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c. Based on the analysis in part b, the auditor should concentrate audit effort on the possibility
of either fictitious billings or the failure to issue credit memos. None of the other hypotheses
explain all the changes. Further, it is naïve to think that a competitor could improve the gross
margin significantly higher than the industry in one year when it is selling to major
customers who have considerable pricing power.
The risks relate to fictitious sales or the failure to issue credit memos. Interestingly, the client had
issued the rebilling invoices only on clients that management knew would not return accounts
receivable confirmations. Some of the audit procedures the auditor should consider include:
• Match the total of credit memos issued to the total of “rebilled invoices” to determine
that the totals are the same.
• Take a sample of credit memos and trace them into the original journal of entry, and
further trace into the general ledger (these two procedures would have detected the
fraud).
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a. Agree. Setting audit risk at a low level such as 5% is acceptable as long as the auditor uses
conservatism elsewhere in the audit engagement. Setting audit risk at .05 implies that 5% of
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b. Agree. Inherent risk may be so low that the auditor may not need to perform direct tests of an
account balance. However, the auditor should perform some indirect tests of the account
balance, such as substantive analytical review procedures, to determine if the account
c. Agree. To support a control risk assessment of low or moderate, the auditor must gather
evidence that not only are controls appropriately designed, but also they are operating as
designed.
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Case 1
Case 2
Case 3
Case 4
Case 5
Case 6
Case 7
Case 8
IR
30%
40%
50%
50%
70%
80%
90%
100%
CR
50%
100%
60%
100%
70%
70%
80%
100%
AR
33%
Generalizations:
• As inherent risk increases, detection risk decreases. In other words, as inherent risk
increases (i.e., it is more likely that a transaction is recorded in error), the auditor is
willing to take less of a chance that audit procedures will not detect a material
misstatement.
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A controls reliance audit includes both tests of controls and substantive procedures, whereas a
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Examples of Changing Nature of Risk Response
• Using inspection to test for the existence of inventory, and using a specialist to test the
valuation of inventory
• At a more global engagement level, this could include changing the nature of the
Examples of Changing Timing of Risk Response
• Conducting procedures at an interim period vs. at year end
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Some ways to introduce unpredictability include:
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• Perform some audit procedures on accounts, disclosures, and assertions that would
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Procedures that can only be completed at or after period-end include:
• Comparing the financial statements to the accounting records
Fraud Focus: Contemporary and Historical Cases
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a. The inherent risks relate to the ability of the company to be competitive, earn a profit, and
remain a going concern. The fact that the company’s controls do not comply with SOX
requirements indicates that the company either does not have the funds to pay for control
improvements, or that management does not have the desire to make that investment. These risks
b.
Ratio
Formula
2008
2007
current
ratio
current Assets/current
liabilities
7,427,061/6244852=1.19
7,295,632/6,570,530=1.11
Quick
(cash+cash
(1,985,818+2,847+2,171,768)
(1,238,212+363,562+2,453,868)
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ratio
AR
turnover
Credit sales/AR
12,845,111/2,171,768=5.91
11,236,612/2,453,868=4.58
Inventory
turnover
Cogs/ending inventory
3,357,441/1933153=1.74
3,154,509/2,008,739=1.57
sales in
365/inventory
turnover
365/1.74=210.25
365/1.57=232.48
inventory
Net profit
margin
NI/net sales
838,969/12,845,111=0.07
1,877,149/11,236,612=0.17
ROE
NI/stockholders’ equity
838,969/1,212,819=0.69
1,877,149/520,002=3.61
Debt to
equity
ratio
Total
liabilities/stockholders’
equity
10,157,729/1,212,819=8.38
10,478,940/520,002=20.15
Liabilities
to assets
Total liabilities/total
assets
10,157,729/11,587,302=0.88
10,478,940/11,161,285=0.94
Asset
liquidity
Current assets/total
assets
7,427,061/11,587,302=0.64
7,295,632/11,161,285=0.65
Sales to
Net sales/total assets
12,845,111/11,587,302=1.11
11,236,612/11,161,285=1.01
The following overall trends would cause the auditor to assess heightened risk:
• Other receivables shows a significant increase.
• There was a significant increase in property and equipment.
The following trends in the ratios would cause the auditor to assess heightened risk:
• The current and quick ratios are relatively low, indicating a potential weakness in
liquidity.
might be present at this client. This issue should have been the subject of a robust brainstorming
session.
c. Assessing the likelihood of going concern will be a priority in the audit. Therefore, the
auditor will focus attention on revenue, profitability, and accounts relating to liquidity and the
ability of the company to pay its considerable debts. So, accounts to focus on would include:
• Sales
• Cash
d. This case provides an example of an audit firm that did very little work and was simply
engaging in a transaction with Kid Castle designed to provide assurance to U.S. regulators and
investors. The lack of professional skepticism is evident because Waggoner did essentially no
e. The steps include the following, with commentary on what went wrong at each step and what
Waggoner should have done differently:
Step 1. Structure the problem. The fundamental problems that Waggoner faced were (a) lack of
Step 2. Assess consequences of decision. The consequences are a loss of reputation and loss of
ability to continue to serve these companies.
Step 3. Assess risks and uncertainties of the problem. The risks and uncertainties relate to the
ability to trust in the work of the foreign auditors, particularly with regard to the fact that they
Step 4. Evaluation information/audit evidence gathering alternatives. Not relevant for this case.
Step 5. Conduct sensitivity analysis. Not relevant for this case.
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Step 6. Gather information/audit evidence. This phase was at the heart of the case. Really,
Step 7. Make decision about audit problem. Fundamentally, Waggoner was not capable of
conducting these audits, and he should have not accepted the engagements in the first place.
f. When auditing a company in a foreign country, the audit firm faces the following risks:
• Communication difficulties
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a. The risks would include:
• A major change in the nature of the operations of the thrift industry opened the doors to
new types of highly risky investments. It also allowed a greater concentration of
investments into high-risk areas, expanded lending authorities beyond traditional
boundaries, and allowed a new type of management to obtain control of many of the
institutions.
• The industry was suffering financial hardships even before the legislation was enacted. It
had a classic financing problem: long-term fixed assets and short-term variable liabilities.
When interest rates soared during the latter part of the 70s, many of the S&Ls would have
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b. The use of appraisals as evidence is a difficult audit issue. When assessing the relevance
and reliability of appraisals as audit evidence, the auditor normally considers:
• The qualifications of the appraiser. For example, if a significant number of appraisals are
from one appraiser, the auditor needs to know whether the appraiser is certified
(certification process is similar to accounting certification.)
• The recency of the appraisals.
• The relationship of the appraisal firm to the client. Is there a specific relationship, or
might there be a relationship so that the appraisal firm gets the company’s business
because the appraisals come out the way management wants them to come out?
Of course, the appraisal is only one aspect of the company’s determination of the valuation of a
loan receivable. The appraisal is important in the case of default. Thus, the auditor will not be
evaluating every appraisal, but will want to (1) determine the client’s procedures for obtaining
independent appraisals before a loan is granted and then grant the loan if the appraisal indicates
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Application Activities
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As of June 2012, the answers are as described below. Obviously, these answers will differ
depending on the date of application.
GE
P&G
Apple
Citigroup
a. number of
analysts
12
17
39
24
estimated sales
growth
c. EPS estimate
d. EPS actual
0.34
0.84
7.79
1.09
e. Analysts’
recommendations
5 upgrades, 3
downgrades
2 upgrades, 5
downgrades
8 new research
firms, all with
2 upgrades, 4
downgrades
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AS 12 discusses the following risk assessment procedures:
• Obtaining an understanding of the company and its environment (paragraphs 7-17);
• Considering information from the client acceptance and retention evaluation, audit
planning activities, past audits, and other engagements performed for the company
(paragraphs 41-45);
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• Conducting a discussion among engagement team members regarding the risks of
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As of June 2012, the answers are as described below for the most recent fiscal year end.
Obviously, these answers will differ depending on the date of application.
Microsoft
“Estimates and Assumptions
Preparing financial statements requires management to make estimates and assumptions that
affect the reported amounts of assets, liabilities, revenue, and expenses. Examples include:
estimates of loss contingencies, product warranties, product life cycles, product returns, and
stock-based compensation forfeiture rates; assumptions such as the elements comprising a
Dell
“Use of Estimates — The preparation of financial statements in accordance with GAAP requires
the use of management’s estimates. These estimates are subjective in nature and involve
Apple
Apple does not specifically mention the use of estimates, but has a significant discussion of
revenue recognition issues, along with some discussion of the use of estimates by specific
account
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a. The answer to this question will depend on the timing of its use, and developments in the
legal cases against Rita Crundwell and the auditors.
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b. Numerous parties are at fault in this case, and these are listed in order from most at fault to
least at fault.
• Of course, Rita herself is most at fault. It seems inconceivable that someone could have
committed such a large-scale fraud without detection for so long, particularly given how
ostentatious her spending was in relation to her income.
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An appropriate standard would be the PCAOB’s Auditing Standard No. 13, “The Auditor’s
Responses to the Risks of Material Misstatement.” AS No. 13 provides the following relevant
guidance in paragraphs 12 -15:
12. The audit procedures that are necessary to address the assessed fraud risks depend
upon the types of risks and the relevant assertions that might be affected.
13. Addressing Fraud Risks in the Audit of Financial Statements. In the audit of financial
statements, the auditor should perform substantive procedures, including tests of details, that
14. The following are examples of ways in which planned audit procedures may be
modified to address assessed fraud risks:
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c. Changing the extent of the procedures applied to obtain more
15. Also, AU sec. 316 indicates that the auditor should perform audit procedures to
specifically address the risk of management override of controls including:
a. Examining journal entries and other adjustments for evidence of possible
Academic Research Cases
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a. The issue being addressed is how client acceptance decisions are made by audit partners.
Auditors evaluate the business risk and audit risk of a potential audit client when making the
client-acceptance decision. This study developed a model to test the evaluation of client risk and
how it is related to the auditor business risk, as well as how auditors handle risk adaptation to
retain the riskier clients.
The model was developed using two stages; a risk evaluation stage and a risk adaptation stage.
The risk evaluation stage evaluates the following: partners’ assessments of client business risk as
related to the client’s audit risk and visa versa, partners’ assessment of audit risk and the client’s
business risk as related to the auditor’s business risk.
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b. The results relating to the risk-evaluation stage of the model showed that partners’
assessments of audit risk affects their assessments of a client’s business risk, and both client
related risk assessments affect auditors’ assessments of the auditor business risk. Therefore, it
was determined that audit partners do consider the complex relationship between audit risk,
client business risk and audit business risk. The relationship between audit risk and auditor
business risk is much stronger than the relationship between the client business risk and the
auditor business risk.
c. There are professional standards that state an audit firm should implement procedures to help
determine the acceptability of audit clients. However, the standards do not give any guidance as
to what those procedures should be. With the increase in litigation against audit firms for audit
failures and the increase in competition for audit clients, procedures for client acceptance are
becoming more and more important to auditors.
d. There were 137 participants from a Big 5 accounting firm. The partners had an average of 19
years experience and had made an average of nine client-acceptance decisions in the last year.
Each partner completed two cases. The cases provided company specific information about
e. The reader should be aware that the research for this paper was based on responses from only
one audit firm and therefore the conclusions may not apply to other firms. Generalization of the
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a. Risk-based auditing is a conventional auditing approach that suggests more (fewer) audit
resources should be focused on higher (lower)-risk accounts.
The author proposes the idea that seemingly low-risk accounts can actually have a higher risk of
fraud associated with it if/when management anticipates this audit strategy of focusing audit
b. Overall findings demonstrate that auditors behave according to the conventional risk-based
auditing approach and allocate audit more resources to high-risk accounts rather than low-risk
accounts.
As might be expected, as client managers gained experience interacting with an auditor they
increasingly anticipated this audit behavior and exploited the resulting weakness by overriding
the low-risk account more often than the high-risk account.
c. This study demonstrates that risk-based auditing must evolve to consider and mitigate the
effect of management’s ability to learn audit techniques and manipulate the resulting exposures.
Since prompting auditors to consider management’s behavior provides favorable results (fewer
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d. The author created a game of strategy whereby 132 upper-division accounting students
representing either a manager or an auditor were paired with one another for 20 rounds. During
each round, both parties are given two system-generated accounts and a risk factor associated
with the possibility of a system-generated error within the account (i.e. a “high–risk” account and
a “low–risk” account).
Managers are the first to receive the accounts and must make a decision to accept each account’s
figure or override the outcome for either account. Next, the auditor is given the accounts, the risk
factors (of system-generated errors), and the current balances (either manipulated or unchanged).
Unbeknownst to managers, some of the auditors are given a strategic prompt intended to help
them consider their opponent’s behavior and how it should impact their own strategy. These
prompted auditors are asked first asked to predict the manager’s belief about the auditor’s
allocation strategy. Furthermore, they are asked to predict the manager’s response to those
beliefs. After this prompt, this group then makes their resource allocation decision.
e. Real-world factors not included in the study may impact decision-making behavior. For
example, the amount of resources available to the auditor (e.g., the audit fee) is determined
through auditor-client negotiation and may influence how subsequent decisions between the two
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a. Audit firms should plan an audit to be responsive to the level of business risk of their clients.
The auditing standards in Japan (which are similar to the ISAs) suggest that the response to
increased client business risk should be increased audit effort. The purpose of this study is to
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b. The authors’ findings suggest that the responses to clients’ business risk vary among the
three firms. Two firms appear to increase audit effort and charge a risk premium for audits with
higher business risk, while the third firm only increases audit effort (without an accompanying
c. The paper is important as it provides evidence on whether auditors respond to increases in
client business risk in a manner that is consistent with the professional auditing guidance. Such
evidence can be used by audit firms to evaluate their audit process and by industry
regulators/standard setters to determine if additional guidance and/or training would be help
improve audit quality.
d. The authors examine their issues of interest by focusing on public companies in Japan in
2007 that were audited by a Big 3 firm. The final sample includes 893 companies. The authors
measure audit effort based on the number of professionals (not including engagement partners)
e. One limitation of this study is the proxies used to measure some of the variables. For
example, audit effort is based on the number of audit team members, which assumes that average
audit hours per person at a particular level (staff, senior) are the same across all engagements in a
particular firm. If this assumption is not true, then the measure of team size may not be an
Ford and Toyota
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Note to instructor: The solutions based upon the FYE 2012 annual reports for Ford and Toyota
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Note to instructor: The solutions based upon the FYE 2012 annual reports for Ford and Toyota