Solutions For Chapter 7: Answers To "Check Your Basic Knowledge" Questions

Financial Statement Auditing: A Risk-Based Approach, 11e
Solutions for Chapter 7
Answers to “Check Your Basic Knowledge” Questions
7-1 F 7-7 c
7-2 T 7-8 d
7-3 d 7-9 F
7-4 a 7-10 F
7-5 F 7-11 c
7-6 T 7-12 c
Review Questions and Short Cases
7-1
A misstatement is an error, either intentional or unintentional, that exists in a transaction or

financial statement account balance. Characteristics that would make a misstatement material
include:
 The misstatement makes it probable that the judgment of a reasonable person relying
on the information would have been changed or influenced by the omission or
misstatement.
 The misstatement would have been viewed by a reasonable investor to have
significantly altered the total mix of information available.
 The relative size of the misstatement.
7-2
The advantage of the less judgment-based 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. 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.
© 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
7-1
7-3
a. Overall materiality (also known as planning materiality) is the materiality amount that the
auditor uses in in determining whether the financial statements overall are materially
correct. In planning the audit, auditors consider planning materiality in terms of the
smallest aggregate level of misstatements that could be material to any one of the
financial statements. For example, if the auditor believes that misstatements aggregating
approximately $100,000 would be material to the income statement, but misstatements
aggregating approximately $200,000 would be material to the balance sheet, the auditor
typically assesses overall materiality at $100,000 or less (not $200,000 or less). Since
many financial statement users of public companies focus on net income, a common
approach for setting planning materiality for the financial statements is to use net income
as the benchmark and a percentage threshold of 5%. The auditor should use the result of
the calculation as a starting point for planning materiality and then adjust as necessary for
qualitative characteristics of the particular audit client. For example, if the client is a
planning a secondary stock offering, the auditor may want to set materiality at a lower
level than suggested by the calculation as the client may be very biased to make the
company look particularly successful.
b. Performance materiality (also known as tolerable error) is the materiality level that the
auditor uses for determining significant accounts, significant locations, and audit
procedures for those accounts and locations. A common approach to determining
performance materiality is to calculate 75% of planning materiality. While the auditor
will commonly use 75% to set performance materiality, this percentage can typically
range from 50% to 75%. If performance materiality is set too high, the auditor might not
perform sufficient procedures to detect material misstatements in the financial statements.
If performance materiality is set too low, the auditor might perform more substantive
procedures than necessary.
c. Posting materiality is the materiality amount that signifies the misstatements identified
throughout the audit that will be considered at the end of the audit in determining whether
the financial statements overall are materially correct. The auditor commonly sets posting
materiality at 5% of planning materiality; however, this percentage can typically range
from 3% to 5%. The auditor will accumulate all errors identified throughout the audit that
are $5,000 or more, and at the end of the audit will consider all of these errors in
determining whether the financial statements overall are materially correct.
d. Quantitative materiality is based on a specific numeric cutoff; e.g., 5% of net income, or

1% of assets. The auditor should use the result of this calculation as a starting point for
planning materiality and then adjust as necessary for qualitative characteristics of the
particular audit client. For example, if the client is planning a secondary stock offering,
the auditor may want to set materiality at a lower level than suggested by the calculation,
as the client may be very biased to make the company look particularly successful. In
7-2
Staff Accounting Bulletin (SAB) No. 99, the SEC expresses concern about auditors not
considering qualitative factors in their materiality assessments:
The use of a percentage as a numerical threshold, such as 5%, may provide the basis
for a preliminary assumption that—without considering all relevant circumstances—a
deviation of less than the specified percentage with respect to a particular item on the
registrant’s financial statements is unlikely to be material. The staff has no objection
to such a “rule of thumb” as an initial step in assessing materiality. Quantifying, in
percentage terms, the magnitude of a misstatement is only the beginning of an
analysis of materiality; it cannot appropriately be used as a substitute for a full
analysis of all relevant considerations.
7-4
The qualitative aspect of materiality recognizes that some items, because of their very nature,
may be quite significant to users – even if the dollar magnitude is less than most quantitative
measures of materiality. As an example, a company may be developing a new line of
business with very high-expected growth. A decline in the rate of growth may be very
significant to the stock market even if the dollar amounts are not material to the overall
financial statements. Auditors understand this concept and need to implement it in the
preparation of financial statement audits. Thus, when planning the audit the auditor’s
materiality assessment has to incorporate qualitative factors that may cause the materiality
amount to be lower than if the auditor based it solely on quantitative factors.
Examples of qualitative factors that may affect the level of materiality:

 Detected misstatements that may threaten the company’s ability to meet or beat
analysts’ forecasts
 First-year engagement
 Management turnover
 High market pressure
 Higher than normal risk of bankruptcy
7-5
a. Using the maximum thresholds for net income, net sales, and total assets yields the
following amounts:
Common
Benchmarks
Maximum Overall
Materiality
% of Net Income 5% = $2,872,800
% of Net Sales 1% = $10,666,910
7-3
% of Total 1% = $6,987,520
Assets
b. 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:
 There have been misstatements in the past in accounts receivable.

 The company is under considerable pressure to make its earnings
forecasts.
 Margins have declined for the company, as has earnings per share. The
company looks worse 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. 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 high potential for misstatement (accounts receivable)
is on the balance sheet. Students may decide to use net income as the benchmark because
of the focus on analyst expectations noted in the problem. Students should note that the
materiality level calculated in part (a) should be decreased due to the many qualitative
factors.
7-6
a. There is an inverse relationship between client riskiness and materiality thresholds. Thus,
a riskier client will require a smaller threshold. In this case, the overall materiality
threshold for Client A should be less than that for Client B.
b. Performance materiality for Client A will be less than performance materiality for Client
B. The auditor will need to collect more audit evidence to obtain the same level of
assurance for Client A as for Client B.
c. Each individual auditor will make different professional judgments compared to other
auditors. Individual characteristics that may affect auditors’ professional judgments
include their level of experience, their training, whether they have encountered a client
that has engaged in fraud, and their professional skepticism, among others.
d. If one auditor were more professionally skeptical than another auditor, that auditor would
likely set the materiality threshold lower than another auditor. Thus, if a less skeptical
auditor set materiality at $4,000, a more skeptical auditor might set it at $3,000, and
would accordingly collect more evidence.
7-4
7-7
a. The FASB defines materiality as the “magnitude of an omission or misstatement of

accounting information that, in light of surrounding circumstances, makes it probable
that the judgment of a reasonable person relying on the information would have been
changed or influenced by the omission or misstatement.” The Supreme Court of the
United States offers a somewhat different definition and states that “a fact is material if
there is a substantial likelihood that the …fact would have been viewed by the reasonable
investor as having significantly altered the 'total mix' of information made available.
Regardless of the definition, materiality includes both the nature of the misstatement, as
well as the dollar amount of misstatement and must be judged in relation to importance
placed on the amount by financial statement users. Thus, auditors need to understand the
users of financial statements and their likely needs and expectations in order to make
appropriate materiality judgments.
b. Examples of items for each dimension might be these:
Dollar Magnitude:
Something that is over 5% of net income or a 5% misstatement of an account balance.
Nature of Item under Consideration:

A misstatement of an account that significantly changes a trend in earnings or reflects on
the integrity of management (such as an intentional misstatement).
Perspective of a Particular User:

Management and board of an outside entity that are considering acquiring the client and
are relying on audited financial statements as an important part of its decision.
c. The auditor's assessment of materiality can, and likely will, change during the course of
the audit. As the auditor acquires additional information about the client and the likely
audited net income, the auditor's assessment of any further undetected misstatement may
change, and the auditor’s assessment of materiality for the client may change as more
qualitative factors are considered.
An auditor's assessment of materiality that changes during the audit to a smaller

materiality amount implies that some of the work performed early in the audit may have
been performed with a larger performance materiality than the auditor now believes
appropriate. Therefore, the auditor should review the previous audit work to determine
whether the amount of work was sufficient to detect a material misstatement as defined
by the revised assessment of materiality. If the auditor believes the work was not
sufficient to detect a material misstatement, the auditor should consider performing
additional audit work in the areas already performed to gather satisfaction that any (now-
defined) material misstatement would be detected.
7-5
7-8
• Client Business Risk—risks affecting the business operations and potential outcomes
of an organization’s activities.
• Inherent Risk—the susceptibility of an assertion about a class of transaction, account
balance, or disclosure to a misstatement that could be material, either individually or
when aggregated with other misstatements, before consideration of any related
controls.
• Control Risk—the risk that a misstatement that could occur in an assertion about a
class of transaction, account balance, or disclosure and that could be material, either
individually or when aggregated with other misstatements, will not be prevented, or
detected and corrected, on a timely basis by the entity’s internal control.
• Audit Risk—the risk that the auditor expresses an inappropriate audit opinion when
the financial statements are materially misstated.
• Detection Risk—the risk that the procedures performed by the auditor to reduce audit
risk to an acceptably low level will not detect a misstatement that exists and that
could be material, either individually or when aggregated with other misstatements.
• Engagement risk (also known as Auditor Business Risk)—this risk is the potential
for loss to the auditor because of being associated with the client. Examples include
the engagement being a publicly traded company, not being a profitable engagement,
damaging the auditor’s reputation, and/or resulting in litigation. Engagement risk is
higher when the client is issuing an initial public stock offering, or is of likely interest
to the PCAOB’s inspection team.
The auditor begins by setting the appropriate level of acceptable audit risk, which the
auditor bases on the audit firm’s potential exposure or risk of being associated with a
client; i.e., engagement risk. For example, consider a public company client in a high-risk
industry that has been the focus of PCAOB inspections. In this case, the auditor would set
audit risk at a low level because of the higher level of potential risk to the audit firm.
Contrast this example with a privately held company where the financial statements will
not be widely distributed. In this case, the auditor sets audit risk at a higher level because
the firm’s potential risk due to association with this client is at a lower level.
Once the auditor sets audit risk, the auditor assess the risk of material misstatement. The
risk of material misstatement includes inherent risk and control risk, which are dependent
upon client business risk. Exhibit 7.2 illustrates that client business risk affects the
inherent and control risks associated with the client. Client business risk is considered as
the risk of material misstatement at the financial statement level, with business risks often
having direct relevant implications for multiple assertions and accounts.
Auditors tend to assess the risk of material misstatement at the assertion level for
significant accounts. That approach provides a basis for planning the audit. Risk of
material misstatement (that is, inherent risk and control risk) originate with the client, are
controllable by the client, and relate to characteristics of the client (e.g., environment,
internal control).
7-6
Having set audit risk and assessed risk of material misstatement, the auditor determines
detection risk. Detection risk is under the control of the auditor, and the audit evidence
that the auditor obtains depends on the level of detection risk. Detection risk relates to the
substantive audit procedures that will achieve the desired overall audit risk. When the risk
of material misstatement is higher, detection risk is lower, in order to reduce audit risk to
an acceptable level. The auditor reduces detection risk through the selection of
substantive audit procedures. As detection risk decreases, evidence obtained by the
auditor through substantive audit procedures should increase. When the risk of material
misstatement is lower, the auditor can accept a higher detection risk and still achieve an
acceptable level of audit risk.
7-9
Controls exist to address the inherent risk of material misstatement. Therefore, it would be
impossible to evaluate the effectiveness of controls without first knowing the risks, or bad
outcomes, that the controls are designed to mitigate.
7-10
The auditor begins by setting the appropriate level of acceptable audit risk, which the auditor
bases on the audit firm’s potential exposure or risk of being associated with a client. For
example, consider a public company client in a high-risk industry that has been the focus of
PCAOB inspections. In this case, the auditor would set audit risk at a low level because of the
higher level of potential risk to the audit firm. Contrast this example with a privately held
company where the financial statements will not be widely distributed. In this case, the auditor
sets audit risk at a higher level because the firm’s potential risk due to association with this client
is at a lower level.
Once the auditor sets audit risk, the auditor will then assess the risk of material misstatement. As
the risk of material misstatement increase, the auditor will decrease detection risk (and thus
gather more evidence). As the risk of material misstatement decreases, the auditor will increase
detection risk (and thus gather less evidence). This response assumes that the auditor does not
decide to change audit. We assume that once the auditor sets audit risk, the auditor does not
change that assessment due to assessments of inherent risk and control risk.
7-11
Audit risk and materiality are intertwined concepts. Audit risk incorporates the idea of
materiality; i.e., it is the likelihood that the auditor issues an audit report indicating that the
financial statements are materially correct when, in fact, the financial statements are materially
misstated. The auditor must design and conduct the audit to gain reasonable assurance that the
audit will detect all material misstatements. AS 1101 notes that audit risk is a function of the risk
of material misstatement and detection risk. The lower the level of materiality, the more audit
work must be done (the lower the detection risk).
7-7
7-12
If engagement risk is higher, the auditor will set audit risk at a low level (e.g., 1%), whereas the
auditor might be willing to set audit risk at a higher level (e.g., 5%) for a client with lower
engagement risk. In addition to influencing audit risk, engagement risk also influences audit
pricing because the audit firm will need to factor in current and potential future engagement
costs in making sure it negotiates considering these costs. However, if engagement risk is too
high, the audit firm may decide to not audit the organization.
7-13
 Management inquiries
 Review of client’s budget
 Tour of client’s plant and operations
 Review relevant government regulations and the client’s legal obligations
 Access the audit firm’s knowledge management systems for relevant information
 Online searches
 Review of SEC filings
 Review of company websites
 Economic statistics, including industry data
 Professional practice bulletins
 Stock analysts’ reports
 Listen to company earnings calls
7-14
a. Management integrity is defined as the general honesty of management and its

motivation for truthfulness (or lack thereof) in financial reporting. Management integrity
reflects the extent to which management shows good business practice and to which the
auditor believes that management's representations are likely to be honest.
If the auditor questions management's integrity, the nature of the audit evidence to be
gathered and the evaluation of that evidence will be affected as follows:
• 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.
7-8
b. 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. This is a difficult judgment call. If management refuses to correct the misstatement, the
stock market reaction might be negative, thereby causing damage to users’ portfolio
values. However, by refusing to correct a misstatement, users do not have access to valid
financial reporting outcomes. This is a classic case of the difficulties of professional
judgment.
d.
i. This is a frequent business practice and is not necessarily considered to reflect

negatively on management's integrity. Many members of management believe that it
is their obligation to minimize their overall tax burden.
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 is
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. 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 personal objectives, no matter how achieved. There have been many
instances of major financial statement fraud by top management who intimidated
lower level managers.
7-9
The auditor must be alert to the potential effect on the overall control environment of
the organization. If employees are punished for not achieving a specific objective or
are highly rewarded for achieving a specific objective, there may be motivation to
accomplish the objective by manipulating the financial reporting process and results.
iii. 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. 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. 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 period without substantial client cooperation. It is
doubtful that such cooperation will be forthcoming.
7-15
7-10
a. Brainstorming usually occurs during the planning/risk assessment phase of the audit, but
on occasion sessions are repeated if actual fraud is detected or at the end of the audit to
ensure that all ideas generated during brainstorming have been addressed during the
conduct of the audit.
b. All members of the engagement team attend the session; the partner or manager typically
leads the session.
c. An additional purpose of a brainstorming session is to transfer knowledge from top-level

auditors to less senior members of the audit team via interactive and constructive group
dialogue and idea exchange.
d. Some guidelines that are helpful to maximizing the effectiveness of a brainstorming

session are:
 Suspension of criticism. Participants are requested to refrain from criticizing or making

value judgments during the session.
 Freedom of expression. Participants are encouraged to try to overcome their inhibitions
about expressing creative ideas, and every idea is noted and accepted as a possibility.
 Quantity of idea generation. Participants are encouraged to provide more ideas rather
than fewer, with the intent to generate a variety of possible risk assessment scenarios that
can then be explored during the conduct of the audit.
 Respectful communication. Participants are encouraged to exchange ideas, further
develop those ideas during the session, and to respect the opinions of others.
e. The steps are:
(1) review prior year client information; (2) consider client information, particularly with
respect to the fraud triangle, i.e., incentive, opportunity, and rationalization; (3) integrate
information from steps 1 and 2 into an assessment of the likelihood of fraud in the
engagement; and (4) identify audit responses to fraud risks.
f. Features of high-quality brainstorming include:

 The audit partner is open to ideas that subordinates express
 The audit partner does not stifle discussion by indicating through tone and/or body
language that s/he is not really interested in the contributions of less-senior members of
the team
 Fraud and information technology specialists contribute to brainstorming
 Auditors conduct brainstorming early in audit planning, not as a ‘check the box’
requirement that is relegated to late in the audit
 Auditors spend a lot of time engaging in meaningful discussions during brainstorming
7-11
 Auditors consciously think about how management might perpetrate fraud
 The extent of time during brainstorming about how the auditors should respond to the
fraud risks that they identify during brainstorming
7-16
a. The following is a list of factors that would lead the auditor to assess control risk at a higher
level:
• poor controls in specific countries or locations
• it is difficult for the auditor to determine or gain access to the organization or individuals
who own and/or control the entity
• little interaction between senior management and operating staff
• weak tone at the top leading to a poor control environment
• inadequate accounting staff, or staff lacking requisite expertise
• inadequate information systems
• growth of the organization exceeds the accounting system infrastructure
• disregard for regulations or controls designed to prevent illegal acts
• no internal audit function, a weak internal audit function, or lack of respect for internal
audit by management
• weak design, implementation, and monitoring of internal controls
• lack of supervision of accounting personnel
b. To have an appropriate level of understanding of the client’s internal controls, the auditor
needs to understand the controls management has designed and implemented to mitigate
identified risks of material misstatement. For entity-wide controls, auditors will typically
review relevant documentation prepared by management and interview appropriate
individuals.
As an example, consider the risk assessment procedures that auditors might perform related
to one component of internal controls—management’s risk assessment. To obtain this
understanding, the auditor typically uses some or all of the following risk assessment
procedures:
 Interview relevant parties to develop an understanding of the processes used by the board
of directors and management to evaluate and manage risks
 Review the risk-based approach used by the internal audit function with the director of
the internal audit function and with the audit committee
 Interview management about its risk approach, risk preferences, risk appetite, and the
relationship of risk analysis to strategic planning
 Review outside regulatory reports, where applicable, that address the company’s policies
and procedures toward risk
 Review company policies and procedures for addressing risk
 Gain a knowledge of company compensation schemes to determine if they are consistent
with the risk policies adopted by the company
 Review prior years’ work to determine if current actions are consistent with risk
approaches discussed with management
7-12
 Review risk management documents
 Determine how management and the board monitor risk, identify changes in risk, and
react to mitigate, manage, or control the risk
Auditors also need to obtain an understanding of the controls designed and implemented at
the process or transaction level. Similar to entity-wide controls, for process or transaction
controls auditors will typically review relevant documentation prepared by management and
interview appropriate individuals with knowledge about these controls. Furthermore, auditors
will perform walkthroughs, following a transaction from origination to when it is reflected in
the financial records to determine if the controls are effectively designed and have been
implemented.
7-17
Ratio and industry trend analysis can be useful in identifying significant trends in the industry or
changes in individual account balances. Ratio analysis can indicate whether the client is lagging
behind the industry in important aspects, such as credit collection or in amounts of inventory
carried. Additionally, this analysis can also help the auditor identify areas where a client seems
to be doing much better than industry, without a valid reason for this difference. This analysis
requires the auditor to first develop expectations about account balances and trends.
Both types of analyses may identify areas where the auditor needs to give special audit attention.
This information then helps the auditor determine the nature, timing, and extent of planned audit
procedures. This analysis forces the auditor to understand the ‘bigger picture’ of the operations
of the client, and helps put into context other audit findings.
7-18
Inventory turnover, number of day’s sales in inventory, and number of day’s sales in receivables
would be very useful in this situation. For formulas, see Exhibit 7.3.
7-19
a.
Potential Risk Indicator Risk Analysis

Inventory increase There is a substantial increase in inventory, both in
dollar terms and as a percentage of sales, which
could indicate potential problems with new
products, with obsolescence, or with
competitiveness with other products. It may indicate
an increase of inventory just before year-end in
anticipation of rise in cost, a strike, or unusually
heavy demand. Inventory may be overstated due to
7-13
misstatements of quantities or prices. This could
also affect the following change.
Cost of goods sold decrease COGS has decreased to 55 percent of sales at the
same time inventory has increased. One explanation
is that COGS has not been booked for some
significant sales. There may also be a change in
product mix. In any event, audit attention should be
directed to these areas.
Accounts payable increase The A/P increase could reflect credit problems or
other financing problems. Such problems could
make it difficult for the company to carry out its on-
going activities. It may simply reflect the purchase
of an unusual amount of inventory just before year-
end.
Inventory turnover Inventory turnover has decreased by 33 percent.

This points to and confirms the problems identified
by the increase in inventory and decrease in cost of
goods sold. There are substantial obsolescence
problems, material items are not correctly recorded,
or the inventory has been increased in anticipation
of some unusual event early next year, such as a
raw material shortage, strike, or unusual demand.
Average number of days

to collect This ratio has increased by 23 percent over the
previous year and is 33 percent above the industry
average. The increase in the ratio could represent a
number of problems:
o Less stringent credit standards.
o Warranty problems (i.e., the customers may

not be paying because of problems with the
products) This would be consistent with the
interpretations associated with inventory
turnover,
o Unrecorded returned items or a significant

lag in issuing credit memos associated with
returned items.
o Potential accounting recording problems.

7-14
Employee turnover This is more difficult to interpret, but there is a 60
percent increase over previous years to a rate that is
double that of the industry. This might indicate
problems with morale, quality control, or other
dissatisfaction with the manner in which the
company is being run.
Return on investments This ratio does not indicate a problem. In fact, the
company exceeds the industry average. An alert
auditor should wonder, however, how the company
is able to maintain a superior return when there are
problems with inventory and receivables.
Debt/Equity ratio This ratio has increased substantially and is double

the industry average. The company has become
highly leveraged. The increased leverage has three
implications the auditor ought to address:
o The existence of new debt covenants that

ought to be addressed as part of the audit.
o A potential problem of remaining a going

concern should there be a downturn in
operations or a significant increase in
interest rates (on how the debt is structured).
o There may be concern with how the debt

proceeds have been utilized by the company.
Does it represent additional capital, or is it
being used for current operating purposes?
The auditor should seek an answer to this
question and consider the implications of the
answer to the audit.
One important use of analytical procedures is to point to potential problem areas that may
affect the audit. The implication is that the auditor should consider specifically how the
identified risk areas might reflect material misstatements in the financial statements. The
risk areas identified above should lead the auditor to plan specific audit tests including,
but not limited to, the following:
 Expanded tests of inventory, pricing, returns, warranties, and the accounting

procedures for recognizing product returns.
7-15
 Expanded tests for potential inventory obsolescence that include a detailed
analysis of industry trends, competitor products, current sales level, and so on.
 An expanded scope of receivables testing to determine the validity and

collectability of receivables that are increasingly older.
 A heightened awareness of any factors that might indicate fraud or material

misrepresentations on the part of management. The inconsistency reflected in
some of the economic data may indicate that management is deliberately
overstating inventory and understating cost of goods sold.
 There should be a specific analysis of going concern issues. The expanded debt,
the employee turnover, and the inventory and receivable problems all point to
significant operating issues.
 In comparison with most standard audits, there should be a greater emphasis on

year-end testing and very little reliance on management representations. The risk
of error should point to a very skeptical audit.
b. One ratio above that might cause the auditor to increase professional skepticism is Return
on Investment. This ratio is better than expected and better than industry. When the
client’s numbers look almost too good to be true, the auditor’s professional skepticism
should be increased. Furthermore, as indicated above, the inconsistency reflected in some
of the economic data may indicate that management is deliberately overstating inventory
and understating cost of goods sold, thereby causing the auditor to have increased
skepticism about these accounts.
7-20
a. Risks include:
 There is a significant trend toward a declining current and quick ratio, which would
indicate liquidity problems for the company, often relating to operating problems.
 Interest coverage has decreased significantly and is substantially below the industry
average, indicating that the company is vulnerable to any downturn in operations or
changes in interest rates. Although it may not immediately signal problems as to
remaining a going concern, it could indicate that such problems could surface in the near
future.
 There is a significant increase in the number of day's sales in receivables, which is one of
the key danger signals for any company of this nature. The increase could reflect
potential problems about product quality, less stringent credit policies, governmental
concerns with the product, fictitious sales, or unrecorded product returns.
 Inventory turnover is steadily decreasing, reflecting a deterioration of the company's
major product and the inability to introduce new products in the market. There may be
net realizable value problems related to inventory, as well as future operating problems.
7-16
 The number of day's sales in inventory has been steadily increasing. This is the same
problem as the decreasing inventory turnover identified above. Some people find that this
ratio better visualizes the problem.
 Indianola has steadily decreased its investment in R&D to a current level that is less than
33 percent of the industry average. This signals potential long-run problems for the
company. Successful research and development is the key to success in the
pharmaceutical industry. Unless the company develops and successfully introduces new
products, it has potential going concern problems.
 Cost of goods sold as a percentage of sales appears to be a positive development. On
further analysis, however, there may be clouds in this silver lining as well: (1) the
primary production of older products rather than the introduction of newer products
and/or (2) accounting errors in recording inventory, sales, or receivables.
 The debt/equity ratio has increased significantly, and there is less interest coverage. In
addition, there may be concerns with debt covenants that may have been violated.
 The significant decrease in earnings per share hampers the company's ability to raise new
capital. Also, the significant decrease that has taken place in the past three years may
cause investors to question current management's ability. Potential suits may be brought
against management if there are signs of mismanagement. The amount and extent of
personal bonuses or potential misuse of corporate funds become important and heighten
the auditor's awareness of potential abuses and lower the qualitative materiality for
investigating corporate expenditures that reimburse or provide benefits to management.
 The sales/tangible asset ratio indicates that the company is not generating an industry
normal volume for assets. This may indicate that there is substantial idle capacity or that
new capacity has not yet gone on line (The inference of new capacity is brought about by
the increase in the debt/equity ratio.). There may be problems with interest capitalization
or write-offs of excess capacity.
 The sales/total assets ratio is well below industry average. But more significant is the fact
that it is markedly lower than the sales/tangible assets average. This would indicate that
the company has substantial capitalized intangible assets. Given the declining
profitability and operations of the company, there may be substantial valuation problems
associated with these intangible assets.
 Sales growth has increased but is less than the industry average. It is also evident that the
increase has come with poorer credit.
The preceding analysis identifies a number of areas on which audit attention ought to be
focused. The company is publicly traded, and SEC reports are required. The dependence
on one major product with a patent about to expire, decreased research and development,
and decreased operating performance all point to potential realization problems. The
audit plan will likely be modified as follows:
 Audit risk will be set at a low level, reflecting the increased risk of being associated with
the client.
 Work on specific audit areas more likely to contain misstatements (e.g., receivables and
inventory) will be expanded.
7-17
 There will be greater effort on net realizable value problems, especially in the area of
intangibles.
b. Other information that you might gather would include:
 Analysis of industry product trends, including the identification of competitor products

and other new product developments (obtained from industry journals).
 The status of client's drugs submitted for approval by the Food and Drug Administration,
as well as the status of competitor products (obtained initially from company but verified
by either reviewing FDA correspondence or confirming status with the FDA).
 Client plans for new products and use of new capacity (management).
 Management's budget, operating plans, and strategy for dealing with current problems
(management)
 Correspondence with financial advisers regarding debt structuring, loan covenants, and so
on (review of company files, confirmation with financial advisers if applicable).
c. Actions that took place in the preceding year would likely have included:
 A major issuance of debt reflected in the debt/equity ratio.

 The acquisition of another company or of other intangible assets reflected in the decrease
in the sales/total assets ratio, which has decreased more than the sales/tangible assets
ratio. This possibility is also suggested by the 15 percent growth in sales over the
previous year, an increase significantly higher than the previous best year growth of 4
percent.
 Major sales problems may exist, with significant increases in number of day's sales in
inventory reflecting some panic thinking on the part of the company.
7-21
a. A number of potential hypotheses may explain the changes in the financial data that has
taken place. The task for the auditor is to determine which of the potential explanations
either (a) best explains all the changes, or (b) best reflects the economic reality of the
situation. The following are possible hypotheses:
 The company is more efficient because of its computerized processing.

 The company has embarked on a program that has led to better customer relations, but it
has come at the cost of deferred receivables.
 The line of credit has led management to put on extra sales efforts during the last quarter
of the year in order to keep from violating the debt covenant.
 The rebilled invoices are either (a) fictitious or (b) were real, but were not accompanied
by the corresponding credit memos going to the same customers.
 The company has more efficient warehousing techniques due to the new computerization.
 A change in customer mix has allowed the company to raise its margins.
7-18
b. The intent of this question is to get the students to exercise professional skepticism in
analyzing the hypotheses without being unduly influenced by management. When the
analysis is performed, the only hypothesis that explains all the ratios is the fourth one (either
fictitious sales or the failure to grant credit to offset the new invoices). The reason this is the
best explanation is that it explains the following changes:
 Increase in November and December billings

 Increase in accounts receivable
 Increase in the gross margin percentage – both for the client and in comparison with
the industry
c. Based on the analysis in part (b), the auditor should concentrate audit effort on the possibility
of either fictitious billings or the failure to issue credit memos. None of the other hypotheses
explain all the changes. Furthermore, it is naïve to think that a competitor could improve the
gross margin significantly higher than the industry in one year when it is selling to major
customers who have considerable pricing power.
The risks relate to fictitious sales or the failure to issue credit memos. Interestingly, the client
had issued the rebilling invoices only on clients that management knew would not return
accounts receivable confirmations. Some of the audit procedures the auditor should consider
include:
• Match the total of credit memos issued to the total of “rebilled invoices” to determine
that the totals are the same.
• Take a sample of credit memos and trace them into the original journal of entry, and
further trace into the general ledger (these two procedures would have detected the
fraud).
• Consider confirming individual “line-items” of accounts receivable with customers
instead of total balance.
• Perform a detailed review of subsequent payments.
• Telephone major customers to determine if they are aware of the “rebilling”
agreements.
• Perform a count of inventory and reconcile with the general ledger. Determine if
some inventory is held on consignment. If it is held on consignment, make
arrangements to observe the inventory. [Note: Given the high risk of fraud associated
with this account, observing the inventory is better than sending out a confirmation to
the warehouse or customer holding the inventory.]
7-22
a. Disagree. Audit risk of zero indicates certainty about the audit opinion—that is, the
auditor would never issue an incorrect audit opinion (indicating that the financial statements
are materially correct when they are not). This approach is not practical.
7-19
b. 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 are recorded at amounts other than expected. If the amounts differ
significantly from expectations, the auditor would need to perform additional direct tests.
Furthermore, for material accounts—such as revenue—some direct testing will always likely
be necessary.
c. Agree. To support a control risk assessment of low or moderate, the auditor must
gather evidence supporting the assertion that the controls are appropriately designed and are
operating as designed.
d. Agree. Detection risk of 50% implies that it is not a strong substantive audit test; such
an approach may be appropriate when inherent and control risk (characteristics of the client)
are low.
e. Disagree. Audit risk is based on the audit firm exposure due to being associated with
the client. The auditor begins by setting the appropriate level of acceptable audit risk, which
the auditor bases on the audit firm’s potential exposure or risk of being associated with a
client. For example, consider a public company client in a high-risk industry that has been
the focus of PCAOB inspections. In this case, the auditor would set audit risk at a low level
because of the higher level of potential risk to the audit firm. Contrast this example with a
privately held company where the financial statements will not be widely distributed. In this
case, the auditor sets audit risk at a higher level because the firm’s potential risk due to
association with this client is at a lower level.
Once the auditor sets audit risk, the auditor will then assess the risk of material misstatement.
As the risk of material misstatement increases, the auditor will decrease detection risk (and
thus gather more evidence). As the risk of material misstatement decreases, the auditor will
increase detection risk (and thus gather less evidence).
f. Agree. Although the audit model appears to be a quantitative approach, it is based on

a significant amount of auditor judgments.
7-23
Case 1 Case 2 Case 3 Case 4 Case 5 Case 6 Case 7 Case 8

IR 30% 40% 50% 50% 70% 80% 90% 100%
CR 50% 100% 60% 100% 70% 70% 80% 100%
AR 5% 5% 5% 5% 1% 1% 1% 1%
DR 33% 12.5% 16.7% 10.0% 2.0% 1.8% 1.4% 1.0%
Generalizations:
7-20
 Holding audit risk and control risk constant, as inherent risk increases, detection risk
decreases. In other words, as inherent risk increases (i.e., it is more likely that a
transaction is recorded in error), the auditor is willing to take less of a chance that audit
procedures will not detect a material misstatement.
 Holding inherent risk and audit risk constant, as control risk increases, detection risk
decreases. In other words, as controls risk increases (i.e., controls become less effective),
the auditor is willing to take less of a chance that audit procedures will not detect a
material misstatement.
 When inherent risk remains the same but control risk increases (case 3 vs. case 4) and
audit risk remains the same, detection risk decreases and audit evidence needs increase.
 When control risk remains the same but inherent risk increases (case 5 vs. case 6) and
audit risk remains the same, detection risk decreases and audit evidence needs increase.
 Holding all other factors constant, when audit risk goes from relatively high (5%) to
relatively low (1%), detection risk declines as well.
 Overall, holding control risk and audit risk constant, inherent risk is negatively associated
with detection risk.
 Overall, holding inherent risk and audit risk constant, control risk is negatively associated
with detection risk.
Based the calculations above, the audit requiring the greatest amount of audit work would be
Case 8, as it has the lowest level of detection risk.
7-24
A controls reliance audit includes both tests of controls and substantive procedures, whereas a
substantive audit relies on substantive procedures and does not include tests of controls. The two
types of audits could be equally effective; it all depends on the nature of assessed risks at a given
client.
7-25
a. Examples of Changing Nature of Risk Response

 Using inspection to test for the existence of inventory, and using a specialist to test the
valuation of inventory
 At a more global engagement level, this could include changing the nature of the
engagement team (e.g., more experienced auditors, auditors with specialized skills, or
hiring outside specialists)
 At a more global engagement level, this could include an increased emphasis on
professional skepticism
b. Examples of Changing Timing of Risk Response

 Conducting procedures at an interim period vs. at year end
 Conducting procedures on an announced schedule vs. an unannounced basis
 Introducing unpredictability in timing (e.g., interim testing vs. year-end testing)
7-21
c. Examples of Changing Extent of Risk Response
 Gathering more evidence through using larger sample sizes
 Observing inventories at more locations / warehouses
7-26
Some ways to introduce unpredictability include:
• Perform some audit procedures on accounts, disclosures, and assertions that would
otherwise not receive scrutiny because they are considered “low risk”
• Change the timing of audit procedures from year to year
• Select items for testing that are outside the normal boundaries for testing; i.e., are
lower than prior-year materiality
• Perform audit procedures on a surprise/unannounced basis
• Vary the location or procedures year to year for multi-location audits
7-27
Procedures that the auditor can only complete at or after period-end include:
• Comparing the financial statements to the accounting records

• Evaluating adjusting journal entries made by management in preparing the financial
statements
• Conducting procedures to respond to risks that management may have engaged in
improper transactions at period-end
Fraud Focus: Contemporary and Historical Cases
7-28
a. There are no ‘right’ answers, but a few potential examples of likely risks:
 Any new company faces risks associated with the startup

 Significant market competition in this service space, from much larger and more
sophisticated providers
 Appropriate revenue recognition may not exist
 Appropriate internal controls may not be in place
 Change is inherently difficult, particularly for a company seeking to begin complying
with the SEC’s reporting rules
 The deferred tax expense relates to items claimed on the financial statements this year,
but not yet recorded on the tax return. It likely relates to revenue because it is possible
that a firm can claim revenue earned on an accrual basis for financial reporting purposes,
but it is not yet taxable income because it is using the cash basis to report taxable income
(i.e., it would not be taxable on the tax return until the cash is collected). For further
explanation of this risk, see Ayers, B. C., J. X. Jiang, and S. K LaPlante. (2009). Taxable
7-22
income as a performance measure: The effects of tax planning and earnings quality.
Contemporary Accounting Research 26(1): 15–54.
b. Potential explanations to cover up the fraud might include:
 Industry norms for profitability are traditionally high; e.g., from Investopedia
(http://www.investopedia.com/ask/answers/060215/what-average-profit-margin-
company-telecommunications-sector.asp):
The average net profit margin for companies in the telecommunications sector, as of
2014, is approximately 11%. Net margins typically average about half of a company's
operating profit margins. Gross profit margins for the sector can run as high as 80 to
90%, but extremely high overhead expenses erode much of that initial profit balance. The
telecommunications equipment area of the sector tends to generate somewhat higher
profit margins than the telecommunications service area, likely due to the fact that the
service part of the industry is such an intensely competitive marketplace.
Read more: What is the average profit margin for a company in the telecommunications
sector? | Investopedia http://www.investopedia.com/ask/answers/060215/what-average-
profit-margin-company-telecommunications-sector.asp#ixzz4lhQK17yS
 Top management expertise

 Streamlined systems to keep overhead costs low
 An IT systems explanation that yields high efficiency
c.
Trend analysis: changes in accounts prior to going public and thereafter to help the auditor
detect patterns and anomalies; depending on the trends, and unexpected changes therein, the
auditor can tailor the audit plan to investigate the validity of the trends.
Industry comparisons: differences from or similarities to other companies in the industry can
yield insights about what the company is doing well, or where it is struggling. For example,
if the company’s overhead costs are lower than the industry, the auditor can work to learn
exactly why this is the case, and how management is achieving such high profitability.
Budget-to-actual comparisons: the auditor can learn how management sets the budget, how it
holds employees accountable for deviations, and whether any budget shortfalls or overages
are occurring, which will then highlight accounts for the auditor to focus on during
substantive testing.
d. ContX would not be subject to SOX 404 internal control reporting because its public float of
stock is less than $75 million.
7-23
e. Clearly, having a Part II of the PCAOB inspection report is not a good signal. As it turns out,
the firm’s quality control weakness that the PCAOB identified were exactly the sort of things
that the auditors got wrong on the ContX audit.
EFP Rotenberg is exactly the kind of audit firm that a fraudster would want to hire.
Fraudsters seek weak oversight, which is exactly what they got with this audit firm. See the
website link below for a discussion of the ‘market for lemons’:
https://en.wikipedia.org/wiki/The_Market_for_Lemons
f. This question is open-ended and encourages classroom dialogue. There is no ‘right answer.’
7-29
a. The inherent risks relate to the ability of the company to be competitive, earn a profit, and
remain a going concern. These risks suggest that the exposure to the audit firm of being
associated with the client are high, and the audit firm might want to use a lower level of audit
risk. The fact that the company’s controls do not comply with SOX requirements indicates
that the company does not have the funds to pay for control improvements, or that
management does not have the desire to make that investment. These risks should be of
concern to a potential auditor because they heighten the risk of material misstatement, which
will result in the auditor determining detection risk to be at a low level and thereby
necessitating greater audit effort than if inherent and control risk were not as high. Of course,
what we learn in the case is that despite these risks BSP did not apply greater audit effort,
which thereby led to the audit performance and quality control deficiencies indicated in the
PCAOB enforcement action.
b.
Ratio Formula 2008 2007
current current assets/current 7,427,061/6244852=1.19 7,295,632/6,570,530=1.11
ratio liabilities
Quick (cash+cash (1,985,818+2,847+2,171,768) (1,238,212+363,562+2,453,868)
ratio equivalents+net /6,244,852=0.67 /6,570,530=0.62
receivables)/current
liabilities
Current Current liabilities/total 6,244,852/11,587,302=0.54 6,570,530/11,161,285=0.59
debt to assets
assets
ratio
AR Credit sales/AR 12,845,111/2,171,768=5.91 11,236,612/2,453,868=4.58
turnover
Days’ 365/AR turnover 365/5.91=61.72 365/4.58=79.71
7-24
sales in
AR
Inventory Cogs/ending inventory 3,357,441/1933153=1.74 3,154,509/2,008,739=1.57
turnover
Days’ 365/inventory turnover 365/1.74=210.25 365/1.57=232.48
sales in
inventory
Net profit NI/net sales 838,969/12,845,111=0.07 1,877,149/11,236,612=0.17
margin
ROE NI/stockholders’ 838,969/1,212,819=0.69 1,877,149/520,002=3.61
equity
Debt to Total 10,157,729/1,212,819=8.38 10,478,940/520,002=20.15
equity liabilities/stockholders’
ratio equity
Liabilities Total liabilities/total 10,157,729/11,587,302=0.88 10,478,940/11,161,285=0.94
to assets assets
Asset Current assets/total 7,427,061/11,587,302=0.64 7,295,632/11,161,285=0.65
liquidity assets
Sales to Net sales/total assets 12,845,111/11,587,302=1.11 11,236,612/11,161,285=1.01
assets
Net worth Stockholders’ 1,212,819/12,845,111=0.09 520,002/11,236,612=0.05
to sales equity/net sales
The following overall trends would cause the auditor to assess heightened risk of material
misstatement:
 Other receivables show a significant increase.
 There was a significant increase in property and equipment.
 There was a significant increase in pledged notes receivable.
 There was a significant decrease in bank borrowings, with a similar size increase in
notes and accounts payable.
 There was a significant increase in accrued expenses.
 The accumulated deficit will be a continuing negative for the near future.
The following trends in the ratios would cause the auditor to assess heightened risk:
 The current and quick ratios are relatively low, indicating a potential weakness in
liquidity.
 Cost of goods sold is increasing significantly, with a corresponding reduction in
profitability.
While the PCAOB release does not suggest that the company’s financial statements were
fraudulent, the trends noted above should have caused the auditor to seriously consider if
fraud might be present at this client. This issue should have been the subject of a robust
brainstorming session.
7-25
c. Assessing the likelihood of going concern will be a priority in the audit. Therefore, the
auditor will focus attention on revenue, profitability, and accounts relating to liquidity and
the ability of the company to pay its considerable debts. So, accounts to focus on would
include:
 Sales
 Cash
 Accounts receivable
 Inventory
 Accounts payable
 Notes payable
d. This case provides an example of an audit firm that did very little work and was simply
engaging in a transaction with Kid Castle designed to provide assurance to U.S. regulators
and investors. The lack of professional skepticism is evident because Waggoner did
essentially no audit work and did not review the local auditors’ workpapers, which were
weak anyway. It is inappropriate for an audit firm to hire away virtually all the audit work to
a foreign audit firm. Of course, there are times when hiring some of the work away is
necessary and appropriate. In this case, BSP did not conduct necessary review or oversight.
e. The steps include the following, with commentary on what went wrong at each step and what
Waggoner should have done differently:
Step 1: Structure the problem. The fundamental problems that Waggoner faced were (a) lack
of familiarity with auditing public companies, or those in a foreign country; (b) lack of
planning and review of audit work done by the foreign auditors.
Step 2: Assess consequences of decision. The consequences are a loss of reputation and loss
of ability to continue to serve these companies.
Step 3: Assess risks and uncertainties of the problem. The risks and uncertainties relate to the
ability to trust in the work of the foreign auditors, particularly with regard to the fact that they
did not respond by improving audit work that was identified as deficient. In addition,
Waggoner took a tremendous risk when he blatantly violated auditing standards by
conducting no work at all on the 2007 audit, when he refused to cooperate with PCAOB
inspectors, and when he destroyed documents. Apparently, the money that he was earning on
these engagements was enticing enough for him to be willing to take these risks.
Step 4: Evaluation information/audit evidence gathering alternatives. Not relevant for this
case.
Step 5: Conduct sensitivity analysis. Not relevant for this case.
Step 6: Gather information/audit evidence. This phase was at the heart of the case. Really,
Waggoner did not gather much, if any, audit evidence. He must have been hoping that the
7-26
companies did not possess a material misstatement in the first place so that his audit opinion
would be correct even if he did not work.
Step 7: Make decision about audit problem. Fundamentally, Waggoner was not capable of
conducting these audits, and he should have not accepted the engagements in the first place.
f. When auditing a company in an international location, the audit firm faces the following
risks:
 Communication difficulties
 Cultural differences
 Logistical difficulties
 Regulatory differences
7-30
a. The risks include:
 A major change in the nature of the operations of the thrift industry opened the
doors to new types of highly risky investments. It also allowed a greater concentration of
investments into high-risk areas, expanded lending authorities beyond traditional
boundaries, and allowed a new type of management to obtain control of many of the
institutions.
 The industry was suffering financial hardships even before the legislation was
enacted. It had a classic financing problem: long-term fixed assets and short-term
variable liabilities. When interest rates soared during the latter part of the 1970s, many of
the S&Ls would have been considered bankrupt had they been forced to value their assets
at current market value, but regulatory accounting procedures tended to hide the problem.
There was a need to go beyond such accounting to understand the economic significance
of the industry's problems.
 Lincoln Federal was purchased by a real estate development entity, was run as a
subsidiary of it, and was used to support the land developments of American Continental
Corporation. It was no longer functioning as a separate, independent entity with the
responsibility to make conservative investments to support family homes.
 Earnings from Lincoln could assist American Continental and its stock price.
 The compensation arrangements for many Keating relatives were clearly
excessive considering (1) Lincoln's size, (2) the nature of its duties, and (3) thrift
institutions of similar size.
 There seemed to be little support, or documentation, for the collateral (and the
value of the collateral) for many of the new investments.
 The company was operating in a section of the country where the myth that "growth was
forever" was perpetuated. This is not a criticism of the Southwest but of the business
mentality that operates on an assumption that above-average growth levels can be
sustained forever.
7-27
 Many of the investments, when subjected to financial analysis, simply did not
hold up. Examples include the Phoenician and other major real estate developments in the
Phoenix area.
 Employees were compensated on a commission basis for selling bonds. This is
unusual practice for an S&L.
b. The use of appraisals as evidence is a difficult audit issue. When assessing the relevance
and reliability of appraisals as audit evidence, the auditor considers:
• The qualifications of the appraiser. For example, if a significant number of appraisals are
from one appraiser, the auditor needs to know whether the appraiser is certified (the
certification process is similar to accounting certification.)
• The recency of the appraisals.
• The relationship of the appraisal firm to the client. Is there a specific relationship, or
might there be a relationship so that the appraisal firm gets the company's business
because the appraisals come out the way management wants them to come out?
• The economic assumptions behind the appraisals. The auditor may want to review these
assumptions to determine (1) their correspondence with economic assumptions that seem
to fit the region, and (2) their sensitivity to the appraised value. For example, if the
appraisal assumes a 10 percent growth rate in population for the next several years, but
the auditor's best estimate is that the growth rate will be 5% at best, the auditor should
perform a sensitivity analysis to determine the impact of such an assumption on the
appraised value.
• The policy of the company in rotating appraisals for significant real estate over time.
Of course, the appraisal is only one aspect of the company's determination of the valuation of
a loan receivable. The appraisal is important in the case of default. The auditor will not be
evaluating every appraisal. However, the auditor will want to: (1) determine the client's
procedures for obtaining independent appraisals before a loan is granted and then grant the
loan if the appraisal indicates substantial collateral for the loan, (2) perform a detailed review
of appraisals on a sample basis for all loans outstanding, and (3) perform a detailed review of
appraisals on a judgment basis for all loans in default or likely to go in default.
The first analysis is the key to company operations; that is, it determines that adequate
collateral is obtained before issuing loans. It may be important, however, to point out to
students that many loan officers in the past have been compensated on the amounts of loans
made, not the quality of the loans. Loan officers were essentially compensated on a
commission basis. It was in the loan officer's best interest to get appraisals that would help a
proposed loan get approval from a loan policy committee.
Application Activities
7-31
7-28
a. The primary risks that the company reveals include the following general categories that
students can find when they download the company’s 10-K from the SEC website.
ITEM 1A. RISK FACTORS

Our business and operations involve numerous risks, some of which are beyond our control which may affect future
results and the future market price of our common shares. In any such case, the market price of our common shares
could decline, and investors may lose all or part of their investment. The following discussion highlights all material
risks known to us.
We have a limited operating history.
Our success depends on our ability to compete effectively in our industry.

Problems in the economy could negatively affect our future operating results.

Rapid technological changes could affect the continued use of our services.

We may not be able to successfully implement our business strategy because we depend upon factors beyond our
control, which could adversely affect our results of operations.

Governmental regulation may negatively affect our operations.

We have incurred secured indebtedness.
We cannot predict our future tax liabilities. If we become subject to increased levels of taxation, our financial
condition and results of operations could be adversely affected.

Competition could substantially impair our business and our operating results.
We depend upon third parties for important parts of our business operations and the failure of those third parties to
provide their products, services and/or technologies could negatively affect our services.

We are dependent upon key personnel.

Our directors and officers will have substantial influence over our operations and control substantially all business
matters.
We will need financing to develop our business and to meet our capital requirements.
We have received substantially all of our revenues from one service provider.

Our primary bank account which receives a substantial portion of our revenues is under the control of another
party.

If we cannot consistently generate positive cash flows or raise sufficient capital then we will not realize our growth
potential and the business could suffer financially.

We have never paid dividends on our Common Stock.
There can be no assurance that our Common Stock will ever be quoted on any market or traded on national
securities exchanges or markets.
7-29
We became a publicly traded company through the acquisition of a public shell company, and we could face
repercussions as a result thereof.

We may be subject to the Securities and Exchange Commission's "penny stock" rules if our Common Stock sells
below $5.00 per share.
Our Director has the right to authorize the issuance of Preferred Stock.
b. A skeptical auditor would check out the locations of these supposed business locations of the
company. The auditor could ask for lease documentation, could try to understand why a
small company operated out of Metamora, Illinois is able to sustain lease payments in high-
end retail locations that these addresses reveal. With respect to the Los Angeles locations, the
skeptical auditor would ask “Why bother with three leased locations that are so incredibly
close to one another? How can that be a good business decision?” Of course, the auditor in
this case was not skeptical, and therefore would not have asked those sorts of questions or
asked for lease documentation, thereby allowing the pervasive fraud to perpetuate.
c. Metamora, Illinois.
https://en.wikipedia.org/wiki/Metamora,_Illinois
Why is the corporate headquarters located in a small town in the middle of nowhere? How is
this advantageous, given the technological nature of the business? How will the company
employ qualified financial individuals in an employment market consisting primarily of
farms? How can a company from a small town operate successfully with far-flung operations
in very large cities all across the US? What is the company’s ‘secret to success’ in such an
economically difficult period of time? Students should recognize that the facts ‘just don’t add
up.’
d. Students can final useful information at

http://www.investopedia.com/ask/answers/060215/what-average-profit-margin-company-
telecommunications-sector.asp. Mean margins are around 11%, but can be as high as 80% if
overhead is maintained a minimum.
e. The SEC’s criticisms of the audit included:
According to AAER 34-78393 (p. 2):
EFP Rotenberg willfullyviolated and Bottini willfully aided and abetted and caused EFP
Rotenberg’s violations of Section 10A(a) of the Exchange Act when it conducted the
ContinuityX Audit without including procedures which were designed to: (1) provide
reasonable assurance of detecting illegal acts; and (2) identify related party transactions.
3. Additionally, EFP Rotenberg and Bottini failed to comply with the standards of the
Public Company Accounting Oversight Board (“PCAOB”).
7-30
EFP Rotenberg and Bottini repeatedly engaged in improper professional conduct that
resulted in violations of professional standards and demonstrated a lack of competence to
practice before the Commission. Specifically, during the ContinuityX Audit, EFP Rotenberg
and Bottini failed to:
(1) appropriately respond to risks of material misstatement;

(2) identify related party transactions;
(3) obtain sufficient audit evidence;
(4) perform procedures to resolve and properly document inconsistencies;
(5) investigate management representations that contradicted other audit evidence; and
(6) exercise due professional care.
Nicholas Bottini, age 54, was the engagement partner on the ContinuityX Audit. Bottini
was a partner in EFP Rotenberg’s public company auditing group, and also served on various
committees within the firm. Bottini was dismissed for cause from EFP Rotenberg on March
5, 2014. On July 1, 2014, Bottini was suspended from appearing or practicing before the
Commission as an accountant with the right to apply for reinstatement after two years and
ordered to pay a $25,000 civil penalty for his actions as part of EFP Rotenberg’s audit of
Universal Travel Group. See Exchange Act Rel. No. 72503 (July 1, 2014).
Ultimately, EFP Rotenberg had to pay a $100,000 fine to the SEC and Bottini had to pay a
$25,000 fine.
f. Clearly, the effect of the failed audit by EFP Rotenberg LLP of the ContX engagement led to
it pulling out of the market for providing audit services to publicly traded companies; the
firm (as of 2017) no longer signs any audit opinions for public companies; the answer is zero.
Students will have differing thoughts about this situation.
7-32
The answers will vary depending on the companies selected.
7-33
AS 2110 discusses the following risk assessment procedures:
 Obtaining an understanding of the company and its environment (paragraphs 7–17);
 Obtaining an understanding of internal control over financial reporting (paragraphs 18–

40);
 Considering information from the client acceptance and retention evaluation, audit
planning activities, past audits, and other engagements performed for the company
(paragraphs 41–45);
 Performing analytical procedures (paragraphs 46–48);

7-31
 Conducting a discussion among engagement team members regarding the risks of
material misstatement (paragraphs 49–53); and
 Inquiring of the audit committee, management, and others within the company about the
risks of material misstatement (paragraphs 54–58).
7-34
AS 2110 provides the following guidance in paragraph 13:
The following matters, if present, are relevant to the necessary understanding of the company's
selection and application of accounting principles, including related disclosures:
 Significant changes in the company's accounting principles, financial reporting

policies, or disclosures and the reasons for such changes;
 The financial reporting competencies of personnel involved in selecting and applying
significant new or complex accounting principles;
 The accounts or disclosures for which judgment is used in the application of
significant accounting principles, especially in determining management's estimates
and assumptions;
 The effect of significant accounting principles in controversial or emerging areas for
which there is a lack of authoritative guidance or consensus;
 The methods the company uses to account for significant transactions that are outside
the normal course of business for the company or that otherwise appear to be unusual
due to their timing, size, or nature ("significant unusual transactions"); and
 Financial reporting standards and laws and regulations that are new to the company,
including when and how the company will adopt such requirements.
7-35
The answers will vary depending on the companies selected.
7-36
a. The answer to this question will depend on the timing of its use, and developments in the
legal cases against Rita Crundwell and the auditors.
b. Numerous parties are at fault in this case, and these parties are listed in order from most at
fault to least at fault.
 Of course, Rita herself is most at fault. It seems inconceivable that someone could have
committed such a large-scale fraud without detection for so long, particularly given how
ostentatious her spending was in relation to her income.
 The City of Dixon, and its leaders, is also at fault because it did not exercise sufficient
oversight or controls over Rita’s activities.
7-32
 The audit firm is somewhat at fault given that it failed to detect the fraud, which is a
known responsibility of auditors. The question that the courts will have to decide is
whether it conducted a GAAS audit, or whether it was negligent.
 Rita’s co-workers or individuals in the community are at some, albeit low, level of fault
because they failed to question her extravagant lifestyle that was so seemingly out of
order in relation to her income.
7-37
An appropriate standard would be AS 2301, “The Auditor's Responses to the Risks of Material
Misstatement.” AS 2301 provides the following relevant guidance in paragraphs 12–15:
12. The audit procedures that are necessary to address the assessed fraud risks depend
upon the types of risks and the relevant assertions that might be affected.
Note: If the auditor identifies deficiencies in controls that are intended to address assessed
fraud risks, the auditor should take into account those deficiencies when designing his or her
response to those fraud risks.
Note: AS 2201 establishes requirements for addressing assessed fraud risks in the audit of
internal control over financial reporting.
13. Addressing Fraud Risks in the Audit of Financial Statements. In the audit of financial
statements, the auditor should perform substantive procedures, including tests of details, that
are specifically responsive to the assessed fraud risks. If the auditor selects certain controls
intended to address the assessed fraud risks for testing in accordance with paragraphs 16–17
of this standard, the auditor should perform tests of those controls.
14. The following are examples of ways in which planned audit procedures may be
modified to address assessed fraud risks:
a. Changing the nature of audit procedures to obtain evidence that is more reliable or to
obtain additional corroborative information;
b. Changing the timing of audit procedures to be closer to the end of the period or to the
points during the period in which fraudulent transactions are more likely to occur; and
c. Changing the extent of the procedures applied to obtain more evidence; e.g., by
increasing sample sizes or applying computer-assisted audit techniques to all of the
items in an account.
Note: AS 2401.54-.67 provide additional examples of responses to assessed fraud risks
relating to fraudulent financial reporting (e.g., revenue recognition, inventory quantities, and
management estimates) and misappropriation of assets in the audit of financial statements.
15. Also, AS 2401 indicates that the auditor should perform audit procedures to
specifically address the risk of management override of controls including:
a. Examining journal entries and other adjustments for evidence of possible material
misstatement due to fraud (AS 2401.58-.62);
b. Reviewing accounting estimates for biases that could result in material misstatement
due to fraud (AS 2401.63-.65); and
7-33
c. Evaluating the business rationale for significant unusual transactions that are outside
the normal course of business for the company or that otherwise appear to be unusual
due to their timing, size, or nature ("significant unusual transactions") indicates that
the transactions may have been entered into to engage in fraudulent financial
reporting or conceal misappropriation of assets (AS 2401.66-.67A).
7-38
Responses will vary depending on the company selected. As an example, risks listed in Pfizer’s
10-K include:
“U.S. and foreign governmental regulations mandating price controls and limitations on
patient access to our products impact our business, and our future results could be adversely
affected by changes in such regulations or policies. In the U.S., many of our
biopharmaceutical products are subject to increasing pricing pressures.”
“Specialty pharmaceuticals are medicines that treat rare or life-threatening conditions that
have smaller patient populations, such as certain types of cancer and multiple sclerosis. The
growing availability and use of innovative specialty pharmaceuticals, combined with their
relative higher cost as compared to other types of pharmaceutical products, is beginning to
generate significant payer interest in developing cost-containment strategies targeted to this
sector. While the impact on us of payers’ efforts to control access to and pricing of specialty
pharmaceuticals has been limited to date, our growing portfolio of specialty products,
combined with the increasing use of health technology assessment in markets around the
world and the deteriorating finances of governments, may lead to a more significant adverse
business impact in the future.”
“Risks and uncertainties apply particularly with respect to product-related, forward-looking

statements. The outcome of the lengthy and complex process of identifying new compounds
and developing new products is inherently uncertain. Drug discovery and development is
time-consuming, expensive and unpredictable. The process from early discovery or design to
development to regulatory approval can take many years. Drug candidates can fail at any
stage of the process. There can be no assurance as to whether or when we will receive
regulatory approval for new products or for new indications or dosage forms for existing
products. Decisions by regulatory authorities regarding labeling, ingredients and other
matters could adversely affect the availability or commercial potential of our products. As
examples, there is no assurance that our late stage pipeline products, such as tofacitinib,
bosutinib and Eliquis (apixaban) for prevention of stroke in patients with atrial fibrillation,
will receive regulatory approval and/or be commercially successful or that recently approved
products, such as Prevnar 13/Prevenar 13 for use in adults 50 years of age and older, Xalkori
(crizotinib) and Inlyta (axitinib) will be approved in other markets and/or be commercially
successful. There is also a risk that we may not adequately address existing regulatory
agency findings concerning the adequacy of our regulatory compliance processes and
systems or implement sustainable processes and procedures to maintain regulatory
compliance and to address future regulatory agency findings, should they occur.”
7-34
Academic Research Cases
7-39
A summary of the study can be accessed at http://commons.aaahq.org/posts/fa0ccd1ebb.
7-40
A summary of the study can be accessed at http://commons.aaahq.org/posts/1c65a3aadc.
7-35

Solutions For Chapter 7: Answers To "Check Your Basic Knowledge" Questions

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Solutions For Chapter 7: Answers To "Check Your Basic Knowledge" Questions

Uploaded by

Copyright:

Available Formats

Financial Statement Auditing: A Risk-Based Approach, 11e

Solutions for Chapter 7

Answers to “Check Your Basic Knowledge” Questions

Review Questions and Short Cases

A misstatement is an error, either intentional or unintentional, that exists in a transaction or

d. Quantitative materiality is based on a specific numeric cutoff; e.g., 5% of net income, or

Examples of qualitative factors that may affect the level of materiality:

 There have been misstatements in the past in accounts receivable.

a. The FASB defines materiality as the “magnitude of an omission or misstatement of

b. Examples of items for each dimension might be these:

Nature of Item under Consideration:

Perspective of a Particular User:

An auditor's assessment of materiality that changes during the audit to a smaller

a. Management integrity is defined as the general honesty of management and its

• The auditor will not be able to rely on management's representations without

• The predecessor auditor, if applicable

i. This is a frequent business practice and is not necessarily considered to reflect

Finally, the mere existence of related parties creates an opportunity to use

c. An additional purpose of a brainstorming session is to transfer knowledge from top-level

d. Some guidelines that are helpful to maximizing the effectiveness of a brainstorming

 Suspension of criticism. Participants are requested to refrain from criticizing or making

e. The steps are:

f. Features of high-quality brainstorming include:

Potential Risk Indicator Risk Analysis

Inventory turnover Inventory turnover has decreased by 33 percent.

Average number of days

o Less stringent credit standards.

o Warranty problems (i.e., the customers may

o Unrecorded returned items or a significant

o Potential accounting recording problems.

Debt/Equity ratio This ratio has increased substantially and is double

o The existence of new debt covenants that

o A potential problem of remaining a going

o There may be concern with how the debt

 Expanded tests of inventory, pricing, returns, warranties, and the accounting

 An expanded scope of receivables testing to determine the validity and

 A heightened awareness of any factors that might indicate fraud or material

 In comparison with most standard audits, there should be a greater emphasis on

b. Other information that you might gather would include:

 Analysis of industry product trends, including the identification of competitor products

 A major issuance of debt reflected in the debt/equity ratio.

 The company is more efficient because of its computerized processing.

 Increase in November and December billings

f. Agree. Although the audit model appears to be a quantitative approach, it is based on

Case 1 Case 2 Case 3 Case 4 Case 5 Case 6 Case 7 Case 8

a. Examples of Changing Nature of Risk Response

b. Examples of Changing Timing of Risk Response

Some ways to introduce unpredictability include:

• Comparing the financial statements to the accounting records

Fraud Focus: Contemporary and Historical Cases

 Any new company faces risks associated with the startup

b. Potential explanations to cover up the fraud might include:

 Top management expertise

Step 5: Conduct sensitivity analysis. Not relevant for this case.

a. The risks include:

ITEM 1A. RISK FACTORS

We have a limited operating history.

Our success depends on our ability to compete effectively in our industry.

d. Students can final useful information at

e. The SEC’s criticisms of the audit included:

According to AAER 34-78393 (p. 2):

(1) appropriately respond to risks of material misstatement;

The answers will vary depending on the companies selected.