This question is from “Auditing and Assurance Services 16th Edition”, Chapter 13

Question

This question is from “Auditing and Assurance Services 16th Edition”, Chapter 13, 13-34

CASES 13-34 (OBJECTIVES 13-3, 13-4) Gale Brewer, CPA, has been the partner in charge of the audit of Merkle Manufacturing Company, a nonpublic company, for 13 years. Merkle has had excellent growth and profits in the past decade, primarily as a result of the excellent leadership provided by Bill Merkle and other competent executives. Brewer has always enjoyed a close relationship with the company and prides himself on having made several constructive comments over the years that have aided in the success of the firm. Several times in the past few years, Brewer's CPA firm has considered rotating a different audit team on the engagement, but this has been strongly resisted by both Brewer and Merkle. For the first few years of the audit, internal controls were inadequate and the account- ing personnel had inadequate qualifications for their responsibilities. Extensive audit evidence was required during the audit, and numerous adjusting entries were necessary However, because of Brewer's constant prodding, internal controls improved gradu- ally and competent personnel were hired. I adjustments required, and the extent of the evidence accumulation was gradually reduced During the past three years, Brewer was able to devote less time to the audit because of the relative ease of conducting the audit and the cooperation obtained throughout the engagement. n recent years, there were normally no audit In the current year's audit, Brewer decided that the total time budget for the engage- ment should be kept approximately the same as in recent years. The senior in charge of the audit, Phil Warren, was new on the job and highly competent, and he had the reputation of being able to cut time off the budget. The fact that Merkle had recently acquired a new division through merger would probably add to the time, but Warren's efficiency would probably compensate for it. The interim tests of controls took somewhat longer than expected because of the use of several new assistants, a change in the accounting system programs for inventory and other accounting records, a change in accounting personnel, and the existence of a few more errors in the tests of the system. Neither Brewer nor Warren was concerned about the budget deficit, however, because they could easily make up the difference at year-en At year-end, Warren assigned the responsibility for inventory to an assistant who also had not been on the audit before but was competent and extremely fast at his work. Even though the total value of inventory had increased, he reduced the size of the sample from that of other years because there had been few errors in the preceding year. He found several items in the sample that were overstated as a result of errors in pricing and obsolescence, but the combination of all of the errors in the sample was immaterial. He completed the tests in 25% less time than the preceding year. The entire audit was com- pleted on schedule and in slightly less time than the preceding year. There were only a few adjusting entries for the year, and only two of them were material. Brewer was extremely pleased with the results and sent an e-mail message to Warren and the inventory assistant complimenting them on the audit

Explanation / Answer

A)--The major deficiencies in the audit and the reasons for their occurrence are:

1. The change in the accounting system to computerize the inventory, a change in accounting personnel, and the existence of a few more errors in the tests of controls should have alerted the auditors to expand the scope of the work. It was questionable to conclude that the internal controls were effective.

2. Reduction in the scope of the inventory work based on the lack of errors last year was improper since new internal controls were in use with new personnel this year and the inventory balance was higher. 3. The new division should have been audited more thoroughly. It came to Merkle through merger and was likely to have different operating characteristics and internal controls. 4. The determination that the errors in the sample were immaterial was improper. The errors should have been projected from the sample to the population, and the projected error should have been compared to performance materiality, also considering sampling risk. The obsolescence problem uncovered in the audit should have been evaluated carefully to consider the implications on potential obsolescence of inventory. 5. Given the new personnel on the engagement, Brewer apparently failed to adequately supervise and review the work of assistants. 6. There was an apparent lack of the use of analytical procedures. A decline in sales should have warned the auditor to a potential decline in profits and obsolete inventory.

B)--Brewer should have been aware that the inventory internal controls and the personnel in that department were new, that the interim tests revealed more errors than normal, and that the inventory tests revealed more errors than normal despite the reduction in scope. In this situation, the scope of the inventory work should have been increased to reveal the magnitude of the problems encountered. In addition, because of the staff turnover on this engagement, Brewer should have devoted more of his time to supervising the work of the staff on this engagement.

C)--. The likelihood of Brewer losing the suit is high. The auditors appear not to have followed several of the principles in the clarified audit standards related to the auditors responsibilities and performance. Although the misstatements result from fraud, the auditors may be held responsible because apparently the audit was not conducted in accordance with auditing standards.

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