Auditing 10e SM CH 7

Auditing: A Risk Based Approach to Conducting a Quality Audit, 10e
Solutions for Chapter 7

True/False Questions
7-1 F
7-2 T
7-3 F
7-4 T
7-5 T
7-6 F
7-7 T
7-8 F
7-9 F
7-10 F
7-11 F
7-12 T
7-13 F
7-14 T
Multiple-Choice Questions
7-15 D
7-16 A
7-17 B
7-18 E
7-19 C
7-20 C
7-21 A
7-22 E
7-23 C
7-24 E
7-25 C
7-26 B
7-27 E
7-28 C
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7-1
Review and Short Case Questions
7-29
A misstatement is an error, either intentional or unintentional, that exists in a transaction or

financial statement account balance. Characteristics that would make a misstatement material
include:
 The misstatement 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 misstatement would have been viewed by a reasonable investor to have significantly
altered the total mix of information available.
 The relative size of the misstatement.
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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.
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a. Performance materiality refers to the amount or amounts set by the auditor at less than the
materiality level for the financial statements as a whole or for particular classes of transactions,
account balances, or disclosures. The term is used with respect to assessing risks of material
misstatement and determining the nature, timing, and extent of further audit procedures.
b. Tolerable misstatement is the amount of misstatement in an account balance that the auditor
could tolerate and still not judge the underlying account balance to be materially misstated.
Tolerable misstatement is the application of performance materiality to a particular sampling
procedure.
c. Clearly trivial means that a misstatement is clearly inconsequential, whether taken

individually or in the aggregate and whether judged by any criteria of size, nature, or
circumstances.
7-2
7-32
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. Thus, when planning the audit, the auditor’s materiality
assessment has to incorporate these qualitative factors which may cause the materiality amount
to be lower than if it were based solely on quantitative factors.
The SEC provides guidance on situations in which a quantitatively small misstatement may still
be considered material because of qualitative reasons. These include:
 the misstatement hides a failure to meet analysts' consensus expectations for the company
 the misstatement changes a loss into income or vice versa
 the misstatement concerns a segment or other portion of the company’s business that
plays a significant role in the company’s operations or profitability
 the misstatement affects the company’s compliance with regulatory requirements
 the misstatement affects the company’s compliance with loan covenants or other
contractual requirements
 the misstatement has the effect of increasing management's compensation – for example,
by satisfying requirements for the award of bonuses or other forms of incentive
compensation
 the misstatement involves concealment of an unlawful transaction.
7-33
a. Using the maximum thresholds for net income, net sales, and total assets, and the 10%
clearly trivial threshold yields the following amounts:
Common
Benchmarks
Maximum Overall Clearly Trivial Threshold (10%)
Materiality Threshold
% of Net Income 5%=$2,872,800 10% X (2,872,800) = $287,280
% of Net Sales 1%=$10,666,910 10% X (10,666,910) =
$1,066,691
% of Total 1%=$6,987,520 10% X (6,987,520) = $698,752
Assets
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b. The difficulty that the different materiality amounts poses for the auditor is that it is
challenging to choose among the alternatives. In practice, consistency with past decisions is
important, so the auditor will likely use the prior year’s benchmark, i.e., if % of net income was
used last year it makes sense to use that benchmark again unless conditions have changed. The
qualitative factors that the auditor should consider in this case are:
o There have been misstatements in the past in accounts receivable, so it is

possible that the posting threshold should be even lower than 10% for this
account.
o The company is under considerable pressure from analysts to make their
earnings forecasts.
o Margins have declined for the company, as has earnings per share. So, the
company looks worse to Wall Street than last year regardless of the outcome of
the issue concerning the write down of accounts receivable. Thus, management
is under considerable pressure to improve the financial results of the company.
c. Because the problem provides no information on the benchmark used in the past, any of the
three benchmarks is a reasonable answer to the question. Students may decide on total assets as
the benchmark because the misstatement is on the balance sheet. Or students may decide on net
income as the benchmark because of the focus on analyst expectations noted in the problem.
Regardless of the benchmark chose, the 10% clearly trivial threshold is calculated in part (a)
above.
d. The fact that misstatements have occurred in this account in the past suggests that a clearly
trivial threshold even lower than 10% might be appropriate. So, for example, students might
decide on a 5% clearly trivial threshold to reflect the qualitative risks noted in the problem. In
that case, the clearly trivial thresholds would be:
Maximum Overall
Common Materiality Clearly Trivial Threshold
Benchmarks Threshold (5%)
% of Net Income 5%=$2,872,800 5% X (2,872,800) = $143,640
% of Net Sales 1%=$10,666,910 5% X (10,666,910) = $533,346
% of Total Assets 1%=$6,987,520 5% X (6,987,520) = $349,376
7-34
a. There is an inverse relationship between client riskiness and materiality thresholds. Thus, a
riskier client will require a smaller threshold. In this case, the materiality threshold for Client A
should be less than that for Client B. Further, the auditor will need to collect more audit evidence
to obtain the same level of assurance for Client A compared to Client B.
b. Each individual auditor will make different professional judgments compared to other
auditors. Some of the individual characteristics that may affect an auditor’s professional
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judgments include their level of experience, their training, whether or not they have encountered
a client that has engaged in fraud, and their professional skepticism, among others.
c. If one auditor is more professionally skeptical than another auditor, that auditor would likely
set the materiality threshold even lower than another auditor in the scenario described in part (a)
of this problem. Thus, if a less skeptical auditor set materiality at $4,000, a more skeptical
auditor might set it at $3,000, and would accordingly collect even more evidence in support of
the judgment about whether accounts receivable was materially misstated.
7-35
a. The FASB defines materiality as the “magnitude of an omission or misstatement of

accounting information that, in 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 Supreme Court of the United States offers a
somewhat different definition and states that “a fact is material if there is a substantial likelihood
that the …fact would have been viewed by the reasonable investor as having significantly altered
the 'total mix' of information made available. Regardless of how it is specifically defined,
materiality includes both the nature of the misstatement, as well as the dollar amount of
misstatement and must be judged in relation to importance placed on the amount by financial
statement users. Thus, auditors need to understand the users of financial statements and their
likely needs and expectations in order to make appropriate materiality judgments.
b. Examples of items for each dimension might be these:
Dollar Magnitude:
Something that is over 5% of net income or a 5% misstatement of an account balance.
Nature of Item under Consideration:

A misstatement of an account that significantly changes a trend in earnings or reflects on
the integrity of management (such as an intentional misstatement).
Perspective of a Particular User:

Management and board of an outside entity that are considering acquiring the client and
is relying on audited financial statements as an important part of its decision.
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 misstatement may change and the
auditor’s 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 materiality
amount implies that some of the work performed early in the audit may have been performed
with a larger planning materiality than the auditor now believes appropriate. Therefore, the
7-5
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.
7-36
• Inherent Risk—the susceptibility of an assertion about a class of transaction, account

balance, or disclosure to a misstatement that could be material, either individually or
when aggregated with other misstatements, before consideration of any related
controls.
• Control Risk—the risk that a misstatement that could occur in an assertion about a
class of transaction, account balance, or disclosure and that could be material, either
individually or when aggregated with other misstatements, will not be prevented, or
detected and corrected, on a timely basis by the entity’s internal control.
• Audit Risk—the risk that the auditor expresses an inappropriate audit opinion when
the financial statements are materially misstated.
• Detection Risk—the risk that the procedures performed by the auditor to reduce audit
risk to an acceptably low level will not detect a misstatement that exists and that
could be material, either individually or when aggregated with other misstatements.
See Exhibit 7.1 for a graphical depiction of how these risks relate to each other. The risk of
material misstatement exists at the overall financial statement level and at the account and
assertion levels; within these levels, risk can be categorized as involving inherent risk and
control risk. These risks originate with the client, are controllable by the client, and are related to
characteristics of the client organization, environment, and internal control. After assessing
inherent and control risks, the auditor then determines the appropriate level of audit risk to
accept. When the risk of material misstatement is higher, the auditor accepts less audit risk (as
low as 1%); conversely, when the risk of material misstatement is lower, the auditor accepts
more audit risk (such as 5%). For example, consider a client that is publicly traded, has a
management team with questionable integrity (with a high inherent risk) that does not place high
importance on the control environment (with a high control risk). In this case, the auditor should
accept only low audit risk (1%) because the auditor is concerned that there exists a reasonable
possibility that a material misstatement exists. Contrast this first example with a client that is
privately held, has a management team with good integrity (a low inherent risk) that places
importance on the control environment (a low control risk). In this case, the auditor accepts
higher audit risk (5%) because a material misstatement is less likely.
Upon determining the level of acceptable audit risk, the auditor should determine detection risk.
Detection risk is under the control of the auditor, and the level of audit effort that the auditor will
expend on the engagement depends on the level of detection risk. When the risk of material
misstatement is higher, detection risk is lower, in order to reduce audit risk to an acceptable
level. The auditor reduces detection risk through the nature, timing, and extent of substantive
audit procedures. As detection risk decreases, evidence obtained by the auditor through
7-6
substantive audit procedures should increase. When the risk of material misstatement is lower,
the auditor can accept a higher detection risk and still achieve an acceptable level of audit risk.
7-37
Controls exist to address the inherent risks of material misstatement. 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 mitigate.
7-38
As the risk of material misstatement increase, the auditor will accept less audit risk, and
detection risk will be decreased. As the risk of material misstatement decrease, the auditor can
accept greater audit risk and detection risk will increase.
7-39
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 reasonable assurance that all material misstatements will be
detected. The lower the level of materiality, the more audit work must be done (the lower the
detection risk). In summary, materiality must first be set in order to determine the appropriate
level of audit risk.
7-40
The following is a list of factors that would lead the auditor to assess inherent risk at the
assertion level at a higher level:
 the account balance represents an asset that is relatively easily stolen, e.g., cash
 the account balance is made up of complex transactions
 the account balance requires a high level of judgment or estimation to value
 the account balance is subject to adjustments that are not in the ordinary processing
routine, e.g., year-end adjustments
 the account balance is composed of a high volume of transactions
7-41
• Operations in regions that are economically unstable, e.g., countries with significant
currency devaluation or highly inflationary economies (a)
• Operations exposed to volatile markets, e.g., futures trading (a)
• Operations that are subject to a high degree of complex regulation (a)
• Going concern and liquidity issues including loss of significant customers, or
constraints on the availability of capital or credit (a)
• Offering new products, or moving into new lines of business (a)
• Changes in the organization such as acquisitions or reorganizations (a)
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• Entities or business segments likely to be sold (a)
• The existence of complex alliances and joint ventures (a)
• Use of off balance sheet financing, special-purpose entities, and other complex
financing arrangements (b)
• Significant transactions with related parties (b)
• Lack of personnel with appropriate accounting and financial reporting skills (c,
control risk)
• Changes in key personnel, including departure of key executives (b)
• Deficiencies in internal control, especially those not addressed by management (c,
control risk)
• Changes in the IT system or environment, and inconsistencies between the entity’s IT
strategy and its business strategies (a; c - could also be considered a control risk)
• Inquiries into the entity’s operations or financial results by regulatory bodies (a & b)
• Past misstatements, history of errors or significant adjustments at period end (b)
• Significant amount of non-routine or non-systematic transactions, including
intercompany transactions and large revenue transactions at period end (b)
• Transactions that are recorded based on management’s intent, e.g., debt refinancing,
assets to be sold and classification of marketable securities (b)
• Accounting measurements that involve complex processes (b)
• Pending litigation and contingent liabilities, e.g., sales warranties, financial
guarantees and environmental remediation (b)
7-42
Pfizer discloses a variety of interesting risks relating to inherent risk at the financial statement
level. These include:
 Increasing pricing pressures related to governmental regulations

 The Company’s growing reliance on selling specialty pharmaceuticals, and the pricing
pressure that governments are making as those governments seek cost-containment
strategies
 The drug discovery and development process is inherently risky in terms of whether
research and development expenditures will result in profitable products
 The regulatory approval process is uncertain and unpredictable, so even if a new drug is
discovered and developed, there is uncertainty about whether the government will allow
Pfizer to sell it.
The auditor would be concerned about these risks because if these negative outcomes happen, it
could threaten the fundamental financial viability of the company, and could provide incentives
for management to misstate various accounts so that the company will appear to be in better
financial position than it really is.
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7-43
 Management inquiries
 Review of client’s budget
 Tour of client’s plant and operations
 Review relevant government regulations and the client’s legal obligations
 Access the audit firm’s knowledge management systems for relevant information
 Online searches
 Review of SEC filings
 Review of company websites
 Economic statistics, including industry data
 Professional practice bulletins
 Stock analysts’ reports
 Listen to company earnings calls
7-44
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
and the evaluation of that evidence 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
• The predecessor auditor, if applicable

• 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
7-9
• Inquiries of federal regulatory agencies
• Private investigation firms
c. Analysis of Management Scenarios:
i. 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 to
obtain sufficient appropriate evidence to obtain reasonable assurance that all related party
transactions are appropriately disclosed.
ii. 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 financial statement fraud by top
management who intimidated lower level managers.
The auditor must be alert to the potential effect on the overall control environment 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 and results.
iii. 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 transactions not being reflected in the
financial statements. The auditor should have a heightened degree of professional skepticism in
the areas of management estimates and the use of reserves, or other changes where subjective
accounting judgments are made.
iv. 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
7-10
determine whether such manipulation violates 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
returns and whether there are potential constraints on the president’s activities that 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.
v. 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.
7-45
a. Brainstorming usually occurs during the planning/risk assessment phase of the audit, but on
occasion sessions are repeated if actual fraud is detected or at the end of the audit to ensure that
all ideas generated during brainstorming have been addressed during the conduct of the audit.
b. All members of the engagement team; the session is most often led by the partner or
manager.
c. To transfer knowledge from top-level auditors to less senior members of the audit team via
interactive and constructive group dialogue and idea exchange.
d. The guidelines are:
 Suspension of criticism. Participants are requested to refrain from criticizing or making

value judgments during the session.
 Freedom of expression. Participants are encouraged to try to overcome their inhibitions
about expressing creative ideas, and every idea is noted and accepted as a possibility.
 Quantity of idea generation. Participants are encouraged to provide more ideas rather
than fewer, with the intent to generate a variety of possible risk assessment scenarios that
can then be explored during the conduct of the audit.
 Respectful communication. Participants are encouraged to exchange ideas, further
develop those ideas during the session, and to respect the opinions of others.
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e. The steps are:
(1) review prior year client information, (2) consider client information, particularly with respect
to the fraud triangle, i.e., incentive, opportunity, and rationalization, (3) integrate information
from steps 1 and 2 into an assessment of the likelihood of fraud in the engagement, and (4)
identify audit responses to fraud risks.
7-46
The following is a list of factors that would lead the auditor to assess control risk at a higher
level:
• poor controls in specific countries or locations
• it is difficult for the auditor to determine or gain access to the organization or individuals
who own and/or control the entity
• little interaction between senior management and operating staff
• weak tone at the top leading to a poor control environment
• inadequate accounting staff, or staff lacking requisite expertise
• inadequate information systems
• growth of the organization exceeds the accounting system infrastructure
• disregard for regulations or controls designed to prevent illegal acts
• no internal audit function, a weak internal audit function, or lack of respect for internal
audit by management
• weak design, implementation, and monitoring of internal controls
• lack of supervision of accounting personnel
To have an appropriate level of understanding of the client’s internal controls, the auditor needs
to understand the controls management has designed and implemented to mitigate identified
risks of material misstatement. For entity-wide controls, auditors will typically review relevant
documentation prepared by management and interview appropriate individuals. As an example,
consider the risk assessment procedures that auditors might perform related to one component of
internal controls—management’s risk assessment. To obtain this understanding, the auditor
typically uses some or all of the following risk assessment procedures:
 Interview relevant parties to develop an understanding of the processes used by the board
of directors and management to evaluate and manage risks
 Review the risk-based approach used by the internal audit function with the director of
the internal audit function and with the audit committee
 Interview management about its risk approach, risk preferences, risk appetite, and the
relationship of risk analysis to strategic planning
 Review outside regulatory reports, where applicable, that address the company’s policies
and procedures toward risk
 Review company policies and procedures for addressing risk
 Gain a knowledge of company compensation schemes to determine if they are consistent
with the risk policies adopted by the company
 Review prior years’ work to determine if current actions are consistent with risk
approaches discussed with management
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 Review risk management documents
 Determine how management and the board monitor risk, identify changes in risk, and
react to mitigate, manage, or control the risk
Auditors also need to obtain an understanding of the controls designed and implemented at the
process or transaction level. Similar to entity-wide controls, for process or transaction controls,
auditors will typically review relevant documentation prepared by management and interview
appropriate individuals with knowledge about these controls. Further, auditors will perform
walkthroughs, following a transaction from origination to when it is reflected in the financial
records to determine if the controls are effectively designed and have been implemented.
7-47
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. Additionally, this analysis can also help the auditor identify areas where a
client seems to be doing much better than industry, without a valid reason for this difference.
This analysis requires the auditor to first develop expectations about account balances and trends.
Both types of analyses may point out areas that need to be given special audit attention. This
information then helps the auditor determine the nature, timing, and extent of planned audit
procedures. This analysis forces the auditor to understand the ‘bigger picture’ of the operations
of the client, and helps put into context other audit findings.
7-48
Inventory turnover, number of day’s sales in inventory, and number of day’s sales in receivables
would be very useful in this situation. For exact formulas, see Exhibit 7.3.
7-49
a. Identification of risk areas for Jones Manufacturing:
Potential Risk Indicator Risk Analysis

Inventory increase 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.
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Cost of goods sold decrease COGS has decreased to 55 percent of sales at the
same time inventory has increased. One explanation
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 on-
going activities. It may simply reflect the purchase
of an unusual amount of inventory just before year-
end.
Inventory turnover 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. 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.
Average number of days

to collect 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.
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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
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.
Debt/Equity ratio 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.
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 An expanded scope of receivables testing to determine the validity and
collectability of receivables that are increasingly older.
 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.
b. One ratio above that might cause the auditor to increase professional skepticism is the Return
on Investments. This ratio is better than expected and better than industry. When the client’s
numbers look almost too good to be true, the auditor’s professional skepticism should be
increased. Further, as indicated above, the inconsistency reflected in some of the economic data
may indicate that management is deliberately overstating inventory and understating cost of
goods sold, thereby causing the auditor to have increased skepticism about these accounts.
7-50
a. Risks include:
 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
net realizable value problems related to inventory, as well as future operating problems.
7-16
 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 going-concern 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 low level, reflecting the increased risk associated with the
client.
 Work on specific audit areas more likely to contain misstatements (e.g., receivables and
inventory) will be expanded.
7-17
 There will be greater effort on net realizable value problems, especially in the area of
intangibles.
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.
 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.
7-51
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.
The following are possible hypotheses:
 The company is more efficient because of its computerized processing.

 The company has embarked on a program that has led to better customer relations, but it
has come at the cost of deferred receivables.
 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.
 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.
 The company has more efficient warehousing techniques due to the new computerization.
 A change in customer mix has allowed the company to raise its margins.
7-18
b. The intent of this question is to get the students to exercise professional skepticism in
analyzing the hypotheses without being unduly influenced by management. When the
analysis is performed, the only hypothesis that explains all the ratios is the fourth one (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 effort 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 naïve 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.]
7-52
a. 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.
7-19
b. 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 substantive 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.
Further, for material accounts—such as revenue—some direct testing will likely be
necessary.
c. Agree. To support a control risk assessment of low or moderate, the auditor must
gather evidence that not only are controls appropriately designed, but also they are operating
as designed.
d. 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.
e. Agree. As the risk of material misstatement increases, audit risk should decrease in
order to protect the auditor from potential litigation or other problems caused by being
associated with the client.
f. Agree. Although the audit model looks like a very quantitative approach it is based on
a significant amount of auditor judgments.
7-53
Case 1 Case 2 Case 3 Case 4 Case 5 Case 6 Case 7 Case 8

IR 30% 40% 50% 50% 70% 80% 90% 100%
CR 50% 100% 60% 100% 70% 70% 80% 100%
AR 5% 5% 5% 5% 1% 1% 1% 1%
DR 33% 12.5% 16.7% 10.0% 2.0% 1.8% 1.4% 1.0%
Generalizations:
 As inherent risk increases, detection risk decreases. In other words, as inherent risk
increases (i.e., it is more likely that a transaction is recorded in error), the auditor is
willing to take less of a chance that audit procedures will not detect a material
misstatement.
 As control risk increases, detection risk decreases. In other words, as controls risk
increases (i.e., controls become less effective), the auditor is willing to take less of a
chance that audit procedures will not detect a material misstatement.
 When inherent risk remains the same but control risk increases (case 3 vs. case 4) and
audit risk remains the same, detection risk decreases.
 When control risk remains the same but inherent risk increases (case 5 vs. case 6) and
audit risk remains the same, detection risk decreases.
7-20
 When audit risk goes from relatively high (5%) to relatively low (1%), detection risk
declines dramatically as well.
 Overall, inherent risk is negatively associated with both audit risk and detection risk.
 Overall, control risk is negatively associated with both audit risk and detection risk.
Based the calculations above, the audit requiring the greatest amount of audit work would be
Case 8, as it has the lowest level of detection risk.
7-54
A controls reliance audit includes both tests of controls and substantive procedures, whereas a
substantive audit relies on substantive procedures and does not include tests of controls. The two
types of audits could be equally effective; it all depends on the nature of assessed risks at a given
client.
7-55
Examples of Changing Nature of Risk Response

 Using inspection to test for the existence of inventory, and using a specialist to test the
valuation of inventory
 At a more global engagement level, this could include changing the nature of the
engagement team (e.g., more experienced auditors, auditors with specialized skills, or
hiring outside specialists)
 At a more global engagement level, this could include an increased emphasis on
professional skepticism
Examples of Changing Timing of Risk Response

 Conducting procedures at an interim period vs. at year end
 Conducting procedures on an announced schedule vs. an unannounced basis
 Introducing unpredictability in timing (e.g., interim testing vs. year-end testing)
Examples of Changing Extent of Risk Response

 Gathering more evidence through using larger sample sizes
 Observing inventories at more locations / warehouses
7-56
Some ways to introduce unpredictability include:
• Perform some audit procedures on accounts, disclosures, and assertions that would
otherwise not receive scrutiny because they are considered “low risk”
• Change the timing of audit procedures from year to year
• Select items for testing that are outside the normal boundaries for testing, i.e., are
lower than prior-year materiality
7-21
• Perform audit procedures on a surprise/unannounced basis
• Vary the location or procedures year to year for multi-location audits
7-57
Procedures that can only be completed at or after period-end include:
• Comparing the financial statements to the accounting records

• Evaluating adjusting journal entries made by management in preparing the financial
statements
• Conducting procedures to respond to risks that management may have engaged in
improper transactions at period-end
Fraud Focus: Contemporary and Historical Cases
7-58
a. The inherent risks relate to the ability of the company to be competitive, earn a profit, and
remain a going concern. The fact that the company’s controls do not comply with SOX
requirements indicates that the company either does not have the funds to pay for control
improvements, or that management does not have the desire to make that investment. These risks
should be of concern to a potential auditor because they heighten the risk of material
misstatement, which will result in the auditor determining audit risk and detection risk to be at a
low level and thereby necessitating greater audit effort than if inherent and control risk were not
as high. Of course, what we learn in the case is that despite these risks, BSP did not apply greater
audit effort, which thereby led to the audit performance and quality control deficiencies indicated
in the PCAOB enforcement action.
b.
Ratio Formula 2008 2007
current current 7,427,061/6244852=1.1 7,295,632/6,570,530=1.11
ratio Assets/current 9
liabilities
Quick (cash+cash (1,985,818+2,847+2,17 (1,238,212+363,562+2,45
ratio equivalents+net 1,768) 3,868)
receivables)/current /6,244,852=0.67 /6,570,530=0.62
liabilities
Current Current 6,244,852/11,587,302=0 6,570,530/11,161,285=0.5
debt to liabilities/total .54 9
assets assets
ratio
AR Credit sales/AR 12,845,111/2,171,768=5 11,236,612/2,453,868=4.5
turnove .91 8
r
7-22
Days’ 365/AR turnover 365/5.91=61.72 365/4.58=79.71
sales in
AR
Inventor Cogs/ending 3,357,441/1933153=1.7 3,154,509/2,008,739=1.57
y inventory 4
turnove
r
Days’ 365/inventory 365/1.74=210.25 365/1.57=232.48
sales in turnover
inventor
y
Net NI/net sales 838,969/12,845,111=0.0 1,877,149/11,236,612=0.1
profit 7 7
margin
ROE NI/stockholders’ 838,969/1,212,819=0.69 1,877,149/520,002=3.61
equity
Debt to Total 10,157,729/1,212,819=8 10,478,940/520,002=20.15
equity liabilities/stockhold .38
ratio ers’ equity
Liabilitie Total liabilities/total 10,157,729/11,587,302= 10,478,940/11,161,285=0.
s to assets 0.88 94
assets
Asset Current assets/total 7,427,061/11,587,302=0 7,295,632/11,161,285=0.6
liquidity assets .64 5
Sales to Net sales/total 12,845,111/11,587,302= 11,236,612/11,161,285=1.
assets assets 1.11 01
Net Stockholders’ 1,212,819/12,845,111=0 520,002/11,236,612=0.05
worth to equity/net sales .09
sales
The following overall trends would cause the auditor to assess heightened risk:
 Other receivables shows a significant increase.
 There was a significant increase in property and equipment.
 There was a significant increase in pledged notes receivable.
 There was a significant decrease in bank borrowings, with a similar size increase in notes
and accounts payable.
 There was a significant increase in accrued expenses.
 The accumulated deficit will be a continuing negative for the foreseeable future.
The following trends in the ratios would cause the auditor to assess heightened risk:
 The current and quick ratios are relatively low, indicating a potential weakness in
liquidity.
 Cost of goods sold is increasing significantly, with a corresponding reduction in
profitability.
7-23
While the PCAOB Release does not suggest that the company’s financial statements were
fraudulent, the trends noted above should have caused the auditor to seriously consider if fraud
might be present at this client. This issue should have been the subject of a robust brainstorming
session.
c. Assessing the likelihood of going concern will be a priority in the audit. Therefore, the
auditor will focus attention on revenue, profitability, and accounts relating to liquidity and the
ability of the company to pay its considerable debts. So, accounts to focus on would include:
 Sales
 Cash
 Accounts receivable
 Inventory
 Accounts payable
 Notes payable
d. This case provides an example of an audit firm that did very little work and was simply
engaging in a transaction with Kid Castle designed to provide assurance to U.S. regulators and
investors. The lack of professional skepticism is evident because Waggoner did essentially no
audit work and did not review the local auditors’ workpapers, which were weak anyway. It is
inappropriate for an audit firm to hire away virtually all the audit work to a foreign audit firm. Of
course, there are times when hiring some of the work away is necessary and appropriate. But in
this case, BSP did not conduct necessary review or oversight.
e. The steps include the following, with commentary on what went wrong at each step and what
Waggoner should have done differently:
Step 1. Structure the problem. The fundamental problems that Waggoner faced were (a) lack of
familiarity with auditing public companies, or those in a foreign country, (b) lack of planning
and review of audit work done by the foreign auditors.
Step 2. Assess consequences of decision. The consequences are a loss of reputation and loss of
ability to continue to serve these companies.
Step 3. Assess risks and uncertainties of the problem. The risks and uncertainties relate to the
ability to trust in the work of the foreign auditors, particularly with regard to the fact that they
did not respond by improving audit work that was identified as deficient. In addition, Waggoner
took a tremendous risk when he blatantly violated auditing standards by conducting no work at
all on the 2007, when he refused to cooperate with PCAOB inspectors, and when he destroyed
documents. Apparently, the money that he was earning on these engagements was enticing
enough for him to be willing to take these risks.
Step 4. Evaluation information/audit evidence gathering alternatives. Not relevant for this case.
7-24
Step 5. Conduct sensitivity analysis. Not relevant for this case.
Step 6. Gather information/audit evidence. This phase was at the heart of the case. Really,
Waggoner did not gather much, if any, audit evidence. He must have been hoping that the
companies did not possess a material misstatement in the first place so that his audit opinion
would be correct even if he did not work.
Step 7. Make decision about audit problem. Fundamentally, Waggoner was not capable of
conducting these audits, and he should have not accepted the engagements in the first place.
f. When auditing a company in a foreign country, the audit firm faces the following risks:
 Communication difficulties
 Cultural differences
 Logistical difficulties
 Regulatory differences
7-59
a. The risks would include:
 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 were 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
7-25
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.
b. The use of appraisals as evidence is a difficult audit issue. When assessing the relevance
and reliability of appraisals as audit evidence, the auditor normally considers:
• 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 recency 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.
7-26
Application Activities
7-60
As of June 2012, the answers are as described below. Obviously, these answers will differ
depending on the date of application.
GE P&G Apple Citigroup

a. number of 12 17 39 24
analysts
b. average 3.8% -3.0% 31% -3.4%
estimated
sales growth
c. EPS 0.32 0.82 5.83 0.96
estimate
d. EPS actual 0.34 0.84 7.79 1.09
e. Analysts’ 5 upgrades, 2 upgrades, 8 new 2 upgrades, 4
recommendati 3 5 research downgrades
ons downgrades downgrades firms, all with
upgrades,
two
downgrades
from existing
research
firms
f. Inherent risk Low to Medium Low Medium
assessment Medium Weak sales Great sales Weak sales
Reasonable growth, more growth, well growth, more
sales growth, downgrades exceeding downgrades
beating EPS, than EPS than
more upgrades estimates, upgrades
upgrades predominantl
than y upgrades
downgrades
7-61
AS 12 discusses the following risk assessment procedures:
 Obtaining an understanding of the company and its environment (paragraphs 7-17);
 Obtaining an understanding of internal control over financial reporting (paragraphs 18-

40);
7-27
 Considering information from the client acceptance and retention evaluation, audit
planning activities, past audits, and other engagements performed for the company
(paragraphs 41-45);
 Performing analytical procedures (paragraphs 46-48);
 Conducting a discussion among engagement team members regarding the risks of

material misstatement (paragraphs 49-53); and
 Inquiring of the audit committee, management, and others within the company about the
risks of material misstatement (paragraphs 54-58).
7-62
As of June 2012, the answers are as described below for the most recent fiscal year end.
Obviously, these answers will differ depending on the date of application.
Microsoft
“Estimates and Assumptions

Preparing financial statements requires management to make estimates and assumptions that
affect the reported amounts of assets, liabilities, revenue, and expenses. Examples include:
estimates of loss contingencies, product warranties, product life cycles, product returns, and
stock-based compensation forfeiture rates; assumptions such as the elements comprising a
software arrangement, including the distinction between upgrades/enhancements and new
products; when technological feasibility is achieved for our products; the potential outcome of
future tax consequences of events that have been recognized in our financial statements or tax
returns; estimating the fair value and/or goodwill impairment for our reporting units; and
determining when investment impairments are other-than-temporary. Actual results and
outcomes may differ from management’s estimates and assumptions.”
Dell
“Use of Estimates — The preparation of financial statements in accordance with GAAP requires
the use of management's estimates. These estimates are subjective in nature and involve
judgments that affect the reported amounts of assets and liabilities, the disclosure of contingent
assets and liabilities at fiscal year-end, and the reported amounts of revenues and expenses
during the fiscal year. Actual results could differ from those estimates.”
Apple
7-28
Apple does not specifically mention the use of estimates, but has a significant discussion of
revenue recognition issues, along with some discussion of the use of estimates by specific
account
7-63
a. The answer to this question will depend on the timing of its use, and developments in the
legal cases against Rita Crundwell and the auditors.
b. Numerous parties are at fault in this case, and these are listed in order from most at fault to
least at fault.
 Of course, Rita herself is most at fault. It seems inconceivable that someone could have
committed such a large-scale fraud without detection for so long, particularly given how
ostentatious her spending was in relation to her income.
 The City of Dixon, and its leaders, is also at fault because they did not exercise sufficient
oversight or controls over Rita’s activities.
 The audit firm is somewhat at fault given that it failed to detect the fraud, which is a
known responsibility of auditors. The question that the courts will have to decide is
whether they conducted a GAAS audit, or whether they were negligent.
 Rita’s co-workers or individuals in the community are at some, albeit low, level of fault
because they failed to question her extravagant lifestyle that was so seemingly out of
order in relation to her income.
7-64
An appropriate standard would be the PCAOB’s Auditing Standard No. 13, “The Auditor's
Responses to the Risks of Material Misstatement.” AS No. 13 provides the following relevant
guidance in paragraphs 12 -15:
12. The audit procedures that are necessary to address the assessed fraud risks depend
upon the types of risks and the relevant assertions that might be affected.
Note: If the auditor identifies deficiencies in controls that are intended to address assessed
fraud risks, the auditor should take into account those deficiencies when designing his or her
response to those fraud risks.
Note: Auditing Standard No. 5 establishes requirements for addressing assessed fraud risks
in the audit of internal control over financial reporting.
13. Addressing Fraud Risks in the Audit of Financial Statements. In the audit of financial
statements, the auditor should perform substantive procedures, including tests of details, that
are specifically responsive to the assessed fraud risks. If the auditor selects certain controls
intended to address the assessed fraud risks for testing in accordance with paragraphs 16-17
of this standard, the auditor should perform tests of those controls.
7-29
14. The following are examples of ways in which planned audit procedures may be
modified to address assessed fraud risks:
a. Changing the nature of audit procedures to obtain evidence that is more reliable or to
obtain additional corroborative information;
b. Changing the timing of audit procedures to be closer to the end of the period or to the
points during the period in which fraudulent transactions are more likely to occur; and
c. Changing the extent of the procedures applied to obtain more evidence, e.g., by
increasing sample sizes or applying computer-assisted audit techniques to all of the
items in an account.
Note: AU secs. 316.54-.67 provide additional examples of responses to assessed fraud risks
relating to fraudulent financial reporting (e.g., revenue recognition, inventory quantities, and
management estimates) and misappropriation of assets in the audit of financial statements.
15. Also, AU sec. 316 indicates that the auditor should perform audit procedures to
specifically address the risk of management override of controls including:
a. Examining journal entries and other adjustments for evidence of possible material
misstatement due to fraud (AU secs. 316.58-.62);
b. Reviewing accounting estimates for biases that could result in material misstatement
due to fraud (AU secs. 316.63-.65); and
c. Evaluating the business rationale for significant unusual transactions (AU secs.
316.66-.67).
Academic Research Cases
7-65
a. The issue being addressed is how client acceptance decisions are made by audit partners.
Auditors evaluate the business risk and audit risk of a potential audit client when making the
client-acceptance decision. This study developed a model to test the evaluation of client risk and
how it is related to the auditor business risk, as well as how auditors handle risk adaptation to
retain the riskier clients.
The model was developed using two stages; a risk evaluation stage and a risk adaptation stage.
The risk evaluation stage evaluates the following: partners’ assessments of client business risk as
related to the client’s audit risk and visa versa, partners’ assessment of audit risk and the client’s
business risk as related to the auditor’s business risk.
The risk adaptation stage included three potential strategies that might be used by the audit
partner to mitigate previously noted risks. The first strategy was based on the assumption that the
partner’s assessment of audit risk and client’s business risk will negatively affect the likelihood
of accepting the client. Strategy two was based on the assumption that the relationship between
the partner’s assessment of the client’s business risk and audit risk and the likelihood of
accepting the client can be mitigated by the partner’s assessment of the auditor’s business risk.
Strategy three was based on the assumption that the partner’s assessment of the client’s business
risk and audit risk as well as the assessment of the auditor’s business risk will relate in a positive
7-30
manner to the use of proactive risk-adaptation strategies. The final assumption is that the
relationship between the partner’s assessment of the client’s business risk, audit risk, and the
auditor’s business risk and the likelihood of accepting the client will be mediated by use of
proactive risk- adaptation strategies.
b. The results relating to the risk-evaluation stage of the model showed that partners’
assessments of audit risk affects their assessments of a client’s business risk, and both client
related risk assessments affect auditors’ assessments of the auditor business risk. Therefore, it
was determined that audit partners do consider the complex relationship between audit risk,
client business risk and audit business risk. The relationship between audit risk and auditor
business risk is much stronger than the relationship between the client business risk and the
auditor business risk.
The results relating to the risk adaptation stage showed that the partners directly linked their
assessments of a client’s business risk with the client-acceptance decision. The partners’
assessments of the auditor’s business risk were also considered as a means of mediating the
effect of the client’s business and audit risk.
However, additional results from this research also indicated that partners did not use proactive
risk-adaptation strategies to mediate the effects of the client’s business risk, audit risk, and
auditor’s business risk assessments on the client-acceptance decision.
The synopsis for this result is that auditors have difficulty shifting auditor’s business risk back to
the client due to competition within the industry and high costs of litigation.
c. There are professional standards that state an audit firm should implement procedures to help
determine the acceptability of audit clients. However, the standards do not give any guidance as
to what those procedures should be. With the increase in litigation against audit firms for audit
failures and the increase in competition for audit clients, procedures for client acceptance are
becoming more and more important to auditors.
d. There were 137 participants from a Big 5 accounting firm. The partners had an average of 19
years experience and had made an average of nine client-acceptance decisions in the last year.
Each partner completed two cases. The cases provided company specific information about
financials and company management. The level of industry competition was also included. The
partners were also provided with information about the company’s internal controls. After
reading each case, the partners evaluated the client-acceptance risks, planned their risk-
adaptation strategies from available alternatives and then provided their client-acceptance
decisions.
Each case was assigned independent variables related to the client’s business risk (high, low),
audit risk (high, low), and auditor’s business risk (high, low). Dependent variables included the
client’s business risk evaluation, audit risk evaluation, auditor’s business risk evaluation,
proactive risk-adaptation strategies, and the client- acceptance decision. Structural equation
modeling, which is a statistical method that simultaneously estimates both the association
7-31
between observed indicators and the measurement model, was used to determine the actual
results.
e. The reader should be aware that the research for this paper was based on responses from only
one audit firm and therefore the conclusions may not apply to other firms. Generalization of the
results regarding the evaluated risks and proactive risk-adaption strategies is limited to the
indicators in the study.
7-66
a. Risk-based auditing is a conventional auditing approach that suggests more (fewer) audit
resources should be focused on higher (lower)-risk accounts.
The author proposes the idea that seemingly low-risk accounts can actually have a higher risk of
fraud associated with it if/when management anticipates this audit strategy of focusing audit
resources on high risk accounts. In other words, an audit resource focus on high-risk areas could
create an opportunity for management manipulation of “lower” risk accounts by exploiting the
fact that the auditor is looking the other way.
The purpose of the study is to expose this potential threat associated with risk-based auditing and
determine if prompting auditors to consider the threat changes their behavior in a positive,
misstatement-reducing manner.
b. Overall findings demonstrate that auditors behave according to the conventional risk-based
auditing approach and allocate audit more resources to high-risk accounts rather than low-risk
accounts.
As might be expected, as client managers gained experience interacting with an auditor they
increasingly anticipated this audit behavior and exploited the resulting weakness by overriding
the low-risk account more often than the high-risk account.
These auditor and client manager behaviors results in more undetected misstatements within a
low-risk account than within a high-risk account.
However, when auditors were prompted to consider management’s strategy (of overriding the
low-risk account), they did increase resource allocation to low-risk accounts (and allocation to
high-risk accounts remained unchanged). Over time, this change in approach resulted in fewer
undetected misstatements in a low-risk account, without any significant change in undetected
misstatements in a high-risk account. Thus, audit effectiveness seems to be improved, and not at
the expense of audit efficiency.
c. This study demonstrates that risk-based auditing must evolve to consider and mitigate the
effect of management’s ability to learn audit techniques and manipulate the resulting exposures.
Since prompting auditors to consider management’s behavior provides favorable results (fewer
undetected misstatements), standard-setters could mandate that audit teams specifically discuss
7-32
which accounts could be perceived by management as low-risk, the likelihood of manipulation,
and how it would occur (if so). This prompt would help the auditors make more strategically
beneficial resource allocation decisions and create an enhanced risk-based auditing approach that
includes strategic risks.
d. The author created a game of strategy whereby 132 upper-division accounting students
representing either a manager or an auditor were paired with one another for 20 rounds. During
each round, both parties are given two system-generated accounts and a risk factor associated
with the possibility of a system-generated error within the account (i.e. a “high-risk” account and
a “low-risk” account).
Managers are the first to receive the accounts and must make a decision to accept each account’s
figure or override the outcome for either account. Next, the auditor is given the accounts, the risk
factors (of system-generated errors), and the current balances (either manipulated or unchanged).
The auditor is provided with a finite number of resources and must decide how to allocate some
or all of the resources between the two accounts. Resources provided to auditors vary between
adequate and excess during each round, and the auditor does not have to use all of the resources
provided (an analogy to a firm keeping part of the audit fee as profit). The auditor is awarded
based on detection of misstatements. Increased resource allocation to an account enhances the
probability of detection while zero resources allocation to an account results in zero chance of
detection. Potential misstatements are caused by manager manipulation (strategic errors) and/or
by account system errors (non-strategic errors).
Unbeknownst to managers, some of the auditors are given a strategic prompt intended to help
them consider their opponent’s behavior and how it should impact their own strategy. These
prompted auditors are asked first asked to predict the manager’s belief about the auditor’s
allocation strategy. Furthermore, they are asked to predict the manager’s response to those
beliefs. After this prompt, this group then makes their resource allocation decision.
Note: to remove preconceived notions, all participants believe they are either a “Chooser”
(representing manager) or a “Guesser” (representing auditor) in a game about an imperfect
marble production process where each group is compensated differently based on their
effectiveness at either getting away with manipulating numbers (manager) or detecting errors
(auditors). Thus, the setting represents a very stark setting that does not have many of the
institutional features that would be found in real world auditing.
e. Real-world factors not included in the study may impact decision-making behavior. For
example, the amount of resources available to the auditor (e.g., the audit fee) is determined
through auditor-client negotiation and may influence how subsequent decisions between the two
parties are made. Additionally, managers were equally capable of manipulating either account. In
the real-world, certain accounts will be more difficult than others to manipulate. Finally, the
study imposes the same penalty for undetected errors and undetected manipulation (fraud). In the
real-world, the penalties may vary depending on the specific nature of the misstatement, which
could cause more auditor sensitivity to the overall strategic nature of an audit.
7-33
7-67
a. Audit firms should plan an audit to be responsive to the level of business risk of their clients.
The auditing standards in Japan (which are similar to the ISAs) suggest that the response to
increased client business risk should be increased audit effort. The purpose of this study is to
determine whether and how the Big 3 audit firms in Japan respond to their clients’ level of
business risk, and whether the responses differ across the firms. (Note to the interested student:
the introduction to the paper provides an overview of the Japanese audit market and provides
details on why on focus on the Big 3 is appropriate. These Big 3 firms conduct 73 percent of all
listed company audits in Japan.) The authors suggest that two types of responses might occur.
One would be to increase audit effort (more audit hours, more experienced auditors) with a
corresponding increase in audit fees to reflect the increased effort; the other would be to charge a
risk premium (a higher hourly rate without an increase in audit effort).
b. The authors’ findings suggest that the responses to clients’ business risk vary among the
three firms. Two firms appear to increase audit effort and charge a risk premium for audits with
higher business risk, while the third firm only increases audit effort (without an accompanying
risk premium). There are alternative explanations as why the response may differ among firms.
Differences may be due to differences in audit firm characteristics (methodology, risk
preference, intended audit quality) or client characteristics (size).
c. The paper is important as it provides evidence on whether auditors respond to increases in

client business risk in a manner that is consistent with the professional auditing guidance. Such
evidence can be used by audit firms to evaluate their audit process and by industry
regulators/standard setters to determine if additional guidance and/or training would be help
improve audit quality.
d. The authors examine their issues of interest by focusing on public companies in Japan in
2007 that were audited by a Big 3 firm. The final sample includes 893 companies. The authors
measure audit effort based on the number of professionals (not including engagement partners)
on the audit team (this information is included in corporate annual reports in Japan). The authors
obtain data on audit fees from a publicly available report. The authors obtain client specific data,
including business risk data, from annual reports. The authors perform various statistical
analyses using this data.
e. One limitation of this study is the proxies used to measure some of the variables. For
example, audit effort is based on the number of audit team members, which assumes that average
audit hours per person at a particular level (staff, senior) are the same across all engagements in a
particular firm. If this assumption is not true, then the measure of team size may not be an
appropriate proxy for audit effort. Client risk measures were obtained from the narrative in the
annual reports, which may be subject to discretionary and opportunistic disclosure by
management. Further, subsequent to the time of this study, listed companies in Japan began
having an audit of internal control. This institutional change may have changed to behavior of
audit firms in ways that would impact the results of this study.
7-34
Ford and Toyota
7-68
Note to instructor: The solutions based upon the FYE 2012 annual reports for Ford and Toyota
are posted at the Cengage web site for the 9th edition of this text. The solutions for FYE 2014 will
be posted at the Cengage web site for the 10th edition of this text.
7-69
Note to instructor: The solutions based upon the FYE 2012 annual reports for Ford and Toyota
are posted at the Cengage web site for the 9th edition of this text. The solutions for FYE 2014 will
be posted at the Cengage web site for the 10th edition of this text. Please note that 7-68 was
originally included as part of 16-91 in the 9th edition of this text.
7-35

Auditing 10e SM CH 7

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Auditing: A Risk Based Approach to Conducting a Quality Audit, 10e

Solutions for Chapter 7

A misstatement is an error, either intentional or unintentional, that exists in a transaction or

c. Clearly trivial means that a misstatement is clearly inconsequential, whether taken

o There have been misstatements in the past in accounts receivable, so it is

a. The FASB defines materiality as the “magnitude of an omission or misstatement of

b. Examples of items for each dimension might be these:

Nature of Item under Consideration:

Perspective of a Particular User:

• Inherent Risk—the susceptibility of an assertion about a class of transaction, account

 Increasing pricing pressures related to governmental regulations

a. Management integrity is defined as the general honesty of management and its

• The auditor will not be able to rely on management's representations without

b. Sources of evidence pertaining to management integrity might include

• The predecessor auditor, if applicable

c. Analysis of Management Scenarios:

i. This is a frequent business practice and is not considered to reflect negatively on

d. The guidelines are:

 Suspension of criticism. Participants are requested to refrain from criticizing or making

a. Identification of risk areas for Jones Manufacturing:

Potential Risk Indicator Risk Analysis

Inventory turnover Inventory turnover has decreased by 33 percent.

Average number of days

o Less stringent credit standards.

o Warranty problems (i.e., the customers may

o Unrecorded returned items or a significant

o Potential accounting recording problems.

Debt/Equity ratio This ratio has increased substantially and is double

o The existence of new debt covenants that

o A potential problem of remaining a going

o There may be concern with how the debt

 Expanded tests of inventory, pricing, returns, warranties, and the accounting

 Expanded tests for potential inventory obsolescence include a detailed analysis of

 A heightened awareness of any factors that might indicate fraud or material

 In comparison with most standard audits, there should be a greater emphasis on

 Inventory turnover is steadily decreasing, reflecting a deterioration of the company's

 Analysis of industry product trends including the identification of competitor products

 A major issuance of debt reflected in the debt/equity ratio.

 The company is more efficient because of its computerized processing.

 Increase in November and December billings

Case 1 Case 2 Case 3 Case 4 Case 5 Case 6 Case 7 Case 8

Examples of Changing Nature of Risk Response

Examples of Changing Timing of Risk Response

Examples of Changing Extent of Risk Response

Some ways to introduce unpredictability include:

Procedures that can only be completed at or after period-end include:

• Comparing the financial statements to the accounting records

Fraud Focus: Contemporary and Historical Cases

a. The risks would include:

GE P&G Apple Citigroup

AS 12 discusses the following risk assessment procedures:

 Obtaining an understanding of the company and its environment (paragraphs 7-17);

 Obtaining an understanding of internal control over financial reporting (paragraphs 18-

 Performing analytical procedures (paragraphs 46-48);

 Conducting a discussion among engagement team members regarding the risks of

“Estimates and Assumptions

Academic Research Cases

c. The paper is important as it provides evidence on whether auditors respond to increases in

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