LO 8-7 integrates the audit risk model (audit risk = inherent risk × control risk × detection risk) to design and execute audit procedures in the acquisition and expenditure cycle, then assess the results to ensure financial statement reliability. The example of Chi-Chi’s Clothing Stores Inc. demonstrates how high inherent and control risks lead to low detection risk, necessitating extensive substantive procedures, with findings evaluated to determine misstatement risks.
Company: A rapidly growing public chain of women’s clothing stores in the northeastern U.S., with 30% annual sales increases.
Auditor: David Escobar, senior auditor, with a firm policy of setting overall audit risk low.
Context: Accounting systems lag growth, prior audit adjustments were needed, and an adverse internal control report was issued last year. Management has incentives to understate costs/liabilities due to stock options tied to profitability, despite an economic downturn.
Inherent Risk (IR): Assessed as high.
Reason: Rapid growth strains systems, untimely invoice reporting from stores, and management bias toward understating costs/liabilities to boost profits and stock options.
Implication: Greater likelihood of misstatements in accounts like accounts payable and expenses.
Control Risk (CR): Assessed as high.
Reason: Controls haven’t kept pace with growth, accounting and internal audit departments are overworked, and insufficient testing/training of new systems occurred.
Implication: Controls are unreliable, increasing reliance on substantive testing.
Detection Risk (DR): Set as low.
Reason: High IR and CR require extensive substantive procedures to reduce the risk that material misstatements go undetected, achieving a low overall audit risk.
Implication: More rigorous audit procedures are planned.
Overall Audit Risk: Targeted as low, per firm policy, balancing high IR/CR with low DR.
Escobar plans substantive procedures to address the completeness and classification assertions, given the high RMM:
Search for Unrecorded Liabilities:
Procedure: Examine a large sample of disbursements after the balance sheet date to identify payments for goods/services received before year-end but not recorded.
Assertion: Completeness – Ensures all liabilities are captured at period-end.
Vendor Confirmations:
Procedure: Send confirmations to vendors with historical activity but small or zero year-end balances, requesting confirmation of outstanding amounts.
Assertion: Completeness – Detects unrecorded liabilities that might be suppressed.
Vouching PP&E Additions:
Procedure: Vouch a sample of additions to property, plant, and equipment (PP&E) accounts to supporting documents (e.g., invoices, purchase orders).
Assertion: Classification – Verifies that items are capitalized correctly and not expensed improperly, or vice versa.
Evaluation of Findings
Unrecorded Liabilities:
Finding: If post-period disbursements reveal significant payments for pre-year-end receipts (e.g., $500,000 in invoices dated December but paid in January), this indicates a material understatement of accounts payable.
Evaluation: Suggests a failure in cutoff controls (invoices not processed timely), requiring adjustment to increase liabilities and expenses, and further investigation into systemic delays.
Vendor Confirmations:
Finding: If vendors report balances (e.g., $200,000 owed) not reflected in the accounts payable ledger, especially for regular suppliers with zero balances, this signals suppression of liabilities.
Evaluation: Indicates potential management override or fraud, necessitating adjustments and expanded testing of other vendors, plus a reassessment of control effectiveness.
PP&E Vouching:
Finding: If sampled additions include operating expenses (e.g., $100,000 in repairs recorded as equipment), this shows misclassification.
Evaluation: Requires reclassification to expense accounts, reducing assets and increasing costs, and highlights a need to test more PP&E entries for similar errors.
Using the Chi-Chi’s example as a framework, here’s how to apply knowledge to perform procedures and evaluate findings across the cycle’s significant accounts:
Procedure: Inspect unmatched receiving reports and vendor invoices from period-end files (Page 19, 339).
Finding: Unmatched reports totaling $300,000 without corresponding invoices suggest unrecorded liabilities.
Evaluation: Adjust accounts payable upward, assess why the three-way match failed (e.g., delayed invoicing), and consider fraud risk if patterns emerge (e.g., specific vendors).
Assertion: Completeness.
Procedure: Perform analytical procedures comparing current-year expenses to prior years and budgets (Page 24, 344).
Finding: A 20% decrease in operating expenses despite 30% sales growth is unexpected.
Evaluation: Investigate potential understatement (e.g., deferred costs), test a sample of transactions for occurrence and cutoff, and adjust if expenses were omitted or misclassified.
Assertions: Completeness, Valuation.
Procedure: Physically inspect PP&E and vouch additions to purchase documents (Page 22, 342).
Finding: Equipment worth $150,000 recorded but not found on-site suggests overstatement.
Evaluation: Remove from PP&E if disposed or fictitious, adjust valuation, and investigate disposal controls or fraud.
Assertions: Existence, Valuation.
Procedure: Recalculate amortization and vouch additions (Page 21, 341).
Finding: Prepaid insurance overstated by $50,000 due to unamortized expired policies.
Evaluation: Adjust prepaid balance down and increase expense, review amortization process for errors.
Assertion: Valuation.
Performing Procedures: Apply risk-based planning (high IR/CR → extensive testing) using vouching, tracing, inspection, and analytics to test assertions like completeness (liabilities), classification (expenses/PP&E), and valuation (assets).
Evaluating Findings: Assess findings for materiality (e.g., $500,000 unrecorded liability vs. materiality threshold), identify root causes (control failure, fraud), and propose adjustments or expanded testing.
Chi-Chi’s Insight: High-growth, weak-control environments amplify RMM, requiring a robust response to ensure reliable period-end balances.