Question

13-35 (Objectives 13-3, 13-4) McClain Plastics has been an audit client of Belcor, Rich, Smith & Barnes, CPAs (BRS&B), for several years. McClain Plastics was started by Evers McClain, who owns 51% of the company’s stock. The balance is owned by about 20 stockholders, who are investors with no operational responsibilities. McClain Plastics makes products that have plastic as their primary material. Some are made to order, but most products are made for inventory. An example of a McClain-manufactured product is a plastic chair pad that is used in a carpeted office. Another is a plastic bushing that is used with certain fastener systems.

McClain has grown from a small, two-product company, when they first engaged BRS&B, to a successful, diverse company. At the time Randall Sessions of BRS&B became manager of the audit, annual sales had grown to $200 million and profits to $10.9 million. Historically, the company presented no unusual audit problems, and BRS&B had issued an unmodified opinion every year.

The audit approach BRS&B always used on the audit of McClain Plastics was a “substantive” audit approach. Under this approach, the in-charge auditor obtained an understanding of internal control as part of the risk assessment procedures, but control risk was assessed at the maximum (100%). Extensive analytical procedures were done on the income statement, and unusual fluctuations were investigated. Detailed audit procedures emphasized balance sheet accounts. The theory was that if the balance sheet accounts were correct at year-end and had been audited as of the beginning of the year, then retained earnings and the income statement must be correct.

Part I

In evaluating the audit approach for McClain for the current year’s audit, Sessions believed that a substantive approach was really only appropriate for the audits of small nonpublic companies. In his judgment, McClain Plastics, with sales of $200 million and 146 employees, had reached the size where it was not economical, and probably not wise, to concentrate all the tests on the balance sheet. Furthermore, although McClain is not a public company, Sessions recognized that similar public companies are required by Section 404 of the Sarbanes–Oxley Act and related PCAOB standards to have an integrated audit of the financial statements and internal control over financial reporting. Therefore, he designed an audit program that emphasized identifying internal controls in all major transaction cycles and included tests of controls. The intended economic benefit of this “reducing control risk” approach was that the time spent testing controls would be more than offset by reduced tests of details of the balance sheet accounts.

In planning tests of inventories, Sessions used the audit risk model included in auditing standards to determine the number of inventory items BRS&B would test at year-end. Because of the number of different products, features, sizes, and colors, McClain’s inventory consisted of 2,450 different items. These were maintained on a perpetual inventory management system that used a relational database.

In using the audit risk model for inventories, Sessions believed that an audit risk of 5% was acceptable. He assessed inherent risk as high (100%) because inventory, by its nature, is subject to many types of misstatements. Based on his understanding of the relevant transaction cycles, Sessions believed that internal controls were effective. He therefore assessed control risk as low (50%) before performing tests of controls. Sessions also planned to use substantive analytical procedures for tests of inventory. These planned tests included comparing gross profit margins by month and reviewing for slow-moving items. Sessions believed that these tests would provide assurance of 40%. Substantive tests of details would include tests of inventory quantities, costs, and net realizable values at an interim date two months before year-end. Cutoff tests would be done at year-end. Inquiries and substantive analytical procedures would be relied on for assurance about events between the interim audit date and fiscal year-end.

Required

Decide which of the following will likely be done under both a reducing control risk approach and a substantive approach:

Assess inherent risk.

Obtain an understanding of internal control.

Perform tests of controls.

Perform substantive analytical procedures.

Assess planned detection risk.

What advantages does the reducing control risk approach Sessions planned to use have over the substantive approach previously used in the audit of McClain Plastics?

What advantages did the substantive approach have over the reducing control risk approach?

Part II

The engagement partner agreed with Sessions’s recommended approach. In planning the audit evidence for detailed inventory tests, the audit risk model was applied with the following results:

PDR=AATIR×CR×APR

where:

PDR=PlanneddetectionriskAAR=acceptableauditriskIR=inherentriskCR=controlriskAPR=analyticalproceduresrisk

Therefore, using Sessions’s assessments and judgments as described previously,

PDR=.051.0×.5×.6PDR=.17

Required

Explain what .17 means in this audit.

Calculate PDR assuming that Sessions had assessed control risk at 100% and all other risks as they are stated.

Explain the effect of your answer in requirement b. on the planned audit procedures and sample size in the audit of inventory compared with the .17 calculated by Sessions.

Part III

Although the planning went well, the actual testing yielded some surprises. When conducting tests of controls over acquisitions and additions to the perpetual inventory, the staff person performing the tests found that the deviation rates for several key controls were significantly higher than expected. As a result, the staff person considered internal control to be operating less effectively, supporting an 80% control risk rather than the 50% level used. Accordingly, the staff person “reworked” the audit risk model as follows:

PDR=.051.0×.8×.6PDR=.10

A 10% test of details risk still seemed to the staff person to be in the “moderate” range, so he recommended no increase in planned sample size for substantive tests.

Required

Do you agree with the staff person’s revised judgments about the effect of tests of controls on planned substantive tests? Explain the nature and basis of any disagreement. If BRS&B was also issuing a report on internal control over financial reporting, describe the implications of these results on the auditor’s internal control report.

Answer 1

Audit risk (also referred to as residual risk) refers to the risk that an auditor may issue an unqualified report due to the auditor's failure to detect material misstatement either due to error or fraud. This risk is composed of inherent risk (IR), control risk (CR) and detection risk (DR), and can be calculated thus:

AR = IR × CR × DR

IR refers to the risk involved in the nature of business or transaction. Example, transactions involving exchange of cash may have higher IR than transactions involving settlement by cheques.

CR refers to the risk that a misstatement could occur but may not be detected and corrected or prevented by the entity's internal control mechanism. Example,control risk assessment may be higher in an entity where separation of duties is not well defined.

DR is the probability that the audit procedures may fail to detect existence of a material error or fraud. While CR depends on the strength or weakness of the internal control procedures, DR is either due to sampling error or human factors.

Large public companies typically engage one of the Big Four accounting firms – PricewaterhouseCoopers, KPMG, Ernst & Young, or Deloitte Touche Tohmatsu – to perform an audit. Many companies hire staff to perform internal audits, and external audit firms may rely on some of the internal work performed. The Big Four was previously the Big Five, but Arthur Andersen lost the ability to perform audit work after being indicted on counts of obstruction of justice for its role in the Enron scandal. According to a 2008 Government Accountability Office (GAO) report, the Big Four firms audit 98% of U.S. companies with annual revenues over $1 billion. Smaller companies are more likely to engage a mid-range firm, such as Grant Thornton.

The Differences Between Audit Risks

The two components of audit risk are the risk of material misstatement and detection risk. Assume, for example, that a large sporting goods store needs an audit performed, and that a CPA firm is assessing the risk of auditing the store's inventory. The risk of material misstatement is the risk that the financial reports are materially incorrect before the audit is performed. In this case, the word "material" refers to a dollar amount that is large enough to change the opinion of a financial statement reader, and the percentage or dollar amount is subjective. If the sporting goods store's inventory balance of $1 million is incorrect by $100,000, a stakeholder reading the financial statements may consider that a material amount.

Detection risk is the risk that the auditor’s procedures do not detect a material misstatement. For example, an auditor needs to perform a physical count of inventory and compare the results to the accounting records, and this work is performed to prove the existence of inventory. If the auditor's inventory count procedures are weak, the detection risk is higher.

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