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Solutions for Chapter 4 Audit Risk, Business Risk, and Audit Planning

Review Questions: 4-1. Business Risk - Those risks that affect the operations and potential outcomes of organizational activities. Engagement Risk - The risk auditors encounter by being associated with a particular client: loss of reputation, inability of the client to pay the auditor, or financial loss because management is not honest and inhibits the audit process. Financial Reporting Risk - Those risks that relate directly to the recording of transactions and the presentation of financial data in an organizations financial statements; also referred to as the risk of material misstatement. Audit Risk - The risk that the auditor may provide an unqualified opinion on financial statements that are materially misstated. 4.2. Business risk management is defined as: Process, effected by an entitys board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risks to within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives. (COSO, 2004) The organization itself bears the responsibility for effective implementation of ERM. It is important for all organizations to implement an effective ERM so that risks are understood and properly controlled by members of the organization, particularly management and the board of directors. 4-3. Corporate losses are tied to risk management because companies simply fail to identify and manage the risks associated with business operations or strategic initiatives. In addition, failures occur because the organization does not fully appreciate the risks associated with dysfunctional compensation schemes. As shown in the chapter, over 80% of the Fortune 500 companies in 1970 did not manage risk effectively, nor did they take appropriate risks in introducing new products, to survive for the next three decades as one of the largest companies in the world. The financial crisis of 2008 clearly demonstrated that financial institutions that did not understand, or manage, their risks failed.

4.4. 4.5.

Controls exist to address risks. Therefore, it would be impossible to evaluate the effectiveness of controls without first knowing the risks, or bad outcomes, that the controls are designed to address. When a company decides to develop a new product, it faces the risk of being unsuccessful, the risk of not fully understanding the technological aspects of their design, or the risk of potential lawsuits. The company also faces a risk if it does not have a comprehensive marketing plan or if it fails to obtain proper regulatory approval for a product. The auditor must consider all of these elements in evaluating the capitalization of research and development costs and the valuation of company products. Finally, knowledge of the risks allows the auditor to become a good business advisor to the client. To identify the risks associated with a client, the auditor should utilize a number of sources and arrive at a decision considering each of them. The major procedures the auditor will utilize to identify fraud risks include: Inquiry of predecessor auditor Inquiries of other professionals in the business community Discussions with other auditors within the audit firm that may have had interaction with management or the client in other capacities. Review of news media and web searches Review of public databases for information about the company, its operations, or any pending legal cases or federal rulings for or against the company. Preliminary interviews with management Interviews with audit committee members Inquiries of federal regulatory agencies Potential use of private investigation firms. Management integrity refers to the trustworthiness of management in such things as acting in the organization's best interest, exhibiting high standards of ethical behavior, providing full access to information needed by the auditor, and acting in an honest and trustworthy manner, not hiding or manipulating information or transactions for personal benefit. The auditor assesses management integrity by making a systematic inquiry of other professionals and reviewing previous interactions with management. Assessment includes An inquiry of professionals in the community in which the client operates, such as bankers and lawyers. A review of recent regulatory or court cases against the client, including recent SEC filings. A review of the financial press, including a comprehensive review of Internet databases, for information or articles about the company and its management.

4-6.

4-7.

An inquiry of predecessor auditors as to management integrity, existence of disagreements about the audit, and management's motivation to manipulate accounting principles. A thorough review of previous financial reports to uncover financial problems and the quality of financial reporting utilized.

The auditors assessment of management integrity is usually considered the most important factor in continuing a client relationship or accepting a new client because management integrity is inversely related to financial reporting risk. Stated another way: the higher management integrity, the lower is the risk of financial reporting fraud or other misstatements. 4-8. The primary factors a public accounting firm ought to consider before accepting a new client include 1. 2. 3. 4. 5. 6. Management's integrity and reputation. Legal proceedings involving the company. The overall financial position of the company and its financial health. The existence of related-party transactions. Status and quality of previous regulatory filings. Quality of the companys internal control over financial reporting.

Other factors the firm may consider include 1. 2. 3. 4. 5. 6. 7. Future growth prospects of the client. Expertise in providing services to the client (industry knowledge). Prestige gained by being associated with the client. Prospects for future business with the client. Prospects for future business in the industry by being associated with the client. Timing of audit engagement and ability to better utilize existing staff personnel. The existence of disputes (either fees or accounting issues) with the previous auditors.

4-9.

Financial Reporting Risk is defined as those risks that relate directly to the recording of transactions and the presentation of financial data in an organizations financial statements. The existence of financial reporting risks implies that the auditor should specifically identify audit procedures that address the risk that a misstatement would occur in a specific account balance. The major factors that lead to high financial reporting risk include, but are not limited to: Subjectivity of judgments affecting the account balance, e.g. estimates or impairments, Complexity of transactions or contracts, e.g. complexity of financial instruments, or complexity of contracts.

Management motivation to misstate the financial statements, e.g. pressure to meet reported earnings. Quality of the companys internal control system, including the risk of management override and the controls developed to mitigate management override.

4-10. A high risk audit client is one in which the auditor believes that (a) association with the client will have a higher than average potential of material loss to the audit firm; or (b) the company operates in an industry that is considered high risk; or (c) the companys financial results are such that financial failure is a possibility. High risk audit clients are generally characterized by: 4.11. Management with questionable integrity Inadequate capital Lack of long-run strategic and operational plans Low cost of entry into the market Dependence on a limited product range Dependence on technologies that may quickly become obsolete Instability of future cash flows History of questionable accounting practices Previous inquiries by the SEC or other regulatory agencies Poor financial condition Large market value stock fluctuations An industry characterized by rapid volatility

Related party transactions represent special risk to the auditor because they are transactions that are controlled by related entities so that the facts of the transaction may not represent the substance of the transaction. However, the auditor might not be aware of the nature of the related party transactions and must therefore institute special procedures to determine if related party transactions existed. If related party transactions are not discovered and properly disclosed, then the financial statements which are purported to represent the results of transactions with outside parties would be misstated. There are two major alternatives to identify related parties. Management inquiry would be a good starting point. Review of vendor lists to attempt to match names or addresses might also turn up potential conflicts of interest. A review of board minutes or other sources for loans granted would be a source as well. A second approach is to identify unusual transactions, or transactions that seem to be designed to accomplish a particular financial purpose, and then investigate those transactions to determine if they are related party transactions. Related party transactions are especially concerning because they represent a potential breakdown of corporate governance, conflicts of interest, and opportunities to influence the financial reporting process. The transactions represent risks to the auditor because they are often covered up by management.

4.12.

The main sources of information that the auditor will look at in determining whether or not to accept a new audit client are: Predecessor auditor Other professionals in the business community Other auditors within the audit firm News media and web searches Public databases Preliminary interviews with management Audit committee members Inquiries of federal regulatory agencies Private investigation firms

It is important to systematically make the accept decision to ensure that all sources are considered, and a quick decision is not made for financial reasons. For example, if a systematic decision was made for the Enron audit by Andersen, they would have been much less likely to retain Enron as a client. It is generally believed that the firm was reluctant to give up the total profitability from all services that Enron was providing. 4-13. The auditor should seek information from the predecessor auditor that will assist in deciding whether to accept the new client and that will help plan the audit. Specifically, they should ask of their beliefs for why an auditor change was made, how management works with auditors, and the general quality of the firms controls. The predecessor auditor should be quizzed on any major disagreements with the audit client, especially those dealing with accounting issues or the payment of fees. The auditor also wants to understand if the previous auditor believes there are any problems with management integrity or competencies as weaknesses in both areas create higher engagement risk. They should find out if there were any communications with the management and/or the audit committee concerning internal control issues, illegal acts, or fraud. 4-14. The engagement letter clarifies the responsibilities and expectations of the auditor and the client. It is formally acknowledged by the client and, in the absence of a formal contract, serves as a contract for an engagement. The engagement letter is referred to if there is a breach of contract suit brought against the auditor. The engagement letter should cover the nature of the audit services to be performed, their timing, the expected fees and the basis on which they will be billed, the responsibilities of the auditor in searching for fraud, the client's responsibilities for preparing information for the audit, and the need for other services to be performed by the CPA firm. 4-15. Potential successor auditors are required to contact the predecessor auditor to gain information from the predecessor auditor that might have led to the dismissal of the predecessor auditor. The successor auditor must first obtain the clients permission to talk with the predecessor auditor because of confidentiality issues. The inquiries should include the disagreements with management as to accounting principles, auditing

procedures, or other similarly significant matters. The auditor should also make inquiries of company management and the audit committee regarding the reasons for changing auditors and whether there were any disputes regarding accounting principles. If the potential audit client is a public company, the previous auditor and management are required to file a report with the SEC detailing all the substantive reasons for the change. The filing must take place within 2 working days. If the potential audit client is not a public company, the major source of information is the predecessor auditor. 4-16. Audit Risk is the risk that the auditor may provide an unqualified opinion on financial statements that are materially misstated. The auditor sets their level of audit risk based on a number of factors. A detailed diagram of those factors is included in Exhibit 4.1. Business risk, engagement risk, and financial reporting risk are directly considered when setting audit risk. Once audit risk is set, the auditor will assess control risk, inherent risk, and then determine the level of detection risk, and therefore will, in turn, determine the nature and extent of audit procedures performed. The important thing to emphasize is that audit risk should be minimized and is determined by the auditor in response to the auditors assessment of engagement risk. 4-17. Audit risk and materiality are intertwined concepts. Audit risk is defined in materiality terms, i.e. it is the likelihood that the financial statements are materially misstated. The auditor must design and conduct the audit to gain assurance that all material misstatements will be detected. The lower the level of materiality, the more audit work must be done. In summary, materiality must first be set in order to implement the audit risk model. 4-18. The critical dimensions of materiality are (1) the dollar magnitude of the item, (2) the nature of the item under consideration, (3) the perspective of a particular user. These items can be based on either individual auditor judgment or can be quantified in tables or computer programs that can be used by auditors. The advantage of the more quantitative approach is that it (a) promotes consistency across audit engagements; (b) ensures that important items are addressed in the audit engagement; and (c) presents an initial basis from which an auditor can adjust the preliminary materiality assessment. The advantage of the individual auditor approach is that the auditor is in the best position to understand the uses of the financial statements, the major users, and pertinent other factors that may affect the overall presentation of the financials statements. For example, the auditor may be aware of debt covenants or other restrictions that may affect the assessment of materiality on specific accounts. There is no one correct approach. Clearly, there is need for individual auditor adjustment to any preliminary assessment of planning materiality. The SEC has been very adamant that materiality is not a 5% cut-off point, i.e. there are many items that are material that may be much less than 5% of net income.

4-19. An accounting estimate could not be materially misstated for two consecutive years, but because of the swing in the estimate, net income could be misstated because the total change in estimate from a best estimate could have a material effect on the financial statements. To illustrate, assume that the auditor has determined that $50,000 is material. In making an estimate of a liability account, lets assume that last year the auditor believed the estimate was too high by $45,000, but did not require an adjustment because it was less than materiality. In the current year, the auditor has concluded that the estimate of the same account is understated by $40,000 again an amount less than materiality. However, the swing in the estimates results in an $85,000 additional increment to the income statement this year an amount that is clearly material. Thus, the auditor has to examine swings in estimates in comparison with the auditors assessment of the best estimate. 4-20. The qualitative aspect of materiality recognizes that some items, because of their very nature, may be quite significant to users even if the dollar magnitude is less than most quantitative measures of materiality. As an example, a company may be developing a new line of business with very high expected growth. A decline in the rate of growth may be very significant to the stock market even if the dollar amounts are not material to the overall financial statements. Auditors understand this concept and will increasingly be called upon to implement it in the preparation of financial statement audits. 4-21. A literal interpretation of setting audit risk at 5% is that if a client's financial statements are materially misstated, the auditor, on average, would fail to detect the misstatement on approximately 5 of every 100 engagements. Obviously, an audit firm could not stay in business if it failed to detect 5 of every 100 material misstatements. To set audit risk at the 5% level, the auditor makes two assumptions. First, not every client's financial statements contain material misstatements. Thus, setting audit risk at 5% does not mean that 5 of 100 audited financial statements issued contain material errors. Second, and more important, the auditor often assumes that inherent risk is 100%, that is, there is a 100 percent probability that the financial statements would have a material misstatement if there were no internal control policies or procedures to prevent or detect and correct the misstatement. Because this is not likely, the auditor's actual level of risk is substantially less than 5%. 4-22. Inherent risk is the susceptibility of transactions to be recorded in error. More formally, it is defined as the susceptibility of an account balance to a material misstatement, assuming that there are no related internal control structure policies or procedures. Inherent risk is difficult to measure and assess. The auditor does know, however, that some transactions are inherently more risky or more susceptible to error in the recording process than are others. Normal sales transactions are less susceptible to error than a complex sale transaction negotiated at the end of the year with shipment to take place early in the next period. Because inherent risk is difficult to measure, auditors tend not to measure it and to assess it at 100% to compensate for setting audit risk at some high level such as 5%.

When choosing to assess inherent risk at less than 100%, the auditor must be aware that actual level of audit risk incurred on the audit engagement may increase unless the auditor also chooses to establish audit risk at less than 5%. The rationale is that the auditor uses 5% because he or she knows that inherent risk is less than 100%. However, if inherent risk is correctly assessed inherent risk at 25% and audit risk is left at 5% and an audit program is built on these parameters, the auditor will incur an actual audit risk of 5%. If, however, inherent risk is 25% and the auditor assesses it at 100%, then actual audit risk will be at 1.25%, significantly less than the nominal 5% level. Thus, auditors ought to be very careful about changing assessed levels of inherent risk without considering the effect on overall audit risk. 4-23. The four primary limitations of the audit risk model are Its difficulty to formally assess. Its subjective determination. Its treatment of each risk component as separate and independent when in fact the components are not independent The lack of precision of audit technology to assess accurately each component of the model. Auditing is based on testing, and precise estimates of the model's components are not possible.

The audit risk model is a conceptual guideline, not a quantitative guideline. An understanding of the risks will allow the auditor to develop an audit within the overall framework. The limitations, if understood, will minimize excess reliance on components of the audit risk model when such reliance is not justified. 4-24. The analysis of the audits of the Lincoln Federal Savings & Loan demonstrate the importance of fully understanding an audit clients business, including the economics of the company, economic trends affecting the client, and the risks inherent in the clients transactions. Had they understood the housing market in the Phoenix area, they could have better assessed the actual substance of the loan transactions. For example, although many of the transactions met the literal interpretation of a specific accounting standard, the substance of the transactions were such that Lincoln was making a loan to an undercapitalized business to purchase real estate from Lincoln Savings & Loan at inflated prices. The auditor could have learned about the nature of the real estate market by utilizing Internet software designed to gather information about businesses, knowledge management systems established by accounting firms, on-line searches, SEC filings, financial press, or broker analyses. It is important for an auditor to know such information about a savings and loan organization because (a) the real economics of a transaction, not the form of the transaction should drive the accounting treatments; (b) the knowledge alerts the auditor to situations where the company is engaging in uneconomic decisions and allows the auditor

to ask penetrating questions and to investigate problems; (c) the knowledge helps the auditor determine if there are violations of regulatory requirements that may affect the client; and (d) the knowledge puts the auditor in a better position to evaluate the collectability of loans as loans represent the major asset of the company. 4-25. When business is declining, the company is likely to see a decline in sales and a consequent build up in inventory, resulting in lower inventory turnover. Also, in a declining business environment, there will likely be downward pressure on the companys products, for example, many automobile companies have had to cut prices in order to move inventory. Further, it is possible that other competitors could still be introducing new products that would make some of the clients older inventory obsolete and a further decline in the value of the inventory. When auditing for those risks, the auditor would: Determine the decrease in inventory, usually by product line, Determine the rate of sales at current sales prices, Determine the decline in market prices for goods sold. Perform a detailed analysis of slowly moving products to determine if they are obsolete, or if they need to be adjusted downward to market value. 4-26. Both the SEC and the PCAOB emphasize that the auditor should utilize a risk-based approach to the conduct of an audit. The main point is that a risk-based approach should consider (a) the business risk affecting the company, and (b) the adequacy of internal controls over account balances in determining the extent of audit testing to perform. For example, if the market for the companys products is deteriorating because of the introduction of superior products by a competitor, then there is a high risk that some of the inventory will be obsolete. Another example is the sub-prime lending failure and the likelihood of an increase in failure rates. These factors signal a slow-down in the economy, as well as higher risks with receivables and loans. The auditor should focus on the valuation of the receivables and loans. The development of independent expectations about the clients performance allows the auditor to plan the audit more effectively and to identify areas needing more audit work. The risk analysis allows for a more efficient audit because the auditor will be able to concentrate on areas where there is a greater likelihood of misstatements. 4-27. The background information that will assist the auditor in determining the existence of a problem with inventory obsolescence or accounts receivable problems include: Comparison of client ratios with industry data. For example, the number of days' sales in receivables or inventory in comparison with industry norms may indicate a potential problem. Review of industry prospects for new products or new competitors. This information is found in industry trade journals and in current business

publications such as The Wall Street Journal, Business Week, Forbes, or Fortune, or through review of major information sources on the Internet. Company product reviews in consumer magazines such as Consumer Reports. Review of industry database or data analysis maintained by the public accounting firm. Many public accounting firms have industry specialists who keep tabs on an industry and prepare periodic analyses of the industry. Review of brokerage firm reports on the industry and on the client. Some brokerage houses develop specialized expertise on certain industries. For example, one may follow the paper industry in detail; another may focus on the retailing industry. Most of them will make their reports available.

In addition to these above sources, the auditor can perform a computerized data search utilizing such traditional services as NEXIS or newer Internet services such as Hoovers On Line to find information about the company or its products. Most audit firms will develop Intelligent Systems and related database systems to gather data about clients, company products, and industry trends. 4-28. The auditor can identify a number of important factors simply by touring a plant that will assist in planning and conducting the audit. These include: 4-29. Visualization of cost centers and the flow of goods into and out of the production process that should be helpful in identifying overhead allocations and in analyzing material variances. Observation of shipping and receiving procedures, inventory controls, potentially obsolete production, and possible operational inefficiencies. Client's use of equipment, as well as observation of idle equipment. New construction and use of new equipment. Extent of scrap and apparent controls over it. Potential obsolete inventory and the general procedures for handling inventory which is useful in making plans to observe inventory. Introduction to key management and production personnel who may need to be contacted later about inventory or cost control procedures. The condition of the companys facilities. The auditor can form a general impression about competitiveness and efficiency.

Ratio and industry trend analysis can be useful in pointing out significant trends in the industry or changes in individual account balances. Ratio analysis can indicate whether the client is lagging behind the industry in important aspects, such as credit collection or in amounts of inventory carried. Both types of analysis may point out areas that need to be given special audit attention. It forces the auditor to understand the bigger picture of the operation of the client, and helps put into context other audit findings.

4-30. Inventory turnover, number of days sales in inventory, and number of days sales in receivables would be very useful in this situation. For exact formulas, see exhibit 4.9. 4-31. Risk analysis affects the account balances as follows: allowance for loan losses: if the account is considered high risk, the auditor would want to gather more data than normal, both internal data and industry data. For example, if competitors in the industry were all seeing increasing loan losses, it is likely that the client would be as well. inventory: if the account was considered high risk, the auditor would probably want to take more physical counts than usual. They would also want to make a greater effort to check for obsolescence (maybe through physical inspections). sales commissions: if the account was considered high risk, the auditor would probably want to perform walk-through procedures to ensure that the proper amount of commission is taken on each type of sale. accounts receivable: if the account was considered high risk, the auditor would probably want to seek more confirmations of account balances, check more subsequent collections, review credit policies, and check the allowance account assumptions. Multiple Choice Questions: 4-32. 4-33. 4-34. 4-35. 4-36. 4-37. 4-38. 4-39. 4-40. 4-41. 4-42. c. d. d. d. c. b. c. a. e d. d

Discussion and Research Questions: 4-43. Business Risk Definition: Those risks that affect the operations and potential outcomes of organizational activities.

Importance to Audit: The auditor must understand the complexity of the business and its risks as a basis for determining (a) whether the auditor has sufficient knowledge to audit the client, (b) whether the auditor understands the approaches taken by management to manage risks, and (c) the measurement of the risks that affect the financial statements. Assessed or Controlled: Assessed Engagement Risk Definition: The risk auditors encounter by being associated with a particular client: loss of reputation, inability of the client to pay the auditor, or financial loss because management is not honest and inhibits the audit process. Importance to Audit: Many firms now have strict client acceptance and client retention procedures in place that are used yearly. If the decision is to maintain a relationship with the client, audit procedures should reflect the riskiness that was determined during the acceptance and retention stages. Assessed or Controlled: Assessed and controlled. The auditor can choose not to accept the client. Financial Reporting Risk Definition: Those risks that relate directly to the recording of transactions and the presentation of financial data in an organizations financial statements. Importance to Audit: The overall audit approach and the extent of the procedures performed are adjusted following the assessment of financial reporting risk. Assessed or Controlled: Assessed. Audit Risk Definition: The risk that the auditor may provide an unqualified opinion on financial statements that are materially misstated. Importance to Audit: The auditor sets their level of audit risk. The level that it is set at determines the amount and type of procedures to be performed. Assessed or Controlled: Controlled. Inherent Risk Definition: Risk that is higher in certain processes merely because of their nature. Importance to Audit: Processes that have a high inherent risk should require a greater focus of attention.

Assessed or Controlled: Assessed.

Control Risk Definition: The likelihood that a material misstatement could occur in a transaction or adjusting entry that will not be detected by the entitys internal controls. Importance to Audit: Control risk exhibits the need for internal control assessments in every audit engagement. The assessment of control risk will then determine the amount and type of audit procedures performed. Assessed or Controlled: Assessed. Detection Risk Definition: The risk that the auditor will not detect a material misstatement that exists in an account balance. Importance to Audit: The determination of detection risk directly determines the nature, amount, and timing of audit procedures to ensure that the audit achieves no more than the desired audit risk. Assessed or Controlled: Controlled. 4-44. a. A company with good risk management will have implemented procedures such that they are aware of their risks, including financial reporting risks, and have taken appropriate steps to mitigate those risks, or to control them at a level consistent with the organizations strategy and risk appetite. As it relates to specific account balances, a company that has good risk management will have a lower likelihood of encountering high levels of obsolete inventory, or high levels of uncollectible receivables. Risk management is more than financial reporting risk and the auditor would find that the company takes calculated risks in introducing new products or acquiring new companies. Typical risks in developing and introducing a new product are: Risk that R&D activities may not produce a viable product Risk that the new product might not meet government standards Risk that the new product might be a deviation from previous products, and thus deteriorate brand equity Risk that the new products sales will be less than expected Risk that new product could cause lawsuits or other liabilities Controls that would be applicable to address these risks might include: capital budgeting process that lays out the cost of development and expected return,

b.

a comprehensive ERM process that includes the development of a risk appetite and a portfolio of risks, i.e. the company will develop many different products at a time. a thorough quality review process to ensure that all new products meet the companys and the governments standards, a culture that the company will meet high consumer expectations. a comprehensive strategy for product development that considers a portfolio of products. quality testing to ensure that the product meets the companys quality expectations as well as user expectations. continuous market testing to determine consumer interest and needs. a research and development strategy that invests in quality personnel and research to bring out high quality products.

Possible effect on the organization if controls are not in place: economic effects, including significant losses due to product not meeting market expectations, quality expectations, or subjecting the company to lawsuits. long-term effects, if a company does not have a long-term strategy or does not have a process to develop high quality products, it may not be able to survive in the marketplace.

c.

There is a direct relationship between risks and controls. All controls are designed to mitigate or control specific risks. Thus, as auditors evaluate controls, it is always in the context of mitigating specific risks. In financial reporting, those risks related to misstated account balances.

4-45. There are a number of risks associated with the payment of a unionized factory worker. Some risks that should be addressed include: Payment made for hours not worked, Someone else punching the employees time card when the employee is not present. Payment made for incorrect amounts, Improper computation of fringe benefits and recording of the associated liabilities, Incorrect allocation of labor to the proper products, Paying a fictitious person.

Some of the controls that a company may consider include:

Supervisory review and sign-off of time worked for each employee in each area (either by the day or by the week), Required data capture of the specific jobs or products worked on (either on the time card, or required punch in at data stations in the factory), Authorized pay rates put into a computer table by the HR department and limited access to change the rates, Proper testing of all computer programs. Periodic review by payroll department and then by internal audit of the calculation of liabilities associated with payroll. separation of management of long-term assets, e.g. pensions, to meet employee obligations. independent internal audits of the payroll process. segregation of duties in payroll such that any complaints about pay rates or benefit administration could be directed to someone other than the person making out or approving the payroll checks or benefits payments.

4-46. a&b. The debate is a meaningful one. Eventually, every audit gets involved in direct testing of account balances to determine whether there is a material misstatement in the account balance or the financial statements as a whole. However, as the research pointed out in the chapter, the major audit failures of the last decade tended to occur because auditors had developed a habit of testing the accounts and looking for technical compliance with GAAP while not understanding the underlying economics of the company and its transactions. The auditor must not only analyze technical requirements, but is called upon increasingly to comment on the overall fairness of presentation at least to the audit committee. Finally, we need to emphasize that there are many areas of financial statement audits where simply technical auditing will not work. For example, the auditor needs to understand strategies, the economy, competition, and so forth to make estimates of inventory obsolescence, collectibility of receivables, or product warranty liabilities. Many audit firms have determined that auditor 2s analysis is the better analysis. Analytical review and a business risk analysis are not designed to replace old fashioned audit testing, but it brings a fuller perspective to the audit tests. It also allows the auditor to focus on accounts most likely to contain a material misstatement. In this way, both auditors approaches are complementary, not conflicting. Regarding Auditor 3, the essence of this chapter is that the auditor is more than an accountant. The auditor must understand a business and its risks in order to perform an efficient and effective audit.

Further, both the SEC and the PCAOB have been pushing the profession to perform risk-based audits in order to achieve greater efficiency in the audit while maintaining audit effectiveness. c. The SEC concerns are well-founded. It should be noted that the SECs concerns apply to the improper implementation of a risk-based approach to an audit; not to the applicability of a risk-based approach to auditing. Rather, the SEC has expressed concern that some firms (especially in the period of time leading up to the issuance of the Sarbanes-Oxley Act of 2002) that auditors were substituting pseudo-risk analysis for real risk analysis and real auditing. Whenever auditors fall into the trap of mindlessly following procedures and not analyzing the implications of their findings, they can fall into an audit approach that will likely miss material misstatements. Analytical review is not the only procedure performed, nor is analytical review only compared with previous company results. The full business risk approach will analyze company results and compare it to industry trends and current economic trends affecting the company. Thus, while the current results may be consistent with previous years, they might not be consistent with other economic trends or with competitor trends. The auditor needs to investigate both and reach a judgment about material misstatement. For example, if the company results were consistent with previous years, but there have been major changes in the economy such as a major interest rate change, a downturn in the economy, a slowdown in housing, new competitors, and so forth, it should heighten the auditors skepticism towards the correctness of the clients account balance. The key is that business risk analysis is much more than analytical review. d. The results should be unexpected, although most clients will regularly argue that due to their superior management, it should be expected that their revenue will increase faster than that of the industry as a whole. That may be the case. However, it is usually difficult for a company to have both (a) increased revenue above industry averages, and (b) an increase in gross margin. The exception to this generalization would be when Apple introduced the iPhone or the iPod. Thus, the auditor would need to explore potential explanations of the ratio changes, which might include: Introduction of a new product such as the iPhone that has great market acceptance, Fictitious sales, Overstatement of year-end inventory (causing a reduction in COGS) New production approaches and efficiencies Application of the risk-based approach to auditing would require the auditor to assess which of the above explanations seem most plausible. Then, the auditor will adjust the audit procedures to focus on the most plausible explanation, thus hopefully developing an efficient audit approach that focuses on the important risks.

4-47. a. Management integrity is defined as the general honesty of management and its motivation for truthfulness (or lack thereof) in financial reporting. It is a reflection of the extent to which management shows good business practice and to which the auditor believes that management's representations are likely to be honest. If the auditor questions management's integrity, the nature of the audit evidence to be gathered will be affected as follows: The auditor will not be able to rely on management's representations without significant corroboration. The audit evidence generated from internal documents must be evaluated with a great deal of skepticism. The auditor will seek more external audit evidence and corroboration from outside parties, including vendors and customers. The auditor must consider the possibility that management would be motivated to misstate the financial statements to accomplish personal objectives. Thus, the auditor should investigate any significant changes in account balances or ratios that may indicate management misstatement. b. Sources of evidence pertaining to management integrity might include Inquiry of members of the professional community in which the client operates, such as bankers and lawyers. Review of recent regulatory or court cases against the client, including recent SEC filings. Review of the financial press, or Internet Business or database providers, for articles about the company and its management. Inquiry of predecessor auditors as to management integrity, existence of disagreements on the audit, and management's motivation to manipulate accounting principles. Review of previous financial reports to uncover financial problems and the quality of financial reporting utilized. Use of private investigators to gather information on management's integrity if the situation merits. c. Analysis of Scenarios: a. This is a frequent business practice and is not considered to reflect negatively on management's integrity. Many members of management believe that it is their obligation to minimize their overall tax burden. The existence of related-party transactions, however, should alert the auditor to plan the audit to ensure that the economic substance of related-party transactions are discovered and described in the annual financial statements.

The auditor should also be alert to tax planning strategies that Congress and the general public consider over the edge because it is likely that such strategies will be challenged if not in court, then at least in the court of public opinion. Finally, the mere existence of related parties creates an opportunity to use transactions with the parties to inappropriately portray the real economics of the business. The auditor should plan a thorough investigation to ensure that all related party transactions are fairly disclosed. b. This is a common business trait and seems to be widely accepted. However, it is also an indication of a potential problem when a member of management is so domineering that he or she can intimidate other members of the organization to achieve their objectives, no matter how achieved. There have been many instances of major management fraud by intimidating managers. The auditor must be alert to the potential effect on the overall control structure of the organization. If employees are punished for not achieving a specific objective or are highly rewarded for achieving a specific objective, there may be motivation to accomplish the objective by manipulating the financial reporting process. c. As in the previous scenarios, this is not an uncommon trait. In the author's view, this is an unfortunate statement about the status of accounting principles in the United States. Two factors in this scenario should raise the auditor's skepticism: the manager (1) has a very short-term orientation and (2) has shown a tendency to change jobs after achieving the short-run objectives. The scenario is one of high risk and should raise the auditor's awareness of significant accounting manipulations resulting in the substance of the transaction not being reflected in the financial statements. The auditor should be critical of the accounting for estimates, the use of reserves, or other changes where subjective accounting judgments are made. d. This should be a good scenario for discussion. Ostensibly the manager is a pillar of the business community. However, two factors are unsettling: (1) the previous conviction on tax evasion and (2) the current manipulation among controlled corporations to avoid tax. Although this latter practice is common, the auditor must determine whether such manipulation does not violate the federal income tax provisions. However, most auditors would consider this to be a high risk situation. The auditor should determine if there are any issues still outstanding from the previous tax return and whether there are potential constraints on the presidents activities resulted from the tax conviction.

The auditor should have management list all controlled or partially controlled organizations and all related-party transactions during the period under audit. e. The scenario reflects poorly on management's integrity. The attitude is that it will do something only after being "caught." Such an attitude raises questions about management's openness with the auditor in disclosing transactions or questionable accounting. This situation raises some interesting questions for the auditor. First, there is a question about whether the auditor wishes to be associated with such a client. The engagement risk may be too high. Second, the auditor will probably have to expand the audit to determine whether any unrecorded liabilities are associated with environmental protection. The auditor must consider whether an audit can be performed within the planned audit time frame without substantial client cooperation. It is doubtful that such cooperation will be forthcoming. f. Charles obviously has charisma. Again, there may be nothing wrong, but there have been a number of situations in which management has exhibited an extravagant life-style that would be difficult to justify by the earnings of the company. The scenario should serve to heighten the auditor's skepticism. The situation would cause the auditor to carefully examine transactions with company management to ensure that they are all legitimate. In other words, if there is any impropriety, the nature of transactions with management becomes material - almost regardless of the dollar amount. Because the company has grown quickly, the auditor must be alert to pressures exerted by management to sustain such growth. That pressure could result in inflated transactions. d. GROUP DISCUSSION. The purpose of this question is to have students focus on the reality of practice that it is often difficult to distinguish between an individual that is a strategic genius versus one that also major ethical failings. Some of the characteristics that the group might identify are: Dominance by management over all activities, Pressure to meet economic goals, Focus on earnings per share and meeting analysts expectation, Pays lip service to risk management, Approves loans to lower levels of management, thus making them somewhat indebted to him or her, Surrounded by an ineffective board or audit committee, Cheats on expense accounts, Blurs the lines between corporate expenses and personal expenses, e.g. use of a corporate airplane, Strong focus on acquisitions that boost current profits, but little attention paid to integrating the operations.

4-48. The client is a continuing audit client; thus, the firm's audit file on the client and reports to the SEC or other users should serve as a major source of information to be used in planning the audit. The primary sources of information the audit should consult include these: 1. Prior year working papers, including the permanent file, to obtain information about Planning materiality. Audit adjustments and difficulties encountered during the audit, Audit budget and actual time on various parts of the audit. Matters of continuing audit importance, such as loan agreements and key personnel. Engagement letter and constraints affecting current years audit. Audit staff personnel assigned Industry accounting or auditing pronouncements as they may affect the client and any actions the client took in previous years to implement the pronouncements. Identification of risk factors. Previous reports. Partner and supervisory memos assessing important audit areas. Account assessments of continuing importance such as allowance accounts, warranty estimates, or loan loss reserves. Comments by the prior year auditors about changes they recommend for the current year audit. Reports to regulatory agencies or other special purpose reports: Identification of important reporting items. Current reporting requirements. Review of regulatory correspondence: Potential risks for client. Potential implications for current year reports. Review of business periodicals: Current business news about the client. Introduction of new products. Overview of current economic developments, competitor actions, and other competitive developments affecting the client. Review of industry databases: Comparison of company developments and financial results with industry averages and trends. Interview with top management:

2.

3.

4.

5.

6.

Operating plans such as new construction, new product developments, or major financial plans such as mergers, acquisitions, or new plant developments. Management's assessment of the company's prospects, risks and so on. The concerns management wishes to have addressed during the audit. 7. Review of internal audit reports: Problem areas identified during their audits. Actions taken by the auditees, management, and audit committees. Potential planning for cooperation with external auditor in performing the yearend audit. Competence and coverage of audit work. Review of audit committee meetings: Special concerns. Previous topics and disposition. Discussion with audit partner: Time budget and personnel assignment preferences. Preliminary assessment of risk factors. Timing for the audit. Due date and type of audit reports or other reports to be issued.

8.

9.

4-49. a. Other Information Integrity of Management Source of Other Information Inquiries of other business professionals. Inquiries of previous auditors. Interviews with management SEC filings. Private investigation. Inquiries of others in firms. Public databases. Interview with management Interview of the Board of Directors Interview with management and the board of directors. Review of annual reports to the public as well as SEC filings. Make inquiries of lawyers regarding knowledge of legal actions against the company.

Expectations of Management Company Strategy

Potential Legal Actions Taken Against Company

Other Information Extent of computerization of operations

Source of Other Information Interview with management Interviews with operating personnel Visit to operations. Interview with management Overall analysis of the industry Comparison of company with competitors Review of company in industry magazines, including company prospects Interview with management Visits to locations. Background information on the client by searching the Internet or other sources of information about the potential client.

Growth Expectations

Locations and general nature of operations.

Analysis of Business Risk

b.

Auditors often bid low on the audit fee because of the anticipation of greater consulting work with a potential client. The positive aspects of such behavior are: lower audit fee for the client. increased emphasis on audit efficiency. potentially lower cost for the client enabling them to pass on cost savings to consumers. The potential negative aspects of the behavior are: audit function becomes non-profitable, thus jeopardizing its ability to attract and retain the type of employees needed for the demanding work. too much emphasis is placed on obtaining other work; possibly at the risk of compromising on audit issues to retain the client. if the audit is not profitable, it may lead to (1) short-cuts in audit procedures resulting in a less effective audit; and (2) lack of investment in new technology to make the audit effective.

c. An intelligent agent could be programmed to search all meaningful databases and newspaper articles for information about the client or its management. The agent could bring relevant items to the auditors attention so that the firm could address potential problems in a timely fashion and to understand emerging risk areas. For example, the intelligent agent may bring information about a new competitive product that may cause obsolescence for some of the clients products. The auditor could then meet with management to determine what plans management has to deal with the potential valuation problem.

Other options of using the internet include: Review on-line chat about the company using such databases as finance.yahoo.com Review industry analysis on a company through a website such as Hoovers online. Perform a Google search on the company and its products. Perform a product review by search relevant industry trade magazines on the companys products. d. Bob would want an engagement letter to ensure that both he and the client understand both the clients and managements responsibilities and expectations regarding the audit. In addition, the engagement letter sets forth information such as the timing of the audit, expected client preparation for the audit, and the tentative fees for the audit.

4-50. Agreement or Disagreement with each of the statements: 1. Agree. Materiality can be applied both quantitatively and qualitatively. It is a concept that helps guide the auditor in determining the amount of evidence to be gathered and making judgments on the correctness of a companys financial statements. 2. Agree. Setting audit risk at a low level such as 5% is acceptable as long as the auditor uses conservatism elsewhere in the audit engagement. Setting audit risk at .05 implies that 5% of audits would end with an incorrect audit opinion. Such a failure rate would be unacceptable to the profession. As a compensation for audit risk in the model, many firms assume inherent risk is 1.0 (100%). This ensures that the audit risk is significantly below the nominal .05 level. 3. Agree. Inherent risk may be so low that the auditor may not need to perform direct tests of an account balance. However, the auditor should perform some indirect tests of the account balance, such as analytical review procedures, to determine if the account balances appear to be stated at amounts other than expected. If the amounts differ significantly from expectations, the auditor would need to perform additional direct tests. 4. Agree. The auditor must gather evidence that not only are controls appropriately designed, but also they are working as designed. 5. Agree. A Detection Risk of 50% implies that it is not a strong audit test and it should be used only as assistance in corroborating other audit evidence.

6. Agree. As engagement risk increases, audit risk should decrease in order to protect the auditor from potential litigation or other problems caused by being associated with the client. 7. Agree. Although the audit model looks like a very quantitative approach it is based on a significant amount of auditor judgments. 4-51. a. Materiality is defined as the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement. The three major dimensions of materiality are (1) the dollar magnitude of the item, (2) the nature of the item under consideration, (3) the perspective of a particular user. The three dimensions interact to determine whether a misstatement or omission would be material to important users of a company's financial statements. Examples of items at the end of the continuum for each dimension might be these: Dollar Magnitude: High: Something that is over 5% of net income or a 5% misstatement of an account balance. Low: A misstatement of $100,000 in some account or net income that represents a relatively minor percentage misstatement. Nature of Item under Consideration: High: A misstatement of an account that significantly changes a trend in earnings or reflects on the integrity of management. Low: A misstatement of an account that represents a misclassification between two noncurrent assets. Perspective of a Particular User: High: Management of an outside entity that is considering acquiring the company and is relying on audited financial statements as an important part of its decision. Low: A labor union that would not be particularly interested in a misstatement of an asset unless it reflects directly on the reported profitability of the company. c. Yes, the auditor's assessment of materiality can, and likely will, change during the course of the audit. As the auditor acquires additional information about the client and the likely audited net income, the auditor's assessment of any further undetected

b.

misstatement may change and the auditors assessment of materiality for the client may change as more qualitative factors are considered. An auditor's assessment of materiality that changes during the audit to a smaller amount implies that some of the work performed early in the audit may have been performed with larger planning materiality than the auditor now believes appropriate. Therefore, the auditor should review the previous audit work to determine whether the amount of work was sufficient to detect a material misstatement as defined by the revised assessment of materiality. If the auditor believes the work was not sufficient to detect a material misstatement, the auditor should consider performing additional audit work in the areas already performed to gather satisfaction that any (now-defined) material misstatement would be detected. 4-52. a. Dealing with the uncertainty of an account balance. Uncertainty is always a part of auditing. The auditor needs to reduce the uncertainty to an amount in which the auditor is comfortable in dealing with the client on the nature of a proposed adjustment. For accounts that are objectively determined, e.g. the gross amount of accounts receivable, the auditor can increase precision by doing more sampling and examining more audit evidence. On the other hand, there are other accounts such as the allowance for uncollectible accounts or a warranty liability where there is not a known correct answer. The auditor and the client may simply disagree on the estimates. However, the existence of uncertainty does not mean the auditor should simply defer to the clients estimate. The auditor should determine that the client has a good information system to identify the correct amount of the estimate. The auditor should be able to test the information system or independently develop an estimate of the account balance to be used in making judgments about the correctness of the account balance. The auditor should always work with a best estimate of the account balance, but must also consider the changes in estimates in relationship to the best estimate each year. The best estimate provides a basis for the auditor to assess the swings in account balances over years and to determine whether management may be manipulating reported earnings by using discretion in the individual account estimates. Thus, while the auditor may work with the clients estimate as being correct within a range in any given year, the auditor should always compare the clients estimates with the auditors best estimates over a 2 or more year period. b. The answer below assumes that the auditor only looks at the effect of this years misstatements on net income. Based on the differences between the booked income and the auditors best estimate, the current year income is misstated as follows:

Assets Liabilities Accounts Receivable (asset) 50,000 Over Prepaid Insurance (asset) 20,000 Over Prepaid Revenue (liability account) 150,000 Under

Income 50,000 Over 20,000 Over 150,000 Over

The net effect of these items is an overstatement of assets of $70,000, an understatement of liabilities by 150,000, and an overstatement of net income of $220,000. (The assumption is that if prepaid revenue is understated, the client has recognized the amount of the understatement as revenue during the period). The $220,000 is more than the $100,000 set as materiality by the auditor. The reported income is misstated by a material amount. It can be concluded that the financial statements are materially misstated for the year and the minimum correction, before considering the effect of previous years misstatement, is to adjust the accounts by at least $120,000. The preferred approach is to adjust all the accounts to the best estimate value. As an alternative, the auditor could suggest the client adjust the Prepaid Revenue to its best estimate and reduce the recorded revenue by $150,000 and increase the liability by that amount. c. In considering the minimum amount of adjustment needed this year, the auditor needs to also consider the effect of previous years misstatements that were not recorded. The effect of the two years misstatements are as follows: Current Year Income Effect After Considering Previous Year $30,000 Under $25,000 Over $240,000 Over $235,000 Over

Current Year Balance Sheet Accounts Receivable $50,000 Prepaid Insurance $20,000 (O) Prepaid Revenue $150,000 (U) Total Effect on Income

Last year Balance Sheet (O) $80,000 (O) $ 5,000(U) $90,000(O)

The net effect of not making any adjustments is that net income will be overstated this year by an amount that is material. There are some offsetting effects between the two years that raises the misstatement from the previous $220,000 to the new estimate of $235,000. More importantly, the balance sheet accounts continue to be misstated and there will be carry-over effects for the following year. In addition, the Prepaid Revenue account is misstated by a material amount. The minimum adjustment is one that decreases the amount of income misstatement and reduces Prepaid Revenue to an amount where it is misstated by less than materiality. In other words, the minimum adjustment is to reduce Prepaid Revenue by an amount greater than $135,000. However, the best approach is to adjust all the accounts to their best estimate so there are no carry-over effects for the next year. Generally management will want flexibility on these accounts because they are estimates. However, as can be seen, they can easily be manipulated to manage reported

income especially if the auditor does not evaluate all the swings in the account estimates each year. d. In looking at the problem, it should be clear that it is always best to make all adjustments. Further, even if the auditor believes that any adjustment within the range of reasonableness is acceptable, there is clear evidence that the Prepaid Revenue account should be adjusted from $1.8 million to at least $1.92 million, or a $112,000 adjustment. Similarly, the prepaid insurance should be adjusted to the $100,000. Accounts receivable can remain as recorded. The rationale for not booking immaterial adjustments typically includes the following: The amounts are not material, ergo they are not significant enough to affect any user and therefore there is no need to book any adjustments. It is costly and time consuming to book the adjustments. There may be legitimate differences of opinion, especially on account balances that require significant judgment, as to the correctness of the account balance. Thus, if the differences are minor and there is a good chance the client is correct, there should be no need to adjust the balances just because the auditor believes he or she has a better estimate in an area in which everyone admits there is considerable uncertainty. Unbooked estimates can be carried forward to the next year for further analysis. Everything evens out in the end.

e.

These arguments are pretty powerful, especially on the accounts in which a definable clear-cut answer is not apparent. However, as one former FASB member put it, if it is not material, why would management object to making the judgment? The fact that management objects to the adjustment tends to reiterate that the estimate is material. Further if adjustments are made each year, it takes away the possibility that management can manipulate reported income in any given year by using management discretion to adjust the swings in account balances requiring estimates. f. Estimates are indeed estimates. However, prepaid insurance is not an estimate. The amounts of prepaid revenue can be further tested because receipt of a payment from a client must either be classified as revenue or as prepaid revenue. The auditor should be able to use statistical sampling to increase the testing on prepaid revenue to even further refine the estimate. Note that the auditor already has a fairly tight estimate of prepaid revenue, i.e. a range from 1.92 to 1.98 indicating that the auditor has already performed a significant amount of testing and has a fairly tight estimate of the account balance. Thus, it can be argued that the auditor has tight estimates on both prepaid insurance and prepaid revenue and

there should be very little negotiation on the account balance. The accounts receivable balance is more difficult. Both management and the auditor should examine previous estimates and compare those estimates with realized collectibility to determine the best model for making the estimates. There is room to negotiate regarding accounts receivable, but not on the other two account balances. 4-53. a. Items that may be covered in the memo: Potential advantages: 1. 2. 3. 4. 5. 6. The company appears to be in a high growth area. New management appears to have a track record of success. There is great potential for additional profitable consulting business. There is opportunity for significant practice growth as the client grows. The company is exciting. The company may go public in the next 3 - 5 years. There may be opportunities for additional work, e.g. Initial Public Offering work which is generally quite profitable for our firm. 7. The new work would expand our expertise into new areas. Potential disadvantages: 1. 2. 3. There are significant valuation problems associated with the client, particularly the 43% of assets in the form of goodwill. Management has a reputation for slashing and burning, rather than building shareholder value through the underlying assets. The company has pushed legal limits in almost all phases of its business. There could be potential problems associated with governmental investigations. Such investigations could harm the reputation of our firm and may have a negative impact on our other business opportunities. The opportunities for other work may cause either (a) actual, or (b) perceived independence problems as company management might leverage our overall relationship with them to achieve favorable financial accounting presentations. The company has become very aggressive in its choice of accounting principles. That aggressiveness may cause our auditing opinion to be questioned. The casino business is high risk and company management does not appear to have any expertise in controlling such a business. Bringing the excitement of Las Vegas to the Internet may also be a (a) very costly; and (b) very risky endeavor for the client. Management will likely take the company public in the next 3 - 5 years thus increasing our potential exposure.

4.

5. 6. 7. 8.

9. There are control problems in the existing lines of business. 10. Our firm may not have industry expertise. b. Factors to consider in deciding how much to bid for the work include: 1. 2. 3. 4. 5. 6. Length of audit contract. Likelihood of additional consulting work. Experience of staff personnel needed on the audit engagement. Risk associated with public offering of stock in the 3 - 5 year range. Future growth prospects of the firm. Integrity of management and any experience others in the firm may have had with new management. 7. Extent that computerization could be used to gain audit efficiency. 8. Desire to be in this particular industry, i.e. the ability to develop industry specialization that could be expanded to potential other clients. 9. Likely reaction of other competing firms. 10. Perceived risk of being associated with the client. c. Other information that should be obtained before bidding on the audit include: 1. 2. 3. 4. 5. 6. 7. 4-54. Tour of Plant Observations: 1. The "antique" production line raises questions about product costing and overhead allocations. The two other lines are mostly automated, which may suggest that traditional approaches to allocating overhead based on direct labor hours may be inappropriate. The older production line may also result in problems with scrap. The auditor needs to determine whether the overhead allocation techniques are appropriate to the production methods. A number of potential risks are associated with this observation: The accounting for idle machines: Should the idle machines be written down to net realizable or disposal value? The idling of the second production line: Does this have implications for inventory reduction or the future production of a product? Does it indicate management's plans to replace or modernize the line? More information on management. Detail on government investigations. Accounting treatment for goodwill in the past. Nature of computer problems with the existing company. Financial information on both companies. Existing business relations, i.e. who are their bankers, investment bankers, etc. What is the perceived integrity of management? Existence of a strategic plan by management.

2.

If the company is operating below planned capacity, will the methods used for allocating overhead to products be sufficient to absorb current overhead? 3. Anytime the client is dealing with hazardous chemicals or similar products, there is a question about compliance with environmental regulations and potential liabilities associated with such disposal. The auditor must consider the need to gather information on the client's compliance with existing environmental regulations and potential legal implications for non-compliance. This represents a weakness in the client's overall control structure. A messy distribution center in which the employees "catch" up on items during non-peak times is prone to error. The auditor considers expanding audit tests to gain assurance that goods are shipped on time, are billed in the correct time period, are properly identified, and are billed at the correct price. This indicates potential obsolescence of the items as well as problems with inventory management that may reflect on other areas of inventory. It also represents an opportunity to make constructive recommendations to the client. The company should have formal procedures to inspect goods as they are received. The lack of such procedures could result in paying for goods that cannot be used, or alternatively, the company might be using goods that are defective subsequently causing the products to be returned for warranty. There is no indication of quality control or inspection (at least on a sampling basis) for goods that are contained in cartons, which could result in the company paying for goods not received or using goods that do not meet quality specifications. This does not necessarily represent a problem if the client has a contract for payment of goods that is clear and is based on goods actually utilized. The other impact is that the auditor has to develop a different approach to auditing the receipt of and payment for these goods. The lack of security signals a potential problem with inventory shrinkage. Because of the weaknesses in control procedures, the auditor should observe and test the taking of a physical inventory at year-end.

4.

5.

6.

7.

8.

9.

Note: All of these situations represent opportunities for the auditor to make constructive comments to the client on areas for which significant improvements in inventory control could be made most without significant cost. These comments might lead to opportunities for management advisory services but may also represent areas in which the auditor with control expertise might assist the client by pointing out controls that would improve inventory control and cut overall costs.

4-55. a. Advantages Identify significant divergences in trends, earnings components, asset and liability structure, and so on. Identify the effect of management policy decisions on the company in comparison with industry average (may be good or bad or simply may raise questions). Identify potential problem areas (e.g., why this company is so much different than the industry as a whole). What assumptions would be required to justify such differences?

Limitations The client may have operations that are significantly different (at least in some portion) than the industry as a whole. The client may have a different operating philosophy (e.g., financing or operating leverage, which may distort all important ratios and other comparisons). On the other hand, the potential downside of such policies may also be identified through comparison with industry data.

The client may use accounting principles that are different from those of other companies in the industry. For example, the client may use LIFO and many of the other companies may use FIFO. Such differences will cause company and industry data to lack comparability. b. Identification of risk areas for Jones Manufacturing: Potential Risk Indicator Inventory increase Risk Analysis There is a substantial increase in inventory, both in dollar terms and as a percentage of sales, which could indicate potential problems with new products, with obsolescence, or with competitiveness with other products. It may indicate an increase of inventory just before year-end in anticipation of rise in cost, a strike, or unusually heavy demand. Inventory may be overstated due to misstatements of quantities or prices. This could also affect the following change. COGS has decreased to 55 percent of sales at the same time inventory has increased. One explanation

Cost of goods sold decrease

is that COGS has not been booked for some significant sales. There may also be a change in product mix. In any event, audit attention should be directed to these areas. Accounts payable increase The A/P increase could reflect credit problems or other financing problems. Such problems could make it difficult for the company to carry out its ongoing activities. It may simply reflect the purchase of an unusual amount of inventory just before yearend. Inventory turnover has decreased by 33 percent. This points to and confirms the problems identified by the increase in inventory and decrease in cost of goods sold. Either there are substantial obsolescence problems, material items are not correctly recorded, or the inventory has been increased in anticipation of some unusual event early next year, such as a raw material shortage, strike, or unusual demand. This ratio has increased by 23 percent over the previous year and is 33 percent above the industry average. The increase in the ratio could represent a number of problems: o Less stringent credit standards. o Warranty problems (i.e., the customers may not be paying because of problems with the products.) This would be consistent with the interpretations associated with inventory turnover, o Unrecorded returned items or a significant lag in issuing credit memos associated with returned items. o Potential accounting recording problems. Employee turnover This is more difficult to interpret, but there is a 60 percent increase over previous years to a rate that is double that of the industry. This might indicate problems with morale, quality control, or other

Inventory turnover

Average number of days to collect

dissatisfaction with the manner in which the company is being run. Return on investments This ratio does not indicate a problem. In fact, the company exceeds the industry average. An alert auditor should wonder however, how the company is able to maintain a superior return when there are problems with inventory and receivables. This ratio has increased substantially and is double the industry average. The company has become highly leveraged. The increased leverage has three implications the auditor ought to address: o The existence of new debt covenants that ought to be addressed as part of the audit. o A potential problem of remaining a going concern should there be a downturn in operations or a significant increase in interest rates (on how the debt is structured). o There may be concern with how the debt proceeds have been utilized by the company. Does it represent additional capital, or is it being used for current operating purposes? The auditor should seek an answer to this question and consider the implications of the answer to the audit. One important use of analytical procedures is to point to potential problem areas that may affect the audit. The implication is that the auditor should consider specifically how the identified risk areas might reflect material misstatements in the financial statements. The risk areas identified above should lead the auditor to plan specific audit tests including, but not limited to, the following: Expanded tests of inventory, pricing, returns, warranties, and the accounting procedures for recognizing product returns. Expanded tests for potential inventory obsolescence include a detailed analysis of industry trends, competitor products, current sales level, and so on. An expanded scope of receivables testing to determine the validity and collectibility of receivables that are increasingly older.

Debt/Equity ratio

A heightened awareness of any factors that might indicate fraud or material misrepresentations on the part of management. The inconsistency reflected in some of the economic data may indicate that management is deliberately overstating inventory and understating cost of goods sold. There should be a specific analysis of going concern issues. The expanded debt, the employee turnover, and the inventory and receivable problems all point to significant operating issues. In comparison with most standard audits, there should be a greater emphasis on year-end testing and very little reliance on management representations. The risk of error should point to a very skeptical audit. 4-56. a. Conclusions regarding financial reporting risk: There is a significant trend toward a declining current and quick ratio which would indicate liquidity problems for the company, often relating to operating problems. Interest coverage has decreased significantly and is substantially below the industry average, indicating that the company is vulnerable to any downturn in operations or changes in interest rates. Although it may not immediately signal problems as to remaining a going concern, it could indicate that such problems could surface in the near future. There is a significant increase in the number of day's sales in receivables, which is one of the key danger signals for any company of this nature. The increase could reflect potential problems from product quality, less stringent credit policies, governmental concerns with the product, fictitious sales, or unrecorded product returns. Inventory turnover is steadily decreasing, reflecting a deterioration of the company's major product and the inability to introduce new products in the market. There may be realizability problems related to inventory as well as future operating problems. The number of day's sales in inventory has been steadily increasing. This is the same problem as the decreasing inventory turnover identified above. Some people find that this ratio better visualizes the problem. Indianola has steadily decreased its investment in R&D, to a current level that is less than 33 percent of the industry average. This signals potential long-run problems with the company, because unless successful research and development is the key to success in the pharmaceutical industry, the company

develops and successfully introduces new products, it has potential goingconcern problems. Cost of goods sold as a percentage of sales appears to be a positive development. On further analysis, however, there may be clouds in this silver lining as well: (1) the primary production of older products rather than the introduction of newer products and/or (2) accounting errors in recording inventory, sales, or receivables. The debt/equity ratio has increased significantly. There is less interest coverage. In addition, there may be concerns with debt covenants that may have been violated. The significant decrease in earnings per share hampers the company's ability to raise new capital. Also, the significant decrease that has taken place in the past three years may cause investors to question current management's ability. Potential suits may be brought against management if there are signs of mismanagement. The amount and extent of personal bonuses or potential misuse of corporate funds become important and heighten the auditor's awareness of potential abuses and lower the qualitative materiality for investigating corporate expenditures that reimburse or provide benefits to management. The sales/tangible asset ratio indicates that the company is not generating an industry normal volume for assets. This may indicate that there is substantial idle capacity or that new capacity has not yet gone on line. (The inference of new capacity is brought about by the increase in the debt/equity ratio.) There may be problems with interest capitalization or write-offs of excess capacity. The sales/total assets ratio is well below industry average. But more significant is the fact that it is markedly lower than the sales/tangible assets average. This would indicate that the company has substantial capitalized intangible assets. Given the declining profitability and operations of the company, there may be substantial valuation problems associated with these intangible assets. Sales growth has increased but less than the industry average. It is also evident that the increase has come with poorer credit. The preceding analysis points out a number of areas on which audit attention ought to be focused. The company is publicly traded and SEC reports are required. The dependence on one major product with a patent about to expire, decreased research and development, and decreased operating performance all point to potential realization problems. The audit work will likely be modified as follows: Audit risk will be set at a level below the industry norm, reflecting the increased engagement risk associated with the client.

Work on specific audit areas more likely to contain misstatements (e.g., receivables and inventory) will be expanded. There will be greater concentration on realizability problems, especially in the area of intangibles. The audit approach will exhibit a great deal of skepticism and will need to corroborate all important management representations.

b.

Other information that might be gathered as part of this audit engagement would include Analysis of industry product trends including the identification of competitor products and other new product developments (obtained from industry journals).

The status of client's drugs submitted for approval by the Food and Drug Administration, as well as the status of competitor products (obtained initially from company but verified by either reviewing FDA correspondence or confirming status with the FDA). Client plans for new products and use of new capacity (management). Management's budget, operating plans, and strategy for dealing with current problems (management) Correspondence with financial advisers regarding debt structuring, loan covenants, and so on (review of company files, confirmation with financial advisers if applicable).

c.

Actions that took place in the preceding year would likely have included A major issuance of debt reflected in the debt/equity ratio. The acquisition of another company or of other intangible assets reflected in the decrease in the sales/total assets ratio, which has decreased more than the sales/tangible assets ratio. This possibility is also evidenced by the 15 percent growth in sales over the previous year, an increase significantly higher than the previous best year growth of 4 percent. A major sales problem may exist with significant increases in number of day's sales in inventory increasing reflecting some panic thinking on the part of the company.

4-57. a. The audit firm was too casual in its process of accepting the new client, perhaps because it was a private company, perhaps because it was a well-known retailer in the state. Therefore, there were numerous deficiencies in the auditors approach to both accepting the client and planning the audit. Some of the deficiencies included: Lack of an engagement letter, Failure to communicate with the predecessor auditor, Failure to investigate the companys business practice and its current relationship with the SEC, Failure to identify the existence of related party transactions (these would have been somewhat apparent because of the race car promotions), Failure to talk with the board of directors and to understand their role in the audit, Lack of assessment regarding the competence and independence of the board and the audit committee. Failure to fully interview the CFO and CFO staff regarding approaches to accounting. The company should have investigated to determine if there is any public debt and therefore public reporting responsibilities, The nature of the audit procedures should not be dictated by management; it should be dictated by the auditor who has assessed various financial reporting risks.

There should not be a different standard in accepting private companies than would be used for accepting public companies, especially when the private company is large and has some responsibility to operate in the public interest. b. (1) The auditor has three choices: a). Resign from the audit engagement, b). Continue on the audit as planned, c) Revise the audit for the risk factors that the auditor knows about. The auditor should write an engagement letter that identifies the nature of the audit and the cost of the audit to respond to risk factors if the auditor decides to stay on the audit engagement. This might be the best choice because the auditor might be sued for a breach of contract if the auditor were to resign from the engagement as it is not necessarily the companys fault that the auditor firm did not do its due diligence. However, given the nature of the companys operations, many (including the authors) would recommend resigning from the audit engagement because of the risk and lack of transparency that took place in the client acceptance process. (2) The engagement letter is a critical piece of information that should have been included in this audit. The engagement letter would lay out expectations of management,

including those related to internal control and disclosure of related party-transactions, as well as the need to change audit fees if additional risks become known to the auditor. The engagement letter would clearly have helped the auditor because it would have been the client that had violated the terms of the engagement and it would make it much more difficult for the client to sue the auditor for breach of contract should the auditor resign. (3) The audit would be expanded in a number of ways: Increased search for related party transactions, Greater skepticism related to accounting estimates, and the need to establish a justifiable basis for accounting estimates, More complete analysis of internal controls with a specific audit plan linkage from deficiencies in controls to identification of additional audit procedures, Emphasis on gathering higher quality audit evidence, including evidence from outside sources. Better understanding the materiality threshold of significant outside parties, e.g. bankers or other lenders, Analyzing key performance data for anomalies either in relationship to prior years or in relationship to others in the industry. Surprise audits of stores inventories.

(4) The auditor has quoted a fixed-fee based on what was represented to the audit firm as the state of the company and its policies. It seems that there is a difference in reality and then what was portrayed to the auditor. Thus, it would seem reasonable that if the auditor stays on there will be a need to adjust fees. If the client does not agree, that would constitute a good rationale for resigning. c. Step 1. The ethical issue is whether or not to resign. Step 2. The affected parties are the audit firm (the right to have a client they can trust and that will not present undue audit risk) and company management (the right to receive audit services when promised). Step 3. Both parties have valid rights, although managements actions and decisions probably make the auditors rights more prominent. Step 4. One course of action is to resign; the other course of action is to stay with the client. Step 5. If the auditor resigns, there may be legal implications. However, since there is no engagement letter management may not have a strong case. If the auditor remains, they will clearly have to do a much more substantive audit and professional skepticism will have to be increased markedly. Step 6. Any of these consequences seems reasonable, and the decision about which consequence to accept will depend on the auditors risk tolerance. The greatest good for the greatest number is not particularly relevant in this scenario since there are just two well-defined parties to the situation. Step 7. The rights framework would imply that the auditors rights have been violated more than the other way around. Step 8. The answer will depend on students beliefs and opinions articulated in the preceding steps, and assumptions about the auditors tolerance for proactively dealing with a high risk client.

4-58. a. The accounting decisions that the company and the auditor must make are as follows: Goodwill. Is there an impairment of goodwill, and if so, how do we measure the amount of the impairment? What is the likely future operations of the companies acquired to which the goodwill is applicable? Plant Assets. How do we account for discontinued operations? Is the lay-offs permanent? Is there an impairment of the plant assets, and if so, how is the impairment measured? Sales. With sales being down, is there an effect on the level of inventory and the potential obsolescence of inventory? How do we measure the obsolescence of inventory, or the current market value of the inventory? Accounts Receivable. With customers paying more slowly, there is evidence that more of the receivables will be uncollectible. However, with the downturn in the economy, we must ask whether the procedures that were used to estimate uncollectible accounts in previous years (years of increasing sales and a good economy), are still applicable. How do we estimate the amount of uncollectible receivables? Return on Company Pension Plans. What kind of investments do we have for the pension plans? Do we expect a lower return over the life of the pension plan? If yes, how does that affect our plan assets and needed contributions to the plan? What is the appropriate value of the pension plan assets?

b. Property, Plant, and Equipment. The audit will focus on managements plans for closing plants and alternative uses of the plant assets buildings, land, and equipment. The auditor will need to determine the best in use value for the plants that have been closed, as well as those that are expected to be closed in the near future. The audit changes from testing depreciation to determining impaired value of the asset. Goodwill. The auditor needs to determine the lines of business to which the goodwill was associated. The auditor will need to look at: Current level of economic activity for that line of business, Future profitability of that line of business, Expected Cash flows from the business, Planned cash flows, Economic changes on that line of business as a whole.

The auditor then needs to compare expected cash flows and the newly projected cash flows in order to measure the impairment of the goodwill.

Receivables: Most of the audit emphasis will be on the valuation of the receivables. The auditor will focus on: Aging of receivables, Economic climate affecting the business, Financial health of major customers, Changes in interest rate in the economy, Future prospects for an upturn in the industry. Previous approaches to estimating the allowance for doubtful accounts.

The changed economic conditions dictates that the previous approaches to measuring uncollectable accounts will not work. The focus must be on developing a realistic estimate of the allowance for uncollectible accounts. Inventory: The downturn in the economy presents two major valuation problems for the auditor: Market value may be changing downward as companies struggle to sell existing inventory, Competitors may continue to introduce new products that will make some of the companys products obsolete.

The auditor will be looking at current sales data, current selling prices, inventory turnover, changing market conditions, and so forth in order to estimate the amount of inventory that should be written down. c. We must recognize that managements optimistic approach may very well be correct. However, the auditor must take a realistic look at economic trends and the impact on the company and the industry to deal with the asset valuations identified above. The lack of a current vibrant economy does not mean that the auditor should ignore that many of the assets may be impaired. Cases: 4-59. a. There are a number of potential hypotheses that may explain the changes in the financial data that has taken place. The task for the auditor is to determine which of the potential explanations either (a) best explains all the changes, or (b) best reflects the economic reality of the situation. In previous classroom situations, the students have offered the following potential hypotheses: 1. The company is more efficient because of its computerized processing.

2. The company has embarked on a program that has led to better customer relations, but it has come at the cost of deferred receivables. 3. The line of credit has led management to put on extra sales efforts during the last quarter of the year in order to keep from violating the debt covenant. 4. The rebilled invoices are either (a) fictitious, or (b) were real, but were not accompanied by the corresponding credit memos going to the same customers. 5. The company has more efficient warehousing techniques due to the new computerization. 6. A change in customer mix has allowed the company to raise its margins. b. The intent of this question is to get the students to analyze the hypotheses before being influenced by management. When the analysis is performed, the only hypotheses that explains all the ratios is no. 4 above (either fictitious sales or the failure to grant credit to offset the new invoices). The reason this is the best explanation is that it explains the following changes: Increase in November and December billings, Increase in Accounts Receivable, Increase in the Gross Margin Percentage both for the client and in comparison with the industry.

c. Based on the analysis in part b, the auditor should concentrate audit efforts on the possibility of either fictitious billings or the failure to issue credit memos. None of the other hypotheses explain all the changes. Further, it is nave to think that a competitor could improve the gross margin significantly higher than the industry in one year when it is selling to major customers who have considerable pricing power. The risks relate to fictitious sales or the failure to issue credit memos. Interestingly, the client had issued the rebilling invoices only on clients that management knew would not return accounts receivable confirmations. Some of the audit procedures the auditor should consider include: Match the total of credit memos issued to the total of rebilled invoices to determine that the totals are the same. Take a sample of credit memos and trace them into the original journal of entry, and further trace into the general ledger (these two procedures would have detected the fraud) Consider confirming individual line-items of accounts receivable with customers instead of total balance.

Perform a detailed review of subsequent payments. Telephone major customers to determine if they are aware of the rebilling agreements. Perform a count of inventory and reconcile with the General Ledger. Determine if some inventory is held on consignment. If it is held on consignment, make arrangements to observe the inventory. [Note: given the high risk of fraud associated with this account, observing the inventory is better than sending out a confirmation to the warehouse or customer holding the inventory.]

4-60. The purpose of this problem is to introduce the student to the process of using public information to identify risks associated with a company. The student should analyze publicly available information and consider setting up an intelligent agent such as a personalized Google page that sends all information about the company directly to the students desk top. 4-61. The authors have used this approach very successfully, although primarily at the graduate level. It can be scaled back at the undergraduate level to provide an opportunity for students to learn about the vast amounts of information available on companies. It also forces them to utilize that information to perform a risk analysis for the company. 4-62. a&b. A number of risk areas should be identified based on the reading of the case

A major change in the nature of the operations of the thrift industry opened the doors to new types of highly risky investments. It also allowed a greater concentration of investments into high-risk areas, expanded lending authorities beyond traditional boundaries, and allowed a new type of management to obtain control of many of the institutions. The industry was suffering financial hardships even before the legislation was enacted. It had a classic financing problem: long-term fixed assets and short-term variable liabilities. When interest rates soared during the latter part of the 70s, many of the S&Ls would have been considered bankrupt had they been forced to value their assets at current market value, but regulatory accounting procedures tended to hide the problem. There was a need to go beyond such accounting to understand the economic significance of the industry's problems.

Lincoln Federal was purchased by a real estate development entity, was run as a subsidiary of it, and was used to support the land developments of American Continental Corporation. It was no longer functioning as a separate, independent entity with the responsibility to make conservative investments to support family homes. Earnings from Lincoln could assist American Continental and its stock price. The compensation arrangements for many Keating relatives was clearly excessive considering (1) Lincoln's size, (2) the nature of their duties, and (3) thrift institutions of similar size. There seemed to be little support, or documentation, for the collateral (and the value of the collateral) for many of the new investments. The company was operating in a section of the country where the myth that "growth was forever" was perpetuated. This is not a criticism of the Southwest but of business mentality that operates on an assumption that above average growth levels can be sustained forever. Many of the investments, when subjected to financial analysis, simply did not hold up. Examples include the Phoenician and other major real estate developments in the Phoenix area. Employees were compensated on a commission basis for selling bonds. This is unusual practice for an S&L.

c.

The use of appraisals as evidence is a difficult audit question. When assessing the persuasiveness of appraisals as audit evidence, the auditor normally considers the following: The qualifications of the appraiser. For example, if a significant number of appraisals are from one appraiser, the auditor needs to know whether the appraiser is certified (certification process is similar to accounting certification.) The recentcy of the appraisals. The relationship of the appraisal firm to the client. Is there a specific relationship, or might there be a relationship so that the appraisal firm gets the company's business because the appraisals come out the way management wants them to come out? The economic assumptions behind the appraisals. The auditor may want to review these assumptions to determine (1) their correspondence with economic assumptions that seem to fit the region, and (2) their sensitivity to the appraised value. For example, if the appraisal assumes a 10 percent growth rate in

population for the next several years, but the auditor's best estimate is that the growth rate will be 5% at best, the auditor should perform a sensitivity analysis to determine the impact of such an assumption on the appraised value. The policy of the company in rotating appraisals for significant real estate over time.

Of course, the appraisal is only one aspect of the company's determination of the valuation of a loan receivable. The appraisal is important in the case of default. Thus, the auditor will not be evaluating every appraisal, but will want to (1) determine the client's procedures for obtaining independent appraisals before a loan is granted and then grant the loan if the appraisal indicates substantial collateral for the loan, and (2) perform a detailed review of appraisals on a sample basis for all loans outstanding, and on a judgment basis for all loans in default or likely to go in default. The first analysis is the key to company operations, that is, it determines that adequate collateral is obtained before issuing loans. It may be important, however, to point out to students that many loan officers in the past have been compensated on the amounts of loans made, not the quality of the loans. Loan officers were essentially compensated on a commission basis. It was in the loan officer's best interest to get appraisals that would help a proposed loan get approval from a loan policy committee.

FORD MOTOR COMPANY AND TOYOTA MOTOR CORPORATION: AUDIT RISK AND CLIENT BUSINESS RISK Part A. Risk Analysis
1a. Describe the primary risks facing Ford. Continued decline in market share. Continued or increased price competition resulting from industry overcapacity, currency fluctuations or other factors. An increase in or acceleration of market shift away from sales of trucks, sport utility vehicles, or other more profitable vehicles in the United States. A significant decline in industry sales, particularly in the United States or Europe, resulting from slowing economic growth, geo-political events or other factors. Lower-than-anticipated market acceptance of new or existing products. Continued or increased high prices for or reduced availability of fuel. Currency or commodity price fluctuations. Adverse effects from the bankruptcy or insolvency of, change in ownership or control of, or alliances entered into by a major competitor. Economic distress of suppliers that has in the past and may in the future require us to provide financial support or take other measures to ensure supplies of components or materials. Labor or other constraints on our ability to restructure our business. Work stoppages at Ford or supplier facilities or other interruptions of supplies. Single-source supply of components or materials. Substantial pension and postretirement health care and life insurance liabilities impairing our liquidity or financial condition. Inability to implement Memorandum of Understanding with UAW to fund and discharge retiree health care obligations because of failure to obtain court approval or otherwise. Worse-than-assumed economic and demographic experience for our postretirement benefit plans (e.g., discount rates, investment returns, and health care cost trends). The discovery of defects in vehicles resulting in delays in new model launches, recall campaigns and/or increased warranty costs. Increased safety, emissions (e.g., CO2), fuel economy, or other regulation resulting in higher costs, cash expenditures, and/or sales restrictions. Unusual or significant litigation or governmental investigations arising out of alleged defects in our products or otherwise. A change in our requirements for parts or materials where we have entered into long-term supply arrangements that commit us to purchase minimum or fixed quantities of certain parts or materials, or to pay a minimum amount to the seller ("take-or-pay" contracts). Adverse effects on our results from a decrease in or cessation of government incentives. Adverse effects on our operations resulting from certain geo-political or other events. Substantial negative Automotive operating-related cash flows for the near- to medium-term affecting our ability to meet our obligations, invest in our business or refinance our debt. Substantial levels of Automotive indebtedness adversely affecting our financial condition or preventing us from fulfilling our debt obligations (which may grow because we are able to incur substantially more debt, including additional secured debt).

Inability of Ford Credit to access debt or securitization markets around the world at competitive rates or in sufficient amounts due to additional credit rating downgrades, market volatility, market disruption or otherwise. Higher-than-expected credit losses. Lower-than-anticipated residual values or higher-than-expected return volumes for leased vehicles. Increased competition from banks or other financial institutions seeking to increase their share of financing Ford vehicles. Changes in interest rates. Collection and servicing problems related to finance receivables and net investment in operating leases. New or increased credit, consumer or data protection or other regulations resulting in higher costs and/or additional financing restrictions.

1b. Describe the primary risks facing Toyota. Industry and Business Risks: The worldwide automobile market is highly competitive. The worldwide automobile industry is highly volatile. Toyotas future success depends on its ability to offer innovative new, price competitive products that meet and satisfy customer demand on a timely basis. Toyotas ability to market and distribute effectively, and maintenance of its brand image, are integral parts of Toyotas successful sales. The worldwide financial services industry is highly competitive.

Political, Regulatory and Economic Risks: Toyotas operations are subject to currency and interest rate fluctuations. The automotive industry is subject to various governmental regulations and legal proceedings. Toyota may be adversely affected by political instabilities, fuel shortages or interruptions in transportation systems, natural calamities, wars, terrorism and labor strikes.

1c. Compare the risks of Ford and Toyota. The two companies report the same general types of risks (e.g., related to competition, industry volatility, product demand, etc.). However, Ford provides risk factor information in much greater detail than Toyota. The biggest substantive differences between the two involve Fords expressed concerns about the demand for their products (their declining market share), product warranties, cash flow concerns, and the resolution of issues involving retirement benefits for employees. 2a. What are related party transactions? Related party transactions are those in which one business, or the executives/owners of one business, conduct business with other businesses with the same executives/owners. 2b. Why do related party transactions pose a risk to audit firms? These transactions pose a risk to audit firms because the transactions do not occur at arms length, i.e., the terms of the transactions may not reflect pricing that is consistent with market based measures. To the

extent that these transactions are not normal, and to the extent that they are controlled by executive management, they can be used to manipulate financial results. Such financial manipulation poses a risk to audit firms. Because related party transactions can and do occur with regularity, auditors need to determine their extent, and conduct tests to understand whether and how the transactions affect the financial results. 2c. Read about the related parties at Ford and Toyota. Does one firm have more related-party transactions than the other? If so, what might be the rationale? Are there any situations that cause you particular concern? Toyota has no related party transactions, other than those conducted in the normal course of business. For Ford, most of the related party transactions described are conducted in the normal course of business, and therefore do not seem to present any unusual conflicts of interest. Of course, the auditors will need to be sure this is actually the case. The transactions that involve senior executives at Ford, particularly with individuals from the founding Ford family, seem to present the most concern. For example, it is unclear the extent to which Ford Motor Company truly benefits from its affiliation with the Detroit Lions. Further, it is unclear the extent to which Ford Motor Company truly benefits from the yearly consulting agreement with William Clay Ford. Shareholders may be concerned that this spending is unnecessary.

Part B. Analytical Analysis


1. Contrast the trends between Ford and Toyota in each of the following categories: 1a. Stock valuation Ford: P/E ratio down significantly; price to sales relatively steady; price to book rebounded after a fall in 2005; price to tangible book steady; price to cash flow steady. Toyota: P/E high and improving; price to sales up; price to book up; price to tangible book up; price to cash flow steady increasing. Comparison: The comparison paints a rather dismal picture for Fords stock position across all ratios. There must be tremendous pressure on Ford management to turn around the stock price. Likewise, there is probably tremendous pressure on Toyota management to maintain the strong stock numbers. Either situation provides an incentive for manipulation of the financial results by management. The 1b. Dividends Ford: dividend payouts have ceased. Toyota: dividend yield and the payout ratio have steadily improved. Comparison: The comparison again paints a dismal picture for Fords stock position, and indicates that cash flow is simply not available for disbursal to shareholders. 1c. Growth Ford: After a marked decline in 2006, sales growth was again positive in 2007; the decline in net income and EPS growth has reversed, with the net loss in 2007 smaller than that in 2006; after increasing in 2005, capital spending has slowed each of the past two years.

Toyota: sales growth much higher in 2007 after a slight dip in 2006; net income and EPS has grown significantly in the past three years; capital spending down significantly over the past three years. Comparison: Ford is clearly on a downsizing mode in which the company is trying to minimize capital spending and moderate the problems with sales and net income growth, while Toyota continues a positive trend in all regards. Of interest is Toyotas slowdown in capital spending. 1d. Financial strength Ford: quick ratio improving, current ratio improving, debt to equity ratios quite unfavorable given the very small values in shareholders equity; interest coverage declined markedly in 2006 but has rebounded to a marginally acceptable level in 2007; book value per share is down in 2007 compared to 2005, but is better than 2006. Toyota: quick and current ratios at very respectable levels, but both are down slightly over the 3 year period; debt to equity ratios steady and acceptable; interest coverage strong and steady, but with a decline in 2007; book value per share is high and improving. Comparison: Fords ratios are again much worse than Toyotas, with the most concern probably involving the levels of debt that Ford must handle. However, Fords liquidity situation is, while not good, at least manageable. In contrast, Toyota is having no troubles with liquidity or its ability to pay its debts in a timely manner. The book value per share for Toyota is much stronger than Fords. 1e. Profitability Ford: after a dip in 2006, margins are rebounding in 2007 after significant declines in 2006. Toyota: margins are steady and strong throughout the 3 year period. Comparison: Toyotas margins are very strong and steady, whereas Ford is clearly experiencing difficulty attaining and achieving sustained profitability. 1f. Management effectiveness Ford: all returns ratios are very low or negative, indicating very weak management effectiveness in terms of use of shareholders assets. Toyota: all returns ratios are high, steady, and improving, indicating very strong management effectiveness in terms of use of shareholders assets. Comparison: Again, the results of Ford are quite dismal compared to those of Toyota. 1g. Efficiency Ford: revenue per employee has increased over the three year period and has improved in 2007 after a dip in 2006; net income per employee has declined over the three year period and is negative in 2006 and 2007; receivable turns are slow and steady at about 1.5 times per year; inventory turns are steady at about 13 times per year; asset and PP&E turns are steady; percentage of PP&E depreciated is about 50-60%.

Toyota: revenue per employee has slightly increased over the three year period and is very comparable in size to Ford; net income per employee is fairly stable over the three year period and hovers around $45K per year; receivable turns are stable over the period at about 9.5 times per year; inventory turns are fairly steady although a bit declining over the period at about 11 times per year; asset and PP&E turns are steady; percentage of PP&E depreciated is about 60%. Comparison: revenue per employee is very similar between the two companies, but the profitability on that revenue is drastically different, with Toyota being much stronger in that regard. Toyota turns their receivables much faster than Ford, although inventory turns between the two companies are relatively similar. Both companies have PP&E that is similarly depreciated, indicating similarly aged plant assets. 2a. What account balances warrant the greatest concern/attention in terms of audit planning for Ford? What questions would you ask of Ford management regarding your concerns? The biggest issue facing Ford is financial viability, and that problem pervades virtually all their account balances. The audit firm should be concerned about the companys ability to remain a going concern and to meet its debt obligations. Regaining profitability is a major concern for Ford. Valuation of receivables is a concern given the low turns in that account compared to Toyota. PP&E is a concern in terms of valuation given the large size of that account in comparison to assets as a whole, and the capital intensive nature of the business. Regarding questions to ask of Ford, the most significant issue is how they plan to regain profitability. As we will see in a future chapter appendix, management had entered into a contract to sell a significant portion of its business and close a large number of North American production facilities. 2b. What account balances warrant the greatest concern/attention in terms of audit planning for Toyota? What questions would you ask of Toyota management regarding your concerns? PP&E is a valuation concern given its large relative size, and the slight slowdown in inventory turns (and the fact that it is below that of Ford) is a concern. Regarding questions to ask of Toyota, the audit firm should inquire about why inventory turns have slowed, and managements plans for improving that metric. 2c. Assume you performing preliminary audit planning and could specify any statistic that you wanted to review for inventory and receivables, e.g. number of days sales in inventory. Looking at only those two accounts, identify 3 5 key financial indicators that you would want to examine in developing an audit program for Ford and/orToyota. Be prepared to explain to your classmates why you identified the specific statistic you identified. You may assume that you are auditing in a period of either no or slow growth in the economy. This question is designed to encourage students to think about operating data and the importance of operating data for the audit. The following list is not necessarily all inclusive, but represents a start for a good class discussion: Receivables: % of receivables due from dealers vs. % due from consumers (finance receivables) Overall financial health of dealers. Aging of receivables (partitioned by type of receivables) Changes in interest rates in the economy (may affect valuation)

Changes in economic conditions, e.g. increases in bankruptcies, or poor financial health due to the subprime crisis. Changes in the composition of consumer receivables, e.g. amounts for car loans vs. mortgages, etc. Inventories: No. of Days Sales in Receivables No. of Days sales on hand Composition of inventory, e.g. trucks, SUVs, cars, economy cars, etc. Backorders from dealers Overall car sales in the industry and the companys share of car sales Quality of cars, e.g. the annual report from J. D. Power & Associates