CHAPTER9

OVERVIEWOFRISKBASED
AUDITPROCESS
Questions
1.

In their investigation of a prospective client, the CPAs should assess the

backgrounds and reputations of the prospect and its major shareholders,
directors, and officers. Thus, inquiries are made of underwriters, bankers, and
attorneys that conduct business with the prospective client. Also, the CPAs are
required to make inquiries of the prospect's predecessor auditors to obtain
information that might enter into the acceptance decision, such as information
regarding the integrity of management. The prospect's financial reports, SEC
filings, credit reports, and tax returns are used as sources of financial
background information.

2.

An engagement letter is sent to the client by the auditors to make clear the
nature of the engagement, any limitations on the scope of the audit, work to be
performed by the client's staff, and the basis for computing the auditors' fee.
The engagement letter represents the written contract for the engagement, and its
primary objective is to prevent possible misunderstandings between the client
and the auditors. It constitutes an executory contract between the auditors and
the client.

3.

Shopping for accounting principles is a practice whereby management

changes auditors to a CPA firm that is more likely to allow an accounting
principle that has been the subject of dispute with the companys prior auditors.
A number of mechanisms serve to discourage the practice, including: (1) the
requirements under PAS No. 84 for the successor auditors to inquire of the
predecessors about the reasons for the change in auditors, (2) the SEC 8-K
requirements for management to report the reasons for a change in auditors
which also require the auditors to express their agreement with the details, and
(3) the requirements under PAS No. 97 that require accountants who are being
asked to provide a report on the accounting treatment of an prospective or
completed transaction to consult with the clients auditors to ensure that they
have a complete understanding of the form and substance of the transaction. In
addition, the Sarbanes-Oxley Act of 2002 requires the audit committee to
assume responsibility for engaging, compensating, and overseeing the auditors.

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4.

The approach described in the statement is not appropriate. Materiality depends

on both the dollar amount and the nature of the item. For example, auditors
apply a more rigorous standard of materiality in evaluating transactions between
related parties and potentially illegal acts than they apply to misstatements in
accounts.

5.

The two types of misstatements due to fraud are (1) misstatements arising from
fraudulent financial reporting, and (2) misstatements arising from
misappropriation of assets (sometimes referred to as defalcation). Fraudulent
financial reporting is of more concern to the auditors because it typically results
in effects that are much more material to the financial statements. Defalcations
often are not material to the financial statements.

6. A business risk is a treat to achieving managements 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

clients industry may threaten to
cause the clients 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.

7.

The audit procedures to be followed in a given engagement depend upon such

factors as the risks of material misstatement of the financial statements, the
assumption about the effectiveness of internal control, the auditors' estimates of
materiality, the nature of the accounting records, the caliber of accounting
personnel, and any special objectives of the engagement. Consequently, a
separate, tailor-made audit program should be prepared for each audit
engagement.

8.

The quotation is misleading because it implies that an audit program is no more

than a checklist of instructions for inexperienced auditors. Actually, audit
programs are essential to assessing that all work is performed and are used on
virtually all audit engagements regardless of the amount of experience of the
auditor. Also, a written audit program is required for all audits.

9.

The risk of material misstatement is the probability that an account, class of

transactions, or disclosure is materially misstated. It consists of inherent risk
(the risk of material misstatement without considering internal control) and

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control risk (the risk that internal control will fail to prevent or detect and correct
the material misstatement).
10. Significant risks often relate to nonroutine transactions and estimation
transactions. Such transactions typically involve more subjective judgment than
routine transactions and, therefore, they often have a higher risk of material
misstatement. Significant risks may also be fraud risks.
11. Factors which may cause an audit engagement to exceed the original time
estimate include the following:
(1) Accounting records may not be up to date and complete.
(2) Inadequacies in internal control may be discovered necessitating a more
detailed audit than anticipated.
(3) A significant risk, such as a fraud risk, may be discovered requiring an
extension of audit procedures.
(4) Fraud may be discovered, and an extended investigation may be
authorized by the client to clarify the situation.
(5) Inadequate supervision of audit staff may permit unnecessary or misdirected work to be performed.
(6) Findings during the course of the audit may cause the client to request
extension of the scope of the work.
In some engagements, clients are charged at agreed daily or hourly rates for the
time used to perform the audit. The difficulty of forecasting time requirements
is a principal reason for the use of per diem rates rather than quoting a fee for
the entire engagement. For many engagements, a maximum fee is agreed upon;
this plan may, of course, force the auditing firm to absorb part of the cost of
unexpected amounts of work. A decision as to charging the client for unusual
amounts of time will involve consideration of all aspects of the engagement and
prior relations with the client. Generally, however, the client should not be
billed for excessive time attributed to audit inefficiencies (e.g. item (5) above).
12. Underreporting of time results in the CPA firm not billing the client for all of the
time actually involved in rendering the professional services. Thus, the firm's
revenue is being restricted. In addition, the underreporting will cause the firm to
underestimate the amount of time required for future engagements. Thus,
auditors on future engagements will be expected to perform audit procedures in
an unrealistically short period of time. This interferes with the performance of
an effective audit as well as the realistic evaluation of firm personnel.

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Cases
1.

a.

Prior to acceptance of the engagement, Argante & Tan should have

communicated with the predecessor auditor regarding:

b.

The form and content of engagement letters may vary, but they would
generally contain information regarding:

2.

a.

Facts that might bear on the integrity of management.

Disagreements with management concerning accounting
principles, auditing procedures, or other significant matters.
The predecessors understanding about the reason for the change.
Any other information that may be of assistance in determining
whether to accept the engagement.

The objective of the audit.

The estimated completion date.
Managements responsibility for the financial statements.
The scope of the audit.
Other communication of the results of the engagement.
The fact that because of the test nature and other inherent
limitations of any system of internal control, there is an
unavoidable risk that even some material misstatement may remain
undiscovered.
Access to whatever records, documentation, and other information
may be requested in connection with the audit.
Arrangements with respect to client assistance in the performance
of the audit engagement.
Expectation of receiving from management written confirmation
concerning representations made in connection with the audit.
Notification of any changes in the original arrangements that might
be necessitated by unknown or unforeseen factors.
Request for the client to confirm the terms of the engagement by
acknowledging receipt of the engagement letter.
The basis on which fees are computed and any billing
arrangements.

Typical engagement letter generally includes the following:

The name and address of the person or persons who retained the
auditor to perform the auditing services.
An opening paragraph that confirms the understanding of the
auditor and the client.

Overview of Risk-Based Audit Process

b.

9-5

A summary of significant events that lead to the retention of the

services of the auditor.
A general description of the CPA firm that will conduct the
examination.
A statement that the examination will be performed in accordance
with auditing standards.
A description of the scope of the services to be rendered, which
should establish the nature of the engagement.
Any scope restrictions or special limitations and their effect on the
auditors report.
A statement regarding the auditors responsibility for the detection
of fraud.
An indication of the possible use of client personnel in connection
with the audit work to be performed.
A statement that the auditor will provide a management letter if
required in the circumstances.
The method and timing of billings as well as billing rates and fee
arrangements.
Space for the client representatives signature, which indicates
acceptance of the letter and the understandings, therein.

The benefits of preparing an engagement letter include the avoidance of

possible problems between the CPA and the client concerning (1) the scope
of the work, (2) the service to be rendered, and (3) the audit fee. In
addition, the in-charge auditor conducting the examination can avoid
misunderstanding the nature and scope of the engagement if the
engagement letter is included in the permanent section of the audit working
papers. The letter should eliminate misunderstandings and confusion about
the type of financial statements to be examined, the estimated report date,
and the type of opinion expected. In addition to avoiding possible
misunderstandings, any legal problems relating to the auditors failure to
perform certain procedures can be reviewed with reference to the
contractual commitment assumed. (For example, if scope limitations
prevent the auditor from performing normal audit procedures, the auditor
cannot be legally responsible if an irregularity is not detected when clearly
it would have been detected if such procedures were performed.)
The engagement letter is also useful as a reference document when
preparing for future engagements.

c.

The CPA usually prepares the engagement letter as a follow-up to a verbal

understanding that he and his client have reached. It is desirable that the
client endorse and return an approved copy of the engagement letter to the

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CPA. It also is acceptable for the client to prepare his own letter
summarizing his understanding of the nature of the engagement.

3.

d.

Preferably the engagement letter should be sent at the beginning of the

engagement so that misunderstandings, if any, can be remedied.

e.

Obviously, the engagement letter will be most useful in clarifying

misunderstandings on a first engagement. But it is desirable that the letter
be renewed periodically. Client personnel or the nature of the engagement
may change, and the resubmission of the letter gives both parties an
opportunity to review the circumstances. Accordingly, for recurring
examinations of financial statements, it is appropriate to prepare an
engagement letter at the start of each examination. For other continuing
engagements, the engagement letter also should be updated periodically
probably on a yearly basis.

a.

The procedures that Francis should follow prior to accepting the

engagement include the following:
(1) Francis should explain to Nikolai the need to inquire of Jo and should
request permission to make such inquiries.
(2) Francis should request that Nikolai authorize Jo to respond fully to all
of Francis inquiries since Jo would be prohibited from disclosing
confidential information obtained in the course of his professional
engagement with Nikolai.
(3) Francis should advise Jo of Nikolais decision to change auditors as an
act of professional courtesy.
(4) Francis should make reasonable inquiries of Jo regarding matters that
will aid in deciding whether to accept the engagement. (Francis
inquiries should include questions regarding facts which might bear on
the integrity of management, disagreements with management as to
accounting principles, auditing procedures or other significant matters,
and Jos understanding of the reason(s) for the change of auditors.)
(5) Francis should weigh all the information received from Jo. If Jo does
not respond fully to Francis questions, Francis should consider the
implications of the limited response in deciding whether to accept the
engagement.
(6) After weighing all information received from Jo, Francis should inform
Nikolai that a first-time audit is more time-consuming than a recurring
audit because the new auditor is generally unfamiliar with clients
operations and does not have the benefit of past knowledge of company
affairs to use a guide.

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9-7

(7) A discussion with Nikolai of the estimated required audit time and fee
arrangement should be coordinated with a clear explanation of the
purpose and scope of the audit. Any work that can be done by client
personnel should also be discussed so that excess audit time might be
eliminated and proposed report deadlines can be reasonably met.
(8) To satisfy Francis quality control objectives, Francis should use
procedures such as reviewing the financial statements of Nikolai;
inquiring of third parties such as Nikolais banks, legal counsel,
investment bankers, and others in the business community as to
Nikolais reputation; and evaluating his ability to serve Nikolai
properly with reference to industry expertise, size of engagement, and
available staff.
(9) If Francis has no reservations, after all significant factors have been
considered, discussed, and agreed to, Francis should accept the
engagement and confirm the understanding in an engagement letter.
b.

Francis procedures on this first-time audit should include the following:

(1) Francis should review the workpapers of Jo to obtain information that
will help plan the audit work.
(2) Francis should make arrangements as early as possible for the initial
meeting with key company personnel who will be contacted
throughout the engagement.
(3) Since basic information about the company is not readily available to
Francis on this first-time audit, information of a general nature should
be obtained as early in the planning stage as possible. (Such
information should include company history, nature of the business,
credit policies, financing methods, sales methods and terms, seasonal
business patterns, products, services, plant locations, internal
procedures, accounting policies, tax status, etc. Client procedures
manuals and manuals of accounts should be read to obtain such
information.)
(4) Francis should immediately start obtaining the data needed to create a
permanent working paper file. (The file should include items such as
articles of incorporation, minutes, internal audit reports, deeds of trust,
pension agreements, loan agreements, leases, important contracts, and
other pertinent data.)
(5) Francis must determine the scope of work necessary to verify the
opening balances. Such balances must be reviewed to determine
whether they are stated on a basis comparable with those of the period
under review. If Francis cannot verify the opening balances, Francis

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should consider disclaiming an opinion on the earnings statement and
statement of changes in financial position.
(6) The composition of all important accounts should be reviewed. Francis
should limit his examination of prior period accounts to a review or
survey of such accounts, without a detailed examination, unless the
results of Francis survey and analyses indicate the need for further
investigation of accounting methods in the prior years.
(7) Francis must consider whether the financial statements are prepared
using financial reporting standards that were consistently applied. If,
after performing necessary audit procedures, Francis cannot be satisfied
as to consistency, considerations must be given to qualifying the
auditors report as to consistency.
Francis should use professional judgment to determine the extent of reliance
that should be placed on the work of Jo. The scope of Francis work may
be reduced as a result of Francis consultation with Jo and a review of the
prior-year workpapers of Jo.
4.

a.

A CPA can use the following sources of information to help decide whether
to accept a new audit client.
Financial information prepared by the prospective client:
Annual reports to shareholders
Interim financial statements
Securities registration statements
Annual report on SEC
Reports to regulatory agencies
Inquiries directed to the prospects business associates:
Banker
Legal counsel
Underwriter
Other persons, e.g., customers, suppliers
Predecessor auditor, if any, communication, re:
Integrity of management, Disagreements with management
Analysis:
Special or unusual risk related to the prospect
Need for special skills (e.g., computer or industry expertise)
Internal search for relationships that would comprise independence

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b.

5.

Students can decide this acceptance question either way, although the brief
facts prejudice the conclusion toward nonacceptance. The CPAs own firm
decided to resign only 10 years ago, presumably over matters of ownermanager integrity. Yet, Mr. Sello appears to be a respected member of his
new community. Maybe his fast and loose accounting past is behind him.
Maybe not.
Benefits of engagement letters are:

Helps establish an understanding between client and auditor of the terms of

the engagement and the nature of the work.

Helps avoid quarrels and misunderstandings between client and auditor.

Helps avoid disputes over the audit fee.

Helps avoid legal liability assertions based on failure to do work that the
CPA may not have contemplated or agreed to do.