Assignment 4: Inherent Risk, Tests of Controls, and Substantive Procedures In this assignment, you will prepare a two to three (2-3) page professional document that addresses the requirements specifie
Cloud 9 - Continuing Case This text is designed to provide you with the opportunity to learn about auditing by using a practical, problem-based approach. Each chapter begins with some information about an example audit client—Cloud 9 Inc. (Cloud 9). The chapter then provides the underlying concepts and background information needed to deal with this client's situation and the problems facing its auditor. As you work through the chapters, you will gradually build your knowledge of auditing by studying how the contents of each chapter are applied to Cloud 9. The end-of-chapter exercises and problems also provide you with the opportunity to study other aspects of Cloud 9's audit, in addition to applying the knowledge gained in the chapter to other practical examples. Cloud 9 Inc., a listed company (publicly traded) in the United States (U.S.), is looking to expand. McLellan's Shoes was seen as a potential target. In 1985, Ron McLellan started McLellan's Shoes in Seattle, Washington, manufacturing and retailing customized basketball shoes. Ron borrowed from the bank to start the company, using his house as security, and over the years he worked very hard to establish a profitable niche in the highly competitive sport shoe market. Ron repaid the bank in 1999, and he vows to never borrow again. As the business grew, Ron's wife and three adult children started to work with him, with responsibility for administration, marketing and sales, production, and distribution. By the early 2000s, Ron's business employed 20 people full-time, most of whom work in production. There are also several casual employees and part-time staff in the retail outlet in Seattle, particularly during busy periods. In February 2020, Ron received a call from Chip Masters, the senior vice president of Cloud 9. Chip expressed an interest in buying McLellan's Shoes. Ron wants to retire, and his children are starting to fight among themselves about who is going to take over their father's business. Ron is looking for an exit strategy, but he does not want Chip to know that. He asks if Chip is ready to talk about the price. Chip says he is, but first he needs to see the audited financial statements for McLellan's Shoes. Ron asks for some time. He tells Chip that he first needs to talk to his family and will then get back to him. When Ron puts the phone down, he immediately calls his friend from the golf club, Ernie Black, who is a CPA. For years, Ernie has been suggesting to Ron that his business affairs need attention. Ron is good at making deals and working hard, but he has never bothered with sophisticated financial arrangements. He is still running his business as a sole proprietor (not a corporation), and his wife does all the tax returns. Ron is in a panic—he wants to sell McLellan's Shoes, but what is he going to do about Chip's request for audited financial statements?
Chip Masters has asked Ron McLellan for audited financial statements of McLellan's Shoes. Ron has never had an audit and is not sure what it involves. He has heard about tax audits, safety audits, efficiency audits, as well as financial statement audits. Are they all the same thing? Ernie explains to Ron that there are several services that people call “audits” that are different from financial statement audits. However, all these services, including financial statement audits, can be defined as assurance services
Ron is not running a corporation. He operates his customized basketball shoe business as a sole proprietor. He is aware that big corporations have to be audited. However, because his business is not a publicly traded company, Ron does not believe that he has to have an audit. Ernie agrees that Ron does not have to follow the same rules, but he also tells him that there are auditing standards in place that apply to a company like his. This means that although all the attention is usually on corporations, sole proprietors can, and may be required to, have their financial statements audited, too.
Ron is not concerned about internal audits—his business is too small for a separate internal audit function. He is also not worried about compliance and operational audits. His priority at the moment is to close the deal with Chip Masters, and he still does not know what he will do about the financial statement audit.
Ron believes that his business has good, reliable financial records. Ron's wife helps him keep tight control of the cash and other assets, and together they prepare some simple reports on a regular basis. Ron believes he knows exactly what is happening in the business and monitors the business's cash flow and profit very closely. However, he has not prepared financial statements that comply with U.S. GAAP. Is this a problem? Ernie explains to Ron that many businesses must apply the accounting standards, even if they are not corporations. It all depends on whether there are individuals or groups who are using the financial statements for decision-making purposes. Ron is a bit worried now—how does he know if he has these users?
Ron tells Ernie that he has no remote users, such as shareholders or lenders, and his business is not very complex. He is the owner and the manager of McLellan's Shoes and therefore has no competing incentives. For all these reasons, he has never felt the need to purchase an audit to assure users of the reliability of his business's financial information. Ernie agrees but points out that there is now a user who is very interested in the reliability of the financial information: Chip Masters.
Ernie stresses to Ron that any financial statements prepared for McLellan's Shoes are Ron's responsibility, even if they are audited. The auditor must be skeptical about the claims made by Ron in the financial statements. These claims include, for example, that the assets shown on the balance sheet exist and are valued correctly, and that the balance sheet contains a complete list of the business's liabilities. In other words, the auditor is not just going to believe whatever Ron tells him or her. Auditors must gather evidence about the financial statements before they can give an audit opinion. Ernie also explains to Ron that because his business is relatively small, he has a choice between large and small audit firms. Very large companies must choose a Big 4 auditor because often the other auditors are too small to do the work and still maintain their independence. If a small audit firm audits a large company, it is open to the criticism that it will not be sufficiently skeptical because it does not want to lose the fees from that client. A large audit firm has many other clients, so the fees from any one client are a relatively small part of its revenue. Ron likes the idea that the smaller audit firms are generally less expensive.
Ernie explains that, in general, the regulators and regulations that apply to publicly traded corporations are not relevant to McLellan's Shoes. However, any auditor Ron engages would apply the auditing and accounting standards that are relevant to an audit engagement when auditing a small business. Since McLellan's Shoes is a private company, the auditors would follow the auditing standards of the ASB when conducting the audit.
Ron believes that Chip Masters would know what an audit can provide, and what it cannot, because Chip is an experienced vice president of a large international company. He deals with auditors on a regular basis. Ron thanks Ernie for his time. Ernie has helped him to understand that preparing more detailed financial statements and engaging an auditor to perform a financial statement audit would not be as bad as he first thought. Ron now understands why Ernie thinks audits are valuable, and not just another business expense. If Chip Masters thinks that Ron's financial statements are more credible with an audit, then it is likely he will be prepared to pay a higher price for Ron's business.
Ron McLellan established his business, McLellan's Shoes, in 1985. Since then, he has run his business as a sole proprietor. Ron keeps records and his wife helps him prepare basic accounting records. As McLellan's Shoes has no outside owners, Ron has never seen the need to have his accounts audited. When Chip Masters from Cloud 9 Inc. expressed an interest in buying McLellan's Shoes in 2020, Ron was asked to provide audited financial statements. Ron discussed his concerns about having an audit with his friend Ernie Black. Ernie is concerned that Ron may forget their conversations and has asked you to prepare a summary of the issues listed below for Ron.
Ron McLellan came to an arrangement with Chip Masters and sold McLellan's Shoes to Cloud 9 Inc. (Cloud 9) in 2021. As part of the sale agreement, Ron McLellan was appointed to the Cloud 9 board of directors. The accounting firm W&S Partners is bidding for the January 31, 2023, audit of Cloud 9. The partner responsible for writing the proposal, Jo Wadley, asks Sharon Gallagher and Josh Thomas to assist. Sharon will be the audit manager if the proposal is successful. Her task is to help write the proposal documents and win the job for the firm. However, even more importantly, she must make sure that there are no surprises for the audit team once they win the audit. Sharon knows how crucial this is. She still has nightmares about an audit she worked on when she was a new graduate at another audit firm. The client in that case threatened to dismiss the auditor when the auditor wanted him to recognize an impairment loss on some assets. The client was the firm's largest account, and the partner was under a lot of pressure to keep the client. Josh is an audit senior. He has not been involved in the proposal process before and needs the experience so he can be promoted to audit manager. Sharon and Josh do not know anything about Cloud 9 except that it manufactures and retails customized basketball and other sports shoes, and it is a publicly listed U.S. company. Sharon stresses to Josh that they want to know that the client is not going to be difficult to deal with and that W&S Partners can do a good job on the audit. Josh asks how they can know that now, before they start the audit.
Familiarity is usually a greater issue for existing clients than for new clients, such as Cloud 9 for W&S Partners. However, there could be personal familiarity issues in any audit engagement. Josh is worried about asking the partners and management of the firm to declare their relationships with the management of Cloud 9. He thinks they might regard that question as impertinent. Sharon tells Josh that she knows that the partners and managers at W&S Partners are very committed to ethical behavior. If they were not to ask this question as part of the process of accepting the new client, Sharon and Josh would be disciplined for poor performance.
Sharon tells Josh about her experience at another accounting firm in which the client tried to pressure the audit partner into dropping a request to write down the asset values. It was an example of an undue influence threat to the auditor's independence. Although it is difficult to stop a client from asking for a favor, the accounting firm needs to have safeguards to prevent a simple request turning into unreasonable pressure on the audit team to meet that request. Sharon and Josh agree they need to consider the specific independence threats and safeguards for the audit of Cloud 9. The accounting firm must be independent, as well as be seen to be independent.
Josh and Sharon know that they will have to put together an audit team where each member is independent with respect to Cloud 9. Jo Wadley, the partner, will discuss this matter with other partners in the office, and with other offices, to ensure that there will be no independence problems. Sharon and Josh both discuss their own independence with Jo, to confirm that there are no independence problems associated with either their investments or relationship with Cloud 9, or the investments or relationships associated with immediate family members or close relatives. Further, W&S Partners has every member of the professional staff complete an independence questionnaire that covers direct stock ownership and spouse employment, and which serves as a basis for quality control related to independence. Jo advises them to discuss independence with all potential members of the audit team. Jo wants Sharon and Josh to make sure that every member of the audit team knows his or her responsibility to be independent, and to advise the firm of any investments in Cloud 9 or of immediate family members or close relatives who may work for Cloud 9.
Josh and Sharon do not know of any current work being done for Cloud 9 by W&S Partners, or any other relationships between members of the audit team and the client's staff. However, they will check with all other departments, particularly the consulting department, and other offices of W&S Partners. They will also ask any new members of the audit team to disclose their interests and relationships with the client before they join the team. Subsequently, the partner, Jo Wadley, advises Sharon and Josh that she has reached out to other offices and discussed the proposal with the other partners in her office. The firm is not working for Cloud 9 on any other matter. Jo, Sharon, and Josh want to make sure that there are no potential independence issues when their proposal is discussed with Cloud 9's audit committee.
Sharon, Josh, and Ian Harper (a first-year audit staff) are having lunch and talking about Cloud 9, a potential audit client. Ian asks, “Cloud 9 is a public company and has operations in a number of states, as well as internationally. I remember from my auditing class that an auditor's legal liability may differ from state to state, and that federal laws, which are different, may take precedence over state laws. In this litigious environment, how does the firm plan to adequately protect itself with this apparent patchwork of different laws?” Sharon turns to Josh, asking him what he thinks about this question. Josh answers that one defense that is virtually universal is the due diligence defense. W&S Partners has invested significant time and effort in developing a strong system of quality control. If the firm's working papers show that the auditors have used due diligence in carrying out their audit, the firm should be able to fend off legal liability. Sharon agrees with Josh. “It is very important that we follow professional standards at all times.”
Sharon Gallagher, Josh Thomas, and Jo Wadley work for the audit firm W&S Partners. Sharon is an audit manager, Josh is an audit senior, and Jo is an audit partner. They meet to discuss the results of a survey of other offices of W&S Partners, as well as their own office. The survey was directed toward determining if W&S Partners had any independence problems with respect to a new prospective client, Cloud 9 Inc. Based on the survey, they learn the following: Jo Wadley and David Collier (Cloud 9's CFO) both serve on the board of directors of the local chapter of Special Olympics. A tax senior in another office has a sister that consults with Cloud 9 on shoe design. Cloud 9 is her largest client. Fifteen employees of W&S Partners, ranging from partners to entry-level staff, own shares in retailers that sell Cloud 9 shoes. A survey shows that 23% of professional staff working for W&S Partners have purchased Cloud 9 shoes in the past. Required Evaluate each of the items above and their impact on the independence of W&S Partners with respect to Cloud 9. If relevant, list any additional actions you might take before making your independence recommendation to Jo Wadley.
Sharon and Josh have already discussed some specific client acceptance issues, such as independence threats and safeguards. Sharon explains they also must consider the overall integrity of the client (that is, management of Cloud 9). This means they need to perform and document procedures that are likely to provide information about the client's integrity. Josh is a little skeptical. “Do you mean that we should ask them if they are honest?” Sharon suggests it is probably more useful to ask others, and the key people to ask are the existing auditors. Josh is still skeptical. “The existing auditors are Ellis & Associates. Are they going to help us take one of their clients from them?” Sharon says the client must give permission first, and, if that is given, the existing auditor will usually state whether or not there were any issues that the new auditor should be aware of before accepting the work. This type of communication is covered by AS 2610 (AU-C 210 for private company clients) and is part of professional ethics. Sharon also gives Josh the task of researching Cloud 9's press coverage, with special focus on anything that may indicate poor management integrity. Sharon emphasizes they must perform and document procedures to determine whether W&S Partners is competent to perform the engagement and has the capabilities, time, and resources to do so. For example, they must make sure they have audit team members who understand the clothing and footwear business. They also must have enough staff to complete the audit on time. In addition, Sharon and Josh must perform and document procedures to show that W&S Partners can comply with all parts of the code of professional conduct, not just those that focus on independence threats and safeguards. Finally, they can draft the engagement letter to cover the contractual relationship between W&S Partners and Cloud 9.
“Great news!” announces Sharon at the weekly team meeting. “We just received word that the audit engagement letter for Cloud 9 has been signed. We are now officially the auditors and the risk assessment phase starts now!” Later, at the first planning meeting, Sharon and Josh focus on assigning the tasks for gaining an understanding of Cloud 9. Ian Harper, a first-year staff, is not happy. He grumbles to another member of the team, Suzie Pickering, as he leaves the room. “This is such a waste of time. Why did we sign an engagement letter if we don't understand the client? Why don't we just get on with the audit? What else is there to know?” “Oh boy, are you missing the point!” Suzie says. “If you don't understand where the risks are greatest, where are you going to start ‘getting on with it‛?” “The same place you always start,” replies Ian. Ian thinks that all audits are pretty much the same and that W&S Partners must have an audit plan they can use for the Cloud 9 audit. Suzie explains that if they tailor the plan to the client, the audit is far more likely to be efficient and effective. That is, they will get the job done without wasting time and ensure that quality evidence is gathered for the accounts that are most at risk of being misstated. If they can do this, W&S Partners will not only issue the right audit report, but they will make a profit from the audit as well. In other words, if the plan is good, performing the audit properly will be easier. Suzie realizes it will be a big job explaining this to Ian and invites him for a coffee in the staff room so they can talk. Suzie is an experienced staff and has worked with other clothing and footwear clients.
Throughout their conversation, Suzie and Ian have been discussing “material” misstatements in financial statements. Ian asks, “Isn't materiality just a number? Companies of about the same size would have the same materiality level, right?” Suzie explains that they will use a percentage of a benchmark, such as income before taxes or total revenue, as a starting place for determining materiality. Then, they will consider increasing or decreasing that amount based on qualitative factors specific to the Cloud 9 audit. For example, since Cloud 9 is a public company subject to regulation and more public scrutiny, the audit team may decide to decrease materiality, which means the team will perform more extensive audit procedures. “Knowledge of the client's industry is important for determining materiality,” continues Suzie. “We must be familiar with the client's operations and the industry to understand what is important, or material, to the users of the client's financial statements.” Ian is worried about getting the materiality level right. “What if we set it too low or too high?” Suzie explains that all parts of the audit plan, including the materiality decisions, will be reviewed throughout the audit and revised, if necessary.
Ian is still struggling with the idea of risk. He knows that audit risk is the risk that the auditor issues the wrong audit report, or gives an inappropriate audit opinion, and that audit risk is related to the client's circumstances. But how does that actually work in practice? What does an auditor do differently for each audit? “Let's break this down,” Suzie advises. “Auditors face the risk of stating that in their opinion the financial statements are not materially misstated, when in fact they are. So, how does a material misstatement get into the published financial statements?” Ian works through the logic. “First, the error has to be created, either by accident or on purpose. Second, the client's internal control system must fail to either prevent the error getting into the accounts or detect the error once it is in the system. And, finally, the auditor has to fail to find the error during the audit.” “Correct!” says Suzie. “Now, before we go on, I want to break down the idea of ‘financial statements,' too. The financial statements are the balance sheet (statement of financial position), income statement (statement of comprehensive income), cash flow statement (statement of cash flows), statement of changes in equity, and all the notes. So when we talk of the risk of misstatements, we are referring to the risk of misstatement in every line item in each of these statements. If we focus on just one line in a balance sheet—say, accounts receivable—what are the possible misstatements that could occur?” Ian tries to work through the logic again. “The amount could be either understated or overstated. I suppose there are lots of errors that could occur. Obviously, basic math mistakes and other clerical errors could affect the total in either direction. In addition, accounts receivable would be understated if management omitted some customer receivables when they calculated the total. I think the deliberate ‘mistakes' are more likely to overstate accounts receivable because that makes the balance sheet look better, and probably means profit is overstated, too. Accounts receivable would be overstated if some of the receivables management claimed in the total did not exist at year-end, did not belong to Cloud 9, were overvalued because bad debts were not written off, or sales from the next period were included in the earlier period.” “Very good,” says Suzie. “It is the same for every line item. Every time management prepares a financial statement, they assert that all these errors did not occur—that all the individual items in the financial statements are not materially misstated. The auditor has to break down the financial statement audit into accounts and assertions and consider the risk of misstatement for each assertion for each account or transaction class. The auditor deals with the risk of material misstatement of the entire set of financial statements by gathering evidence at the assertion level for each account. Then, all the evidence is put together so the auditor can form an opinion on the overall financial statements.”
Cloud 9 sells athletic shoes and apparel. The shoes are likely to “go out of fashion” reasonably quickly, making obsolescence a big issue. These factors affect the inherent risk of inventory valuation. There is also a risk of errors occurring in transactions with suppliers and customers, which will affect inventory balances. How high is the control risk? Much to Suzie's delight, Ian suggests they will be able to make better assessments of both inherent and control risk for all assertions once they have a better understanding of the client and its system of internal control.
Suzie explains that Cloud 9's audit could be planned and conducted in different ways, depending on the audit strategy adopted. In fact, the overall audit strategy sets the scope, timing, and direction of the audit, and guides the development of the detailed audit plan. “What audit strategy would be suitable for Cloud 9? Start by thinking about the scope of the audit,” she prompts. “The scope is about the different types of work we have to do—some audits have extra requirements.” “I suppose we should find out if Cloud 9 has any special requirements. The fact that it is a public company means we must follow the PCAOB auditing standards and conduct an audit of both the financial statements and the effectiveness of internal controls,” Ian suggests. “That is a good start,” says Suzie. “What else?” “Well, I can think of several other things, such as whether any other auditors will be involved, whether there are any foreign currency translation issues, any industry-specific regulations (although I don't think this is as big an issue for clothing and footwear as it would be for banks, for example), whether there are any service organizations involved such as payroll services, and whether software-aided audit technology is going to be used.” “Very good,” says Suzie. “That will do for now. What about timing issues? Are there any special things we should take into account for Cloud 9?” “What is the date the audit has to be finished?” asks Ian. “Good question,” says Suzie. “We will have a deadline, so we obviously have to work toward it.” “Also,” says Ian, “when are our staff available, and when are Cloud 9's key people available to talk to us?” “Yes,” says Suzie. “This is all basic. But if we don't ask these really important questions, we will find ourselves unable to meet the deadline and perhaps under pressure to cut corners. We also have to think about timing of requests to third parties for information. Now, can you think of anything regarding the direction of the audit?” “I understand about the extra requirements and working out the timing. But I don't really know what you mean by direction,” Ian says, confused. “We have already discussed it to some extent,” Suzie explains. “Remember when we spoke about the risk for Cloud 9 created by obsolescence of inventory, and errors occurring with transactions with customers and suppliers? ‘Direction' is about where we think there should be extra attention because of higher risk, and how we give that extra attention. We could, for example, make sure we have suitable experts available, if required, to value the inventory. This is also where we bring in our work on materiality, both setting materiality for planning purposes, and identifying the material account balances. In our plan, we need to allocate additional time to areas where there may be higher risk of material misstatement. And, one of our biggest tasks will be considering the evidence about the design and operating effectiveness of internal controls at Cloud 9, which we haven't yet considered in detail.” “I see,” says Ian. “If we assess the internal controls as being strong, then we plan to do more testing of controls (to confirm our assessment), and less testing of the underlying substance of transactions and account balances. We have to put this in our plan now. But what if our first thoughts about controls are wrong? Will our plan be wrong?” “That happens,” replies Suzie. “That is why our initial plan is constantly changing as we gather more information about the client. Particularly, as in this case, for a new client that we don't have a lot of detailed information on yet. However, we already know what accounts are important to Cloud 9—the client's previous years' financial statements and interim results show us that.”
Suzie explains fraud risk is always present, even though actual fraud is reasonably rare, and auditors must explicitly consider it as part of their risk assessment. Being aware of the incentives, pressures, opportunities, and attitudes within the client relating to fraud helps the auditor make the assessment. Ian admits he has a little trouble understanding the difference between incentives and attitudes. He thinks he understands the concept of opportunity. Suzie explains that incentives relate to the factor that pushes (or pulls) a person to commit a fraud. Examples include a need for money to pay debts or gamble. Attitudes, or rationalization, relate to the thinking about the act of fraud. For example, the person believes it is acceptable to steal from a mean boss; that is, the theft is justified by the boss's “meanness.”
W&S Partners has just won the January 31, 2023, audit for Cloud 9. The audit team assigned to this client is: Partner, Jo Wadley Audit manager, Sharon Gallagher Audit senior, Josh Thomas IT audit manager, Mark Batten Experienced staff, Suzie Pickering First-year staff, Ian Harper As a part of the risk assessment phase for the new audit, the audit team needs to gain an understanding of Cloud 9's structure and its business environment, determine materiality, and assess the risk of material misstatement. This will assist the team in developing an audit strategy and designing the nature, extent, and timing of audit procedures. One task during the planning phase is to consider the concept of materiality as it applies to the client. Auditors will design procedures to identify and correct errors or irregularities that would have a material effect on the financial statements and affect the decision-making of the users of the financial statements. Materiality is used in determining audit procedures and sample selections, and evaluating differences from client records to audit results. Materiality is the maximum amount of misstatement, individually or in aggregate, that can be accepted in the financial statements. In selecting the benchmark to be used to calculate materiality, the auditors should consider the key drivers of the business. They should ask, “What are the end users (that is, stockholders, banks, etc.) of the accounts going to be looking at?” For example, will stockholders be interested in profit figures that can be used to pay dividends and increase share price? W&S Partners' audit methodology dictates that one planning materiality (PM) amount is to be used for the financial statements as a whole. The benchmark selected for determining materiality is the one determined to be the key driver of the business. W&S Partners use the following percentages as starting points for the various benchmarks:
Benchmark Threshold (%)
Income before tax 5.0
Total revenue 0.5
Gross profit 2.0
Total assets 0.5
Equity 1.0
These starting points can be increased or decreased by taking into account qualitative client factors, which could be:
The nature of the client's business and industry (for example, rapidly changing, either through growth or downsizing, or an unstable environment).
Whether the client is a public company (or subsidiary of) subject to regulations.
The knowledge of or high risk of fraud.
Typically, income before tax is used; however, it cannot be used if reporting a loss for the year or if profitability is not consistent. When calculating PM based on interim figures, it may be necessary to annualize the results. This allows the auditors to plan the audit properly based on an approximate projected year-end balance. Then, at year-end, the figure is adjusted, if necessary, to reflect the actual results. Required Answer the following questions based on the information presented for Cloud 9 in the appendix to this text and in the current chapter and previous chapters. a. Using the October 31, 2022, trial balance (in the appendix to this text), calculate planning materiality and include the justification for the benchmark that you have used for your calculation. b. Discuss how the planning materiality would be used to determine performance materiality. c. If the planning materiality amount is subsequently increased or decreased later in the audit, how would that impact the audit?
