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###################CHAPTER 10UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT AND
ASSESSING THE RISKS OF MATERIAL MISSTATEMENTI. Review Questions1.
A
business risk is a treat to achieving management�s objectives. There are many
examples of business risks that may result in a risk of material misstatement of
the financial statements. Two are shown below:
Business Risk#Risk of
Material Misstatement#####Rapidly changing technology in the client�s industry
may threaten to cause the client�s products to become obsolete.#Inventory may be
overvalued because it is not valued at net realizable value.#####Economic
conditions in the industry may result in significant uncollectible accounts
receivable.#Accounts receivable may be overvalued because the allowance for
uncollectible accounts is not adequate.##2.
An audit plan provides essential
background information for an audit assignment, and outlines the objectives,
timing, staffing, special risks and considerations, and other requirements of
the engagement. An audit program is a detailed outline of the auditing work to
be performed, specifying the procedures to be followed in verification of each
item in the financial statements. Although both the audit plan and the audit

program are technically plans, the audit plan serves more as a broad overview of
the engagement, while the audit program is more specific and limited in scope.3.
The purpose of the team meeting on fraud risk is designed to allow the
more experienced team members to share insights and exchange ideas about how and
where the entity�s financial statements might be susceptible to material
misstatement due to fraud, to discuss how to design appropriate tests to detect
the misstatements, and to emphasize the importance of maintaining the proper
degree of professional skepticism regarding the possibility of fraud.4.
During the planning process, the auditors make preliminary estimates of
both risk and materiality for the engagement. The auditors must plan their
engagements to reduce the audit risk of issuing an unqualified opinion on
materially misstated financial statements to a relatively low level. At the
account balance level, audit risk actually has three components: (1) inherent
risk, (2) control risk, and (3) detection risk. On audits where the risk of
misstatement is relatively high, the auditors must compensate by increasing the
effectiveness of their audit procedures. They may design more effective
procedures, increase the number of items selected for testing, or perform more
procedures at the balance sheet date rather than at an interim date. They may
also add an element of unpredictability to the procedures.The auditors'
preliminary estimates of levels of materiality also affect the nature, timing,
and extent of their planned procedures. Materiality levels determine which
accounts are significant enough to require audit, affect the size of the test
samples, and determine the dollar amount of individual items that warrant
examination.5.
(a)
Auditors must obtain an understanding of the client and
its environment in order to determine whether the client should be accepted and
to plan the audit. This understanding encompasses the following:The nature of
the client, including the client�s application of accounting policies�The
auditors� understanding of this area will include the client�s competitive

position, organizational structure, accounting policies and procedures,
ownership, capital structure, and product lines. The understanding will also
encompass an understanding of the client�s business model and its major business
processes.The industry, regulatory, and other external factors�The factors
included here are industry conditions, such as the competitive environment,
supplier and customer relationships, and technological developments. They also
include the regulatory, legal, and political environment, and general economic
conditions. Objectives and strategies and related business risks�The auditors
obtain an understanding of the operating and financing strategies of management.
They also obtain an understanding of management�s risk assessment process. This
assists the auditors in identifying significant business risks that may create
risks of material misstatement of the financial statements.Methods of measuring
and reviewing performance�The auditors obtain an understanding of the methods


management uses to measure and review performance at various levels within the
organization. These methods are important to determining incentives of
management and other employees. The measures may also be used in designing
effective analytical procedures.Internal control�The auditors� understanding of
internal control assists them in planning the audit and assessing control risk.
(b)
Sources of information on prospective clients include trade publications,
and governmental agency publications. Previous audit reports, annual reports to
stockholders, SEC filings, and prior years' tax returns are excellent sources of
financial background information. Informal discussions between the auditors and
key officers can provide information about the history, size, operations,
accounting records, and controls of the enterprise. Inquiries of others within
the organization can provide information that confirms inquiries of management,
and provides more detailed information about risks and business processes.
Inspection of internal documents and records can provide information about the

nature of the client�s operations and internal control. The predecessor auditor
may also provide information.(c)
Knowledge of the client and its environment
helps the auditors in:(1)
Identifying areas that may need special
consideration.(2) Identifying significant business risks that may result in
risks of material misstatement of the financial statements. (3) Assessing
inherent risk and making preliminary assessments of control risk.(4)
Making
judgments about the appropriateness of accounting principles in use and the
adequacy of disclosures.(5)
Evaluating the reasonableness of estimates, such
as depreciation lives and the allowance for doubtful accounts.(6)
Evaluating the reasonableness of management representations.(7)
Developing an efficient audit strategy.(8)
Determining the staffing
requirements of the engagement.
6.
During the tour of the client's
plant facilities, Sison inspects all inventory areas and makes note of the
location, types, security, "housekeeping," and general condition of the
inventories. He also visits the receiving and shipping departments and reviews
the types of documents maintained. His observations in these areas enable him
to form a preliminary impression of the adequacy of internal controls for
inventories, and possible problems with respect to obsolete or slow-moving
inventories. He also can begin formulating plans for staffing and carrying out
the physical inventory observation.Sison�s observation of the productive
processes will acquaint him with the client's physical plant facilities and
layout, the nature of the products and computer applications employed in the
production process. He may also obtain information on the client's

documentation such as for production orders, raw materials requisitioned to
production, direct and indirect labor, and inspection and testing of finished
products. He meets the supervisory personnel, engineers, and other key
personnel responsible for production, and through inquiries and conversations
learns of any unique production problems, including excessive spoilage and
scrap. As a result, he will be in a position to evaluate the client's cost
accounting system during the course of the audit. He will also inquire about
the details of the client�s business processes.Throughout the tour, Sison will
add to his impression of the client's business processes, control procedures and
accounting records. He will notice, for example, what personnel have access to
computer terminals and accounting records, whether plant assets have
identification tags, and whether documents such as production orders and
receiving reports are serially numbered or controlled by the computer.7.
(a)
Misstatements due to fraudulent financial reporting are intentional
misstatements or omissions of amounts or disclosures in the financial statements
to deceive financial statement users. Misstatements arising from
misappropriation of assets (sometimes referred to as defalcation) involve the
theft of an entity�s assets where the effect of the theft causes the financial
statement not to be presented in conformity with generally accepted accounting
principles. (b)
The three conditions necessary for the commission of fraud
include: (1) some type of incentive or pressure, (2) an opportunity to commit
the fraud, and (3) an attitude that allows the individual to rationalize the
act. In a case of fraudulent financial reporting, members of top management may
have an incentive to commit the act relating to maintaining the value of their
stock options. They may have an opportunity based on weaknesses in the
corporate governance of the organization. Finally, they may be able to
rationalize the act by assuming that the company will make enough income next

period to allow them to correct the misstatement.
(c)
The
auditors may respond to fraud risks by (1) a modification in the approach
having an overall effect on how the audit is conducted, (2) an alteration in the
nature, timing, and extent of the procedures performed, and (3) performance of
procedures to further address the risk of management override of internal
control.8. (a)
Shin may respond to fraud risks in the following three ways:
(1) A modification in the overall approach to the audit which might involve:(a)
Applying increased professional skepticism and designing procedures that
provide more reliable evidence.(b)
Assigning additional staff with
specialized skill and knowledge or by assigning more experienced staff to the
engagement. Also the extent of the supervision of the staff should be adjusted
to reflect the fraud risks. (c)
Giving further consideration to the
appropriateness of the accounting principles used by the client. (d)
Incorporating an added element of unpredictability in the selection of
auditing procedures.
(2)
An alteration in the nature, timing and extent of
the procedures performed. For example, Shin might apply procedures that provide
more reliable evidence, shift more audit tests to year-end, or increase sample
sizes for certain substantive tests. (3) Perform procedures to further address
the possibility of management override of internal control, including (1)
examining journal entries and other adjustments for evidence of fraud, (2)
reviewing accounting estimates for biases, and (3) evaluating the business
rationale for significant unusual transactions.

(b) Whenever the auditors
believe that there is evidence that fraud may exist, the matter should be
brought to the attention of an appropriate level of management. Fraud involving
senior management and fraud that causes a material misstatement of the financial
statements should be reported directly to the audit committee. In very serious
situations the auditors should consider resigning the engagement.II.
Multiple
Choice Questions1.
d#6. d#####2.
a#7. d#####3.
d#8. d#####4.
d#9. d#####5.
d#10. d#####III. Comprehensive CasesCase 1.
(1)
(a)
There is an increased risk of fraudulent financial reporting by subsidiary
management. More specifically, subsidiary management would likely attempt to
increase revenue or decrease expenses.
(b)
The auditors would probably
respond by performing more procedures at the subsidiary location. Additional
tests of revenue would be performed and the auditors would likely decide to
observe inventory at year-end. In addition, some of the procedures may be
performed on an unannounced basis. (2)
(a)
There is an increased risk of
fraudulent financial reporting by management related to revenue.
(b)
The
auditors would likely respond by utilizing more experienced audit team members.

Specifically, audit staff that had experience with complex revenue contracts in
the telecommunications industry. They would also likely increase the extent of
the substantive tests of revenue. (3)
(a)
There is an increased risk that
the futures traders will fraudulent overstate the value of the contracts to
increase their compensation.
(b)
The auditors would likely respond to
this situation by bringing in a specialist to assist in valuing the contracts.
In addition, they would do extensive testing of the valuation of the contracts.
(4)
(a)
There is an increased risk that management may be fraudulently
overstating
income at one or more of the stores.
(b)
The auditors
would likely respond by doing increased testing of revenue and inventory at the
stores. The auditors could use the results of the analytical procedures to
identify stores that are more likely to have fraudulent reported results (e.g.,
those with unusually high profit margins). The auditors also may not disclose
the locations that they intend to visit for inventory observation.


Case 2.
Mr. Gian LeePresidentPalace CorporationDear Mr. Lee:Our recent tour
of Palace's plant was a most pleasant and interesting experience. The
information obtained on this tour and during the discussion of your financial
statements and accounting records has enabled us to plan the scope of an audit

especially suited to your needs.Our fees are based on the time spent on the
engagement by various members of our audit staff, and will be billed at our
established rates. The total time required for an initial engagement is usually
somewhat greater than in repeat examinations, since the latter do not require
analysis of past years' transactions. Considerable savings in the cost of the
audit may be made by utilizing the services of your accounting staff to help us
in certain phases of the work. We can arrange for your employees to prepare for
us a number of working papers. If you approve, we shall indicate to your chief
accountant the exact nature of the working papers to be prepared.Our audit will
be performed in accordance with generally accepted auditing standards and will
include all procedures which we consider necessary to provide a basis for
expression of our opinion on the fairness of the financial statements. The
audit will include:(1) A consideration of the internal control.(2)
Tests of
the financial statement accounts and balances to the extent we consider
necessary, based on our consideration of risks and internal control.(3)
Preparation of the federal and state income tax returns.(4)Issuance of our
auditor's report upon your financial statements.If our investigation indicates
the desirability of any changes in internal control procedures, we shall prepare
a report on this subject for your consideration. However, an audit cannot be
relied upon to identify all weaknesses in internal control. The purpose of our
audit is to enable us to express an opinion on the fairness of the financial
statements; the audit is designed to provide reasonable, but not absolute,
assurance of detecting material fraud and defalcations, and we will notify you
if our audit does bring them to light.Although it is not possible to determine
in advance the exact number of days required for the engagement, our estimates
indicate that the total fee will be between ___________ and _________. The
audit will be completed and our report submitted by March 1, 2009.We would like
an opportunity during the next few days to discuss with you and your chief
accountant the nature of the preliminary work to be done by your staff. We

shall also be pleased to answer any further questions which you may have
concerning the determination of audit fees.
Very truly yours, Chariya, Modena
and Company, CPAs####10-# PAGE #4#
Solutions Manual - Assurance Principles,
Professional Ethics�Understanding the Entity and Its Environment�
10-# PAGE
#5#
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