CASE 2
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
The question of materiality is certainly one of the most complex issues in all of
auditing. No clear-cut guidelines have ever been established to aid the auditor in
deciding whether a specific balance or transaction is “material.” This lack of an
official standard provides the auditor with the freedom to base all final decisions
on professional judgment. Unfortunately, without a formal rule, the auditor has
little guidance in applying judgment to a particular situation.
Materiality has traditionally been held to be any factor that would influence the
decisions of those parties relying on the financial statements. Identifying a
proper basis of comparison is an important aspect in determining whether an
uncertainty is material. Net income is the most obvious standard of comparison,
although another consideration is which of the statements is affected (e.g.,
Balance Sheet, Income Statement, or both?). The situation questioned by King
(2)
The CPA firm must talk with the predecessor auditor before accepting the
engagement. The new auditors can learn about the integrity of the potential
(3)
The information given by the predecessor auditor as to the integrity of the client’s
management must weigh heavily in the decision to seek a new client. Because
(4)
In a peer review, a team of outside auditors is hired by a CPA firm to review its
system of quality controls, the policies and procedures utilized by that
organization to ensure that its members are following all professional
standards audit, accounting and review, ethics, etc. This review helps to ensure
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(5)
Audit documents are intended to provide a record of the
auditor’s examination and the evidence accumulated. Thus, all testing done in
each audit area should be documented and included within the working paper
file. In addition, the audit documents must verify that the examination was
(6)
As a professional, the independent auditor has a responsibility to ensure that a
prospective client understands the function of an audit prior to accepting an
(7)
The providing of adequate service to a client would always require that the CPA
firm suggest a review rather than an audit whenever it might meet the company’s
(8)
Many students may want to reject this engagement based on the internal control
problems, the impairment of value issue, and Rogers’ arguments with the
predecessor auditors, but such situations are not uncommon occurrences in
SUGGESTED ANSWERS TO EXERCISES
Case 2 – Exercise 1
Abernethy and Chapman
ANALYSIS OF POTENTIAL LEGAL LIABILITY
Potential Client: The Lakeside Company
Type of Engagement: Audit
Form Completed By:
Date:
(1) Is the potential client privately held or publicly held?
(2) Evaluate the possible liability to the client that Abernethy and Chapman
might incur, if the engagement is accepted.
The basic liability to the client is for losses occurring as a result of any firm
(3) List the third parties that presently have a financial association with the
potential client and could be expected to see the financial statements. These
parties are also called primary and foreseen beneficiaries.
(4) Discuss the possibility that other third parties will be brought into a position
where they would be expected to see the financial statements of the
potential client. These parties are also called foreseeable beneficiaries.
(5) Evaluate the possible legal liability to third parties, both present and
potential, that Abernethy and Chapman might incur if the engagement is
accepted.
As a privately held business, this audit does not fall under federal security
laws. Thus, the auditor is bound by common law and is judged under such
precedents as the Ultramares case, the CIT Financial Corp. case, and the
Abernethy and Chapman
INFORMATION FROM PREDECESSOR AUDITOR
Potential Client: Lakeside Company
Form Completed By:
Predecessor Auditor: King & Company
Date of Interview:
(1) Discuss the predecessor auditor’s evaluation of the integrity of the
management of the potential client.
(2) Did the predecessor auditor reveal any disagreements with management as
to accounting principles, auditing procedures, or other similarly significant
matters? If so, fully describe these disagreements.
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(3) What was the predecessor auditor’s understanding as to the reasons for the
change in auditors?
(4) Did the predecessor auditor give any indication of other significant audit
problems associated with the potential client?
(5) Did the predecessor auditor indicate any problem in allowing Abernethy and
Chapman to review prior years’ audit documentation for the potential client?
If “yes,” explain.
(6) Was the predecessor auditor‘s response limited in any way?
Case 2 – Exercise 2
[Note: The auditor will perform a number of steps in reviewing the audit
documents of the predecessor auditor. The major objective is to examine the
types of information that would be available to an auditor in an ongoing
extensive review necessary in an initial audit can be held to a minimum].
Abernethy and Chapman
Review of Predecessor Auditor’s Documentation
Client: The Lakeside Company
Predecessor Auditor: King & Company
Prepared by:
Date:
Prepare a list of the specific contents of the predecessor auditor’s documentation
that should be examined by Abernethy and Chapman. Indicate each area that
should be reviewed and the purpose of studying these particular areas of the audit
documentation. Use the following format.
Area that Should be Reviewed Purpose of Review
Proposed Adjusting Entries To determine the type and materiality
of the proposed adjustments
Tests of beginning balances in
To determine that satisfactory evidence
Review internal control evaluations. To determine if there were any internal
control weaknesses/deficiencies noted
or if there are any particularly strong
areas of control noted.
Review the analysis of contingencies. To determine if adjustments or
disclosures need to be made for
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(3)
Note: Student answers will vary greatly due to the nature of the assignment.
Preliminary Judgment about Materiality
Client: Lakeside Company
Balance Sheet Date: December 31, 2012
Prepared by:
Determine the preliminary judgment about materiality for the client as a whole.
Express your answer as a dollar amount. Determine the appropriate level of
materiality based on all analyses completed for the client thus far. Fully support
and discuss the materiality level that you determine.
Quantitative Considerations: Because materiality is relative, it is necessary to
Base (from
previous year)
Dollar Amount
of Base
Percentage
Range
Base x Percentage
Qualitative Considerations: Certain types of misstatements are likely to be more
important to users than others, even if the dollar amounts are the same. For
Item to be Considered Impact on Materiality
Outdated accounting systems Reduce the level
Preliminary Judgment about Materiality: Combine the quantitative and qualitative
considerations into one overall materiality level.
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Discussion: Discuss how you arrived at this dollar amount for the preliminary
judgment about materiality. That is, how did you combine the qualitative and
quantitative considerations to arrive at this dollar amount?
The preliminary judgment about materiality is set at $50,000. Since there are
(4)
This answer assumes that King and Company, the predecessor auditor, has no
reason to believe that their previous report is not still appropriate. Furthermore,
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INDEPENDENT AUDITOR’S REPORT
To the Stockholders:
We have audited the accompanying balance sheet of the Lakeside
Company as of December 31, 2012, and the related statements of income,
retained earnings, and cash flows for the year then ended. These financial
statements are the responsibility of the Company’s management. Our
responsibility is to express an opinion on these financial statements based on our
audit. The financial statements of Lakeside Company as of December 31, 2011,
were audited by other auditors whose report dated [give date], on those
statements included a qualified opinion because of inadequate disclosure of an
impairment of value. The impairment of value concerned the Company’s
investment in one of its stores.