1. The Lakeside Company
Case 3: Audit Risk and Analytical
Procedures
Group 3
Carla Duran, Cindy Martinez, Marissa
Mata, Nadejda Nedeva
2. 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.
3. 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.
4. 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.
5. 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.
6. 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.
7. 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.
8. 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.
9. 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.
10. 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
11. 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.
12. 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
13. 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
14. 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
15. 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
24. 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.
26. 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.
27. 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
28. 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
29. 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
30. 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.
31. 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
32. 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
The bases were chosen on the nature of the client’s business. Typical users of the financial statements of a company in consumer electronics industry will likely focus on profits, net sales and total assets. The percentage ranges are typical for the bases. Assets and net sales are typically the largest bases and have smaller percentage ranges than does net income before taxes. At a $50,000 materiality level, then a total impairment of the carrying value of Store 6 ($186,000) would be material, as would an impairment of half the carrying value. The firm should discuss with Rogers the strong possibility of a write down of Store 6, should an impairment test warrant one.
