McCartney Plastics has been an audit client of Belcor, Rich, Smith & Barnes (BRS&B), chartered accountants, for several years. McCartney Plastics was started by Evan McCartney, who owns 51% of the company's issued share capital. The balance is owned by about 20 shareholders, who are investors with no operational responsibilities. McCartney Plastics makes products that have plastic as their primary material. Some are made to order, but most products are made for inventory. An example of a McCartney-manufactured product is a plastic chair pad that is used in a carpeted office. Another is a plastic bushing that is used with certain fastener systems.

McCartney has grown from a small two-product company, when it first engaged BRS&B, to a successful diverse manufacturer. At the time Randall Smart of BRS&B became manager of the audit, annual sales had grown to $20 million and profits to $1.9 million. Historically, the company had presented no unusual audit problems, and BRS&B had issued an unmodified audit opinion every year. The audit approach BRS&B always used on the audit of McCartney Plastics was a 'substantive' audit approach. Under this approach, the in-charge auditor obtained an understanding of internal control as part of the risk assessment procedures, but control risk was assumed to be at the maximum (100%). Extensive analytical procedures were carried out on the income statement, and unusual fluctuations were investigated. Detailed audit procedures emphasised balance sheet accounts. The theory was that if the balance sheet accounts were correct at year-end and had been audited as of the beginning of the year, then retained profits and the income statement must be correct.

Part I

In evaluating the audit approach for McCartney for the current year's audit, Smart believed that a substantive approach was certainly within the bounds of auditing standards but was really only appropriate for the audits of small companies. In his judgment, McCartney Plastics, with sales of $20 million and 56 employees, had reached the size where it was not economical, and probably not wise, to concentrate all the tests on the balance sheet. Therefore, he designed an audit program that emphasised identifying internal controls in all major transaction cycles and included tests of controls. The intended economic benefit of this 'reducing control risk' approach was that the time spent testing controls would be more than offset by reduced tests of details of the balance sheet accounts.

In planning tests of inventories, Smart used the audit risk model included in Australian auditing standards to determine the number of inventory items BRS&B would test at year-end. Because of the number of different products, features, sizes and colours, McCartney's inventory consisted of 2450 different items. These were maintained on a perpetual inventory management system that used a relational database. In using the audit risk model for inventories, Smart believed that an audit risk of 5% was acceptable. He assessed inherent risk as high (100%) because inventory, by its nature, is subject to many types of misstatements. Based on his understanding of the relevant transaction cycles, Smart believed that internal controls were good. He therefore assessed control risk as low before performing tests of controls. Smart also planned to use analytical procedures for tests of inventory. These planned tests included comparing gross profit margins by month and reviewing for slow-moving items. Substantive tests of details would include tests of inventory quantities, costs, and net realisable values at an interim date two months before year-end. Cutoff tests would be done at year-end. Inquiries and analytical procedures would be relied on for assurance about events between the interim audit date and financial year-end.

REQUIRED

a. Decide which of the following would likely be done under both a 'reducing control risk' approach and a 'substantive' approach:

(1) Assess acceptable audit risk.

(2) Assess inherent risk.

(3) Obtain an understanding of internal control.

(4) Assess control risk at less than 100%.

(5) Perform analytical procedures.

(6) Assess planned detection risk.

b. What advantages does the 'reducing control risk' approach Smart plans to use have over the 'substantive' approach previously used in the audit of McCartney Plastics?

c. What advantages does the 'substantive' approach have over the 'reducing control risk' approach?

Part II

The engagement partner agreed with Smart's recommended approach. In planning the audit evidence for detailed inventory tests, the audit risk model was applied. Although the planning went well, the actual testing yielded some surprises. When conducting tests of controls over acquisitions and additions to the perpetual inventory, the staff person performing the tests found that the exception rates for several important controls were significantly higher than expected. As a result, the staff person considered internal control to be weak, supporting a much higher control risk rather than that used in the audit plan. Accordingly, the staff person 'reworked' the audit risk model. Because planned detection risk still seemed to the staff person to be in the 'moderate' range, he recommended no increase in planned sample size for substantive tests and no change in other substantive tests.

REQUIRED

Do you agree with the staff person's revised judgments about the effect of tests of controls on planned substantive tests? Explain the nature and basis of any disagreement.