CHAPTER 9
RISK ASSESSMENT – PART I
Answers to Questions
1. In their investigation of a prospective client, the CPAs should assess the
backgrounds and reputations of the prospect and its major shareholders,
directors, and officers. Thus, inquiries are made of underwriters,
bankers, and attorneys that conduct business with the prospective client.
Also, the CPAs are required to make inquiries of the prospect's
predecessor auditors to obtain information that might enter into the
acceptance decision, such as information regarding the integrity of
management. The prospect's financial reports, SEC filings, credit reports,
and tax returns are used as sources of financial background information.
2. An engagement letter is sent to the client by the auditors to make clear
the nature of the engagement, any limitations on the scope of the audit,
work to be performed by the client's staff, and the basis for computing
the auditors' fee. The engagement letter represents the written contract
for the engagement, and its primary objective is to prevent possible
misunderstandings between the client and the auditors. It constitutes an
executory contract between the auditors and the client.
3. “Shopping for accounting principles” is a practice whereby management
changes auditors to a CPA firm that is more likely to allow an accounting
principle that has been the subject of dispute with the company’s prior
auditors. A number of mechanisms serve to discourage the practice,
including: (1) the requirements under PAS for the successor auditors to
inquire of the predecessors about the reasons for the change in auditors,
(2) the SEC requirements for management to report the reasons for a
change in auditors which also require the auditors to express their
agreement with the details, and (3) the requirements under PAS that
require accountants who are being asked to provide a report on the
accounting treatment of an prospective or completed transaction to
consult with the client’s auditors to ensure that they have a complete
understanding of the form and substance of the transaction. In addition,
the SEC requires the audit committee to assume responsibility for
engaging, compensating, and overseeing the auditors.
4. The approach described in the statement is not appropriate. Materiality
depends on both the peso amount and the nature of the item. For
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example, auditors apply a more rigorous standard of materiality in
evaluating transactions between related parties and potentially illegal acts
than they apply to misstatements in accounts.
5. The two types of misstatements due to fraud are (1) misstatements
arising from fraudulent financial reporting, and (2) misstatements arising
from misappropriation of assets (sometimes referred to as defalcation).
Fraudulent financial reporting is of more concern to the auditors because
it typically results in effects that are much more material to the financial
statements. Defalcations often are not material to the financial
statements.
6. A business risk is a threat to achieving management’s objectives. There
are many examples of business risks that may result in a risk of material
misstatement of the financial statements. Two are shown below:
Business Risk Risk of Material Misstatement
Rapidly changing technology in Inventory may be overvalued
the client’s industry may threaten because it is not valued at net
to cause the client’s products to realizable value.
become obsolete.
Economic conditions in the Accounts receivable may be
industry may result in significant overvalued because the allowance
uncollectible accounts receivable. for uncollectible accounts is not
adequate.
7. The audit procedures to be followed in a given engagement depend upon
such factors as the risks of material misstatement of the financial
statements, the assumption about the effectiveness of internal control, the
auditors' estimates of materiality, the nature of the accounting records,
the caliber of accounting personnel, and any special objectives of the
engagement. Consequently, a separate, tailor-made audit program
should be prepared for each audit engagement.
8. The quotation is misleading because it implies that an audit program is
no more than a checklist of instructions for inexperienced auditors.
Actually, audit programs are essential to assessing that all work is
performed and are used on virtually all audit engagements regardless of
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the amount of experience of the auditor. Also, a written audit program is
required for all audits.
9. The risk of material misstatement is the probability that an account, class
of transactions, or disclosure is materially misstated. It consists of
inherent risk (the risk of material misstatement without considering
internal control) and control risk (the risk that internal control will fail to
prevent or detect and correct the material misstatement).
10. Significant risks often relate to nonroutine transactions and estimation
transactions. Such transactions typically involve more subjective
judgment than routine transactions and, therefore, they often have a
higher risk of material misstatement. Significant risks may also be fraud
risks.
11. Factors which may cause an audit engagement to exceed the original
time estimate include the following:
(1) Accounting records may not be up to date and complete.
(2) Inadequacies in internal control may be discovered necessitating
a more detailed audit than anticipated.
(3) A significant risk, such as a fraud risk, may be discovered
requiring an extension of audit procedures.
(4) Fraud may be discovered, and an extended investigation may be
authorized by the client to clarify the situation.
(5) Inadequate supervision of audit staff may permit unnecessary or
misdirected work to be performed.
(6) Findings during the course of the audit may cause the client to
request extension of the scope of the work.
In some engagements, clients are charged at agreed daily or hourly rates
for the time used to perform the audit. The difficulty of forecasting time
requirements is a principal reason for the use of per diem rates rather
than quoting a fee for the entire engagement. For many engagements, a
maximum fee is agreed upon; this plan may, of course, force the auditing
firm to absorb part of the cost of unexpected amounts of work. A
decision as to charging the client for unusual amounts of time will
involve consideration of all aspects of the engagement and prior relations
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with the client. Generally, however, the client should not be billed for
excessive time attributed to audit inefficiencies (e.g. item (5) above).
12. Underreporting of time results in the CPA firm not billing the client for
all of the time actually involved in rendering the professional services.
Thus, the firm's revenue is being restricted. In addition, the
underreporting will cause the firm to underestimate the amount of time
required for future engagements. Thus, auditors on future engagements
will be expected to perform audit procedures in an unrealistically short
period of time. This interferes with the performance of an effective audit
as well as the realistic evaluation of firm personnel.
13. The overall audit strategy, audit plan, and the time budget are developed
to help insure compliance with the generally accepted auditing standards
documentation requirements. The overall audit strategy addresses overall
characteristics of the audit which demine its scope such as industry
reporting requirements. The audit plan is more detailed than the audit
strategy and includes the nature, timing and extent of audit procedures to
be performed. The time budget is constructed by estimating the time
required for each step in the audit plan.
14. The purpose of the team meeting on fraud risk is designed to 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 fraud, to discuss how to
design appropriate procedures to detect the misstatements, and to
emphasize the importance of maintaining the proper degree of
professional skepticism regarding the possibility of fraud.
15. During the planning process, the auditors make preliminary estimates of
both risk and materiality for the engagement. The auditors must plan
their engagements to reduce the audit risk of issuing an unqualified
opinion on materially misstated financial statements to a relatively low
level. At the account balance level, audit risk actually has three
components: (1) inherent risk, (2) control risk, and (3) detection risk.
On audits where the risk of misstatement is relatively high, the auditors
must compensate by increasing the effectiveness of their audit
procedures. They may design more effective procedures, increase the
number of items selected for testing, or perform more procedures at the
balance sheet date rather than at an interim date. They may also add an
element of unpredictability to the procedures.
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The auditors' preliminary estimates of levels of materiality also affect the
nature, timing, and extent of their planned procedures. Materiality levels
determine which accounts are significant enough to require audit, affect
the size of the test samples, and determine the peso amount of individual
items that warrant examination.
Answers to Multiple Choice Questions
1. C
2. D
3. D
4. C
5. C
6. D
7. B
8. C
9. B
Answers to Cases
Case 1
a. Prior to acceptance of the engagement, Argante & Tan should have
communicated with the predecessor auditor regarding:
Facts that might bear on the integrity of management.
Disagreements with management concerning accounting
principles, auditing procedures, or other significant matters.
The predecessor’s understanding about the reason for the
change.
Any other information that may be of assistance in
determining whether to accept the engagement.
b. The form and content of engagement letters may vary, but they
would generally contain information regarding:
The objective of the audit.
The estimated completion date.
Management’s responsibility for the financial statements.
The scope of the audit.
Other communication of the results of the engagement.
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The fact that because of the test nature and other inherent
limitations of any system of internal control, there is an
unavoidable risk that even some material misstatement may
remain undiscovered.
Access to whatever records, documentation, and other
information may be requested in connection with the audit.
Arrangements with respect to client assistance in the
performance of the audit engagement.
Expectation of receiving from management written
confirmation concerning representations made in connection
with the audit.
Notification of any changes in the original arrangements that
might be necessitated by unknown or unforeseen factors.
Request for the client to confirm the terms of the
engagement by acknowledging receipt of the engagement
letter.
The basis on which fees are computed and any billing
arrangements.
Case 2
a. Typical engagement letter generally includes the following:
The name and address of the person or persons who retained
the auditor to perform the auditing services.
An opening paragraph that confirms the understanding of the
auditor and the client.
A summary of significant events that lead to the retention of
the services of the auditor.
A general description of the CPA firm that will conduct the
examination.
A statement that the examination will be performed in
accordance with auditing standards.
A description of the scope of the services to be rendered,
which should establish the nature of the engagement.
Any scope restrictions or special limitations and their effect
on the auditor’s report.
A statement regarding the auditor’s responsibility for the
detection of fraud.
An indication of the possible use of client personnel in
connection with the audit work to be performed.
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A statement that the auditor will provide a management
letter if required in the circumstances.
The method and timing of billings as well as billing rates and
fee arrangements.
Space for the client representative’s signature, which
indicates “acceptance” of the letter and the understandings,
therein.
b. The benefits of preparing an engagement letter include the avoidance
of possible problems between the CPA and the client concerning (1)
the scope of the work, (2) the service to be rendered, and (3) the
audit fee. In addition, the “in-charge” auditor conducting the
examination can avoid misunderstanding the nature and scope of the
engagement if the engagement letter is included in the permanent
section of the audit working papers. The letter should eliminate
misunderstandings and confusion about the type of financial
statements to be examined, the estimated report date, and the type of
opinion expected. In addition to avoiding possible
misunderstandings, any legal problems relating to the auditor’s
failure to perform certain procedures can be reviewed with reference
to the contractual commitment assumed. (For example, if scope
limitations prevent the auditor from performing normal audit
procedures, the auditor cannot be legally responsible if an
irregularity is not detected when clearly it would have been detected
if such procedures were performed.)
The engagement letter is also useful as a reference document when
preparing for future engagements.
c. The CPA usually prepares the engagement letter as a follow-up to a
verbal understanding that he and his client have reached. It is
desirable that the client endorse and return an approved copy of the
engagement letter to the CPA. It also is acceptable for the client to
prepare his own letter summarizing his understanding of the nature
of the engagement.
d. Preferably the engagement letter should be sent at the beginning of
the engagement so that misunderstandings, if any, can be remedied.
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e. Obviously, the engagement letter will be most useful in clarifying
misunderstandings on a first engagement. But it is desirable that the
letter be renewed periodically. Client personnel or the nature of the
engagement may change, and the resubmission of the letter gives
both parties an opportunity to review the circumstances.
Accordingly, for recurring examinations of financial statements, it is
appropriate to prepare an engagement letter at the start of each
examination. For other continuing engagements, the engagement
letter also should be updated periodically – probably on a yearly
basis.
Case 3
a. The procedures that Francis should follow prior to accepting the
engagement include the following:
(1) Francis should explain to Nikolai the need to inquire of Jo and
should request permission to make such inquiries.
(2) Francis should request that Nikolai authorize Jo to respond fully
to all of Francis’ inquiries since Jo would be prohibited from
disclosing confidential information obtained in the course of his
professional engagement with Nikolai.
(3) Francis should advise Jo of Nikolai’s decision to change auditors
as an act of professional courtesy.
(4) Francis should make reasonable inquiries of Jo regarding matters
that will aid in deciding whether to accept the engagement.
(Francis’ inquiries should include questions regarding facts
which might bear on the integrity of management, disagreements
with management as to accounting principles, auditing
procedures or other significant matters, and Jo’s understanding
of the reason(s) for the change of auditors.)
(5) Francis should weigh all the information received from Jo. If Jo
does not respond fully to Francis’ questions, Francis should
consider the implications of the limited response in deciding
whether to accept the engagement.
(6) After weighing all information received from Jo, Francis should
inform Nikolai that a first-time audit is more time-consuming
than a recurring audit because the new auditor is generally
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unfamiliar with client’s operations and does not have the benefit
of past knowledge of company affairs to use a guide.
(7) A discussion with Nikolai of the estimated required audit time
and fee arrangement should be coordinated with a clear
explanation of the purpose and scope of the audit. Any work
that can be done by client personnel should also be discussed so
that excess audit time might be eliminated and proposed report
deadlines can be reasonably met.
(8) To satisfy Francis’ quality control objectives, Francis should use
procedures such as reviewing the financial statements of Nikolai;
inquiring of third parties such as Nikolai’s banks, legal counsel,
investment bankers, and others in the business community as to
Nikolai’s reputation; and evaluating his ability to serve Nikolai
properly with reference to industry expertise, size of
engagement, and available staff.
(9) If Francis has no reservations, after all significant factors have
been considered, discussed, and agreed to, Francis should accept
the engagement and confirm the understanding in an engagement
letter.
b. Francis’ procedures on this first-time audit should include the
following:
(1) Francis should review the workpapers of Jo to obtain
information that will help plan the audit work.
(2) Francis should make arrangements as early as possible for the
initial meeting with “key” company personnel who will be
contacted throughout the engagement.
(3) Since basic information about the company is not readily
available to Francis on this first-time audit, information of a
general nature should be obtained as early in the planning stage
as possible. (Such information should include company history,
nature of the business, credit policies, financing methods, sales
methods and terms, seasonal business patterns, products,
services, plant locations, internal procedures, accounting
policies, tax status, etc. Client procedures manuals and manuals
of accounts should be read to obtain such information.)
(4) Francis should immediately start obtaining the data needed to
create a permanent working paper file. (The file should include
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items such as articles of incorporation, minutes, internal audit
reports, deeds of trust, pension agreements, loan agreements,
leases, important contracts, and other pertinent data.)
(5) Francis must determine the scope of work necessary to verify the
opening balances. Such balances must be reviewed to determine
whether they are stated on a basis comparable with those of the
period under review. If Francis cannot verify the opening
balances, Francis should consider disclaiming an opinion on the
earnings statement and statement of changes in financial
position.
(6) The composition of all important accounts should be reviewed.
Francis should limit his examination of prior period accounts to a
review or survey of such accounts, without a detailed
examination, unless the results of Francis’ survey and analyses
indicate the need for further investigation of accounting methods
in the prior years.
(7) Francis must consider whether the financial statements are
prepared using financial reporting standards that were
consistently applied. If, after performing necessary audit
procedures, Francis cannot be satisfied as to consistency,
considerations must be given to qualifying the auditor’s report as
to consistency.
Francis should use professional judgment to determine the extent of
reliance that should be placed on the work of Jo. The scope of
Francis’ work may be reduced as a result of Francis’ consultation
with Jo and a review of the prior-year workpapers of Jo.
Case 4
a. A CPA can use the following sources of information to help decide
whether to accept a new audit client.
Financial information prepared by the prospective client:
Annual reports to shareholders
Interim financial statements
Securities registration statements
Annual report on SEC
Reports to regulatory agencies
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Inquiries directed to the prospect’s business associates:
Banker
Legal counsel
Underwriter
Other persons, e.g., customers, suppliers
Predecessor auditor, if any, communication, re:
Integrity of management, Disagreements with management
Analysis:
Special or unusual risk related to the prospect
Need for special skills (e.g., computer or industry expertise)
Internal search for relationships that would comprise independence
b. Students can decide this acceptance question either way, although
the brief facts prejudice the conclusion toward nonacceptance. The
CPA’s own firm decided to resign only 10 years ago, presumably
over matters of owner-manager integrity. Yet, Mr. Sello appears to
be a respected member of his new community. Maybe his “fast and
loose” accounting past is behind him. Maybe not.
Case 5
Benefits of engagement letters are:
Helps establish an understanding between client and auditor of the
terms of the engagement and the nature of the work.
Helps avoid quarrels and misunderstandings between client and
auditor.
Helps avoid disputes over the audit fee.
Helps avoid legal liability assertions based on failure to do work that
the CPA may not have contemplated or agreed to do.
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Case 6
Students may arrive at a variety of estimates. Those suggested in the text
include:
(a) (b)
Franklin Co. Tyler Co.
Rules of Thumb:
5 percent of net income before taxes P 800,000 P 45,000
10 percent of net income before taxes 1,600,000 90,000
1/2 percent of total assets 1,745,000 135,000
1 percent of total assets 3,490,000 270,000
1/2 percent of total revenues 1,480,000 225,000
1 percent of total revenues 2,960,000 450,000
1 percent of total equity 1,380,000 100,000
(c) Characteristics of a small misstatement that might render it
qualitatively material include misstatements of the financial
statements that (5 required):
Affect a company's compliance with a contractual
agreement.
Reverse a trend of earnings (or other trends).
Cause a company not to make the consensus earnings per
share.
Arise from an item capable of precise measurement.
Changes a loss into income, or vice versa.
Concerns a segment or other portion of a company's business
that has been identified as significant to operations or
profitability.
Affects compliance with regulatory requirements.
Affects compliance with loan covenants.
Increases management's compensation.
Involves concealment of an unlawful transaction.
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