McClain Plastics has been an audit client of Belcor, Rich, Smith & Barnes, CPAs (BRS&B), for several years. McClain Plastics was started by Evers McClain, who owns 51% of the company’s stock. The balance is owned by about 20 stockholders who are investors with no operational responsibilities. McClain 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 McClain-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.

Part I

In evaluating the audit approach for McClain for the current year’s audit, Sessions believed that a substantive approach was really only appropriate for the audits of small nonpublic companies. In his judgment, McClain Plastics, with sales of $200 million and 146 employees, had reached the size where it was not economical, and probably not wise, to concentrate all the tests on the balance sheet. Furthermore, although McClain is not a public company, Sessions recognized that similar public companies are required by Section 404 of the Sarbanes–Oxley Act and related PCAOB standards to have an integrated audit of the financial statements and internal control over financial reporting. Therefore, he designed an audit program that emphasized 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 will be more than offset by reduced tests of details of the balance sheet accounts.

Required

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

(1) Assess inherent risk.

(2) Obtain an understanding of internal control.

(3) Perform tests of controls.

(4) Perform analytical procedures.

(5) Assess planned detection risk.

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

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

Part II

The engagement partner agreed with Sessions’s recommended approach. In planning the audit evidence for detailed inventory tests, the audit risk model was applied with the following results:

Required

a. Explain what .17 means in this audit.

b. Calculate TDR assuming that Sessions had assessed control risk at 100% and all other risks as they are stated.

c. Explain the effect of your answer in requirement b. on the planned audit procedures and sample size in the audit of inventory compared with the .17 calculated by Sessions.

Part III

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 key controls were significantly higher than expected. As a result, the staff person considered internal control to not be operating effectively, supporting an 80% control risk rather than the 50% level used. Accordingly, the staff person “reworked” the audit risk model as follows:

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. Also, describe the implications of these results on the auditor’s report on internal control over financial reporting.