Chapter 8 :

Chapter 8, Problem 1RQ

There are three major benefits from planning the audit, first it helps the
auditor in obtaining sufficient data and evidence for the situations, secondly
it helps in keeping the audit costs reasonable and lastly it helps in avoiding
misunderstandings with the client.

Chapter 8, Problem 2RQ

The successor (new auditor) is required by AU 315 to communicate
with the predecessor auditor. This allows the successor to get
information about the client so that he or she can evaluate whether
the engagement is to be accepted or not.

Permission has to be obtained from the client before the

communication can be done as the requirement of confidentiality has
to be maintained as per the Code of Professional Conduct. The
predecessor is needed to respond to the request of the successor for
information however, the reply might be limited to state that no
information would be given.

Chapter 8, Problem 3RQ

(0)

The standards of audit require the auditor to document the

understanding of the engagement terms with the client in the letter of
engagement. The letter of engagement should include the objective of
the engagement, the auditor’s responsibilities and the limitations of
the engagement.

An engagement letter is the agreement between the client and CPA

firm which is concerned about the audit conduct and related services.
It should state what all services would be provided, whether any
restrictions would be imposed on the work of the auditor, deadline for
the audit completion. This letter might also include the fee of the
auditor.

Chapter 8, Problem 4RQ

The audit committee is viewed as the client in the audit of public companies,
because the Sarbanes Oxley Act 2002 shifts the responsibility for firing and
hiring of the auditor from the management to the audit committee for public
companies.

Chapter 8, Problem 5RQ

The second standard of the fieldwork needs the auditor to get the
understanding of the company’s or entity’s environment. The auditors
need an understanding of the business of the client and its industry
because of the business nature and the industry affects the business
risk and risk of material mistakes in the financial statements.

The information sources that are commonly used by the auditors are
as follows:

• External and industry environment

• Business processes and operations

• Governance and management

• Objectives and strategies of client

• Performance and measurement

Chapter 8, Problem 6RQ

Customer business risk is the risk that the substance neglects to
accomplish its destinations or execute its techniques. Business risk
can emerge from components, for example, critical changes in
industry conditions or occasions like administrative changes, or from
the setting of unseemly targets or procedures. For instance, the
inspector may distinguish decreases in monetary conditions that
antagonistically influence deals and the collectability of records
receivable.

The risk of material misstatement is the risk that the budget

summaries contain a material misstatement because of
misrepresentation or blunder preceding the review. The risk of
material misstatement is a component of the powerlessness of the
budget summaries (in general or in individual records) to error, and the
viability of the customer's controls in forestalling or recognizing and
remedying the errors. Proceeding with the past model, declining
financial conditions may improve the probability that the organization
may make improper moves to meet deals targets or downplay the
stipend for dicey records, particularly if the customer doesn't have
satisfactory powers over deals and assortment of records receivable.

Evaluating worthy review risk, customer business risk, and risk of

material misstatement is a significant piece of review arranging since
it decides the review methods and measure of proof that should be
gathered, just as the experience level of staff required for the
commitment.

A few elements have expanded the significance of understanding the

customer's business and industry:

¢ Fluctuations in monetary conditions around the globe are probably

going to altogether expand a customer's business chances. Examiners
need to comprehend the idea of the customer's business to
comprehend the effect of major monetary slumps or expansionary
periods on the customer's fiscal summaries and related exposures.

¢ Information innovation associates customer organizations with

significant clients, providers, and outsider specialist co-ops.
Accordingly, reviewers need more prominent information about
significant clients, providers, and outsider sellers and related risks.
That availability likewise opens the customer to potential digital risks
that the evaluator ought to consider.

* Clients have extended tasks internationally, regularly through joint

endeavours or key coalitions.

¢ Information innovation influences inside customer measures,

improving the quality and practicality of bookkeeping data

The expanded significance of human resources and other theoretical

resources has expanded bookkeeping intricacy and the significance of
the board decisions and appraisals.
¢ Many customers may have put resources into complex monetary
instruments, for example, collateralized obligation commitments or
home loan sponsored protections, which may have declined in worth,
may require complex bookkeeping medicines, and frequently include
obscure counterparties who may make surprising monetary risks for
the customer.

Thus, since current economic and other events count for major audit
risks for which auditor would have to check for. Thus, it is very
essential component to be considered while audit planning.

Chapter 8, Problem 7RQ

During the course of the tour of the plant, the CPA would obtain the
perspective of the business of the client, which would contribute to
the understanding of the auditor of the entity’s environment. The
important aspect of the audit would be the effective analysis of the
inventory cost system.

Thus the auditor would observe the company’s nature of products, the
manufacturing processes and facilities and the material flow so that
the information could be obtained and can be related to the cost
system function.

The nature of the company’s manufacturing facilities and products

would reveal the features of the cost system that would need close
audit. The auditor’s observation of the processes would reveal whether
there is idle machinery or plant that might need disclosure in the
financial statements.

While studying the material flow, the auditor would be alert for the
possible problems that might come up in connection with the
observation of the physical inventory. In this aspect the auditor would
notice various storage areas and how the material is stored.

The CPA’s tour of the plant would give him the understanding of the
terminology of the plant which would enable the CPA to communicate
fluently with the personnel.

Chapter 8, Problem 8RQ

A related party as defined in AU 334 is the affiliated company, main
owner of the client entity, or any other party with which the client
deals where any one of the party can affect the management or
policies of the company. Party transactions which are material should
be disclosed in the financial statements by the management.

Thus the auditor should identify all the parties and make an effort for
determining that all party transactions have been revealed in the
financial statements, as the instances of fraud in the financial
reporting often contain the transactions with the related parties.

Chapter 8, Problem 9RQ

The following items in the mortgage would be relevant for the auditor:

• Parties to the agreement

• Amounts mentioned in the agreement

• Effective date of the agreement

• Repayment scheduled needed by the agreement

• Terms and definition of default

• Assets encumbered or pledged by the agreement

• Restrictions of liquidity imposed by the agreement

• Restrictions of purchase imposed by the agreement

• Rate of interest specified in the agreement

• Requirement of audit report or other reports on compliance with

agreement

Chapter 8, Problem 10RQ

The information that would be important in the minutes of the client
for the auditor would include the following:

• Dividend declaration
• Authorized officer’s compensation

• Acceptance of agreements and contracts

• Merger approval

• Long term loan authorization

• Authorization for the individuals to sign the checks

Chapter 8, Problem 11RQ

The three categories of the objectives of client are as follows:

1) Reliability of financial reporting: If the management looks at the

reliability of the financial reporting as the important objective, and if
determination can be done by the auditor the financial reporting
system is accurate, then the auditor can reduce his assessment of
risk. On the contrary if the management has very less regard for the
reliability of the financial reporting of the management, the auditor
would raise the assessment of inherent risk and obtain more evidence
during the audit.

2) Compliance with regulations and laws: It is necessary for the

auditor to understand the regulations and laws that affect the client’s
audit, which includes the contracts signed with the client.

3) Efficiency and effectiveness of operations: This area is of the major

concern to many clients. The auditors need to have knowledge about
the efficiency and effectiveness of the operations of the client to
assess the business risk of the client and the risk inherent in financial
statements.

Chapter 8, Problem 12RQ

Performance measurement system measures business performance. It
further communicates the performance to help management to
manage and improve business performance.

The client’s performance measurement system measures the

performance of the client towards the standard objectives. The system
not only evaluates and analyses the performance but also controls and
communicates the performance and the strategies. The client’s
performance measurement system relies on the Customer
Performance Indicators (CPI) which are as follows:

• Customer value

• Customer satisfaction

• Customer loyalty and retention

• Customer equity

• Customer turnover, margins, and profits.

The client’s performance measurement system is useful to the

auditors since measuring the client’s performance ensures the high
benchmark for the formulation of the audit strategies. It further
ensures the correct execution and reporting by integrating the audit
strategy with the business strategy. The performance measurement
system helps the auditors understand the adverse variance and thus,
help them to address the root causes of such variances.

Give examples of the key performance indicators for the businesses in

the following manner:

(1) A chain of retail clothing stores:

a. Sales and Gross margin by product line

b. Sales return as a percentage of clothing sales

c. Average customer spends

d. Sales turnover by product line

e. Number of customer complaints received

f. Delivery schedule achievement

(2) An internet portal:

a. Number of website hits or bounce rate

b. Speed of search engine and onsite search queries

c. Pages viewed per session

d. Average time on page

e. Top landing pages

f. Top exit pages

(3) A hotel chain:

a. Occupancy percentage of rooms

b. Supply cost per rented room

c. Revenue per available room

d. Average daily rate

Chapter 8, Problem 13RQ

Mr G could improve the quality of the analytical tests by the following
ways:

• Making the internal comparison to the ratios of the previous years or

to the forecast of the budget.

• In the cases where the client has more than one branch in various
industries, then computing the ratios of every branch and then
comparing them to the ratios of the industry.

Chapter 8, Problem 14RQ

The reduction in the current ratio indicates the liquidity problem for
the Company H, as the ratio has dropped to the level near to the
necessities of the bond indenture. Special caution should be applied
by the auditor for determining the ratio of 2.05 which is proper as
management should be driven to hide the lower ratio.
The auditor should increase the procedures for testing all the current
liabilities for cutoff and possible understatement.

Chapter 8, Problem 15RQ

Materiality means the magnitude of the misstatement or omission of
the accounting information which in the light of the surrounding
situations, makes it probable that the judgment of the reasonable
individual relying on the information must have been influenced or
changed by the misstatement or omission.

“Obtain reasonable assurance” which is used in the reports of audit,

means that the auditor doesn’t insure or guarantee the fair
presentation of the financial statements. There is certain risk that the
statements contain some material misstatement.

Chapter 8, Problem 16RQ

Materiality is important as the financial statements are misstated
materially, the decisions of the users might be affected, and thus
cause financial loss to them. It is not possible to apply as there are
many users of the financial statements. The auditor should thus make
the assessment of the users who would use these statements.

Materiality is also difficult for applying as it is a relative concept. The

professional standards of audit offer little guidance regarding the
applicability of materiality. Auditors, thus exercise professional
judgment in the application of materiality.

Chapter 8, Problem 17RQ

As the materiality is relative and not absolute, it is necessary to have
the base for establishing where the misstatements in the financial
statements are material. For instance, in the audit of the
manufacturing company, the auditor uses the bases set such as net
income before taxes, current assets, total assets and working capital.

For the government unit, such as the school, there is no net income
before taxes, and thus that would not be the base available. Instead,
the main base would be the total assets, fund balances and thus total
revenue.

Chapter 8, Problem 18RQ

Auditors must obtain reasonable assurance about whether the
financial statements are whole free from material misstatements.
Auditors when performing the audit and evaluating the effect of
identified misstatements on the audit and incorrect misstatements if
any in the financial statements. In this case Xinran Wang, CPA is using
5 percent of net income before taxes, current assets, or current
liabilities for evaluating materiality.

According to the Xinran Wang, CPA if combined misstatements are not

exceeding 5 percent of net income before taxes, current assets, or
current liabilities that financial statements will be fairly stated. If
exceed the that bench mark set by Xinran Wang in that case that
statements are will not consider fairly stated. If total misstatements
are exceed the 5 percent of net income before taxes, current assets,
or current liabilities than Auditor must give the qualitative factors
effecting financial statements materially. There are some
misstatements which effect financial statements materially-

1. The misstatement which changes the loss into income or income to

lose.

2. Misstatements effecting statutory obligations.

3. Misstatements by fraud even the amount below bench mark set by

Xinran Wang.

4. The potential effect of the misstatements on the company

compliances and regulatory provisions

Hence we conclude that if the combined misstatement exceed the

limit or bench mark set by Xinran Wang than we must consider
qualitative factors which we discussed above.

Chapter 8, Problem 19RQ

If the audit is performed on a medium sized company which is the part
of the conglomerate company, the auditor should make a materiality
judgment on the basis of the conglomerate. Materiality might be larger
for the company which is the part of the conglomerate as even though
the financial statements of the medium sized company might be
misstated, the statements of the large conglomerate might be stated
fairly.

If, however the auditor is giving a separate opinion on the medium-

sized company, the materiality would be lower for the audit of the
conglomerate.

Chapter 8, Problem 20RQ

One of the possible answers for this could be:

Note: Fixed assets and cash are tested for overstatement and long
term loans for understatement as the objective of the auditor in this
case is to test for the overstatement of the equity of the owner.

The least amount of misstatement was allocated to the cash as they

are easier for audit. Majority of the total allocation was to the fixed
assets as there is larger likelihood of the fixed asset misstatement in
the audit.

Chapter 8, Problem 21RQ

The estimate of the total misstatement in the segment is the estimate
of the total misstatement on the basis of the sample results. If only the
sample of population is selected and then audited, the auditor should
then project the total sample misstatements to the population for
estimating the total misstatement. This is done for each of the audit
area.

Misstatement in each of the area of audit should be totaled for making

the estimate of the misstatement in the financial statements. It is
necessary to make these estimates so the auditor could evaluate
whether the financial statements might be materially misstated.

Chapter 8, Problem 22RQ

The auditor should do the analytical procedure again and try to find out the reason for the
overstatement. If it is not found then the comment regarding the overstatement could be made in the
audit report. Chapter 8, Problem 23MCQ

Chapter 8, Problem 23MCQ

Planning an audit comes up with a process like

1. Accept the client and understand the business of the clients entity.

2. Apply analytical procedures and set judgement about the materiality

3. Identify the significant risk due to fraud or error

4. Asses the audit risk that is inherent and control risk and finalize the
audit plan

(A).Analytical procedures are procedures applied before commencing

an audit. These are applied to identify the specific risks that may
cause in the audit where evidence is so much evidently needed

(B).While identifying the material misstatements related party

transactions play a key role

Uncertainity in the transactions must be observed when the trend of

the transaction and the partiality given any to them

(C). Audit engagement letter is a letter given by the auditor to his

clients defining the scope of the audit and audit terms and the
responsibilities of the management

By applying the above concepts the answers to the given question is:

a.) Analytical procedures used in planning an audit should focus on –

areas that may represent specific risks relevant to that audit
b.) The most likely indication of existence of related parties –
borrowing money at a rate significantly below the market rate

c.) As the engagement letter is given to the client before conducting

an audit description of the level of assurance obtained when
conducting the audit will not be included in audit engagement letter

Chapter 8, Problem 24MCQ

Client acceptance

An experienced auditor has to make an important decision of whether

to accept a new client or to continue with the existing client. The
auditor has to take an early decision in this regard to avoid any
irrecoverable related costs.

a.

(1), (2) and (3)

The procedures explained in those options may not assist the

successor with the information by the predecessor. Hence, those
options are not correct answer.

(4)

In accordance with the auditing standards, the successor auditor is

required to communicate with predecessor auditor in evaluating
whether to accept the engagement.

Therefore, the correct answer for this is .

b.

(1), (2) and (3)

The successor may not likely make specific inquiries of the

predecessor auditor regarding the matter as explained in those
options. Hence, those options are not correct answer.

(4)
The communication between the predecessor and successor auditor
informs the successor auditor about the disagreement with
management as to auditing procedures.

Therefore, the correct answer for this is .

c.

(1), (3) and (4)

The circumstances explained in those options may not pose any big
risk in accepting a new audit engagement. Hence, those options are
not correct answer.

(2)

If there is a client-imposed scope limitation for the auditor, it may

most likely pose the greatest risk in accepting a new audit
engagement, because this may work against the audit objective and
the audit may not be complete.

Therefore, the correct answer is .

Chapter 8, Problem 25MCQ

Concept of Materiality

Materiality refers to the magnitude of omission or misstatement as

regards the financial information that could affect the judgement of
the reasonable users of such information.

a.

(1), (2), and (3)

The statements of those options are not true in regards to concept of

materiality. Thus, those options are not correct.

(4)
There is no specific guideline for determining the concept of
materiality. It is only by professional judgement, the materiality is
determined.

Therefore, the correct answer is .

b.

(2), (3), and (4)

The aggregate amounts of misstatement in those options are not

appropriate to design the audit procedures. Thus, those options are
not correct.

(1)

In the present case, the auditor believes that the misstatement

aggregating $10,000 will have a material effect on the income
statement, but that will also affect the balance sheet, even if he/she
believes that misstatements aggregating $20,000 will materially affect
the balance sheet.

Therefore, the correct answer is

c.

(2), (3) and (4)

The statements made in those options are not correct regarding the
financial statement presentation. Thus those options are not correct
answers.

(1)

When the aggregate misstatement in the financial statement is not

material, the financial statement is considered free from material
misstatement and no disclosure is required in the notes to the
financial statement.

Therefore, the correct answer is .

Chapter 8, Problem 26MCQ
Materiality in auditing

The International Auditing and Assurance Standards Board (IAASB) is

an autonomous standard-setting body that serves the public interest
by setting top notch worldwide norms for auditing, confirmation, and
other related standards. The IAASB issues the International Standards
on Auditing, which comprises of a developing number of individual
guidelines.

Regarding ISA 200, the motivation behind a review is to upgrade the

level of certainty of expected clients in the fiscal reports. The
examiner communicates an assessment on whether the fiscal
summaries are readied, on the whole material regards, as per a
pertinent monetary revealing structure, for example, IFRS. ISA 320,
section A3, states that this evaluation of what is material involves
proficient judgment.

The idea of materiality is applied by the inspector both in arranging

and playing out the review, and in assessing the impact of
distinguished misquotes on the review and of uncorrected errors,
assuming any, on the fiscal summaries and in shaping the assessment
in the reviewer's report.

ISA 320, section 10, requires that "arranging materiality" be set

preceding the initiation of itemized testing. ISA 320, passage 12
necessitates that materiality be overhauled as the review advances, if
(and just if) data is uncovered that, whenever known at the beginning
of the review, would have made the reviewer set a lower materiality.
By and by, materiality is re-evaluated in any event once, during the
finish of the review, preceding the giving of the review report. This
materiality is alluded to as "definite materiality".

ISA 320, section 11, requires the evaluator to set "execution

materiality". ISA 320, passage 9, characterizes execution materiality
as a sum or sums that is not exactly the materiality for the fiscal
reports in general ("by and large materiality"). It incorporates
materiality that is applied to specific exchanges, account adjusts or
exposures. Passage 9 likewise expresses that the reason for setting
execution materiality is to decrease the danger that the total absolute
of uncorrected errors could be material to the fiscal reports.

Regarding ISA 320, section A1, a relationship exists between review

danger and materiality. This relationship is opposite. The higher the
review hazard, the lower the materiality will be set. The lower the
review hazard, the higher the materiality will be set.

As far as the Conceptual Framework (see "materiality in bookkeeping"

above), materiality additionally has a subjective angle. This implies
that, regardless of whether an error isn't material in "Dollar" (or other
division) terms, it might in any case be material in view of its
temperament. A model is if a revelation is overlooked from the budget
reports.

a.

Materiality levels would be re-evaluated by an auditor in following

situations:

The auditor will amend materiality for the financial statements overall
(and, if relevant, the materiality level or levels for specific classes of
transaction, account adjusts or revelations) in case of getting mindful
of data during the review that would have made the reviewer have
decided an alternate sum (or sums) at first. Materiality may be
amended because of an adjustment in conditions that happened during
the review (for instance, a choice to discard a significant piece of the
substance's business), new data, or an adjustment in the evaluator's
comprehension of the element and its tasks because of performing
further review systems.

In the given case, auditor would least likely re evaluate materiality

levels when client has a significant contractual arrangement for
drawing attention on particular business aspect which is separately
disclosed in financial statements.

Thus, correct option is d.

b.
Planning is definitely not a discrete period of a review, yet rather a
persistent and iterative interaction that frequently starts not long after
(or regarding) the culmination of the past review and proceeds until
the finishing of the current review commitment. Planning, nonetheless,
incorporates thought of the circumstance of specific exercises and
review systems that should be finished preceding the exhibition of
additional review methodology. For instance, arranging incorporates
the need to consider, preceding the inspector's distinguishing proof
and appraisal of the dangers of material error, such matters as:

• The logical techniques to be applied as risk evaluation systems.

• Obtaining an overall comprehension of the legitimate and

administrative system appropriate to the substance and how the
element is consenting to that structure.

• The assurance of materiality.

• The association of specialists.

• The exhibition of other risk appraisal systems.

In the given case, auditor shall determine timing for tests; he would
also take a tour of client’s facilities and would also determine
Technology effect on audit. He would least likely inquire outside legal
counsel for pending litigation as it is done after planning not during
planning.

Thus, correct option is c.

c.

As a successor auditor can communicate previous auditor for

assessing client’s internal audit function objectivity; his
communication with management and those charged with governance
concerning significant deficiencies in internal controls; and about
accounts receivable’s confirmation response rate.

He would not ask for how many engagement personnel were assigned
by him to the audit as it varies from one audit firm to other on basis of
number of human resource they own.
Thus, correct option is a.

Chapter 8, Problem 27DQP

Audit Planning

An audit plan is a set of guidelines that are to be followed by an audit

firm while an audit process takes place. The process helps the auditor
in gathering information about the client’s circumstances which will
help in planning the process of audit accordingly.

The part of audit planning process undertaken by the auditor in each

case, is discussed below-

1. Client Industry

By reviewing accounting principles that are unique to the client’s

industry shows that the audit firm wants to gather an understanding
of client’s business as well as industry as a whole.

2. Users of Financial Statements

If the audit firm is trying to understand the users of the company’s

financial statements then it shows that the firm has accepted the
client and has initiated the audit planning procedure.

3. Measure of evaluating financial statements

The audit firm is determining the amounts that may be considered to

be material in the eyes of the users of financial statements. This
shows that the firm is making judgments about materiality in terms of
performance of the firm.

4. Specialist

If the audit firm is trying to identify the need of specialists for

engagement with the company then it shows that the firm
has accepted the client and has initiated the audit planning
procedure.

5. Engagement Letter
If the audit firm sends a letter of engagement to the client company
then it shows that the firm has accepted the client and has initiated
the audit planning procedure.

6. Client’s plants and offices

By visiting the client’s plants and offices shows that the audit firm
wants to gather an understanding of client’s business as well as
industry as a whole.

7. Accounts Receivables

The audit firm is determining the amounts of accounts receivables that

may be considered to be material in the eyes of the users of financial
statements. This shows that the firm is making judgments about
materiality in terms of performance of the firm.

8. Key Ratios

The audit firm is comparing the client’s key ratios with those of the
industry as a whole. This shows that the firm is performing
preliminary analytical procedures.

9. Management Risk and Control

By assessing the client’s management risk and controls and internal

processes shows that the audit firm wants to gather an understanding
of client’s business as well as industry as a whole.

10. Potential related parties

By assessing the client’s related parties current as well as potential

which may be needed to be disclosed shows that the audit firm wants
to gather an understanding of client’s business as well as industry as
a whole.

Chapter 8, Problem 28DQP

Related party – A party that is by the same token:

(i) A connected party as characterized in the relevant financial

reporting system; or
(ii) Where the appropriate financial reporting system sets up negligible
or no connected party necessities:

a. An individual or other substance that has control or huge impact,

straightforwardly or by implication through at least one mediators,
over the revealing element;

b. Another element over which the revealing substance has control or

huge impact, straightforwardly or by implication through at least one
middle people; or

c. Another substance that is under normal control with the detailing

element through having:

I. Basic controlling possession;

ii. Proprietors who are close relatives; or

iii. Regular key administration.

Nonetheless, elements that are under regular control by a state (i.e., a

public, territorial or neighbourhood government) are not viewed as
related except if they participate in critical exchanges or offer assets
to a huge degree with each other.

Numerous monetary detailing systems talk about the ideas of control

and critical impact. In spite of the fact that they may examine these
ideas utilizing various terms, they by and large clarify that:

(a) Control is the ability to oversee the monetary and working

approaches of a substance in order to acquire profits by its exercises;
and

(b) Significant impact (which might be acquired by share

proprietorship, rule or arrangement) is the ability to take an interest in
the monetary and working strategy choices of a substance, however
isn't command over those strategies.

The presence of the accompanying connections may show the

presence of control or huge impact:
(a) Direct or circuitous value possessions or other monetary interests
in the substance.

(b) The substance's possessions of immediate or aberrant value or

other monetary interests in different elements.

(c) Being essential for those accused of administration or key

administration (i.e., those individuals from the board who have the
position and duty regarding arranging, coordinating and controlling the
exercises of the element).

(d) Being a nearby relative of any individual alluded to in subparagraph

(c).

(e) Having a critical business relationship with any individual alluded

to in subparagraph (c).

a.

Related party means such company, Client Company’s principal owner,

or any such party of client who deals with client where management or
operating policies are influenced by others management or operating
policies.

b.

In the given case, following transactions would be considered as

related party transactions:

1. M Company would be considered as related party for C Company as

M Company is owned by Mr. A who is member of board of director in C
Company.

2. H Company would be considered as related party for C Company as

it is associated with C Company for a long term of 25 years.

c.

Implication on financial statements of related party transactions

would be that C Company would be required to provide disclosures for
such transactions. These transactions are to be audited in detail by
auditor as there is always a doubt of significant misstatement for such
transactions.

d.

To identify potential related party transactions, auditor can inquire

from management for:

(a) For which are entity’s related parties and is there any changes for
addition or deletion of related parties as compared to last year.

(b) What is the relationships between entity and related parties; and

(c) Whether any transaction is entered by entity related parties during

the period; type and purpose of transactions.

Chapter 8, Problem 29DQP

Planning is definitely not a discrete period of a review, yet rather a
persistent and iterative interaction that frequently starts not long after
(or regarding) the culmination of the past review and proceeds until
the finishing of the current review commitment. Planning, nonetheless,
incorporates thought of the circumstance of specific exercises and
review systems that should be finished preceding the exhibition of
additional review methodology. For instance, arranging incorporates
the need to consider, preceding the inspector's distinguishing proof
and appraisal of the dangers of material error, such matters as:

• The logical techniques to be applied as risk evaluation systems.

• Obtaining an overall comprehension of the legitimate and

administrative system appropriate to the substance and how the
element is consenting to that structure.

• The assurance of materiality.

• The association of specialists.

• The exhibition of other risk appraisal systems.

a.
Three business risks for B Company are as follows:

1. There would be reduction in sales for B Company for demand for

personally owned sedan would reduce in market in coming time.

2. This may also lead to a risk of ongoing going concern assumption.

As reduced sales would lead to lower profits and may be losses also
which may impact going concern considerably.

3. There is also a risk of loss of reputation. As due to accident a

customer has filed a suit against B Company. This would also lead to
loss of market share.

b.

Following would be financial implications of business risks identified

above:

1. Reduction in sales would be reflected in financial statements. It

would lead to lower profitability ratios.

2. Risk of going concern assumption would be reflected in financial

statement with the help of disclosures. Also, all non-current assets
and liabilities would be converted into current assets and liabilities.

3. Amount of claim filed by customer would be disclosed in contingent

liabilities in disclosures.

c.

1. Online protection

It's a danger that self-ruling vehicle organizations can't overlook. All

organizations, of all shapes and sizes, are powerless to breaks and
noxious entertainers. The danger for independent vehicles is gigantic.
An information penetrate could uncover touchy client data,
remembering data for movement designs, and that is only the start.

2. Consumer Trust:

Indeed, even once the innovation is idealized and the guidelines are
resolved, customers should be persuaded that independent vehicles
are protected. Prominent mishaps, including the walker passing
brought about by just as different deadly crashes including Tesla
vehicles in Autopilot mode, have shaken shopper trust.

As indicated by AAA, in 2017, 63% of American drivers reviewed said

they would be too hesitant to even think about riding in a completely
self-driving vehicle. In 2018, that figure expanded to 73%. Then, a
survey from Reuters/Ipsos found that 63% of individuals overviewed
would not compensation extra for self-driving highlights. The market
for self-governing vehicles may demonstrate more modest than
foreseen, at any rate at first. By and by, case could result if investors
feel deceived.

Questions to be asked from CEO:

1. How the company has planned to provide cyber security to clients.

2. How the company has planned to build customer trust after one of
its customer has filed complaint against it.

3. What measures have company taken to ensure that its going

concern assumption would not cease to exist in near future.

4. What steps has company taken to meet sales targets and ensure
that future sales are not going to be reduced.

d.

Additional potential business risks can be identified using company’s

financial information; industry’s average financial information; market
price of company’s share as compared to peer performance; financial
magazines; financial news channels, news papers etc.

d.

Chapter 8, Problem 30DQP

Planning is definitely not a discrete period of a review, yet rather a
persistent and iterative interaction that frequently starts not long after
(or regarding) the culmination of the past review and proceeds until
the finishing of the current review commitment. Planning, nonetheless,
incorporates thought of the circumstance of specific exercises and
review systems that should be finished preceding the exhibition of
additional review methodology. For instance, arranging incorporates
the need to consider, preceding the inspector's distinguishing proof
and appraisal of the dangers of material error, such matters as:

• The logical techniques to be applied as risk evaluation systems.

• Obtaining an overall comprehension of the legitimate and

administrative system appropriate to the substance and how the
element is consenting to that structure.

• The assurance of materiality.

• The association of specialists.

• The exhibition of other risk appraisal systems.

a.

As an auditor we would enquire from management and take written

representation from management that all information and documents
relevant for audit are provided by management. Also, we can check
register of meetings for determining number of meetings held during
year and then it can be verified that all minutes are received by
auditor.

b.

Following is the table required:

c.

Following information pertains to 2018 in minutes of 2019:

1. Approval of bonus to office staff for 2018:

Auditor might have taken written representations from management

for providing for bonus to office staff for 2018.

2. Litigation for EPA

Auditor might have enquired outside legal counsel of company to know

the status of pending litigations against company and then vouch for
the correctness of treatment made in books.

3. Financing from Bank for acquisition of competitor

Auditor can have a discussion with bank which is going to finance the
acquisition to know amount of loan, covenants of loan and
compliances required.

Chapter 8, Problem 31DQP

"Analytical Procedures" signifies assessments of monetary data
through investigation of conceivable connections among both
monetary and non-monetary information. Analytical Procedures
likewise incorporate such examination as is fundamental of
distinguished variances or connections that are conflicting with other
important data or that contrast from anticipated qualities by a huge
sum. The evaluator's selection of methodology, strategies and level of
utilization involves proficient judgment.

Analytical Procedures incorporate the thought of correlations of the

substance's monetary data with, for instance:

• Comparable data for earlier periods.

• Anticipated aftereffects of the substance, like financial plans or

figures, or assumptions for the reviewer, like an assessment of
deterioration.

• Similar industry data, for example, an examination of the substance's

proportion of deals to debt claims with industry midpoints or with
different elements of tantamount size in a similar industry.

a.

Calculation of Gross Profit ratio for drugs and non drugs:

Thus, statement of A is correct as gross profit ratio for industry is
declining continuously for 3 years. May be due to excessive
competition, there is a significant fall as compared to industry in 2019.

b.

Gross profit of company is affected mainly due to sales and cost of

goods sold. Thus, to audit it in detail, detailed investigation would be
required for following aspects of financial statements:

1. Sales

2. Valuation of Opening and Closing Stock

3. Purchases

4. Direct Expenses

Chapter 8, Problem 32DQP

Solution

a.

Each of the changes indicates possible misstatement which is

required to be tested by the auditor. The potential significance of each
of the given item is as follows-

1. This increase indicates possibility of excess commission being paid.

Commission may have been paid on incorrect sales amount or non
commissionable sales.

2. This decrease indicates possibility of inflated inventory which can

be due to incorrect quantity or value.

3. This decrease indicates possibility of inflated inventory which can

be due to incorrect quantity or value.

4. Inflated accounts receivable is possible in this situation. This may

be possible due to old doubtful receivable not written off.
5. Doubtful balances of receivable have not been written off resulting
in decrease in ratio.

6. The depreciation has not been correctly or completely recorded

resulting in lower ratio.

b.

For each of the possible misstatements the following procedures

should be performed to confirm the same –

1. Substantive testing for accuracy of commission paid.

2. Substantive testing for the correct valuation of inventory and

physical verification to identify the correct quantity.

3. Substantive testing for the correct valuation of inventory and

physical verification to identify the correct quantity.

4. Review of AR ageing to identify old receivable and perform balance

confirmation.

5. Review of AR ageing to identify old receivable and perform balance

confirmation.

6. Checking that all depreciable assets have been depreciated at

correct rates.

Chapter 8, Problem 33DQP

"Analytical Procedures" signifies assessments of monetary data
through investigation of conceivable connections among both
monetary and non-monetary information. Analytical Procedures
likewise incorporate such examination as is fundamental of
distinguished variances or connections that are conflicting with other
important data or that contrast from anticipated qualities by a huge
sum. The evaluator's selection of methodology, strategies and level of
utilization involves proficient judgment.

Analytical Procedures incorporate the thought of correlations of the

substance's monetary data with, for instance:
• Comparable data for earlier periods.

• Anticipated aftereffects of the substance, like financial plans or

figures, or assumptions for the reviewer, like an assessment of
deterioration.

• Similar industry data, for example, an examination of the substance's

proportion of deals to debt claims with industry midpoints or with
different elements of tantamount size in a similar industry.

a.

After reading company’s business description as per part I, Item 1 of

Form 10-K it is seen that both companies are similar in a way that they
sell name brand goods to their clients at reasonable costs.

b.

Yes, year ending 31st January makes sense for both companies. This is
because its a peak season for grocery and wholesale retailers in
month of December due to Christmas Vacations. And year end should
be one which has lower benefits.

c.

As per financial statements for year ending 31st January 2018, gross
margin is 26.23% for T Company and 33.84% for K Company. Inventory
turnover for T Company is 1.75 and for K Company is 1.10. Thus, K
Company has highest gross profit ratio and T Company has highest
Inventory turnover.

d.

For K, lower inventory with higher gross margin would not make sense.

Chapter 8, Problem 34DQP

(a.)

The direct projection of the error is calculated as follows:

Thus the direct projection of error is .

(b)

No, the financial statements are not at all acceptable. Including the
error for inventory, the total overstatement errors are $58,000 which
exceeds the materiality of $50,000.

(c)

The auditor should either propose the audit adjustment so that the
unadjusted amount is less than materiality, or perform more testing to
obtain the better estimate of the misstatements.

Chapter 8, Problem 35DQP

Performance Materiality

Performance materiality refers to the amount(s) fixed by the auditor

which is less than the overall materiality set for the financial
statement, with a bid to lessen the probability to a low level of the
aggregate of uncorrected and undetected misstatement become more
than the materiality of the financial statement as a whole.

a.

While setting performance materiality for asset accounts, L must

consider the following factors;

1. L expects that certain assets would have more misstatements than

others.

2. L must consider both overstatements and understatements.

3. L must consider the cost of audit while determining the materiality.

b.

L set lowest amount performance materiality for cash because, cash

can be completely audited at a low cost without any misstatement
expected.

c.

Since for Company M which is in the electronic component industry,

the inventory become obsolete for rapid change in technology, L set
the materiality at lower amount to gather larger audit evidence to
reduce the chance of undetected and uncorrected misstatement. The
performance materiality is set less than the accounts receivable,
PP&E and other assets because, inventory is most important and
sensitive assets and the possibility of any misstatement is more.

d.

Company M has a strong credit policy and most of its customers pay
their full balance on time, hence the possibility of any misstatement is
very less in comparison to other assets. Therefore, L has set the
highest amount as performance materiality for accounts receivable.

e.

The performance materiality and the amount of evidence that an

auditor accumulates are inversely related. Hence, setting materiality
at a lower level result in collecting more audit evidence as compared
to setting materiality at a high level.

Chapter 8, Problem 36DQP

Proficient judgment is to be utilized consistently in setting and
applying materiality rules. As an overall rule, the accompanying
strategies are to be applied:

1. The joined absolute of misquotes in the financial statement

surpassing 6 percent is regularly viewed as material. A consolidated
absolute of less than 3 percent is attempted to be insignificant without
subjective variables. Joined errors between 3 percent and 6 percent
require the best measure of expert judgment to decide their
materiality.

2. The 3 percent to 6 percent should be estimated comparable to the

fitting benchmark. Ordinarily there is more than one benchmark to
which errors ought to be thought about. The accompanying aides are
suggested in choosing the fitting benchmark:

a. Income Statement: Joined errors in the income statement ought to

usually be estimated at 3 percent to 6 percent of working pay before
charges. A rule of 3 percent to 6 percent might be wrong in a year in
which pay is bizarrely huge or little. While working pay in a given year
isn't viewed as agent, it is attractive to substitute as a benchmark a
more delegate pay measure. For instance, normal working pay for a 3-
year time span might be utilized as the benchmark.

b. Balance Sheet: Consolidated misquotes yet to be determined sheet

ought to initially be assessed for current assets, current liabilities, and
complete assets. For current assets and current liabilities, the rules
ought to be between 3 percent and 6 percent, applied similarly
concerning the income statement. For complete assets, the rules
ought to be between 1 percent and 3 percent, applied similarly with
respect to the income statement.

3. Subjective variables ought to be deliberately assessed on all

reviews. In numerous cases, they are a higher priority than the rules
applied to the pay explanation and monetary record. The planned
employments of the budget reports and the idea of the data in the
proclamations, including references, should be deliberately assessed.

a.

Using above illustrative guidelines, following is the preliminary

judgement about materiality (In thousands):
Thus, as per auditor misstatements in operating income is less than
$6,006,000 then it would be said that financial statements are true and
fair. On the other hand if misstatements are more than $12,012,000;
then financial statements would not be showing true and fair view.
And if misstatements are in range of $6,006,000 and $12,012,000; then
auditor would have to consider the situation very carefully.

Thus, as per auditor misstatements in current assets is less than

$67,623,000 then it would be said that financial statements are true
and fair. On the other hand if misstatements are more than
$135,246,000; then financial statements would not be showing true
and fair view. And if misstatements are in range of $67,623,000 and
$135,246,000; then auditor would have to consider the situation very
carefully.

Thus, as per auditor misstatements in total assets is less than

$38,607,000 then it would be said that financial statements are true
and fair. On the other hand if misstatements are more than
$115,821,000; then financial statements would not be showing true
and fair view. And if misstatements are in range of $38,607,000 and
$115,821,000; then auditor would have to consider the situation very
carefully.

Thus, as per auditor misstatements in current liabilities is less than

$36,447,000 then it would be said that financial statements are true
and fair. On the other hand if misstatements are more than
$72,894,000; then financial statements would not be showing true and
fair view. And if misstatements are in range of $36,447,000 and
$72,894,000; then auditor would have to consider the situation very
carefully.

b.

As 5% materiality level is decided for financial statement as a while,

thus, materiality level for items related to income statement would be
$10,010 (i.e. $200,207x5%) and items related to balance sheet would
be $193,037 (i.e. $200,207x5%).

c.

Most examiners like to use before-tax net profit rather than after-tax
net income while computing materiality dependent on income
statement predominantly in light of the fact that it kills the effect of
outer impacts (i.e. Changes in duty laws, changes in the assessment
rates and so forth) that could fundamentally affect an organization's
net profit and accordingly the overall gain materiality base.

d.

When it is decided that 75% of preliminary judgement is allocated to

accounts receivable; inventory and creditors; then evidences for other
accounts would not be collected as they are having lower risk of
material misstatements. Also, more number of evidences would

be required for debtors, stock valuation and creditors as they are

prone to higher risk of material misstatements.

e.

When actual misstatement in earnings are more than that of

materiality level determined in preliminary judgement; then auditor
would carefully vouch for the items of income statement specially the
one in which he has encountered such misstatements. The items in
which material misstatements are found, the auditor would increase
his testing. He may also consider based on the circumstances if it is
required to revise the materiality levels.

Chapter 8, Problem 38C

(a)

AU 161 incorporates the AICPA quality statement governing the audit

practice into GAAS. One of the standards needs that the firm
maintains the acceptance of the client. More to the point, AU 315
makes the importance of effective communication by the auditor with
predecessor abundantly clear.

(b)

In the audit program of the long term contracts, it is necessary to get

assurance that the contract is enforceable so that the money can be
recognized on the completion basis. It is also necessary to keep in
mind the other aspects of the contract which is in relation to various
concepts of accounting.

(c)

GAAS compliance is the matter which is subject to the professional

judgment. One auditor might conclude that GAAS has been violated.