Arens AAS17 sm 07 - Answers to Audit and Assurance Services PDF

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Chapter 7 Audit Planning and Materiality

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Concept Checks

P. 209 1. The eight major steps i n planni ng audits are: 1. 2. 3. 4. 5. 6. 7. 8.

Accept client and perform initial planni ng Understand the client’ s business and industry Perform preliminary analytical procedures Set preliminary judgment of materiality and performance materiality Identify significant risks due to fraud or error Assess inherent risk Understand internal control and assess control risk Finalize overall audit strategy and audit plan

2. Prior to accepting a client, the auditor should i nvestigate the client. The auditor should evaluate the client’s standi ng i n the business community, financial stability, and relations with its previous CPA firm. The primary purpose of new client investigation is to ascertain the integrity of the client and the possibility of fraud. The auditor should be especially concerned with the possibility of fraudulent fi nancial reporti ng si nce it is difficult to uncover. The auditor does not want to needlessly expose himself or herself to the possibility of a lawsuit for failure to detect such fraud. 3. The five elements of a strategic understanding of the client’s business are: 1. 2.

3.

4. 5.

Industry and External Environment – Understand risks and accounting requirements unique to the client’s industry. Business Operations and Processes – Considers factors such as key customers and suppliers, sources of fi nanci ng, and manufacturing operations. Management and Governance – Encompasses the organizational structure and the activities of the board of directors and audit committee. Client Objectives and Strategies – Understand the client’s strategic plan and objectives related to financial reporti ng, effectiveness and efficiency of operations, and compliance with laws and regulations. Measurement and Performance – Understand key performance indicators used by management to assess progress toward its objectives. Copyright © 2020 Pea rson Education Ltd.

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P. 218 1. The prelimi nary judgment about materiali ty is the maximum amount by which the auditor believes the financial statements could be misstated and still not affect the decisions of reasonable users. Several factors affect the preliminary judgment about materiality and are as follows: 1. 2. 3. 4.

5.

Materiality is a relative, rather than an absolute, concept. Benchmarks are needed for evaluating materiality. Qualitati ve factors affect materiality decisions. If the financial statements are widely di stributed to users, the preliminary judgment of materiali ty will probably be set lower than if the fi nancial statements are not widely distributed. The level of acceptable audi t risk will also affect the preliminary judgment of materiality.

2. A preliminary judgment about materiality is set for the fi nancial statements as a whole. Performance materiality is the maximum amount of misstatement that would be considered material for an indi vidual segment of the audit, or account balance. The amount of performance materiality for any given segment or account is dependent upon the preliminary judgment about materiality. Ordi narily, performance materiality for any given segment or account would have to be lower than the preliminary judgment about materiality. In many cases, it will be considerably lower because of the possibility of misstatements i n different accounts that, i n total, cannot exceed the prelimi nary judgment about materiality. 3. Known misstatements are those where the auditor can determine the actual amount of the misstatement. Likely misstatements are from differences in management’s and the auditor’s judgment about an estimate, or from the projection of sample misstatements to the population being tested. If the auditor tests a sample of $100,000 of inventory and finds misstatements totaling $5,000, the likely misstatement if the account balance is $500,000 is $25,000 ($5,000/100,000 x $500,000).

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Review Questions

7-1 There are three primary benefits from planning audits: it helps the auditor obtain sufficient appropriate evidence for the circumstances, helps keep audit costs reasonable, and helps avoid misunderstandings with the client. 7-2 The new auditor (successor) is required by auditing standards to communicate with the predecessor audi tor. This enables the successor to obtai n i nformation about the client so that he or she may evaluate whether to accept the engagement.

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7-2 (continued) The predecessor is required to respond to the successor ’ s request for information; however, the response may be limited to stati ng that no i nformation will be given. The successor auditor should be wary if the predecessor is reluctant to provide information about the client. 7-3 While assessing acceptable audit risk, an auditor needs to identify his client’s reasons for audit. As this assessment is influenced by the intended uses of statements, the auditor is likely to accumulate more evidence when the statements are to be used extensi vely, as is often the case for publicly held companies, those with extensi ve indebtedness, and companies that are to be sold in the near future. The most likely uses of the statements can be determined from previous experience with the client and discussions with management. Throughout the engagement, the auditor may get additional information about why the client is havi ng an audit and the likely uses of the financial statements. 7-4 Because the Sarbanes–Oxley Act of 2002 explicitly shifts responsibility for hiring and firing of the auditor from management to the audit committee for public companies, the audit committee is viewed as “the client” in those engagements. 7-5 There are fi ve major aspects of a client’s busi ness and i ndustry that an auditor has to be aware of in order to form a strategic understanding: 1. Industry and external environment 2. Business operations and processes 3. Management and governance 4. Objectives and strategies 5. Measurement and performance to understand the client’s business and industry. 7-6 Volatility i n stock and bond markets can result when factors such as the globalization of business, technological advances, and regulatory actions create uncertai nty about the future profitability of certain industries and/or specific companies. Uncertai nty about future cash flows makes it more difficult for auditors to develop expectations about fi nancial reporting results or evaluate management’s estimates for reasonableness , and can also create incentives and pressures for management to misreport. For example, a loss of sales revenue may place undue pressure on management to meet revenue targets, i ncreasing fraud risk. Technological advances can result i n rapid changes i n IT infrastructure and financial reporti ng systems, making it difficult to maintain and assess the effectiveness of i nternal controls over financial reporting, particularly automated controls. In addition, changes i n regulations, such as tax laws, create uncertai nly and make it even more important for companies to have highly qualified employees in financial reporting roles. The auditor may also need to consider including specialists on the engagement team. If the impact of any of these factors on a company is sufficiently negative, the auditors should closely evaluate the entity’s ability to continue as a going concern. There may be i nstances where the audi tor’s report should be modified to include an explanatory paragraph Copyright © 2020 Pearson Education Ltd.

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7-6 (continued) describing the auditor’s substantial doubt about the entity’s ability to conti nue as a going concern. In summary, profitability, internal controls, and incenti ves and opportunities to misreport can all change rapidly in the current environment, making it imperative that the auditor understand these factors in addition to the client’s industry and operating environment. 7-7 Companies frequently communicate the entity’s values and ethical standards through policy statements and codes of conduct. Due to requirements of Sarbanes–Oxley Act, the SEC requires each public company to disclose whether it has adopted a code of ethics that applies to senior management. A company that has not adopted such a code must disclose this fact and explain why it has not done so. The SEC also requires companies to promptly disclose amendments and waivers to the code of ethics for any of those officers. Auditors should gain knowledge of the company’s code of ethics and examine any changes and wai vers of the code of conduct that have implications about the governance system and related integrity and ethical values of senior management. 7-8 A related party is defined by auditing standards as an affiliated company, principal owner of the client company, or any other party with which the client deals where one of the parties can influence the management or operating policies of the other. Material related party transactions must be disclosed in the fi nancial statements by management. Therefore, the auditor must identify related parties and make a reasonable effort to determine that all material related party transactions have been properly disclosed in the financial statements . Because instances of fraudulent financial reporting often i nvolve transactions with related parties, auditors should be alert for the presence of fraud risk. 7-9 Tour Client Facilities and Operations - a tour of the client’s facilities is helpful in obtaining a better understanding of the client’s business operations because it provides an opportunity to observe operations firsthand and to meet key personnel. B y viewing the physical facilities, the auditor can assess physical safeguards over assets and interpret accounti ng data related to assets such as inventory i n process and factory equipment. Identify Related Parties - transactions with related parties are important to auditors because accounting standards require that they be disclosed i n the financial statements if they are material. A related party is defi ned in auditing standards as an affiliated company, a principal owner of the client company, or any other party with which the client deals, where one of the parties can i nfluence the management or operating policies of the other. A related party transaction is any transaction between the client and a related party. 7-10 Information in the client’ s minutes that is likely to be relevant to the auditor includes the following: Copyright © 2020 Pearson Education Ltd.

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7-10 (continued) 1. Declaration of dividends 2. Authori zed compensation of officers 3. Acceptance of contracts and agreements 4. Authori zation for the acquisition of property 5. Approval of mergers 6. Authori zation of long-term loans 7. Approval to pledge securities 8. Authori zation of indi viduals to sign checks 9. Reports on the progress of operations 10. Discussion about outstanding litigation and other contingencies It is important to read the minutes early i n the engagement to identify items that need to be followed up on as a part of conducting the audit. For instance, if a long-term loan is authorized in the minutes, the auditor will want to make certain that the loan is recorded as part of long-term liabilities. 7-11 Three primary reasons for obtaining a good understanding of the client’s industry and external environment are as follows: 1. Risks associated with specific industries may affect the auditor’s assessment of client business risk and acceptable audit risk and may even i nfluence auditors against accepting engagements in riskier industries. 2. Familiarity with those risks aids the auditor in determi ning their relevance to the client when assessi ng client business risk and risk of material misstatement. Examples include potential inventory obsolescence in the fashion clothi ng i ndustry, accounts receivable collection risk in the consumer loan i ndustry, and loss reserve risk in the casualty insurance industry. 3. Unique accounti ng requirements that the auditor must understand to evaluate whether the client’s financial statements are in accordance with accounti ng standards. For example, if the auditor is doing an audit of a city government, the auditor must understand governmental accounting and auditing requirements. Unique accounti ng requirements exist for construction companies, railroads, not-for-profit organizations, financial institutions, and many other organizations. 7-12 The purpose of a client’ s performance measurement system is to measure the client’ s progress toward specific objectives. Performance measurement includes ratio analysis and benchmarki ng against key competitors . Performance measurements for a chai n of retail clothing stores could include gross profit by product line, sales returns as a percentage of clothing sales, and inventory turnover by product line. An Internet portal ’ s performance measurements might i nclude number of website hits or search engine speed. A Copyright © 2020 Pearson Education Ltd.

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7-12 (continued) hotel chai n’s performance measures include occupancy percentages and average room rate. 7-13

Gordon could improve the quality of his analytical tests by: 1. 2.

Making internal comparisons to ratios of previous years or to budget forecasts. In cases where the client has more than one branch in different industries, computi ng the ratios for each branch and compari ng these to the industry ratios.

7-14 The decrease of the current ratio indicates a liquidity problem for Harper Company since the ratio has dropped to a level close to the requirements of the bond indenture. Special care should be exercised by the auditor to determine that the 2.05 ratio is proper since management would be moti vated to hide any lower ratio. The auditor should expand procedures to test all current assets for proper cutoff and possible overstatement and to test all current liabilities for proper cutoff and possible understatement. 7-15 Materiality is defined as the magnitude of misstatements that i ndi vidually, or when aggregated with other misstatements, could reasonably be expected to influence the economic decisions of users made on the basis of the financial statements. “Obtain reasonable assurance,” as used i n the audit report, means that the a udi tor does not guarantee or i nsure the fai r presentation of the financial statements. There is some risk that the financial statements contain a material misstatement. 7-16 Materiality is important because if financial statements are materially misstated, users’ decisions may be affected, and thereby cause financial loss to them. It i s difficult to apply because there are often many different users of the fi nancial statements. The auditor must therefore make an assessment of the likely users and the decisions they wi ll make. Materiality is also difficult to apply because it is a relative concept. Audi ting standards offer li ttle specific guidance regarding the appli cati on of materiali ty. The auditor must, therefore, exerci se considerable professional judgment in the application of materiality. 7-17 Because materiality is relative rather than absolute, it is necessary to have benchmarks for establishi ng whether misstatements are material. For example, in the audit of a manufacturing company, the auditor might use as benchmarks: net i ncome before taxes, total assets, current assets, and working capital. For a governmental unit, such as a school district, there is no net i ncome before taxes, and therefore that would not be an available benchmark. Instead, the primary benchmarks would likely be fund balances, total assets, and perhaps total revenue.

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7-18 The following quali tati ve factors are likely to be considered in evaluating materiality: a. b. c.

Amounts involvi ng fraud are usually considered more important than unintentional errors of equal dollar amounts. Misstatements that are otherwise minor may be mate rial if there are possible consequences arisi ng from contractual obligations. Misstatements that are otherwise immaterial may be material if they affect a trend in earni ngs.

7-19 During an audit, auditors may change their preliminary judgement about materiality, and this is referred to as the revised judgement about materiality. Auditors are likely to make the revision because of changes i n one of the factors used to determine the preliminary judgment; that is, the auditor decides that the preliminary judgment was too large or too small. For example, a preliminary judgment about materiality is often determi ned before year -end and is based on prior years’ financial statements or annualized i nterim fi nancial statement information. The judgment may be re-evaluated after current fi nancial statements are available. Or, client circumstances may have changed due to qualitati ve events such as the issuance of debt, which created a new class of financial statement users. 7-20 There are several possible answers to the question. One example is: Cash Fixed assets Long-term loans

$ 500 $3,000 $1,500

Overstatement Overstatement Understatement

Note: Cash and fixed assets are tested for overstatement and long -term loans for understatement because the auditor’s objective i n this case is to test for overstatements of owner’s equity. The least amount of performance materiality was allocated to cash and long-term loans because they are relatively easy to audit. The majority of the total allocation was to fixed assets because there is a greater likelihood of misstatement of fixed assets i n a typical audit. 7-21 When allocati ng the preliminary judgment about materiality for the financial statements as a whole to individual segments, the auditor considers both efficiency and effectiveness of the audit. An auditor might set a lower level of performance materiality for a particular account balance if it is easy to audit and no misstatements are expected (e.g., notes payable), or if the auditor expects that a misstatement of a lower amount in a particular account or transaction might i nfluence an i nvestor (e.g., disclosure of a related party transaction). 7-22 If performance materiali ty for accounts receivable is $40,000 and the auditor finds a $55,000 overstatement of a recei vable balance, the auditor would document the misstatement and evaluate results of the remaini ng audit procedures i n accounts receivable. The $55,000 overstatement is an example Copyright © 2020 Pearson Education Ltd.

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of a known misstatement. The auditor could request the client make an adjustment to correct the overstatement or make a note of the overstatement for follow-up at a later point in the audi t. If accounts recei vable testing was performed usi ng sampli ng techniques, the audi tor would also project total known misstatements to the population and may perform additional tests dependi ng on the outcome. Discussion Questions And Problems 7-23 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 7-24 a.

b.

(1) (1) (1) (2) (4) (3) (2) (2) (1) (4)

Accept client and perform i niti al audit planning. Accept client and perform i niti al audit planning Accept client and perform i niti al audi t planni ng Understand the cli ent’s busi ness and industry Perform preliminary analytical procedures Assess client business risk Understand the client’s business and i ndustry Understand the client’s business and industry Accept client and perform i niti al audit planning Perform preliminary analytical procedures

A related party transaction occurs when one party to a transaction has the ability to impose contract terms that would not have occurred if the parties had been unrelated. Accounti ng standards conclude that related parties consist of all affiliates of an enterprise, including (1) its management and their immediate families, (2) its principal owners and their immediate fami l...