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DISCUSSION QUESTION 1
Even though an engagement letter is not officially required, SAS 8 (AU10) requires that auditors document their understanding of an engagement in the audit files. This documentation should include engagement objectives, responsibilities of both the auditor and management and any engagement limitations.
The engagement letter is important because it provides a clear understanding of the terms of the engagement for both the auditor and the client.
Items that should be included in the letter are
1. Whether the auditor will perform an audit, review or compilation.
. Any other services such as tax returns or management consulting.
. Any restrictions to be imposed on the auditors work.
4. Deadlines for completing the audit.
5. Client’s personnel to be provided to assist the auditor in obtaining records and documents.
6. Schedules to be prepared for the auditor.
7. An agreement on fees.
8. A statement that the auditor cannot guarantee that all acts of fraud will be detected.
CPA Responsibilities
1. Perform an audit of Lakeside’s financial statements.
. Prepare Lakeside’s federal and state income tax returns.
. Complete the audit report by February , 004.
4. To perform the audit in accordance with Generally Accepted Auditing Standards.
Management Responsibilities
1. Establishing and maintaining effective internal controls over the financial statements.
. Identifying and ensuring the company complies with the laws and regulations applicable to its activities.
. Making all financial records and related information available to the auditor.
4. Providing a representation letter that will confirm management’s responsibility for the preparation of the financial statements in conformity with GAAP, the availability of financial records and related data, the completeness and availability of all minutes of the board and committee meetings, and to the best of its knowledge and belief, the absence of fraud involving management or those employees who have a significant role in the entity’s internal control.
DISCUSSION QUESTION
As an auditor on the Lakeside Case there are a few sources that should be looked at when arriving at an expected figure for Cost of Goods Sold. The analytical review should be composed of financial ratios, such as Days to Sell Inventory, and profit margin. After these ratios have been computed they can then be compared to the average of those in their industry. These industry ratios are reported by such companies as Standard and Poor’s. Another analysis would be of prior years. Analyze the income statements (Cost of Goods Sold, Gross Profit) from the prior two years to identify trends.
DISCUSSION QUESTION
Inherent risk would be high for Lakeside’s inventory account and also for their Plant, Property and Equipment. Since the predecessor auditor felt that there was a material misstatement in the valuation of one of Lakeside’s stores, a more vigorous audit should be planned for Plant, Property & Equipment. Retail businesses have a high inherent risk for obsolete inventory. The auditor should examine Lakeside’s internal controls where transactions affecting inventory are concerned. Because Lakeside has several stores, inventory theft and fraud could exist. Again, a more vigorous audit should be performed on inventory.
Abernethy is auditing Lakeside for the first time. Auditors gain more knowledge about a client’s business and their internal controls after auditing a client’s financial statements for several years. There is an inherent risk for first time auditors that material misstatements will not be detected.
DISCUSSION QUESTION 4
According to the textbook, “Essentials of Auditing and Assurance Services”, evidence is “any information used by the auditor to determine whether the information being audited is stated in accordance with the established criteria”. Examples of evidence are oral testimony of the auditee (client), written communication with outsiders, observations by the auditor, and electronic data about transactions. Every auditor is faced with the decision to determine the appropriate types and amounts of evidence to accumulate to be satisfied that the components of the client’s financial statements are fairly stated.
The quantity of evidence obtained determines its sufficiency. The sufficiency of evidence is measured primarily by the sample size the auditor selects. There are several factors that determine the appropriate sample size in audits. However, the two most important ones are the auditor’s expectation of misstatements and the effectiveness of the client’s internal controls. In addition to sample size, the individual items tested affect the sufficiency of evidence. Samples containing population items with large dollar values, items with a high likelihood of misstatement, and items that are representative of the population are usually considered sufficient.
DISCUSSION QUESTION 5
In auditing, there are seven types of evidence. Mitchell is applying one type of evidence, analytical procedures, that use comparisons and relationships to assess whether account balances or other data appear reasonable. Analytical procedures are used extensively in practice and their use has increased with the availability of computers to perform the calculations. The Auditing Standards Board has concluded that analytical procedures are so important that they are required during the planning and completions phases on all audits.
There are many reasons to analytical procedures for Lakeside’s trial balance and other accounting data. First, analytical procedures provide an understanding of the client’s industry and business. By comparing the current year’s unaudited information to the prior year’s audited information, changes are highlighted and can represent important trends or specific events, which influence the planning of the audit. Next, assessing the company’s ability to continue as a going concern is another function of analytical procedures. Certain procedures such as evaluating a higher-than-normal ratio of long-term debt to net worth is combined with a lower-than-average ratio of profits of total assets, a relatively high risk of financial failure maybe revealed. The last and almost certainly the most significant purpose of analytical procedures are indicating the presence of possible misstatements in the financial statements. Significant unexpected differences between the current year’s unaudited financial data and other data used in comparisons are commonly called unusual fluctuations. Unusual fluctuations occur because of an accounting misstatement because significant differences are not expected but do exist or when significant differences are expected but do not exist.
Exercise 1(a)
Ratio 001 00 Significance of Change
Current 1.6 1.6 No fluctuation, indicating a stable liquidity
position (based on this measure of liquidity).
Avg Collection 0.6 4.71 This fluctuation indicates that it is taking longer for
Period (Days) Lakeside to collect customer accounts. Lakeside should
be cautious and not allow the average collection days to
be too high, so that the allowance for doubtful accounts
becomes larger therefore losing profits.
Days to Sell .04 100.5 The increase in days to sell inventory indicates a difficulty
Inventory in selling inventory. Companies seek to sell inventory
quicker in order to create accounts receivables sooner,
thus collecting cash more rapidly.
Net Profit .78 .7 Not a significant fluctuation, however, for a company like
Margin % Lakeside, the goal for a larger the profit for every $1
it generates in revenue should be in order for next year.
Return on 8.47 6.7 This ratio is frequently the main performance indicator of a
Assets company. A decrease in this ratio for Lakeside indicates
that the company is misusing its assets and losing profit.
Return on .17 6.41 Significant decrease indicates less income in 00 for
Equity every $1 invested by common shareholders when
compared to 001. Therefore, the higher this ratio, the
better.
Times Interest .57 .7 Because the ratio lowered from 001 to 00, this
Earned suggests a difficulty in paying interest expense. This may
be due to the decrease in income from operations and the
increase in notes payable-trade throughout the year.
Debt To Total 74.45 74.5 No significant fluctuation. Indicates that Lakeside has
Assets % used debt to finance approximately 75% of its assets &
ownders financed the rest. Creditors view a high debt ratio
with caution.
Exercise 1(b)
Ratio Industry Avg. Lakeside00 Significance of Change
Current 1.7 1.6 Lakesides current ratio stayed the same from 001 to
00. However, it is below the industry average. This
could mean a shortage of working capital required for
competition in the industry.
Avg Collection 11.0 4.71 Lakeside is well above the industry average. This would
Period (Days) mean a larger allowance for bad debt. However,
Lakesides allowance for bad debt went from 6.5% of
Receivables in 001 to only 6.% in 00. This may also
indicate short-term solvency problems.
Days to Sell 65.40 100.5 Lakeside is well above the industry average which means
Inventory their inventory levels are too high. This could create
cash flow problems for Lakeside.
Net Profit . .7 Lakeside is lower than the industry average but not
Margin % significantly.
Return on 6.0 6.7 Their return on assets is higher than the industry average.
Assets This shows Lakesides ability to generate larger profits
for each dollar of assets.
Return on 1.7 6.41 Lakeside is well above the industry average. The EPS
Equity of Lakeside is quite high.
Times Interest .8 .7 Lakeside is well below the industry average. This means
Earned there could be a serious problem concerning their
ability to make interest payments on their loans.
The industry average has increased over the past three
years while Lakesides ratio has decreased.
Debt To Total 1.6 74.5 Lakeside has an extremely high debt to asset ratio.
Assets % There borrowing capacity is severely compromised.
Lakesides profitability ratios seem to meet or exceed industry norms. However, their liquidity and
solvency ratios are not good. Abernethy should pay close attention to their liability accounts and
examine their loan agreements and notes payable.
EXERCISE 1 (C)
Findings Significance
1. Debit in Allowance for Doubtful Accounts Bad Accts may be increasing or debit entry misposted.
. Inventory has increased from 001 to 00. Sales have decreased or inventory needed has been overestimated.
. Accounts Payable have increased. Possibly due to the overestimation of inventory needed, creditor amounts increase.
4. Estimated bonus liability has increased significantly. Employees taking larger
bonuses, possible bonus policy change.
5. Notes Payable have increased. Possibility due to overestimation of inventory.
6. Cost of Goods Sold in Store # have risen. Check into the expenses in store .
7. Repairs & Maintenance have increased. Check possible problems.
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