Audit Case Study 1

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Presented to the
College of Accountancy
PAMANTASAN NG LUNGSOD NG SAN PABLO
San Pablo, Laguna

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In Partial Fulfillment of the Final Requirements in

AUDITING IN CIS ENVIRONMENT

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Submitted by:

CAÑADA, MARIZ D.
GARCERA, PRECIOUS KATELYN C.

June 2023
WORK TASK – CLIENT ACCEPTANCE DECISION
1. An auditor has to collect information for the client acceptance decision. Define atleast five procedures
that an auditor should perform to collect relevant information for his/her decision whether to accept
4-Airlines as client or not.
a) OBTAINING ENTITY'S BRIEF DESCRIPTION: This procedure allows the auditor to have an
idea of the entity's general reputation, perceived integrity, and financial stability of the 4-airlines and its
key officers and shareholders.
b) PRE-ENGAGEMENT ASSESSMENT: This procedure would involve checking the financial
statements of 4-Airlines and determining if it is sufficient for the auditor to know possible factors which
may greatly affect the decision of making the entity as a new audit client.
c) COMMUNICATING WITH PREDECESSOR AUDITOR; In this procedure, the prospective
auditor sets an appointment with the previous auditor of the entity to obtain relevant information about the
client that will be useful in deciding whether to accept the engagement. This will only be possible once
the successor auditor obtains the client's permission to communicate with the predecessor auditor. This
will let the successor auditor have an understanding as to the reasons for auditor change, and
disagreements between the auditor and its client.
d) INDEPENDENCE ASSESSMENT : In this procedure, the entity shall prepare client
acceptance questionnaires and checklists. This procedure will demonstrate how independent the
auditor/audit committee is by disclosing all the information regarding its relationship with the client
entity, so is its compliance with the professional standards expected from them.
e) RISK ASSESSMENT: In this procedure, the auditor communicates with the employees or
other related parties of the entity and allows for additional knowledge as to the reasons for disagreements
and problems between the employees and entity's management. This is one of the critical factors which
may affect the presentation of the FS or the entity's assertion.

2. To get a first impression about 4-Airlines’ financial situation and performance, use the financial
information integrated in the case to calculate liquidity ratios (i.e. Accounts Receivable Turnover, Debt to
Equity and Current Ratios), profitability ratios (i.e. ROE, ROA, Profit Margin, Share of Fuel Cost in Total
Cost, Share of Aircraft Leases in Total Cost) and solvency ratios (i.e. Asset to Equity, Times Interest
Earned). Also, compare 4-Airlines’ ratios to the industry ratios provided in the case. Identify and discuss
any major differences. Try to analyze which risks may result from modifications to the balance sheet and
income statement with respect to key figures for the auditor.
 Liquidity Ratios (2XX1) Industry Company Difference

Return on Equity (ROE) 18.52% 4.47% 14.05%

Return on Assets (ROA) 3.78% 1.22% 2.56%

Operating Profit Margin 8.3% 1.11% 7.19%

Asset to Equity 5.92 3.69 2.23

Accounts Receivable Turnover 16.5 18.9 -2.4

Average Collection Period 22.1 19.31 2.79

Debt to Equity 4.9 2.69 2.21

Times Interest Earned 5.19 9.73 -4.54

Current Ratio 0.72 1.06 -.34

Share of Fuel cost in Total cost 27.3% 18.06% 9.24%

Share of Aircraft Leases in Total Cost 10.5% 14.1% -3.6%

Based on the table above, the comparison shows that the company ratios relating to the AR
turnover, Times interest earned, current ratio, and share of aircraft leases in Total cost, are higher
compared to the industry ratios. This may not conclude everything since there are a lot of other different
factors, but this could be used as one of the basis in assessing whether to accept the new audit client.

3. Are there other financial matters that should be considered before accepting 4- Airlines as a client?
Yes, there are other financial matters that must be considered such as the reasons for
disagreements between the CEO and CFO regarding the adjustments to be made in the financial
statements. This is an important factor to consider since it involves the share price and capital
requirements of 4-Airlines. It was also mentioned in the case that there are still some problems with the
cost calculation, sales invoice overdue and payables control, e-ticketing and booking over the internet,
control for spare parts, materials, and supplies for aircraft maintenance, which resulted to reports on
receivables and payables outstanding to be drafted with inaccuracy. There were also many cases which
made the airlines pay penalties since the online flight ticket booking system had some problems. These
are just a few of the many factors to be considered before accepting a new audit client.

4. Beside financial matters, other aspects should be considered before accepting 4- Airlines as a client.
What non-financial matters mentioned in this case study could be relevant for the client acceptance
decision? How important are each of these non-financial matters?
 A. One of the financial matters that must be given attention before accepting the engagement is the
CEO's consistent view that accounting issues are minor and irrelevant to the growth of the firm.
This stimulates aggressive accounting which makes the financial statements less reliable. This
matter is important because the CEO's/management's attitude might influence the audit
specifically if they are very firm into reaching the investors' and creditors' requirements.
B. Another non-financial matter that must be considered is the new IT system of 4-Airlines since it
has been creating more problems not only to the accounting environment but also with the
employees using it because of its complexities. This is an important matter; the complexities
might affect the risk assessment such as the scope of the audit and the fees for auditing such a
complex system.
C. The problems that occurred during the transition of CFO are also a matter of concern that must be
considered. The incompleteness of the new IT system's implementation creates an ongoing
training demand since its features take time to be familiarized. There are also some modifications
to work on that is why it is very important to consider this before accepting the engagement so
that the auditor is aware of the possible risks it may bring.

5. 4-Airlines expects that Europestars will help to optimize the new IT system. What are the pros and cons
when an audit firm provides both auditing and IT consulting services? Discuss whether European
regulation and the IFAC code of ethics will allow Europestars to help 4-Airlines with their IT system and
at the same time to carry out a statutory audit of the financial statements.
The pros of hiring a firm that offers both auditing and IT consulting services is that it can help in
finding the weaknesses of the client when it come to particular aspect specifically IT system.
Additionally, the client firm may have every opportunity to enhance its IT system so that it will not bring
negative result during the engagement. However, the cons could be that the audit firm may not stay true to
their principle of integrity when the circumstances challenged them such as when they had to audit the IT
system that the client company consulted from them. It may not want to uncover the nonconformities and
deficiencies of the IT system found during the audit so that their reputation in consulting services will not
go down.

6. As indicated in the case, one of the partners in another firm of the ‘Allstars’ network has invested in a
venture capital fund that owns shares of 4-Airlines Equity. Does this fact violate the auditor’s
independence? Discuss why or why not and consider the consequences.
This fact does not violate the independence of the auditor because the 2% share of that one
partner of 'Allstars' is deemed to be immaterial and has no direct control over the operations of the client
company. It will have no direct effect on the independence of the audit team of EuropeStars since that one
partner will not take part in the audit engagement.

7. Your team has to make a recommendation to the managing partner as to whether Europestars should
accept the audit engagement of the 4-Airlines Company. What would you recommend? Include
consideration of reasons both for and against acceptance and use both financial and non-financial
information to justify your recommendation.

Recommendation:
The client firm, 4-Airlines, gained a great value adding service opportunity which is a positive
factor since it shows how they value their customers/passengers. However, there are more negative factors
that need to be considered before accepting the engagement. The drawbacks that were discussed in the
previous numbers such as the financial and nonfinancial matter have direct and indirect effect with the
risk of taking the engagement. Those are vital in conducting an audit with accuracy and integrity.
To conclude the auditor's pre-audit investigation and evaluation of the client company,
4-Airlines, the suggestion is to reject the engagement since the auditors classified it as a moderate to very
risky audit engagement client. However, there is still another way in which Europestars could be of help
to the 4-Airlines, which is through its IT consulting services since one of the major problems of this firm
comes from the newly implemented IT system. With that, Europestars will not be violating the ethical
standards for independence and integrity.
WORK TASK - DETERMINING MATERIALITY
1. Briefly list and discuss the five or six most important critical factors or risk areas that
will likely affect how the audit is conducted.
1. Inherent Risk
2. Control Risk
3. Detection Risk
4. Access Control Risk
5. Audit Risk
6. Material Misstatement Risk
7. Significant Risk

2. Briefly list and discuss the five or six most important critical factors or risk areas that
will likely affect how the audit is conducted.
1. Inherent Risk- risk that is associated with the unique characteristics of the business or industry of
the client.
2. Control Risk- the risk that the control structure is flawed because controls are either absent or
inadequate to prevent or detect errors in the account. The risk is evaluated using a variety of analytical
techniques, information currently available about the entity and industry, as well as extensive audit data.
3. Audit risk- risk that the auditor will render unqualified opinions on financial statements that are,
in fact,materially misstated.
4. Detection Risk- risk that auditors are willing to take that errors not detected or prevented by the
control structure will
also not be detected by the auditor.
5. Material Misstatement Risk- the risk that the financial statements are materially misstated prior
to audit.

3. Quantify the risks regarding management issues, accounting environment, operating environment and
audit issues and determine a general risk level of the ‘4- Airlines’ audit, on an evaluation scale from one
to five. (Please use the risk assessment sheet given in the appendix).
4. Show the impact of the analysis you have performed within task 3 on the materiality.

The results which were accumulated from the previous table illustrate that there is a low degree
of risk associated with proper remuneration of activities of the management and those in charge of
governance, the client's liquidity and to the extent to which financial statements will be used by the users
of the financial statements, the changes in profitability and external investments. The statement of
financial position itself, along with the management's attitude on financial reporting, pose a medium risk.
On the other hand, there is high risk on the management's experience and knowledge about their
operations and has a very high risk with regards to frequent change of auditors and management's control
capability with regards to the previous experience. Other things considered, the highest scale associated
with audit risk is the control risk of management issues with the experience, attitude and ability of
management at a medium to high risk scale that can affect materiality. When it comes to the accounting
environment segment, the inherent risk has the highest risk scale, only a small percentage of the control
risk and zero detection risk, because the factors contributing to the high inherent risk of the accounting
segment are attitudes of accounting employees, inaccurate financial information about past performance,
the frequency and materiality that are difficult to audit, and other types of risk factors that can result in
material misstatements in the absence of controls.
On the other hand, the operating environment which has a high degree of control risk that affects
the materiality of the financial statements which results from frequent change in the nature and
computation ratios. Another audit issue is the inherent risk which displays the highest risk factor to be
considered based on the table quantification which affects the materiality of the financial statements.

5. Determine the materiality, as well as other materiality-related aspects according to ISA 320 (e.g.,
performance materiality), relying on the information presented within the case study and the annexes.

The concept of materiality serves as a critical tool for effective information management. Its
primary objective is to ensure that all financial data that may impact investors' decisions is accurately
displayed in the company's financial statements. Materiality is a widely accepted principle that applies not
only to disclosure and information display but also to crucial accounting decisions, including recognition
and measurement. It refers to items that significantly affect how users of business data make important
decisions. Deciding what is material, falls upon the discretion of the accountant.

Furthermore, materiality plays a crucial role in audit planning and conducting. The auditor must
apply the concept of materiality both when developing the overall audit plan and during its
implementation. The auditor must establish materiality thresholds for all financial statements in order to
ensure that they accurately reflect all relevant financial information. Overall, materiality is a key aspect of
financial reporting and is essential for effective decision-making by investors. With regards to this, the
auditors must depict the performance materiality of the firm in order to assess the risk of material and
significant misstatement in order to know the scope of additional audit procedures that the auditor will do,
according to ISA 320. That is the amount less than the level of overall materiality, and is reduced in order
to allow for the risk that there may be several smaller errors or omissions that have not been identified by
the auditor.

6. Describe the relevance of the materiality in planning the audit engagement and specify if the
materiality determined based on the unaudited financial statements can be changed while the audit is in
progress.

Materiality is an accounting principle which states that all items that are reasonably likely to
impact investors’ decision-making must be recorded or reported in detail in a business’s financial
statements using GAAP standards. Its goal is to ensure that the financial data that can affect investors'
choices is presented in the financial statements. The idea of materialism is widely accepted. It pertains to
both the display and disclosure of information as well as choices on measurement and recognition. In
making decisions about materiality, companies must take into account a variety of issues and conditions,
like the quantitative elements (such as the how big or small the sum of the amounts of items in the
financial reports) and the qualitative factors (such as the nature of the business and specific managerial
decision that could affect the company). Whenever the idea of materiality is not used appropriately by the
management, it could lead to disclosure of excessive amounts of information or can lead to too little
information collection. Ultimately, the type of information that’s material to an organization’s financial
statements will vary and depend on the size, scope, and business priorities of the firm.

Therefore, the auditor should determine the materiality of the financial statements as a whole
when determining the overall audit strategy. Example, one or more specific types of transactions, account
balances or disclosures in which, under the entity's particular circumstances, a misstatement of an amount
less than material to the financial statements as a whole could reasonably be expected to influence the
entity's economic decisions. So auditors must practice due care and diligence when judgment for
materiality is involved. With this the level of materiality that applies to a particular category of
transaction, account balance, or disclosure must be thoroughly considered. Auditors must determine the
materiality of performance for a particular purpose. They should assess the risk of material misstatement
and determine the nature, timing and extent of further work that will be involved.

Designing an audit to detect only individual material misstatements ignores the fact that the
combined effect of individual minor misstatements can cause material misstatements of the financial
statements and leaves no allowance for potential undetected misstatements. The performance materiality
is then set to reduce to an appropriately low level of probability that the total number of uncorrected and
unnoticed errors in the financial statements exceeds the materiality in the financial statements as a whole.
Similarly, the performance materiality associated with the materiality level assigned to a particular class
of transaction, account balance or disclosure is set to reduce to an appropriately low level of probability
that the total number of uncorrected and undetected errors in that the particular class of transaction,
account balance or disclosure exceeds the materiality level for that particular class of transactions,
account balance or disclosure. Determining performance materiality is not a simple calculation, but
involves thorough professional judgment. It is influenced by the auditor's understanding of the nature of
the entity which is an influence in the determination of the risk assessment procedures, as well as the
nature and extent of errors discovered during previous audits and thus the auditor's expectations of errors
in the current period.

Revision as the Audit Progresses

AICPA 2021 stated that if information becomes available during the audit that would have led the
auditor to determine a different amount (or amounts) in the first place, the auditor should review the
materiality of the financial statements as a whole and if applicable, the materiality level or amounts for
certain transaction categories, account balances or disclosures. And if the auditor considers that a lower
level of materiality for the financial statements as a whole (and, where suitable, certain types of
transactions, account balances or disclosures) is appropriate, the auditor should determine whether the
materiality of the performance needs to be reviewed and revised and if the nature, timing and extent of
additional audit procedures continue to be appropriate.

7. While performing the audit, the team identifies five errors related to the valuation or the disclosure of
the items in the financial statements. What is the impact of the identified errors on the audit opinion from
the standpoint of the materiality?
 When inaccuracies are discovered in evaluating or disclosing financial statements, the level of
materiality must be reassessed to determine whether the inaccuracy has an impact on the financial
statements. The auditor is likely to issue a qualified opinion on the financial statements if these five
misstatements are detrimental enough to affect readers and users of the financial statements but not large
enough to obscure the fair presentation of the financial statements as a whole. On the other hand, if the
auditor finds that the errors have a material effect on the financial statements and that it affects many
items, the auditor is likely to present an adverse opinion. An adverse opinion states that the financial
statements do not present fairly the financial position, results of operations, or cash flows of the entity in
conformity with generally accepted accounting principles.
On the contrary, an unqualified opinion can be issued by the auditor when the company's five
valuation or disclosure issues or errors are addressed, revised and repaired in compliance with the
standard.