Auditing-Seminar 4 Discussion Questions

Auditing-Seminar 4

Discussion Questions

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What are the major advantages and disadvantages of each approach? Which approach do you favor? Explain.

Most audit firms provide specific written guidance and decision aids to assist auditors in making consistent materiality judgements. The guidelines usually involve applying percentages to some base, such as total assets, revenue or net income. In choosing, a base, the auditor considers the stability of the base from year to year, so the materiality does not fluctuate significantly between annual audits. Some audit firms have more complicated guidelines that may be based on the nature of the industry or a composite of materiality decisions made by experts in the firm. Any guideline is just that, a guideline. The auditor should use the guideline as a starting point and then adjust as necessary for qualitative characteristics of the particular audit client. (Chapter 7, p. 287. The disadvantage: the magnitude of a misstatement is only the beginning of an analysis of materiality; it cannot be appropriately used as a substitute for a full analysis of all relevant information. (Chapter 7, p. 291). Either guidelines are appropriate, as long as the auditor follows the guidelines, the U.S. auditing standards and accounting boards’ standards and regulations, incorporates analytical procedures, looks for misstatements in the financials, and implements risk assessment procedures used to identify fraud risk factors.

a. What is the relationship between the level of riskiness of the client and the level of misstatement in an account balance that an auditor would consider material?

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Should the materiality threshold for Client A be the same as, more than, or less than that for Client B? The materiality threshold for Client A should be less than the materiality threshold for Client B.

Further, which client will require more audit evidence to be collected, Client A or Client B? Client A

b. How might an auditor’s individual characteristics affect his or her professional judgments about materiality?

Perhaps the biggest concern for the auditor in dealing with opinion units is not to lose sight of the qualitative aspects of materiality in evaluating his or her audit results. Their professional judgement can be either impaired or enhanced. They must stay focused, implement due professional care, due diligence, have ethics, stay up to date on their standards, respect themselves, and respect the client and maintain the objective of performing an honest and reliable audit in accordance to the accounting boards standards and procedures. c. Compare the possible alternative monetary thresholds that a more versus less skeptical auditor might make for Client A.

A less skeptical auditor could use a lower monetary threshold. The auditor could conclude that the misstatement in an account balance (accounts receivable) for the materiality was $4,000. Therefore the auditor would have to back up his assertion, and perform more tests, due to his opinion on what constitutes a higher risk of material misstatement.

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What is the directional relationship between the risk of the material misstatement (inherent and control risk) and both audit risk and detection risk? In other words, if the risk of material misstatement increases of decreases, how are audit risk and detection risk affected? After assessing inherent and control risks, the auditor then determines the appropriate level o of audit risk to accept. When risk of material misstatement is higher, the auditor accepts less audit risk (as low as 1%); conversely, when the risk of material misstatement is lower, the auditor accepts more audit risk (such as 5%). Chapter 7, p. 293).

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a. Define management integrity and discuss its importance to the auditor in determining the type of evidence to be gathered on an audit and in evaluating the evidence. Management integrity is the quality of being honest and having strong moral principles, and high ethical standards in representing the company, open in disclosing its internal controls, and the companies’ financials in auditing. The auditor has to trust and believe that management is being responsible in not misstating financials or committing fraud. Therefore, there has to be open and sincere communication between management with the auditor in order to evaluate the evidence in accordance to the accounting boards’ standards and procedures. Auditors use a variety of tools to understand the clients’ business and integrity.

Management inquiries-the auditor should interview management to identify its strategic plans, its analysis of industry trends, the potential impact of actions it has taken or might take, and its management style. Reviews’ of clients’ budgets-the budget, represents managements’ fiscal plan for the forthcoming year, insight to their approach to operations and to risks the organization might face. Tour of clients’ plant and distribution facilities offers much insight into potential audit issues. The auditor can visualize cost centers as well as shipping and receiving procedures, inventory controls, potentially obsolete inventory and possible inefficiencies. The tour increase the auditors’ awareness of company procedures and operations, providing direct experience into sites and situations that are otherwise encountered only in company documents or observations of client personnel. Knowledge of management systems-audit firms have developed these systems around industries, clients. These systems also capture information about relevant accounting or regulatory requirements for the companies and can be used to develop risk alerts for the companies. Company earning calls-the auditor can observe or read the transcripts of managements’ earnings call in order to understand the most up to date issues that the company is facing, along with managements’ publicly disclosed plans. Review of SEC findings-can be searched online through the EDGAR system. The filings include company annual and quarterly reports, proxy information, and registrations statements for new security issues, the filings contain information about the company, its affiliates, officer, and directors. (Chapter 7, p. 296-297.

b. Identify the types of evidence the auditor would gather in assessing the integrity of management. What are sources of each type of evidence? P. 298

Predecessor auditor-information obtained directly through inquiries is required by professional auditing standards. Other professionals in the business community-examples include lawyers, and bankers with whom the auditor normally has good working relationships and of whom the auditor makes inquiries as part of the process to get to know the client. Other auditors in audit firm-may have dealt with current management. News media and websites-information about the company and its management. Public data bases-search public documents dealing with management or the company. Preliminary interviews with management-helpful in analyzing the frankness or evasiveness of management in dealing with important company issues affecting the audit. Audit committee members-might have been involved in disputes between the previous auditors and management and might have additional insight. Private investigation firms-auditor becomes aware of issues that merit further inquiry about management integrity or management’s’ involvement in potential illegal activities. And inquiries of federal regulatory agencies-regarding pending actions against the company or the history of regularity actions taken with the respect to the company and its management.

For each of the following management scenarios, (1) indicate whether you believe the scenario reflects negatively on management integrity, and explain why; and (2) indicated how the assessment would affect the auditors’ planning of the audit.

i. Since they engage extensively in related party transactions to minimize the overall tax burden, they might be doing this to avoid additional tax consequences, and the auditor could overall consider them as high risk for material misstatement.

ii.The president is representing the company, and he should be setting an example, that he is professional and has integrity. However, the president has control and arbitrary issues, and does not know how discuss important issues or relate to management, and obviously does not respect management. Therefore, he may not be compliant with the auditor on issues regarding the financials.

iii. In circumventing FASB pronouncements to keep debt off the balance sheet and in manipulating accounting to achieve the short term earnings is be very unethical and not following the procedures and standards set by the FASB. She is in violation of the regulatory agency and is at high risk for material misstatement, and possibly fraud. The auditor should look into all the different company financials for material misstatement due to the high risk factors that the vice president is circumventing on the financials.

iv. The president definitely has no integrity. He is intentionally, materially misstating the financials by moving income around to avoid taxes. The auditor should look into the matter because the president is at a very high risk for deliberately committing tax fraud.

v. The president is deliberately and illegally causing deleterious damage to the environment. He lacks leadership and integrity as a man in his position, and as a responsible individual who is not compliant with the government standards. He is not facing up to his responsibilities as a leader. Therefore, he is at very high risk for doing other inappropriate actions, and the auditor should further investigate the situation.

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Explain how ratio analysis and industry comparison (performed as part of planning analytical procedures) can be useful to the auditor in identifying potential risk of material misstatement on an audit engagement. Ratio analysis Comparing ratio data overt time for a client and its industry can yield useful insights, and identify potential problems. For example, if the average collection period of accounts receivable in an industry is forty-three days, but the clients’ average collection period is sixty-five days, this might indicate problems with product quality or credit risk. How can such an analysis also help the auditor plan the audit? The analysis is beneficial to the auditor because it can help the auditor to design audit procedures in order to identify the cause of the difference to determine whether a material misstatement exists, The auditor can incorporate ratio analysis by comparing current and past data that is prepared as a routine part of planning an audit can highlight risks of misstatements. The auditor often develops ratios on asset turnover, liquidity, and product-line profitability to search for potential signals of risks. Also, it is important that the auditor goes through each step in the process beginning with the development of expectations. (Chapter 7, p. 307)

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a.What potential hypotheses would likely explain the changes in the financial data given? Identify all that might explain the change in ratios, including those identified by management. Potential hypotheses: Management explains that the large increase in receivables is due to a new computer system that has increased productivity, a new policy of rebilling items previously sold to customers, (and rebilling the existing inventory) thereby extending the due date from October to April which essentially gives an interest free loan to the customer, and a new policy, whereby management negotiated with customers to determine the approximate amount of seasonal goods on hand at the end of the season in order to provide better service.. The auditor has to research the possible risk factors associated with managements’ explanations.

b.Of those identified, which hypothesis would best explain all the changes in the ratios and financial account balances? Explain the rationale for your answer. The new policy of rebilling of items previously sold to customers, as well as the rebilling the existing inventory would set off red flags and would cause concern for due professional care. If the rebilling items are properly accounted for, why is there a large increase in sales for the last two months of the year when the total sales for the previous year is practically the same as that of the preceding year.

c.Given the most likely hypothesis identified, what specific audit procedures do you recommend as highest priority? Why?

The auditor should be concerned with: the company has a large increase in gross margins, and this seems unlikely because it is selling to large chains with considerable purchasing power. If the rebilllings are for holding the inventory at customers’ locations, the auditor should determine if the items were properly recorded as a sale in the first place or if they should still be recorded as inventory, what the client’s motivation is for extending credit to the customers indicated, and whether it is a coincidence that all of the rebilled items were to large retailers who do not respond to account receivable confirmations received from the auditors.

Johnstone, K., Gramling, A., & Rittenberg, L. E. (2015). Auditing: A Risk Based-Approach to Conducting a Quality Audit. Boston, MA: Cengage