CHAPTER 7 SHORT CASES
7-30: Some audit firms develop very specific quantitative guidelines, either through quantitative
measures or in tables, relating planning materiality to the size of sales or assets for a client. Other
audit firms leave the materiality judgments up to the individual partner or manager in charge of
the audit. What are the major advantages and disadvantages of each approach? Which approach
do you favor? Explain.
The advantage of the more quantitative approach is that it (a) promotes consistency across audit
engagements; (b) ensures that important items are addressed in the audit engagement; and (c)
presents an initial basis from which an auditor can adjust the preliminary materiality
assessment. The advantage of the individual auditor approach is that the auditor is in the best
position to understand the uses of the financial statements, the major users, and pertinent other
factors that may affect the overall presentation of the financials statements. For example, the
auditor may be aware of debt covenants or other restrictions that may affect the assessment of
materiality on specific accounts. There is no one correct approach. Clearly, there is need for
individual auditor adjustment to any preliminary assessment of planning materiality. The SEC
has been very adamant that materiality is not a 5% cut-off point, i.e., there are many items that
are material that may be much less than 5% of net income.
7-33:
December 31, 2015 (unaudited) December 31, 2014 (audited)
Total assets $698,752,000 $542,609,000
Accounts receivable $25,152,000 $19,041,000
Total sales $1,066,691,000 $828,971,000
Cost of goods sold $842,255,000 $628,534,000
Net income $57,456,000 $58,849,000
Earnings per share $1.81 $1.88
a. Use the three common benchmarks for making materiality judgments (net income,
total assets, and net sales) to establish materiality for the financial statements overall.
Using the maximum thresholds for net income, net sales, and total assets, and the
10% clearly trivial threshold yields the following amounts:
Common
Benchmarks
Maximum Overall Clearly Trivial Threshold (10%)
Materiality
Threshold
% of Net Income 5%=$2,872,800 10% X (2,872,800) = $287,280
% of Net Sales 1%=$10,666,910 10% X (10,666,910) =
$1,066,691
% of Total 1%=$6,987,520 10% X (6,987,520) = $698,752
Assets
b. What difficulties does the auditor face when the alternative benchmarks yield
differing conclusions about materiality? What qualitative factors should the auditor
consider in making the materiality judgment for this company?
The difficulty that the different materiality amounts poses for the auditor is that it is
challenging to choose among the alternatives. In practice, consistency with past decisions is
important, so the auditor will likely use the prior year’s benchmark, i.e., if % of net income was
used last year it makes sense to use that benchmark again unless conditions have changed. The
qualitative factors that the auditor should consider in this case are:
o There have been misstatements in the past in accounts receivable, so it is
possible that the posting threshold should be even lower than 10% for this
account.
o The company is under considerable pressure from analysts to make their
earnings forecasts.
o Margins have declined for the company, as has earnings per share. So, the
company looks worse to Wall Street than last year regardless of the outcome of
the issue concerning the write down of accounts receivable. Thus, management
is under considerable pressure to improve the financial results of the company.
c. Articulate a reason for choosing one particular benchmark among the three calculated
in part (a), and use that benchmark to calculate the clearly trivial threshold for the
accounts receivable account.
Because the problem provides no information on the benchmark used in the past, any
of the three benchmarks is a reasonable answer to the question. Students may decide
on total assets as the benchmark because the misstatement is on the balance sheet. Or
students may decide on net income as the benchmark because of the focus on analyst
expectations noted in the problem.
d. What effect will the qualitative factors in this case have on the auditor’s clearly trivial
threshold for the accounts receivable account?
The fact that misstatements have occurred in this account in the past suggests that a
clearly trivial threshold even lower than 10% might be appropriate. So, for example,
students might decide on a 5% clearly trivial threshold to reflect the qualitative risks
noted in the problem.
7-41: Inherent risk at the financial statement level relates to (a) business and operating-related
risks and (b) financial reporting risks. The Professional Judgment in Context feature “Risks
Associated with Financial Statement Misstatements ” summarizes various risks from ISA 315;
that list is reproduced here. For each risk factor, categorize it as indicating (a) business and
operating risk, (b) financial reporting risk, or (c) other (if other, describe).
1. Operations in regions that are economically unstable, such as countries with
significant currency devaluation or highly inflationary economies A
2. Operations exposed to volatile markets, such as futures trading A
3. Operations that are subject to a high degree of complex regulation A
4. Going concern and liquidity issues, including loss of significant customers or
constraints on the availability of capital or credit A
5. Offering new products or moving into new lines of business A
6. Changes in the organization such as acquisitions or reorganizations A
7. Entities or business segments likely to be sold A
8. The existence of complex alliances and joint ventures. A
9. Use of off-balance sheet financing, special-purpose entities, and other complex
financing arrangements B
10. Significant transactions with related parties B
11. Lack of personnel with appropriate accounting and financial reporting skills C
(CONTROL RISK)
12. Changes in key personnel, including departure of key executives B
13. Deficiencies in internal control, especially those not addressed by management C
( CONTROL RISK)
14. Changes in the IT system or environment and inconsistencies between the entity’s
IT strategy and its business strategies A
15. Inquiries into the entity’s operations or financial results by regulatory bodies A
16. Past misstatements, history of errors, or significant adjustments at period end B
17. Significant amount of nonroutine or nonsystematic transactions, including
intercompany transactions and large revenue transactions at period end B
18. Transactions that are recorded based on management’s intent, such as debt
refinancing, assets to be sold, and classification of marketable securities B
19. Accounting measurements that involve complex processes B
20. Pending litigation and contingent liabilities, such as sales warranties, financial
guarantees, and environmental remediation B
7-44: FRAUD PROFESSIONAL SKEPTICISM The auditor needs to assess management
integrity as a potential indicator of inherent risk, particularly as it relates to the potential for
fraud. Although the assessment of management integrity takes place on every audit engagement,
it is a difficult and subjective task. It requires professional skepticism on the part of the auditor
because it is human nature to trust people whom we know and interact with.
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 defined as the general honesty of management and its
motivation for truthfulness (or lack thereof) in financial reporting. It is a reflection of the
extent to which management shows good business practice and to which the auditor
believes that management's representations are likely to be honest.The auditor will not be
able to rely on management's representations without significant corroboration. The audit
evidence generated from internal documents must be evaluated with a great deal of
skepticism.The auditor will seek more external audit evidence and corroboration from
outside parties, including vendors and customers.The auditor must consider the
possibility that management would be motivated to misstate the financial statements to
accomplish personal objectives. Thus, the auditor should investigate any significant
changes in account balances or ratios that may indicate management misstatement.
b. Identify the types of evidence the auditor would gather in assessing the integrity
of management. What are sources of each type of evidence.,
Sources of evidence pertaining to management integrity might include
• The predecessor auditor, if applicable
• Other professionals in the business community
• Other auditors within the audit firm
• News media and Web searches
• Public databases
• Preliminary interviews with management
• Audit committee members
• Inquiries of federal regulatory agencies
• Private investigation firms
c. For each of the following management scenarios, (1) indicate whether you believe
the scenario reflects negatively on management integrity, and explain why; and
(2) indicate how the assessment would affect the auditor’s planning of the audit.’
Management Scenarios
i. The owner/manager of a privately held company also owns three other
companies. The individual companies could be run as one combined
company, but they engage extensively in related-party transactions to
minimize the overall tax burden for the owner/manager. The existence
of related-party transactions, however, should alert the auditor to
plan the audit to ensure that the economic substance of related-party
transactions are discovered and described in the annual financial
statements. The auditor should also be alert to tax planning strategies
that Congress and the general public consider ‘over the edge’ because
it is likely that such strategies will be challenged – if not in court, then
at least in the court of public opinion. Finally, the mere existence of
related parties creates an opportunity to use transactions with the
parties to inappropriately portray the real economics of the business.
The auditor should plan to obtain sufficient appropriate evidence to
obtain reasonable assurance that all related party transactions are
appropriately disclosed.
ii. The president of a publicly held company has a reputation for being
stubborn with a violent temper. He fired a divisional manager on the
spot when the manager did not achieve profit goals.
This is a common business trait and seems to be widely accepted. However, it is also an
indication of a potential problem when a member of management is so domineering that
he or she can intimidate other members of the organization to achieve their objectives,
no matter how achieved. There have been many instances of major financial statement
fraud by top management who intimidated lower level managers.
iii. The financial vice president of a publicly held company has worked
her way to the top by gaining a reputation as a great accounting
manipulator. She has earned the reputation by being very creative in
finding ways to circumvent FASB pronouncements to keep debt off
the balance sheet and in manipulating accounting to achieve short-term
earnings. After each short-term success, she has moved on to another
company to utilize her skills.
As in the previous scenarios, this is not an uncommon trait. In the author's view, this is
an unfortunate statement about the status of accounting principles in the United States.
Two factors in this scenario should raise the auditor's skepticism: the manager (1) has a
very short-term orientation and (2) has shown a tendency to change jobs after achieving
the short-run objectives. The scenario is one of high risk and should raise the auditor's
awareness of significant accounting manipulations resulting in the substance of
transactions not being reflected in the financial statements. The auditor should have a
heightened degree of professional skepticism in the areas of management estimates and
the use of reserves, or other changes where subjective accounting judgments are made.
iv. The president of a small publicly held company was indicted on tax
evasion charges seven years ago. He settled with the Internal Revenue
Service and served time doing community service. Since then, he has
been considered a pillar of the community, making significant
contributions to local charities. Inquiries of local bankers yield
information that he is the partial or controlling owner of several
companies that may serve as “shell” company whose sole purpose is to
assist the manager in moving income around to avoid taxes.
Ostensibly the manager is a pillar of the business community. However, two factors are
unsettling: (1) the previous conviction on tax evasion and (2) the current manipulation
among controlled corporations to avoid tax. Although this latter practice is common, the
auditor must determine whether such manipulation violates the federal income tax
provisions. However, most auditors would consider this to be a high risk situation. The
auditor should determine if there are any issues still outstanding from the previous tax
returns and whether there are potential constraints on the president’s activities that
resulted from the tax conviction. The auditor should have management list all controlled
or partially controlled organizations and all related-party transactions during the period
under audit.
v. James J. James is the president of a privately held company that has
been accused of illegally dumping waste and failing to meet
government standards for worker safety. James responds that his
attitude is to meet the minimum requirements of the law; if the
government deems that he has not, he will clean up. “Besides,” he
asserts, “it is good business; it is less costly to clean up only when I
have to, even if small fines are involved, than it is to take leadership
positions and exceed government standards.”
The scenario reflects poorly on management's integrity. The
attitude is that it will do something only after being "caught." Such an attitude raises
questions about management's openness with the auditor in disclosing transactions or
questionable accounting. This situation raises some interesting questions for the auditor.
First, there is a question about whether the auditor wishes to be associated with such a
client. The engagement risk may be too high. Second, the auditor will probably have to
expand the audit to determine whether any unrecorded liabilities are associated with
environmental protection. The auditor must consider whether an audit can be performed
within the planned audit time frame without substantial client cooperation. It is doubtful
that such cooperation will be forthcoming.
7-52: A staff auditor was listening to a conversation between two senior auditors regarding the
audit risk model. The following are some statements made in that conversation regarding the
audit risk model. State whether you agree or disagree with each of the statements, and explain
why.
a. Setting audit risk at 5% is valid for controlling audit risk at a low level only if the
auditor assumes that inherent risk is 100%, or significantly greater than the real
level of inherent risk. Agree. Setting audit risk at a low level such as 5% is
acceptable as long as the auditor uses conservatism elsewhere in the audit
engagement. Setting audit risk at .05 implies that 5% of audits would end with an
incorrect audit opinion. Such a failure rate would be unacceptable to the
profession. As a compensation for audit risk in the model, many firms assume
inherent risk is 1.0 (100%). This ensures that the audit risk is significantly below
the nominal .05 level.
b. Inherent risk may be very small for some accounts (such as the recording of
payroll transactions at Wal-Mart). In fact, some inherent risks may be close to
0.01%. In such cases, the auditor does not need to perform direct tests of account
balances if he or she can be assured that inherent risk is indeed that low and that
internal controls, as designed, are working appropriately. Agree. Inherent risk
may be so low that the auditor may not need to perform direct tests of an account
balance. However, the auditor should perform some indirect tests of the account
balance, such as substantive analytical review procedures, to determine if the
account balances appear to be stated at amounts other than expected. If the
amounts differ significantly from expectations, the auditor would need to perform
additional direct tests. Further, for material accounts—such as revenue—some
direct testing will likely be necessary.
c. Control risk refers to both (a) the design of controls and (b) the operation of
controls. To assess control risk as low, the auditor must gather evidence on both
the design and operation of controls. Agree. To support a control risk assessment
of low or moderate, the auditor must gather evidence that not only are controls
appropriately designed, but also they are operating as designed.
d. Detection risk at 50% implies that the substantive tests of the account balance has
a 50% chance of not detecting a material misstatement and that the auditor is
relying on the client actions (assessment of inherent and control risk) to address
the additional uncertainty regarding the possibility of a material misstatement.
Agree. A Detection Risk of 50% implies that it is not a strong audit test and it
should be used only as assistance in corroborating other audit evidence.
e. Audit risk should vary inversely with both inherent risk and control risk; the
higher the risk of material misstatement, the lower should be the audit risk taken.
Agree. As the risk of material misstatement increases, audit risk should decrease
in order to protect the auditor from potential litigation or other problems caused
by being associated with the client.
f. In analyzing the audit risk model, it is important to understand that much of it is
judgmental. For example, setting audit risk is judgmental, assessing inherent and
control risk is judgmental, and setting detection risk is simply a matter of the
individual risk preferences of the auditor. Agree. Although the audit model looks
like a very quantitative approach it is based on a significant amount of auditor
judgments.
