Preliminary Auditing Planning: Understanding The Auditee's Business

CHAPTER 5
Preliminary Auditing Planning: Understanding the Auditees

Business
SOLUTIOS !OR RE"IE# CHEC$POITS
5-1 The three main steps are risk assessment, response to assessed risks, and concluding by
forming the audit opinion and issuing an appropriate audit report.
5-2 The ongoing activities that are required by C! throughout the engagement include"
Communications among audit team members throughout the process,
#ocumentation of the audit decisions and $ndings,
%evisions to risk assessments and planned responses if appropriate due to kno&ledge
obtained during audit process, and
Communications &ith those charged &ith the auditee's governance and its
management.
other valid activities may be noted
5-( )ublicly listed companies need to be audited according to the securities regulations that
apply to them. )rivate companies often don't need audits, depending on the *urisdiction,
because in some cases shareholders of smaller corporations can &aive a statutory audit
requirement. +n some cases, the company's stakeholders, such as ma*or shareholders or
lenders, may require an audit of the $nancial statements even if it could be &aived.
5-, -udit clients. are the people &ho engaged the auditor and pay his or her fees. The auditee
is the actual entity &hose $nancial statements are being audited. /ften in practice the
auditor is engaged by the those charged &ith governance 0usually the board of directors1 as
part of their responsibilities to the shareholders, in &hich case the 2client' and 2auditee' are
one in the same.
5-5 -Those charged &ith governance. of an entity are the people &ho are responsible for its
operations and accountable to its stakeholders.
5-3 n auditor can use the follo&ing sources of information to help decide &hether to accept a
ne& audit auditee.
4inancial information prepared by the prospective auditee"
nnual reports to shareholders
+nterim $nancial statements
!ecurities registration statements
%eports to regulatory agencies
+nquiries directed to the prospect5s business associates"
6anker
7egal counsel
8nder&riter
/ther persons, e.g., customers, suppliers
)redecessor auditor, if any, communication, re"
+ntegrity of management, #isagreements &ith management
!mieliauskas 9 6e&ley, Auditing: An International Approach, 3
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:dition )age 5-1
!olutions ;anual < 2=1(, ;c>ra&-?ill %yerson 7td. ll %ights %eserved
nalysis"
!pecial or unusual risk related to the prospect
@eed for special skills 0e.g., computer or industry eApertise1
+nternal search for relationships that &ould compromise independence
5-B uditee consent is required because the rules of professional conduct C code of ethics
applicable to the practice of public accounting 0as issued by various professional
accounting bodies1 prohibit the predecessor auditor from revealing con$dential information
to the successor &ithout the consent of the auditee. Con$dentiality remains even &hen the
auditor-auditee relationship ends.
5-D n auditor may decide to take on lo&, moderate, or even a high risk engagement, as long
as the auditor is con$dent that the risk can be managed do&n to an acceptable level
through careful performance of the audit &ork. This decision depends on the *udgment of
each auditor, &hich is based on their capacity to manage the risks, and their personal
tolerance for risk. uditor 's *udgment in this case is that the engagement is too risky, but
uditor 6's *udgment is that the risk can be reduced to an acceptable level by performing
the audit &ork.
5-E :ngagement letter bene$ts"
F
?elps establish an understanding bet&een auditee and auditor of the terms of the
engagement and the nature of the &ork.
F
?elps avoid quarrels and misunderstandings bet&een auditee and auditor. ?elps
avoid disputes over the audit fee.
F
?elps avoid legal liability assertions based on failure to do &ork that the ) may not
have contemplated or agreed to do.
5-1= time budget sho&s the diGerent audit team members assigned to the various segments
of the audit &ork, the time eApected to be needed to perform procedures for each segment,
and other information useful for planning such as &hether the &ork is to be done at a
interim date or at year end. The actual time spent on the assigned audit &ork is recorded
so that 011 there is a record for billing the auditee, 021 the eHciency of the audit team
members can be evaluated, and 0(1 there is a record for planning the neAt audit.
5-11 +nterim audit &ork refers to procedures performed several &eeks or months before the
balance sheet date. Iear-end audit &ork refers to procedures performed shortly before and
after the balance sheet date. udit $rms typically spread the &orkload out during the year
by scheduling interim audit &ork so they &ill have enough time and people available &hen
several audits have year-ends on the same date 0#ecember (1 is common1.
5-12 uditors must understand the"
6road economic environment in &hich the auditee operates
:Gects of national economic policies
>eographic location and its economy
#evelopments in taAation and regulatory areas
+ndustry characteristics that are important
!igni$cant +T applications in the company5s that produce accounting information
The business strategy, the business risks the strategy addresses, and the business
processes used to operate the business
The auditor's ob*ective in obtaining an understanding of the auditee's business, its
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:dition )age 5-2
environment and its risks is to design an eGective audit program that addresses all the
signi$cant risks of $nancial statement misstatements. udit standards require a discussion
among the engagement team about the susceptibility of the auditee's $nancial statements
to material misstatement. 6ased on this shared understanding, the audit team can identify
&hat can go &rong at the $nancial statement level, determine the signi$cance of the risks
and assess ho& likely it is that these risks occurred. The standards further require the
auditor to perform this risk assessment at the $nancial statement level by considering
classes of transactions, account balances and disclosures in the $nancial statements. The
auditor also assesses risks at the assertion levelJ assertions are discussed later in this
chapter. ccounting is supposed to reKect the economic substance of transactions and this
usually requires asking the right business questions of management. :Gective questioning
requires strong understanding of the auditee's business, its environment and risks.
5-1( The broad economic environment includes eAternal factors that can aGect the auditee's
success but over &hich it may have little control. These present risks that the auditee's
management needs to take into account in developing its strategy. These factors include"
international trade restrictions, duties and tariGsJ foreign eAchange rates, global commodity
prices 0&hich can be aGected by &eather or political unrest, or other unpredictable eAternal
events1J taAation and regulatory changes.
5-1, The broad economic factors &ill aGect diGerent industries diGerently. 4or eAample global
commodity prices aGect companies that supply or use each particular commodity. The
auditee's industry may be targeted by foreign governments for punitive -anti-dumping.
duties 0e.g. soft&ood lumber or steel1, or may be particularly vulnerable to lo& cost foreign
suppliers 0e.g. clothing or furniture1. :nergy shortages and price increases &ill aGect energy
intensive industries more signi$cantly than other industries. ;arket demand Kuctuations in
the auditee's market need to be considered by the auditor as they &ill aGect its $nancial
condition and performance. lso, speci$c taA regulations may aGect the auditee's industry.
5-15 The %+; eAample in the chapter highlights risks in high-tech companies related to
protecting intellectual property rights and eGective patent $ling and searching processes to
avoid infringement by others, and la&suits for infringement. >oing beyond the chapter
section, high tech businesses also face risk of obsolescence, competition, failure to
generate cash Ko&s from users of their technology, failure to set pricing to cover costs, etc.
+n the forestry industry, companies face risks of commodity price or currency Kuctuations
that are hard to plan for, and changes in eAport duties to countries they eAport to, and
competition &ith other countries that produce forest products &ith lo&er costs.. The
bitibi6o&ater case in the chapter illustrates an eAample of the risks in the forestry
industry.
5-13 The purpose of performing preliminary analytical procedures in the audit planning stage is
to direct attention to potential problem areas so the audit &ork can be planned to reduce
the risk of missing something important.
5-1B The auditor's understanding the business and risks is highly integrated &ith planning and
eAecuting the rest of the audit &ork. The auditor needs to understand the business in order
to recogniLe &hat analytical procedures are telling him or her. The fact that something is
diGerent from last year may or may not be something that needs to investigatedJ kno&ing
the business helps the auditor make that *udgment. The $nal set of audit procedures
eAecuted to complete the audit must take into account all the relevant kno&ledge that the
audit team gains during the audit engagement, including internal control and risks.
5-1D 4ive types of general analytical revie& procedures"
1. Compare $nancial information &ith prior period0s1.
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:dition )age 5-(
2. Compare $nancial information &ith budgets or forecasts.
(. !tudy predictable $nancial information patterns based on the entity5s eAperience.
,. Compare $nancial information to industry statistics.
5. !tudy $nancial information relationships to non$nancial information.
5.1E /Hcial documents and authoriLations that can be read as part of a preliminary analytical
revie&"
Corporate charter
Corporate byla&s
rticles of partnership
#irectors5 minutes
:Aecutive committee minutes
udit committee minutes
4inance committee minutes
@e& contracts and leases
5-2= /Hcers5 Compensation
uthoriLation of oHcers5 salaries.
uthoriLation of stock options and other MperkM compensation.
6usiness /perations
mount of dividends declared.
cceptance of contracts, agreements, la&suit settlements.
pproval of ma*or purchases of property and investments.
#iscussions of merger and divestiture progress.
Corporate 4inance
mount of dividends declared.
#iscussions of merger and divestiture progress.
uthoriLation of $nancing by stock issues, long-term debt, and leases.
pproval to pledge assets as security for debts.
#iscussion of negotiations on bank loans and payment &aivers.
ccounting )olicies and Control
pproval of accounting policies and accounting for estimates and unusual
transactions.
uthoriLations of individuals to sign bank cheques.
5-21 The auditor's understanding of the business risks is important in identifying &hat kinds of
changes and relations are eApected based on ho& the business performed during the
audited period and &hat kinds might indicate the $nancial information is misstated.
6usiness risk is the auditee risk that the entity &ill be unable to achieve its business
ob*ectives or eAecute its strategies. 8nderstanding management's risk assessment process
helps to assess the risk that the $nancial statements could be materially misstated.
uditing standards 0e.g., ?andbook C! (151 emphasiLe the auditor's need to understand
business risk and the Mentity5s risk assessment process. in order to plan and eAecute
appropriate audit procedures. This is referred to in the teAt as the business risk approach to
planning and eAecuting the audit. The auditor may identify risks of material misstatement
that management's risk assessment process failed to identify and if the auditor believes
there is a material &eakness in the entity5s risk assessment process, the auditor needs to
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:dition )age 5-,
communicate this to the audit committee or equivalent. >enerally, the business risk
approach requires the auditor to take a broader vie& of the &hole organiLation and assess
the risks of material misstatements that arise from a variety of aspects of the business.
5-22 They are the $nancial statements management has prepared for the current year that &ill
be, but have not yet been, audited. They are the starting point for the audit planning.
5-2( The steps auditors can use to apply comparison and ratio analysis to unaudited $nancial
statements are" 011 obtain or prepare comparative common-siLe $nancial statements and
calculate ratios, 021 study the data and describe the company5s $nancial activities, 0(1 ask
relevant questions about questionable relationships, and 0,1 obtain or prepare a cash Ko&
statement to begin the analysis of the going-concern status of the company.
5-2, Nertical analysis refers to $nancial statement amounts eApressed each year as proportions
of a base, such as sales for the income statement accounts and total assets for the balance
sheet accounts. These 2common-siLe' statements sho& ho& the various components
related to each other - this analysis provides a starting point for further evaluation and
enquiry by the auditor. They can be further analyLed horiLontally, to see ho& the relations
have changed over time.
5-25 ?oriLontal analysis refers to changes of $nancial statement numbers and ratios across t&o
or more years. This basic analytical data can indicate unusual or uneApected Kuctuations
that suggest further evaluation and enquiry that the auditor should perform.
5-23 The ratios in ppendiA 5- are" current ratio, days5 sales in receivables, doubtful accounts
ratio, days5 sales in inventory, receivables turnover, inventory turnover, cost of goods sold
ratio, return on equity, and ltman5s $nancial distress ratios and discriminant score.
!tudents may be able to name other relevant ratios.
5-2B #ecrease in accounts receivable turnover ratio can indicate slo& collections, that may
indicate more uncollectible accounts should be provided for in the allo&ance for bad debts,
i.e. net C% balance is overstated. +t can also indicate the C% balance is overstated because
it has been manipulated fraudulently.
5-2D +ncrease in number of day's sales in inventory can indicate slo& moving inventory that is
more likely to be obsolete or other&ise hard to sell, that may indicate a bigger provision
should be made for inventory obsolescence, i.e. net inventory balance is overstated. +t can
also indicate the inventory balance is overstated because it has been manipulated
fraudulently.
5-2E The prior year retained earnings 0OE==,===1 plus current year income 0O(B=,===1 does not
add up to the current year ending retained earnings 0O1,23=,===1. %etained earnings has
been reduced by O1=,===, probably dividends declared and paid. The balance sheet does
not sho& dividends payable, and no other information is given.
5-(= @et cash Ko& is negative O,==,===
@et cash Ko& P @et income QC- changes in &orking capital and non-cash items, QC-
$nancing and investing cash Ko&s P change in cash balance
(B=,===-(E====-1=====-1=====-2====Q(=====QB5====-2=====-1====-1======P-
,=====
5-(1 nalysis directs attention to areas that look unusual, &here misstatements may have
occurred. This indicates questions auditors should raise &ith management. ;anagement
may provide valid business reasons for the Kuctuations, but the analysis alone does not
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:dition )age 5-5
con$rm or refute these eAplanations. ;ore tangible evidence is required to form a
conclusion about &hether a particular $nancial statement amount is fairly stated or not.
5-(2 ;ateriality is one of the $rst important *udgments the auditor must make since it aGects
every other planning, eAamination and reporting decision.
5-(( M;aterial informationM in accounting and auditing is information that should be disclosed if
it is likely to inKuence the economic decisions of $nancial statement users.
M/verall materialityM in an audit conteAt is the largest amount of uncorrected dollar
misstatement that could eAist in published $nancial statements, yet they &ould still fairly
present the company5s $nancial position and results of operations in conformity &ith >).
5-(, !ome amount of inaccuracy al&ays eAists in $nancial statements because inaccuracies do
not aGect users' decisions and hence are not material, the cost of $nding and correcting
small errors is too great, and the time taken to $nd them &ould delay issuance of $nancial
statements. lso, accounting numbers involve estimates and predictions about future
events that may not turn out as eApected.
5-(5 The audit of an estimate involves the auditors producing their o&n estimate and comparing
it to management's estimate. /ften a range for an estimated amount is generated. 4or
eAample, management may estimate an allo&ance for doubtful accounts to be O5=,===,
and the auditors may estimate that the allo&ance could be O,=,=== to O55,===. +n this case
management's estimate is &ithin the auditors' range of reasonableness. ?o&ever, the
auditors should take note that the management estimate leans to&ard the conservative
side 0more than the auditors' O,=,=== lo&er estimate, but not much less than the auditors'
higher O55,=== estimate1. +f other estimates eAhibit the same conservatism, and the eGect
is material, the auditors &ill need to evaluate the overall reasonableness of the eGect of all
estimates taken together.
+f the auditors develop an estimate that diGers 0e.g., a range of O55,=== to OB=,=== for the
allo&ance that management estimated at O5=,===1, the preferred treatment is to consider
the diGerence bet&een management's estimate and the closest end of the auditors' range
as an error 0in this case, error P O5,=== P auditors' O55,=== minus management's
O5=,===1. The remaining diGerence to the farthest end of the range 0O15,=== P OB=,=== R
O55,===1 is noted and reconsidered in combination &ith the $ndings on all management's
estimates.
5-(3 The best ob*ective evidence of the reasonableness of an estimate 0for eAample, the
allo&ance for doubtful accounts receivable1 is the actual events that occur later 0for
eAample, the &rite-oG of accounts that eAisted at the time the allo&ance &as estimated1.
The comparison of estimates &ith subsequent actual eAperience can often be used as a
hindsight test of the ob*ective reasonableness of accounting estimates. ?o&ever, some
estimates 0for eAample, pension eApense1 may have such long time horiLons that actual
eAperience may not be available before ne& estimates must be made.
5-(B /verall ;ateriality is set for the $nancial statements as a &holeJ it applies to the largest
amount of misstatement that in the auditors vie& &ould not aGect user decisions. /verall
)erformance ;ateriality is an amount less than the overall materiality levelJ it allo&s a
cushion since there are likely misstatements that the auditors procedures &on't detect,
even in a competent audit. The cushion is to lo&er the risk of giving a clean opinion on
$nancial statements that are materially misstated.
5-(D +f the auditor decides the materiality should be revised to a smaller amount, the auditor &ill
probably have to eAtend any testing that &as done based on the larger materiality level. s
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:dition )age 5-3
the audit materiality level gets smaller, the auditor must do more &ork to $nd any material
misstatements. +f materiality is lo&ered after test eAtents have been determined and
procedures conducted, the auditor &ould need to consider &hether these eAtents are
adequate &ith a lo&er materiality level. +f not, it may be necessary to increase the eAtent of
testing. +f some accounts had been sub*ect to minimal audit &ork because they &ere much
less material, this also &ould need to be reconsidered based on the ne& lo&er materiality.
lso, any 2trivial' misstatements discovered &ould also need to be reconsidered, as &ell as
the overall decision on &hat level of misstatements &ill be treated as 2trivial' since this may
be lo&er if materiality is lo&er.
5-(E Sualitative aspects of materiality are important because even quantitatively small
misstatements resulting from intentional misstatement, intentional violation of the la&, or
intentional earnings manipulation must be considered material because of their potential
impact on users. Sualitative criteria allo& the auditor to stand back to take a broad
perspective and consider other factors that may be informative about the consequences of
the materiality level used. The qualitative aspects of materiality are equally important as
comparison to an arbitrary $Aed dollar amount that may be chosen to some eAtent on the
basis of an auditor's costCbene$t decision 0i.e., a business decision of the auditor or audit
$rm1.
5-,= uditing standards do not require auditors to use any speci$c quantitative benchmarks for
setting materiality levels.
5-,1 ny fraud committed against eAternal stakeholders for the company's bene$t is material no
matter ho& small. ?o&ever, in frauds against the company materiality is determined by the
usual qualitative and quantitative guidelines discussed in the chapter. +n the case of
controls in place to prevent fraud, if the risk of a theft or misstatement is more than remote,
then this is considered a 2material' internal control de$ciency must be reported to the audit
committee or 6oard.
5-,2 8sing one /verall ;ateriality level is the simplest approach, in comparison to various
methods that might be used to allocate the amount to diGerent accounts 0i.e., 2!peci$c
;ateriality' levels1. This approach also results in the least testing and is the approach
implied by the ?andbook audit guidance.
5-,( 4ive principal assertions in $nancial statements"
1. :Aistence assertion"
The practical ob*ective is to establish &ith evidence that assets, liabilities and equities
actually eAist and that sales and eApense transactions actually occurred. Cut-oG can
be considered an aspect of the eAistence assertion 0:Aistence in a speci$ed time
period1. C! (15 uses the term occurrence &hen eAistence is applied to transactions.
2. Completeness assertion"
The practical ob*ective is to establish &ith evidence that all transactions of the period
are in the $nancial statements and all transactions that properly belong in the
preceding or follo&ing accounting periods are eAcluded. nother term for these
aspects of completeness is cut-oG.
Completeness also refers to proper inclusion in $nancial statements of all assets,
liabilities, revenue, eApense and related disclosures.
(. /&nership 0or %ights and /bligations1 assertion"
The practical ob*ectives related to rights and obligations are to establish &ith
evidence that assets are o&ned 0or rights such as capitaliLed leases are sho&n1 and
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:dition )age 5-B
liabilities are o&ed.
,. Naluation 0or llocation, ;easurement1 assertion"
The practical ob*ective is to establish &ith evidence that proper values have been
assigned to things 0assets, liabilities, equities and related disclosures1 and events
0revenues, eApenses and related disclosures1. 2llocation' refers to the practical
ob*ective of obtaining evidence about MvaluationsM achieved by cost allocations such
as depreciation and inventory costing methods. 2;easurement' is the term used to
refer to application of an appropriate generally accepted method to determine the
dollar amount to include in a $nancial statement, as in C+C s.1=== or other
conceptual accounting frame&orks.
5- )resentation and #isclosure assertion"
The practical ob*ective is to establish &ith evidence that accounting principles used
by management are appropriate in the circumstances and are applied properly, and
that disclosures contain all information required by generally accepted accounting
principles.
5-,, ssertions are the focal points for all audit procedures because they are the fundamental
management claims that are being audited. udit procedures produce evidence that
relates to one or more speci$c assertions. s &ill be eAplained in detail later in Chapter D,
auditors use -audit ob*ectives. that are derived from the $ve principal assertions to design
speci$c evidence gathering procedures.
5-,5 uditing completeness involves getting evidence about &hat is not there. uditors have to
depend on management's representations to some eAtent, and corroborate these &ith
evidence from a variety of sources, including internal controls. There is rarely a 2slam dunk'
type of procedure that provides strong conclusive evidence that everything that should
have been included has been included.
5-,3 uditors should think about a Mcompliance assertionM even though it is not eAplicitly listed
in the auditing standards because auditors have responsibilities regarding these
compliance-type events" 011 company employees observing the company5s internal control
policies and procedures 0see Chapter E1, 021 irregularities and illegal acts 0see Chapter B1,
and 0(1 compliance &ith la&s and regulations in government-standard audits 0see Chapter
211.
The practical ob*ective of the compliance assertion, though not listed in the C+C
?andbook, can be stated as" to establish &ith evidence that the entity has complied &ith
applicable public la&s and regulations and &ith the terms of private contracts and
agreements. The compliance assertions are particularly important &hen auditing
governmental agencies 0most uditor >eneral audits as &ell as ones done by )s1. +nternal
audits eAtend the concept to compliance &ith managerial policies.
5-,B +f you are given a list of audit procedures 0this is called an audit 2program'1 and are using
them to plan this year's audit, you need to consider" -That are the assertions management
is making by reporting this $nancial informationU. Thich assertion0s1 does this procedure
produce evidence aboutU. -#oes the list of procedures 0the audit program1 cover all the
assertionsU. /ne aspect that may be missing in many standard audit programs is to
consider the compliance assertion, as discussed in the chapter.
5-,D The overall audit strategy is outlined in C! (==. The components suggested in the standard
include documents information about 011 investigation or revie& of the prospective or
continuing engagement and client relationshipJ 021 staG, technical, or industry eApertise
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:dition )age 5-D
requiredJ 0(1 preliminary materiality levelsJ 0,1 assessment of signi$cant industry or
company risks and related audit issuesJ 051 identi$cation of unusual accounting principlesJ
031 use of substantive or combined audit approachJ 0B1 nature and eAtent of resources
requiredJ 0D1 staG assignment and scheduling of team communications and $eld &orkJ and
0E1 special considerations for initial or group audit engagements.
5-,E The overall audit strategy guides development of the detailed audit plan, &hich contains
the audit program details. The audit programs include speci$c audit ob*ectives and
procedures for determining inherent and control risk, obtaining the suHcient competent
evidence that is the basis for the audit report, and producing the required documentation.
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:dition )age 5-E
SOLUTIOS !OR E%ERCISES A& PROBLE'S
:)5-1 nalytical %evie& %atio %elationships
a. The current ratio &as made larger than it should have been. The current asset
numerator &as made larger 0$ctitious accounts receivable larger than the inventory
removed1 &hile the current liability denominator did not change. 0?o&ever, if the
income taA eGect of the error is included,
the current liabilities change by a greater proportion that the current assets change,
and it turns out that the current ratio &as made smallerV1
b. +n this case the relative rate of change is important, because both the numerator and
denominator of the current ratio are changed by the same amount.
1. Current ratio 0before1 &as greater than 1"1--the incorrect accounting makes the
ratio larger than it should be.
:Aample" 6efore O1==,=== C O2=,=== P 5.="1
fter O E=,=== C O1=,=== P E.="1
2. Current ratio 0before1 &as equal to 1"1--the incorrect accounting does not
change the ratio.
:Aample" 6efore O1==,=== C O1==,=== P 1"1
fter O E=,=== C O E=,=== P 1"1
(. Current ratio 0before1 &as less than 1"1--the incorrect accounting makes the
ratio smaller than it should be.
:Aample" 6efore O 2=,=== C O1==,=== P =.2"1
fter O 1=,=== C O E=,=== P =.11"1
c. :Gect of unrecorded purchase counted in physical inventory, assuming the accounts
are ad*usted to include the inventory on hand.
+nventory is not misstated.
Cost of goods sold is understated.
>ross pro$t is overstated.
@et income is overstated.
The question asks for the eGect on the ratios compared to &hat they &ould have been
&ithout the error.
Current ratio"
>reater than 1"1 before. The error of recording the inventory and not
the current payable makes the ratio larger.
:qual to 1"1 before. The error makes the ratio larger.
7ess than 1"1 before. The error makes the ratio larger.
>ross margin ratio" The error makes it larger.
Cost of goods sold ratio" The error makes it smaller.
%eceivables turnover" The error does not aGect either the sales numerator or the
receivables denominator, so the ratio is not aGected.
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:dition )age 5-1=
d. +n this case the net receivables amount is correct. The proper ad*ustment should be to
reduce gross receivables and the allo&ance for doubtful accounts by an equal
amount.
Current ratio" @ot aGected because the current asset and current liability totals
are not aGected.
#ay5s sales in receivables" @ot aGected &hen the net receivables is used to
calculate the ratio.
#oubtful account ratio" The improper accounting causes the ratio to be larger
than it should be. 0)roper accounting &ould cause the
allo&ance numerator to be reduced to a greater eAtent,
by a faster rate, than the receivables denominator.1
%eceivables turnover" @ot aGected &hen the net receivables is used to calculate
the ratio.
%eturn on beginning equity" @ot aGected because the income is measured
properly &ith adequate allo&ance for doubtful
accounts.
Torking capitalCTotal assets" @ot aGected because both terms are measured
properly.
e. The eGect on the ltman 01E3D1 discriminate W score is a larger score because of the
directional eGect of all the changes mentioned"
Torking capitalCTotal assets" The ratio is larger because TC is greater and T
is smaller.
%etained earningsCTotal assets" The ratio is larger because retained earnings
remained the same &hile T is smaller.
:arnings 6+TCTotal assets" The ratio is larger, because :6+T is about the same
as last year, and T is smaller.
;arket equityCTotal debt" The ratio is larger because market equity is the
same, &hile total debt is lo&er.
@et salesCTotal assets" The ratio is larger because net sales have decreased less 05X1 than
the total assets have decreased 01=X1.
:)5-2 8nderstand the 6usiness--Transactions and ccounts
ccounting systems may diGer, so the solution belo& accommodates most possibilities.
Yformatting request from revie&er" can this be converted to a table format &ith grid linesUZ
#ebits Credits
Cash receipts Cash !ales revenue
ccounts receivable
+nvestment income
Cash disbursements ccounts payable Cash
th
:dition )age 5-11
+nventory
4iAed assets
7ong term debt
:Apenses
Credit sales ccounts receivable !ales revenue
!ales returns and allo&ances !ales revenue ccounts receivable
0contra return account1 Cash 0cash refunds1
)urchases on credit +nventory ccounts payable
4iAed assets
:Apenses
)urchase returns Cash 0cash refund1 +nventory
ccounts payable 0contra return acct.1
8ncollectible account llo&ance for ccounts receivable
Trite-oGs doubtful accounts
:)5-( uditing an ccounting :stimate
The audit problem is to develop a range of valuation of the inventory in order to evaluate
management5s estimate.
7o& ?igh
!elling price O BD,=== O E2,===
dvertising and
shipping eApenses B,=== 5,===
uditors5 estimate of
the range for the
inventory valuation O B1,=== O DB,===
a. Ies, an ad*ustment can be proposed.
7oss 0or Cost of >oods !old1 O 12,===
+nventory O12,===
Trite do&n the inventory to
the nearest end of the
auditors5 range.
b. @o ad*ustment is necessary. The management estimate of OD=,=== is &ithin the
auditors5 range estimate.
:)5-,
%isk of ;isstatement in Narious ccounts
a. 6ased on information you have available in Chapter 5, &hich accounts may be most
susceptible to overstatementU 8nderstatementU
+nventory understatements may occur from counting and pricing errors.
4iAed asset understatements may result from failure to capitaliLe costs 0eApensing
them instead1 or from erroneous depreciation calculations.
th
:dition )age 5-12
7iability understatement and eApense understatement appear to be quite common.
b. Thy do you think a company might permit asset accounts to be understatedU
sset understatements can result from accounting errors, misapplication of
accounting principles, and measurement errors 0such as undercounting the
inventory1. company might be motivated by taA evasion to understated assets and
income.
c. Thy do you think a company might permit liability accounts to be overstatedU
:stimated liabilities might be measured large for conservatism. The company might
over accrue eApenses in order to reduce taAable income. fraud might be imbedded
in false payables to false vendors.
d. Thich direction of misstatement is most likely" income overstatement or income
understatementU
%esearch studies indicate that income overstatement occurs most frequentlyJ the
cause is often understatement of eApenses 0e.g. accrued eApenses1, or overstatement
of revenues 0e.g. inappropriate revenue recognition policy choice or interpretation1.
:)5-5 udit planning
a1 Talter should"
[ \no& the business and industry
[ %evie& [ prior years' $les
[ auditee correspondence
[ engagement letter or obtain one
[ Coordinate staG
[ ?old a planning meeting &ith the staG
[ )repare risk and materiality assessments
[ /btain draft statements for analytical revie&
[ #evelop a preliminary audit strategy
[ +dentify key dates, i.e., inventory count
[ Consider need for specialists or other auditors
[ Consider role of internal auditors
[ :stimate fees and time
[ #evelop audit programs
[ )repare $les and supplies
[ ?ave plan approved by partner.
b1 Nalidity [ all amounts in the 4C! should be there
:Aistence [ all assets and liabilities eAist at a given date
Completeness [ everything that should have been included in the 4C! is there
/&nership [ assetsCliabilities are o&nedCo&ed by the entity
Naluation [ all 4C! items are properly valued
Cut-oG [ all transactions are included in the correct period
#isclosure [ all information required in the 4C! has been disclosed either in the
body of the statements or in notes
;easurement [ %evenues and eApenses are recorded in the proper amounts
th
:dition )age 5-1(
and in the proper period.
:)5-3 ssertions
ssertions used by the auditor fall into the follo&ing
categories"
0a1 assertions about classes of transactions and
events for the period under audit"
0i1 occurrence ] transactions and events that
have been recorded have occurred and pertain
to the entityJ
0ii1 completeness ] all transactions and events
that should have been recorded have been
recordedJ
0iii1 accuracy ] amounts and other data relating to
recorded transactions and events have been
recorded appropriatelyJ
0iv1 cut-oG ] transactions and events have been
recorded in the correct accounting periodJ and
0v1 classi$cation ] transactions and events have
been recorded in the proper accountsJ
0b1 assertions about account balances at the period end"
0i1 eAistence ] assets, liabilities and equity
interests eAistJ
0ii1 rights and obligations ] the entity holds or
controls the rights to assets, and liabilities are
the obligations of the entityJ
0iii1 completeness ] all assets, liabilities and
equity interests that should have been
recorded have been recordedJ and
0iv1 valuation and allocation ] assets, liabilities
and equity interests are included in the
$nancial statements at appropriate amounts
and any resulting valuation or allocation
ad*ustments are appropriately recordedJ and
0c1 assertions about presentation and disclosure"
0i1 occurrence and rights and obligations ]
disclosed events, transactions and other
matters have occurred and pertain to the
entityJ
0ii1 completeness ] all disclosures that should
have been included in the $nancial statements
have been includedJ
0iii1 classi$cation and understandability ] $nancial
information is appropriately presented and
described, and disclosures are clearly
eApressedJ and
0iv1 accuracy and valuation ] $nancial and other
information are disclosed fairly and at
appropriate amounts.
:Aistence
Completeness
Naluation
:Aistence and
completeness
)resentation
:Aistence
/&nership
Completeness
Naluation
:Aistence and /&nership
Completeness
)resentation
th
:dition )age 5-1,
The auditor may use the assertions as described above or
may eApress them diGerently provided all aspects described
above have been covered. 4or eAample, the auditor may
choose to combine the assertions about transactions and
events &ith the assertions about account balances. s
another eAample, there may not be a separate assertion
related to cut-oG of transactions and events &hen the
occurrence and completeness assertions include appropriate
consideration of recording transactions in the correct
accounting period.
!ource" C+C ssurance ?andbook, C! (15
Naluation
#iGerent terms are used to provide $ner de$nitions. The $ner de$nitions can be helpful for
developing more speci$c statements of the auditing ob*ectives, that relate speci$c $nancial
statement components and to auditing procedures. 4or eAample, to describe the eAistence
assertion as it relates to a transaction stream some people $nd it easier to think about
&hether transactions really 2occurred' rather than &hether the transactions really 2eAist'.
nother term used for eAistence is validity, i.e., are the balances valid, are the transactions
validU Narious alternate terms have been used historically and so they are retained, but
they can be vie&ed as synonyms. /verall, suHcient appropriate audit evidence must be
obtained to address the $ve principle assertions discussed in the teAt, &ith regard to the
level of risk of misstatement in each assertion, for each account balance, class of
transactions, and disclosure.
:)5-B :Aperts' Tork as audit evidence
Then eApertsCspecialists are engaged, auditors must ensure they have appropriate
professional quali$cations and good reputations. n eApert should be unrelated to the
company under audit, if possible. uditors must obtain an understanding of the eApert's
methods and assumptions. The auditor also must verify all signi$cant information that the
eApert's conclusions are based on if the eApert's &ork &ill be a signi$cant piece of evidence
used to form the audit opinion 0C! 32=1. 4or eAample, if the eApert is providing an opinion
on mineral reserves valuation, the auditor should tie the reports used by the eApert into
other documentation to verify the properties evaluated are o&ned by the auditee, and
check commodity price assumptions to eAternal data such as published commodity trading
statistics.
:)5-5-D The professional standards âck is applying in the end of chapter pplication Case and
nalysis include"
C!SC-1 Suality control for $rms that perform audits and revie&s of $nancial statements,
and other assurance engagementsJ
C! 2== /verall ob*ectives of the independent auditor and the conduct of an audit in
accordance &ith Canadian auditing standardsJ
C! 21= greeing the terms of audit engagementsJ
C! (== )lanning an audit of $nancial statementsJ and
C! (15 +dentifying and assessing the risks of material misstatement through
understanding the entity and its environment.
!elected eAcerpts of relevant sections of these standards are given belo& for each of the
seven steps in the Case nalysis. !tudents can also be assigned to revie& the standards to
identify these and other requirements that call for the acceptance considerations set out in
the case.
th
:dition )age 5-15
/verall, the ob*ective set out in C!SC-1 is being applied by âck's $rm's procedures in this
case. e.g.,
C!SC-1
/b*ective
11. The ob*ective of the $rm is to establish and maintain a system of quality
control to provide it &ith reasonable assurance that"
0a1 The $rm and its personnel comply &ith professional standards and
applicable legal and regulatory requirementsJ and
0b1 %eports issued by the $rm or engagement partners are appropriate in the
circumstances..
%eferring to the standards more speci$cally, note the follo&ing professional requirements
being met by the seven steps âck is taking.
1. /btaining and revie&ing $nancial information about the prospective auditee
organiLation to determine purpose, main users, and basis of accounting.
_ This step allo&s the $rm to comply &ith C!SC-1, paragraphs 23 and 2B, e.g.,
cceptance and Continuance of Client %elationships and !peci$c :ngagements
23. The $rm shall establish policies and procedures for the acceptance and
continuance of client relationships and speci$c engagements, designed
to provide the $rm &ith reasonable assurance that it &ill only undertake
or continue relationships and engagements &here the $rm"
0a1 +s competent to perform the engagement and has the capabilities,
including time and resources, to do soJ 0%ef" )ara. 1D, 2(1
0b1 Can comply &ith relevant ethical requirementsJ and
0c1 ?as considered the integrity of the client, and does not have information
that &ould lead it to conclude that the client lacks integrity. 0%ef" )ara.
1E-2=, 2(1
2B. !uch policies and procedures shall require"
0a1 The $rm to obtain such information as it considers necessary in the
circumstances before accepting an engagement &ith a ne& client, &hen
deciding &hether to continue an eAisting engagement, and &hen
considering acceptance of a ne& engagement &ith an eAisting client.
0%ef" )ara. 21, 2(1
0b1 +f a potential conKict of interest is identi$ed in accepting an engagement
from a ne& or an eAisting client, the $rm to determine &hether it is
appropriate to accept the engagement.
0c1 +f issues have been identi$ed, and the $rm decides to accept or continue
the client relationship or a speci$c engagement, the $rm to document
ho& the issues &ere resolved..
_ +t also meets C! 22=, paragraph 12 in regards to the speci$c audit engagements
âck $rm is considering accepting. e.g.,
C! 22=
12. The engagement partner shall be satis$ed that appropriate procedures
regarding the acceptance and continuance of client relationships and
audit engagements have been follo&ed, and shall determine that
conclusions reached in this regard are appropriate. 0%ef" )ara. D-E1

th
:dition )age 5-13
2. :valuating the public accounting $rm's and individual auditors' independence from
the prospect
_ This step meets requirements of C!SC-1 and C! 22=, paragraphs 11 and C! 2==,
paragraph 1,. e.g.,
C!SC-1, paragraphs 21 and .2,
+ndependence
21. The $rm shall establish policies and procedures designed to provide it
&ith reasonable assurance that the $rm, its personnel and, &here
applicable, others sub*ect to independence requirements 0including
net&ork $rm personnel1 maintain independence &here required by
relevant ethical requirements. !uch policies and procedures shall enable
the $rm to" 0%ef" )ara. 1=1
0a1 Communicate its independence requirements to its personnel and, &here
applicable, others sub*ect to themJ and
0b1 +dentify and evaluate circumstances and relationships that create threats
to independence, and to take appropriate action to eliminate those
threats or reduce them to an acceptable level by applying safeguards, or,
if considered appropriate, to &ithdra& from the engagement, &here
&ithdra&al is possible under applicable la& or regulation.
2,. t least annually, the $rm shall obtain &ritten con$rmation of compliance
&ith its policies and procedures on independence from all $rm personnel
required to be independent by relevant ethical requirements. 0%ef" )ara.
1=-111 .
e.g., C! 2==
:thical %equirements %elating to an udit of 4inancial !tatements
1,. The auditor shall comply &ith relevant ethical requirements, including
those pertaining to independence, relating to $nancial statement audit
engagements. 0%ef" )ara. C1,-1B1.
(. Considering &hether the public accounting $rm has competency, resources, any
special skills required
_This step applies C!SC-1, paragraph 2E, C! 22=, paragraphs 12-1, 0see above1,
and C! (==, paragraph D, e.g.,
C!SC-1 ?uman %esources
2E. The $rm shall establish policies and procedures designed to provide it
&ith reasonable assurance that it has suHcient personnel &ith the
competence, capabilities, and commitment to ethical principles
necessary to"
0a1 )erform engagements in accordance &ith professional standards and
applicable legal and regulatory requirementsJ and
0b1 :nable the $rm or engagement partners to issue reports that are
appropriate in the circumstances. 0%ef" )ara. 2,-2E1
C! (==
D. +n establishing the overall audit strategy, the auditor shall"
0a1 +dentify the characteristics of the engagement that de$ne its scopeJ
0b1 scertain the reporting ob*ectives of the engagement to plan the timing of
the audit and the nature of the communications requiredJ
0c1 Consider the factors that, in the auditor5s professional *udgment, are
signi$cant in directing the engagement team5s eGortsJ
th
:dition )age 5-1B
0d1 Consider the results of preliminary engagement activities and, &here
applicable, &hether kno&ledge gained on other engagements performed
by the engagement partner for the entity is relevantJ and
0e1 scertain the nature, timing and eAtent of resources necessary to perform
the engagement. 0%ef" )ara. D-111.
,. /btaining information from management as to &hether the prospect's management
accepts responsibility for the $nancial statement preparation and implementing
adequate controls to reduce risk of errors and fraud
_ This step complies &ith C! 21=, paragraph 3 allo&ing âck's $rm to determine
&hether pre-conditions for the audits are present. This kno&ledge &ill also be useful
in complying &ith C! (==, paragraph 3, and C! (15, paragraphs 3-B
e.g.,
C! (15
3. The risk assessment procedures shall include the follo&ing"
0a1 +nquiries of management, and of others &ithin the entity &ho in the
auditor5s *udgment may have information that is likely to assist in
identifying risks of material misstatement due to fraud or error. 0%ef"
)ara. 31
0b1 nalytical procedures. 0%ef" )ara. B-1=1
0c1 /bservation and inspection. 0%ef" )ara. 111
B. The auditor shall consider &hether information obtained from the auditor5s
client acceptance or continuance process is relevant to identifying risks
of material misstatement..
5. Considering &hether the engagement &ould require special attention or involve
unusual risks
_This step also allo&s âck's $rm to comply &ith C! 22= and the other standards
concerning audit engagement continuance and acceptance
3. !earching for ne&s reports and, &hen possible, asking business associates about the
organiLation
_This step can provide information related to the acceptance standards noted above
in C! 22=, as &ell as kno&ledge relevant in identifying and assessing risks of
misstatement that are set out in C! (15.
B. 4or ne& audits, communicating &ith the previous auditor
_This step arises in the C! from the requirements to comply &ith relevant ethical
requirement for public accountants. These include the rules of conduct or ethics
codes of the various provincial accounting bodies.e.g.,
C! 22=, paragraph CB0n1
C0n1 %elevant ethical requirements R :thical requirements to &hich the
engagement team and engagement quality control revie&er are sub*ect,
&hich comprise relevant independence and other ethical requirements
set out in rules of professional conduct C code of ethics applicable to the
practice of public accounting issued by the various professional
accounting bodies. Y+n +! 22=, this paragraph states" %elevant ethical
th
:dition )age 5-1D
requirements R :thical requirements to &hich the engagement team and
engagement quality control revie&er are sub*ect, &hich ordinarily
comprise )arts and 6 of the +nternational :thics !tandards 6oard for
ccountants5 Code of :thics for )rofessional ccountants 0+:!6 Code1
related to an audit of $nancial statements together &ith national
requirements that are more restrictive.Z.
th
:dition )age 5-1E
SOLUTIOS !OR &ISCUSSIO CASES
#C5-1 Communications bet&een predecessor and successor auditors
The procedures you should follo& prior to accepting the engagement include the follo&ing"
1. Iou should eAplain to your prospective auditee your $rm's need to inquire of #iggs
and should request permission to make such inquiries. 0This means that the )resident
of 7yrac &ill need to contact #iggs to inform him that he is no longer the company's
auditor, even though the )resident does not &ant to. !ince the auditor must be
engaged, and dismissed, by those charged &ith governance of 7yrac, it &ould not be
appropriate for your $rm to do this.1
2. Iou should ask your prospective auditee to authoriLe #iggs to respond fully to all
inquiries since #iggs &ould be prohibited from disclosing con$dential information
&ithout its former auditee's permission.
(. Tith permission, you should contact #iggs about your prospective auditee's decision
to change auditors, as an act of professional courtesy.
,. Iou should make reasonable inquiries of #iggs regarding matters that &ill aid in
deciding &hether to accept the 7yrac audit engagement. 0Iour inquiries should ask
about facts &hich might bear on the integrity of management, disagreements &ith
management about accounting and auditing matters, and #iggs5 understanding of the
reason0s1 for the change of auditors.1
5. +f #iggs does not respond fully to your questions, you should consider the implications
of the limited response in deciding &hether to accept the engagement.
3. fter &eighing all information received from #iggs, you should inform your auditee
that a $rst-time audit is more time-consuming than a recurring audit because the ne&
auditor is generally unfamiliar &ith the auditee5s operations and does not have the
bene$t of past kno&ledge of company aGairs to use as a guide.
B. discussion &ith your auditee of the estimated required audit time and fee
arrangement should be coordinated &ith a clear eAplanation of the purpose and
scope of the audit. ny &ork that can be done by auditee personnel should also be
discussed so that eAcess audit time might be eliminated and proposed report
deadlines can be reasonably met.
D. To satisfy your quality control ob*ective, you should use procedures such as revie&ing
the $nancial statements of the auditeeJ inquiring of third parties such as its banks,
legal counsel, investment bankers, and others in the business community as to its
reputationJ and evaluating his ability to serve this auditee properly &ith reference to
industry eApertise, siLe of engagement, and available staG.
E. +f you have no reservations, after all signi$cant factors have been considered,
discussed, and agreed to, you should accept the engagement and con$rm the
understandings in an engagement letter.
#C5-2 udit engagement acceptance
a. The sources of information and inquiries include"
+nquiry, +ncluding )rior Torking )apers--prior audit &orking papers, personnel &ho
&orked on the audit in prior years are available to convey their understanding of the
business, inquiry and intervie&s &ith the company5s management, directors, and
audit committee.
/bservation--take a tour of the company5s physical facilities, keeping eyes open for
activities and things that should be reKected in the accounting records. The tour is the
time to see company personnel in their normal &orkplaces.
th
:dition )age 5-2=
!tudy. @umerous sources--C+C and +C) industry accounting and auditing guides,
specialiLed trade magaLines and *ournals, registration statements and nnual %eports
$led &ith the securities market regulators, general business magaLines and
ne&spapers 04inancial )ost, %eport on 6usiness, 6usiness Teek, 4orbes, 4ortune,
?arvard 6usiness %evie&, 6arron5s, and the Tall street ôurnal1.
b. @o, but Suality Control !tandards require $rms to investigate prospective auditees.
c. !tudents can decide this acceptance question either &ay, although the brief facts
may pre*udice the conclusion to&ard nonacceptance. The )5s o&n $rm decided to
resign 1= years ago, presumably over matters of o&ner-manager integrity. Iet, ;r.
!hine appears to be a respected member of his ne& community. ;aybe his Mfast and
looseM accounting past is behind him. ;aybe not. !tudent should use the facts
available, and madke reasonable assumptions, to provide arguments that support the
choice they make.
#C5-( a1 4actors to consider before accepting the audit engagement include"
- +s the ) $rm independentU
- #oes the ) $rm have the eApertise to conduct the auditU
- Till the auditee be able to pay the audit feeU
- +s the auditee a going concernU
- +s management highly questionableU
- #o they need an auditU
- +s the risk arising from kno&n users of the $nancial statements reasonably
determinable and acceptableU
b1 %isk assessment procedures include the follo&ing activities.
+dentify users of $nancial statements Ro&nerCma*or shareholder &ho has asked for
audit for $rst time this year, and potential lenders she &ill likely give the audited
$nancial statements to, and &ho likely &ill use the fCs to evaluate the risk of the
company not paying back its loan and interest.
/ther qualitative factors could be relevant, like contracts or covenants based on fCs
balances, transaction volumes, pledges of assets as collateral, etc.

c1 4or quantitative assessment, apply appropriate benchmarks, e.g. 5-1=X normal
income, =.5 - 1X revenues or assets,
?ere there is no 2@ormal income' as it is a ne&, start-up company.
/ther bases suggested can be considered, such as"
ssets" O25=== to 5====
%evenues" O,=== to D===
Then also consider qualitative factors, to generate reasonable range.
ssets is probably most appropriate since the start up stage also means revenues are
not good performance indicators yet, and user decisions not likely to depend on
revenue information.
s the auditor, you must select one amount from the range to provide a materiality
level for planning the audit. Iour choice needs to be *usti$ed based on qualitative
factors. 4or eAample, in this case it &ould be appropriate and prudent go to the lo&er
end of asset-based range, O25,===, since it is a $rst time audit, users are kno&n to be
relying at least partly on $nancial statements for important $nancial decisions, but
the best information in the $nancial statements at this stage of the business's life is
the asset values.
;ateriality is the most important *udgment and is made early in the audit because the
th
:dition )age 5-21
auditor's assessment of risk of material misstatement requires a preliminary
benchmark of &hat it 2material' - this then aGects every other planning decision.
d1 !ome possible ratios"
Current ratioCquick ratio
R may indicate liquidity problem, $nancial condition is poor, risk of business
failure.
/perating cash Ko&s over payables
- indicates cash burn for start up stage business
- indicates &orking capital requirements to fund operating shortfall and risk
if not likely to be met.
>ross margin percentR may suggest performance of operation is ineHcient as costs
not covered by revenues, or price competition aGecting viability
- other valid ratios, implications are also acceptable for this case
:Aample of additional information - 4or more meaningful ratio analysis, further
information is needed for more diGerent comparisons, e.g. more operating periods to
compute turnover, eHciency ratios, industry averages,
#C5-, )redecessor and !uccessor uditors
Tells 9 %atley need to initiate communications &ith both predecessor auditors. The
situation is unusual, but T9% need to obtain complete information from all the
predecessors involved since the last audit 02=12 $nancial statements1. 6oth Canby 9 Co.
and lbrecht 9 ?ubbard are predecessors. 0+f Canby 9 Co. had completed the 2=1( audit,
and T9% had been hired to perform the 2=1, audit, then Canby 9 Co. &ould be the only
)redecessor. 9? &ould be history.1
+nquiry of only one of the predecessors &ould not result in complete information because
the circumstances surrounding each auditor change may be diGerent. The t&o
predecessors, having served at diGerent times and for diGerent lengths of time, may have
diGerent kno&ledge about llpurpose 7oan Company and its president.
+f the company is public and sub*ect to securities market reporting requirements, reports for
both changes should have been $led &ith the regulator.
#C5-5 Calculate a )lanning ;ateriality mount
This solution provides a stock price-based method of determining &hat is material to users
based on the impact of an income misstatement is eApected to have on the share price, as
indicated by the 2multiple' that market participants are using to price this company's
shares. This approach provides an alternative &ay of thinking about the materiality
concept, though simpler methods based on $nancial statement amounts 0usually pre-taA
income1 are more commonly used in practice.
3X )rice :Gect
!tock price 013 A O=.3DB1 O 11.== 0slightly rounded1
)rice materiality *udgment O .33
d*usted stock price O 1=.(,
th
:dition )age 5-22
d*usted earnings per share
0divide by 13 multiple1 O .3,325
+ndicated net income
0multiply by B5=,=== shares1 O ,D,,3DD 0rounded1
dd pre-taA accounts that can
be audited completely"
+nterest eApense O -=-
+ncome taA eApense 0(5X1 O 23=,ED3 0rounded1
+ndicated pre-taA income O B,5,3B,
8naudited pre-taA income O BE2,(=D 0rounded1
0O515,===C=.351
+ndicated planning materiality
based on pre-taA income O ,3,3(,
#C5-3 )reliminary nalysis, ;ateriality, ssertions.
a1 To assess the risk of material misstatement, the auditor must understand the nature
of the business on &hat needs to be accounted for, because it &ill aGect &hat
inherent risks eAist in the business and thus its accounts. This illustrates the
importance to the auditor of understanding ho& a business creates value and earns
pro$ts. The case requires one to apply one's kno&ledge of the business, given the
facts provided in the case and other reasonable assumptions, to *udge the relevant
inherent risks for diGerent $nancial statement components in relation to the $ve
principle assertions" eAistence, completeness, o&nership, valuation and presentation
Y:C/N)Z
b1 To make a decision on materiality, &e $rst identify the main users of $nancial
statements R these are the minority shareholders &ho have asked for an audit for the
$rst time this year. lso, the bank holding the long term loan sho&n in the trial
balance likely &ill use the fCs to evaluate the risk of the company not paying back its
loan. /ther qualitative factors could be relevant, like contracts or covenants based on
fCs balances, transaction volumes, indicators of fraud, etc. 4or quantitative
assessment, apply appropriate benchmarks, e.g. 5-1=X pre-taA normal income, =.5-
1X revenues or assets, and then also consider qualitative factors, to generate
reasonable range. !elect one level from range and *ustify the quantitative choice
based on qualitative factors.
c1 T&o possible ratios that could be calculated for analysis are"
i1 current ratioCquick ratio
R may indicate liquidity problem, $nancial condition is poor, risk of business failure.
ii1 gross margin percent
R may suggest performance of operation is ineHcient, or price competition aGecting
viability
- for more meaningful ratios and analysis, further information is needed, e.g. past
periods to compute turnover, eHciency ratios, industry average, to allo& for more
diGerent comparisons.
/ther valid ratios, implications, and related further investigation are also acceptable if
clearly eAplained and supported
th
:dition )age 5-2(
d1 ssessment of the risk of material misstatement 0%;;1 takes into consideration both
the inherent and control risks, at the assertion level. The inherent risk assessments
are based on the nature of the item and the risk that an error can have occurred in
accounting for that item in the $rst place, regardless of controls. The general
tendency is for high value items that are attractive to steal, like TNs, to have higher
inherent risks related to the eAistence assertion. 4or #a&ood, it is manufacturing the
TN and monitors, so the valuation may be sub*ect to errors in compleA cost
allocations, and the net realiLable value may fall due to technological obsolescence,
so the valuation assertion has high risk of misstatement. !everal other accounts could
also be noted as high risk, such as &arranty provision 0high valuation assertion risk as
this is an estimate1 or )): because it is highly material and may become obsolete or
ineHcient over time, aGecting its valuation. nother item that may have high inherent
risk in #a&ood is the accounts receivable balance if there is a concern about
collectibility, as the valuation assertion &ould have a high risk of misstatement.
T&o items that may have lo& inherent risk assessments are the bank loan - it is
straightfor&ard to value it and con$rm its eAistence and completeness. !hare capital
might also be noted as a lo& risk account, since its o&nership is &ell documented and
since it is not compleA to account for, its eAistence, valuation and completeness
&ould not have high inherent risk.
>enerally, assessing high inherent risk leads the auditor to eApect management to
have strong risk assessment processes, and strong controls in place to oGsetCreduce
these risks. +f this is the case, &hen inherent risk and control risk are combined as
%;;, the assessed risk could be lo&er than the inherent risk alone. ?o&ever, to rely
on this assessment the auditor must test the relevant controls. +n #a&ood's case it
may be feasible and eHcient for the auditor to test these controls and get some
assurance from them, and that &ill lo&er the amount of assurance required from
substantive tests. /n the other hand, if the controls are not very strong the %;; &ill
be very high for high inherent risk items and the auditor &ill need a lot of substantive
evidence to be able to get reasonable assurance to form an opinion about &hether
the fCss are fairly stated.
e1 +nventory in manufacturing business &ill have ra& material, T+) and $nished goods
ssertions" 0note - assessments of %;; belo& are for $nished goods, T+) risk
assessments may diGer1
:Aistence" moderate
- The question is &hether all the TNs and monitors recorded really are on hand. !ince
these items could be easily stolen, the risk is raised, but veri$cation by physical
inspection can provide very reliable evidence. 4urther, if controls in place appear
strong over recording the purchases, it &ould be diHcult to make an entry for an
inventory purchase that doesn't eAist. Thus the risk is moderated.
Completeness" moderate
- The question is &hether all the inventory the company actually o&ns has been
recorded. This depends on good controls over recording all purchases, and moving
costs of T+) through the production accounting process properly. !ince it is possible
to miss recording unless controls are good, and inventory is key to the company's
success, &e can assume the controls over this are good and the risk is moderated.
Naluation" high
- The question is &hether the dollar amount allocated to the $nished goods is
correctly calculated and complies &ith >) 0i.e., the $nancial reporting frame&ork
selected by management, including the relevant inventory valuation policies and
methods1. There are a number of factors that can lead to risk of misstatement of the
valuation assertions, such as" the TNs might not be able to be sold at eApected pricesJ
the ra& materials and componement used may not be of suitable qualityJ the costs of
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:dition )age 5-2,
the components may not be correctly recordedJ all production costs incurred in the
process may not be captured accurately such overhead allocations.
/&nership" lo&
- The question is &hether #a&ood has proper title to the inventory. The risk is
assessed as lo& since it is unlikely that #a&ood &ill record inventory that is has not
purchased and taken title to upon delivery, or &ill include inventory once it is sold
0under an assumption that the terms of sale for this type of business are not compleA
to follo&, and title transfers &hen goods are delivered &ith little uncertainty about
completing the sale 1
)resentation" lo&
- The question is &hether the inventory is properly classi$ed in the $nancial
statements and all disclosures required by >) are complied &ith. This is assessed
as a lo& risk assertion since the classi$cation not compleA 0as long as there are
reasonable systems controls in place to measure the diGerent classes of inventory"
%;, T+) and 4>1, accounting policies for inventory valuation 9 disclosure are clear to
apply, management is assume to have the required accounting skills.
/ther valid risk assessments could be made based on diGerent assumptions, or on
diGerent interpretations of the facts provided since these are fairly limited in the case.
#C5-B ;ateriality 7evel %educed

The case requires consideration of the factors that determine the materiality level for audit
purposes, in particular a decision to reduce the materiality level.
a1 The magnitude of net income, other $nancial statement items, the users and the
potential impact of errors on their decisions, and other qualitative factors can be
discussed.
b1 7o&er materiality &ill tend to require more audit procedures, e.g. higher sample
eAtents &hen representative samples are tested, and this &ill apply &hether eAtents
are determined statistically or *udgmentally - if a smaller error matters, more has to be
looked at to get the same assurance that a material error is unlikely to have occurred.
c1 +n this case the auditors need to consider the impact of a lo&er materiality level on
the unad*usted errors 0and the potentially undetected errors1 in the opening balances.
+t may be that at the lo&er materiality level these errors &ould have needed to be
ad*usted. !ince they &ere not, and they aGected a current asset, they &ill reverse in
this year, and &hich in turn materially aGects the current year-end balances. +t &ill be
important for the auditor to take the reversal of this prior period error into account
#C5-D ;ateriality pproaches in udit )ractice.
;ateriality decisions are highly *udgmental, so a lot of variability in practice is inevitable.
:ven the same auditor may &ant to use a diGerent approach in diGerent audits, since the
decision is based on many qualitative factors that &ill be conteAt-speci$c. C! (2= provides
a lot of options so that auditors are not constrained from applying their *udgment. C! (2=
also highlights the diGerent considerations and requires the auditor to consider diGerent
factors and *ustify the decision on each $nancial statement audit. llo&ing for these
diGerent approaches in the standards can prevent auditors in practice from starting to take
too much of a literal, 2cookbook' attitude about &hat the standards require.
#C5-E ;ateriality and ;isstatements in :stimates
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:dition )age 5-25
The case is based on the !:C's la&suit against the @ortel eAecutives, alleging they used
2cookie *ar' reserves to make their 2==( bonus. The data provided can be analyLed to sho&
management may be using measurement uncertainty strategically, to bias the estimate.
8sing large reservesCprovisions to understate income in one year can allo& a higher income
to reported in a later period, &hen the result &ill push the company into pro$t and make the
eAecutives eligible for bonuses. The auditor &ould need to assess the reasonable range of
these estimates in each year, and compare the company management's suggested
estimate to see if it is outside the range. The direction of any diGerence bet&een the
auditor' and management's estimates is important to track across all the company's
estimates in a period - do they tend to go in the same direction in terms of impact on
earningsU This could suggest a conscious attempt to over or understate the reserves to
have control over the reported results in the follo&ing periods. The analysis of auditor
ranges to management's in subsequent periods should also take into account the reversal
of provisions in previous periods, to assess potential for bias.
#C5-1= Suantitative and qualitative materiality criteria
a1 The follo&ing accounts &ill be overstated"
ccounts receivable
Current assets and total assets
!ales revenue
+ncome and retained earnings
This cut-oG error most clearly aGects the :`+!T:@C: 0or /CC8%%:@C:1 assertion since
it results in the year's sales and year-end C% balance being overstated.
b1 Current ratio calculations"
including error P 1,1==,===CD3=,=== P 1.2D
&ith error corrected P 011=====-25====1 C 0D3=,===1 P =.EE
+mpact is to lo&er the ratio from 1.2D to =.EE
This brings the ratio belo& the level required by the bank covenant.
c1 6ased on quantitative criteria only, an auditor might conclude it is not material since it is
less than 5X of @+6T. ?o&ever, another auditor might *udge it to be close enough to
quantitative thresholds for it to be considered material, since it is ,X of @+6T, 2.(X
current assets, etc.
+n any case, since correcting the error &ill push ratio belo& the minimum level set in the
bank covenant of 1.2 to 1, the error aGects a key $nancial ratio that the bankCuser is
monitoring and &ill aGect banks decision to continue loan or call it back. This is a
qualitative factor that makes it a material misstatement. +n conclusion, it should be
considered material based on qualitative considerations.
#C5-11 /verall udit !trategy, %etail +ndustry
This case involves $nding t&o real companies in the same industry and applying the
chapter planning concepts in this conteAt. The -/verall udit !trategy. checklist in
:Ahibit 5-E can be used as a guide. !ome other guiding questions that students can
consider include"
- That business are the companies in. ?o& does each make moneyU That are its main
strategic ob*ectivesU That business risks does it face that could prevent it from meeting its
strategyU 0%efer to the relevant risk factors listed in C! (15 ppendiA1 #iscuss t&o
business processes that are likely to be important in this business considering its strategy
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:dition )age 5-23
and risks, and &hy these &ould be most important.
- /utline the company's corporate governance structure 0e.g., 6oard of #irectors
composition and quali$cation and independence, udit or other board committees1, as
indicated or implied in their nnual %eport.
-#etermine the audit risk level the audit team &ould be &illing to accept for this
engagement, and the materiality level for planning purposes. ûstify your choices. -%evie&
the company5s main accounting policies, including those for revenue, inventory, capital
assets, and any other that seem relevant in this business and comment on their
appropriateness 0i.e., are the policies chosen by management conservative, aggressive,
etcU1.
-)resent the result of key analytical revie& procedures and eAplain the impact of these
$nding on your audit approach. !ummariLe your $ndings in the report and provide details
in an :Ahibit. Comment on the impact of accounting policy choices on the results of the
analytical procedures.
-6ased on your research and business risk assessment above, identify t&o or three key
audit issues, and their impact on your audit approach. key audit issue is an area &here
you think there is a particularly high risk that the company5s $nancial statements are
materially misstated. !upport your selection of these key audit issues by eAplaining
speci$cally ho& the business risks and other company factors you identi$ed might lead to
higher risk of material misstatement in this company5s $nancial statements.
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:dition )age 5-2B

Preliminary Auditing Planning: Understanding The Auditee's Business

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CHAPTER 5

Preliminary Auditing Planning: Understanding the Auditees

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