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In an environment that is highlyautomated, an auditor determines that it is not possible to reducedetection risk solely by using substantive tests of transactions.Under these circumstances, the auditor most likely would

(A) Apply analytical procedures and consider the effect oncontrol risk.

(B) Increase the sample size to reduce sampling risk anddetection risk.

(C) Perform tests of controls to support a lower level ofassessed control risk.

(D) Adjust the materiality level and consider the effect oninherent risk.

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Jean Keeling
Jean KeelingLv2
28 Sep 2019

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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 company’s 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 “substantive” 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 currentyear’s 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 Sarbanes–Oxley 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 “reducing controlrisk” 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,McClain’s 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 Sessions’s recommendedapproach. In planning the audit evidence for detailed inventorytests, the audit risk model was applied with the followingresults:

PDR=AATIR×CR×APR

where:

PDR=PlanneddetectionriskAAR=acceptableauditriskIR=inherentriskCR=controlriskAPR=analyticalproceduresrisk

Therefore, using Sessions’s assessments and judgments asdescribed previously,

PDR=.051.0×.5×.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 “reworked” the audit riskmodel as follows:

PDR=.051.0×.8×.6PDR=.10

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

Required

Do you agree with the staff person’s 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 auditor’sinternal control report.

Which of the following statements is most correct regarding the independent auditor's reliance on the tests of controls performed by the internal auditors to reduce their substantive testing?

1-The independent auditor must obtain assurance of the independence of the internal auditors but need not test their work.
2-It is not acceptable for the independent auditor to rely upon the work of the internal auditors.
3-There are no restrictions in relying upon the work of internal auditors.
4-The independent auditor must evaluate the competency and objectivity of the internal auditors and must test a sample of the work of the internal auditors in order to rely upon their work.

The term "materiality" as used in auditing is best described as the

1-substance of the auditing procedures.
2-amount of misstatement on the financial statements that would influence a decision maker.
3-underlying evidence upon which the audit opinion is based.
4-amount of material the auditor gathers as evidence to support the audit opinion.

Prior to accepting an audit client an auditor has a professional obligation to

1-contact the predecessor auditor.
2-perform preliminary analytical review procedures.
3-do all of the listed actions.
4-obtain approval for the audit engagement from the SEC.

Which of the following best represents financial statement fraud?

1-The transfer agent issues 40,000 shares of the company's stock to a friend without authorization by the board of directors.
2-The controller of the company decreases a contingent liability by $3 million so the company will meet analysts' expectations this quarter.
3-The in-house attorney receives payments from the French government for negotiating the development of a new plant in Paris.
4-The accounts receivable clerk covers up the theft of cash receipts by writing off older receivables without authorization.

Sampling risk is the risk that

1-errors are inherent and may be present in the population without regard to the internal controls.
2-the population will not contain characteristics representative of the sample such that inferences made about that sample will be incorrect.
3-internal controls are not adequate to prevent or detect material errors.
4-the sample will not contain characteristics representative of the population such that inferences made about that population will be incorrect.

Control risk that is assessed excessively high (i.e. the auditor believes control risk is high when in reality it is moderate or low) leads to:

1-audit inefficiency.
2-a less expensive audit.
3-reduced substantive testing.
4-errors that are more likely to occur than anticipated.

The purchasing process consists of each of the following phases except

1-receipts of goods and services.
2-approval of items for payment.
3-authorized request for goods and services.
4-cash receipts.

d.1. The major advantage to using statistical techniquesis:

a. it limits the risk of incorrect acceptance

b. it relate sample size to audit risk

c. it limits the risk of inefficiency

d. it limits sample size to the smallest appropriate size

2. If the auditor is performing an audit of a nonpubliccompany and the client refuses to provide a managementrepresentation letter, the auditor may:

a. issue a financial statement audit report

b. issue an integrated audit report

c. issue a financial statement audit report with a scopelimitation

d. dependening on the circumstances the auditor may choose anyof the alternitives

3. Which of the following would be least likely topreclude an audit firm from proposing on a potential client due toindependence concerns?

a. A recently-promoted partner in the audit firm holds afinancial interest in the potential client company.

b. Someone who resigned from the audit firm three years ago isnow the Chief Accounting Officer at the potentialclient company.

c. The audit firm provides internal audit outsourcing andcertain nonaudit services to the client company.

d. The audit firm's pension plan holds securities of thepotential client company.

4. If an auditor determines that a client company'sinternal controls are producing reliable and complete financialinformation, the auditor will rely upon the internal control systemand:

a. reduce the extent of controls testing in the interim phase ofthe financial statement audit.

b. reduce the planned substantive testing during the financialstatement audit.

c. increase the amount of evidence collected during thefinancial statement audit.

d. increase the planned substantive testing during the financialstatement audit.

5. Which of the following internal control activitiesmost likely would deter lapping of collections fromcustomers?

a. Independent internal verification of dates of entry in thecash receipts journal with dates of daily cash summaries.

b. Separation of duties between receiving cash and posting theaccounts receivable ledger.

c. Authorization of write-offs of uncollectible accounts by asupervisor independent of credit approval.

d. Supervisory comparison of the daily cash summary with the sumof the cash receipts journal entries.

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