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CASE 1

1.) Following the above conference with Rogers, Abernethy asks Andrews to produce a
memo listing the potential problems that the firm might encounter in this audit.
Prepare this memo for the Lakeside engagement. Include all accounts and
transactions that seem to require special attention. Evaluate each possible severity of
each of these concerns.

ANSWER:
PSA 200(Revised and Redrafted), “Overall Objectives of the Independent Auditor and the
Conduct of an Audit is accordance with the Philippine Standards on Auditing”, establishes
the independent auditor’s overall responsibilities when conducting on audit of financial
statements in accordance with PSAs. Here’s a Memo Listing of the potential problem that
the firm might encounter.
Potential Problems
Description of the client’s company (it’s structure, nature of business, and orgnization)
Relationship between Lakeside and Cypress. Identifying the cash discounts, quality, and
timing of the supplies.
Monitoring the Accounts Receivables and probability of its collection.
Monitoring the Inventory and evaluating the contingent liabilities for the product
returned/warranty by the customers.
Analyzing the outstanding loans and evaluating each loan agreement.
Lakeside’s accounting system is outdated.
Negotiation on professional fees.
The qualified opinion rendered on Lakeside’s financial statements.
Regulating and monitoring the bonus system.

2.) Andrews was also assigned to visit the headquarters/ warehouse of Lakeside to tour
the facility. What should Andrews observe, and what factors should he be especially
aware of during his visit?

ANSWER:

During a tour to the Lakeside’s headquarters/warehouse, Andrews should aware of several


key items that could portray a clear picture of the entity and what prospective auditing
process of the company would entail. The item includes: Structural/Organizational chart of
the company, Inspect Inventory (includes the type of inventory method used, its EOQ, and
the timing of orders from suppliers), review ledgers, bank records, financial statements and
order forms for clear and sufficient preparation/recording and observe the responsibilities
and effectiveness of management’s controls.

3.) Prepare the auditor’s report that King and Company rendered at the end of the 1990
engagement. How does this qualified opinion differ from a standard auditor’s report?

ANSWER:

REPORT OF INDEPENDENT AUDITORS

Addressed to the Board of Directors of the Lakeside Company:

We have audited the balance sheet of the Lakeside Company as of December 31,1990, in
addition to the related income statements, retained earnings, and cash flows for this year
ended. The reporting of these documents are the responsibility of the management of
Lakeside Company. Our responsibility as auditors is to express an opinion on these
financial statements based on our audit.

We conducted our audit in accordance with auditing standards generally accepted


in the Philippines. These standards require that we plan and perform the audit to obtain a
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining evidence supporting the amounts
and disclosures in the financial statements. An audit also includes assessing the
accounting principles used and estimates made by management, as well as evaluating
the overall financial statement presentation. We believe that the evidence we have attained
in our audit provides a reasonable basis for our opinion.

During the prior year, 1989, the Lakeside Company invested in a retail store located
in Richmond, Virginia. However, it is uncertain that the Lakeside Company will make any
return on this investment as the break-even point was not reached by the year-ended. Our
opinion is that it is more likely than not that the value of the investment asset is lower and
should thus be adjusted in accordance with Generally Accepted Accounting Principles.
However, management of the Lakeside Company has committed a departure from
Generally Accepted Accounting Principles in that they have not accounted for this loss.
Except for the effects of the departure from Generally Accepted Accounting Principles
mentioned above, the financial statements present fairly, in all material respects, the
financial position of the Lakeside Company at December 31, 1990, and the outputs of its
operations for the year then ended are in conformity with accounting principles generally
accepted in the Philippines.

King and Company, CPA Firm


Dated [last day of audit work]

In qualified opinion, the auditor includes the Emphasis of Matter paragraph in the auditor's
report provided the auditor has obtained sufficient appropriate audit evidence. The auditor
consider it is necessary to draw user's attention to a matter presented or disclosed in the
financial statement that, in auditor's judgment, is of such importantance that it is
fundamental to users' understanding of the financial staements.
CASE 2
1.) Exhibits 2-1 and 2-2 are attached. From the information that has been presented in
the first two cases, complete these forms.

ANSWER:
Exhibit 2-1
Abernethy and Chapman
ANALYSIS OF POTENTIAL LEGAL LIABILITY

Potential Client:

Type of Engagement:

Form Completed By: _________ Date:______

(1) Is the potential client privately held or publicly held?


(2) Evaluate the possible liability to the client that Abernethy and Chapman might incur, if
the engagement is accepted.
(3) List the third parties that presently have a financial association with the potential client
and could be expected to see the financial statements. These parties are also called primary
and foreseen beneficiaries.
(4) Discuss the possibility that other third parties will be brought into a position where they
would be expected to see the financial statements of the potential client.
These parties are also called foreseeable beneficiaries.
(5) Evaluate the possible legal liability to third parties, both present and potential, that
Abernethy and Chapman might incur if the engagement is accepted.

Exhibit 2-1
Abernethy and Chapman
ANALYSIS OF POTENTIAL LEGAL LIABILITY
Potential Client: Lakeside Company

Type of Engagement:

Form Completed By: _________ Date:______

Privately held
The basic liability to the client is for losses occurring as a result of any firm negligence. If
Abernethy and Chapman performs the engagement as an average, prudent auditor would,
no problem exists. If not, the client may sue for return of its audit fee as well as any other
resulting losses. A special problem area exists in the Lakeside case: the client's weak
internal control. Such weaknesses increase the likelihood of fraud or embezzlement. The
control problems also make discovery of such defalcations more difficult. In addition,
proving that the firm is innocent of negligence is often difficult to do if the client loses
money through defalcations not discovered by the auditor.
The current stockholders Cypress Products
Two banks financing the inventory
National Insurance Company of Virginia (mortgage loans)
Possibly other creditors
As Rogers has expressed considerable interest in expansion, the CPA firm should anticipate
that the financial statements could be presented to potential stockholders or lenders.
As a privately held business, this audit does not fall under federal security laws. Thus, the
auditor is bound by common law and is judged under such precedents as the Ultramares
case, the CIT Financial Corp. case, and the Rusch Factors case. In the Lakeside audit, the
CPA firm should have no liability to third parties unless the audit is performed in a grossly
negligent manner or the firm is negligently responsible for careless financial
misrepresentations. In a few jurisdictions, they may be held liable to foreseen or
foreseeable beneficiaries for ordinary negligence.
Exhibit 2-2

Abernethy and Chapman


INFORMATION FROM PREDECESSOR AUDITOR
Potential Client:

Form Completed By:

Predecessor Auditor:

Date of Interview:

(1) Discuss the predecessor auditor's evaluation of the integrity of the management of the
potential client.
(2) Did the predecessor auditor reveal any disagreements with management as to
accounting principles, auditing procedures, or other similarly significant matters? If so,
fully describe these disagreements.
(3) What was the predecessor auditor's understanding as to the reasons for the change in
auditors?
(4) Did the predecessor auditor give any indication of other significant audit problems
associated with the potential client?
(5) Did the predecessor auditor indicate any problem in allowing Abernethy and Chapman
to review prior years' audit documentation for the potential client? If "yes," explain.
(6) Was the predecessor auditor's response limited in any way?

Exhibit 2-2
Abernethy and Chapman
INFORMATION FROM PREDECESSOR AUDITOR
Potential Client:______________
Form Completed By:____________________

Predecessor Auditor: _______________________

Date of Interview: ____________________________


Predecessor auditor indicated no problems with the integrity of the Lakeside Management
A major problem existed between Lakeside and the predecessor auditor involving an
explanatory paragraph in the 2005 report. This uncertainty issue revolved around the
potential loss foreseen in the possible closing of one of Lakeside’s stores.
Predecessor auditor stated that the firm was discharged over the wording of the previous
audit opinion.
The predecessor auditor also mentioned weaknesses in Lakeside's internal control and
Rogers' unwillingness to improve these systems.
Predecessor auditor stated that the audit documents could be reviewed.
No limitation was indicated.

2.) If the firm of Abernethy and Chapman does seek and receive this audit engagement,
a review will be made of the working papers produced by the predecessor auditor.
Prepare a list of the specific contents that should be examined. Indicate each area that
should be reviewed and the purpose of studying these particular working papers.

ANSWER:
The auditor will perform a number of steps in reviewing the audit documents of the
predecessor auditor. The major objective is to examine the types of information that would
be available to an auditor in an ongoing engagement. Through this review, the auditor can
gain satisfaction as to the validity of beginning account balances as well as accounting
principles applied in the previous audits. By relying on the work of the predecessor auditor,
the extensive review necessary in an initial audit can be held to a minimum.

The audit working paper review should include the following steps:
Determine that satisfactory evidence has been obtained to verify beginning-of-year
balances in such accounts as inventory, land, buildings, equipment, paid-in capital, and
retained earnings.
Ascertain the specific accounting principles applied in the previous fiscal year.
Review internal control evaluations for obvious weak areas and for strengths.
Review the analysis of contingencies.
Watch for any problem areas (such as slow collection of accounts receivable) that were
singled out in the previous year.
Review the adjusting entries proposed by the auditors to determine the type and materiality
of these adjustments.

3.) Assume that Abernethy and Chapman audits Lakeside’s 1991 financial statements
and gathers sufficient, competent evidence to render an unqualified opinion without
any mention of the uncertainty. Assume further that Lakeside opts to issue
comparative statements showing figures for 1990 to 1991. Write a single audit report
that will inform the reader of both opinions, as well as the examination made by the
previous auditors.

ANSWER:

INDEPENDENT AUDITOR'S REPORT

To the Stockholders:

We have audited the accompanying balance sheet of the Lakeside Company as of


December 31, 1991, and the related statements of income, retained earnings, and cash flows
for the year then ended. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial statements
based on our audit. The financial statements of Lakeside Company as of December 31,
1990, were audited by other auditors whose report dated [give date], on those statements
included a qualified opinion because of inadequate disclosure of an impairment of value.
The impairment of value concerned the Company's investment in one of its stores.

We conducted our audit in accordance with auditing standards generally accepted in the
Philippines. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting the
amounts and disclosures in the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our audit provides
a reasonable basis for our opinion.

In our opinion, the 1991 financial statements referred to above present fairly, in all material
respects, the financial position of the Lakeside Company as of December 31, 1991, and the
results of its operations and its cash flows for the year then ended in conformity with
accounting principles generally accepted in the Philippines.

Abernethy and Chapman


Certified Public Accountants
Date: December 31, 1991
CASE 3
1.) To gain an understanding of the client's present accounting systems, the firm of
Abernethy and Chapman has a policy that all systems must be recorded in either a
memo (i.e., narrative) format or a flowcharting format. By using both, staff
members are able to achieve a better and a quicker understanding of the design of
each system.

Based on Exhibit 3-4 (a memo explanation of the Revenue Recognition section of the
Revenue and Cash Receipts cycle), prepare a flowchart to provide a graphic display
of this system. Use the flowchart symbols that appear in Exhibit 3-3.

Next, analyze Exhibit 3-5 a flowchart representation of the Cash Receipts


procedures, and prepare a written memorandum to accompany and explain this
particular system.

2.) At the firm of Abernethy and Chapman, after the memo and flowchart have been
prepared, a preliminary analysis is made of the internal control policies and
procedures found in the system. The auditor is searching for weaknesses within the
structure of the system as well as any particularly strong features that would reduce
control risk. To assist the auditor in evaluating a system, Abernethy and Chapman
utilizes the internal control questionnaire presented in Exhibit 3-6. Complete this
document based on the flowchart in Exhibit 3-5, representing the Cash Receipts
section of the Revenue and Cash Receipts cycle. Be especially careful to note any
internal control weaknesses or strengths that may be indicated.

3.) Rogers has stated that he wants the auditing firm to help improve Lakeside's
accounting systems. Exhibit 3-4 identifies the revenue recognition procedures
currently used in connection with distributorship sales. List the improvements that
could be made to this system.

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