ACCT 475 Lecture 19: ACCT 475 – Lecture 19

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16 Jan 2018

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Chapter 10: substantive testing and balance sheet accounts. 2 cases this week (capital bank-cash, happiness express-receivables/payables) Risk and substantive procedures: extent of substantive procedures. Trivial or immaterial accounts are either ignored or subjected to analytical procedures only. Audit risk model used to make a risk assessment on each significant account or disclosure. High ir, cr: do not rely on and test controls, use significant amount of substantive testing to reduce dr to acceptable level. Low ir, cr: testing controls shows them to be effective, limited substantive testing required: timing of substantive procedures. Lower dr, more work done at year end. Audit firm must also consider availability of resources to conduct procedures around year end. Page 1: other matters to consider in designing substantive procedures. Ensure procedures respond to specific risk faced by client from both ir and cr factors: different clients may have same overall level of risk but risk caused by different factors procedures would be also different.

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13-35 (Objectives 13-3, 13-4) McClain Plastics has been an auditclient of Belcor, Rich, Smith & Barnes, CPAs (BRS&B), forseveral years. McClain Plastics was started by Evers McClain, whoowns 51% of the companyâs stock. The balance is owned by about 20stockholders, who are investors with no operationalresponsibilities. McClain Plastics makes products that have plasticas their primary material. Some are made to order, but mostproducts are made for inventory. An example of aMcClain-manufactured product is a plastic chair pad that is used ina carpeted office. Another is a plastic bushing that is used withcertain fastener systems.

McClain has grown from a small, two-product company, when theyfirst engaged BRS&B, to a successful, diverse company. At thetime Randall Sessions of BRS&B became manager of the audit,annual sales had grown to $200 million and profits to $10.9million. Historically, the company presented no unusual auditproblems, and BRS&B had issued an unmodified opinion everyyear.

The audit approach BRS&B always used on the audit of McClainPlastics was a âsubstantiveâ audit approach. Under this approach,the in-charge auditor obtained an understanding of internal controlas part of the risk assessment procedures, but control risk wasassessed at the maximum (100%). Extensive analytical procedureswere done on the income statement, and unusual fluctuations wereinvestigated. Detailed audit procedures emphasized balance sheetaccounts. The theory was that if the balance sheet accounts werecorrect at year-end and had been audited as of the beginning of theyear, then retained earnings and the income statement must becorrect.

Part I

In evaluating the audit approach for McClain for the currentyearâs audit, Sessions believed that a substantive approach wasreally only appropriate for the audits of small nonpubliccompanies. In his judgment, McClain Plastics, with sales of $200million and 146 employees, had reached the size where it was noteconomical, and probably not wise, to concentrate all the tests onthe balance sheet. Furthermore, although McClain is not a publiccompany, Sessions recognized that similar public companies arerequired by Section 404 of the SarbanesâOxley Act and related PCAOBstandards to have an integrated audit of the financial statementsand internal control over financial reporting. Therefore, hedesigned an audit program that emphasized identifying internalcontrols in all major transaction cycles and included tests ofcontrols. The intended economic benefit of this âreducing controlriskâ approach was that the time spent testing controls would bemore than offset by reduced tests of details of the balance sheetaccounts.

In planning tests of inventories, Sessions used the audit riskmodel included in auditing standards to determine the number ofinventory items BRS&B would test at year-end. Because of thenumber of different products, features, sizes, and colors,McClainâs inventory consisted of 2,450 different items. These weremaintained on a perpetual inventory management system that used arelational database.

In using the audit risk model for inventories, Sessions believedthat an audit risk of 5% was acceptable. He assessed inherent riskas high (100%) because inventory, by its nature, is subject to manytypes of misstatements. Based on his understanding of the relevanttransaction cycles, Sessions believed that internal controls wereeffective. He therefore assessed control risk as low (50%) beforeperforming tests of controls. Sessions also planned to usesubstantive analytical procedures for tests of inventory. Theseplanned tests included comparing gross profit margins by month andreviewing for slow-moving items. Sessions believed that these testswould provide assurance of 40%. Substantive tests of details wouldinclude tests of inventory quantities, costs, and net realizablevalues at an interim date two months before year-end. Cutoff testswould be done at year-end. Inquiries and substantive analyticalprocedures would be relied on for assurance about events betweenthe interim audit date and fiscal year-end.

Required

Decide which of the following will likely be done under both areducing control risk approach and a substantive approach:

Assess inherent risk.

Obtain an understanding of internal control.

Perform tests of controls.

Perform substantive analytical procedures.

Assess planned detection risk.

What advantages does the reducing control risk approach Sessionsplanned to use have over the substantive approach previously usedin the audit of McClain Plastics?

What advantages did the substantive approach have over thereducing control risk approach?

Part II

The engagement partner agreed with Sessionsâs recommendedapproach. In planning the audit evidence for detailed inventorytests, the audit risk model was applied with the followingresults:

PDR=AATIRÃCRÃAPR

where:

PDR=PlanneddetectionriskAAR=acceptableauditriskIR=inherentriskCR=controlriskAPR=analyticalproceduresrisk

Therefore, using Sessionsâs assessments and judgments asdescribed previously,

PDR=.051.0Ã.5Ã.6PDR=.17

Required

Explain what .17 means in this audit.

Calculate PDR assuming that Sessions had assessedcontrol risk at 100% and all other risks as they are stated.

Explain the effect of your answer in requirement b. on theplanned audit procedures and sample size in the audit of inventorycompared with the .17 calculated by Sessions.

Part III

Although the planning went well, the actual testing yielded somesurprises. When conducting tests of controls over acquisitions andadditions to the perpetual inventory, the staff person performingthe tests found that the deviation rates for several key controlswere significantly higher than expected. As a result, the staffperson considered internal control to be operating lesseffectively, supporting an 80% control risk rather than the 50%level used. Accordingly, the staff person âreworkedâ the audit riskmodel as follows:

PDR=.051.0Ã.8Ã.6PDR=.10

A 10% test of details risk still seemed to the staff person tobe in the âmoderateâ range, so he recommended no increase inplanned sample size for substantive tests.

Required

Do you agree with the staff personâs revised judgments about theeffect of tests of controls on planned substantive tests? Explainthe nature and basis of any disagreement. If BRS&B was alsoissuing a report on internal control over financial reporting,describe the implications of these results on the auditorâsinternal control report.

A424

Homework #3

Due Tuesday, February 28

Worth 100 Points

Note: Students are expected to work independently (i.e., on your own) on all homework assignments. Please type and post to Canvas.

Part I. Risk Assessments

1. For each illustration, select the component of audit risk that is most directly illustrated. The components of audit risk may be used once, more than once, or not at all. (10 points, 1 point each).

Components: Inherent Risk (IR), Control risk (CR), or Detection Risk (DR)

a. A client fails to discover employee fraud on a timely basis because bank accounts are not reconciled monthly.

b. Cash is more susceptible to theft than an inventory of coal.

c. Confirmation of receivables by an auditor fails to detect a material misstatement.

d. Disbursements have occurred without proper approval.

e. There is inadequate segregation of duties.

f. A necessary substantive audit procedure is omitted.

g. Notes receivable are susceptible to material misstatement, assuming there are no related internal controls.

h. Technological developments make a major product obsolete.

i. The client is very close to violating debt covenants.

j. XYZ Company, a client, lacks sufficient working capital to continue operations.

2. Read Case 1.6, Nextcard, Inc. from our Casebook. Pretend you are the auditor for Nexcard, Inc. in the planning phase of the audit for FY 2000 and perform the following risk assessment procedures. That is, just focus on the information in the case prior to the discovery of the fraud (pages 83-86). (50 points total)

a. Perform a risk assessment as part of your audit plan for fiscal year 2000. Set or assess each component/factor of the audit risk model. Describe in detail how you set or assessed each factor (i.e., include specific risk factors from the case and explain how they influenced your assessment). (25 points)

b. Perform a fraud risk assessment for the risk of material misstatement due to fraudulent financial reporting. That is, identify and briefly describe specific fraud risk factors (i.e., more than 1) for each of the three components of the fraud risk triangle, specific to fraudulent financial reporting. (15 points)

c. Identify and describe one significant pervasive risk present during the Nextcard audit. In doing so, explain how the pervasive risk affects the risk of material misstatement. Then, describe how the auditor could respond to that pervasive risk (how could they change the audit plan to address that risk). (5 points)

d. Identify and describe one significant specific risk present during the Nextcard audit. In doing so, explain how the specific risk affects the risk of material misstatement. Then, describe how the auditor could respond to that specific risk (how could they change the audit plan to address that risk). (5 points)

Part II. Evidence and Management Assertions

1. For each of the following specific audit procedures, indicate the type of audit procedure it represents: (1) inspection of records or documents, (2) inspection of tangible assets, (3) observation, (4) inquiry, (5) confirmation, (6) recalculation, (7) reperformance, (8) analytical procedures, and (9) scanning. (10 points, 1 point each)

a. sending a written request to the entityâs customers requesting that they report the amount owed to the entity

b. examining large sales invoices for a period of two days before and after year-end to determine if sales are recorded in the proper period.

c. agreeing the total of the accounts receivable subsidiary ledger to the accounts receivable general ledger account.

d. discussing the adequacy of the allowance for doubtful accounts with the credit manager.

e. comparing the current-year gross profit percentage with the gross profit percentage for the last four years.

f. examining a new plastic extrusion machine to ensure that this major acquisition was received.

g. watching the entityâs warehouse personnel count the raw materials inventory.

h. performing test counts of the warehouse personnelâs count of the raw material.

i. obtaining a letter from the entityâs attorney indicating that there were no lawsuits in progress against the entity.

j. tracing the prices used by the entityâs billing program for pricing sales invoices to the entityâs approved price list.

2. For each of the audit procedures listed above in Part II. 1. (a-j), identify the category (assertions about classes of transactions and events, or assertions about account balances) and identify the primary management assertion being tested. (30 points, 3 points each)

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ACCT 475 Lecture 19: ACCT 475 – Lecture 19

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