Case 2 – Chapter 9

Required:

a. List the items that should be included in the typical engagement letter.

The typical engagement letter includes the following:

 The name and address of the person/s who kept the auditor to perform the auditing
services.
 An opening paragraph that attests the understanding of the auditor and the client.
 A summary of the significant events that direct to the auditor’s retention of the auditing
services.
 A general description of the firm that will conduct the examination.
 A statement that the examination will be conducted according to the auditing
standards.
 A description of the scope of the services to be yielded.
 Any scope restrictions or special limitations and their effects on the auditor’s report.
 A statement concerning the auditor’s responsibility for the detection of fraud.
 A notion of the possible use of client personnel in connection with the audit work to be
performed.
 A statement that the auditor will provide a management letter, only if, required.
 The method and the timing of billings, including the billing rates and the fee
arrangements.
 A space for the client’s signature, which signifies the acceptance of the letter.

b. Describe the benefits derived from preparing an engagement letter.

The benefits derived from preparing an engagement letter include the prevention of the
possible problems between the auditor and the client regarding the scope of the work, the
service to be performed, and the audit fee arrangements. Moreover, the in-charge auditor can
prevent misunderstanding the nature and the scope of the engagement if there is an
engagement letter included in the audit working papers. The engagement letter should rule out
all the misunderstandings and confusion about everything. Also, the engagement letter can be a
reference document when preparing for future engagements.

c. Who should prepare and sign the engagement letter?

Usually, the CPA (the auditor) prepares the engagement letter as a follow-up to the
verbal agreement that he and his client have engaged. As the client can endorse and return an
 approved copy of the engagement letter, he, as well, can prepare his own engagement letter.
But preferably, the auditor should prepare the engagement letter, and both will sign the letter.

d. Why should the engagement letter be sent?

The engagement letter should be sent so that if there are some misunderstandings, it
can be remedied. Ideally, it should be sent at the beginning of the engagement.

e. Why should the engagement letter be renewed periodically?

The engagement letter is very useful when some misunderstandings need to be clarified
on the first engagement. For sure there will be changes, so it needs to be renewed periodically.
For recurring examinations of the financial statements, an engagement letter should be
prepared at the start of each examination. And for the other continuing engagements, the
engagement letter should be updated periodically.

Case 6 – Chapter 9

Required:

a. Develop an estimate if the appropriate materiality amount for planning for Franklin Co. and
describe how you arrived at the estimate.

Planning materiality: (P 34,900,000 – P 30,000,000) x .00313 + P 178,000 = P 193, 337

Net income: (P 1,600,000 x 0.05) = P 80,000

Total assets: (P 34,900,000 x 0.005) = P 174,500

Total revenue: (P 29,600,000 x 0.005) = P 148,000

Total equity: (P 13,800,000 x 0.01) = P 138,000

b. Develop an estimate if the appropriate materiality amount for planning for Tyler Co., and
describe how you arrived at the estimate.

Planning materiality: (P 4,500,000 – P 3,000,000) x .00670 + P 38,300 = P 48,350

Net income: (P 90,000 x 0.10) = P 9,000

Total assets: (P 2,700,000 x 0.01) = P 27,000

Total revenue: (P 4,500,000 x 0.01) = P 45,000

Total equity: (P 1,000,000 x 0.01) = P 10,000

 c. Describe five characteristics of a small misstatement that might render it qualitatively material.
 It occurs from an item that can be specifically measured.
 It hides the illegal transactions.
 A compliance with a loan agreement
 It conforms with the regulatory requirements.
 Probably, it has to do with a part of the business that is necessary for it to be profitable.

Case 1 – Chapter 10

Required:

a. For each of the four circumstances indicate the fraud risk that the auditors should consider.
b. For each of the four circumstances indicate a possible appropriate response by the auditors.

1. 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.

(a) There is an increased risk of fraudulent financial reporting by the subsidiary management.
More precisely, the subsidiary management would likely to attempt increase revenues and
decrease expenses.

(b) The auditors should respond by performing more procedures at the location of the
subsidiary management. There should be additional tests of revenue and observation of the
inventory at year-end. Moreover, some procedures may be performed unannounced.

2. The compensation of management of a telecommunications firm is significantly tied to revenue

and analytical procedures indicate that revenue may be overstated. The company engages in
complex sales agreements.

(a) There is an increased risk of fraudulent financial reporting by the management pertained to
revenue.

(b) The auditors should respond by operating more with the more experienced audit team
members and by increasing the extent of the substantive tests of revenue.
3. Futures traders in an energy company are compensated based on the performance of their
purchases and sales energy futures contracts. The markets for theses contracts have few
participants resulting in the need to value contracts on hand at year-end based on complex
valuation models applied by the traders.
 (a) There is an increased fraud risk by the futures traders by overstating the value of the
contracts to increase their compensations.

(b) The auditors should respond by bringing in a specialist to assist in valuing the contracts. Also,
by doing an extensive testing of the valuation of the contracts.

4. A chain of discount markets has inconsistent profit margins across stores as indicated by
analytical procedures.

(a) There is an increased risk that the management may be fraudulently overstating the income
at one or may be more stores.

(b) The auditors should respond by doing an increased testing of revenue and inventory at all
stores. They can also use the results of the analytical procedures to identify which stores are
more likely to have fraudulent results. Lastly, they can choose not to disclose any of the location
of the stores they want to visit for observation.