CHAPTER10

UNDERSTANDINGTHEENTITY
Questions
1.

A business risk is a treat to achieving managements objectives. There are many

examples of business risks that may result in a risk of material misstatement of
the financial statements. Two are shown below:
Business Risk

Risk of Material Misstatement

Rapidly changing technology in the

clients industry may threaten to
cause the clients products to become
obsolete.

Inventory may be overvalued because

it is not valued at net realizable value.

Economic conditions in the industry

may result in significant uncollectible
accounts receivable.

Accounts receivable may be

overvalued because the allowance for
uncollectible accounts is not
adequate.

2.

An audit plan provides essential background information for an audit

assignment, and outlines the objectives, timing, staffing, special risks and
considerations, and other requirements of the engagement. An audit program is
a detailed outline of the auditing work to be performed, specifying the
procedures to be followed in verification of each item in the financial
statements. Although both the audit plan and the audit program are technically
plans, the audit plan serves more as a broad overview of the engagement, while
the audit program is more specific and limited in scope.

3.

The purpose of the team meeting on fraud risk is designed to allow the more
experienced team members to share insights and exchange ideas about how and
where the entitys financial statements might be susceptible to material
misstatement due to fraud, to discuss how to design appropriate tests to detect
the misstatements, and to emphasize the importance of maintaining the proper
degree of professional skepticism regarding the possibility of fraud.

4.

During the planning process, the auditors make preliminary estimates of both
risk and materiality for the engagement. The auditors must plan their
engagements to reduce the audit risk of issuing an unqualified opinion on

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materially misstated financial statements to a relatively low level. At the
account balance level, audit risk actually has three components: (1) inherent
risk, (2) control risk, and (3) detection risk. On audits where the risk of
misstatement is relatively high, the auditors must compensate by increasing the
effectiveness of their audit procedures. They may design more effective
procedures, increase the number of items selected for testing, or perform more
procedures at the balance sheet date rather than at an interim date. They may
also add an element of unpredictability to the procedures.
The auditors' preliminary estimates of levels of materiality also affect the nature,
timing, and extent of their planned procedures. Materiality levels determine
which accounts are significant enough to require audit, affect the size of the test
samples, and determine the dollar amount of individual items that warrant
examination.

5.

(a) Auditors must obtain an understanding of the client and its environment in
order to determine whether the client should be accepted and to plan the
audit. This understanding encompasses the following:
(1)

The nature of the client, including the clients application of

accounting policiesThe auditors understanding of this area will
include the clients competitive position, organizational structure,
accounting policies and procedures, ownership, capital structure, and
product lines.
The understanding will also encompass an
understanding of the clients business model and its major business
processes.

(2)

The industry, regulatory, and other external factorsThe

factors included here are industry conditions, such as the competitive
environment, supplier and customer relationships, and technological
developments. They also include the regulatory, legal, and political
environment, and general economic conditions.

(3)

Objectives and strategies and related business risksThe

auditors obtain an understanding of the operating and financing
strategies of management. They also obtain an understanding of
managements risk assessment process. This assists the auditors in
identifying significant business risks that may create risks of material
misstatement of the financial statements.

(4)

Methods of measuring and reviewing performanceThe

auditors obtain an understanding of the methods management uses to
measure and review performance at various levels within the
organization. These methods are important to determining incentives

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of management and other employees. The measures may also be used

in designing effective analytical procedures.
(5)

Internal controlThe auditors understanding of internal

control assists them in planning the audit and assessing control risk.
(b) Sources of information on prospective clients include trade publications,
and governmental agency publications. Previous audit reports, annual
reports to stockholders, SEC filings, and prior years' tax returns are
excellent sources of financial background information.
Informal
discussions between the auditors and key officers can provide information
about the history, size, operations, accounting records, and controls of the
enterprise. Inquiries of others within the organization can provide
information that confirms inquiries of management, and provides more
detailed information about risks and business processes. Inspection of
internal documents and records can provide information about the nature of
the clients operations and internal control. The predecessor auditor may
also provide information.
(c) Knowledge of the client and its environment helps the auditors in:
(1) Identifying areas that may need special consideration.
(2) Identifying significant business risks that may result in risks of material
misstatement of the financial statements.
(3) Assessing inherent risk and making preliminary assessments of control
risk.
(4) Making judgments about the appropriateness of accounting principles
in use and the adequacy of disclosures.
(5) Evaluating the reasonableness of estimates, such as depreciation lives
and the allowance for doubtful accounts.
(6) Evaluating the reasonableness of management representations.
(7) Developing an efficient audit strategy.
(8) Determining the staffing requirements of the engagement.
6.

During the tour of the client's plant facilities, Sison inspects all inventory areas
and makes note of the location, types, security, "housekeeping," and general
condition of the inventories. He also visits the receiving and shipping
departments and reviews the types of documents maintained. His observations
in these areas enable him to form a preliminary impression of the adequacy of
internal controls for inventories, and possible problems with respect to obsolete
or slow-moving inventories. He also can begin formulating plans for staffing
and carrying out the physical inventory observation.
Sisons observation of the productive processes will acquaint him with the
client's physical plant facilities and layout, the nature of the products and
computer applications employed in the production process. He may also obtain

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information on the client's documentation such as for production orders, raw
materials requisitioned to production, direct and indirect labor, and inspection
and testing of finished products. He meets the supervisory personnel, engineers,
and other key personnel responsible for production, and through inquiries and
conversations learns of any unique production problems, including excessive
spoilage and scrap. As a result, he will be in a position to evaluate the client's
cost accounting system during the course of the audit. He will also inquire
about the details of the clients business processes.
Throughout the tour, Sison will add to his impression of the client's business
processes, control procedures and accounting records. He will notice, for
example, what personnel have access to computer terminals and accounting
records, whether plant assets have identification tags, and whether documents
such as production orders and receiving reports are serially numbered or
controlled by the computer.

7.

(a) Misstatements due to fraudulent financial reporting are intentional

misstatements or omissions of amounts or disclosures in the financial
statements to deceive financial statement users. Misstatements arising from
misappropriation of assets (sometimes referred to as defalcation) involve
the theft of an entitys assets where the effect of the theft causes the
financial statement not to be presented in conformity with generally
accepted accounting principles.
(b) The three conditions necessary for the commission of fraud include: (1)
some type of incentive or pressure, (2) an opportunity to commit the fraud,
and (3) an attitude that allows the individual to rationalize the act. In a case
of fraudulent financial reporting, members of top management may have an
incentive to commit the act relating to maintaining the value of their stock
options. They may have an opportunity based on weaknesses in the
corporate governance of the organization. Finally, they may be able to
rationalize the act by assuming that the company will make enough income
next period to allow them to correct the misstatement.
(c) The auditors may respond to fraud risks by (1) a modification in the
approach having an overall effect on how the audit is conducted, (2) an
alteration in the nature, timing, and extent of the procedures performed, and
(3) performance of procedures to further address the risk of management
override of internal control.

8.

(a) Shin may respond to fraud risks in the following three ways:
(1)

A modification in the overall approach to the audit which might

involve:
(a) Applying increased professional skepticism and designing

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procedures that provide more reliable evidence.

(b) Assigning additional staff with specialized skill and knowledge or
by assigning more experienced staff to the engagement. Also the
extent of the supervision of the staff should be adjusted to reflect
the fraud risks.
(c) Giving further consideration to the appropriateness of the
accounting principles used by the client.
(d) Incorporating an added element of unpredictability in the selection
of auditing procedures.
(2) An alteration in the nature, timing and extent of the procedures
performed. For example, Shin might apply procedures that provide
more reliable evidence, shift more audit tests to year-end, or increase
sample sizes for certain substantive tests.
(3) Perform procedures to further address the possibility of management
override of internal control, including (1) examining journal entries and
other adjustments for evidence of fraud, (2) reviewing accounting
estimates for biases, and (3) evaluating the business rationale for
significant unusual transactions.
(b) Whenever the auditors believe that there is evidence that fraud may exist,
the matter should be brought to the attention of an appropriate level of
management. Fraud involving senior management and fraud that causes a
material misstatement of the financial statements should be reported directly
to the audit committee. In very serious situations the auditors should
consider resigning the engagement.
Multiple Choice Questions
1.
2.
3.
4.
5.

d
a
d
d
d

6.
7.
8.
9.
10.

d
d
d
d
d

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Cases
1.

(1) (a) There is an increased risk of fraudulent financial reporting by

subsidiary management. More specifically, subsidiary management
would likely attempt to increase revenue or decrease expenses.
(b) The auditors would probably respond by performing more procedures
at the subsidiary location. Additional tests of revenue would be
performed and the auditors would likely decide to observe inventory at
year-end. In addition, some of the procedures may be performed on an
unannounced basis.
(2) (a) There is an increased risk of fraudulent financial reporting by
management related to revenue.
(b) The auditors would likely respond by utilizing more experienced audit
team members. Specifically, audit staff that had experience with
complex revenue contracts in the telecommunications industry. They
would also likely increase the extent of the substantive tests of revenue.
(3) (a) There is an increased risk that the futures traders will fraudulent
overstate the value of the contracts to increase their compensation.
(b) The auditors would likely respond to this situation by bringing in a
specialist to assist in valuing the contracts. In addition, they would do
extensive testing of the valuation of the contracts.
(4) (a) There is an increased risk that management may be fraudulently
overstating income at one or more of the stores.
(b) The auditors would likely respond by doing increased testing of
revenue and inventory at the stores. The auditors could use the results
of the analytical procedures to identify stores that are more likely to
have fraudulent reported results (e.g., those with unusually high profit
margins). The auditors also may not disclose the locations that they
intend to visit for inventory observation.

Understanding the Entity

2.

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Mr. Gian Lee

President
Palace Corporation
Dear Mr. Lee:
Our recent tour of Palace's plant was a most pleasant and interesting
experience. The information obtained on this tour and during the discussion of
your financial statements and accounting records has enabled us to plan the
scope of an audit especially suited to your needs.
Our fees are based on the time spent on the engagement by various
members of our audit staff, and will be billed at our established rates. The total
time required for an initial engagement is usually somewhat greater than in
repeat examinations, since the latter do not require analysis of past years'
transactions. Considerable savings in the cost of the audit may be made by
utilizing the services of your accounting staff to help us in certain phases of the
work. We can arrange for your employees to prepare for us a number of
working papers. If you approve, we shall indicate to your chief accountant the
exact nature of the working papers to be prepared.
Our audit will be performed in accordance with generally accepted auditing
standards and will include all procedures which we consider necessary to
provide a basis for expression of our opinion on the fairness of the financial
statements. The audit will include:
(1) A consideration of the internal control.
(2) Tests of the financial statement accounts and balances to the extent we
consider necessary, based on our consideration of risks and internal
control.
(3) Preparation of the federal and state income tax returns.
(4) Issuance of our auditor's report upon your financial statements.
If our investigation indicates the desirability of any changes in internal
control procedures, we shall prepare a report on this subject for your
consideration. However, an audit cannot be relied upon to identify all
weaknesses in internal control. The purpose of our audit is to enable us to
express an opinion on the fairness of the financial statements; the audit is
designed to provide reasonable, but not absolute, assurance of detecting material
fraud and defalcations, and we will notify you if our audit does bring them to
light.
Although it is not possible to determine in advance the exact number of
days required for the engagement, our estimates indicate that the total fee will be

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between ___________ and _________. The audit will be completed and our
report submitted by March 1, 2014.
We would like an opportunity during the next few days to discuss with you
and your chief accountant the nature of the preliminary work to be done by your
staff. We shall also be pleased to answer any further questions which you may
have concerning the determination of audit fees.
Very truly yours,
Chariya, Modena and Company, CPAs