Question

Bellows Home Inspection is a private business that provides home inspection . It has been in business for years and Ethan , the owner , is proud of their strong internal control system .

The business is showing a loss for the first time in five years . The business is very cyclical : the large majority of its sales occur when a home is purchased , so it is affected by the real estate market . It gets most of its business through Bellows Realty , a real estate broker company held by Ethan and his mother . Bellows Realty will directly purchase the home inspection from Bellows Home Inspection on behalf of its clients .

Bellows recently acquired a competitor , Home Guards Inc. To complete the purchase , it has received a significant loan from the bank . The bank will be a new user of Bellow's financial statements .

The accounting manager , however , has indicated that it has been difficult to integrate the operations of Home Guards because its internal controls over financial reporting were pretty much non - existent at the time of the acquisition .

Required : Identify four key audit issues in this company , and explain how these will affect your audit risk , using the audit risk model .

Answer 1

Audit risk model is a tool used by auditors to understand the relationship between various risks arising from an audit engagement enabling them to manage the overall audit risk. Audit risk model suggests that overall audit risk of an engagement is the product of the following three component risks:

• Inherent Risk
• Control Risk
• Detection Risk

This is often represented in equation form as follows:

Audit Risk = Inherent Risk × Control Risk × Detection Risk

In the given case study Bellows recently acquired a competitor , Home Guards Inc. To complete the purchase and the key audit issues in this company can be :

Auditors failed to properly assess inherent risk and adjust the audit program accordingly. The best way for a firm to remedy such deficiencies is to promote more involvement by audit firm executives—partners and managers—in planning the engagement.

Relying on internal controls (rely too much/failing to react to known control weaknesses).due to which internal risk is high thus accordingly audit risk in high

Recognizing/disclosing key related partieswas the auditor’s failure to recognize or disclose transactions with related parties. The auditor was either unaware of the related party or appeared to cooperate in the client’s decision to conceal a transaction with this party. Such transactions often resulted in inflated asset values.due to this inherent risk is more.

The three most common deficiencies all reflect engagement management problems affecting many areas of the audit: a failure to gather sufficient, competent evidence, lack of due care and lack of professional skepticism. In many cases, the best remedy for such problems is for auditors to develop a properly designed and executed quality control system. Such a system creates a culture that encourages all members of the audit team to maintain a baseline acceptable level of performance, regardless of perceived day-to-day engagement and firm pressures.

CPA firms should evaluate their own quality control systems to ensure policies and procedures emphasize the importance of proper audit planning, supervision and review, including timely involvement by engagement and concurring partners. Additionally, firms should reexamine existing quality control procedures to make sure they are detailed enough to assure firm leaders that audit teams are examining appropriate documentation (final documentation, not drafts) and that teams complete all audit program steps. Those procedures should emphasize that auditors should corroborate management representations with additional evidence and not overuse management inquiry as a form of audit evidence.

The firm’s “tone at the top.” Another means of reducing office-wide audit problems is to address the attitudes at the firm’s highest levels. Here are some values a CPA firm’s managing partners should clearly communicate to their employees. Firms should

Define “client” to include not only management but also the entity’s board of directors, audit committee, stockholders and the investing public to ensure the audit team considers all affected parties throughout the engagement.

Signal to their audit teams that providing high quality audit services is a top priority and that the firm does not view such services as a commodity. A firm can do this by emphasizing the importance of audit quality in training programs and annual performance reviews.

Encourage all personnel to maintain an attitude of professional skepticism that focuses on the importance of the auditor’s role in protecting the public interest and maintaining strong capital markets. A firm can accomplish this by conducting periodic engagement-wide team meetings to discuss concerns about management integrity issues and by highlighting for staff members the risks of not being skeptical.

Performance measurement and compensation. Audit firms can benefit from closely examining their performance measurement and compensation systems. In many of the fraud cases, it appeared auditors simply chose not to pursue identified audit issues, perhaps fearing the time spent investigating those issues would hinder career advancement or result in penalties during salary and bonus reviews because they ran overtime budgets or missed client-imposed deadlines.

A clear message should be part of all personnel decisions (hiring, retention and promotion) that the firm values high quality audit services and that all other considerations—including time budgets, firm administration, development of nonaudit services and other practice development issues—are secondary. Firms also need to carefully evaluate whether fee and deadline pressures will have an impact on the audit team’s ability to deliver a high quality audit.

GAAP violations. CPA firms that perform audits can take a number of steps to reduce the incidence of GAAP violations among audit personnel, including

Requiring specific internal firm consultation with technical A&A partners or industry specialists when certain accounting issues arise.

Expanding the coverage of technical accounting topics and industry-specific requirements in firm-sponsored training courses to ensure audit personnel understand the nuances of GAAP, particularly those involving unique industry issues.

Ensuring that firm personnel understand the provisions of SAS no. 69, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles in the Independent Auditor’s Report [GAAP hierarchy]. Implementing this recommendation might require the firm to develop or purchase guidance on implementing GAAP’s more obscure aspects.

Audit planning. Auditors can best remedy audit planning deficiencies by promoting more extensive and timely involvement by partners—both engagement and concurring—and managers in planning the engagement. Such involvement increases the likelihood the auditor will correctly assess risks (both inherent and control) and modify the firm’s audit approach (nature, extent and timing of tests) as appropriate. Involving the audit team partner and manager during the planning phase will help ensure that audit plans emphasize careful scrutiny of nonroutine transactions, particularly those recorded near yearend—when management sometimes records inappropriate transactions.

Management estimates. At a minimum, auditors need to carefully review the underlying data, assumptions and methods a company’s management used to develop financial statement estimates. An adequate review hinges on auditors with an appropriate level of both general and industry-specific expertise being involved. In cases of particularly complex or unusual estimates, specialists may be needed.

Confirming accounts receivable. CPA firms need to ensure their audit teams are effectively handling the confirmation process. Firms should remind team members to

Confirm accounts receivable (unless conditions under SAS no. 67, The Confirmation Process, suggest confirmations would not be effective).

Confirm an adequate portion of the receivables.

Maintain control of the confirmation process.

Employ alternative procedures when confirmations are not returned or exceptions exist.

Related-party transactions. To increase the likelihood of detecting related-party transactions, the auditor should:

Prepare a list of related parties, continually updating it throughout the engagement and distribute it to all audit team members.

Make inquiries of management regarding the existence of related-party transactions.

Confirm with the counter-party the nature and existence of material or unusual client transactions, including whether a relationship exists between the counter-party and the client or its management.

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