ofthe financial reporting process ofthe company, they are required by generally accepted
auditing standards. Chapters 7 and 16 present a detailed discussion of the required communications to audit committees.
Not all entities have audit committees. For example, the concept of an audit committee
does not apply to businesses organized as sole proprietorships, partnerships, and small,
closely held corporations. Arrangements for an audit of these businesses often are made
with the owners, apartner, or an executive, such as the president or the controller.
Fee Arrangements

When the business engages the services of independent public accountants, it will usually
ask for an estimate of the cost of the audit. Stafftime is the basic unit of measurement for
audit fees. Each public accounting flrm develops a per hour or per diem fee schedule for each
category ofaudit stafl based on direct salaries and such related costs as payroll taxes and
benefits. The direct rate is then increased for overhead costs and a profit element. In addition
to standard per diem or per hour fees, clients are charged for direct costs incurred by the public accounting firm for stafftravel, report processing, and other out-of-pocket expenditures.
Estimating a fee for an audit involves the application of the CPA flrm's daily or hourly
rates to the estimated time required. Since the exact number of hours cannot be determined in advance, the auditors may merely give a rough estimate of the fee. Or they may
multiply the rates by the estimated time and quote a range or bracket of amounts within
which the total fee will fall. In a competitive situation, a fixed fee may be quoted that is
"discounted" from the standard to meet the competition.

Communication
-'Jith Predecessor
i ud itors

AICPA AU 210 (PCAOB 315) requires the successor auditors to attempt to communicate with the predecessor before accepting the engagement. Beca:use the predeCeSSOr
auditors are an excellent source of information about a prospective client, in many circumstances this communication will occur before a formal proposal is presented to a prospective client. In other situations (e.g., the prospective client's request or other reasons),
the communication will occur subsequent to presentation of a formal proposal.
Because auditors are ethically prohibited from disclosing confidential client information without the client's consent, the successor auditors must ask management of the
prospective client to authorize the predecessor auditors to respond fully to the successor's inquiries. If a prospective client is reluctant to authorize communications with the
predecessor auditors, the successor auditors should seriously consider the implications in
deciding whether to accept the engagement.

'!gfi

Chapter Six

(which may be
When permission has been granted, the successor auditors' inquiries
whether to
in
determining
auditors
the
assist
will
that
written oioral) are aimed at maiters
at obtainaimed
inquiries
include
may
the
auditors
accept the engagement. Accordingly,
ing information about:

.
"
.
*
-

The integrity of management.


Disagreements with management over accounting, auditing, or similarly significant
matters.
regarding
Predecessor auditors' communications to those charged with governance
fraud and noncompliance with laws or regulations'
predecessor auditors' communications to management and those charged with governance regarding internal control significant deficiencies and material weaknesses'
ofauditors'
The predecessor auditors' understanding about the reasons for the change

in evaluThis communication is extremely important since it aids the successor auditors


the
audit' A
risk
of
the
to
related
issues
other
ating the integrity of managemint ina
of the
number
significant
in
a
that
reveals
fraud
revilw of casis invotving rianagement
of
disbecause
often
auditors,
company's
the
cases management had ricentlylhanged
agreements over accounting principles.
For public companies, ther" is-uoother source of information available for investito its
gating a change in auditors. Regulations of the SEC require companies subject
reasons
the
and
independent.auditors
in
changes
i:risiiction to-file a Form 8-K reporting
iherefore. The companies also must report the details of any significant disagreements
years' The auditors
between management and the auditors occurring over the prior three
whether they
indicating
response,
provide
a
must
that have resigned or been discharged
requirement
This
details.
necessary
any
providing
with tG .oropurry's form and

agree
principles,
discourages -rrug"*"rt from the practice oflhopping for accounting
to sanction
likely
more
is
that
firm
CPA
a
to
in which management changes urriitot.
search
for
example,
might,
management
a disputed acco-unting princille. A company's
in
as
being
method
recognition
revenue
questiona6le
for auditors who would accept a
also
shopping
about
Concern
principles.
accordance with generally accepted accounting
qtS ecAoB 625), which provides guidance to public
led to the issuance of AICPA eU
treataccountants when they get a request for a written or oral report on the accounting
another
by
is
audited
that
a
company
from
ment of a prospectivetrlompleied transaction

CPA firm.
to
Before providing a report on accounting principles, accountants should take steps
transacthe
of
substance
form
and
the
of
make sureihey have a complete understanding
iion, includinj consulting with the company's current auditors' They also should review
provide
exisiing u."o*ting prinJiptes and consult appropriate referenggs_ and experts to
actually
management
in
which
cases
Afhough
an adef,uate basisl& their conclusions.
is allowed
shops for accounting principles are not cofilmon, it is clear that if management
independence.
placed
on
auditors'
is
pressure
to change auditors casually, undue
the
Shopiping for accounting principles is also discouraged by the provision of
be
public
company
of
a
committee
audit
the
that
Sa*anes-Oxtey Act of 200i requiring
auditors.
the
of
oversight
and
responsible foithe appointment, compensation,

Plannin

Aud

Explain the auditors' responsibilities when planning m audit.

it

Audit planning involves developing an overall audit strategy for the conduct, otganiza'
tion, and staffi:ng of the audit. The nature, timing, and extent of planning varyby characteristics of the Company being audited and the auditors' experience with that company'
But, for
Certainly the planning of the audit of a new client is ordinarily more difficult'
it
continues
in
that
is
iterative
process
and
all audits, planning bigins very early in the
throughoui th. uriit ai the auditors modiff planned procedures in response to circumstances identified throughout the audit.

Audit Planning, Understanding the Client, Assessing Risks, and Responding 191

Establishing an
Understanding
with the Client

The auditors should establish an understanding with the client regarding the services
to be performed. This understanding should include (l) the objective and scope of the
audir, (2) auditor and management responsibilities, (3) inherent limitations of an audit,
(4) the applicable financial reporting framework (e.g., GAAP), and (5) the expected form
and content ofreports to be issued by the auditors. This understanding should be in the
form of a written engagement letter (or other suitable written agreement). When the
engagement letter is accepted by the authorized client official, it presents an executor
contract between the auditor and the client. While engagement letters do not follow a
standard format, a sample engagement letter is presented in Figure 6.2.

FIGURE 5.2
Engagement Letter for

Letterhead

Frnancial Statement
September 1, 20X5

Audit
Mr. Terry Keystone, Chairman of Board of Directors
Keystone Computers & Networks, lnc.
14645 40th street
Phoenix, A284280
Dear Mr. Keystone:
[The objective and scope of the audit]

You have requested that we audit the financial statements of Keystone Computers &
Networks, lnc., which comprise the balance sheet at December 31,20X5, and the related
statements of income, changes in stockholders' equity, and cash flows for the year then ended
and the related notes to the financial statements. We are pleased to confirm our acceptance
and our understanding of this audit engagement by means of this letter. Our audit will be
conducted with the objective of our expressing an opinion on the financial statements.

[The responsibilities of the auditor]


We will conduct our audit in accordance with auditing standards generally accepted in the
United States (GAAS). 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 involves performing procedures to obtain audit evidence about the amounts
and disclosures in the financial statements. The procedures selected depend on the auditor's
judgment, including the assessment of the risks of material misstatement of the financial
statements, whether due to fraud or error. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made
by management, as well as evaluating the overall presentation of the financial statements.
Because of the inherent limitations of an audit, together with the inherent limitations of
internal control, there is an unavoidable risk that some material misstatements may not be
detected, even though the audit is properly planned and performed in accordance with GAAS.
ln making our risk assessments, we consider internal control relevanttothe entity's preparation of the financial statements 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 entity's internal control. However, we will communicate to you in writing concerning any
significant deficiencies in internal control relevant to the audit of the financial statements
that we have identified during the audit.
[The responsibilities of management and identification of the applicable financial reporting
frameworkl
Management is responsible for the preparation and fair presentation of these financial statements in accordance with accounting principles generally accepted in the United States of
America; this includes the design, implementation. and maintenance of internal control relevant to the preparation and fair presentation of consolidated financial statements that are
free from material misstatement, whether due to fraud or error.
Our audit will be conducted on the basis that management [an4 where appropriate, those
charged with governancel acknowledge and understand that they have responsibility:
(a) For the preparation and fair presentation of the financial statements in accordance with
accounting principles generally accepted in the United States.
(b) 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; and

ChaPter Six

a,

to the preparation or

is aware is rerevant
ff ;lll;.rrrtion that manaeementdocumentation'
f T::tfinancial
and other matters;
t"i

the
"tl"lttOs'
""'"'"""it' that we
may request from
(ii) Additional information

of
management for the purpose

the audit; and

(iii)Unrestrictedaccesstopersonswithintheentityfromwhomwedetermineitnecessary
to obtain audit evidence'
where appropriate'
request from management [and'
made to us
part of our audit process' we will

As
those charged *i*, gorernTn.;i;;;iiJ.;"firmation'conclrning
in connection with the audit'

representations

Welookforwardtofullcooperationfromyourstaffduringouraudit.
|tnsertotherinformation,suchasfeearrangements,billings,timing,andotherspecificterms,
as apProPriate'1

lReportingl

Theformandcontentotourreportmayneedtobeamendedinthelightofourauditfindings.
uuait of Kevstone computers &
the board of directors'
We will issue a writte" il;f;;;;'comRletion'ot-oui
our report *itl u" uaat"tsed to
Networks, lnc.,s financial ,iJa"r"nar.
be. expressed' circumstances
will
opinion
*rnooiri"d

.*"r:;;i;;i'"n
emphasis o{ matter or
modify o'ioplnion' add an
i'
""l""tivi;;;t1; the ensagement'
H.''#;*r';"rlgtuprtttl' ;.. *ithd'u* from

we cannot provide

mav arise in which it

Pleasesignandreturntheattachedcopyofthislettertoindicateyour.acknowledgementof,
itt" financial statements including
for our
"'Oit'tf
and aqreement with, the

"'-g"'"nii

our reipective responsibilities'


Very truly Yours,

e/4d,b4ln

44'

on behalf or Kevstone
i:i;l;ffiil3IIiun'""a
iturned bv ctientl

iitiii"J,iii"d,

bv:
computers & Networks' lnc'

and

Inadditiontoobtaininganunderstandingwiththeclient,theauditorswillperform

procedures to determine that:

independence requirements'
The firm meets professional

Therearenoissuesrelatingtomanagemenrintegrirythatmayaffecttheauditors,willingness to continue the engagements'


the engagement'
with the client as to the terms of
There is no misunaerstanjing

Forrecurringaudits,assesswhethercircumstancesrequirethe|lmsoftheaudittobe
either inwriting or orally'
of tire terms oiihl.ngug"-*t
client
reminiihe
not,
tf
revised.

DeveloP an
Overall Audit
StrategY and

Audit Plan

which
Whentheauditorshaveobtainedasufflcientunderstandingo|,l"client,theyestabJtrarac"teristics of the audit
";"q*r.."rrt1,
,tiri;y;" """rii"tt-ir'ot"
the
and
lish an overall
locations'
client
"raii
industry ."p;;;;
deadlines
determine its scope, such as
audit'
as timing of the
basis of reporting f";]fr"f,6^rt. !ii*i.
from manasement will be
;eceived
i'rot-uti";;il;" judgments
for reporting, u,,a rt"ylut"l
o" u'"u'-of high risk of
'riuiwill make p."tl.irruty
approach
determined. Also, the uJiaffi

il;-;;

expected

locations,.an;;;.;;#; dJtermine theand industry factors'


rorr.ia"ri"."rt significant client
are able to start

material misstatement, material


,"o
to considering irrt"*ui"""*it

auditors
uiiii.,ru*g, fru. U""n .ttuUfiihed, thethan
the audit strategy and
*o."-J"ruif.d
"
The
devetoping the audit plan.
"*r: ll"1ll

When tt

ou"ratf

in
^toibiain
includesthenature,timing'andextentof'"ai'p'""t4*"*lgP"performedbytheaudit
Although audit plans differ
sufficie",
team mernberc in oro.,
""oii."ioence'

Audit Planning, Understanding the Aient, Assessing Risks, and Responding 193

form and content among public accounting firms, a typical plan includes a description
the nature, timing, and extent of:
1. Planned

risk

assessment procedures sufficient

to

assess

of

the risks of material

misstatement.

2. Planned further audit procedures for each material class of transactions, account
balance, and disclosure. This includes tests ofcontrols and substantive procedures.
3. Other audit procedures in order to comply with generally accepted auditing standards.
The audit plan is documented with an audit program, which is a detailed list of the
audit procedures to be performed in the course of the audit. A tentative audit program is
developed based on the auditors' initial risk assessments. This tentative program, however,
may require frequent modification as the audit progresses. For example, the nature, timing,
and extent ofsubstantive procedures are influenced by the auditors' final assessment ofthe
risk of material misstatement. Thus, not until tests of controls have been completed can a
fina1 version of the audit progmm be completed. Even this version may require modification if the auditors revise their preliminary estimates of materiality or risk for the engage-

ment, or if substantive procedures disclose unexpected problems such as an additional


fraud risk factor. Audit programs are discussed in detail in the final section of this chapter.
Public accounting firms usually charge clients on a time basis, and detailed time budgets can assist the auditor in estimating the audit fee. A time budget for an audit is constructed by estimating the time required for each step in the audit program for each of the
various levels of auditors and totaling those estimated amounts. Time budgets serve other
functions in addition to providing a basis for estimating fees. The time'budget communicates to the audit staff those areas the manager or partner believes are of high risk and
require more time. It also is an important tool of the audit senior, who uses it to measure
the efficiency of the staff and to determine at each stage of the engagement whether the

work is progressing at a satisfactory rate.


There is always pressure to complete an audit within the estimated time. The staff
assistant who takes more time than normal to complete a task is not likely to be popular with supelisors or to win rapid advancement. Ability to do satisfactory work when
given abundant time is not a sufficient qualification,for time is never abundant in public
accounting.
The development of time budgets is facilitated in repeat engagements by reference
to the preceding year's detailed time records. Sometimes time budgets prove quite unattainable because the client's records are not in satisfactory condition or because of other
special circumstances that arise. Even when time estimates are exceeded, there can be
no compromise with qualitative standards in the performance of the fleldwork. The CPA
firm's professional reputation and its legal liability to clients and third parties do not permit
any shortcuts or the omission of audit procedures to meet a predetermined time estimate.

Use

of the Client's
Staff

The auditors should obtain an understanding with the client as to the extent to which the
client's stafl including the internal auditors, can help prepare for the audit. The client's
staff may prepare many audit working papers for the auditors, thus reducing the cost of
the audit. Among the tasks that may be assigned to the client's employees are preparation
ofa trial balance ofthe general ledger, preparation ofan aged trial balance ofaccounts
receivable, analyses of accounts receivable written ofl lists of property additions and
retirements during the year, and analyses of various revenue and expense accounts. Most
of these "working papers" will ordinarily be in the form of computer spreadsheets and
other computeized data files.

lnvolvement of
ilrlore than One

When a portion of the client (e.g., a subsidiary in a distant city) is audited by another
CPA firm, efforts must be coordinated. For example, if the accounts of the subsidiary arc
to be consolidated with the overall enterprise, and if that subsidiary is audited by another

CPA Firm

rl[q',

Chapter Six

reports andprocedures to
CpA firm, the auditors must coordinate the timing of necessary
17'
be performed. This situation is discussed in Chapter

Use

of Specialists

CPAsmaylackthequalificationsnecessarytoperformcertaintechni:,l,,'ti:]111q
inventory may requre
to the audit. For example, judging the valuation of a diamond
:oying a specialisi;';drp;taisal, or evaluating the reasonableness of the fair
require the use of a securities
value of a complex financial der-ivative instrument may
the appropriate use of specialvaluation expert. Bff."ilr" fturrrirrg involves arranging
This should include consideration
ists both inside and outside tfthe client organizatioi.
the.audit of the client's
of the need fo, sp".iuiir"d skills in asseising the etr9c-t1 on
was discussed in detail in
use of information technology. Using the worf of specialists
Chapter 5.

Additional
First-Year
Considerations

sufficient appropriate evidence


In the first audit of the client, the auditors should obtain
accounts contain misstatements
about whether the Opening balanCS for the various
For example, consider
statements'
financial
period's
that materially affect it
" "itt"n
To determine the propriety of
accounts such as pfunt ,"J equipment and inventories.

proper balances in plant and equipment


depreciation expense i".irr" current year and the
plan to investigate the validity of
accounts at the balance street date, ihe auditors musi
period. Similarly, if the auditors arc
the property accounts at the beginning of the current

of beginning"inventories, they
unable to obtain satisfactory evidenci as to the balince
it may be necessary to
have sufficient evidence about cost of goods sold, and
,rrv
"", an opinion on the income statement'
disclaim

whether the
AICPAAU 510 leceoe 315) requires that the auditors determine
to the current period'
prior period,s closing balances were properly brought^forward
of appropriate accounting poliand whether those balances reflect the appiication
have been performed by a
cies. when satisfactory p.io, yea, audits ;f the business
will ordinarily have
predecessor auditor, u, d'ir"orr"a earlier, the successor auditors

about matters such as management iiT?11?,


have had with management, communlcamay
disagreements that the piedecessor
understanding of the reason
predecessor's
the
and
tions with the audit committee,
a-second communicafor the change of auditors. Auditors also ordinarily initiate
new client' This
ofthe
to
acceptance
subsequent
tion with the predecessor auditors
of the predecessor auditors'
second communicatitn relates primarily to the contenis
of application. of
working papers ,.rut a to opening balances and the consistency
predecessor auditors' working
accounting principles. In addition to reviewing the
will evaluate whether
papers relating to op""l"g balances, the successor auditors
the open'roait
pro""auies planned ior the current audit will provide evidence about
will decide whether
ing balances. Based on this evaluation, the succesior auditors
to obtain eviit is necessary to perform additional procedures specifically designed
dence regarding the opening balances'
communicated

with;" ;;;"""ssor

performed, an extensive analyIn cases in which no satisfactory recent audit has been
to establish account balances as ofthe
sis oftransactloffi ofprior years *ltt t" necessary

beginning ofthe current Year.

obtaining an understanding of the client and lts Environment


auditors to help plan the
The required understanding of the client is used by the
Desoibe the natue of the risk
assessment procedues that auditom use to obtain an understandhg

of the client md its enviroment.

'"iit'{
and relevant
to assess the risks of material misstatement at ihe financial statement
of the client is cor
assertion levels. Guidance on obtaining this required understanding
tained in AICPA AU 315 (PCAOB 314)'

Audit Planning, Understanding the Client, Assessing Risks' and Responding 195

Risk Assessment

To obtain the understanding of the entity and its environment, auditors perform risk

Procedures

assessment procedures, which include:

"
.
.
,

Inquiries of management and others within the entity.

Analytical procedures.
Observation and inspection relating to client activities, operations, documents, reports,
and premises.
Other procedures, such as inquiries of others outside the company (e.g., legal counsel,
valuation experts) and reviewing information from external sources (e.g., analysts,
banks, rating organizations, and business and industryjournals).

These risk assessment procedures are supplemented by further audit procedures in the
form of tests of controls and substantive procedures to obtain sufficient audit evidence to
express an opinion on the flnancial statements.

Information on the Client's Business and lts Environment


When should a health club recognize its revenue from the sale of lifetime mernberships?
Is a company orgatizedto produce a single motion picture a going concern? What basis
should bi used to record a barter of goods over the lnternet? What is a reasonable
depreciable life for today's most advanced information systems? We will not attempt
toinswer these questions in this textbook; we raise them simply to demonstrate that the
auditors must obtain a good working knowledge of an audit client's business and its environment if they are to design effective audit procedures. An understanding of the client
and its environment encompasses:

'
"
"
"

The nature ofthe client, including the client's application of accounting policies.
The industry, regulatory, and other external factors affecting the client'
The client's objectives and strategies and related business risks.
Methods used by the client to measure and review performance.
The client's intemal control.

Performing procedures to obtain an understanding of the entity and its environment


is an essenti al part of planning and performing an audit. Specifically, the understanding
establishes a frame ofreference for the auditors to use in (1) considering the appropriateness of the accounting policies applied by the client, (2) identifying areas where special
audit consideration may be necessary (specialized risks), (3) establishing appropriate
materiality, (4) developing expectations for analytical procedures, (5) designing and performing audit procedures, and (6) evaluating audit evidence.
The Nature of the Client

What is the client's business model? Who are its major customers and suppliers? What
types oftransactions does the client engage in? How are they accounted for? These are
the types of questions that the auditors attempt to answer to obtain an understanding
of the nature of the client. The auditors' understanding of the nature of the client will
include the client's competitive position, organizational structure, governance processes,
accounting policies and procedures, ownership, capital structure, and product lines. Then
the auditors turn their attention to the client's critical business processes and obtain an
understanding of how these processes create value for the client's customers. Using a
manufacturing company as an example, the auditors will obtain an understanding of:

.
"
.
.

The processes used to procure, store, and manage raw materials.


The processes used to machine, assemble, package, and test products.
The processes used to create demand for products and services and to manage relations with customers.
The processes used to establish contract terms and to bill and collect receivables.
The processes used to take orders and deliver goods.

196

Chapter Six

"

The activities performed after the goods and services have been delivered (e.9.,
installation, training, warrat$, and customer service).

"

The processes used to acquire and maintain human resources and technology, including
research and development.

Industry, Regulatory, and Other External Factors


The factors envisioned here include industry conditions, such as the competitive environment, supplier and customer relationships, and technological developments. They also
include the regulatory ,legal, and political environment and general economic conditions.
These factors may subject the client to specialized risks that may in turn affect the audit'
Many firms-including the Big 4 flrms to varying degrees-have adopted a financial
model to evaluate the client's industry that considers the attractiveness and other characteristics of the industry. Conceming the overall attractiveness of the industry, auditors
consider such factors as:

"
"
.

Barriers to entry.
Strength of competitors.
Bargaining power of suppliers of raw materials and labor.
Bargaining powff of customers.

The other characteristics of the client's industry that auditors consider include factors
such as economic conditions and financial trends, govemmental regulations, changes in
technology, and widely used accounting methods
Objectives and Strategies and Related Business Risks
The client's objectives are the overall plans of the entity as defined by management.
Management attempts to achieve these objectives by developing strategies, or operational
actions. However, achieving management's objectives is always subject to business risks.
As described in the previous section, these are the conditions that threaten management's
ability to execute strategies and achieve objectives. The auditors obtain an understanding
of thi client's operating and financing strategies and attempt to identi$r significant business risks faced by the client. Significant risks that may be identifled for a particular client
might include risks related to competition, changes in government regulations, changes
in iechnology, volatility of raw materials prices, intemrption of supplies of critical raw
in major markets, or increases in interest rates. In obtaining their
materials,
"hurrg"r
understanding of these matters, the auditors are particularly interested in management's
risk assessment process. Well-operated companies use formal processes for identiffing business risks and devising ways to mitigate them. An understanding of this process
can assist the auditors in identi$zing significant business risks and evaluating their audit
significance. Many of these business risks may create risks of material misstatement of
the financial statements.

Methods of Measuring and Reviewing Pedotmance


Management may use a variety of techniques to measure and review performance, such as
budgets, key performance indicators, variance analysis, and segment performance reports.
Many firms have developed a balanced scorecard that-uses a combination of financial
and nonfinancial performance measures to assess the fnancial, customer, internal business
process, and learning and growth perspectives of the organization. These measurement sysiems assist management in gauging progress toward meeting its objectives. Extemal parties also may measure and review the client's performance. Examples include bond rating
agencies, credit agencies, and financial analysts. The methods of measuring and reviewing
performance are important to the auditors in determining the incentives of management
and other employees because their compensation is often tied to the measures. These incentives may create pressure on management or employees to misstate the financial statements
or otherwise engage in fraud. In addition, the auditors may use these measures in designing
ana$ical procedures to provide evidence about the fairness of the financial statements.

Audit Planning, Understanding the Client, Assessing Risks' and Responding 197

Internal Control
Internal control is designed to provide reasonable assurance

of achieving objectives

and comrelated to reliable financial reporting, efficiency and effectiveness of operations,


work to
of
the
audit
piiu*r with applicable laws and t.gulutiort. The nature and extent
te performeA on a particular engaglement depend large.lil upon the effectiveness of the
in the financial
client's internal control ln preveriting or detecting material misstatements
control, they need
statements. Before auditors can evJuate the effectiveness of intemal
exist and who performs
a knowledge and understanding of how it works: what controls
what accounting
them, how-various types of tran;actions are pfocessed and recorded, and
a sufficient underrecords and supporting documentation exisi. The auditors must have
plan the audit. Chaptet 7
standing of the iesignLd implementation of intemal control to
focuses=on the auditors' consideration of internal control'

Sources of

lnformation

inquiries of
Much information about the nature of the client may be obtained through
inquiry to determanagement and other personnel. For example, the auditors_-u{.or"
customers' The
mine the major types of sales transactions and the nature of the client's
inquiry and inspection to determine the content of sales contracts
auditors -uy

"o-Lirre
and the accounting policies used

for tecognizingrevenues under the contracts' They also


production
make inquiries oiothe. personnel within the organization. As an example,
production
p*"""i can provide the auditors with a more detailed understanding of
the auditors and key officers of the
iro."rr"r. In aidition, informal discussions betweensize,
operations, accounting records,
ilient can provide information about the history,
make numerous inquiries
and intemal control of the enterprise. Finally, the auditors may
chapter'
this
in
later
described
as
risks
to identifu and assess fraud
AICPA
Many other sources of information on clients are available to the auditors.
governand
publications,
trade
Alerts,
Risk
Industry
and
Audit and Accounting Guides
the client's industry'
mental agency publications are useful in ottaining an orientation to
and prior years' tax
filings,
SEC
to
stockholders,
reports
reports, annual
Previous-audit
retums are excellent sources of financial background information.

Electronic Research
to efficiently
A number of computerized research tools are available to allow the auditors
include:
examples
Some
audits.
their
obtain information for use in
retrieved on the
1. Accounting and auditing professional standards may be searched and
ONLINE
TeSOURCE
AICPA'S
FASB'S Financial .l"roiiting Research System and the
on
standards
its
provides
Accounting and Auditing Lilerature.In addition, the FASB
on
provides,
System
Research
its Web site, www.fasb.6rg. The Finqncial Accounting
Task
Issues
Emerging
a CD-ROM, Statements in Financial Accounting Standards'
TeSOURCE ONLINE
Force Abstracts, and FASB Implementation Guides. The AICPA',s
AICPA professional
to
all
Accounting ,nd Audfting Literature provides access
over the Internet'
practice
aids
audit and accounting guides, and technical
standards,

in the client's industry may be obtained from


2. Financial information about companies
-Compustat
and DisclosuVe SEC Database (Discloa number of sources, including
retrieve financial datathat have been
and
search
may
sure). Stbscribers to Disclosuri
public companies. Auditors also may
of
reports
annual
extracted from SEC filings and
including their flnancial statepublic
companies,
obtain the SEC filings Jf certain
and Retrieval system), which
Analysis,
Gathering,
Data
ments, on EDGAR(Eiectronic
may be accessed on the Internet.
from the
3. Current developments for companies and their industries may be obtained
joumal
articles'.fn
and
Intemet. The Internet provides online access to newspaper
.o.puries and industry associations have home pages that describe
addition,
addresses
curent developmenis and statistics. Appendix 64 includes several Internet
that may be uslful in performing accounting and auditing research.

-rry

Chapter Six

ffiffi

lllustrative Case

ffiffiffiil
u;ffiffi ffi

U nde

rsta nd

ng the

Cl i

ent's

Business

ffiffiffi
;:r,ffiilfi!ffi

The importance of an understanding of the client's


business was dramatically
illustrated by the Volkswagen AG case. ln this case, the company reported that "criminal manipulation" of its foreignexchange positions had cost the firm as much as $259 million.
$

The fraud prompted the resignation of the company's chief


financial officer and the firing of its foreign-exchange manager. The auditors did not detect the fraud until fraudulent
contracts came due and were rejected by banks. An insider
suggested that auditors often don't know enough about
complicated currency instruments to detect such problems.

Tour of Plant and Offices


Another useful preliminary step for the auditors is to arrange an inspection tour of the plant
and offices of a prospective client. This tour will give the auditors some understanding
of the plant layout, manufacturing process, principal products, and physical safeguards
surrounding inventories. During the tour, the auditors should be alert for signs ofpotential problems. Rust on equipment may indicate that plant assets have been idle; excessive dust on raw materials or finished goods may indicate a problem of obsolescence. A
knowledge of the physical facilities will assist the auditors in planning how many audit
staffmembers will be needed to participate in observing the physical inventory.
The tour affords the auditors an opporfunity to observe firsthand what ffies of information technology and intemal documentation are used to record such activities as receiving
raw materials, transferring materials into production, and shipping finished goods to customers. An understanding of these computer applications and documentation is essential
to the auditors' consideration ofinternal control. Inquiries ofpersonnel invarious departments may provide the auditors with critical information about the client's operations
and may serve to confirm information obtained from financial management.
In visiting the offices, the auditors will learn the location of various facilities and
accounting records. The auditors can ascertain the practical extent ofsegregation ofduties
within the client organization by observing the number of office employees. In addition,
the tour will afford an opportunity to meet the key personnel whose names appear on the
organization chart. The auditors will record the background information about the client
in a permanentfile available for reference in future engagements.

Analytical Procedures
As described in Chapter 5, analytical procedures involve comparisons of financial statement balances and ratios for the period under audit with auditor expectations developed
from sources such as the client's prior years'financial statements, published industry statistics, and budgets. When used for risk assessment pu{poses, analfiical procedures assist the
auditors in planning the nature, timing, and extent of audit procedures that will be used for
the specific accounts. The approach used is one ofobtaining an understanding ofthe client's
business and transactions and identifying areas that may represent higher risks. The auditors will then plan a more thorough investigation of these potentiil problem areas. Auditors
perform analfiicalprocedures as a part ofthe risk assessmeni process for every audit.
An example of the use of an analytical procedure for risk assessment purposes is the
comparison of the client's inventory turnover for the current year with comparable statistics from prior years. A significant decrease in inventory turnover might lead the auditors
to consider the possibility that the client has excessive amounts of inventory. As a result,
the auditors would plan more extensive procedures to search for inventory items that may
be obsolete.
The Statement of Cash Flow and Obtaining an Understanding of the Client

The auditors may use the statement of cash flows to analyze cash flows while obtaining an understanding of the client, particularly as a part of risk assessment analytical

Audit Planning, Understanding the Client, Assessing

Risks, and

Responding 199

procedures. For a profltable, growing company, one ordinarily expects positive operating
cash flows, perhaps slightly t igh". than net income due to the addition of depreciation
and amortiiationltems baik to ir"o*e. Cash flows from investing are often negative
for such a company as it makes capital expenditures and investments. The direction of
and
cash flows from financing is expected to vary among years depending upon issuance
redemption of stock and debt.
Continuing with the example of a profltable, growing company, when the auditors find
that cash from operations is slgnificantly less than net income, investigation of the reason
(e.g.,
or reasons is appropriate. Possible reasons include large increases in current assets
payable),
accounts receivible and inventory) and decreases in liabilities (e.g., accounts
While
and recognition of large amounts of revenues for which no cash has been received.
such conditions may or may not indicate a misstatement, they are worthy of follow-up
and explanation.

Determining
Materiality

presenThe concept of materiality recognizes that some matters are important to the fair
tation of financial statements, while others are not. The materiality concept is basic to
the audit, because the audit repoft states that an audit is performed to obtain reasonable
assurance about whether the financial statements are free of material misstatement.
Materiality judgments depend both upon the financial reporting framework being used
prinand on the auditors' professional judgment. U.S. generally accepted accounting

ciples refer to FASB Statement of Financial Accounting concepts No. 2, "Qualitative


Ciraracteristics of Accounting Information," which defines materiality as
that, in the light of
. . . the magnitude of an omission or misstatement of financial information
person relying
surrounding circumstances, makes it probable that the judgment of a reasonable
or
misstatements.
the
omission
by
on the information would have been changed or influenced

Altematively, pCAOB Auditing Standard No. 11, "Consideration of Materiality in Planning and feiforming an Audit,i points out that in interpreting the federal securities laws
the"Supreme Court of the United States has held that a fact is material

if there is:

likelihood that the . . . fact would have been viewed by the reasonable investor
having significantly altered the "total mix" of information made available.
a substantial

as

Although one may question whether these two descriptions differ significantly from
or" ,roth"r, it is impoitant to realize that they both involve a consideration of quantitative and qualitative factors-particularly when evaluating a misstatement that has been
identified. Under certain circumstances, a misstatement that would ordinarily be considered immaterial in quantitative terms may be material because of its nature' As an
example, an illegal payment of an otherwise immaterial amount could be material if there
is a reasonabte possiUitity that it could lead to a material contingent liability or a material
loss ofrevenue.
Auditors consider materiality both in planning the audit and in evaluating audit findings. In planning the audit, auditors use materiality in determining the proper scope of
detecting
urr"dit pro""ar."r. Th" audit must be planned to obtain reasonable assurance of
material misstatements of the financial statements. In evaluating audit flndings, the auditors use materiality to evaluate whether actual or likely misstatements that have been
found are material to the financial statements. This is a critical decision because a material
misstatement should result in audit opinion modification, while an immaterial misstatement should not. Because this chapter emphasizes planning, we will emphasize the plarrning concept of materiality, but we also will provide a brief discussion of materiality for
evJuation pulposes. Materiality for evaluation purposes is also addressed in Chapter 16'

Planning MaterialiQ
The auditors' purpose in considering materiality at the planning stage of the audit is to
determine the appropriate scope of their audit procedures. Audit procedures should be
designed to deteii miterial misstatements, so that the auditors do not waste time searching

200

Chapter Six

for immaterial misstatements that cannot affect the auditors' report. As described in
Chapter 5, the scope ofthe auditors' procedures for an account is directly related to the
risk of material misstatement of that account. The auditors will perform extensive procedures on an account with a high risk of material misstatement. No audit procedures will
be performed on an account that is quantitatively immaterial unless, based on qualitative

considerations, the account is significant. For example, an Accounts Receivable from


Officers account might be considered material regardless of its size.
While planning the audit, the auditors also may become aware of a number of accounting expediencies followed by the client that may result in immaterial misstatements. The
concept of materiality often allows auditors to "pass over" certain conceptual accounting
errors, such as charging low-cost items like small tools or business machines directly to
expense accounts. But even in these situations, the auditors need to carefully consider
the possibility that the effect of such accounting expediencies may differ materially from
results obtained following generally accepted accounting principles. Accounting expediencies are not acceptable simply because the client's management says the amounts
involved are immaterial or because the amounts involved were considered immaterial in
the past.

Quantifying Planning Materiality at the Oyerall Financial Statement Level Auditing


standards require that auditors determine materiality levels for the overall financial statements. As an example, the auditors may conclude that a $100,000 misstatement of net
income before taxes is material for purposes of the income statement, and $200,000 for
the balance sheet. Many possible misstatements affect both the balance sheet and the
income statement; for example, an overstatement of ending inventory both overstates
assets on the balance sheet and net income on the income statement. Because of such
possible misstatements, the auditors will design their audit to detect the smallest misstatement that would be material to any one of the financial statements, in this case $100,000.
Auditors may use rules of thumb related to a financial statement base, such as net
income, total revenues, or total assets, to develop these estimates of overall materiality.
Rules of thumb that are commonly used in practice include:

.
.
.
.

to 10 percent ofnet income before taxes.


lzpercent to 1 percent oftotal assets.
Yzpercentto I percent oftotal revenues.
I percent oftotal equify.

5 percent

The appropriate financial statement base for computing materiality will vary based
on the nature of the client's business. For example, total revenues for a financial institution are often too small to use as the base in conjunction with the percentages presented
above. In addition, if a company is in a near break-even position, net income for the
year will be much too small to be used as the financial statement base. In that situation,
the auditors will often choose another financial statement base or use an average of net
income over a number of prior years.
Auditors often use a "sliding scale" for calculating overall materiality. For example,
they might use 1 percent of total sales for materiality on the audit of a small business and
Yz percent of total sales on the audit of a large corporation. This is because the absolute
amount of materiality is also important. Consider a small business with $2,000,000 in
revenue. If lzpercent of total revenue was used as a rule of thumb, $10,000 would be calculated as overall materiality. However, it is unlikely that $10,000 would affect a user's
decision about the financial position and results ofoperations ofany such company. In
addition, it would be impractical to audit the company to that level of precision.

Allocating Overall Materiality to Individual Accounts Once the auditors have determined planning materiality for the overall financial statements, they may allocate materiality to individual flnancial statement accounts. Such an allocation is most frequently
made to help establish the scope of substantive procedures when audit sampling is being

@L

.-.=-----!-r-C

Audit Planning, Understanding the Client, Assessing Risks' and Responding

lllustrative Case

M ateri

ity G u i de I i nes

the Big 4 CPA firms developed the following table to assist its audit staff in determinplanning
materiality based on the greater of total assets or total sales.
ing

One of

lf the Greater of Total


Assets or Total Revenues ls:

Materiality ls:
The Excess Over

But Not Over

$o
30,000
100,000
300,000
1,000,000
3,000,000
1 0,000,000
30,000,000
1 00,000,000
300,000,000
1,000,000,000
3.000,000,000
1 0,000,000.000
30,000,000,000
1 00,000,000,000
300,000,000,000

0 + .05900

$o

+ .03'100
3,970 + .02140
8.300 + .01450

30,000
100,000
300,000
1,000,000
3,000,000
1 0,000,000
30,000,000
1 00,000,000
300,000,000
1,000,000,000
3,000,000,000
1 0,000,000,000
30,000,000,000
100,000,000,000
300,000,000,000

30,000
100,000
300,000

1,780

'1,000,000

3,000,000
10,000,000
30,000,000
1 00,000,000
300,000,000
1,000,000,000
3,000,000,000
1 0,000,000,000
30,000,000,000
1 00,000,000,000
300,000,000,000

18,400 +.01000

38,300 + .00670
85,500 + .00460
178,000 +.00313

397,000 + .00214
826,000 + .00145
1,840,000

+ .00100

3,830,000 + .00057
8,550,000 + .00046
17,800,000

.00031

39,700,000 + .00021
82,600,000 +.00015

To illustrate application of the table, assume that a company has $t2,670,000 of total assets and $20,520,000 of total
revenue. Planning materiality would be calculated as described below:
$Bs,soo + .00460 ($20,s20,000

- $10,000,000)

$133,892

used for one or more accounts. When materiality is allocated to a particular account,
Statements on Auditing Standards and the International Auditing Standards refer to
this amount as performance materiality for the account. At the individual audit test
level, the amount may be further adjusted to arrive at tolerable misstatement. For example, assume that auditors are using statistical sampling for several tests relating to the
iccounts receivable account. Also assume that planning materiality is set at $1,000,000
for the overall financial statements. To facilitate audit testing, the auditors may decide
that $750,000 is the appropriate amount for performance materiality for accounts receivable, and $600,000 is the appropriate amount for tolerable misstatement for the individual tests of accounts receivable.
When considering the allocation of materiality to individual accounts, it is important
to understand that simply allocating planning materiality to all accounts dollar for dollar,
so that the total amount of all the performance materiality or tolerable misstatement disaggregation is equal to overall planning materiality, is far too conservative. The reason is
that misstatements of various accounts often counterbalance each other. That is, the overstatement of one asset may be offset by the understatement of another. Another reason
that mateiality should not be allocated dollar for dollar is the double-entry bookkeeping system, which allows detection of misstatements in an account by auditing a related
1

pCAOB Auditing Standards do not include the performance materiality concept. but use tolerable
misstatement to include both the disaggregated planning materiality amount for accounts and for
1

individual audit tests.

2O2 Chapter

Six

account. For example , if at year-end a purchase of inventory on credit is recorded at an


improper amount, the misstatement may be detected by the tests of inventories, accounts
payable, or cost ofgoods sold.

A number of techniques are used to allocate materiality to individual accounts in


practice-we will describe two. In using the first technique, the auditors multiply the
amount of overall planning materiality by some factor, usually from 1.5 to 2. This amount
is then allocated to the various balance sheet accounts.
The second technique involves allocating materiality only to those accounts that are
to be tested with audit sampling. In using this approach, the auditors typically determine performance materiality by reducing overall planning materiality by an estimate

of the aggregate amount of misstatement that will go undetected. Some amount of


undetected misstatement is expected in every audit because the auditors design their
tests to detect only material misstatement-smaller amounts often go undetected.
Finally, the auditors determine tolerable misstatement for the particular audit test based
on the amount of performance materiality for the account. Tolerable misstatement may
be the same amount or lower than performance materiality for the account depending on the audit sampling technique being used. Chapter 9 illustrates how tolerable
misstatement is used in conjunction with substantive procedures using various audit
sampling techniques.
Evaluation Mat eriality
As indicated previously, the use of evaluation materiality typically involves circumstances in which one or more misstatements have been identified and the'auditors must
evaluate whether the amounts involved are material. The auditors' approach is to first
consider whether the misstatements identified are quantitatively material. Here the auditors must consider not only the known amount of misstatement but also any likely or
projected misstatement. As an example, if the auditors test l0 percent of a population and
find a $10,000 misstatement, they would estimate that the entire population is misstated
by about $100,000 ($10,000 + l0Yo).2 Rules-of-thumb materiality amounts applied for
planning pulposes are often used in this quantitative analysis. If the auditors believe
that the estimated amount of misstatement is not quantitatively maleiral, they must still
consider whether qualitative factors make the item material.
Qualitative Considerations of MaterialiQ Qualitative factors are particularly significant
to evaluation materiality. As an example, related party transactions of relatively smalI
amounts might be considered material to the company's flnancial statements. Examples
of other factors thatmay make an item qualitatively material include the following:

misstatement of the flnancial statements that would affect a company's compliwith a contractual agreement might be material regardless of its amount. As an
illustration, assume that a company's long-term debt agreement requires the company
to maintain working capital of at least $500,000; otherwise, the total debt becomes
payable upon demand. If the company's working capital on the balance sheet is only
slightly more than $500,000, a small misstatement might disguise a violation of the
debt agreement. Since the violation would mean that the company's long-term debt
should be reclassified as a current liability, the small misstatement becomes material
to the financial statements.
A misstatement that would cause a company not to make the consensus earningsper-share estimate of financial analysts might be considered material even though it
is somewhat less than what would normally be considered material.
ance

Evaluation materiality and the overall process


described in greater detail in Chapter 16.
2

The topics of projection


Chapters 9 and 16.

of

evaluating audit procedures are

of misstatements and evaluating overall audit findings are discussed in

Aru)ir Planning, Llnderstanding the Client,lsse.r.singRlslrs, and Responding

of Material Misstatement
ninq Further Audit Procedures

Assessing the Risks

and Desi

De*ribe the mmer in which


m audit is affected by the auditon' asessment of audii risk
rurerialiry

and

As discussed in Chapter 5, the term audit risk refers to the possibility that the auditors
may unknowingly fail to appropriately modifu their opinion on financial statements that
are materially misstated. At the overall financial statement level, audit risk is the chance
that a material misstatement exists in the financial statements and the auditors do not
detect it with their audit procedures. Auditors are aware that few audits involve material
misstatements of financial statements, but when such misstatements do exist, they can
result in millions of dollars of potential liability to the auditors. Experience has shown
that many undetected misstatements of financial statements are intentional fraud, rather
than unintentional errors.

Assessing Risks

of Material
Misstatement

The auditors must plan and perform the audit to obtain reasonable assurance that material
misstatements, whether caused by errors or fraud, are detected. Accordingly, in designing
an audit, the auditors must identify and assess the risks of material misstatement of the
financial statements. Remember that this risk is a combination of inherent and control risk.
The general approach followed during risk assessment is to use all the evidence
obtained about the client and its environment to:

.
.
.

Identify risks.
Relate the identified risks to what can go wrong at the relevant assertion level.

Consider whether the risks are

of a magnitude that could result in a material

misstatement.
Consider the likelihood that the risks could result in a material misstatement.

In other words, the auditors try to relate each identified risk to "what can go wrong" at the
assertion level. As an example, if the auditors identitr a risk of inventory obsolescence'
this means that there is a risk that the inventory may be misstated with respect to the valuation assertion. In assessing this risk, the auditors will consider any controls established
by management to mitigate this risk. Then, the auditors consider whether this risk could
risult in i material misstatement of inventory and cost of goods sold, and the likelihood
that the material misstatement could actually occur. Finally, they use all of these risk
assessments to plan and perform the audit.
In performing risk assessment, it is important for the auditors to recognize that risks of
material misstatement occur at both the financial statement leve1 and the relevant asser-

tion level for account balances, transaction classes, and disclosures. These two types of
risks may affect the audit in different ways.

Financial Statement Level Risks


Risks at the financial statement level are those that relate to the overall financial statements and potentially affect many individual assertions. The following examples help to
illustrate financial statement level risks:

.
.
"
"

Risks related to an ineffective control environment arid weaknesses in general information technology controls (discussed in Chapters 7 and 8).
A lack of sufficient capital to continue operations.
A declining industry.
Risks related to the selection and application of significant accounting policies.

Financial statement level risks potentially affect relevant assertions about many
accounts and disclosures. As a result, assessing their audit impact often requires considerable judgment. For example, poor controls over access to the IT system may allow
unauthorized personnel to inappropriately change data affecting many different transaction classes and account balances. Questions about the integrity of management may raise

204

Chapter Six
a variety

of questions relating to numerous financial statement amounts and disclosures.

Because of the characteristicsof financial statement level risks, an overall response by the
auditor is often appropriate, such as:

.
"
*

Assigning to the audit more experienced staffor individuals with specialized skills'
providing more supervision for the audit staff and emphasizing the need for them to
maintain professional skepticism.
Incorporating additional elements of unpredictability in the selection of further audit
procedures to be performed.

"

Increasing the overall scope ofaudit procedures.

Relevant Assertion Level Risl<s


Most risks of misstatement relate to one or a few relevant assertions that relate to one or
more significant accounts or disclosures. Recall from Chapter 5 that a relevant assertion is
one that-has a reasonable possibility of containing amateialmisstatement (without regard
to controls over it). Simiiarly, the PCAOB defines a significant account or disclosure as
one that has a reasonable possibility of containing a material misstatement. Recall that we
have summarized these assertions as:
1.

Existence or occurence.

2. Rights and obligations.


J.

Completeness.

4. Cutoff.

5. Valuation or allocation.
6. Presentation and disclosure.
As an example, a risk related to inaccurate counting of inventory at year-end affects the
valuation ofinventory and the accuracy ofcost ofgoods sold. For this type ofrisk, the
auditors consider the risk and the related controls and assess the magnitude and likelihood of the risk for each of the relevant assertions. Finally, they will adjust the nature,
timing, or extent of the audit procedures designed to detect the misstatement. In this case,

if the-auditors conclude therels an increased risk of material misstatement of the financial


statements due to inaccurate inventory counting, they may decide to assign more audit
staffmembers to observe the inventory count by client personnel'

Significant Risks that Require Special Audit Consideration


While assessing risks, the auditors should determine which of the identified risks require
special audit consideration. Such risks are referred to as significant risks, and it is
&pected that one or more will be identified on every audit. In Chapter 5, we distinguished among routine, nonroutine, and estimation transactions (see pages 139-140).

Significant risks often relate to nonroutine transactions and estimation transactions. For
eximple, estimates of the value of a significant inventory of precious metals or gems
mighirepresent a significant risk in an audit of a chain ofjewelry stores. In otherbusi,"r-.r"., such risks miy arise due to transactions such as unusual revenue transactions or
critical accruals that must be subjectively determined by management. In addition, a significant risk for a particular audit may arise from a fraud risk Inresponding to significant
risks, the auditors must:

.
*
.

carefully consider the design and implementation of the related controls.


Not rely on evidence about the operating effectiveness of the related controls that has
been gathered in prior periods.3
Not rely solely on analytical procedures to obtain audit evidence about the related
flnancial statement assertions.

Details on tests of controls are presented in Chapter 7. As discussed in that chapter, reliance upon
prior period tests of controls may be justified for other controls under certain circumstances.

Audit Planning, Understanding the Client, Assessing

Risks, and

Responding 205

As indicated on the previous page, significant risks often involve risks related to fraud.
Because of the importance and unique nature of fraud, the Auditing Standards Board
issued AICPA AU 240 (PCAOB 3 16) to provide more specific guidance for the auditors
in assessing the risks of material misstatement of the flnancial statements dtetofraud.

Addressing the
Risks of Material
Misstatement Due
to Fraud

The auditors' consideration of risks of material misstatement from fraud recognizes that

fraudulent financial reporting (management fraud), and, (2) misstatements arising from misappropriation of
assets (defalcations). The auditors' fraud risk assessment involves identifying risks of

there are two distinct types: (1) misstatements arising from

material misstatement of the financial statements due to fraud and determining the appropriate audit response. To identify fraud risks, the auditors perform a ntrmber of procedures,
including having discussions with engagement personnel, making inquiries of management and others within the organization, performinganalyticalprocedures, and considering
fraud risk factors.
Discussions with Engagement Pers onnel

f:scribe how the auditors

-ud

risk.

address

AICPA AU 315 (PCAOB 314) requires that auditors have a discussion with the audit
team members about the susceptibility of the client's financial statements to material
misstatements, while AICPA AU 240 (PCAOB 316) requires a discussion on susceptibility to fraud. For efficiency, the two discussions are often held concurrently. These discussions allow the more experienced team members to share insights and exchange ideas
about how and where the entity's financial statements might be susceptible to material
misstatement-due to either error or fraud-and to emphasize the importance of maintaining the proper degree of professional skepticism regarding the possibility of such
misstatements. The discussion also will review errors that are expected to occur based on
the results of prior audits. The discussion should involve the auditor with final responsibility for the audit (the engagement partner) and key members of the audit team. Although
having all team members present may often be possible and desirable, this is not required.
Professional judgment is also used in determining how and when it should occur and the
extent of the discussion. Related, the PCAOB standards emphasize that communication
among the team members about significant matters affecting the risks of material misstatement should continue throughout the audit.
Making Inquiries Related to Fraud
Inquiries of management and other personnel assist the auditors in identifuing fraud
risks. Therefore, the auditors are required to inquire of members of management as to
their knowledge of fraud and alleged fraud, their understanding of the risks of fraud, and

lllustrative Case

{,
*r

Litigation and Management


Fraud

A recent analysis of

SEC

enforcement cases involving fraud reported that in 89


percent of cases the CEO and/or the CFO in the company
were named in the fraud. Misappropriation of assets was
indicated in only 14 percent of the cases. ln a vast majority

of the cases, management engaged in fraudulent financial


reporting motivated by such factors as meeting analysts'
earnings expectations, concealing deteriorating financial
conditions, and preparing for debt or equity offerings.
Finally, revenue frauds accounted for over 60 percent of the
cases,4

Mark Beasley; Joseph Carcello; Dana Hermanson; and Terry Neal, "Fraudulent Financial Reporting:
1998-2007-An Analysis of U.5. Public Companies (2010)," the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

Chapter Six

Fraud at WorldCom

At the time, WorldCom, lnc.,


became the largest company
to file for bankruptcy in corporate history. The bankruptcy was precipitated by the discovery of one of the largest accounting frauds, with profits

fraudulently inflated by more than $11 billion. Company


internal memos indicate that senior WorldCom executives
overrode internal control and ordered subordinates to alter
the companyt books.

programs or controls that have been implemented to mitigate those risks. The auditors
also inquire about how management monitors operating units or business segments in
other locations, and how management cofirmunicates its views about ethical behavior to
employees. The auditors should obtain management's perspective regarding the effectiveness ofinternal control in detecting fraud and whether this perspective has been reported

to the audit committee.


Inquiries are directed to intemal auditors and members of the audit committee to get
their views about fraud risks and determine whether these individuals have knowledge
of fraud or suspected fraud. To get a more complete perspective and corroborate management's responses, auditors should also make inquiries of other emplbyees, such as
operating personnel not directly involved in financial reporting; employees involved in
initiating, recording, or processing complex or unusual transactions; and in-house legal
counsel. These inquiries are important because fraud often is uncovered through information received in response to inquiries.

Analytical Procedures to ldentify Fraud Rislrs


Risk assessment analytical procedures also may provide the auditors with indications of
fraud risks. When the results of analytical procedures reveal an unusual or unexpected
relationship, this may provide an indication that the financial statements may be mis-

Performing

Risk Assessment

stated due to fraud. Because revenue manipulation is one of the most common techniques

in fraudulent financial reporting, the professional standards require the auditor to


perform risk assessment analytical procedures related to revenue. For example, the auditors might compare monthly revenue for the current year with comparable prior years for
an indication that revenue may be misstated.
used

Considering Fraud Risk Factors

In identitring fraud risks, the auditors also consider various fraud risk factors. Fraud risk
factors do not necessarily indicate fraud; however, they often are present where fraud
exists. AICPA AU 240 (PCAOB 316) provides lists of such factors organized around
the three fundamental conditions necessary for the commission of fraud: (1) some type
of incentive or pressure, (2) an opportunity to commit the fraud, and (3) an attitude that
allows the individual to rationalize the act. As an illustration, an accounts receivable
clerk who is having financial difficulty may feel pressured tb commit fraud, and a weakness in internal control may provide that individual with the opportunity to steal cash
receipts. Finally, the employee may be able to rationalize the theft based on a belief that
he or she is underpaid. Appendix 68 provides listings of fraud risk factors for misstatements arising from both fraudulent financial reporting and misappropriation of assets.
Identifuing Fraud Risks
After holding the engagement team discussion, performing the inquiries and planning
analytical procedures, and considering the presence offraud risk factors and other information that might be relevant, the auditors are ready to identify fraud risks that may
require an audit response. In identifring the risks that require an audit response, the

Audit Planning, Understanding the Client, Assessing Risks, and Responding 207

auditors consider a number of factors, including the type and significance of the risk, the
likelihood that the risk will result in amaterial misstatement, and its pervasiveness. Since
material misstatements due to fraudulent financial reporting often involve management
override of intemal control, resulting in overstatement of revenue, auditors ordinarily
should presume that there is a fraud risk related to revenue recognition. For all fraud risks
identified by the auditors, they should obtain an understanding of the programs and controls enacted by management to mitigate the risks. This information about controls will
assist the auditors in determining the significance of the risk and in designing an effective
audit approach to address the risks.
Even if specific risks of material misstatement due to fraud are not identified by the
auditors, there is always a possibility of management override of internal control. Therefore, the professional standards require the auditors to address this risk apart from whether
they identify other fraud risks. Figure 6.3 provides conditions that may indicate fraud.
Responding to Fraud Risks

How do the auditors respond to fraud risks? They respond in the following three ways:

(l) a modification in approach having an overall effect on how the audit is conducted; (2) an
alteration in the nature, timing, and extent of the procedures performed; and (3) performance
of procedures to further address the risk of management override of internal control.
Overall Response In response to fraud risks, the auditors may modify their overall
approach to the audit in one or more of the following ways:

"
FIGURE

6"3

Professional skepticism and audit evidence. The auditors may respond by designing
procedures to obtain more reliable evidence in support of specific financial statement

Conditions Indicative of Fraud

Conflicting or Missing
Evidential Matter

Discrepancies in the
Accounting Records
Transactions that are not
recorded in a complete
or timely manner or are

improperly recorded as
to amount, accounting
period, classification, or
entity policy
Unsupported or unauthorized balances or
transactions

inute adj ustments


that significantly affect
financial results
Evidence of employees'
Last-m

to systems and
records inconsistent with
that necessary to perform
their authorized duties
access

Missing documents

{ Unavailability of other than


photocopied or electronically
transmitted documents when
documents in original form are

Problematic or Unusual Relationships


between the Auditors and Client
Denial of access to records, facilities,
certain employees, customers, vendors,
or others from whom audit evidence
might be sought

expected to exist

Undue time pressures imposed by


management to resolve complex or

Significant unexplained items on

contentious issues

reconciliations
lnconsistent, vague, or implausible
responses from management or
employees arising from inquiries or
analytical procedures
Unusual discrepancies between the
entity's records and confirmation
replies
Missing inventory or physical assets

Complaints by management about the


conduct of the audit or management

of significant magnitude
Unavailable or missing electronic
evidence, inconsistent with the
entity's record-retention practices
or policies
lnability to produce evidence of
key systems development and
program-change testing and
implementation activities for
current-year system changes and
deployments

intimidation of audit team members,


particularly in connection with the
auditors' critical assessment of audit
evidence or in the resolution of potential
disagreements with management
Unusual delays by the entity in providing
requested information
Tips or complaints to the auditors about

fraud
Unwillingness to facilitate auditor access

to key electronic files for testing through


use of computer-assisted audit
techniques
Denial of access to key information
technology operations staff and facilities
including security, operations, and
systems development personnel

the

208

Chapter Six

of management's explanations or
through third-party confirmation,
as
such
matters,
material
representatior. .oo""*irg
from independent sources.
of
documentation
examination
the use of a specialist, or
Assigning personnel and supervision. The auditors may respond by assigning additlonit stitr with specialized skill and knowledge or by assigning more experienced
staff to the engagiment. In addition, the extent of the supervision of the audit staff
should be adjusted to reflect the fraud risks identified.
Accounting principles. The auditors may decide to further consider management's
selection ai] application of significant accounting principles, particularly those related
to subjective measurements and complex transactions'
Predictability of auditing procedures. The auditors may incorporate an added element
of unpredictabiiity in the ielection of auditing procedures. As examples, they may use
ditrering sampling techniques, adjust the timing of testing from what otherwise would
be expeited, or perform procedures at locations on an unannounced basis.
items or by obtaining additional corroboration

"
.

Alterations in Audit Procedures Alterations of the nature, timing, or extent of audit


procedures to address a fratd risk may involve applying procedures that provide more
ieliable evidence, shifting tests from the interim period to near year-end, or increasing
the sample size for a particular substantive procedure. As an example, the auditors might
decide to interview pirsonnel involved in activities in areas where a fraud risk has been
identified to obtain their insights about the risk and how controls address that risk. Linking audit procedures to risks is described in more detail later in this chapter..
Response to the Possibitity of Management Override As indicated previously, on every
audit, the auditors are requiied to design procedures to further address the risk of management override of controls. Specifically, these procedures include:

Examinirug journal entries and other adjustments for evidence of material misstatement due"to fraud. Matet'ral misstatements of financial statements due to fraud often
involve the manipulation of the financial reporting process by recording inappropriate

joumal entries oi adjustments. Therefore, the auditors should review such entries and
Ldjustments for suspicious characteristics, such as entries made to unrelated, unusual,
or seldom-used accounts; entries recorded at the end of the period or as post-closing
entries that have little or no explanation or description; or entries made either before or

during the preparation of the financial statements that do not have account numbers.
Reviewing accounting estimates for biases. Fraudulent financial reporting often is
accompliihed through intentional misstatement of accounting estimates, such as the
allowance for uncollectible accounts. Thus, auditors should perform a retrospective
review of significant accounting estimates reflected in the financial statements of the
prior year to determine whether management judgments and assumptions relating to
ihe esiimates indicate a possible bias on the part of management. For example, in performing a retrospective review of the allowance for uncollectible accounts, the audimanagement's estimate used in the prior financial statements with
tors might
"o*pir"
the amounts eventually determined to be uncollectible. Evidence of bias in the prior
year should be considered in auditing the current year accounling estimates.
Evaluating the business rationale for significant unusual transactions. During the
course of-the audit, ifthe auditors encounter signiflcant transactions that are outside
the normal course of business for the client or otherwise appear unusual, they should
gain an understanding oftheir business rationale. The auditors should be especially

il"tt fot significant unusual

transactions with related parties'

Evaluating the Results of Audit Tests The auditors' concern about fraud does not stop
at the plaining phase oi the audit. Throughout the engagement, the auditors should be
alert for condiiions thatmay indicate that a fraud was committed, such as those presented
in Figure 6.3. In addition, analytical procedures performed during the course of the audit
mayieveal unusual o, uo"*p""t"d relationships that may indicate the occurrence of fraud.

Risks' and Responding 2O9


Audit Planning, Understanding the Client, Assessing

volume as determined from the


As an example, an unexpected relationship between sales
production statistics maintained
accounting records uri'J., volume deftrmined from

byoperati-onspersonnelmayindicateaaaudulentmisstatementofsales.
-'

whether the accumuo, near completion oithe audit, the auditors should evaluate
of the risks
assessment
affect the
lated results of audit procedures and other observations
the audit'
of material misstatement due to fraud made earlier in
obtain evidence of fraud? They
Discovery of Fraud what do the auditors do if they
their suspicions to an
should evaluate the implications for the audit and communicate
above the level involved' If the fraud
appropriate level of mairagement, at least one level
of the financial statements' the
involves senior .u"ug.f*, or material misstatement
the board of directors' In very serious
matter should be ,.poi.J to the audit committee of
the engagement'
situations, the auditors may decide to withdraw from

it

Designing Further
Audit Procedures
in Response to
Assessed Risks

@
ffiT"lH'ff#i:Li*;T

pome to the assessed risks of


mterial misstatement.

is based on the materiality of the


The auditors, selection of further audit procedures
being auditgd a1d the assessed risks of
account balances, transactions, and disclosures
include substantive procedures-for
material misstatement. These further audit procedures
tests of controls. Tests of controls are needed when
all relevant assertions ,"J, ii
"".4"d,
that-controls are operating effecthe auditors' risk assessment includes an expectation
provide sufffrcient appropriate audit
tively, or when suUstantive procedures alone do not
iilustrations of tests of controls and
evidence. Chapters f Olnt"rigf, f6 include detailed
overview of factot's that may affect
substantive procedures. Uere-we simply provide an
the nature of further audit procedures'
process that involves complex judgDesigning further urrOii p.o""a*es is a-critical
risks at the relevant assertion
ment to link specific u"aii-pto""a*"s with the assessed

consider the nuture, timing,


level. When a"rlgrrirg fuJtrer audit procedures, auditors
in Chapter 5, the higher the risk' the
and extentof app.opri?te f.o""a*"t. is discussed
auditor' For
relwani is lhe nature of the audit evidence sought by the

more reliable and


to increase the use of externally generexample, to improve reliability it may be possible
the timing of audit procedures, auditors
ated evidenc" in u rrf.y ur"u-'wt
"orrid"rirg
",
ut ,1r. interim date or at period
may perform tests olcontrols or substantive piocedure.
the more likely it is that the auditors
end. The higher the risk of material misstatement,
at, the period end. In addition, a
may decide to perform audit procedures nearer to, or
may result in an increase in
high risk of material misstatement for a particular assertion
respond 19 h'-gl:t risk on an overall basis'
the extentof audit pro""J*"t performed' To
in the selection of audit
auditors may incorporate additional elements of unpredictability

procedures(".g.,*oalt'thetimingandapproachielatedtoinventoryobservationsand
receivable confirmations).
are
appropriate when assessed risks of material misstatement
what other r".porr",
high-risk
in
working
those
high? First, all auditors on th" engagement, but particularly
the high-risk audit' the
staffing
In
skeptiiism.
of
d"gi".
height"r"a
a
areas, should apply
firm should consider:

*"

.
,
.

Assigning more experienced staffto the engagement'- Assigning individuals with specialized skills to the engagement'
Increasing the extent of supervision for the engagement'

levels of risk may lead


Thus, further audit procedures in response to high assessed
procedures and to changes in the
both to changes in the nature, timing, and extent of audit
substantive audit procedures
staffing and supervision of the engagement. As indicated,
of the risks of material misstatement
are determined based on the auditori' assessment
balances, transactions'
(inherent urd corrt ol risks) of various assertions about account
substantive procedure-s that
and disclosures. It is important for the auditors to design
an example, assume that a software
are clearly focused o" u"a linked to the risks. As
using standard contracts'
company sells expensive software systems and maintenance

2'10 Chapter

Six

Also assume that the auditors have identified as a signiflcant business risk and inherent
risk that sales personnel, informally or through written side agreements, may be modifying the terms of contracts with customers, which may affect the amount of revenue that
should be recognized. The auditors must design tests that are focused on determining
whether such modifications of terms have been made, perhaps by using tailored confirmations from customers about the existence of such side agreements. In addition, to the
extent considered necessary, staffwith experience with this sort of transaction might be
assigned to the audit, and supervision of staff in this area may be increased. Details of
audit procedures for account balances, transactions, and disclosures are emphasized in
Chapters 10 through 16.

Audit Documentation
For the risk assessment, the auditors should document (1) the discussion of the audit team
concerning the risk of material misstatements due to effor or fraud, (2) the key elements
of the understanding of the entity and its environment, (3) the assessment of the risk
of material misstatement at both the financial statement level and the relevant assertion
level, and (4) the risks identified. After the procedures have been performed, the auditors
should document:

'

The auditors' overall responses to address the assessed risk of misstatement at the
financial statement level.

"
.
"
,
"

The nature, timing, and extent of further audit procedures performed.


The linkage ofthose procedures with the assessed risks at the relevant assertion level.
The results ofthe audit procedures.

With regard to the use of audit evidence, the conclusions reached about the operating
effectiveness ofcontrols obtained in a prior audit (this is discussed in Chapter 7).
Significant risks identified and related conkols.
Those circumstances in which substantive procedures alone will not provide sufficient
evidence.

With respect to the auditors' consideration of fraud, the requirements are similar in
that auditors must document (1) the discussion among engagement team personnel about
fraud risks; (2) the procedures performed to identifu fraud risks; (3) the fraud risks identified and the response to those risks; (4) any other conditions that caused the auditors to
perform additional fraud-related procedures; and (5) the nature of any communications
made to management, the audit committee, or others about fraud.

The Audit Trail


and Directional
Testing

In developing audit procedures, the auditors are assisted by the organized manner in
which accounting systems record, classify, and summarize data. The flow of accounting
data begins with the recording of thousands of individual transactions on such documents
as invoices and checks. The information recorded on these original "source" documents
is summarized in joumals and the amounts in the joumals are posted to ledger accounts.
At the end ofthe year, the balances in the ledger accounts are arranged in the form of
financial statements.
In thinking of the accounting records as a whole, we may say that a continuous trail
of evidence exists-a trail of evidence that links the thousands of individual transactions
composing a year's business aclivity with the summary figures in the financial statements. In a manual accounting system, this audit trail consists of source documents,
journal entries, and ledger entries. An audit trail also exists within a computer-based
accounting system, although it may have a substantially different form; this is discussed

in Chapter

8.

Just as a hiker may walk in either direction along a mountain path, an auditor may follow the audit trail in either of two directions. Figure 6.4 illustrates these concepts relating

tothe direction of testing. For example, the auditor may follow specific kansactions from

Autlit Planning, Llnclerstanding the Client, ,4ssassing Rlsts, and Responding

FIGURE 6.4
Ilirection of Tests

Test

for

Existence or Occurrence

Accounting System

their origin (the source documents) forward to their inclusion in the financial statement

figures. This approach provides the auditor with assurance that all transactions
have been properly interpreted and processed; it is a test ofthe completeness assertion.
If a transaction was never recorded, the omission can be detected only by tracing in the
direction from the source documents to the journals and ledgers' Note, however, that
transactions that are not supported can never be found by tracing forWard frorn source
documents to the journal entries (left to right)'
If the auditors; objective is to detect unsupported financial statement amounts, they
should follow the stream ofevidence back to its source. This type oftest involves tracjouring back amounts recorded in the financial statements for the period to ledgers and
and
invoices
as
na'is and, flnally, vouching them to the original source documents, such
identi$r
may
receiving reports. By vouihing from right to left in Figure 6.4,the auditors
journal Jntries that arenot supported and, possibly, not valid. This process ofvouching,
working backward from the financial statement figures to the detailed documents, provides evidence that financial statement figures are based upon valid transactions; it tests

,o.n

rur!

the existence or occulTence assertion.

Although the technique of working along the audit trail is a useful one, bear in mind
that the urrditorr also must acquire evidence from sources other than the client's accounting records.

A transaction ycle, or class oftransactions, is the sequence ofprocedures applied by

Transaction
Cycles (Classes

Transactions)

of

the client in processing a particular type of recurring transaction. The term cycle conveys
the idea that the ,u-" ..qo.rce of procedures is applied to each included transaction.
Because of their importance to financial reporting, the auditors' consideration of intemal
control often is oryinizedaround the client's major transaction cycles. While they differ
from company to company, typical cycles include (1) the revenue (sales and collections)
cycle, (2) the acquisition 1p*ihur"s and disbursements)'cycle, (3) the conversion (rroduction) cycle, 141 the payroll cycle, (5) the investing cycle, and (6) the financing cycle'
To illustrate a specific transaction cycle, consider a company's processes for sales and
collections of receivables. The activities performed to process sales transactions might
include receiving a customer's purchase order, approving credit, shipping merchartdise,
preparing the sales invoice, recording the sale, recording the accounts receivable, billing
itre customer, and handling and recording the cash remitted by the customer. Ultimately,
both a sales entry (recorded in the salesjournal) and a cash receipts entry (recorded in the
cash receipts journal) capture the essential information for financial reporting purposes.
That informaiion is then recorded in the appropriate ledger accounts (e.g., accounts
receivable, sales, and cash). Figure 6.5 shows the accounts receivable general ledger

212

Chapter Six

FfGURE 6.5
Transactions Affecting
Accounts Receivable

Accounts Receivable

Beginning

$150,200

balance
Sales (sales

and

$856,343

collections

$852,643

<-

cycle)

Cash receipts
(sales and

collections cycle)

Ending +
balance

$20,208

Sa/es

$q,sOz

returns and
allowances
Uncollectible
account write-offs

$129,190

account and how the sales and collections cycle affects that account. The figure also illustrates how sales returns and allowances and write-offs of uncollectible accounts affect the

Accounts Receivable account.

The Auciit Frogranr


The audit program may be viewed as including two major sections. The first section deals
Distinguish between the systems
md the substantive procedures
portions of the audit progrm.

The Systems
(lnternal Control)
Portion of the
Program

with the procedures to assess the effectiveness of the client's intemal control (the "systems portion"), and the second section deals with financial statement account balances
(the "substantive test portion").

As indicated above, the systems portion of the audit program is generally organized
around the major transaction cycles of the client's accounting system. Audit procedures
in the systems portion of the program typically include obtaining an understanding of the
controls for each transaction cycle, preparing a flowchart for each cycle, testing the significant controls, and assessing control risk for the related financial statement assertions.
Figure 6.5 is he1pfu1 in illustrating the relationship between tests of controls over
transactions and substantive procedures. Note that while the auditors' overall objective
is to determine whether the ending financial statement balance is correct, two approaches

are possible: (1) testing controls over transactions that occurred during the year, or
(2) testing the ending account balance directly. That is, if the controls over the transactions that are recorded into the account are effective, assurance is obtained regarding the ending balance. Alternatively, auditors may directly test the ending balance of
the account. As a practicalmalter, auditors use a combination of these two approaches.
Indeed, even if controls are considered extremely strong, some substantive procedures
must be performed for all significant financial statement accounts.
The systems portion of the audit program includes tests of controls over transactions.
The evidence obtained from these tests may be of two types: evidence about the effectiveness ofcontrols and evidence that substantiates the recorded amount ofthe transactions.
For example, a test of a control may involve selecting a sample of sales transactions to
test whether recorded transactions were properly approved. This procedure provides evidence to help assess control risk (or the combination ofinherent risk and control risk).
It does not provide evidence to restrict detection risk, since no evidence substantiating
the transactions and related balances has been collected (for example, a sale may be
approved but may be recorded at an erroneous amount). However, if the auditors simply extend the test to include a determination of whether the transactions were properly

Audit Planning, (Inderstanding the Client, Assessing

Risl<s, and

Responding 213

recorded, evidence is collected to substantiate sales transactions and the accounts receivable balance.
Accordingly, some tests of controls provide substantive evidence about an account or
class of transactions. These procedures are referred to as dual-purpose procedures
(tests) since they serve as both a test ofcontrols and a substantive test ofthe details of
the transactions that occurred during the year. It should be emphasized, however, that
the systems portion of the audit program primarily addresses tests of intemal control and
assessing control risk.

As a result of their consideration of internal control, the auditors will make appropriate
modiflcations in the substantive procedures portion of the audit program. For example,
because of weaknesses in internal control over the proper recording of sales, the auditors
may assess control risk (or combined inherent and control risk) for the assertion of existence of accounts receivable as high and decide to send additional accounts receivable
confirmations. Alternatively, strong controls may lead the auditors to decide to perform
less extensive substantive procedures than would be the case if controls did not function
effectively.

The Substantive
Procedures

Portion of the
Program

The portion of the audit program aimed at substantiating financial statement amounts
is organized in terms of major financial statement accounts and classes of transactions,
such as cash, accounts receivable, sales, inventories, andplant and equipment. Substantive procedures are used to restrict detection risk for these accounts. As an example,
consider the financial statement account, accounts receivable. Examples of audit procedures for accounts receivable include: Confirm with debtors their balance due, review
the year-end cutoff of sales transactions, and analyze subsequent collections of yearend receivables. These procedures all help substantiate the year-end accounts receivable
balance.

Most audit firms organize much of the substantive portion of their audit programs
around the balance sheet accounts. Then, they complete the programs with any additional procedures needed to substantiate income statement accounts and information in
financial statement notes. An advantage of this balance sheet approach is that highly
reliable evidence generally is available to substantiate assets and liabilities. For example,
the ending balance of accounts receivable as presented in Figure 6.6 is usually subject
to direct verification by such procedures as inspection of extemally created documentary evidence, confirmation, and review ofsubsequent cash collections. Other assets such
as inventory may be physically examined. Liabilities can be verified by examination of
extemally created documents, confirmation, and inspection of canceled checks after the

liability has been paid.


In contrast, consider the nature ofrevenues and expenses in double-entry accounting.
The entry to record revenues or expenses has two parts: (1) the recognition ofthe revenue
or expense, and(2) the corresponding change in an asset or liability account. Revenues
and expenses have no tangible form; they exist only as entries in the client's accounting
records, representing changes in owners' equity. Consequently, the best evidence supporting the existence ofrevenues or expenses is often the verifiable change in the related
asset or liability account. As a result, many income statement accounts may be verified
indirectly by auditing the related balance sheet accounts.

Indirect Verffication of Income Statement Accounts


Figure 6.6 shows the relationship between income statement accounts and the related
changes in cash or other balance sheet items. By substantiating the changes in the asset
and liability accounts, the auditors indirectly verifu revenue, cost of goods sold, and
expenses. As an example, most revenue transactions involve a debit to either Cash or
Accounts Receivable. If the auditors are able to satistz themselves that all cash receipts
and all changes in accounts receivable during the year have been properly recorded, they
have indirect evidence that revenue transactions have been accounted for properly.

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Audit Planning, (Jnderstanding the Client, Assessing

Risks, and

Responding 215

Direct Verification of Income Statement Accounts


Not all of the audit evidence pertaining to income statement accounts is indirect. The verifistatement
cation of a major balance sheit item often involves several closely related income
in
For
example,
evidence'
direct
or
other
computation
through
verified
be
accognts that ian
colsubstantiating the marketable securities owned by the client, it is a simple maltet !o

pute the retat-ea interest revenue, dividends revenue, and gains or losses on sales ofsecuriiies. tn substantiating the balance sheet items of plant assets and accumulated depreciation,
the auditors make computations that also substantiate depreciation expense. Uncollectible
item Allowance for
accounts expense is substantiated in conjunction with the balance sheet
Doubtful Aicounts. In addition to these computations, the auditors' analytical procedures
provide direct evidence as to the reasonableness ofvarious revenues and expenses'
that the
Certain income statement accounts, such as fevenues, are of such significance
typiauditors virtually always obtain direct evidence about the faimess of the amounts,
cally by performing tests of details of a sample of transactions or substantive analytical
procedures.

Summary of the
Relationship
between Tests
of Controls and
Substantive
Procedures

Objectives of
Audit Programs

General
Objectives of
Audit Programs
for Assets

are in
Tests of controls provide auditors with evidence as to whether prescribed controls
in
evaluating
auditors
the
assist
tests
these
of
results
The
use and operating effectively.
procedures, on th9
the likelihood that material misstatements have occurred. Substantive
in the financial
exist
they
if
misstatements
material
detect
other hand, are designed to
influenced
greatly
is
auditors
the
by
done
testing
statements. The amount of substantive
exist.
misstatements
material
that
by their assessment of the likelihood
To illustrate, assume that a client's procedures manual indicates that the finished
personnel'
goods warehouse is to be locked at all times and accessible only to authorized
that the
learn
auditors
the
observation,
and
inquiry
of
ihrougtr tests of controls consisting
to
be in
authorized
not
are
who
employees
several
wareh6use often is unlocked andtiat
is
procedure
control
internal
the
client's
Because
there.
the warehouse regularly eat lunch
shortages
risk
inventory
the
that
recognize
should
not operating p.olperty, ttre auditors
-of
shortis increased. However, the tests of controls have not determined that an inventory
age does, in fact, exist.
"
The piincipal substantive procedure to detect shortages ofinventories is the auditors'
the
observation oi a physical inventory taken by the client. As part of this observation,
the
warehouse,
the
unlocked
of
case
In
the
items.
auditors make test counts of various
prevent
shortages.
to
upon
relied
be
cannot
control
auditors, test has shown that internal
verify the
Therefore, the auditors should increase the number of test counts in an effort to
existence of inventory.

to
The audit procedures contained in the audit progmm are designed to be responsive
prothe
that
sure
make
To
statements.
financial
potential material misstatements of the
gram addresses all potential misstatements, auditors often develop audit objectives for
iach significant account balance and class oftransactions. These objectives follow directly
From
from management assertions that are contained in the cliegt's- financial statements.
balance
of
type
major
for
each
developed
these assertions, general objectives may be
income
sheet account, including assets, liabilities, and owners' equity, and the related
statements,
financial
between
relationships
statement accounts. Figure 6.7 presents the
management's account-balance issertions (discussed in Chapter 5), and audit objectives.

potenThe audit progmm for each financial statement account must be tailored to address
to
identical
not
are
for
cash
tial misstiements of that account. The potential misstatements
proper
about
questions
For
example,
the potential misstatements for accounts receivable.
it
netiealizablevalue cause valuation to be a bigger risk for accounts receivable. However,
to
general
approach
the
same
basically
is useful to realizethat each audit program follows

216

Chapter Six

FIGURE 6.7
Relationship of
Financial Statement
Assertions to the Audit
Existence or Occurrence
Rights and Obligations

Completeness

Cutoff
Valuation
.Presentati

n a nd

D iscl osu re

Designed Based on Management


Assertions

Determined Based on the Risks of Material


Misstatement (lnherent Risks and Control Risks) at the
Assertion (Audit Objective) Level and Documented in
the Audit Program

Summarized in Audit Documentation

verify the balance sheet items and related income statement amounts. To varying degrees
based on the auditors' assessments ofrisk, the substantive audit program for each asset
account will need to include procedures to address the following general objectives:

Substantive Audit Program for Asset Accounts Stated in Terms


of General Objectives
A.

Establish the exrstence of assets.


B. Establish that the company has r4ghts to the assets.

C. Establish completeness of recorded assets.


D. Verify the cutoff of transactions.
E. Determine the appropriate valuation of the assets.
F. Determinetheappropriatefinancial statementpresentationanddisclosureof

theassets.

in these audit objectives, with respect to audit progmms for liability


owners' equity accounts, will be discussed in later chapters.
Changes

and

Audit Planning, Understanding the Client, Assessing

Risl<s, and

Responding 217

Substantiation of Account Balances


The central pulpose of the auditors' risk assessment process, including their assessment
of control risk, is to determine the nature, timing, and extent of the audit work necessary
to substantiate the account. In subsequent chapters, considerable attention will be given
to the auditors' inherent and control risk assessments; let us now discuss the objectives of
the auditors' substantive procedures.

Existence
of Assets

The first step in substantiating an asset is to verifii the existence of the item. For assets
such as cash on hand, marketable securities, and inventories, existence ofthe asset usually may be verified by physical observation or inspection, and by vouching from the
recorded entry to the documents created when the assets were acquired.
When assets are in the custody of others, such as cash in banks and inventory on consignment, the appropriate audit procedure may be direct confirmation with the outside
party. The existence of accounts receivable normally is verified by confirming with customers the amounts receivable. To verify the existence of intangibles, the auditors must
gather evidence that costs have been incurred and that these costs represent probable
future economic benefits.

Rights to
the Assets

Usually, the same procedures that veri$ existence also establish the con-rpany's rights to
the asset. For example, confirming cash balances in bank accounts establishes existence
of the cash and the company's ownership rights to that cash. Similarly, inspecting marketable securities verifies both existence and ownership because the registered owner's
name usually appears on the face of the security certificate.
With other assets, such as plant and equipment, physical examination establishes
existence but not ownership. Plant and equipment may be rented or leased rather than
owned. To veri$z the client's rights to plant assets, the auditors must inspect documentary
evidence such as property tax bills, purchase documents, and deeds.
The client may not hold legal title to all assets that are appropriately included in the
financial statements. Instead, the client may own rights to use the assets conveyed by
contracts, such as leases. The ownership of these rights may be established by reviewing
the underlying contracts.

Establishing
Completeness

Effective internal control provides assurance that acquisitions are recorded and helps the
auditors to establish the completeness of recorded assets. When such controls are found
to be ineffective, the scope of substantive procedures must be increased, but this is often
a difficult task. When the auditors are testing the completeness of assets, they are looking
for assets that have been acquired but not recorded in the accounting records. Therefore,
analyzing recorded entries in the asset accounts will not be effective for this purpose; the
auditors must take a different approach.
Many tests for unrecorded assets involve tracing from the "source documents" created
when the assets were acquired to entries in the accounting iecords. To test for unrecorded
accounts receivable, for example, the auditors might select a sample of shipping documents related to sales made during the year and determine that accounts receivable were
properly recorded.
Observation and physical examination are important to testing the completeness of
recorded physical assets. To illustrate, during the observation of the client's physical
inventory, the auditors are alert for inventory items that are not counted or included in the
inventory summary. Physically examining equipment may reveal purchases that have not
been properly capitalized.
Analytical procedures also may be used to bring conditions to light that indicate that
all assets may not be recorded. For example, a low gross profit percentage for the current

218

Chapter Six

year in comparison to prior years may indicate that the client has a substantial amount
unrecorded inventory.

Verifying
the Cutoff

of

As a part of the auditors' procedures for establishing completeness as well as existence


of recorded assets, the auditors will verifu the client's cutoffof transactions included in

the period. The financial statements should reflect al1 transactions occurring through the
end of ttre period and none that occur subsequently. The term cutofftefers to the process
ofdetermining that transactions occurring near the balance sheet date are assigned to the
proper accounting period.
'it . impact of-cutoff errors upon the financial statements varies with the nature of the
error. For ixample, a cutofferror in recording acquisitions of plant assets affects the balance
not
sheet but probatly does not affect the income statement, since depreciation usually is
cutofferror
hand,
a
the
other
On
year-end.
of
days
a
few
within
recorded on assets acquired
in recording shipmenti of merchandise to customers affects both inventory and the cost of
open"
sales. ln orJer to improve their financial picture, some clients may "hold their records
period.
next
part
the
of
fust
the
from
revenue
and
receipts
year
cash
to include in the current
To verifu the client's cutoff of transactions, the auditors should review transactions
recorded shtrtly before and after the balance sheet date to ascertain that these transactions
and
are assignedtoihe properperiod. Since such documents as checks, receiving reports,
issued
number
serial
the
last
noting
numbered,
serially
usually
shippin[ documenti aie
A*i"g ihe period will assist tire auditors in determining that a proper cutoff has been

'

made in recording transactions.

Valuation
of Assets

Determining the proper valuation of assets requires a thorough knowledge of generally


accepted ac-counting principles. The auditors must not only establish that the accounting
method used to value a particular asset is generally accepted, but also determine that the
method of valuation is appropriate and properly applied in the circumstances' Once the
proare satisfied as to the appropriateness of the method, the auditors will perform
auditors

asset.
cedures to test the accuracy of the client's application of the method of valuation to the
is to
procedure
audit
coillmon
a
Therefore,
cost.
at
A number of assets are valued
evidence.
documentary
other
and
paid
checks
to
vouch the acquisition cost of assets

If

the acquisition cost is subject to depreciation or amortization, the auditors must evaluate the reasonablene.. oi th" cost allocation program and verifl' the computation of

the remaining unallocated cost. Increasingly, generally accepted accounting principles


require assets-to be valued at fair values. Assets valued at fair value, or the lower of cost
or market, and those whose carrying value must be compared to fair value to determine
whether their values are impaired necessitate an examination of their fair values. Fair
values are audited by comparison to prices on existing markets or by examination of
valuation models used to develop the values.
Finally, the amount appearing as an asset on a financial statement is almost always the
accumolaiion of many smaller items. For example, the amount of inventory on a financial statement might ionsist of the cost of thousands or, perhaps, hundreds of thousands
of individual products. The auditors must test the clerical"accrtracy of the underlying
records to detirmine that they accumulate to the total appearing in the general ledger
and, therefore, the amount in the financial statements. The auditors often use their audit
software to perform these tests ofclerical accuracy ofthe records'

Financial

Statement
Presentation
and Disclosure

Even after all dollar amounts have been substantiated, the auditors must perform procedures to ensure that the financial statement presentation conforms to the requirements
of authoritative accounting pronouncements and the general principle of adequate disclosure. procedures falling into this category include the review of subsequent events;

search

for related party iransactions; investigation of loss contingencies; review of

Audit Planning, Understdnding the Client, Assessing Risks, and Responding 219

disclosure of such items as accounting policies, leases, compensating balances, and


pledged assets; and consideration of the classification and description of items in the
financial statements.

An lllustration of Audit Program Design


The preceding general objectives apply to all types of assets. Audit procedures for a
partiiular asset account must be designed to address the specffic audit obiectives and
ristrs related to that asset. These specific objectives and risks vary with the nature of
the asset and the generally accepted accounting principles that govern its valuation and
presentation.
In designing an audit program for a specific account, the auditors start by listing the
specific ob3""tir.r related to the account. Then, they identifu the inherent risks related
to each of these specific audit objectives. You can think of these risks as declarations
of "what could go wrong and thereby result in a mateial misstatement of the account."

Figure 6.8 provides a description of the relationships among audit objectives, risks of
material misstatement, and audit procedures.
Figure 6.8 includes examples of identified risks related to each audit objective and
only one procedure to address each risk. Usually, a greater number of risks are related to
eac-h objeitive and several procedures may have to be performed to address a particular
risk. For example, the audit objective of determining that receivables a.re properly presented in the bilance sheet is not achieved solely by performing procedures focusing on
the risk of inadequate disclosure of related party transactions. The audit program must
include procedures that focus on other risks related to presentation and disclosure, such
ur p.o""drrres that focus on the risk that the financial statements fail to disclose that
receivables have been pledged as collateral for debt. In addition, the complete audit program will include testJ of the client's internal control that provide support for the auditors' assessments of control risk.
Chapters 10 through 16 consider the manner in which auditors design tests of controls and substantive procedures for various financial statement accounts. Specific
audit objectives and sample audit procedures are presented for various accounts to
provide i framework for our discussion. It is important to remember that the audit progra** presented in the textbook merely illustrate typical procedures. In actual practice,
audit programs must be tailored to each client's risks and internal control. The audit
procedures comprising audit programs may vary substantially from one engagement to
the next.

Timing of
Audit Work

The value of audited financial statements is enhanced if the statements are available on a
timely basis after the year-end. To facilitate an early release of the audit report, auditors
normally begin the audit well before the balance sheet date. The period before the balance
sheet date is termed the interim period. Audit work that can always be started during
the interim period includes the consideration ofinternal conlrol, and substantive tests of
kansactions that have occurred to the interim date.
As discussed in Chapter 5, interim tests of certain financial statement balances, such as
accounts receivable, may also be performed, but this results in additional risk that must
be controlled by the auditors. Significant misstatements due to error or fraud could arise
in these accounts during the remaining periodbetween the time that the interim test was

performed and the balance sheet date. Thus, to rely on the interim test of a significant
account balance, the auditors must perform additional tests of the account during the
remaining period.
Performlng audit work during the interim period has numerous advantages, in addition to facilitating the timely release of the audited financial statements. The independent
auditors may be able to assess internal control more effectively by observing and testing

Chapter Six
Procedures
Retationships among Audit Objectives, Risks of Material Misstatement, and Audit

General Audit
Objectives for

n!$f.

Existence of
assets

Risks of Material
Misstatement: "What
Can Go Wrong"

Specific Audit
Objectives for
Accounts Receivable

All recorded
receivables exist.

Example Audit Procedures

Receivables may have been


recorded that do not exist.

Confirm a sample of receivables


by direct communication with

Management maY have


f raudulently overstated

Review monthlY adjusting entries

debtors.

for suspicious items.

revenue and receivables bY


making inapProPriate adjusting journal entries.
Rights to assets

The client has rights


to the receivables.

Accounting personnel maY


erroneouslY be treating a sale
of receivables as a liabilitY.

Review confirmations

of

liabilities to determine if
receivables have been sold or

factored.
Completeness of
assets

All receivables are


recorded.

Management maY have


shipped ltems before the end
of the period but not recorded
the sales and related
receivables until the

Select a sample of sales invoices


in the subsequent Period

and examine the related


shipping document for date of
shipment.

subsequent Period.

Cutoff of
transactions

Sales and cash

receipt transac-

tions are recorded


In the proper

Sales

and receivables for the

next period maY be recorded


in the current Period.

Vouch sales and cash receiPt


transactions occurring near
period end.

period.

Valuation of
assets

Receivables are

presented at net
realizable value.

Allowance for uncollectible


accounts maY be misestimated
by management.

lnvestigate the credit ratings


for delinquent and large

Allowance for sales returns


and allowances maY be
misestimated bY management.

Compare the amount of


credits given to customers
in the subsequent Period to
the amount estimated bY
management.

Software routine to develoP

Obtain an aged trial balance


of receivables, test its clerical
accuracy, and reconcile to the

aged trial balance of receivables may have been erroneously programmed.


Financial

statement
presentation
of assets

Receivables are Prop-

erly presented in

the balance sheet,


with appropriate

Accounting Personnel maY have


failed to identify related PartY
transactions.

receivables.

ledgers.

Provide a list of related parties to


all members of the audit team
to assist in identif ication of the
transactions.

disclosures.

to
controls at various times throughout the year. Also, they can give early consideration
uniform
more
accounting problems. Another advafltage is that interim auditing cleates a
workloadlor CPA firms. With alarge client, such as Genelal Motors, the auditors may
have office space within the client's buildings and perform audit procedures throughoril
the entire year.

Atrlit Planning, Llnderstonding tlte Client,lsses.slrugRlsfts, and Responding

This chapter explained the manner in which auditors plan an audit, obtain an understanding of the client, assess risks of misstatements, and respond to those risks. To summarize:
1. The audit process may be viewed as including the following six stages: (a) plan the
inter3g61it; (b) oUtuin an understanding of the client and its environment, including
procedures;
audit
firther
design
and
misstatement
of
risks
(c)
the
assess
nal control;
(71 perform further audit procedures; (e) complete the audit; and (f) form an opinion

Chapter
Summary

and issue the audit report.

2. Investigating a potential audit client is essential because auditors want to avoid

3.

acceptiirg clients ttrat have unscrupulous management. As part of their investigation,


the auditors are required to attempt communication with the predecessor auditors.
In planning the audit, the auditors establish an understanding with the client, ordi,urily i, .niitirrg through use of an engagement letter that makes clear the nature of
the engagement, any limitations on the work, and the responsibilities of the client.
Durin[planning, auditors develop an overall audit strategy and audit plan, including
u1 uodii pro$am. The audit procedures that are contained in the audit program are
designedaroLd the assertions of management, which are embodied in the financial
staternents and the auditors' assessments of risks and controls.

4. The auditors perform risk assessment procedures (including inquiries, analltical pro-

cedures, observation and inspection, and other procedures) to obtain an understanding of the client and its environment. They plan their audit to provide reasonable
urrorura" that the financial statements are free from material misstatement, whether
caused by error or fraud.

5. Auditors are particularly concemed about fraud-both fraudulent financial reporting and misappropriation of assets. To identifu fraud risks, the auditors have an
audit team discussion of potential fraud (as well as errors), make inquiries, perform
analyticalprocedures, and consider the presence offraud risk factors. The auditors

to fraud risks as they do to other risks of material misstatements, with an overall response or a modificition of the natvre, timing, and extent of audit procedures.
Additi,onally, the auditors are required in all audits to perform procedures to address
the risk of management override of internal control'
6. The auditors must apply the materiality concept, which recognizes that some matters are important to tne fair presentation of financial statements, while others are
not. Auditors arrive at a measure of materiality for planning purposes and disaggregate itinto tolerable misstatements for the various accounts. In evaluating findings,
auditors also use materiality. While the materiality measures for both planning and
evaluation include quantitative and qualitative considerations, the planning measure
emphasizes quantitative considerations, while the evaluation measure emphasizes
both quantitative and qualitative considerations'
7. Auditors assess the risks of misstatement they have identified to design further audit
procedures. Further audit procedures include both tests of conkols and substantive

,"r.i

procedures.

lcyl Terms
btroduced or
tsrphasized in

frnpter

Analytical procedures (198) Tests that involve comparisons of financial data for the current year
to that of piio. y.urr, buclgets, nonflnancial data. or industry averages. From a planning standpoint,
analytical procedures help the auditors obtain an understanding ofthe client's business, identify financial
problems.
statement amounts that appear to be affected by effors or fraud, or identify other potential
Assertions (185) Representations of management that are communicated, explicitly or implicitly, by
the financial statements.

Audit committee (188) A committee cornposed of outside directors (members of the board of directors

and
who are neither officers nor employees) charged with responsibiiity for appointing, compensating,
overseeing the auditors.

Chapter Six
nature, timing, and extent of the audit procedures to be
program.
audit
with
an
performed. It is often documented
Audit program (193) A detailed listing ofthe specific audit procedures to be performed in the course
of an audit engagement. Audit programs provide a basis for assigning and scheduling audit work and
for determining what work remains to be done. Audit programs are specially tailored to the risks and
internal controls of each engagement.
Audit risk (203) At the overall engagement level, this is the risk that the auditors may unknowingly
fail to appropriately modify their opinion on financial statements that are materially misstated. At the
flnancial statement assefiion level, it is the risk that a particuiar assetlion about an account balance is

Audit ptan (192) A description of the

materially misstated.

(185) Risks that threaten management's ability to achieve the organization's objectives.
Control risk (185) The risk that a material misstatement that could occur in an account will not be

Business risks

prevented or detected on a timely basis by intemal control.

Dual-purpose procedure (test) (213) An audit procedure that sewes as a test of controls and a
substantive test of the details of the transactions that occurred during the year. For example, a test
of controls over equipment acquisitions may address authorization (providing evidence on control
effectiveness) and whether the transaction tested has been properly recorded in the year's acquisitions
(providing substantive evidence on the dollar amounts). As another example, a substantive procedure
may reveal a misstatement and be extended to determine the nature of the control that did not operate
effectively, thereby providing evidence on operating effectiveness.
Engagement letter (191) A formal letter sent by the auditors to the client at the beginning of an
engagement summarizing such matters as the nature of the engagement, any limitations on the scope
of auait work, work to be done by the client's staff, and the basis for the audit fee. The purpose of
engagement ietters is to avoid misunderstandings; they are essential on nonaudit engagements as well
as audits.

The risk of loss or injury to the auditors' reputation by association with a


client that goes bankrupt or one whose management lacks integrity'
Fraudulent financial reporting (management fraud) (205) Material misstatement of financial
statements by management with the intent to mislead financial statement users.

Engagement risk

(188)

Further audit procedures (209) Substantive procedures for all relevant assefiions andtests ofcontrols
when the auditors' risk assessment includes an expectation that controls are operating effectively, or
when substantive procedures alone do not provide sufficient appropriate audit evidence. The auditors
perform risk assessment procedures to obtain an understanding of the client and its environment.
including intemal control. They then conduct a risk assessment and deter:rnine the appropriate further
audit procedures.

Inherent risk (185) The risk of material misstatement of an assertion about an account without
considering intemal control.

Interim period (219) The time interval from the beginning of audit work to the balance

sheet date.

Many audit procedures can be performed during the interim period to facilitate early issuance of the
audit report.
as a giant
scatterec
are
computers
which
"Web
servers,"
on
are
stored
computing network. Data on the Intemet
world.
the
throughout
Misappropriation of assets (defalcations) (205) Theft of client assets by an employee or officer oi

Internet (195) An international network ofindependently owned computers that operates

the organization.

(194) Those account balances that exist at the beginning ofthe period. Opening
the closing balances of the prior period and reflect the effects of transactions
upon
are
based
balances
and events ofprior periods and accounting policies applied in the prior period. Opening balances alsi
include matters requiring disclosure that existed at the beginning ofthe period, such as contingencie.
Opening balances

and commitments.

Overall audit strategy (192) This strategy involves determining overall characteristics of th;
engagement that define its scope, determining the engagement's reporting objectives to plan the timtn-.
of procedures, and considering important factors that will determine the focus of the audit team's effons

When the overall audit strategy has been established, the auditors start the development of a mordetailed audit plan to address the various matters identified in the audit strategy.
performance materiality (201) The amount set by the auditors at less than materiality for accoun:,
(or individual financial statements) to reduce to an appropriately low level the probability that t::

Risks' and Responding


Auclit Planning, Understantling the Client' lssesslng

exceeds materiality for the financial statements


aggregate ofuncorrected and undetected misstatements
as a whole.

served as auditor but has resigned from the


terminated'
been
have
services
its
that
engagement or has been notified
has a reasonable possibility ofcontaining
that
assefiion
Relevant assertion (194) A flnancial statement
statements to be materially misstated'
flnancial
the
cause
would
a misstatement or misstatements that
is based on inherent risk' without
determination of whether an asserlion is a relevant assertion

Predecessor auditors

(189) A CPA flrm that formerly

The

regard to the effect ofcontrols.

performed to obtain an understanding of the


Risk assessment procedures (185) The audit procedures
identiff and assess the
including the entity's intemal control. They are designedto
entity and its environment,
oI erof, at the financial statement and assertion levels'
risks of material misstatement, *h.L., due io fraud
and others within the entity; (b) analytical
management
of
(a)
inquiries
fusk assessment procedures include
including inquiries ofothers outside the entity'
procedures; and (c) observation and other procedures,

Shoppingforaccountingprinciples(190)Conductbysomeenterprisesthatdischargeone
accounting

firm that will sanction a disputed


independent auditing firro-uft., ,..king out another
principie or financial statement presentation'
material misstatement that' in the auditor's
Signiflcant risks (204) Identified and assessed risks of
judgment, require special audit consideration'
and transactions designed to detect any
Substantive procedures (185) Tests of account balances
nature, timing' and extent of substantive
material misstatements in the flnancial statements. The
and their consideration of the client's
risks
of
procedures are determined by the auditors' assessment
internal control.
an engagement or wbo have been invited
successor auditors (189) The auditors who have accepted
tomakeaproposalfo,u,,.ngug..enttoreplacetheCPAfirmtlratformerlyservedasauditor.
or operation of a control to assess its
Tests of controls (185) Tests directed toward the design
of financial statement assertions'
effectiveness in preventing or detecting material misstatements

Timebudget(193)Anestimateofthetimerequiredtoperformeachstepintheaudit.

by the client in processing a particular


Transaction cycle (211) The sequence ofprocedures applied
the same sequence ofprocedures is
that
idea
type ofrecurring tansaction. The ierm cycle reflectsthe
internal control often is organized
of
consideration
auditors'
The
applied to each similar transaction.
around the client's major transaction cycles'

Review
Questions

.
6-2.

6_1

6-3.
64.
6-5.

of a prospective client?
What information should a CPA firm seek in its investigation
of the board of directors satisfy in
In a public company, what requirements must members
order to serve on the audit committee?
letter'
State the purpose and nature of an engagement

principles'" what mechanisms


Discuss what is meant by the phrase "shopping for accounting
management?
by
practice
this
prevent
have served to
we will define a
statement: "Throughout this audit, for all purposes,

6--6.

criticize the following

'material amount' as $500,000 "


which one generally is of more concem
Describe the two types of misstatements due to fraud.
to the auditors?

6-7.

Many cPA flrms are taking


ness risk. Provide un

a business

.*u*pl.

risk approach to audits'.Define what is meant by busi-

of a business rist< ttrat could result in a risk of material misstate-

ment of the financial statements'

6_3.ShouldaSeparateauditprogrambepreparedforeachauditengagement,orcanastandard

6-9.

6-10.

program be used for most engagements?


.,An audit program is desirable when new staffmembers are assigned to an engagement' but
an audit without reference to an audit proan e*perierrcel auditor should be able to conduct
gram." Do You agree? Discuss'
List the two components that make
Describe the risk of material misstatement of an assertion'
uP this risk.

6-1

1.

6-12.

special audit consideration' Describe the


Cerlain audit risks are significant in that they require
typical characteristics of these significant risks'
to exceed the original time estiSuggest some factors that might cause an audit engagement
mate. Would the extra time be charged to the client?

chapter Six

6-13.
6-14.

6,15.

underreport the amount


What problems are created for a cPA flrm when audit staffmembers
procedures?
audit
of time spent in performing specific
rather than income stateWhy is audit work usually organized around balance sheet accounts
ment accounts?
with respect to any
Identify the general objectives of the auditors' substantive procedures
major asset category.
in the cutoff
by making a ploper year-end cutofr Explaln the effects of errors
sheet.
balance
the
and
statement
of sales tfansactions in both the income
of journal entries forWhat are the purposes of the audit procedures of (a) tracing a sample

6-16. what is meant


6-17

6-18.

6-19.

610.
6-21.

wardtotheledgersand(b)vouchingasampleofledgerentriesbacktothejournals?
audits at the end of the calendar
Charles Halstead, CPA, has a number of clients who desire
the year, he is preparing
throughout
uniformly
more
year. ln an effort to spread his workload
the year-end balance
before
satisfactorily
performed
be
could
that
procedures
a list of audit
sheetdate.Whatauditwork,ifany,mightbedoneinadvanceofthebalancesheetdate?
procedure'
Define and differentiate between a test ofcontrols and a substantive
working papers
important
three
are
budget
time
the
and
The audit plan, the audit program,
in the auditors'
selve
papers
working
these
do
functions
what
audii.
prepared early in an
compliance with generally accepted auditing standards? Discuss'
the risk of fraud for
standards require the auditors to have a team meeting regarding

6-22.
6,23.

LO2

6-24.

Requiring
Analysis

Auditing

the engagement. What is the purpose of this meeting?


papers in a recurring audit?
How can a cPA make use of the preceding year's audit working
must assess the 1evels of risk and mateliality for the

When planning an audit, the auditors


these two factors affbct the auditors.
engagement. Explain how the auditors, judgments about
planned audit Procedures.

wants to engage Morgan to


Morgan, cPA, is approached by a prospective audit client who
client was audited b1'
perform an audit for the current yeal. In prior years, this prospective
in deciding whether
follow
should
CPA. Identifi the specific procedures that Morgan
another

to accePt this client.


LO

2,3

6-25.MaryDeminghasbeenaskedtoacceptanengagementtoauditasmallfinancialinstitution.

Deming has not previously audited a financial institution'


that
a. Describe the types of knowledge about the prospective client and its environment
Deming must obtain to plan the engagement'

Required:

Explain how Deming may obtain this knowledge'


will help Deming in planDiscuss how this knowledge of the client and its environment
auditing standards'
ning and perfbrming an a;i i, accordance with generally accepted
Manufacturing company' You
Assume that you have been assigned to the audit of Lockyer
the company and its environabout
have completed the procedures for gathering information
ment, including intemal control'

b.
c.
LO

1,3,4,7

6-26.

a.
b.

Describe the next stage ofthe audit process'


and high risk audi:
Explain how the auditors may respond to high risk audit engagements
assertions.

the procedures mu-':


Describe the nature of further audit procedures, including when
include tests of controis.
for the firs:
A CPA has been asked to audit the financial statements ofa nonpublic company
th'
company'
the
cPA,
the
time. A11 preliminary discussions have been completed between

c.
LO3

6-27.

predeces.o.auditors,andallothernecessaryparties'TheCPAisnowpreparinganengagi-

LO5
Required:

6-28.

letter'
ment letter. List the items that should be included in the engagement
assulance of detectin;
reasonable
provide
to
Auditors must pian and perform their audits
from fraud'
resulting
those
including
statements,
financial
material misstatements in

a.Distinguishbetweenfraudulentfinancialreportingandmisappropriationofassets.
fraud' Pror
&. Describe the three fundamental conditions necessary for the commission of
reporting'
financial
an iilustration of these three conditions for a case of fraudulent

c.Describethethreewaysinwhichtheauditorsmayrespondtofraudrisksinanaudit.

ic'

Audit Planning, Llnderstanding the Client, lsses.slng Rlstr, and Responding

LO5

629.

In planning every audit, the auditors are required to consider materiality for audit purposes
Described below are flnancial statement data from two separate companies:

Total assets
Total revenue
Equity
Net income before taxes
Required:

r'9I!Elo.

Tyler Co.

$34,900,000
29,600,000
1 3,800,000
1,600.000

$2,700,000
4,500,000
1,000,000
90,000

a.

Deveiop an estimate of the appropriate amount of planning materiality for Franklin Co.,
and describe how you arrived at the estimate.

b.

Develop an estimate of the appropriate amount of planning materiality for Tyler Co', and
describe how you arrived at the estimate.
Describe five characteristics of a sma1l misstatement that might render it qualitatively

c.

material.

LO5

6-30.

Required:

The auditors sometimes decide to allocate the amount of planning materiality to various flnancial statement accounts.

a.

Explain why auditors typically decide to allocate planning materiality to individual flnan-

6.

cial statement accounts.


Describe why the total amount of planning materiality allocated to individual accounts
may exceed overall materialitY.

LO6

G31.

John Wells, CPA, is planning the audit of CVG Services, Inc. As a result of his risk assessment procedures, We1ls has identifled several fraud risks.

a.

Required:

b.

Explain in detail how Wells might respond to risks of material misstatement of the financial statements due to fraud.
Describe the auditors' communication responsibilities in situations in which the auditors
believe fraud has occurred.

LO

3,4

6-32.

Listed below are several of the auditors' general objectives in performing substantive
procedures on an asset account:

1. Establish the existence ofassets.


2. Establish that the company has rights to the assets.
3. Establish the completeness ofrecorded assets.
4. Verify the cutoffof transactions.
5. Determine the appropriate valuation of the assets.
6. Establish the clerical accuracy ofthe underlying records.
7. Determine the appropriate flnancial statement presentation and disc'losure

of the assets.

lndicate the general objective (or objectives) ofeach ofthe following audit procedures:

Required:

a. Obserue the client's physical inventory.


b. Locate on the client's premises a sample

of the equipment items listed in the subsidiary

plant and equipment ledger.

c. Obtain a listing of inventory and reconcile the total to the general iedger'
d. Trace a sample ofshipping documents to recorded sales transactions.
e. Identifyrelatedparlies.
/. Vouch selected purchases of securities to brokers' advices.
1O4,5

6-33.

In designing further audit procedures, the auditors must assess the risks of material misstatement of the financial statements.

a. Describe the auditors' general approach to such risk assessment.


&. Identify potential responses to financial statement level risks.
c. Explain what is meant by a significant risk.

Required:

d
LO7

6-34.

Describe how a significant risk must be treated in an audit.

Richard Foster, an assistant auditor, was assigned to the year-end audit work of Sipher
Corporation. Sipher is a small manufacturer of language translation equipment. As his flrst
assignment, Foster was instructed to test the cutoffofyear-end sales transactions. Since Sipher

J
226

Chapter Six
uses a calendar year-end for its financial statements, Foster began by obtaining the computergenerated sales ledgers and journals for December and January. He then traced ledger postings
for a few days before and after December 3 1 to the sales joumals, noting the dates of the jour-

nal entries. Foster noted no joumal entries that were posted to the ledger in the wrong accounting period. Thus, he concluded that the client's cutoffofsales transactions was effective.
Comment on the validity of Foster's conclusion. Explain ful1y.

Required:
LO

2,3,4,5

35.

SEC fi1ings of certain public companies can be accessed from EDGAR (Electronic Data
Gathering, Analysis, and Retrieval systern), which has the following Intemet address:
www.sec. gov/edga r,shtml

a. Use EDGAR to locate a company in the softu'ate industry.


6. Access the latest Fonr-r 10-K for the company and read the "Management's

Required:

Discussion and

Anrlysis" section.

c.
LO

6-36.

Describe four significant business risks of the company as described in its "Management's
Discussion and AnalYsis."

In every audit engagement, the auditors must identify fi'aud risks that may require an audit
response. Described below are four circumstances or factors that may create an increased risk
of material misstatement of the financial statements due to fraud'

1.

2.

The compensation of management of a subsidiary of the client is heavily dependent on the


net income of the subsidiary and controls over subsidiary management are weak.
The compensation of management of a telecommunications firm is significantly tied to
revenue, and analytical procediires indicate that revenue may be overstated. The company
engages in complex sales agreements.

3.

Futures traders in an energy company are compensated based on the perfonnance oftheir
purchases and sales ofenergy futures contracts. The markets for these contracts have feu'
participants, resulting in the need to value contracts on hand at year-end based on compiex
valuation models applied by the traders.

4. A chain of discount markets has inconsistent profit margins

across stores as indicated

b-v

analytical procedures.

a. For each ofthe four circumstances, indicate the fraud risk that the auditors should consider'
6. Foreachoftheforrcircumstances,indicateapossibleappropriateresponsebytheauditors.

Require1:
LO

6-3i

The text of the Securities Exchange Act of 1934 may be accessed on the Intemet, using the

following address:

www.law. uc.ed u/CCL/34Act/index. html

a.
6.

Reqttired:

Objective

use the Intemet to access the text of the Securities Exchange Act of 1934.
Read and summarize the internal control requirements of Section 13(b)(2) of the act.

All applicable

Questions lo o

6-38.

questions are available with McGraw-I1,ill's ConnectrM Accounting. ffi eSfX'lCt-.

Multiple Choice Questions


Select the best answer for each

a.

ofthe following. Explain the reasons for your selection.

In plaruring and performing an audit, auditors are concerned about risk factors for two distinct types of fraud: fraudulent financial reporting and misappropriation of assets. Which
ofthe following is a risk factor for misappropriation ofassets?

(1) Generous performance-based compensation systems.


(2) Management preoccupation with increased financial perfotmance.
(3) An unreliable accounting system.

(4)
LO2

Strained relationships between management and the auditors.

D. The audit committee of a company must be made up of:


(1) Representatives from the client's management, investors, suppliers, and customers.
(2) The audit partner, the chieffinancial olicer, the lega1 counsel, and at least one outsider
(3) Representatives of the major equity interests, such as preferred and common stockholders
(4) Members of the board of directors who are not officers or employees.

Audit Planning, Understanding the Client, lssessing Rl.sfrs, and Responding

2,3

LO

c.

Which of the following should not normally be included in the engagement letter for an
audit?

(1)
(2)
(3)
(4)

A description ofthe responsibilities ofclient personnel to provide

assistance.

An indication of the amount of the audit fee.

A description of the limitations of an audit.


A listing ofthe client's branch offices selected for testing.

Which portion of an audit is least like1y to be completed before the balance sheet date?

LO7

(1)
(2)

Issuance

(3)

Substantive procedures.

(4)

Assessment of control risk.

Tests ofcontrols.

ofan engagement letter.

Which of the following should the auditors obtain from the predecessor auditors before

LO2

accepting an audit engagement?

(1) Analysis ofbalance sheet accounts.


(2) Analysis of income statement accounts.
(3) A11 matters of continuing accounting significance.
(4) Facts that might bear on the integrity of management.
LO4

As one step in testing sales transactions, a CPA traces a random sample of saies joumal
entries to debits in the accounts receivable subsidiary ledger. This test provides evidence
as to whether:
(I

Each recorded sale represents a bona fide transaction.

(2) All sales have been recorded in the sales joumal.


(3) A11 debit entries in the accounts receivable subsidiary ledger

are properly supported

by sales joumal entries.

(4)
LO

Recorded sales have been properly posted to customer accounts.

The primary objective of tests of details of transactions performed as substantive proce-

1,7

dures is to:

(1) Comply with generally accepted auditing standards.


(2) Attain assurance about the reliability of the accounting system.
(3) Detect material misstatements in the flnancial statements.
(4) Evaluate whether management's policies and procedures are operating effectively.
LO5

h.

The risk that the auditors will conclude, based on substantive procedures, that a material
misstatement does not exist in an account balance when, in fact, such misstatement does
exist is referred to as

(1) Business risk.


(2) Engagement risk.
(3) Control risk.
(4) Detection risk.
Which of the following elements underlies the application of generally accepted auditing
standards, particularly the standards of fieldwork and reporting?

LO5

(1)
(2)
(3)
(4)
LO5

Adequate disclosure.
Quality control.

Materiality and audit risk.


Client acceptance.

Which of the following best describes what is meant by the term "fraud risk factor"?

(1)
(2)
(3)
(4)

Factors that, when present, indicate that risk exists.


Factors often observed in circumstances where frauds have occurred.
Factors that, when present, require modification ofplanned audit procedures.
Weaknesses in internal control identified during an audit.

Chapter Six

ft.

LO6

Three conditions generally are present when fraud occurs. Select the one below that is
one of those conditions.

(1)
(2)
(3)
(4)
LO

/.

6,7

rol

Incentive or pressure.
Opportunity.
Supervisory position.

Attitude.

Which of the following is most likely to be an overall response to fraud risks identified in
an audit?

(1) Super-vise members of the audit team less closely and rely more upon judgment.
(2) Use less predictable audit procedures.
(3) Use only certified public accountants on the engagement'
(4) place increased emphasis on the audit ofobjective transactions rather than subjective
transactions.

(AICPA, adaPted)
LO 3, 4,

6-39.

Simulation
Michael Green, CPA, is considering audit risk at the flnancial statement level in planning
the audit of National Federal Bank (NFB) Company's financial statements for the year ended
December 31, 20X1. Audit risk at the financial statement level is influenced by the risks of
material misstatements (including fraud risks), which may be indicated by a combination
of factors related to management, the environment, and the entity. For each of the following factors, indicate whether they increase or decrease the risk of material misstatement and
(2) whether they create a risk of fraud.
Effect on Risks of
Material Misstatement
(lncrease or Decrease)

Factor

a.

NFB is a

continuing audit client.

b. The banking industry has been significantly


impacted by the downturn in the economy in
recent years.

c.

NFB operates in a

growing, prosperous area and

has remained profitable over the years.

d.

Government regulation and overview of the banking industry is extensive and effective.

e.

NFB's board

of directors is controlled by Smith, the


majority stockholdel who also acts as the chief

executive officer.

f.

lnterest rates have been very volatile recently.

g.

Management at the bank's branch offices has authority for directing and controlling NFB's operations and
is compensated based on branch profitability.

h.

The internal auditor reports directly to Harris, a


minority shareholder, who also acts as chairman of
the board's audit committee.

i.

The accounting department has experienced little


turnover in personnel during the five years Green
has audited NFB.

j.

During 20X1, NFB increased the efficiency of its


accounting operations by installing a new, sophisticated computer system.

k.

NFB's formula has consistently underestimated the


allowance for loan losses in current years.

l.

Management has been receptive to Green's suggestions relating to accounting adjustments.

Create a Risk
of Fraud?
(Yes or No)

Atrclit Planning, Understanding the Clien:' -1-r-se-ising Rlsks, and

LO 4,

640.

Reslr'-''

Simulation
are working with Wiiliam Bond, CPA, and you are considerirg the risk of material mrsstatement in planning the audit of Toxic Waste Disposal (T\!D) Company's financial statements for the year ended December 3 1, 20X0. TWD is a privatel,v os ned entity that contracts
with municipal govemments to remove environmental waste.
Based only on the information below, indicate whether each of the following factors

you

would most likely increase (I), decrease (D), or have no effect Q'iE) on the risk of material
misstatement.

Effect on Risk of Material

Misstatement

lnformation
municipalities have received increased federal and state funding for environmental purposes, TWD returned to profitability for the first year following three years

a. Because

with

b.

losses.

TWD,S Board
as

of Directors

is

controlled by Mead, the majority stockholderi who also acts

the chief executive officer.

c. The internal auditor reports to the controller and the controller reports to Mead.
d. The accounting department has experienced a high rate of turnover of keY personnel'
e. TWD',s bank has a loan officer who meets regularly with TWD's cEo and controller to
monitor TWD's financial performance'

f.

TWD's employees are paid biweekly.

TWD has such a strong financial presence in its industry to allow it often to dictate the
terms or conditions of transactions with its suppliers.
h. During 20X1, TWD changed its method of preparing its financial statements from the
cash basis to generally accepted accounting principles.

g.

i.
J

k.

l.

During 20X1, TWD sold one-half of its controlling interest in United Equipment Leasing
(UEL) Co. TWD retained significant influence over UEL.
During 20X1, litigation filed against TWD from an action 10 years ago that alleged that
TWD discharged pollutants into state waterways was dropped by the state. Loss contingency disclosures that TWD included in prior years'financial statements are being
removed from the 20X1 financial statements.
During December 20x1, TWD signed a contract to lease disposal equipment from an
entity owned by Mead's parents. This related-party transaction is not disclosed in TWD's
notes to the 20X1 financial statements.
During Decembei 20X1, TWD completed a barter transaction with a municipality' TwD
removed waste from the municipally owned site and acquired title to another contaminated site at below market price. TWD intends to service this new site in 20X2.
20X1, TWD increased its casualty insurance coverage on several pieces
of sophisticated machinery from historical cost to replacement cost'

m. During December
n.

lnquiries about the substantial increase in revenue TWD recorded in the fourth quarter
of 20X1 disclosed a new operating policy. TWD guaranteed to several municipalities that
it would refund the federal and state funding paid to TWD if any municipality fails a
federal or state site clean-up inspection in 20X2'

o. An initial
LO

public offering of TWD's stock is planned for late 20X2.

2,3,4,5,6,7

641

Simulation

you have been hired to perform the audit of Hanmei, Inc.'s financial statements. When planning such an audit, you often may need to access the profession's auditing standards to perform research. For each of the following circumstances, select the topic most closely related
in the Professional Standards topics on the following page. A topic may be selected once'
more than once. or not at all.
Transactions

a.
6.

Possible risk factors related to misappropriation ofassets


The relationship between materiality used for planning versus evaluation purposes

230

Chapter Six
Hanmei, Inc., has transactions with the colporation president's brother
year's audited results
comparing a client's unaudited results for the year with iast

c.

e.Requirementsrelatingtoidentifyingviolationsofoccupationalsafetyandhealth
regulations
accounts could be intenTheneed to "brainstorm" among audit team members about how

f.

tionally misstated

g. Details on considering design effectiveness ofcontrols


h. Theimporlance of considering the possibility of overstated

revenues (e.g., through prema-

ture revenue recognition)


P ro.fess i o n a

Sta nd a rds ToP

ic

AnalYical procedures

2.
3.

Materiality in pianning and performing an audit


Consideration of fraud in a flnancial statement audit

4.Understandingtheentityanditsenvironmentandassessingtherisksofmaterial
misstatement

5. Consideration of laws and regulations


6. Management rePresentations
7. Related Parlies
1O4,5

642.

system' Reply to the fo1Assume the following general flow of documents in an accounting

lowing questions:

valid transactions that

The auditors are concemed about source documents that reflect


havenotbeenrecordedinthejournals.Whichprocedurewouldbemosteffective?
(1) Tracefrom soutce documents /o journals'

(2) Yowhfrom journals /o source


(3) Either (1) or (2).
b.

documents'

joumals (and

in the
The auditors are concemed about transactions that have been recorded
a transaction is fecorded, but it did
is,
valid-that
not
are
that
ledgers)
the
in
subsequently

notactuallyoccur(e.g.,afraudulentoverstatementofsales).Whichprocedurewouldbe
most effective?

(1) Tracefrom source documents /o journals'


(2) Yowhfron journals lo source documents'
(3) Either (1) or (2).
c.

for improper
The auditors are concemed about transactions that have been recorded
amounts. Which procedure would be most effective?

(l)

Tracefrom source documents lo journals'

(2) Youchfrom joumals /o source


(3) Either (1) or (2).
d.

documents'

Tracing from source documents to journals most directly tests:

(1) Completeness (understatements).


(2) Existence (overstatements).
e.

Vouchingfromjournals(orledgers)tosourcedocumentsmostdirectlytests:

(1)

Completeness (uhderstatements)'

(overslatements)'
12-) Existence

Audit Planning, Linderstantling the

LO

643.

All

Def

Cli ent, lssessing Rrfr.s, and Responding

For each definition (or porlion of a deflnition) in the flrst column, select the temr that most
closely applies. Each term may be used only once or not at all.

inition (or Portion)

Term

a. A detailed listing of the specific audit procedures to

1. Audit plan
2. Audit program
3. Audit risk

be

performed in the course of an audit engagement.


b. A description of the nature, timing, and extent of the audit procedures to be performed. lt is often documented with an audit

4. Representation

program.
c. An estimate of the time required to perform each step in the audit.
d. The purpose of this document is to avoid misunderstandings
between the auditors and the client.
e. The risk of material misstatement of an assertion about an account
without considering internal control.
f . At the overall engagement level, this is the risk that the
auditors may unknowingly fail to appropriately modify their opinion
on financial statements that are materially misstated.
g. An identified risk that requires special audit consideration.
h. A risk that threatens management's ability to achieve the
organization's objectives.

Problems

All applicable problems are available with McGraw-IIill's


LO 1, 2,

644.

letter

5. Business risk
6. Control risk
7. Engagement letter

8. lnherent

risk

9. Significant risk
10. Survival risk
11. Time budget

ConnectrM AccountinC. tX COfSleCl

You are invited by John Bray. the president of Cheviot Corporation, to discuss with him the
pr-rssibility of your condr,rcting an audit of the company. The corporation is a small, closely
held manufacturing organization that appears to be expanding. No previous audit has been
perfonned by independent certifled public accountants. Your discussions with Bray include
an analysis ofthe recent monthly financial statements, inspection ofthe accounting records,
and discussion ofpolicies u,ith the chiefaccountant. You also are taken on a guided tour ofthe
plant by the president. He then makes the following statement:
Before making defiuitc arangements for an audit, I would like to knorv about how long it rvill take
and about how much it will cost. I want quality r.vork and expect to pay a fair price, but since this is
our first experience w-ith independent auditors, I would like a full explanation as to horv the cost of
the audit is determined. Will you please send me a memorandum covering these points?

Write the utemorandum requested by John Bray.


LO 3,

6 15.

Va11ey Finance

Company opened four personal loan offices in neighboring cities on January 2.

Small cash loans are made to borowers who repay the principal with interest in monthly
installments over a period not exceeding two years. Ralph Norris, president of the company,
uses one of the offices as a central office and visits the other offices periodically for supen'ision and intemal auditing purposes.

Required:

Assume that you agreed to audit Val1ey Finance Company's financial statements for the year
ended December 31. No scope limitations were imposed.

a. How

would you determine the scope necessary to complete your audit satisfactorily?

Discuss.

D. Would you be responsible for the discovery of fraud in this


LO

6-46.

audit? Discuss.

You are a new staff assistant with the Houston office of a national public accounting
firm. Yesterday you read an article in The Wall Street Journal in which the nranaging
partner of your firm's New York office discussed the problems caused for the pub1ic accounting profession by auditors underreporting the number of hours worked on
audits.

You found this article interesting because ofthe experience you are having on the audit
of Regal Industries, one of your office's largest clients. The lieldwork at Regal is being
run by Mark Thomas, a very hard-working senior who is highly regarded within your
office. Thornas made senior in record time and has established a reputation for bringing
jobs in on schedule. Four staffassistarrts, including yourself, are working under Thomas.

Chapter 5ix

At the end of the engagement, Thomas will write

a performance report on each assistant,


which will be placed in the assistant's personnel file. The managel on the engagement also
writes a performance evaluation on each assistant and on Thomas. You have heard, however, that managers usualiy agree with whatever the senior has said about an assistant's

performance.
The budgeted time estimates for almost every audit procedure being performed at Regal
seem too short. No one is able to finish anything on schedule. Last week, Thomas approached
all the staffassistants about working Saturday to "catch up." He said that he was going to work
a shorl day on Saturday and would not repofi the hours on his time sheet. He said that if you
would do the same, he would buy lunch after you finished up on Saturday. You and two other
assistants agreed. The fourlh assistant, Dave Scott. deciined, saying that he was going to a
baseball game on Saturday.
The work on Saturday ran smoothly, and it was nice to wear jeans instead of dress clothes.
You did quit a little early, although it was about 3:30, not noon. Afterward, Thomas bought
everyone lunch at a popular restaurant.
During the foilowing workweek, you noticed that Thomas seemed quite friendly toward
you and the other two assistants who had worked on Saturday. He also was complimentary of
your work. He was not complimentary of Scott's work; in fact, you heard him cotnment to the
engagement manager that he thought Scott would be a "short-timer," a phrase used to describe
staff assistants who do not last long in public accounting. You were not too sympathetic to
Scott's plight, however, as you and the other staffassistants also feel that Scott's work on the
engagement has been substandard.

It is now Thursday aftemoon, and Thomas has just asked the three of you who worked
last Saturday if you witl do the same thing again this week. He did not ask Scott. Again.
Thomas offered to buy lunch if you would leave the hours off your time sheets. You suspect that Thomas has read the article in The Wall Street Journal, because he seemed a litt1e
defensive about asking you to underepofi your time. He pointed out that you ale not paid
by the hour anyway, so leaving the extra hours offyour time sheet "doesn't really cost you

anything."

a.

Required.

Briefly explain why the managing partner of an office would probably oppose the practice
of underreporting hours worked by the audit staff.

b.
c.

Briefly explain why a senior might flol oppose the practice.


Explain how you think the other two staffassistants asked to work Saturday will probabll
respond.

d
LO 3, 4,

647.

Ifyou would

respond differently, explain.

Suggest quatity control procedures that you think could be implemented by a CPA firm to
discourage the underreporting of time by audit staffmembers.

Precision Industries, Inc., is a manufacturer of electronic components. When a purchase order


is received from a customer, a sales clerk prepares a serially numbered sales order and sends
copies to the shipping and accounting depadments. When the merchandise is shipped to the
customer, the shipping deparhnent prepales a serially numbered shipping advice and sends a
copy to the accounting depaftment. Upon receipt ofthe appropriate documents, the accounting depafiment records the sale in the accounting records. A1l shipments are FOB shipping

point.

a.

Required:

How can the auditors determine whether Precision Industries, Inc., has made a proper
year-end cutoff of sales transactions?

D. Assume that all shipments for the flrst flve days of the following year were recorded as
occuring in the current year. If not corrected, what effect will this cutofferror have upon
the financial statements for the current year?

Ethics
Case

LO

2.6

R
-r

6-48.

Tammy Potter, a new partner with the regional CPA firm of Tower & Tower, was recentlr
appointed to the board ofdirectors ofa local civic organization. The chairman ofthe board of
the civic organization is Lewis Edmond, who is also the owner of a real estate development
flrm, Tiera Corporation.
Potter was quite excited when Edmond indicated that his corporation needed an audit and
he wished to discuss the matter with her. During the discussion, Potter was told that Tiena
Corporation needed the audit to obtain a substantial amount of additional financing to acquire
another company. Presently, Tierra Corporation is successful, profltable, and committed to

growth. The audit fee for the engagement should be substantial.

Atulit Planning, IJnderstanding the Ctient, lssessingRlsts, and Responding


Since Tierra Cotporation appeared to be a good client prospect, Potter tentatively indicated

that Tower & Tower wanted to do the wofk. Potter then mentioned that Tower & Tower's
quality control policies require an investigation ofnew clients and approval by the managing

Required:

partner, Lee Tower.


Potter obtained the authorization of Edmond to make the necessary inquiries for the new
client investigation. Edmond was found to be a highly respected member of the community.
Also, Tierra Corporation was highly regarded by its banker and its attomey, and the Dun &
Bradstreet report on the corporation reflected nothing negative.
As a flna1 part of the investigation process, Potter contacted Edmond's former tax accountant, Bill Turner. Potter was surprised to discover that Turner did not share the others' high
opinion of Edmond. Tigner related that on an IRS audit 10 years ago, Edmond was questioned
about the details of a large capital loss reported on the sale of a tract of land to a trust. Edmond
told the IRS agent that he had lost all the supporting documentation for the transaction, and that
he had no way of finding out the names of the principals of the trust. A search by an IRS auditor
revealed that the land was recorded in the name of Edmond's married daughter and that Edmond
himself was listed as the trustee. The IRS disallowed the loss and Edmond was assessed a
civil fraud penalty. Potter was concerned about these findings, but eventually concluded
that Edmond had probably matured to a point where he would not engage in such activities.
a. present arguments supporting a decision to accept Tierra Corporation as an audit client.

D. present arguments supporting a decision not to

accept Tierra Corporation as an auo\t.

client.

c.

Assuming that you are Lee Tower, set forth your decision regarding acceptance of the client, identifying those arguments from part (a) or part (b) that you found most persuasive.

-,oPendix 6A

A
\d#r
'

Selected Internet Addresses


Accounting and Auditing W'eb Sites
American Institute of CPAs-www .aicpa.org
Association of Certifl ed Fraud Examiners-www.acfe.com
The Committee of Sponsoring Organizations of the Treadway Commission
The Institute of Intemal

Auditors-www.theiia.org

The Intemational Federation of Accountants-www.ifac.org

Large Accounting Firms


BDO USA LlP-www.bdo.com/
Deloitte LLP-www. deloitte.com/
Ernst & Young LlP-www.eY.com/
Grant Thornton LlP-wrnvv. gt.com/

KPMG LlP-www.us.kpmg.com/
McGladrey LlP-www.mcgladrey.com/
PricewaterhouseCoopers

LlP-www.pwcgloba1. com/

Securities and Exchange Commission


Home page-www.sec.gov/

EDGAR page-www.sec.goviedgar.shtml
Securities Act of 1 933-www.1aw.uc.edu,/CCli33Actlindex.html
Securities Exchange Act of I 934-www.law.uc.edu/CCll34AcVindex.html
Public Company Accounting Oversight Board
PCAOB-www.pcaob.org

(CoSO)-www.coso.org

231i. Chapter Six

ExamPles of Fraud Risk Factors


ffiy
1-)
INCENTIVES AND PRESSURES
inclustry' or entity operating cor.rditions'
1. Financial stabitity or profitability is threatened by economic,
such as (or as indicated bY):
declining urargins.
a. High dcgree of comp"iition ol. market saturation. accompanied by

6.Highvulncrabilitytor.apidchanges,suchaschangesintechnology,pl.odtrctobsolescence,or
intercst rates.
business failures in eitlier the industry or
c.. Signilicant declines in customer clemand and increasing
overall economY.
o[ hostile takeover imuinent'
r/. operating losses making thc threat of bankruptcy. foreclosure,
generate cash flou''s lrom operato
inability
or
an
operations
e. Recurring negative casli flo*s from
tions lvhile reporting earnings and eatnings grolvth'
other companies in t[.re same
o, unJrual profitability, ..pe.ia1ly compared to tl.rat of

l.

2.

Rapid

gro*th

industry.
g. New accouuting, statutory' or regulatory requirements'
requirements or expectations of third paltics
Excessive pressure exists for management to meet t1-re
due to thc follou'ing:

investors, signifior tr-end level expectations of investment allalysts" institutional


aggressire
unduly
are
that
expectations
cant creditors. ol.other external parties (particularly
optioverly
for
example'
in'
management
or unreallstic.), including expectatiolls created by
nlessages'
mistic press t'eleases ot annual report
corrrpetitive including fitrancing ol
Need to obtain additional debt or equity flrrancing to stay

a. profitability

D.

major research and development or capital expenditures'


or other debt covenant
to meet exchange listing requirernents or debt repayment

c. Marginal ability
requirements.

d. perceivedorrealadverseeffectsofreportingpoorflnancialresultsonsignificantpendingtransac-

3.

tions, such as busincss combinations or colltract awards'


of directors'personal flnancial situaInforn-ration available indicates that management or the board
from the follor,ving:
tion is threatened by the entity,s financial perfornrance arising
a. Significant linancial interests in the entity'
stock options' and earl-ottt
D. Significant porlions of their compensation (for example, bonuses,
for stock price' operatilrr
targets
aggressive
achieving
upon
arranger-*ents) being contingent
results, financial position, or cash flow'
Personal guarantees ofdebts ofthe entity'
personnel to meet financial targcts set up b]'
There is excessive pl.essure on manageluelrt or operating
profltability incentivc goals'
the board of directors oI management. inclu<ling sales or

c.

4.

OPPORTUNITIES
frauduler
or the entity's opcrations provides oppoltunities to engage in
financial reporting that can arise from the following:
a. Significantrelatedpanytransactionsnotintheorclinarycourseofbusinessorwithrelatedentitre'

1. The nature ofthe

i1<1ustr.y

not auditcd or audited by another firni'


sector that allows the enti:
6. A strong financial presence or ability ro dominate l certain industry
in inappropriate or nLr: result
may
that
to dictate tems or conclitions to suppliers or customers
arm' s-lengtli transactions.
estimates that involve sub'iecti''
Assets. liabilities, revenues. or expenses based on signilicant
judgments or uncertaintics that are dillicutt to corroborate'
those close to period end th''
Sigiin.u,.,,, unusual, or.6ighly complex transactions, especially
pose

dillicult "substance over fonn" cluestions'

AuditPlanning,(JnderstcmdingtheClient,AssessingRisks'andResponding235

e. Significant operations located or conducted

2.

across international borders in jurisdictions where

differing business environments and cultures exist'


jurisdictions for which
/ Signiflcant bank accounts or subsidiary or branch operations in tax-haven
justiflcation'
there appears to be no clear business
-lhereis ineffective monitoring of management as a result of the following:
busia. Domination of management by a single person or small group (in a non-owner-managed
controls.
ness) without compensating
process
b. Ineffective board of directors or audit committee oversight over the financial reporting
and intemal control.

3.

There is a complex or unstable organizational structure' as evidenced by the following:


in the
a. Difficulty in determining theirgarizxion or individuals that have controlling interest
entlty.

b. Oveily complex

organizational structure involving unusual legal entities or managerial lines

of

authoritY.

c. High turnover of senior

4.

management, counsel, or board members'

Intemal control components are deficient as a result of the following:


a. Inadeqtatemonitoring of controls, including automated controls and controls over interim financial reporting (where extemal reporting is required)'
techrates or employrnent of ineffective accounting, intemal audit, or information
nology staff.
and information systems, including situations involving reportable

b. High turnover

c. Ineffective accounting
conditions.

ATTITU DES AN D RATIONALIZATIONS

or employRisk factors reflective of attitudes and/or rationalizations by board members, management,


susceptible
not
be
may
reporting
justiff
flnancial
fraudulent
ees that allow them to engage in and/or
of such
the
existence
of
aware
becomes
who
auditor
the
to observation by the audito-r. Nevertheless,
from fraudulent
arising
misstatement
material
of
risks
the
in
identiffing
it
consider
information should
information that may
flnancial reporting. For example, auditors may become aware of the following
indicate a risk factor:
1

2.

values or ethical
Ineffective communication, implementation, support, or enforcement of the entity's
standards'
or
ethical
values
standards by management or the communication of inappropriate
with the selection of
Nonfinancial management's excessive participation in or preoccupation

accorrntingprinciplesorthedeterminationofsignificantestimates.
securities laws or other laws and regulations, or claims against the

3. Known history of violations of

4.

laws and regulations'


entity, its senior management, or board members alleging fraud or violations of
price or earnings
stock
Excessive interest by management in maintaining or increasing the entityh

hend.
parties to achieve
practice by management of committing to analysts, creditors, and other third
aggressive or unrealistic forecasts.
Management failing to correct known significant deflciencies on a timely basis.
for taxAn interest by management in employing inappropriate means to minimize reported earnings

5. A
6.
7.

motivated reasons.

8.

Recurring attempts by management to


materiality.

justiff

marginal or inappropriate accounting on the basis

of

auditoq as exhibited by
strained relationship between management and the current of predecessor
the following:
reporting
a. Frequent disputes with the current or predecessor auditor on accounting, auditing, or

9. A

b.

c.

matters.
regarding the comUnreasonable demands on the auditor, such as unreasonable time constraints
pletion ofthe audit or the issuance ofthe auditor's report'
people or inforFormal or informal restrictions on the auditor that inappropriately limit access to
committee.
or
audit
directors
of
board
the
with
effectively
mation or the ability to communicate
attempts to
involving
especially
auditor,
the
with
in
dealing
behavior
management
Domineering
assigned to
influence the scope-ofthe auditorh work or the selection or continuance ofpersonnel
or consulted on the audit engagement'

Chapter 5ix

Risk Factors Relating

to Misstaterner:ts Arising

from Misappropriation of Assets


INCENTIVES AND PRESSURES

1.

Personal flnancial obligations may create pressure on management or employees with access to cash
or other assets susceptibie to theft to misappropriate those assets.

2.

Adverse relationships between the entity and employees with access to cash or other assets susceptible to theft may motivate those employees to misappropriate those assets. For example, adverse
relationships may be created by the following:
a. Known or anticipated future employee layoffs.
b. Recent or anticipated changes to employee compensation or benefit plans.
c. Promotions, compensation, or other rewards inconsistent with expectations.

OPPORTUNITIES

1. Certain characteristics or circumstances may increase the susceptibility of assets to misappropriation. For example, opportunities to misappropriate assets increase when there are the
following:
a. Large amounts of cash on hand or processed.
D. Inventory items that are small in size, of high value, or in high demand.

c. Easily convertible assets, such as bearer bonds, diamonds, or computer chips.


d. Fixed assets that are small in size, marketable, or lacking observable identiflcation of
ownership.

2.

Inadequate internal control over assets may increase the susceptibility ofmisappropriation ofthose
assets. For example, misappropriation of assets may occur because there is the following:
a. Inadeqtate segregation of duties or independent checks.
b. Inadequate management oversight ofemployees responsible for assets (for example, inadequate
supervision or monitoring of remote locations).
c. Inadequatejob applicant screening ofemployees with access to assets.
Inadequate record keeping with respect to assets.
e. lnadequate system of authorizatior and approval of transactions (for example, in purchasing).

d
/

Inadequate physical safeguards over cash, investments, inventory, or flxed assets.


Lack of complete and timely reconciliations of assets.
Lack of timely and appropriate documentation of transactions (for example, credits for merchandise retums).
i. Lack of mandatory vacations for employees performing key control functions.
7. Inadequate management understanding of information technology, which enables information
technology employees to perpetrate a misappropriation.
ft. Inadequate access controls over automated records, including controls over and review ofcomputer systems event logs.

g.
h.

ATTITU DES AN D RATIONALIZATIONS

fusk factors reflective of employee attitudes and/or rationalizations that allow them to justifr misappropriations ofassets are generally not susceptible to observation by the auditor. Nevertheless, the auditor who becomes aware of the existence of such information should consider it in identifuing the risks
of material misstatement arising from misappropriation of assets. For example, auditors may become
aware of the following attitudes or behavior of employees who have access to assets susceptible to
misappropriation:
1

2.

Disregard for the need for monitoring or reducing risks related to misappropriation of assets.
Disregard for internal control over misappropriation of assets by overriding existing controls or by
failing to cor:rect known internal control deflciencies.

3. Behavior indicating

displeasure

or dissatisfaction with the company or its treatment of

employee.

4.

Changes in behavior or lifestyle that may indicate assets have been misappropriated.

the

Audit Planning, (Jnderstanding the Client, Assessing Risla, and Responding

lllustrative Audit Case: KeYstone


Computers & Networks, lnc.
Part l: Audit Planning
to illustrate audit
The Keystone Computers & Networks, Inc. (KCN) case is used throughout the text
and
workstations
computer
installs
and
procedures and meihodology. KCN is a company that sells
the
has
audited
&
Co'
Bames
Adams,
firm
of
The
CPA
networking software to business customers.
audit planselective
illustrates
case
part
ofthe
years.
This
past
three
the
for
ofKCN
financial statements
You should read
ning working papers prepared by the statrof Adams, Bames & Co. for this year's audit'
is important to
that
information
the
of
through the inlormation to obtain an understanding of the nature
papers
include:
planning an audit engagement. The working

,
.

The balance sheet and income statement for the company for the prior

yeat,20x4.

A trial balance for l2l31lx5,with comparative amounts for 12l3llx4.


KEYSTONE COMPUTERS & NETWORKS, INC.
Balance Sheet

December 31,2OX4
Assets
Current Assets

Cash

Trade receivables, less allowance


Accounts receivable-off icers

s3,964

8,438,524
57,643

for doubtful accounts of $96,000

1,234,589
1 56,900

lnventory
Prepaid expenses
Total current assets
Equipment and leasehold improvements, at cost
Equipment and furniture
Leasehold improvements
Less

accumulated dePreciation

lntangible assets

net of amortization

9,941,620

1,090,634
98,900

1,189,534
(2s0.987)

938,s47

1,000,000

!]lEqgJ-qZ
Liabilities and Stockholders' Equity
Current Liabilities
Line of credit
Accounts payable
Current maturities of capital lease obligations
Accrued expenses
Total current liabilities
Capital lease obligations, less current maturities

Total liabilities
Stockholders' equitY
Common stock, $1 par value; 1,O0O,OOO shares authorized;
2OO,OOO shares issued and outstanding
Additional Paid-in caPital
Retained earnings

5,512,s50
't,349,839
1

43,200
78,900

8.184,489

4s5,700

8,641,189

200.000
423,500

2,615,478

g!,9!9J92

23a

Chapter.Six

KEYSTONE COMPUTERS & NETWORKS, INC.

Statements of lncome and Retained Earnings


Year Ended December 31,2OX4
$96,4s9,s66

Net sales
Cost of goods sold
Gross

74,',t22,435

profit

$22,337,131

Selling expenses:
$3,1 67,889

Salaries

Payroll benefits and taxes


Advertising and promotion
Travel and entertainment
Miscellaneous

913,456
1,200,786
609,788
334,890

$
Operating and administration expenses:
Operating salaries
Administrative salaries
Payroll benefits and taxes

$4,878,900

4,234,234
1,812,344

Utilities

797,800
210,495

lnsurance
Legal and accounting

356,890
457,577

Bad debt
Supplies

234,500

Rent

Depreciation and amortization


Software development
Miscellaneous

6,226,809

556,345
334,565
289,1 00

234,556
$14,397,306

Total selling, operating, and

$20,624,115

administrative expenses
Operating income

1,713,016
421,344

'1,2s1,672

lnterest expense
lncome before income taxes
lncome taxes:
Current
Deferred

256,76s
45,632

Net income
Retained earnings, January 1, 20X4
Retained earnings, December 31, 20X4

3A2397
989,27s

$
$

1,625,203

$-28],4r3

The analytical ratios working paper, partially completed. (The ratios for 20X5 have been left of.)
The audit plan for the audit of the financial statements for the year ended12l3llX5.

A fraud risk

assessment.

The engagement letter for the audit, presented in Figure 6.2 @tages l9l-192) of this chapter.

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240

ll
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ll

Audit Planning, Understanding the Client, lssessing Rlsfts, and Responding

KEYSTONE COMPUTERS & NETWORKS, INC.


Analytical Review Ratios
For the Period Ended December 31, 20X5

Preoared bv
Reviewed by

Ending

WL

Ending

1213'llKs 121311X4 lndustrY

Ratio
Current ratio
Days'sales in accounts receivable. computed with average
accounts receivable
Allowance for doubtful accounts/accounts receivable
Bad debt expense/net sales
Total liabilities/net worth
Return on total assets
Return on net worth
Return on net sales

profiUnet sales
Selling, operating, and administrative expenselnet sales
Times interest earned
Gross

1.233.2

1.3

37.0

1.1%
0.20/o

2.7

2.9

8.3o/o
30.5o/o
1.Oo/o
23.2o/o
21.4%
4.1

9,Oo/o
29.Oo/o

2.3%
24.0o/o
23.90/o

5.5

KEYSTONE COMPUTERS & NETWORKS, INC.

Audit Strategy
December 31,20X5

Date
Prepared by:
Reviewed by:
Reviewed by:

Warren Love (Senior)

August 14,20X5

Karen West (Manager)


Charles Adams (Partner)

August 28, 20X5


September 5, 20X5

OBJECTIVES OF THE ENGAGEMENT


Audit of the fnancial statements of Keystone Computers & Networks, Inc. (KCN), for the year ended
December 31,20X5. Also, the company's debt agreement with Western Financial Services requires the
company to furnish the lender a report by our firm on KCN's compliance with various restrictive debt
covenants.

BUSINESS AND INDUSTRY CONDITIONS

KCN sells and installs computers and networking hardware and software to business customers and provides other information technology consulting services. KCN also has begun developing its own computer networking software to be sold as a product to its customers. The company's primary competitive
strategy is to maintain a high level of technical expertise and a broad range of services.
KCN's long-tenn success is contingent on its ability to attract and retain qualified information technology personnel. The market for such individuals is very competitive. However, the company has a
competitive advantage because ofits desirable geographic location (Phoenix), which has a large number
of colleges with technology programs.
The market for computers and related products is extremely competitive. KCN competes with
large retailers of computers, such as Dell, Hewlett Packard, and Apple. The company also competes
with other value-added resellers who provide computers and software products and consulting services directly to customers. To effectively compete, the company must be able to obtain inventories
of state-of-the-art equipment on a timely basis. Because the company does not have the buying power
of some of its other competitors, it generally must charge a higher price for its products. Its customers
are willing to pay the higher price because of the high level of expertise and service that the company
provides.
The market for computer products and technology services is also very sensitive to economic conditions. Recent reports indicate that the U.S. economy will be challenged for the next few years. The
annual growth in spending for information technology products and services is expected to be 3 percent
per year for the next three years. In the past year, the company has decided to increase sales by extending credit to clients with slightly higher credit risk.

242

Chapter Six

PLANNING MEETINGS
to
on July 20, Kuen West and I met with Loren Steele, controller, and Sam Best, president, of KCN
in
our
held
was
aplannrngmeeting
2,
August
year.
On
the planning of the audit for the current
discuss

office with all members of the engagement team assigned to the audit'
OWNERSHIP AND MANAGEMENT
KCN is a closely held company owned by flve stockholders: Terry Keystone, Mark Keystone, John
the comKeystone, Keith Young, and Rita Young. Terry and Mark Keystone are active members of
of the
pany,s board of directors. None of the other owners take an active part in the management
husiness.

OBJECTIVES, STRATEGIES, AND BUSINESS RISKS

by 6 percent and increase net


to achieve those objectives
strategies
Major
income by 8 percent each year for the next three years'

KCN's primary business objectives are to

increase revenues

include:
Aggressive marketing of products and sen'ices tl-rrough increased advertising
Sales to customers with a higher credit risk profile'

New sotlu'are develoPment.


The primary business risks associated \vith the company's stlategies inciude:
The U.S. economy may suffer on additional significant donnturn'
Competitors may engage in predatory pricing to gain market share'
Increased adverllsing expenditures may not produce desired results.
Credit losses may exceed the benefits of increased sales'

Soflware development activities may not generate viable products'


The company has developed the followlng responses to tl-rese risks:
Careful monitoring of economy and industry conditions'
Careful monitoling ol competitor acl ions.
Hiring of marketing consulting firm to evaluate the perfontance of advertising methods'
Daily review of aging of accounts receivable by Loren Steele, controller.
Use of carefully controlled software developrnent budget'

MEASUREMENT AND REVIEW OF FINANCIAL PERFORMANCE


Management uses the following measrres to monitor the company's performance:

.
'
'
.
.

Inventory and receivables tumover.

Aging ofaccounts receivable.


Sales and gross margins by

tlpe ofrevenue.

Net income.

Totalinventorybalance.

AN UNDERSTANDING OF THE CLIENT AND ITS ENVIRONMENT


The following procedures were performed to update our understanding of the client and its
PROCEDURES TO OBTAIN

environment:

.
.

Roll forward of information from the prior year's audit


lnquiries of management:
Loren

Steele

Sam Best

'
.
'
'
'

7120,8115
'7

i20.8it6

Reading of quarterly board of directors' meetings held on 4105 arld7 112


Review of monthly performance reports for Jal.t.oary through July'

Industry reports-IT and consulting services.


Review of KCN's Web site'
Review of selected articles in The Wall Street Journal'

Audit Planning, Understanding the Client, Assessing Risks, and Responding 243

SIGN!FICANT R!SKS
Several significant risks were noted as a result of obtaining information about KCN and its environment,
including:

lmplications and Response

Risk
'1. KCN has engaged in a strategy to sell to customers with higher credit risk.
2. The officers of the company receive
significant bonuses based on quarterly results.

SIGNIFICANT ACCOUNTING AND AUDITING MATTERS

The company began oflering for sale extended warranties on computers during the current year. We
need to review the method of revenue recognition to determine whether it complies with the requirements ofFTSB ASC 605-20-25.
In the prior year, KCN began developing networking software products for sale. This year the company has started capitalizitg certait costs of development. We need to review the method of accounting
for the cost of software development to determine whether it complies with the requirements of FASB

ASC 98s-20-2s.

kt 20X3, KCN acquired for $1,200,000 a small business accounting system (Plumbtree Systems)
that it licenses to its customers. Recently, sales of the licenses for the software have begun to decline.
In addition, a recent article in a trade joumal ranked the system poor in relation to its competitors. This
may indicate that an impairment in the value of the so{tware may have occurred.
PLANNING MATERIALIW
Because the firm has experienced steady growth in sales and earnings over the last three years, we
believe that operating results are the most appropriate basis for estimating planning materiality as
described below:

Comparison of Bases

Computation of Planning Materiality

Financial Annualized for


Statement Base 121311X5

Base

Amount

Sales

Sales

$92,000,000
1 3,000,000

1
1

$920,000
1 30,000

320,000

10

32,000

Total assets
Pretax net
income

Materiality

$92,000,000
1 3,000,000

Total assets
Pretax net
income

320,000

Percentage
o/o

Estimate

The range for planning materiality is from $32,000 to $920,000. Based on the company's steady
growth in sales and eamings and the fact that the company is not a public company, we have selected
$300,000 as a reasonable materiality amount for planning purposes.
SCHEDULING AND STAFFING PLAN
Based on discussions with Ms. Steele, the following are tentative dates of importance for the audit:

Begin interim audit work


Complete interim audit work
Issue management letter on interim work
Observe physical inventory
Begin year-end audit work
Complete fieldwork
Closing conference
Issue audit report
Issue letter required by financing agreement
Issue updated management letter

October 15,20X5
byNovember 15,20X5
by November 30,20X5
December 31,20X5
February 7,20X6
by Febnrary 20,20X6

February25,20X6

byMarch 5,20X6
byMarch 5,20X6
by March 10,20X6

Staffng time requirements for the engagement are described below:

Manager

Partner

Total

Assistant

Senior

lnterim

40

40

10

Final

40

30

15

12

97

80

70

25

20

195

98

244

Chapter Six

Client: Keystone Computers & Networks, Inc.


Financial Statement Date: I 2 /3 I /X5

for a description
discussion.

See G-21

1. Consider the results of the discussion among engagement


personnel about the risk of material misstatement due to
fraud.
2. Consider results of inquiries of management about the
risks of fraud and how they are addressed.
3. Consider the results of risk assessment analytical procedures.
4. Consider the existence of fraud risk factors listed on G-30

of the
CA
CA
CA

through G-35.
5. Consider any other information that might be relevant
to the risk of material misstatement due to fraud.
Risks of Material Misstatement Due to Fraud

CA

Management may be motivated to misstate financial results


due to impending sale of the company.
Responses

Overall Responses
Risks were considered in staffing the engagement and
determining the appropriate level of supervision.
Alterations of the Nature, Timing, and Extent of Further Audit Procedures
Risks were considered in designing audit procedures for sales
and accounts receivable and inventories. (See R-6 and R-9.)
Procedures were performed to address the risk of management
override of internal controls. (See G-23-G-24.)

Appendix

LO

6C-1.

6C Problems

The audit plan for the audit ofKeystone Computers & Networks, Inc., appears on pages 237-)1:
Review each major section ofthe audit plan and briefly describe the purpose and content ofthe se; tion. Organize your solution in the following manner:

Section

Purpose

Content

objectives of the
engagement

To describe the
services that are

The objectives are (1) audit of KCN's financial


statements for the year ended 12i31lX5, and
(2) issuance of a letter on compliance with covenants of the client's letter of credit agreemen:

to be

rendered to the client.

3,4

6C-2.

LO7

6C-3.

LO

Required:

LO

3,4

6C4.

In the audit plan for the audit of Keystone Computers & Networks, Inc., on page 243 there is a se: tion on significant risks. For each ofthe risks, identify the implications and potential responses.
In the audit plan for the audit of Keystone Computers & Networks, Inc., on page 243 there is a s.-- tion on significant accounting and auditing matters. The second matter described involves cap:r".izing the costs ofdeveloping a software program for sale.

a.

Research this issue and write a brief memorandum for the working papers describin-e ::.
issue and summarizing the appropriate method of accounting for the development costs

&.

Based on your research, describe the major audit issue that you believe
auditing the software development costs.

ffi:''t

be involr'ec

A parlially completed analytical ratios working paper for Keystone Computers & Networks, Inc
presented on page 24

Required:

will

a.

Complete the working paper by computing the financial ratios for 20X5.
the ratios and identify financial statement accounts :: -'
should be investigated because the related ratios are not comparable to prior-year rat- - .
industry averages, or your knowledge ofthe company.

D. After completing paft (a.), review

c.

For each account identified in parl (b), list potential reasons for the unexpected accc*-balances and related ratios.