Chapter 3 Homework This Brainstorming Session Needs Encourage The Involvement

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CASE 3

SUGGESTED ANSWERS TO DISCUSSION QUESTIONS

(1)

Although this question can be answered by a simple reading of Exhibit 3-1, it

does force the student to consider the contractual obligations being assumed by

both parties. One portion of this letter that might warrant discussion is the CPA

firm’s declaration that absolute assurance is not being given in regard to major

misstatements. The students can be queried as to the reasons for including this

statement. In addition, the students can be asked to discuss the method by

which the client company can draw the distinction between reasonable

assurance and absolute assurance. As a different line of questioning, the

students can discuss other responsibilities that could have been accepted by

either party.

The engagement letter is required. Responsibilities of the CPA firm found in the

engagement letter:

* To perform an audit in order to express an opinion on the client’s financial

statements,

Responsibilities of the client:

* To pay the audit fee,

(2)

In performing analytical procedures, auditor expectations should be derived from

a wide variety of sources. For cost of goods sold, Abernethy and Chapman

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should consider each of the following in arriving at an anticipated total:

– Past figures. If cost of goods sold has always been a certain percentage

of Lakeside’s sales, that same relationship would be expected to continue

– Industry averages. By studying trade publications, Abernethy and

Chapman can determine an industry average for cost of goods sold as a

– Competitors. If available, the financial statements of competing

companies can be used to determine the normal relationship of cost of

– Budgeted figures. If Lakeside has an annual budget, the numbers

(3)

– Lakeside holds an inventory of high-technology items: consumer

electronic equipment. Obsolescence of a portion of this merchandise is

an ever-present danger because of new innovations. The inventory can

also be easily damaged, a problem that is not always visually obvious.

(4)

The auditor must be satisfied that sufficient, competent evidence has been

obtained to substantiate an opinion concerning the fair presentation of the client‘s

financial statements. The decision as to the sufficiency of this evidence is left

solely to the judgment of the auditor. Only through years of experience can the

(5)

Any discussion as to the “quality” of evidence being gathered by analytical

procedures must be based on the objective of the testing. Analytical procedures

performed in the planning stage are not primarily designed for the purpose of

(6)

Knowledge of the consumer electronics business is just one aspect of Cline’s

expertise that will allow him to evaluate the fair presentation of Lakeside’s

financial statements. Overall knowledge of the client company and the industry in

which it operates should also allow the auditor to

– identify areas that may need special consideration;

– assess conditions under which accounting data are produced, processed,

Knowledge of a business and the industry in which it operates may be obtained

from examining the client company’s accounting records and inquiry of the client

personnel. This information can be supplemented through review of the prior

(7)

A number of the current concerns faced by auditing firms as well as the auditing

profession as a whole relate either directly or indirectly to increased price

competition. Through class discussion of this particular question, students should

be able to ascertain at least three of these problems:

* Price competition forces narrow time constraints on the work of the

independent auditor. In order to finish an audit engagement in a short

* Because the initial year of an audit will often require significantly more time

* Many auditors also feel that price competition is generally detrimental to the

public accounting profession. The main thrust of this argument is that price

(8)

According to the audit risk model, planned detection risk (PDR) equals

acceptable audit risk (AAR) divided by the product of inherent risk (IR) and

control risk (CR). Holding inherent risk and acceptable audit risk constant, there

(9)

According to SAS 99, the assessment of the risk of fraud begins with a meeting

of the entire team for such purpose. This brainstorming session needs to

encourage the involvement of all team members and cannot be just a staff

(10)

The registration process is not difficult. Maintaining the status of a registered

CPA firm is more difficult and requires that the firm be willing to adjust its

SUGGESTED ANSWERS TO EXERCISES

(1)

Performing analytical procedures is one aspect of an auditing course that

traditionally generates a lot of student interest and enthusiasm. One method of

approaching this question is to have the class list the potential problems that

were discovered and then discuss the relative severity of each. The students

a) Ratio analysis from 2010 to 2011.

Ratio 2010 2011 Significance

Current 1.35 1.35 No significant change

# Days inventory on

hand

93 101 Increase may indicate obsolete or

slow-moving inventory on hand

Receivable collection

period (days)

21 25 Slight increase may indicate relaxing

of credit policies and/or possible

understatement of allowance

Conclusion: Lakeside had no significant changes in its liquidity or solvency

b) Ratio analysis: comparison to industry.

Ratio Industry Avg. Lakeside 2011 Significance

Current 2.16 1.35 Lakeside is below the industry

average. This may indicate short-term

solvency (liquidity) problems.

Days inventory on

hand

69 101 Lakeside is well above the industry

average. This may indicate short-term

solvency problems.

Receivables collection

period

15 25 Lakeside is well above the industry

average. This may indicate short-term

solvency problems.

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Ratio Industry Avg. Lakeside 2011 Significance

industry average.

c. Scan the financial statements and the trial balances.

Procedure Results Significance

Scan the income statement

[Note: Instructors may want to

suggest that students prepare a

common size income statement.]

The company’s stores continue

to report an overall loss, which is

increasing in amount.

These losses suggest the

possibility that the stores will

eventually be discontinued by

Lakeside or drastically altered in

some manner.

Scan the balance sheet [Note:

Instructors may want to suggest

Significant increases in short–

term borrowings.

The short-term nature of the

borrowing could result in short-

Procedure Results Significance

equipment has decreased in

2012.

indicate that the company has

acquired new property.

Scan the trial balance The Repairs and Maintenance

account has increased by over

This significant increment may

indicate a posting error that will

Scan the trial balance

The “Gain on Disposition of Fixed

Asset” balance of $14,000

warrants investigation.

Often a company will fail to

remove the appropriate cost and

related accumulated depreciation

when a plant asset is sold. The

auditor should also ascertain that

Scan the trial balance The Allowance for Doubtful

Accounts balance shows a debit

compared to a credit balance one

The auditor should determine if

the client has written off an

Scan the trial balance The company’s two bank credit

lines now have a total balance

that exceeds the $750,000

The auditor should verify that no

loan covenants have been

broken. In addition, because of

Scan the trial balance The long-term notes payable

have increased by $50,000. The

The auditor should determine the

application of those funds as well

Scan the trial balance Sales returns have increased

significantly for both the company

stores and the distributorship.

The auditors need to ascertain

the reasons for such an increase.

Any change in the trend for sales

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Procedure Results Significance

an increase from the previous

additional equipment during the

Exercise 3-2

Note: Refer the students to Case 1 and Case 2. Student answers will vary greatly

Exercise 3-2

Overall Inherent Risk Level

Client: The Lakeside Company

Balance Sheet Date: December 31, 2012

Prepared by:

(IR) is a measure of the susceptibility of material misstatement

Factor Discussion Low Moderate

High

business

Consumer electronics

industry is subject to swings

in the economy and is very

competitive.

X

Results of previous

Qualified opinion rendered by

X

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Factor Discussion Low Moderate

High

for accounts

Potential for fraudulent

financial reporting

(fraud risk factors)

Many risk factors for

fraudulent financial reporting

were identified in case 1.

X

Discussion: Discuss how you arrived at this overall level of inherent risk.