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

McClain has grown from a small, two-product company, when they first engaged BRS&B, to a successful diverse company. At the time Randall Sessions of BRS&B became manager of the audit, annual sales had grown to $200 million and profits to $10.9 million. Historically, the company presented no unusual audit problems, and BRS&B had issued an unqualified opinion every year.
The audit approach BRS&B always used on the audit of McClain 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 assessed at the maximum (100%). Extensive analytical procedures were done on the income statement, and unusual fluctuations were investigated. Detailed audit procedures emphasized 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 earnings and the income statement must be correct.

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.

       In planning tests of inventories, Sessions used the audit risk model included in auditing standards to determine the number of inventory items BRS&B will test at year-end. Because of the number of different products, features, sizes, and colors, McClain’s inventory consisted of 2,450 different items. These were maintained on a perpetual inventory management system that used a relational database.
         In using the audit risk model for inventories, Sessions 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, Sessions believed that internal controls were good. He therefore assessed control risk as low (50%) before performing tests of controls. Sessions 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. Sessions believed that these tests will provide assurance of 40%. Substantive tests of details will include tests of inventory quantities, costs, and net realizable values at an interim date 2 months before year-end. Cutoff tests will be done at year-end. Inquiries and analytical procedures will be relied on for assurance about events between the interim audit date and fiscal year-end.

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:

                            TDR =           AAR         
                                          IR × CR × APR

where:
                         TDR      =    test of details risk
                         AAR     =    acceptable audit risk
                         IR        =    inherent risk
                         CR       =   control risk
                         APR     =   analytical procedures risk

Therefore, using Sessions’s assessments and judgments as described previously,

                                   TDR =           .05       
                                                 1.0 × .5 × .6

                                   TDR =    .17

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:

                                   TDR =         .05        

                                                1.0 × .8 × .6
                                   TDR =   .10

Required

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