EP 6-2

1) Bellows Home Inspection seems to be getting majority of their business from

Bellows Realty. This could be considered to be related party transactions
which may increase inherent risk – the risk of misstatement in financial reports.
2) Bellows received a significant loan from the bank to acquire another business.
Nature of transaction could increase inherent risk. Control risk could also
increase as internal controls should be reviewed.
3) At time of acquisition, internal controls were non-existent. This increases
control risk
4) Difficulty in integration of Home Guards operations with Bellows Home
Inspection. Control risk may increase due to lack of internal controls
implementation.

DC 6-1

Audit risk (AR) = Inherent risk (IR) × Internal control risk (CR) × Detection risk (DR).

1) Ohlsen’s conclusion is not appropriate. Her belief of IR=0 needs to be supposed

by evidence. Since she did not see any adjustment recommended, Limberg’s
control system must be great and working well for the company. But if IR =0 then
AR=0 so no audit work needed. Without solid evidence, a PA cannot come to this
conclusion.

2) Jones conclusion is not appropriate. His belief of CR=0 needs to be backed by

evidence as well. She completed the study on Nov 30 and the fiscal year end is
Dec 31, so she has missed a month and there is a chance of material
misstatement. Control procedures can always be changed but her belief that no
material errors could slip through is not enough as a PA to conclude CR=0. If
CR=0, then AR=0.

3) If DR=0.02 then CR=1 and IR=1, AR=0.02. The risk is very small. However,
Fields gave no thought to IR and conducted a limited review of the internal
control system so he did not the complete the audit properly. Therefore the
conclusion is not appropriate.

4) It seems like there is high inherent risk and control risk compared to last year
when everything was operating smoothly.

DC 6-5 
1) Factors to consider:
a. Review financial information. Need to understand business risks,
business process,
b. Independence, ensure there is no conflict of interest.
 c. Competency, will the firm be able to perform the audit engagement.
Does it have all the resources?
2) Current Ratio- 1.6:1 and A/R turnover- 24.3 times.
Current ratio measure the company’s liability to pay short term obligations due
within one year.
A/R turnover ratio measures a company’s effectiveness in collecting its
receivables. There may be some collection delays which can result in bad
debt.
3) 5-10% normal operating income.
NIBT 1.6 million
$1.6mil @ 5%= $80,000
70% of $80,000 = $56,000 is overall performance materiality.
4) OMS planning to grow so there is chance of risk. Management preparing
statements according to GAAP standards. Assessing business risk. Low is
appropriate.
5) Geographic location, economic conditions, business risks. Expanding might be
a fail.

DC 6-6

1) Promotion: Jackie mentioned there was some trouble keeping up with

deliveries so some December sales might have been delivered after year end.
Also revenue may not have been recognized when they were earned. Need to
assess further to ensure all sales were recorded and shipped before year end.
2) Weddings: Increase net income for current year by recognizing the deposits
received for an event to take place in the next year. No-one else in the industry
follows this practice so clearly its not a standard practice and might increase
risk of material misstatement. Need to assess and evaluate control risk.
3) Organic Lunch Box- BCI is in middle of a lawsuit for misleading information.
There was no money kept aside for this lawsuit so it overstates net income.
Need to discuss further with legal counsel regarding the matter.