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External Auditing Case Study

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Question 1

AS 1005. 02: Independence

As stated in this auditing standard, auditors are required to review client’s financial report without bias, since they, representing public interest, should provide reasonable assurance that financial reports are free from material misstatement. But in this case, after knowing “Medicis’s reliance on the exchange exception and concluding that the exchange exception did not support Medicis’s use of replacement cost”, E&Y’s patterners and E&Y personnel(quality review team) applied another accounting rationale to explain company’s improper accounting method instead of  documenting this inconsistent with GAAP (PCAOB Release No. 105-2012-001, p. 12-13). Their behaviors seem to perform audit on the basis of client's interest. Therefore, it is reasonable to doubt that E&Y patterners and personnel may negotiate with Medicis’ management to cover up the improper method. The external auditors may breach of the requirement of independence in order to pursue secret financial benefits.

AS 2405. 05; AS 2405. 09; AS 2405. 11: Illegal Acts by Client

According to AS 2405. 05, if auditors judge relevant laws and regulations to have " a direct and material effect on the determination of financial statement amounts", then they will apply AS 2405 to clients' illegal activities. In Medicis’ fraud, Medicis used the exchange exception to SFAS 48 as legal support of estimating reserve of returns at replacement cost. However, their customers who were resellers did not concur with “ultimate customers”(PCAOB Release No. 105-2012-001,  p. 10-11). Therefore, Medicis violated the GAAP, a principle which is the fundamental instruction of public firm's accounting method. Just as AS 2405. 05 required, E&Y should have considered Medicis' violation of GAAP as an illegal act.

Besides, standard AS 2405. 09 illustrates specific situations relevant to concerns of illegal acts that include “Violations of laws or regulations cited in reports of examinations by regulatory agencies that have been made available to the auditor” E&Y should have identified client’s illegal acts.

Moreover, AS 2405. 11 required necessary additional audit procedures such as examining supporting documents etc. that should be implemented during the audit process. But E&Y only "accepted the analogy to warranty accounting" rather than perform any substantive analytical procedures described in this standard. As the result, E&Y failed to follow this requirement with professional skepticism.

AS 1105: Audit Evidence

According to AS 1105, external auditors should gather quality audit evidence that is both appropriate and sufficient. Moreover, this standard also emphasizes that when using information produced by the company, auditors should "test the accuracy and completeness of the information and evaluate whether the information is sufficiently precise and detailed." But after questioning Medicis’ new estimation methodology of return reserve estimation, E&Y  did not test both the sufficiency and appropriateness of management's explanation. The management had incentive to inflate net income by decreasing the amounts of return reserve, so their explanation about the estimation method is not reliance. E&Y should gather more appropriate evidence to form their audit opinion instead of relying on one-source evidence(consultation with management). For example, they may consult other GAAP specialists who can help them determine the appropriateness of returns reserve estimation.

AS 1015. 07-09: Due Professional Care in the Performance of Work

According to this part, “due professional care requires the auditor to exercise professional skepticism” To be specific, auditor should not “be satisfied with less than persuasive evidence because of a belief that management is honest” By  performing AQR program, E&Y actually identified the appropriateness of Medicis’ reliance on the exchange exception to SFAS 48(PCAOB Release No. 105-2012-001, supra, pp. 12). Although E&Y held Product returns consultation to gain detailed explanation, they failed to consider whether “the analogy to warranty accounting” explained by Medicis was sufficient and appropriate enough for quality audit evidence with professional professionalism.

Question 2

Through investigating this case, I learned the importance of characteristic of audit evidence mentioned in Chapter 6. To support audit opinion, auditors should obtain quality audit evidence that is sufficient and appropriate(Johnstone et al., 2018). In this case, the main driven force behind expressing inappropriate audit opinion when the financial statements are materially misstated is that E&Y did not consider the appropriateness and efficiency of management's explanation. E&Y should have realized that Medicis’ management may manipulate their financial report, since, in 2007, Medicis continued to change their estimation method of sales returns reserve estimate. This abnormal situation could have alarmed auditors that explanation by management is not reliance and that more assessments of this explanation are needed. Moreover, E&Y failed to gather substantive evidence other than management's explanation to meet the requirement of sufficiency. Even though the risk of material misstatement in Medicis is high, if they planning more substantive analytical procedures and tests of details, the detection risk will go down.

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