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The auditor should determine
• The reliability of the facts.
• Whether the development or event had occurred by the report date. Issuance of revised
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Fazio failed to make sure that engagement personnel evaluated subsequent events related to
product returns after year-end. Fazio did not review the estimate for product returns after year
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Dual dating can occur when the auditor becomes aware of an event that occurs after the original
audit report date but before the issuance of the audit report (period B in Exhibit 14.8). The
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(2) This should be disclosed only since the accident occurred after the balance sheet date,
and no conditions existed at the balance sheet date.
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(5)
(a) No adjustment or disclosure is required for the approval of officer’s salaries for the
next year.
(b) Approval of the sale of a significant bond issue should be disclosed only.
(c) There are differences of opinion about disclosing a strike after year-end. A strike does
(6) The loss did not exist at year-end, but the client will not be able to recover this asset’s
value and, therefore, should be disclosed.
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The purposes of the review are to help assure that the audit and audit documentation are
complete and support the audit opinion on the financial statements and, for public companies, on
the client’s internal controls. Some of the procedures the reviewer should perform as part of the
review process include:
• Discussing significant matters related to the financial statements and internal controls,
including the audit team’s identification of material control deficiencies and audit of
significant risks
• Assessing whether appropriate matters have been communicated to audit committee
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a. The engagement quality reviewing partner should retain the following documentation to
provide evidence that they have properly evaluated the consistent quality of the audit
work that they reviewed:
• Evidence about who performed the engagement quality review
• Documents reviewed by the quality engagement reviewer
b. It is helpful for auditors to describe their reasoning processes in memos that are retained
in the audit documentation. In this way, an independent reviewer such as the concurring
partner (or possibly even a PCAOB inspection team at some later date) can learn why the
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a. The auditor can test the subsequent sale of the questionable items to determine whether the
market decline had a material effect on the subsequent year’s profits. For those inventory
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The auditor should decide whether the previously issued audit report can still be supported in
light of the omitted procedures. If not, the omitted or alternative procedures should be promptly
performed and documented.
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• Auditor’s responsibility under GAAS. Important because the audit committee
needs a clear understanding of the auditor’s responsibility in order to develop
realistic expectations about what the auditor can and cannot do.
• Overview and planned scope of the audit. Important because the audit committee
stewardship and accountability of management.
• Judgments about the quality of the company’s accounting principles. Important
because the quality of the company’s accounting principles directly reflects on
management’s financial reporting choices and the quality thereof.
• Other information in annual reports. Important because the audit committee needs
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The following are considerations that are relevant in assessing the quality, not just the
acceptability, of significant accounting policies:
• Consistency of application of principles
• Clarity of financial statements and disclosures
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14-94
The purpose of the management letter is used to make significant operational or control
recommendations to the client, thereby providing management comfort that the auditor has done
a quality job and that the auditor knows the client’s business. In contrast, the management
The major observations are as follows:
• Information technology systems require improvement
• The allowance for doubtful accounts requires a better estimation process
Management agreed to make all the changes suggested by the auditor, so their tone is very
positive and demonstrates a commitment to financial reporting quality.
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a. The PCAOB’s inspection process is necessary because it provides a mechanism of
accountability for accounting firms. The firms (and the auditors who work for those firms) know
that there is a chance that the engagement they are working on will come under the careful
b. The Ernst & Young auditors properly requested that the client increase the reserve for
excess and obsolete inventory, which would decrease income. The client then countered by
proposing an equal and offsetting journal entry to increase the value of inventory received in a
bankruptcy settlement (even though the client had originally decided that the inventory
c. The PCAOB is concerned about this issue because they recognize that auditors and their
clients sometimes negotiate on the proper accounting for transactions. In addition, it is clearly
inappropriate for clients to “offset” one proposed adjusting journal entry with another. By
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d. First, identify the ethical issue. The issue the manager faces is whether to go along with
the offsetting journal entry, thereby disagreeing with the partner and the client, or to take some
action that would assure accurate financial reporting. The affected parties and their rights include
shareholders/creditors/government/regulators (the right to receive accurate financial
Fraud Focus: Contemporary and Historical Cases
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a. Dell’s recording and discussion of the rebate payments from Intel was materially
misleading because:
• They portrayed the rebates as a reduction in cost of goods sold when the rebates could
b. This is a difficult question because the management of Dell did not change significantly
during that period; for example, Dell was still led by Michael Dell. However, there were some
c. Audit software can be very effective in identifying situations that would not seem to be
normal, for example, receiving payments from vendors. One of the issues is for an audit firm to
identify such situations and then make the procedures common across all audit engagements.
This would not be difficult because there have been a number of similar problems in the grocery
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d. This is an interesting variation. The key is that the supply contract has a contingency,
such that the supply contract is contingent on Dell not purchasing similar supplies from AMD.
This poses a couple of problems for the auditor:
• First, the auditor should review all long-term sales or procurement contracts to
understand the major elements of the contract. If reviewed, the auditor should be aware
e. It is true that in tough economic times companies negotiate lower prices and therefore a
reduction in prices from a supplier would not be considered unusual. As noted in part d, the only
f. There are a number of items that the engagement quality review partner would consider
in the review. They include:
• An analytical review of changes in COGS in relationship to sales.
• A cost review of purchases from major vendors, including a trend analysis.
g. The key issue is whether there is intent to deceive on the part of management. In this
case, management purposely misrepresented a rebate from the vendor that was not likely to
continue into the future as something that would continue when they hid the rebates in COGS. It
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a. The essence of the fraud is that MCA reported a gain on the sale of each property in an
amount equal to the difference between the purchase price and the artificially inflated sales price
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(which only reflected the amount that the property could potentially be rented for after extensive
rehabilitation). The sale is essentially a sham because it is to a related party, and those related
party transactions are not disclosed in the financial statements. MCA did not disclose in its
b. Morris and Rybicki each had mortgages with MCA. Rybicki and Ajemian were close
personal friends. There were extremely extensive personal relationships and favors exchanged
between the audit firms and MCA.
c. The auditors in this case violated rules 101 and 102 of the AICPA’s rule of conduct. Of
course, it is not problematic for auditors and their clients to socialize at some level. However, the
closeness of that relationship needs to be carefully considered because it can have a detrimental
effect on professional skepticism. When management and the auditor have low ethics and are not
d. In the AAER publication, the SEC disclosed the following sanctions placed upon the
For Grant Thornton:
1. Monetary Payment: Within 10 days of the date of this Order, Grant Thornton shall pay $1.5
million as a penalty (“penalty amount”). Payment of the penalty amount shall be: (a) made by
United States postal money order, certified check, bank cashier’s check or bank money order;
(b) made payable to the Securities and Exchange Commission; (c) hand-delivered or mailed to
the Office of Financial Management, Securities and Exchange Commission, Operations
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2. Firm-wide Fraud-Detection Training: Grant Thornton shall require its audit professionals to
undergo fraud detection training conducted by the Association of Certified Fraud Examiners.
3. Cessation of Joint Audits: For a period of 5 years, Grant Thornton shall cease all joint audit
For Doeren Mayhew:
1. Doeren Mayhew, which voluntarily discontinued conducting public audits as of March 19,
2. For a three-year period commencing with the retention of Doeren Mayhew to conduct an audit
of the financial statements of an “issuer” as that term is defined in Section 10A(f) of the
Securities Exchange Act of 1934 (a “public company audit”), Doeren Mayhew will establish
and implement the following policies and procedures specifically designed to improve the
quality of its public company audit practice as described below:
a. Development of Procedures for Public Company Audits
Doeren Mayhew undertakes to appoint knowledgeable and experienced directors of its
firm to oversee the specific areas targeted for improvement herein – public company audit
planning and staffing; public company audit quality control; and public company audit
independence. The directors designated to carry out these roles will be responsible for
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engagement director. The engagement director shall confirm that such consultation has
occurred prior to signing off on the audit.
The Public Company Audit Oversight Director shall not act as the engagement director or
concurring director or perform other work on the relevant public company audit except in
the capacity of Public Company Audit Oversight Director.
Quality Control Director: Doeren Mayhew will designate a Quality Control Director as
the person responsible for reviewing the execution of each public company audit to
ensure compliance with GAAS. The Quality Control Director may act as the concurring
As noted above, upon completion of the relevant public company audit, the Quality
Control Director and the Public Company Audit Oversight Director shall consult with
one another about the planning and execution of the audit and discuss any outstanding
issues with the engagement director. The engagement director shall confirm that such
consultation has occurred prior to signing off on the audit.
The Quality Control Director shall not act as the engagement director or otherwise work
on the relevant public company audit other than as set forth in this section.
Independence Oversight Director: To promote the independent judgment necessary for
high quality public company audit work, Doeren Mayhew will develop and maintain
policies and procedures relating to independence, objectivity and integrity. Such policies
Doeren Mayhew will require written representations from personnel engaged in public
company audits, upon hire and on an annual basis, that they are familiar with and are in
compliance with professional standards and Doeren Mayhew’s policies and procedures
regarding independence, integrity and objectivity. The Independence Oversight Director
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development meetings, in the acceptance and continuance of public company audit
clients and engagements, and in the performance of engagements, including discussing
the implications regarding engagements for financial institutions, such as prohibiting any
member of the engagement team from having a loan with the institution, and the types of
nonattest services and relationships that could affect independence.
b. Development of Standards for Public Company Audits
Professional Development Program: Doeren Mayhew will establish procedures designed to
provide reasonable assurances that all public company audits are performed, supervised,
reviewed, documented, and communicated in accordance with the relevant professional,
regulatory and firm requirements. Doeren Mayhew will maintain a professional development
Personnel assignments for public company audits will be made based on the degree of
technical training and proficiency required in the circumstances and the nature and extent of
available supervision. Assignments of personnel will be based on such factors as:
c. Evaluation of New and Existing Public Company Audit Clients
Doeren Mayhew will employ procedures to evaluate new and existing public company audit
clients. This evaluation shall include: a review of Doeren Mayhew’s client
acceptance/continuance evaluation; review of risk assessments and audit procedures related
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d. Joint Public Company Audits
Doeren Mayhew undertakes that, as a condition of its participation in any joint public
company audit, the engagement letter shall specifically state that each participating audit
firm be deemed jointly responsible for the performance of the audit. These responsibilities
When participating in a joint audit, Doeren Mayhew will confirm the independence of the
other firm or firms performing parts of an engagement, and, when Doeren Mayhew acts as
e. Third Party Review of Audit Procedures and Process
Within one year of Doeren Mayhew’s engagement to conduct a public company audit,
Doeren Mayhew will retain an independent accounting firm to review the personnel and
quality enhancements undertaken consistent with this Order. The independent accounting
firm shall, with respect to public company audits performed by Doeren Mayhew during that
Application Activities
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a. Ernst & Young auditors failed because they were responsible for providing reasonable
assurance on the following, but they did not do so:
• The estimates are reasonable
• The estimates are presented in conformity with GAAP
b. Of course, we will never know the individual reasons for the lack of professional
skepticism, but the following may be relevant:
• Not wanting to anger or disagree with the client
• Fear that the client will fire the audit firm if they disagree with the client
c. The stock price from 2005 through early 2008 was in the high 20’s to low 30’s per share.
From June 2008 to the time nearing the restatement on November 10, 2008, the stock price
d. The most important risk for Medicis is that management clearly is not invested in quality
financial reporting, which should raise concerns on the part of an audit firm in terms of
management integrity. As of 12/31/11, Ernst & Young was still the auditor for Medicis. The firm
earned about $1.4 million in audit fees. Students will likely question why Ernst &Young is still
the auditor for Medicis. Why would E&Y want to continue a relationship with a client that got
the firm into trouble with the PCAOB? The audit fees may be an explanation. On September 3,
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This is a good exercise to complete in class. The instructor should upload the most recent
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Students should note that while some of the discussion in the MD&A is factual in nature and
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a. Of course, hindsight is 20:20, but most people would agree that Ernst & Young failed to
provide adequate warning to the users of Northwest’s financial statements.
b. Management has the responsibility to recognize and report on the going-concern status of
the company. The auditor has the responsibility to make sure management exercises its
responsibility. In making the going concern assessment, the auditor will address the following
questions:
c. Auditors have difficulty in assessing going-concern likelihood. They are in a difficult
position because if they issue the going-concern opinion then the company may find it even more
difficult to obtain short-term financing, which may result in the company failing and the
d. Ernst & Young may have been reluctant to issue a going-concern report because it may
have caused immediate cash flow problems for Northwest. For example, imagine gasoline
suppliers’ reaction to such an announcement. If those suppliers were extending credit, they likely
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The purpose of this exercise is to realize that while management’s certification acknowledges the
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a. IRIDEX is one of the worldwide leaders in developing, manufacturing, marketing, selling
and servicing innovative medical laser systems. The company has three key elements in its
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Features of IRIDEX that indicate going-concern risks include:
• Liquidity concerns
• Violations of debt covenants
• Difficulty integrating and achieving profitability in a new acquisition that the company
recently made
• Difficulties in remediating previously identified internal control material weaknesses
b. The purpose of the 8-K is to notify the SEC and users of the financial statements that
PwC resigned from the IRIDEX engagement effective August 23, 2007. Important risk factors
noted in the 8-K filing include:
• The audit committee of IRIDEX commenced a review of the company’s revenue
recognition process and detected errors in that process.
c. Burr, Pilger & Mayer LLP, which is a regional audit firm in the San Francisco Bay area,
accepted the audit engagement. Burr, Pilger & Mayer (BPM) differs significantly from PwC in
that they are much smaller audit firm. They have 325 employees and five locations in the Bay
area. While they do conduct audits of public companies, their market presence in terms of the
number of public clients that they audit is much smaller than that of PwC.
In terms of audit firm portfolio management strategies, a client may be unattractive to one audit
firm, but very attractive to another audit firm. In this case, IRIDEX was likely a risky client that
PwC decided was not worth the risk in relation to the level of audit fees and degree of client
involvement necessary to conduct a high quality audit. PwC has a lot of reputational capital to
lose if they become embroiled in a shareholder lawsuit, and they are likely an attractive target to
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d. Audit fees and total fees were as follows:
FYE 12-31-2006 (PwC): audit fees $500,000, total fees $520,000
FYE 12-31-2007 (BPM): $ audit fees $551,000, total fees $1,763,000
FYE 12-31-2008 (BPM): $ audit fees $250,000, total fees $344,000
From an audit firm portfolio risk management perspective, the following inferences may be
made:
• The audit and total fees that PwC was earning on this engagement were likely not high
enough to warrant the continued relationship with an otherwise very risky client
• The audit and total fees that BPM earned in the year of transition were very high, likely
e. The ethical decisions that come into play during client acceptance and client continuance
decisions concern the trade-off between audit fees, resulting audit effort, and the ability to
conduct a quality audit. Given the fee data that we examined in part (d) of this question, one has
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a. The standard for the PCAOB is AS 16; the standard for the AICPA is AU-C 260; the
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b. The AICPA/IAASB standard defines “those charged with governance” as follows:
“The person(s) or organization(s) (for example, a corporate trustee) with responsibility
for overseeing the strategic direction of the entity and the obligations related to the
c. The shift in focus from marginalizing audit committee-auditor communication stems
from the corporate governance failures of the early 2000s and the regulatory changes that
resulted, i.e., SOX.
d. The objectives of the auditor are to:
• Communicate to the audit committee the responsibilities of the auditor in relation to
the audit and establish an understanding of the terms of the audit engagement with the
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a. The two standards are quite distinct. The PCAOB standard dates back to 1979 and is only
one page long. The harmonized AICPA/IAASB standard is quite detailed and obviously more
current.
Academic Research Case
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a. The issue being addressed in the paper is the auditor going-concern judgment, and factors
that influence it. The study distinguishes between management turnaround initiatives. Prior
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b. The findings of the paper confirm the result from prior research with respect to the
positive association between cost-cutting turnaround initiatives and the likelihood of a company
receiving a going-concern opinion. The results extend prior research by showing that auditors’
attention to and recall of positive financial evidence is lower in the case of cost-cutting
turnaround initiatives.
c. This paper is important to audit practice because it reveals that auditors’ knowledge of
the nature of the client’s turnaround initiatives early in the audit process affects their attention to
financial evidence that they encounter during the audit. Client companies can learn from this
d. The method is an experiment using 49 experienced auditors completing a case involving
a going-concern decision. There are three experimental cells: (1) a strategic initiative, (2) a cost-
cutting initiative, and (3) a control condition.
e. The authors note four limitations of the study. The first is a relatively small number of
participants. Second, the case involves a client that is in severe financial distress, having broken
Ford and Toyota
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Note to instructor: The solutions based upon the FYE 2012 annual reports for Ford and Toyota