chapter 8 review questions
Terms in this set (24)
what are the benefits derived from planning audits
There are three primary benefits from planning audits: it helps the auditor obtain sufficient appropriate evidence for the circumstances, helps keep audit costs reasonable, and helps avoid misunderstandings with the client.
Identify the eight major steps in planning audits.
Eight major steps in planning audits are:
1. Accept client and perform initial planning
2. Understand the client's business and industry
3. Assess client business risk
4. Perform preliminary analytical procedures
5. Set materiality, and assess acceptable audit risk and inherent risk
6. Understand internal control and assess control risk
7. Gather information to assess fraud risks
8. Develop overall audit strategy and audit program
What are the responsibilities of the successor and predecessor auditors when a company is changing auditors?
The new auditor (successor) is required by auditing standards to communicate with the predecessor auditor. This enables the successor to obtain information about the client so that he or she may evaluate whether to accept the engagement. Permission must be obtained from the client before communication can be made because of the confidentiality requirement in the Code of Professional Conduct. The predecessor is required to respond to the successor's request for information; however, the response may be limited to stating that no information will be given. The successor auditor should be wary if the predecessor is reluctant to provide information about the client.
What factors should an auditor consider prior to accepting an engagement? Explain.
Prior to accepting a client, the auditor should investigate the client. The auditor should evaluate the client's standing in the business community, financial stability, and relations with its previous CPA firm. The primary purpose of new client investigation is to ascertain the integrity of the client and the possibility of fraud. The auditor should be especially concerned with the possibility of fraudulent financial reporting since it is difficult to uncover. The auditor does not want to needlessly expose himself or herself to the possibility of a lawsuit for failure to detect such fraud.
What is the purpose of an engagement letter? What subjects should be covered in such a letter?
Auditing standards require auditors to document their understanding of the terms of the engagement with the client in an engagement letter. The engagement letter should include the engagement's objectives, the responsibilities of the auditor and management, and the engagement's limitations. An engagement letter is an agreement between the CPA firm and the client concerning the conduct of the audit and related services. It should state what services will be provided, whether any restrictions will be imposed on the auditor's work, deadlines for completing the audit, and assistance to be provided by client personnel. The engagement letter may also include the auditor's fees. In addition, the engagement letter informs the client that the auditor cannot guarantee that all acts of fraud will be discovered.
Who is considered the client when auditing public companies?
Because the Sarbanes-Oxley Act of 2002 explicitly shifts responsibility for hiring and firing of the auditor from management to the audit committee for public companies, the audit committee is viewed as "the client" in those engagements.
Which services must be preapproved by the by the audit committee of a public company?
All audit and non-audit services must be preapproved by the audit committee for public companies.
Explain why auditors need an understanding of the client's industry . What information sources are commonly used by auditors to learn about the client's industry?
One of the principles underlying auditing standards notes that the auditor obtains an understanding of the entity and its environment to provide a basis for identifying and assessing the risks of material misstatements in the financial statements. Auditors need an understanding of the client's business and industry because the nature of the business and industry affect business risk and the risk of material misstatements in the financial statements. Auditors use the knowledge of these risks to determine the appropriate extent of further audit procedures.
The five major aspects of understanding the client's business and industry, along with potential sources of information that auditors commonly use for each of the five areas, are as follows:
1. Industry and External Environment - Read industry trade publications, AICPA Industry Audit Guides, and regulatory requirements.
2. Business Operations and Processes - Tour the plant and offices, identify related parties, and inquire of management.
3. Management and Governance - Read the corporate charter and bylaws, read minutes of board of directors and stockholders, and inquire of management.
4. Client Objectives and Strategies - Inquire of management regarding their objectives for the reliability of financial reporting, effectiveness and efficiency of operations, and compliance with laws and regulations; read contracts and other legal documents, such as those for notes and bonds payable, stock options, and pension plans.
5. Measurement and Performance - Read financial statements, perform ratio analysis, and inquire of management about key performance indicators that management uses to measure progress toward its objectives.
When a CPA has accepted an engagement from a new client who is a manufacturer, it is customary for the CPA to tour the client's plant facilities. Discuss the ways in which the CPA's observations made during the course of the plant tour will be of help in planning and conducting the audit.
During the course of the plant tour, the CPA will obtain a perspective of the client's business, which will contribute to the auditor's understanding of the entity and its environment. Remember that an important aspect of the audit will be an effective analysis of the inventory cost system. Therefore, the auditor will observe the nature of the company's products, the manufacturing facilities and processes, and the flow of materials so that the information obtained can later be related to the functions of the cost system.
The nature of the company's products and the manufacturing facilities and processes will reveal the features of the cost system that will require close audit attention. For example, the audit of a company engaged in the custom-manufacture of costly products such as yachts would require attention to the correct charging of material and labor to specific jobs, whereas the allocation of material and labor charges in the audit of a beverage-bottling plant would not be verified on the same basis. The CPA will note the stages at which finished products emerge and where additional materials must be added. He or she will also be alert for points at which scrap is generated or spoilage occurs. The auditor may find it advisable, after viewing the operations, to refer to auditing literature for problems encountered and solved by other CPAs in similar audits.
The auditor's observation of the manufacturing processes will reveal whether there is idle plant or machinery that may require disclosure in the financial statements. Should the machinery appear to be old or poorly maintained, the CPA might expect to find heavy expenditures in the accounts for repairs and maintenance. On the other hand, if the auditor determines that the company has recently installed new equipment or constructed a new building, he or she will expect to find these new assets on the books.
In studying the flow of materials, the auditor will be alert for possible problems that may arise in connection with the observation of the physical inventory, and he or she may make preliminary estimates of audit staff requirements. In this regard, the auditor will notice the various storage areas and how the materials are stored. The auditor may also keep in mind for further investigation any apparently obsolete inventory.
The auditor's study of the flow of materials will disclose the points at which various documents such as material requisitions arise. He or she will also meet some of the key manufacturing personnel who may give the auditor an insight into production problems and other matters such as excess or obsolete materials, and scrap and spoilage. The auditor will be alert for the attitude of the manufacturing personnel toward internal controls. The CPA may make some inquiries about the methods of production scheduling, timekeeping procedures, and whether work standards are employed. As a result of these observations, the internal documents that relate to the flow of materials will be more meaningful as accounting evidence.
The CPA's tour of the plant will give him or her an understanding of the plant terminology that will enable the CPA to communicate fluently with the client's personnel. The measures taken by the client to safeguard assets, such as protection of inventory from fire or theft, will be an indication of the client's attention to internal control measures. The location of the receiving and shipping departments and the procedures in effect will bear upon the CPA's evaluation of internal control. The auditor's overall impression of the client's plant will suggest the accuracy and adequacy of the accounting records that will be audited.
An auditor often tries to acquire background knowledge of the client's industry as an aid to audit work. How does the acquisition of this knowledge aid the auditor in distinguishing between obsolete and current inventory?
One type of information the auditor obtains in gaining knowledge about the client's industry is the nature of the client's products, including the likelihood of their technological obsolescence and future salability. This information is essential in helping the auditor evaluate whether the client's inventory may be obsolete or have a market value lower than cost.
Define what is meant by a related party. What are the auditor's responsibilities for related parties and related party transactions?
A related party is defined by auditing standards as an affiliated company, principal owner of the client company, or any other party with which the client deals where one of the parties can influence the management or operating policies of the other.
Material related party transactions must be disclosed in the financial statements by management. Therefore, the auditor must identify related parties and make a reasonable effort to determine that all material related party transactions have been properly disclosed in the financial statements. Because instances of fraudulent financial reporting often involve transactions with related parties, auditors should be alert for the presence of fraud risk.
Which type of loans to executives are permitted by the Sarbanes Oxley Act?
Because of the lack of independence between the parties involved, the Sarbanes-Oxley Act prohibits related party transactions that involve personal loans to executives. It is now unlawful for any public company to provide personal credit or loans to any director or executive officer of the company. Banks or other financial institutions are permitted to make normal loans to their directors and officers using market rates, such as residential mortgages.
In recent years the global economy has experienced recession levels unprecedented since the Great Depression and the instability of the Euro continues to cause volatility in stock and bond markets. Why might it be important for you to consider current economic events as part of planning an audit?
The recent economic events and the continued instability in global financial markets have led to the collapse of several large financial services and other entities that has triggered a broader economic decline affecting all industries. The unstable global economy has resulted in a significant slowdown in many businesses. These declines are likely to have a significant impact on financial reporting. First, severe market declines may impact the accounting for many types of investments and other assets that now may be impaired or may have experienced significant declines in their fair values. The determination of those accounts is largely dependent on numerous management judgments and estimates. Auditors should apply appropriate professional skepticism as they evaluate management's judgments and estimates. Second, the significant lack of sales and other revenues may place undue pressure on management to meet revenue targets, including the need for entity survival. Thus, there may be a greater presence of fraud risk due to these significant pressures. Third, auditors should closely evaluate the entity's ability to continue as a going concern. There may be instances where the auditor's report should be modified to include an explanatory paragraph describing the auditor's substantial doubt about the entity's ability to continue as a going concern.
For the audit of Radline Manufacturing Company, the audit partner asks you to carefully read the new mortgage contract with the First National Bank and abstract all pertinent information. List the information in a mortgage that is likely to be relevant to the auditor.
The information in a mortgage that is likely to be relevant to the auditor includes the following:
1. The parties to the agreement
2. The effective date of the agreement
3. The amounts included in the agreement
4. The repayment schedule required by the agreement
5. The definition and terms of default
6. Prepayment options and penalties specified in the agreement
7. Assets pledged as collateral or encumbered by the agreement
8. Liquidity restrictions imposed by the agreement
9. Purchase restrictions imposed by the agreement
10. Operating restrictions imposed by the agreement
11. Requirements for audit reports or other types of reports on compliance with the agreement
12. The interest rate specified in the agreement
13. Any other requirements, limitations, or agreements specified in the document
Identify two types of information in the client's minutes of the board of directors meetings early in the engagement
Information in the client's minutes that is likely to be relevant to the auditor includes the following:
1. Declaration of dividends
2. Authorized compensation of officers
3. Acceptance of contracts and agreements
4. Authorization for the acquisition of property
5. Approval of mergers
6. Authorization of long-term loans
7. Approval to pledge securities
8. Authorization of individuals to sign checks
9. Reports on the progress of operations
10. Discussion about outstanding litigation and other contingencies
It is important to read the minutes early in the engagement to identify items that need to be followed up on as a part of conducting the audit. For instance, if a long-term loan is authorized in the minutes, the auditor will want to make certain that the loan is recorded as part of long-term liabilities.
Identify the three categories of client objectives. Indicate how each objective may affect the auditor's assessment of inherent risk and need for evidence accumulation.
The three categories of client objectives are (1) reliability of financial reporting, (2) effectiveness and efficiency of operations, and (3) compliance with laws and regulations. Each of these objectives affects the auditor's assessment of inherent risk and evidence accumulation as follows:
1. Reliability of financial reporting - The financial reporting framework selected by management may affect the reliability of financial reporting. For example, management's selection of the cash basis of accounting may affect the risks of material misstatement differently
than the risks of material misstatement that might be present if management selects U.S. GAAP or IFRS as the framework for financial reporting. Furthermore, recent changes in those standards by the standards-setting bodies may impact the complexity of the underlying accounting for transactions, accounts, and disclosures, which increases inherent risks. If management sees the reliability of financial reporting as an important objective, and if the auditor can determine that the financial reporting system is accurate and reliable, then the auditor can often reduce his or her assessment of inherent risk and planned evidence accumulation for material accounts. In contrast, if management has little regard for the reliability of management's financial reporting, the auditor must increase inherent risk assessments and gather more appropriate evidence during the audit.
2. Effectiveness and efficiency of operations - This area is of primary concern to most clients. Auditors need knowledge about the effectiveness and efficiency of a client's operations in order to assess client business risk and inherent risk in the financial statements. For example, if a client is experiencing inventory management problems, this would most likely increase the auditor's assessment of inherent risk for the planned evidence accumulation for inventory.
3. Compliance with laws and regulations - It is important for the auditor to understand the laws and regulations that affect an audit client, including significant contracts signed by the client. For example, the provisions in a pension plan document would significantly affect the auditor's assessment of inherent risk and evidence accumulation in the audit of the unfunded liability for pensions. If the client were in violation of the provisions of the pension plan document, inherent risk and planned evidence for pension-related accounts would increase.
What is the purpose of the client's performance measurement system? How might that system be useful to the auditor? Give examples of key performance indicators for the following businesses:
1. a chain of retail clothing stores;
2. an internet portal
3. a hotel chain
The purpose of a client's performance measurement system is to measure the client's progress toward specific objectives. Performance measurement includes ratio analysis and benchmarking against key competitors.
Performance measurements for a chain of retail clothing stores could include gross profit by product line, sales returns as a percentage of clothing sales, and inventory turnover by product line. An Internet portal's performance measurements might include number of Web site hits or search engine speed. A hotel chain's performance measures include vacancy percentages and supply cost per rented room.
Describe client business risk and describe several sources of client business risk. What is the auditor's primary concern when evaluating client business risk?
Client business risk is the risk that the client will fail to achieve its objectives. Sources of client business risk include any of the factors affecting the client and its environment, including competitor performance, new technology, industry conditions, and the regulatory environment. The auditor's primary concern when evaluating client business risk is the risk of material misstatements in the financial statements due to client business risk. For example, if the client's industry is experiencing a significant and unexpected downturn, client business risk increases. This increase would most likely increase the risk of material misstatements in the financial statements. The auditor's assessment of the risk of
material misstatements is then used to classify risks using the audit risk model to determine the appropriate extent of audit evidence.
Describe top management controls and relation to client business risk. Give two examples of effective management and governance controls
Management establishes the strategies and business processes followed by a client's business. One top management control is management's philosophy and operating style, including management's attitude toward the importance of internal control. Other top management controls include a well-defined organizational structure, an effective board of directors, and an involved and effective audit committee. If the board of directors is effective, this increases management's ability to appropriately respond to risks. An effective audit committee can help management reduce the likelihood of overly aggressive accounting.
What are the purposes of preliminary analytical procedures? What types of comparisons are useful when performing preliminary analytical procedures?
Analytical procedures are performed during the planning phase of an engagement to assist the auditor in determining the nature, extent, and timing of work to be performed. Preliminary analytical procedures also help the auditor identify accounts and classes of transactions where misstatements are likely. Comparisons that are useful when performing preliminary analytical procedures include:
Compare client and industry data
Compare client data with similar prior period data
Compare client data with client-determined expected results
Compare client data with auditor-determined expected results
Compare client data with expected results, using nonfinancial data
When are analytical procedures required on an audit? What is the primary purpose of analytical procedures during the completing phase of the audit?
Analytical procedures are required during two phases of the audit: (1) during the planning phase to assist the auditor in determining the nature, extent, and timing of work to be performed and (2) during the completion phase, as a final review for material misstatements or financial problems. Analytical procedures are also often done during the testing phase of the audit as part of the auditor's further audit procedures, but they are not required in this phase.
Gale Gordon, CPA, has found ratio and trend analysis relatively useless as a tool in conducting audits. For several engagements, he computed the industry standards. For most engagements , the client's business was significantly different from the industry in data in the publication and the client automatically explained away away an discrepancies by attributing them to the unique nature of its operations. In cases in which the client had more than one branch in different industries, Gordon found the ratio analysis to be no help at all. How can Gordon improve the quality of his analytical procedures?
Gordon could improve the quality of his analytical tests by:
1. Making internal comparisons to ratios of previous years or to budget forecasts.
2. In cases where the client has more than one branch in different industries, computing the ratios for each branch and comparing these to the industry ratios.
At the completion of every audit, Roger Morris, CPA, calculates a large number of ratios and trends for comparison with industry averages and prior-year calculations. He believes that calculations are worth the relatively small cost of doing them because they provide him with an excellent overview of the client's operations. If the ratios are out of line, Morris discusses the reasons with the client and often makes suggestions on how to bring the ratio back in line in the future. In some cases, these discussions with management have been the basis for management consulting engagements. Discuss the major strengths and shortcomings in Morris's use of ratio and trend analysis.
Roger Morris performs ratio and trend analysis at the end of every audit. By that time, the audit procedures are completed. If the analysis was done at an interim date, the scope of the audit could be adjusted to compensate for the findings, especially when the results suggest a greater likelihood of material misstatements. Analytical procedures must be performed in the planning phase of the audit and near the completion of the audit.
The use of ratio and trend analysis appears to give Roger Morris an insight into his client's business and affords him an opportunity to provide excellent business advice to his client. It also helps provide a richer context for Roger to really understand his client's business, which should help Roger in assessing the risk of material misstatements.
Name the four categories of financial ratios and give and example of a ratio in each category. What is the primary information provided by each financial ratio category?
The four categories of financial ratios and examples of ratios in each category are as follows:
1. Short-term debt-paying ability - Cash ratio, quick ratio, and current ratio.
2. Liquidity activity - Accounts receivable turnover, days to collect receivables, inventory turnover, and days to sell inventory.
3. Ability to meet long-term debt obligations - Debt to equity and times interest earned.
4. Profitability - Earnings per share, gross profit percent, profit margin, return on assets, and return on common equity