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Auditing and Assurance Services (16th Edition) question 7-29objective (7-4) The following audit procedures were performed inthe audit of inventory to satisfy specific balance-related auditobjective as discussed in chapter 6. The audit procedures assumethat the auditor has obtained the inventory count sheets that listthe clients inventory. The general balance-related audit objectivesfrom chapter 6 are also included. Audit procedures 1) select asample of inventory items in the factory warehouse and trace eachitem to the inventory count sheets to determine if it has beenincluded and if the quantity and description are correct. 2) traceselected quantities from the inventory list to the physicalinventory to make sure that it exists and the quantities are thesame. 3) compare the quantites on hand and unit prices on thisyears inventory count sheets with those in the preceding year as atest for large differences. 4) test the extension of unit pricestimes quantity on the inventory list for a sample of the inventoryitems, test foot the list, and compare the total to the generalledger. 5) send letters directly to third parties who hold theclients inventory, and request that they respondf directly to theauditors. 6) examine sales invoices and contracts with customers todetermine whether any goods are out on consignment with customers.Similarly, examine vendors in-voices and contracts with vendors todetermine whether any goods on the inventory listing are owned byvendors. 7) question operating personnel about the possibility ofobsolete or slow-moving inventory. General balance-related auditobjectiveexistence,completeness,accuracy,classification,cutoff,detailtie-in,realizable vaule,rights and obligations

a) identify the type of audit evidence used for each aduitprocedure.

b) identify the general balance-related audit objective orobjectives satisfied by each audit procedure.

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Auditing and Assurance Services (16th Edition)

question 7-29

objective (7-4) The following audit procedures were performed inthe audit of inventory to satisfy specific balance-related auditobjective as discussed in chapter 6. The audit procedures assumethat the auditor has obtained the inventory count sheets that listthe clients inventory. The general balance-related audit objectivesfrom chapter 6 are also included.

Audit procedures

1) select a sample of inventory items in the factory warehouseand trace each item to the inventory count sheets to determine ifit has been included and if the quantity and description arecorrect.

2) trace selected quantities from the inventory list to thephysical inventory to make sure that it exists and the quantitiesare the same.

3) compare the quantites on hand and unit prices on this yearsinventory count sheets with those in the preceding year as a testfor large differences.

4) test the extension of unit prices times quantity on theinventory list for a sample of the inventory items, test foot thelist, and compare the total to the general ledger.

5) send letters directly to third parties who hold the clientsinventory, and request that they respondf directly to theauditors.

6) examine sales invoices and contracts with customers todetermine whether any goods are out on consignment with customers.Similarly, examine vendors in-voices and contracts with vendors todetermine whether any goods on the inventory listing are owned byvendors.

7) question operating personnel about the possibility ofobsolete or slow-moving inventory.

General balance-related audit objective

existence,completeness,accuracy,classification,cutoff,detailtie-in,realizable vaule,rights and obligations

a) identify the type of audit evidence used for each aduitprocedure.

b) identify the general balance-related audit objective orobjectives satisfied by each audit procedure.

34
The following audit procedures were performed in the audit of
inventory to satisfy speci(c balance-related audit objectives as
discussed in Chapter 6. The audit procedures assume that the
auditor has obtained the inventory count sheets that list the client’s
inventory. The general balance-related audit objectives from
Chapter 6 are also included.
Audit Procedures
1. Test extend unit prices times quantity on the inventory list, test foot
the list, and compare the total to the general ledger.
2. Trace selected quantities from the inventory list to the physical
inventory to make sure that it exists and the quantities are the same.
3. Question operating personnel about the possibility of obsolete or slow-
moving inventory.
4. Select a sample of quantities of inventory in the factory warehouse and
trace each item to the inventory count sheets to determine if it has
been included and if the quantity and description are correct.
5. Compare the quantities on hand and unit prices on this year’s
inventory count sheets with those in the preceding year as a test for
large di5erences.
6. Examine sales invoices and contracts with customers to determine
whether any goods are out on consignment with customers. Similarly,
examine vendors’ invoices and contracts with vendors to determine
whether any goods on the inventory listing are owned by vendors.
7. Send letters directly to third parties who hold the client’s inventory and
request that they respond directly to the auditors.
General Balance-Related Audit Objectives
Existence Cuto5
Completeness Detail tie-in
Accuracy Realizable value
Classi$cation Rights and obligations
Required
a. Identify the type of audit evidence used for each audit procedure.
b. Identify the general balance-related audit objective or objectives
satis$ed by each audit procedure

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

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

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

Part I

In evaluating the audit approach for McClain for the currentyear’s audit, Sessions believed that a substantive approach wasreally only appropriate for the audits of small nonpubliccompanies. In his judgment, McClain Plastics, with sales of $200million and 146 employees, had reached the size where it was noteconomical, and probably not wise, to concentrate all the tests onthe balance sheet. Furthermore, although McClain is not a publiccompany, Sessions recognized that similar public companies arerequired by Section 404 of the Sarbanes–Oxley Act and related PCAOBstandards to have an integrated audit of the financial statementsand internal control over financial reporting. Therefore, hedesigned an audit program that emphasized identifying internalcontrols in all major transaction cycles and included tests ofcontrols. The intended economic benefit of this “reducing controlrisk” approach was that the time spent testing controls would bemore than offset by reduced tests of details of the balance sheetaccounts.

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

In using the audit risk model for inventories, Sessions believedthat an audit risk of 5% was acceptable. He assessed inherent riskas high (100%) because inventory, by its nature, is subject to manytypes of misstatements. Based on his understanding of the relevanttransaction cycles, Sessions believed that internal controls wereeffective. He therefore assessed control risk as low (50%) beforeperforming tests of controls. Sessions also planned to usesubstantive analytical procedures for tests of inventory. Theseplanned tests included comparing gross profit margins by month andreviewing for slow-moving items. Sessions believed that these testswould provide assurance of 40%. Substantive tests of details wouldinclude tests of inventory quantities, costs, and net realizablevalues at an interim date two months before year-end. Cutoff testswould be done at year-end. Inquiries and substantive analyticalprocedures would be relied on for assurance about events betweenthe interim audit date and fiscal year-end.

Required

Decide which of the following will likely be done under both areducing 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 Sessionsplanned to use have over the substantive approach previously usedin the audit of McClain Plastics?

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

Part II

The engagement partner agreed with Sessions’s recommendedapproach. In planning the audit evidence for detailed inventorytests, the audit risk model was applied with the followingresults:

PDR=AATIR×CR×APR

where:

PDR=PlanneddetectionriskAAR=acceptableauditriskIR=inherentriskCR=controlriskAPR=analyticalproceduresrisk

Therefore, using Sessions’s assessments and judgments asdescribed previously,

PDR=.051.0×.5×.6PDR=.17

Required

Explain what .17 means in this audit.

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

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

Part III

Although the planning went well, the actual testing yielded somesurprises. When conducting tests of controls over acquisitions andadditions to the perpetual inventory, the staff person performingthe tests found that the deviation rates for several key controlswere significantly higher than expected. As a result, the staffperson considered internal control to be operating lesseffectively, supporting an 80% control risk rather than the 50%level used. Accordingly, the staff person “reworked” the audit riskmodel as follows:

PDR=.051.0×.8×.6PDR=.10

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

Required

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

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