CHAPTER 10

A RISK-BASED AUDIT APPROACH – PART I

I. Review Questions

1. Holding a belief that a potential conflict of interests always exists causes

auditors to perform procedures to search for errors or irregularities that would
have a material effect on financial statements. This tends to make audits more
extensive for the auditor and more expensive for the client. The situation is not
a desirable one in the vast majority of audits where no errors or irregularities
exist.

2. Errors and irregularities: Auditors are required to plan the audit to detect errors
and irregularities that would have a material effect on the financial statements.

Clients’ illegal acts: Auditors are not required to search for illegal acts, but they
are warned to be alert to any that might be detected in the ordinary course of an
audit.

3. Seven major assertions in financial statements:

a. Existence assertion:
The practical objective is to establish with evidence that assets, liabilities
and equities actually exist and that sales and expense transactions actually
occurred. Cut-off can be considered an aspect of the existence assertion.

b. Occurrence assertion:
The practical objective is to establish with evidence that recorded
transactions or events that occurred during a given accounting period
pertained to the entity.

c. Completeness assertion:
The practical objective is to establish with evidence that all transactions of
the period are in the financial statements and all transactions that properly
belong in the preceding or following accounting periods are excluded.
Another term for these aspects of completeness is cut-off.

Completeness also refers to proper inclusion in financial statements of all

assets, liabilities, revenue, expense, and related disclosures.
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d. Rights and Obligations assertion:

The practical objectives related to rights and obligations are to establish
with evidence that assets are owned (or rights such as capitalized leases are
shown) and liabilities are owed.

e. Measurement assertion:
The practical objective is to establish with evidence that a transaction or
event is recorded at the proper amount and revenue or expense is allocated
to the proper period.

f. Valuation assertion:
The practical objective is to establish with evidence that proper values have
been assigned to things (assets, liabilities, equities and related disclosures)
and events (revenues, expenses and related disclosures). Auditing
Standards refer to the practical objective of obtaining evidence about
“valuations” achieved by cost allocations such as depreciation and
inventory costing methods.

g. Presentation and Disclosure assertion:

The practical objective is to establish with evidence that accounting
principles used by management are appropriate in the circumstances and are
applied properly, and that disclosures contain all information required by
generally accepted accounting principles.

4. Benefits of preliminary assessment of materiality:

Fine-tune the audit for effectiveness and efficiency.
Help auditors avoid surprises related to:
Finding out too late about not auditing enough.
Finding out later about auditing too much.
Is P500,000 material? Maybe.
Absolute size. If you think so, it’s material just because it’s a large
number.
Relative size.
No. If P500,000 is less than 5% of a relevant base.
Maybe. If P500,000 is between 5% and 10% of a relevant base.
Yes. If P500,000 is 10% or more of a relevant base.
Nature of the item. Yes, P500,000 is material if it arises from an illegal
act.
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5. Yes, auditors have credited discovery of errors and irregularities to analytical
review procedures in 27.1% of the cases in a set of audits, and another 18.5%
discovery rate was attributed to “prior expectations” and “discussions.”

6. In assessing inherent risk and control risk, the auditor must consider the types of
errors or irregularities that might occur and their impact on the financial
statements (materiality.) In evaluating materiality, the auditor should consider
the impact of errors and irregularities both individually and in the aggregate.
Auditing Standards require that the auditor design the audit to provide
reasonable assurance of detecting errors and irregularities that are material to the
financial statements. Auditing Standards require that audit risk and materiality
be considered both in planning the audit and in evaluating audit results.

Control risk and inherent risk are also directly related to the setting of
materiality thresholds. If, for example, application of analytical procedures
(inherent risk analysis) leads the auditor to suspect earnings inflation, individual
item materiality thresholds should be reduced accordingly (i.e., either the
materiality percentage or the amount of unaudited income should be decreased.)
Similarly, if control risk analysis leads the auditor to suspect numerous errors,
aggregate materiality thresholds need to be lowered accordingly.

7. An auditor’s reaction to an immaterial error may differ from his or her reaction
to an immaterial irregularity. Auditors generally accumulate the amount of
individual immaterial errors to be sure that the aggregate of all errors is not
material. In addition, the auditor is concerned about whether an error came from
a misunderstanding or other cause that would have resulted in yet more errors
during the period. An auditor is expected to report all irregularities to the audit
committee or the board of directors and senior management.

8. Refer to pages 410 to 411 of the textbook.

9. Refer to pages 413 to 414 of the textbook.

10. Refer to page 403 of the textbook.

11. Inventory is included in the acquisitions and payments, payroll and personnel
(for manufacturing concerns), and production and warehousing cycles.

12. Tolerable misstatement is the amount of materiality allocated to an account or

class of transactions. Tolerable misstatement is a portion of planning materiality
allocated to the audit of an account or class of transactions and is directly related
to materiality.

13. The factors that should be considered are the peso amount of the account, the
likelihood of error, and the cost of auditing the account.
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14. In evaluating audit risk for an engagement, auditing standards indicate that an
auditor should consider (1) management characteristics, (2) operating and
industry characteristics, and (3) engagement characteristics.
II. Multiple Choice Questions

1. d 6. a 11. d 16. a 21. b

2. c 7. c 12. a 17. a
3. c 8. d 13. c 18. d
4. b 9. c 14. c 19. b
5. d 10. d 15. a 20. d

III. Comprehensive Cases

Case 1. a. Antonio’s activity is an irregularity (intentional distortion of financial

statements) rather than error (unintentional mistake). It is also an illegal act
on Antonio’s individual part.

b. The problem does not describe the kind of related party transactions
discussed in PSA 550.

c. Yes, a weakness in internal control exists. It may be considered a material

weakness because the compensating control (internal auditors’ work on
slow-moving inventory) did not operate in a timely enough manner to detect
the irregularity before it had gotten large.

If a material weakness in internal control exists, Brava & Campos are

obligated to report it to management and/or the board of directors.

d. The problem description indicates that this element of the audit was
conducted in a negligent manner. There’s nothing wrong about auditing a
sample of the transactions, but Campos’ follow-up and explanation of the
missing receiving reports leaves much to be desired. At the very least he
could have reviewed the reports produced by Antonio at a later date, and he
could have traced the purchases to the inventory records and perhaps
noticed an over-stocking condition. The auditors had some evidence that an
irregularity might exist, but they failed to apply extended audit procedures
properly.

Case 2. a. Yes. Nicolas was a party to the issuance of false financial statements
and as such is a joint tortfeasor. The elements necessary to establish an
action for common law fraud are present. There was a material
misstatement of fact, knowledge of falsity (scienter), intent that the plaintiff
bank rely on the false statement, actual reliance and damage to the bank as a
result thereof. If action is based upon fraud there is no requirement that the
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bank establish privity of contract with the CPA. Moreover, if the action by
the bank is based upon ordinary negligence, which does not require a
showing of scienter, the bank may recover as a third-party beneficiary (an
exception to the strict privity requirement). Thus, the bank will be able to
recover its loss from Nicolas under either theory.

b. No. The lessor was a party to the secret agreement. As such, the lessor
cannot claim reliance on the financial statements and cannot recover
uncollected rents. Even if he was damaged indirectly, his own fraudulent
actions led to his loss, and the equitable principle of “unclean hands”
precludes him from obtaining relief.

c. Nicolas was not independent. His report is improper and he is probably

subject to disciplinary action by the professional organization or regulatory
body. According to the ethics interpretation on actual or threatened
litigation:

“An expressed intention by the present management to commence litigation

against the auditor alleging deficiencies in audit work for the client is
considered to impair independence if the auditor concludes that there is a
strong possibility that such a claim will be filed.”

Case 3.
1. h 4. j 7. o 10. b 13. i
2. k 5. f 8. l 11. n 14. d
3. g 6. a 9. c 12. p

Case 4. 1. a. Sales and collections cycle

b. Presentation and disclosure

2. a. Production and warehousing

b. Valuation

3. a. Acquisitions and payments

b. Existence

4. a. Investing and financing

b. Existence

5. a. Acquisitions and payments

b. Existence

6. a. Investing and financing

b. Valuation
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7. a. Investing and financing
b. Rights and obligations

Case 5. a. Audit Risk = Inherent Risk x Control Risk x Detection Risk

Detection Risk = Audit Risk / (Inherent Risk x Control Risk)
Detection Risk = 3% / (100% x 50%)
Detection Risk = 6%

b. Detection Risk = Audit Risk / (Inherent Risk x Control Risk)

Detection Risk = 5% / (100% x 50%)
Detection Risk = 10 %

Case 6. (1) Adjustment is not necessary for two reasons:

(a) The amount involved is not material.
(b) The present classification is an acceptable one.

(2) Reclassification of the credit balances is not warranted because the amounts
are not material.

(3) Making direct entries in the general ledger without use of journals is not an
acceptable practice. It prevents proper authorization, is conducive to errors,
and may be used to conceal fraud. Journal entries should be developed by
the client for the transactions in question regardless of the amounts
involved.

(4) Credit memoranda should be controlled by serial numbers and should bear
the approval signature of an executive in all cases. Any violation of these
rules is a virtual invitation to the concealment of irregular transactions. The
client should be so advised in the report on internal control.

(5) Explanations should be required for all general journal entries. A

transaction regarded as usual by one employee might be considered as
unusual by another, and the practice now in effect will surely lead to journal
entries not readily understandable. The client should be so advised.

(6) Missing posting references should be determined and inserted in the ledger
by the client’s employees.

(7) No adjustment is required because the amount is not material. Even if the
amount were material, no adjustment would be required for the purpose of
calendar year financial statements.

(8) This insignificant shortage should be called to the attention of the petty cash
custodian and any paper work thereby avoided; the amount involved does
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not warrant any action by the auditors.

(9) An adjusting entry should be proposed as follows:

Advertising Expense ....................... 3,000
Miscellaneous Expense............ 3,000
To correct erroneous classification for expenditures for
advertising.

(10) An adjusting entry is probably warranted in the case although the amount is
relatively small. As a means of assuring that all notes payable outstanding
are reflected in the accounts, it is helpful to compute each period’s interest
expense exactly and to reconcile this amount with the notes shown as
outstanding.
Prepaid Interest................................ 1,000
Interest Expense ...................... 1,000
To defer interest expense applicable to the succeeding period.
(P12,000 x 10/120.)

Case 7. The purposes of obtaining the representation letter are to have management
acknowledge their primary responsibility for the financial statements, and to get
in writing the important oral representations that have been obtained from
management during the course of the audit. PSA 500, Audit Evidence, requires
that the auditors obtain written representations from management on every audit
engagement. Failure to do so is a “scope limitation,” which precludes the
auditors from issuing an unqualified opinion. The representation letter should
be signed by members of management that are responsible for and
knowledgeable about the matters covered by the representations and that,
normally, they should be signed by the chief executive officer and the chief
financial officer. The auditors should consider the effects of management’s
refusal to furnish written representations on their ability to rely on other of their
representations.

PSA 700, The Auditor’s Report on Financial Statements, states that when the client
imposes restrictions that significantly limit the scope of the audit, the auditors
generally should issue a disclaimer of opinion.

(a) The following are alternative courses of action that are available to you, and
supporting arguments.

(1) You could accept Angeles’ suggestion and issue an unqualified

opinion. Delos Santos is no longer part of management of the
company. Therefore, there is no reason to require his signature on the
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representation letter. Your firm can still adhere to the letter of the
standard by having Gamboa sign the letter.

(2) You could issue a qualified opinion because of the scope limitation.
delos Santos was an important part of management during the period
under audit. He is knowledgeable of and responsible for many of the
matters covered by the representations. Failure to obtain his signature
would be a significant scope limitation. Since delos Santos is no longer
part of management, this is not a scope limitation imposed by the client
that would generally result in a disclaimer of opinion.

(3) You could issue a disclaimer of opinion, using the arguments from (2),
but concluding that the refusal to sign is a scope limitation imposed by
management. The mysterious circumstances surrounding the
resignation of delos Santos might also support this conclusion.

(4) You could withdraw from the engagement. This course of action may
be justified if delos Santos’ refusal to sign the letter causes you to
question the integrity of management. The unanswered questions
regarding the reasons for delos Santos’ resignation also provide some
support for this course of action.

(b) Our opinion:

The mysterious circumstances surrounding the resignation of delos Santos should be

of as much concern as delos Santos’ failure to sign the representation letter.
Perhaps delos Santos’ was being forced by other members of management
to misstate the financial statements. Assuming that the auditors could
resolve their concerns about that matter, it probably would not be necessary
to obtain delos Santos’ signature on the letter, and an unqualified opinion
could be issued. Obtaining the signature of Gamboa on the letter also is
probably not important, because he is neither knowledgeable of nor
responsible for the matters contained in the representation letter.