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CHAPTER 2 SOLUTIONS
The Audit Planning Process: Understanding the Risk of Material
Misstatement
REVIEW QUESTIONS
1. The purpose of an audit is to increase the level of confidence that users of the
financial statements can place in the financial information. The level of confidence
is increased when an auditor, independent from the company, expresses an opinion
on whether the financial statements are prepared in accordance with the applicable
financial reporting framework (generally accepted accounting standards). An audit
conducted in accordance with generally accepted auditing standards and relevant
ethical requirements allows the auditor to form that opinion.
2.
The Audit Process
Planning Phase:
Consider the Preconditions for an Audit and Accept or Reject the Audit Engagement
Understand the Entity and Its Environment, Determine Materiality, and
Assess the Risks of Material Misstatements
Develop an Audit Strategy and an Audit Plan to Respond to the Assessed Risks
Testing Phase:
Test Internal Controls? Yes No
Perform Tests of Controls if “Yes”
Perform Substantive Tests of Transactions
Perform Substantive Tests of Balances
Assess the Likelihood of Material Misstatement
Decision Phase:
Review the Presentation and Disclosure Assertions
Evaluate the Evidence to Determine if the Financial Statements are Prepared in
Accordance with the applicable Financial Reporting Framework
Issue Audit Report
Communicate with the Audit Committee
3. The engagement letter establishes the: objective and scope of the audit,
responsibilities of the auditor, responsibilities of management and identification
of the applicable financial reporting framework, and other information, such as
fee arrangements, billing and other specific terms, as appropriate.
This letter benefits both the auditor and management because it establishes the
terms of the engagement, what will be done, when it will be done, and the
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outcome of the audit. In addition, practical matters such as the fee charged for the
audit, are agreed upon.
4. The system of quality control established by the accounting firm should address the
following elements:
Leadership responsibilities for quality within the firm
Relevant ethical requirements
Acceptance and continuance of client relationships and specific engagements
Human resources
Engagement performance
Monitoring
Documentation
The accounting firm is expected to document its policies and procedures and
communicate them to the firm’s personnel.
5. The auditor asks the client questions about the business; he becomes familiar with
the industry and economic conditions by reading industry journals and business
newspapers like The Wall Street Journal. The auditing standards require the
auditor to understand:
industry, regulatory and other external factors relevant to the entity,
the nature of the entity, including its operations, ownership and governance
structures, the types of investments the entity makes, and the way the entity is
structured and financed,
the entity’s selection and use of accounting policies, including any changes in
these policies,
the entity’s objectives and strategies and the related business risks that may
lead to the risk of material misstatement, and
the methods used by the entity to measure and review of the entity’s financial
performance.
6. The auditor determines materiality based on professional judgment. The
materiality amount should be the amount that the auditor believes would cause an
outsider to change his or her decision about the company.
The AICPA Audit Sampling Guide provides a sample worksheet for calculating
materiality. This worksheet can be used by the auditor to determine materiality.
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7. The risk of material misstatement is the risk that the account balance or class of
transactions includes a material misstatement. The risk of material misstatement is
composed of the risk that the internal controls fail to detect or prevent
misstatements times the inherent risk in the account balance or class of transactions
(IR x CR). Inherent risk is the susceptibility of management assertions in an
accounting business process to a material misstatement assuming no internal
controls.
The auditor responds to this risk by designing audit procedures to keep this risk to
an acceptably low level.
8. The audit strategy establishes the scope, timing and direction of the audit and
guides the auditor when he prepares the audit plan.
The audit plan is more detailed than the audit strategy. The specific procedures
listed on the audit plan depend on the outcome of the risk assessment procedures.
The documentation of the audit plan is a record of the nature, timing, and extent of
risk assessment procedures and additional audit procedures at the relevant assertion
level in response to the assessed risks.
The audit plan developed by the auditor depends on the assessed risk of material
misstatement. The audit plan is developed to keep the risk of material misstatement
to an acceptably low level.
9. Audit risk is the risk that the auditor expresses an inappropriate audit opinion when
the financial statements are materially misstated. An inappropriate audit opinion
when the financial statements are materially misstated is an unqualified audit
opinion. Therefore audit risk is the risk that the auditor issues an unqualified
opinion when the financial statements are materially misstated.
MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS
10. c
11. b
12. d
13. d
14. d
15. c
16. b
17. b
18. a
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DISCUSSION QUESTIONS AND RESEARCH PROBLEMS
19. a. DR = AR/IR x CR
DR = .05/.50 x .30
DR = .05/.0015
DR = .33
b. Inherent risk is assessed by professional judgment. The auditor cannot
gather evidence using sampling to support his or her inherent risk
assessment. Instead, the decision is made based on the professional
judgment of the auditor.
Control risk is assessed by professional judgment. The auditor uses
internal control tests to gather evidence to support his or her assessment.
This evidence will either show that internal control risk is at the level
expected by the auditor (30%, 50%, or 70%) or it will provide evidence
that internal control risk is higher than the auditor’s assessment. If control
risk is 1 (100%), the auditor does not gather evidence to support the
assessment.
c. (1) DR = .05/.50 x .50
DR = .20
(2) You will perform more substantive testwork. As detection risk
decreases the amount of substantive evidence increases. So, a DR
of .20 will result in more substantive testing than a DR of .33. The
auditor gets less evidence from control testing when CR is .50,
than when control risk is .30. Less internal control evidence means
that the auditor needs more substantive evidence to determine
whether the accounts contain material misstatements.
(3) You will perform more internal control testing when the CR is .30,
than when the control risk is .50. In this situation, the auditor has
performed the test work required for a CR of .30, but has found
more control deviations than permitted to support an assessment of
control risk at .30.
d. If you assess CR at .50 instead of .70, you will do more internal control
testing. Lower CR requires more internal control testing.
If CR decreases from .70 to .50, you will do less substantive testing. More
internal control testing means less substantive testing.
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Consider for example, inherent risk of .30. What is the impact on DR
when CR changes from .70 to .50?
When IR =.30 and CR =.70, DR =.24
DR = .05/.70 x .30
DR = .24
When IR =.30 and CR =.50, DR =.33
DR =.05/.50 x .30
DR =.33
Lower DR, more substantive testing.
e. The auditor controls only DR and AR. IR and CR must be assessed by the
auditor, but they are controlled by the company.
f. Audit risk is the risk that the auditor issues a clean opinion when the
financial statements are materially misstated.
Audit risk at the beginning of the audit differs among clients. Some
clients are riskier to audit than others. At the end of the audit, audit risk
should be approximately equal for each client. At the end of the audit,
audit risk should be at an acceptably low level (about 5%).
g. The auditor controls audit risk by adjusting the level of DR to a point
where audit risk is at an acceptably low level. This means that the auditor
increases the amount of substantive testing to the point where audit risk is
at the acceptably low level. In practice, we believe that the acceptably low
level is about 5%, but the auditing standards do not specify what an
“acceptably low level” is.
20. a. The auditor determines a materiality level during the planning
process. This level will be used to determine, for example, the amount of
substantive testing needed to allow the auditor to reduce the risk of
material misstatement to an acceptable level.
The materiality level is used at the end of the audit to evaluate the
proposed audit adjustments. Any audit adjustments alone or in aggregate
that are greater than the materiality level should be recorded before the
auditor issues a clean opinion on the financial statements. The auditor
should also consider the nature of the misstatements in determining
whether they are material.
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b. Materiality might be used in the revenue business process to evaluate the
misstatements found during the audit process. Misstatements relating to
sales revenue, sales returns and allowances, accounts receivable, and the
allowance for doubtful accounts should be individually or in aggregate
less than materiality. The auditor may assign a tolerable materiality to the
accounts in the revenue business process (usually 50-75% of planning
materiality). The auditor determines that misstatements relating to the
revenue business process do not exceed tolerable materiality.
c. No, the auditor should not issue an unqualified opinion in this situation.
An unqualified opinion states that the auditor is reasonably assured that
the financial statements are free of material misstatement. In this
situation, the auditor should ask the client to record some of the audit
adjustments to reduce the level of misstatement to less than the materiality
level. If the client does not comply with this request, the auditor should
consider issuing a qualified opinion.
d. No, substantive testing is always done because the risk of material
misstatement will never be 0.
e. Yes, internal control testing is only done when the auditor believes that the
company has internal controls that prevent or detect misstatements in the
financial statements. So it is possible, to do no control testing for a client.
f. Yes, the auditor often uses both internal control and substantive evidence
on an audit engagement. The auditor combines the results from both types
of tests using the audit risk model. The audit risk model allows the auditor
to calculate DR after determining CR based on internal control testing
using the AR desired for the engagement.
21. a. Materiality based on the worksheet:
Base amount: $49,205 million
Materiality: $23,791,960 or
17,800,000 + (.000312 x 19,205,000,000) $23.791 million
17,800,000 + 5,991,960
b. This materiality level will be used to determine the amount of substantive
testing necessary. The auditor should gather sufficient appropriate
evidence to keep the level of misstatement in the financial statements to an
amount less than materiality. In this case, the misstatement should be less
than $23,791,960.
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c. The materiality level will be used to evaluate the proposed audit
adjustments at the end of the audit. The proposed audit adjustments
should be less individually or in aggregate than the materiality level.
d. If the proposed audit adjustments at the end of the audit are not less than
the materiality level, and the client refuses to record the adjustments, then
the auditor would modify the audit opinion to reflect the fact the financial
statements are materially misstated.
22. a. In a bookstore, the risk of material misstatement in the financial
statements is likely to be higher for inventory than for any other account.
The audit strategy might include a plan to count inventory at year-end and
to perform tests to determine that inventory is correctly priced according to
FIFO and valued at lower of cost or market at year end. The auditor
would plan to attend the physical inventory count and to perform test
counts at this time.
The internal controls for the inventory process are also important. The
auditor would plan to document internal controls for inventory and to test
the controls. The important inventory controls are related to the assertions
of existence and valuation.
b. Materiality based on the worksheet:
Base amount: $1,675,000,000
Materiality: $2,511,625
1,840,000 + (.000995 x 675,000,000)
1,840,000 + 671,625
Materiality is used to determine the amount of testing needed to keep the
risk of material misstatement to an acceptably low level.
c.
Significant accounts are inventory and sales revenue.
Relevant assertions for inventory are existence and valuation.
Relevant assertion for sales revenue is existence.
The auditor assesses inherent risks for these accounts based on
professional judgment.
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The auditor assesses control risk based on his or her understanding
of internal controls that apply to the relevant assertions for the
significant accounts. So, for example, the auditor documents the
internal controls for existence and valuation for inventory. If he
believes that internal controls are designed to prevent or detect
misstatements, he will test internal controls. This test will either
support his or her assessment or give him evidence to revise his or
her estimate upwards.
d. The auditor will calculate the inventory turnover ratio and will compare
the current year’s ratio to the prior year’s ratio. The auditor will also
compare the current year balance in sales revenue and inventory to the
prior year’s balance.
The results from the analytical procedures will be used to identify
unexpected changes in the current year from the prior year. Unexpected
changes indicate a risk of material misstatement. The auditor will design
his or her audit procedures to determine whether these accounts are
materially misstated (to find the misstatements and ask the client to correct
them).
e. The auditor will perform tests of internal controls to see if they are in
place. At a control risk of .50, the auditor will perform a certain number
of tests (based on firm procedures for sampling) and will be allowed a
certain number of exceptions for missing controls. (Control exceptions
are almost always controls that are missing or mistakes found when testing
controls).
If the results of the tests do not support an assessment of CR at .50, the
auditor will increase control risk to .70 or 1.00, depending on the results
from the internal control tests. To make this decision, the auditor
determines whether the results from the test support a control risk of .70 or
1.00.
f. The more internal control testing the auditor does, the less substantive
testing that will be needed (assuming of course that the results of the
control testing support the levels of CR assessed by the auditor).
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g. Misstatements that are greater than the materiality level are material
misstatements. The auditor should not issue a clean opinion on the
financial statements unless the client corrects misstatements to the point
where they are below the materiality level. The client corrects
misstatements by recording the proposed adjustment in the financial
statements for the year under audit.
So, the decision you make about the financial statements is that they are
materially misstated.
The correct action is to issue an unqualified opinion only if the client
corrects the misstatements so they are below the materiality level.
h. The appropriate audit opinion is determined based on the amount of
evidence the auditor has gathered and the misstatements found during the
audit. To issue an unqualified audit opinion, the auditor must gather
sufficient appropriate audit evidence to reduce audit risk to an acceptably
low level and the level of misstatements in the financial statements must
be immaterial.
23. a. Materiality based on the worksheet:
Base amount: $2,800,000
Materiality: $36,310
18,400 + (.00995 x 1,800,000)
18,400 + 17,910
Materiality is used in the audit to determine the amount of substantive
testing. The auditor will also use the materiality level to design audit
procedures so the risk of material misstatement is less than the materiality
level.
b. Significant accounts for the company are inventory and revenue. A
significant disclosure might be a strike at the docks that occurred during
the year under audit. Relevant assertions for inventory and revenue are
existence and valuation. Relevant assertions for disclosure are
completeness and accuracy (presentation and disclosure assertions are (1)
occurrence, rights and obligation, (2) completeness, (3) classification and
understandability, and (4) accuracy and valuation). The auditor
determines the significant accounts and disclosures by considering the
areas of greatest risk in the company.
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c. It may not be possible to test internal controls in the company. With only
2 employees, there is no segregation of duties. You might expect to see
internal controls related to the physical custody of the inventory. For
example, the auditor would expect to see controls to safeguard the
physical custody of the inventory (doors to the warehouse are locked, etc.)
d. Evidence will be gathered by substantive tests related to inventory and
sales revenue. For disclosure, the auditor gathers evidence primarily with
inquiries with the client. The issue of disclosure is most important if the
port is closed at year-end or if the port had been closed so long that it calls
into question the company’s ability to stay in business.
e. The financial statements are materially correct because $32,206 is less
than the materiality level. The auditor would also consider whether the
level of misstatement for individual accounts s greater than the tolerable
misstatement for the individual balance sheet or income statement
accounts. In this case, the auditor could issue a clean opinion if he has
gathered sufficient appropriate evidence to reduce audit risk to an
acceptably low level.
REAL-WORLD AUDITING PROBLEMS
24. a. From the description of the accounting fraud, it appears that the
auditor’s assessments of inherent risk and control risk were not based on
sound professional judgment, but rather an attempt by the auditor to please
an important client. Correct usage of the audit risk model (an increase in
CR and IR for the revenue cycle) would have led the auditor to gather
more substantive evidence related to the client’s recognition of sales
revenue. This may have led the auditor to a more accurate assessment of
material misstatements in the sales revenue account.
b. It appears that the auditors may have assessed control risk too low. Topside adjusting entries made at the end of the reporting period (quarter end
of year end) seem to be initiated by upper management with no controls in
place to prevent or detect the actions by management to manipulate
revenue at the end of the reporting period.
c. It appears that the auditors may have assessed inherent risk too low. The
auditing standards currently require the auditor to assume there is a risk of
material misstatement in the revenue business process. Even without this
requirement, sales revenue associated with leases should carry a higher
inherent risk that other types of revenue. The accounting rules for leases
are complex so the inherent risk for leases should be higher than revenue
from other sources.
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d. The auditor should have determined that the financial statements prepared
by Xerox did not contain misstatements that were greater than the level of
materiality for the company. In this case, it appears that the financial
statements of Xerox contained misstatements that would have caused
outsiders to change their decisions about the company if they had known
about the misstatements.
e. The SEC’s belief was that the auditors failed to prevent Xerox from
recognizing revenue early because they considered the company to be an
important and lucrative audit client. KPMG auditors seemed to have
information from other country locations in the audit firm to suggest that
the revenue recognition method used by the company was incorrect. And
the partners seemed to have ignored the information available to them.
They allowed the client to determine revenue recognition policies, rather
than assuring that the client prepared the financial statements in
accordance with the applicable financial reporting framework. In other
words, the auditor did not care if the client followed the accounting
standards in the preparation of the financial statements.
25. a. The auditors assessed IR and CR and used the audit risk model to
calculate DR. The DR gave the auditors the amount of substantive testing
needed. It appears that the auditors did not correctly assess IR and CR and
as a result of this, they did not gather sufficient appropriate substantive
evidence to reduce audit risk to an acceptably low level. The proper
assessment of IR and CR might have led the auditors to more substantive
testing, which might have led the auditors to uncovering the material
misstatement. However, in this case, it looks like the auditors ignored all
the evidence available to them about the misstatement in the Parmalat
financial statements to keep an important client happy.
b. No, the auditor did not keep AR to an acceptably low level. The auditor
may have been wrong in assessing IR and CR too low. Or the auditor may
have assessed IR and CR correctly, and then failed to gather sufficient
substantive evidence. Or the auditor may have assessed IR and CR
correctly, performed adequate substantive tests, and then simply ignored
all the evidence to keep the audit client happy.
c. Risk assessment did not play any role in the decisions made by Deloitte.
It appears that Deloitte made decisions that would keep the client happy.
This of course is contrary to the requirements of the auditing standards.
d. No, it appears that the audit adjustments were material, because once
outsiders became aware of them, they changed their decisions about the
company. The auditors ignored the audit adjustments to please the audit
client.
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e. This simply reflects the extent that Deloitte & Touche was willing to go to
keep this client happy.
f. Not good. It is the auditor’s job to ask difficult questions. For an
accounting firm to tell associate offices of the firm to ignore Bonlat was
inconsistent with the accounting and auditing standards. Clearly this
auditor was not acting in the interests of the shareholders of the company.
Instead, the auditor was protecting his or her interests and the interests of
management.
26. a. Materiality based on the worksheet:
Base amount: $2,233,520,000
Materiality: $3,067,352
1,840,000 + (.000995 x 1,233,520,000)
1,840,000 + 1,227,352
b. No, the illegal payments are not quantitatively material. The amount of
the payments is less than the materiality amount. Illegal payments of
$223,000 are less than materiality of $3,067,352.
c. The auditing standards require the auditor to consider both the amount of
the misstatement (223,000 compared to 3,067,352) and the nature of the
misstatements (what caused the misstatement?). In this case, the illegal
payments would probably be material because they are illegal.
d. A company who engages in illegal actions should have a higher risk of
material misstatement than a company who does not engage in illegal
actions. The logic is: if the company engages in this illegal act, what else
might they do?
e. The auditor would first ask the client if there were any additional illegal
payments made in other countries. The auditor would also increase the
amount of testing done…by either performing additional internal controls
tests or increasing the level of substantive testing. The purpose of the
increased testing is to find the misstatements if they exist.
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INTERNET ASSIGNMENTS
27. A drug manufacturer is in a risky business. The footnotes of the company will
usually mention the possible contingent liabilities associated with manufacturing
drugs.
In general, most annual reports will not say very much about risk.
28. Select this problem only if students have access to a database for audit opinions
