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Auditing Exam 1

Terms in this set (69)

Purpose and Premise of an Audit:
An audit is to provide an opinion by an auditor on whether financial statements are presented fairly, in all material respects, according to the applicable framework. Management and those charged with governance are responsible for the preparation and fair presentation of the financial statements and for the design, implementation, and maintenance of internal control over financial reporting. They are also responsible for providing the auditor with all information relevant to the preparation of the financial statements.

Responsibilities:
Auditors are responsible for having appropriate competence and capabilities to perform the audit; complying with relevant ethical requirements; and maintaining professional skepticism and exercising professional judgment, throughout the planning and performance of the audit.

It was inappropriate for Jones to hire the two students to conduct the audit, because they do not have appropriate competence and capabilities.

In order to comply with ethical requirements, Jones must be without bias with respect to the client under audit. Because of the financial interest in whether the bank loan is granted to Boucher, Jones is not independent in either fact or appearance with respect to the assignment undertaken.

Neither Jones nor her two assistants exercised professional skepticism or professional judgment in performing the audit.
Performance:
The auditor must obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error. To do so, the auditor must plan the work and supervise any assistants; determine an appropriate materiality level; identify and assess risks of material misstatement based on an understanding of the entity and its environment, including its internal control; and obtain sufficient appropriate audit evidence about whether misstatements exist. The auditor is unable to obtain absolute assurance that the financial statements are free from material misstatements.

Jones failed to supervise the assistants. The work performed was not adequately planned.

Jones did not study the client or its environment, including internal control, nor did the assistants. Consequently, she could not have identified risks of material misstatements.

Jones acquired little evidence that would support the fairness of the financial statements. Jones merely checked the mathematical accuracy of the records and summarized the accounts. Several standard audit procedures and techniques were neglected.

Responsibilities:
Auditors are responsible for having appropriate competence and capabilities to perform the audit; complying with relevant ethical requirements; and maintaining professional skepticism and exercising professional judgment, throughout the planning and performance of the audit.

It was inappropriate for Jones to hire the two students to conduct the audit, because they do not have appropriate competence and capabilities.

In order to comply with ethical requirements, Jones must be without bias with respect to the client under audit. Because of the financial interest in whether the bank loan is granted to Boucher, Jones is not independent in either fact or appearance with respect to the assignment undertaken.

Neither Jones nor her two assistants exercised professional skepticism or professional judgment in performing the audit.


Performance:
The auditor must obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error. To do so, the auditor must plan the work and supervise any assistants; determine an appropriate materiality level; identify and assess risks of material misstatement based on an understanding of the entity and its environment, including its internal control; and obtain sufficient appropriate audit evidence about whether misstatements exist. The auditor is unable to obtain absolute assurance that the financial statements are free from material misstatements.

Jones failed to supervise the assistants. The work performed was not adequately planned.

Jones did not study the client or its environment, including internal control, nor did the assistants. Consequently, she could not have identified risks of material misstatements.

Jones acquired little evidence that would support the fairness of the financial statements. Jones merely checked the mathematical accuracy of the records and summarized the accounts. Several standard audit procedures and techniques were neglected.


Reporting:
Based on an evaluation of the audit evidence obtained, the auditor expresses an opinion in accordance with the auditor's findings, or states that an opinion cannot be expressed. The opinion states whether the financial statements are presented fairly, in all material respects, in accordance with the applicable financial reporting framework.
Part I: Merry-Go-Round (MGR), a clothing retailer located primarily in shopping malls, was founded in 1968.10 By the early 1990s, the company had gone public and had expanded to approximately 1,500 stores, 15,000 employees, and $1 billion in annual sales. The company's locations in malls targeted the youth and teen market. The company was listed by Forbes magazine as one of the top 25 companies in the late 1980s. However, in the early 1990s, the company faced many challenges. One of its cofounders died, and the other left to pursue unrelated business interests. The company faced stiff competition from other retailers (e.g., The Gap and Banana Republic), fashion trends changed, and mall traffic declined. Sales fell, and experts speculated that MGR failed to anticipate key industry trends and lost sight of its cus- tomer market. To try to regain its strong position, the company acquired Chess King, Inc., a struggling chain of men's clothing stores located in malls, in 1993.

The company's sales continued to fall, and later in 1993 the company brought back one of its cofounders to manage the company and wrote down a significant amount of inventory. However, this inventory write-down caused the company to violate loan covenants. Facing bankruptcy, the company, based on the advice of its newly hired law firm Swidler and Berlin, hired turnaround specialists from Ernst and Young (E&Y) to help overcome the financial crisis and develop a long- term business plan. However, the company's decline continued, and it filed for Chapter 11 reorganization in 1994. In 1996, the remaining assets were sold for pen- nies on the dollar.

Subsequently, a group of 9,000 creditors (including former employees and stock- holders) began litigation against parties it deemed responsible for their losses. These parties included E&Y, which the creditors sued for $4 billion in punitive and com- pensatory damages (E&Y's fees from MGR totaled $4.5 million).The lawsuit alleged that E&Y's incompetence was the main cause of MGR's decline and demise.

The lawsuit alleged in part that
∙ The turnaround team did not act quickly enough.
∙ The leader of the team took an eight-day vacation at a critical point during theengagement.
∙ The cost-cutting strategy called for only $11 million in annual savings, despite thefact that the company was projected to lose up to $200 million in 1994.
∙ While closing unprofitable stores was key to MGR's survival, by 1995 only 230 of 1,434 stores had been closed and MGR still operated two stores in some malls.
∙ The turnaround team included inexperienced personnel—a retired consultant, a partner with little experience in the United States or with retail firms in general,and two recent college graduates.
∙ E&Y charged exorbitant hourly rates and charged unreasonable expenses (e.g.,charges included reimbursement for a dinner for three of the consultants totaling in excess of $200).

E&Y denied any wrongdoing but in April 1999 agreed to pay $185 million to settle with the injured parties.

Required:
a. Although this was not an audit engagement for E&Y, some of the allegations against the firm can be framed in terms of the 10 generally accepted auditing standards. Which of the 10 GAAS was E&Y alleged to have violated?
3-26 a. Prior to acceptance of the engagement, Tish & Field should have communicated with the predecessor auditor regarding:
· Information that might bear on the integrity of management.
· Disagreements with management concerning accounting principles, auditing procedures, or other similarly significant matters.
· Communications to those charged with governance regarding fraud and noncompliance with laws or regulations by the entity.
· Communications to management and those charged with governance regarding significant deficiencies and material weaknesses in internal control.
· The predecessor auditor's understanding about the reasons for the change in auditors.

b. The additional procedures Tish & Field should perform before accepting the engagement include the following:
· Obtain and review available financial information (annual reports, interim financial statements, income tax returns, etc.).
· Inquire of third parties about any information concerning the integrity of the prospective client and its management. (Such inquiries should be directed to the prospective client's bankers and attorneys, credit agencies, and other members of the business community who may have such knowledge.)
· Consider whether the prospective client has any circumstances that will require special attention or that may represent unusual business or audit risks, such as litigation or going concern issues.
· Determine if the firm is independent of the client and able to provide the desired service.
· Determine if the firm has the necessary technical skills and knowledge of the industry to complete the engagement.
· Determine if acceptance of the client would violate any applicable regulatory agency requirements or the Code of Professional Conduct.

c. The form and content of engagement letters may vary (refer to Exhibit 3-1), but they would generally contain information regarding:
· The objective of the audit.
· The estimated completion date.
· Management's responsibility for the financial statements.
· The scope of the audit.
· Other communication of the results of the engagement.
· The fact that because of the test nature and other inherent limitations of an audit, together with the inherent limitations of any system of internal control, there is an unavoidable risk that even some material misstatement may remain undiscovered.
· Access to whatever records, documentation, and other information may be requested in connection with the audit.
· Arrangements with respect to client assistance in the performance of the audit engagement.
· Expectation of receiving from management written confirmation concerning representations made in connection with the audit.
· Notification of any changes in the original arrangements that might be necessitated by unknown or unforeseen factors.
· A request for the client to confirm the terms of the engagement by acknowledging receipt of the engagement letter.
· The basis on which fees are computed and any billing arrangements.
Scenario 1:
a. Because Murphy & Johnson is a profit-oriented entity, net income before taxes is likely to be the most appropriate benchmark for determining overall materiality. Murphy & Johnson's auditor could use 3 - 5% of net income before operations for determining overall materiality. If we assume that the auditor uses 5%, overall materiality would be $1.05 million ($21 million ´ .05). Assume further that the auditor's firm provides guidance that tolerable misstatement will be set 50% of overall materiality or $525,000.

b. In this case, the two detected misstatements exceed overall materiality ($1.25 million versus $1.05 million). Thus, the auditor needs to propose an adjustment to the financial statements. If both of the misstatements are factual (known) misstatements, the auditor should request the client to book both misstatements. If the misstatements are judgmental or projected misstatements, the auditor will have to determine whether the misstatements arose from an accounting estimate or an audit sample. In our example, the auditor's proposed adjustment would need to be at least $200,000 so that the remaining misstatement would be equal to or less than $1.05 million. The auditor should also understand the cause of the misstatements and determine the impact of the material misstatements on the auditor's assessment of fraud and control risk. If Murphy & Johnson is a public company, subject to Sarbanes Oxley 404 requirements (see Chapter 7), the material misstatements are strong indicators of material weaknesses in controls.


Scenario 2:
a. Delta Investments is in the mutual fund industry and total assets would likely be the most appropriate benchmark for determining overall materiality. Delta's auditor could use .25 - 2% of total assets (see Table 3-5) for determining overall materiality. If we assume that the auditor uses .5%, overall materiality would be $21.5 million ($4.3 billion ´ .005). Assume further that the auditor's firm provides guidance that tolerable misstatement will be set 50% of overall materiality or $10.75 million.
b. The two detected misstatements are less than both tolerable misstatement and overall materiality so no adjustment to the financial statements would be necessary. However, the auditor should understand the cause of the misstatement and determine the impact of the misstatements on the auditor's assessment of fraud and control risk. If either of the two misstatements were factual misstatements, the auditor would request that the client make an adjustment. If Delta Investments is a public company, subject to Sarbanes Oxley 404 requirements (see Chapter 7), the misstatements may represent significant weaknesses in controls.

Scenario 3:
Swell Computers is a profit-oriented entity and net income before taxes would normally be the most appropriate benchmark for determining overall materiality. However, Swell's profit ($500,000 net income on $7 billion of revenue) is close to breakeven. In this case, Swell's auditor can use total assets (.25 - 2%) or total revenues (.5 - 5%) for the base. Assume Delta's auditor decides to use .5% of total assets for determining overall materiality. Thus, overall materiality would be $11.0 million ($2.2 billion ´ .005). Assume further that the auditor's firm provides guidance that tolerable misstatement will be set 50% of overall materiality or $5.5 million. Note that other scenario answers are feasible.

The detected misstatement is less than both tolerable misstatement and overall materiality. However, in this instance the adjustment of $1.5 million turns a profit into a loss. This is one of the qualitative factors that SAB No. 99 requires the auditor to consider (see Chapter 17), so an adjustment to the financial statements would be necessary. In addition, the auditor should understand the cause of the misstatement and determine the impact of the misstatements on the auditor's assessment of fraud and control risk. If Swell Computer is a public company, subject to Sarbanes Oxley 404 requirements (see Chapter 7), the misstatements may represent significant weaknesses in controls.
For each of the following independent situations, indicate the type of financial statement audit report that you would issue and briefly explain your reasoning. Assume that all companies mentioned are private companies and that each item is at least material.

b) The management of Bonner Corporation has decided to exclude the statement of cash flows from its financial statements because it believes that its bankers do not find the statement to be very useful.

c) You are auditing Diverse Carbon, a manufacturer of nerve gas for the military, for the year ended September 30. On September 1, one of its manufacturing plants caught fire, releasing nerve gas into the surrounding area. Two thousand people were killed and numerous others paralyzed. The company's legal counsel indicates that the company is liable and that the amount of the liability can be reasonably estimated, but the company refuses to disclose this information in the financial statements.

d) During your audit of Cuccia Coal Company, the controller, Tracy Tricks, refuses to allow you to confirm accounts receivable because she is concerned about complaints from her customers. You are unable to satisfy yourself about accounts receivable by other audit procedures and you are concerned about Tracy's true motives.

e) On January 31, Asare Toy Manufacturing hired your firm you audit the company's financial statements for the prior year. You were unable to observe the client's inventory on December 31. However, you were able to satisfy yourself about the inventory balance using other auditing procedures.

f)Gelato Bros., Inc., leases its manufacturing facility from a partnership controlled by the chief executive officer and major shareholder of Gelato. Your review of the lease indicates that the rental terms are in excess of rental terms for similar buildings in the area. The company refuses to disclose this related-party transaction in the footnotes.

g)Johnstone Manufacturing Company has used the double-declining balance method to depreciate its machinery. During the current year, management switched to the straight-line method because it held that it better represented the utilization of the assets. You concur with its decision. All information is adequately disclosed in the financial statements.
b. The auditor should issue a qualified audit report because management has not complied with GAAP. The auditor is not required to prepare the statement of cash flows for disclosure in the audit report.
d. Because the client wouldn't allow the confirmations to be sent, the appropriate response would generally be either a qualified opinion or a disclaimer of opinion for a scope limitation imposed by the client's management, depending on the materiality of accounts receivable. However, even if accounts receivable isn't highly material, if the auditor suspects fraud by upper management, the scope limitation would merit a disclaimer.
e. Since the auditor is satisfied about the inventory balance using alternative audit procedures, a standard unqualified audit report can be issued. The alternative audit procedures would normally include a physical count subsequent to year end and reconciliation to the balance at the end of the reporting period.

f. Since the client fails to disclose the related-party transaction, the auditor should issue a qualified or adverse audit report depending on the materiality of the matter. The client's failure to disclose the related parties means that the financial statements do not comply with GAAP.
g. Recall that the instructions to the problem indicate the assumption that all matters listed are at least material. Since the change in accounting principle is properly accounted for, the auditor should issue an unqualified audit report with an explanatory paragraph for a lack of consistency in the application of GAAP.