Auditing
Question 1: Engagement Letter
An engagement letter is one of the documents that an independent auditor can use to document that he/she has indeed established an understanding of the audit engagement with the client. According to ISA 210 (Term of Audit engagements). “It is in the interest of both client and
auditor that the auditor sends an engagement letter, preferably before the commencement of the
engagement, to help in avoiding misunderstandings with respect to the engagement.”
The Letter of Engagement is meant to define the extent of an auditor’s responsibilities, minimize any misunderstanding that may exist between the auditor and client, serve as a written confirmation of the verbal agreements, and inform & educate the client.
Principal contents of an engagement letter
The engagement letter has to address issues pertaining to the planned audit and should include:
Objective of the audit of the client’s financial statements – the engagement letter must outline the statutory duties, the auditor’s statutory and professional responsibilities. As such, this section should include:
a) The responsibilities of the Management or Board relating to proper accounting records as well as financial statements depicting a true and fair look and comply with the Act. In addition, it carries the Management’s responsibility to make avail all the accounting records and other relevant information and minutes of meetings to the auditors.
b) The auditor’s primary responsibility to report accurately on the financial statements and as well as consistency of view on the director’s report.
c) Detailed scope of the auditor’s work i.e. auditing standards, accounting systems review, gathering of audit evidence, tests & reliance on internal controls. This should also be accompanied with reference to applicable legislation.
d) The dispatching of a letter of weakness to the Board.
e) Deadlines for the completion of the audit.
f) Any unique factors such as relations with the internal audit, audit of branches or divisions, any overseas location issues, other auditors (if any), and significance reliance of on management’s supervision in small propriety companies.
g) The necessity of a letter of representation from the Board/Management,
h) Any irregularities and fraud
– The director’s core responsibility
– The auditor’s design of the audit to carry reasonable expectation of unearthing material misstatements in the client’s accounts
– Non-reliance on the auditors to discover frauds and irregularities because on the test nature and inherent limitations of an auditing resulting in unavoidable risk of leaving some material misstatement undiscovered.
i) The Chinese Wall Idea – Where tax or accounting services are conducted the staff may be different the those involved in the audit work, thus the information relayed to accounting or tax staff would not be extended to the audit staff.
j) Auditor’s request to unrestricted access to the client’s documents and records in connection with the audit
k) The fees and the breakdown on how they are charged
Question 2: Cost of Goods Sold
Cost of Goods Sold refers to “the direct costs associated to the production of the goods sold by a company”. It includes the cost of material spent in producing the good together with the direct labor costs that went into creating the good. An auditor for the Lakeside Company has several sources that must be considered in reaching the expected figure for Cost of Goods Sold.
There are several formulas at the disposal of an auditor in calculating the Cost of Goods Sold for a business such as Lakeside Company. However, the most common way would be to start by adding the beginning inventory for the period and the total amount of purchases spent during the period, followed by subtracting the ending inventory for the period. I.e.
Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold
Inventory refers to the goods stocked by a company for sale in the normal course of business. These could include raw materials, work in progress, as well as finished goods. Therefore, inventory cost refers to all costs incurred in purchasing the inventory and preparing them for sale. As such, beginning inventory and purchase figures are add to establish how much of the inventory was at the disposal of the company for sale. How much remained unsold is revealed by an inventory count, and the difference is the cost of goods sold.
Alternatively, an auditor would calculate Lakeside Company’s Cost of Goods Sold would be to use the Average Cost method:
[Beginning Inventory + Purchases (in dollars)] ÷ [Beginning Inventory + Purchases (in units)] = Average Cost per Unit
Average Cost per Unit x Units Sold = Cost of Goods Sold
Cost of Goods Sold is a very significant figure in auditing because it helps determine the gross margin of the company, and if the gross margin incorrect, then the net income (bottom-line profit) would also be incorrect (Tracy & CPA, 2008).
Question 3: high level inherent risks
Inherent risk (IR) refers to “the susceptibility of an assertion to a misstatement, because of error of fraud, that could be material, individually or in combination with other misstatements, before consideration of any related controls,” (Rittenberg et al, 2011). In other words, inherent risk appreciates that the probability of an error to occur is more likely in specific areas compared to others. Thus a high level inherent risk implies that the company is more likely to register misstatements linked with such risks. Areas with high inherent risk in a business like the Lakeside Company would be in the making of deferred income tax forecasts or calculation of foreign currency translation amounts as compared to recording a normal sale.
Other high level inherent risk for Lakeside Company is susceptibility to theft, fraud, and mismanagement such as cash and inventory. This is because the company has many transactions affecting its account translating that “cash” had higher inherent risk compared to that of “prepaid expenses”. The cost of preventative controls for Cash as a high level inherent risk is always warranted and expected by industry regulators (Puncel, 2007). However, a detective control cannot be regarded as the ultimate suitable alternative unless where there is guarantee that it will result in prompt detection of error or fraud together with the certainty for recovery of the erroneous or property under fraud. For instance, safeguarding of clients’ cash calls for implementation of rather highly effective preventive controls. As such, the clients’ cash is safeguarded by keeping it in a trust account and consistently performing relevant monthly reconciliations (Puncel, 2007).
Prepaid expenses refer to current assets that offer economic benefit for not more than a year. The inherent risk linked with prepaid expenses is often considered as low because the accounts they affect (such as prepaid insurance, prepaid rent, prepaid interest) do not involve any contentious or complex accounting issues that are synonymous with cash accounts. In identifying accounts or transactions that are highly susceptible to material misstatement, an auditor needs to adjust the audit plan so as to reflect the particular increased inherent risk (Rittenberg et al, 2011).
Question 4: Sufficient Evidence
Audit evidence refers to all the information and data used by an auditor to form conclusions on which an audit opinion is founded. Sufficiency means the quantity of evidence accumulated. Generally, an audit of financial statements of a firm can be said to be a process of accumulating evidence and evaluation (Delaney & Whittington, 2009). This is because it contains information drawn from the accounting records underlying the financial statements together with other relevant information. It is a process that puts an auditor in a position to come up with an informed opinion relating to whether the financial statements have been fairly presented in line with US generally accepted principles. Collection of sufficient evidence to form an opinion is the second attestation standard and the third audit fieldwork standard, and the evidence may either be written or oral.
Accumulating sufficient appropriate evidence translates that the auditor is in possession of the right quality and quantity of evidence (White & Harding, 2007). A sampling and testing plan is developed during the formulation of an audit to provide guidance to the auditor to assure that sufficient amount of evidence has been accumulated. As such, an auditor can be said to have accumulated sufficient information if the following key conditions have been met:
– An auditor is able to reach conclusions without sampling all records from each operating area of the given facility under auditing. The auditor does not have to examine all the information at his/her disposal owing to the fact that he/she can ordinarily form an opinion by use of sampling together with other means of selecting items for testing (Garczynski, 2008). The data or information should be objective in the sense that another auditor would be able to reach the same conclusion using the same data/information. Furthermore, the data should be persuasive enough to the audit team leader, the entire audit team and facility personnel (CCPS, 2011).
– If the judgmental sampling was employed, which is common practice, a pattern from the sampled records and interviews provided a confident opinion in the auditor as relates to the conclusions drawn.
– The auditor has made reliable observations that offer additional evidence pertaining to how the PSM program was implemented in the firm. Information obtained during a PSM audit must result in a flow of logic from the discoveries of the auditor to the conclusions or opinions formed (CCPS, 2011)..
– If the auditor has gained understanding of the PSM management system is meant to work as well as how that management system itself has been implemented, and has thorough comprehension on the basis of the evidence, if the internal controls used by the management system are functional or not. The feedback obtained when interviewing management on their adherence to specific procedures should be free from bias.
– If the people at the bottom of the pyramid who are responsible for the activities under audit have been reached as well as if these persons have been sufficiently interviewed. The auditor must be in a position to make out any discrepancy of opinion discovered in the course of the interviews and has addressed those differences (CCPS, 2011).
CPA Responsibilities
i) Conduct an audit of Lakeside Company’s financial statements.
ii) Generate state and federal income tax returns for Lakeside Company.
iii) Determination of the deadline for the audit report
iv) To carry out the audit in line with the Generally Accepted Auditing Standards.
Question 7:
Acquiring clients through price competition among CPA firms is increasingly becoming inevitable today and it is bound to increase going forth. However, prevalent cutthroat pricing has long-range adverse implications on the CPA firms. It is a requirement that for a CPA firm to successfully employ a low-price strategy, it must a significant cost of production advantage over its competitors. If the opposite is true, however, the low prices will translate into lower profits or even losses for the CPA firm (Forgang, 2004).
It then translates that the lower earnings of the CPA firm makes it to compromise the quality of service it offers to the public both in the short and long run.
Question 9: Assessing the risk of fraud in CPA firm
CPA firms are always at risk of fraud because of the nature of information provided to theses accounting and auditing companies. Accountants and auditors are offered sensitive information which they utilize to conduct services for their clients. There is danger of this sensitive information ending up in the wrong hands which means that the CPA firms always face the challenge of securing such information. The CPA firms adhere to strict internal control mechanisms in order to avert the risk of fraud. CPA firms gather information from both internal and external sources through brainstorming, analytical procedures, interviews, review of prior fraud, review of auditor’s management letter among others.
The CPA form also assesses where incentives, opportunities and pressures to commit fraud exist based on information gathered. The specific fraud risks in specific areas are then listed, and the likelihood together with significance of each of the potential fraud risk assessed. Thereafter, mechanisms to strengthen the internal controls are curved out which is followed by tracking and monitoring of any significant changes in the internal control systems of the firm.
Exercise 1
Ratio 2007 2008 Significance of change
Current 1.36 1.36 No fluctuation, showing a stable liquidity position
Average Collection 20.63 : 24.71. This fluctuation shows that it is taking longer for Lakeside to collect its customer accounts. Lakeside should be careful and not permit the average collection days to be that high, so that the respective allowances for doubtful accounts becomes larger and make it lose profits.
b)
Ratio Industry average Lakeside 2008 Significance of change
Current 1.73 1.36 No change
Lakeside’s current ratio remained the same but was below the industry average because limited working capital for competition in the market.
Lakeside’s Avg Collection of 11.30:24.71is above the industry average, meaning larger allowance for bad debt. However, bad debt reduced from 6.5% to 6.2% indicating short-term solvency problems.
Lakeside’s Days to Sell ratio of 65.40:100.52 is above industry average meaning its inventory levels are too high and could result in cash flow problems.
Lakeside’s Net Profit ratio of 2.93:2.27 is lower than industry average. Its return on assets is above the industry average, reflecting Lakeside’s capability to register larger profits for each dollar of assets.
Lakeside’s Debt to Total ratio of 13.26:74.53 is extremely high compared to debt to asset ratio. Assets % Lakeside’s borrowing capacity is greatly compromised. Its profitability ratios tend to meet or exceed the industry norms. However, its liquidity & solvency ratios are not impressive. Abernethy ought to focus on Lakeside’s liability accounts and assess its loan agreements & notes payable.
c)
Procedure Findings Significance
Scan the trial balances. A debit balance appears in the
″Allowance for Doubtful accounts″ account. Bad accounts may be rising or a debit entry was misposted.
Significance of findings
1. Debit in Allowance for Doubtful Accounts & Bad Accts may be on the rise or the debit entry was posted incorrectly.
2. Inventory has increased while sales have decreased, or inventory required was overestimated.
3. Accounts Payable increased possibly because of overestimation of inventory required, & creditor amounts increased.
4. Estimated bonus liability increased significantly. Employees took higher bonuses probably because of bonus policy change.
5. Notes Payable increased as a result of overestimation of inventory.
6. Cost of Goods Sold in Store # 3 rose because of increase in expenses in store 3.
7. Repairs & Maintenance increased indicating problems.
References:
CCPS. (2011). Guidelines for Auditing Process Safety Management Systems. New York: John Wiley & Sons.
Dauber, A. N. (1998). How to Prepare for the CPA Certified Public Accountant Examination. Barron’s Educational Series. Australia: CCH.
Delaney, R. P. & Whittington, R. O. (2009). Wiley CPA Exam Review 2010, Auditing and Attestation. New York: John Wiley & Sons.
Garczynski. F. M. (2008). Knowledge-Based Audits of Health Care Entities.
Puncel, L. (2007). Audit Procedures 2008. Australia: CCH.
Rittenberg, E. L. (2011). Auditing: A Business Risk Approach. Connecticut: Cengage Learning.
