The Lakeside Company

Case 3: Audit Risk and Analytical Procedures

Group 3

Carla Duran, Cindy Martinez, Marissa Mata, Nadejda Nedeva

Discussion Question 1

The engagement letter a requirement. Responsibilities of the CPA firm

found in the engagement letter:

To perform an audit in order to express an opinion on the client's

financial statements,

To make a search for material misstatements,

To report any internal control weaknesses,

To report any potential fee changes,

To provide the final audit report by February 22, 2013.

Responsibilities of the client:

To pay the audit fee,

To provide a year-end trial balance by January 17, 2013, and an

interim trial balance by October 17, 2012,

To provide audit documents to the CPA firm as specified.

Discussion Question 2 During the analytical procedure, an auditor’s expectations should come from an array of

sources. In the case of Abernethy & Chapman, they should consider the following:

Past figures. Determine the COGS percentage with that of the total sales. Also

examine the relationship and verify that unexpected factors resulted in the change of

percentage. Had Lakeside, for example, switched from cheaper products to more

expensive ones, the relationship between cost of goods sold and sales would possibly be

affected. Or, if Lakeside has dropped the Cypress line in order to sell the products of some

other manufacturer, a similar change might have been anticipated. However, without an

adjustment of this type, cost of goods sold as a percentage of sales would be expected to

remain stable.

Industry averages. This can be determined by studying trade

publications, Abernethy and Chapman can determine an industry average for cost of goods

sold as a percentage of sales. Although Lakeside's results could not be expected to be

exactly the same as this average, the auditors should not anticipate a significant variation

to occur without some adequate explanation.

Competitors. Examination of the financial statements of competing companies can

be used to determine the normal relationship of cost of goods sold to sales. Although no

two companies are ever alike, important comparisons such as this one should be made

between similar companies.

Budgeted figures. Comparison of current year budget to prior years. The numbers

estimated by the company at the beginning of the period can be used by the auditor in

establishing an expected cost of goods sold.

Discussion Question 3

Due to Lakeside inventory of high-technology items: obsolescence of a

portion of this merchandise is an ever-present danger because of new

innovations. The Inventory can be easily damaged.

Lakeside distributes merchandise to retail stores. A generous return

policy is provided; thus, an estimate must be made of the sales returns that

will be received by the company after the audit is concluded.

Lakeside sells on credit throughout two states. Hence, estimating

collections from accounts receivable may be difficult.

Lakeside rents a number of its stores. The auditor must determine

whether capitalization of these leases is required.

Lakeside has a large amount of debt. The auditor has to ensure that

all debt is being properly reported and disclosed. The interest expense

associated with these liabilities must also be correctly calculated and

recognized. In addition, the auditors need to verify that all loan covenants

are being met.

Lakeside is considering going public. A company attempting to raise

significant capital may be tempted to overestimate assets and revenues.

The auditor needs to be particularly careful on accounts that lend

themselves to significant estimate.

Discussion Question 4

An auditor will be content that sufficient as well as

competent evidence has been obtained to stand by an

opinion that fairly represent the financial statements of

the client.

The decision of substantial and sufficient evidence is at

the discretion of each auditor.

Discussion Question 5

The quality of evidence gather for the analytical

procedure is based on the type of testing done.

Analytical procedures performed in the planning stage

are not designed for the purpose of indicating the fair

presentation of financial information. Instead, they are

used in the assessment of risk, to alert the auditor to

potential problem areas that may require additional

substantive testing. In that respect, analytical

procedures serve a vital audit purpose.

Discussion Question 6

The auditor should have sufficient knowledge about the client’s industry

that would allow him or her to:

• evaluate the fair presentation of company's financial statements,

adequacy of disclosures, and management representations;

• understand the management’s philosophy and aspirations for the

business

• identify the areas of high risk where audit efforts should be

concentrated;

• obtain an understanding of how accounting data is produced,

processed, reviewed, and accumulated;

• make judgments about the appropriateness of the client’s

accounting principles, policies and procedures;

• assess the potential for use of analytical procedures, and identify

the information which can be used to make predictions and

comparisons.

Discussion Question 6 Cont.

Sources of information for client’s business and

industry:

the client’s accounting records;

interviews with client’s employees;

other CPA firms working with firms in the same

industry, including client’s previous auditors;

publications regarding the company’s industry and

business;

financial statements from other companies in the

same industry.

Discussion Question 7

Potential problems arising from acquiring clients through price competition:

less time per client to provide quality services;

need to have more clients in order to cover expenses;

not be able to acquire the depth of knowledge;

accept less than sufficient evidence;

fail to identify the areas of high risk;

may impair auditor’s objectivity and independence;

decrease in the overall audit quality.

Discussion Question 8

Planned detection risk (PDR): the risk that substantive audit procedures will fail to detect misstatements in the financial statements.

PDR = AAR/ CR x IR, AAR=.05

There is an inverse relationship between PDR and CR an increase in CR results in a decrease in PDR

a decrease CR results in an increase in PDR

A higher risk of material misstatement will result in a lower detection risk, the auditor will gather more substantive evidence

A higher detection risk means that the auditor will gather less substantive evidence

Discussion Question 9

• Primary responsibility for fraud prevention rests with the company’s management

The auditor is expected to conduct the audit expressing professional skepticism

SAS 99 requires the audit team to discuss the susceptibility of the financial statements to fraud, including: A discussion of management’s involvement in supervising employees

with access to cash or other assets susceptible to misappropriation

A consideration of unusual or unexplained changes in the behavior or

lifestyle of employees that have come to the auditor’s attention

A consideration of the types of circumstances that indicate the possibility

of fraud (Fraud Examiners Manual, Association of Certified Fraud Examiners)

A discussion of how an element of unpredictability can be built into the

nature, timing, and extent of audit procedures

A discussion of any allegations of fraud that have come to the auditor’s

attention

• An increase of the fraud risk signifies an increase in inherent risk

and/or an increase in the control risk.

Discussion Question 10

Abernathy and Chapman may accept Lakeside as client before PCAOB Registration

PCAOB Registration is fairly easy and quick

Applying is online The Board has up to 45 days to take action on

the application

Should consider the changes in the company’s operations due to PCAOB regulations for publicly traded clients

Should inform Lakeside that they are not currently registered but they will pursue registration

Liquidity : The ability to convert an asset to cash

quickly.

Solvency: The ability of a company to meet its long-

term financial obligations

Profitability: The state or condition of yielding

a financial profit or gain.

Exercise 1

Categories of Ratios

Previous Current

Ratio Year Year

2010 2011

Current ratio 1.36 1.36 Average days inventory on hand (93.03) (100.52)Average days to collect receivables 20.63 24.71

Debt-to-total assets 0.74 0.75

Times interest earned 3.57 2.79

Profit margin 0.03 0.02

Return on assets 0.08 0.07

Return on equity 0.33 0.26

Exercise 1-A

Industry Average Ratios

Liquidity : Industry Ave. Lakeside

Current ratio 2.16 to 1 1.36

Average days inventory

on hand 15 24.71

Average days to collect

receivables 69 100.52

Profitability:

Profit margin 4.20% 2.00%

Return on assets 8.10% 7.00%

Return on equity 19.30% 26.00%

Leverage:

Debt-to-total assets 52% 75%

Times interest earned 9.16 2.79

Exercise 1-B

Lakeside Company

Statement of Cash Flows

YE December 31

Exercise 1

Analysis Conclusion

Stable internal liquidity

Good internal profitability

Increased debt

Failure to cover Interest payments with operating income

Stockholder's Investment required

Exercise 3-2

Overall Inherent Risk Level

Exercise 3-2

Overall Inherent Risk Level

Exercise 3-2

Overall Inherent Risk Level

Overall inherent risk for this client should be placed at a high

level. Because the Lakeside Company engagement is a first

year engagement, we will place this overall risk a little higher

than we normally would in order to compensate for any

uncertainties or areas where we may lack knowledge about

the client. Subsequently, a high inherent risk will decrease

the level of planned detection risk and we will have to gather

more evidence for this firm in the first few years of

engagement. After a few years, we will be able to lower this

level of inherent risk, and eventually we will not need to

gather as much evidence as the planned detection risk

increases.

Exercise 3-3 Preliminary Judgment about Materiality

Exercise 3-3 Preliminary Judgment about Materiality

Discuss how you arrived at this dollar amount for the

preliminary judgment about materiality. That is, how did

you combine the qualitative and quantitative

considerations to arrive at this dollar amount?

The preliminary judgment about materiality is set at $50,000.

There are three qualitative considerations that reduce the

level, we chose the lower of the ranges of the quantitative

considerations.

The average of the lower ranges is $52,020 [($12,240 +

$36,280 + $107,540) / 3 = $52,020]. We rounded to a

conservative $50,000.

Apply Your Research 1

Risks in Audit• Audit Risk (AR): the possibility that the auditor will express an inappropriate audit

opinion when the financial statements are materially misstated

should be kept at acceptably low level ( usually 5%)

• Detection risk (DR): the risk that substantive audit procedures will fail to detect

misstatements in the financial statements

(DR =AR/ IR x CR , AR = .05)

• Inherent risk (IR): the susceptibility of management assertions to a material

misstatement assuming no internal control

exist independently of the audit

Control risk (CR): the possibility that the internal controls will fail to prevent or detect

misstatements in the financial statements

the auditor cannot control it

Apply Your Research 1 Cont.

Risks in Audit

The auditor assesses inherent risk and control risk for the

financial statements as a whole and for relevant assertions

for significant accounts

low risk (.30), medium risk (.50), and high risk (.70).

Maximum risk = 1.0

The auditor does not gather evidence to support the inherent risk assessment

The auditor does support his or her assessment of control risk by performing internal control tests.

Detection Risk

The only risk the auditor can control

by increasing or decreasing the amount of substantive testing

Apply Your Research 1 Cont.

Risks in Audit

Audit Risk Model shows the risks’ interrelationship:

Audit Risk = Inherent Risk x Control Risk x

Detection Risk

If inherent and control risks are high, the detection risk is

at a lower level to keep the audit risk at acceptable

more substantive evidence is needed

increasing the sample size for audit testing

If the inherent and control risks are low, detection risk is at

a higher level

less substantive evidence is needed

Apply Your Research 2

Analytical Procedure

Analytical procedures are applied throughout the audit engagement

in audit planning, execution, and review

They are used:

To assist in planning the nature, timing, and extent of other auditing procedures;

As a substantive test to obtain audit evidence about particular assertions related to account balances or classes of transactions;

As an overall review of the financial information in the final review stage of the audit.

Apply Your Research 2 Cont.

Analytical Procedure

Types of analytical procedures:

comparing financial statement numbers for the current year with those of the previous year and calculates the dollar amount and percentage of change

calculating financial ratios for the current financial statements and compares them with ratios for the previous year’s

compare the client’s financial and nonfinancial data with industry data

Effectiveness and efficiency

more effective or efficient than some substantive tests

can help in detecting fraud

less time consuming

Apply Your Research 3

Industry Comparison

Best Buy

Good internal liquidity

Very Good internal

profitability (22.23%)

High Receivable

Turnover (21.1 days)

Assets Financed (72%)

Good Return on Equity,

No Investment from

stockholders required

RadioShack

• Good internal liquidity

• Very Good internal

profitability (34.13%)

• High Receivable

Turnover (81.5 days)

• Assets Financed

(87%)

• Stockholder's

Investment required

THANK YOU!

QUESTIONS?