ACCT Audit Presentation

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Appendix K1

Young Fashions: Understanding of Entity and Its Environment

This appendix is nonauthoritative and is included for informational purposes only.

Observations and Suggestions

You are required to obtain an understanding of your client and its environment. Not only does this understanding allow you to identify and assess risks of material misstatement, it also allows you to exercise informed judgment about other audit matters such as

materiality, performance materiality, and tolerable misstatement.

whether the client's selection and application of accounting policies are appropriate and financial statement disclosures are adequate.

areas where special audit consideration may be necessary, for example, related party transactions.

the expectation of recorded amounts that you develop for performing analytical procedures.

the design and performance of further audit procedures.

the evaluation of audit evidence.

Your understanding of the client encompasses the following aspects of the clients business:

External factors

The nature of the client, such as its operations and organizational structure

The clients objectives and strategies and resulting business risks

How management measures and reviews the entity's financial performance

The clients internal control

This appendix illustrates an example form and the documentation of your understanding of all of these elements, except for internal control. Appendixes K2, K21, K3, and K4 illustrate the documentation of the understanding of internal control at both the entity and activity level, including an understanding of IT controls.

This example assumes that the auditor will carry forward audit evidence regarding controls that was obtained in previous audits. When audit evidence is carried forward in this manner, you should perform procedures to determine that the audit evidence remains relevant for the current audit. This example illustrates how you might document the procedures performed to update audit evidence from a prior period as well as the results of those procedures.

Some of the procedures performed to update the understanding of the entity involve inquiries of company management. As a matter of audit efficiency, you may wish to make inquiries of management about the risks of fraud (as required by AUC section 240, Consideration of Fraud

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in a Financial Statement Audit [AICPA, Professional Standards]) when making inquiries to update your understanding of the entity and its environment.

One of the primary objectives of obtaining an understanding of the entity and its environment, including internal control, is to identify risks of material misstatement. This example illustrates how you might document identified risks of material misstatement. These risks of material misstatement have been crossreferenced to appendix K5, which illustrates how you might document your assessment of the risk of material misstatement

All information that appears in this font style illustrates information completed by the auditor.

Instructions for Preparation

This form documents the procedures performed and understanding obtained about the following aspects of your client's business:

External factors

The nature of the client

The client's objectives and strategies and resulting business risks [principle 6 and principle 7]

How management measures and reviews the entity's financial performance

Part I of this form is divided into four segments, which correspond to these items. Within each segment are three parts:

Understanding obtained in prior engagements. This part presents your understanding of the client that has been carried forward from previous engagements

Procedures performed. This part documents the risk assessment and other procedures you performed to determine that your understanding from the prior period remains relevant in the current period.

Changes in the current period. This part documents changes at the client or in its environment that you identified while updating our understanding. [principle 9]

Part II of the form is the documentation of planning analytical procedures. These procedures also provide audit evidence supporting your understanding of the client and its environment.

Your understanding of the client and its environment may lead you to identify risks of material misstatement. Part III of this form summarizes the risks of material misstatement identified in other parts of the form.

Part I

Understanding the Entity and Its Environment

Overview of the Client

As part of our client acceptance and continuance procedures, we updated the general understanding of the client obtained in prior years.

Understanding Obtained in Prior Engagements

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Young Fashions is a privately held company that designs and sells men's and women's apparel. The company has two distinct brands: J Young Couture, which is a highend, fashion forward line, and JY Sport, which provides more casual wear. The company sells it lines through department stores and clothing stores and also operates a small chain of its own retail outlets.

The company does not manufacture its own garments, but instead outsources the manufacturing to third party suppliers located in Asia and Europe. In most cases, Young owns the goods at the manufacturer. See inventory system documentation [not included in this illustration]. The company is owned by the Young family and is run by the children of its founder.

In the prior year the Company recorded all adjustments proposed by the auditor. In prior periods the auditor communicated the lack of IT security and the need for an IT director as material weaknesses. The company indicated these issues would be addressed in the current period.

Written Understanding.

See Engagement Letter [not included].

Procedures Performed to Update our Understanding

We performed the following procedures to assess the continued relevance of the audit evidence obtained in previous engagements and to identify changes in the nature of the client’s overall business. This included a review of the client’s assessment of changes in risks as well as our independent assessment of this factor. [principle 9]

See Client Continuance Form (also includes procedures performed) [not included].

Changes to Our Understanding in the Current Period

As a result of performing the procedures indicated, we noted the following changes in the company's overall business that have occurred since the prior engagement and that may affect the current period audit.

The company hired an IT director during the year and security controls have been strengthened over the year, although they may not have been effective for the entire year. For further detail, see the Internal Controls documentation (reference).

Observations and Suggestions

The remaining part of this appendix is divided into four segments, each one relating to different aspects of the company and its environment (for example, external factors, nature of the client, and so on).

Each of these segments is further divided into the following parts:

Understanding obtained in prior engagements

Procedures performed to update the understanding obtained in the prior engagement

Changes to the understanding of the client's business from the prior engagement

This organization scheme follows the process for updating your understanding of the client's business from prior engagements, which is discussed in more detail in paragraphs 3.130–.142 of this guide.

External Factors

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In obtaining our understanding of the apparel industry and other external factors affecting the client, we considered the following matters:

Industry conditions

Regulatory environment

Government policies affecting the conduct of the client's business

Other external factors that affect the client's business

Understanding Obtained in Prior Engagements

The men's and women's apparel industry is extremely competitive, and no one brand dominates market share. J Young Couture and JY Sport are smaller players in the industry and are considered a niche brand. The competition for market share, together with the constant availability of discounted garments available over the Internet (for example, eBay and a variety of discount retailers) create a consistent downward pressure on prices.

The industry is quite seasonal, tracking with the four seasons. Most designers release two collections per year, spring/summer and fall/winter. The end of each season is marked by significant markdowns by the company's customers in order to move inventory and prepare for the new season. Within the retail industry, these endofseason markdowns are partially paid for by the supplier (Young Fashions). Once the amount of the markdown is determined, an allowance is calculated which is used to offset the amounts due the supplier (Young Fashions).

The company's year end is December 31. By that date, all winter merchandise has been shipped and most has been paid for, although markdowns will still be coming in January, February, and March (see working paper XXX for the audit of this estimate). The December 31 year end means there will be lower inherent risk for the yearend shipping and sales cutoff, since the winter line has mostly been shipped and the spring line is not yet ready to be shipped. There is some production of spring season merchandise at December 31, and there might be shipments between the vendor and the manufacturer or between the manufacturer and the company warehouse. These are not extensive since many of the vendors and manufacturers close the last week of the year.

Since the early 19X0s, very few U.S. apparel companies have manufactured their own garments, and Young Fashions is no different. Suppliers generally are located in Europe (predominately Italy) and Southeast Asia (Malaysia, Hong Kong, and China).

Technology and IT systems play an important part in the industry. Customers may stock out of items and need new shipments; raw materials must be shipped to thirdparty manufacturers; finished goods must be shipped to the company warehouse or direct to customers; and customer orders must be managed. To remain competitive, companies in this industry have IT systems capable of managing all aspects of operations. Larger retailers also require their suppliers (for example, Young Fashions) to meet certain guidelines, which include supplier IT systems that integrate with the retailer's inventory and purchasing functions. Among other things, this integration provides the supplier with information about inventory balances and sales by product, which is important for estimating endofseason markdowns.

The use of offshore suppliers is regulated and subjects the company to certain laws and taxes. Changes in the regulations, such as tariffs, can have a significant effect on company business. Offshore suppliers also subject the company to a variety of federal and state taxes.

Some business practices that are standard in Europe or Southeast Asia may be viewed as exploitive or unethical in the United States. Issues such as employee working conditions may cast the company in an unfavorable light and hurt its brand.

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Procedures Performed

We performed the following procedures to assess the continued relevance of the audit evidence obtained in previous engagements and to identify changes in external factors affecting the client:

Discussion with Jane Young Ching (8/15), Josh Young (8/15), and Bob Maguire, Operations Manager (8/22)

Read memo dated February 10, 20X4 from Bob Maguire, Operations Manager, and Barry Gregg, Sales Manager, to Young Fashions' customers, "Current Weather Problems in Malaysia"

Read article "Begnini Makes Good on Promises to Labor," The Economist, April 8, 20X4

Tracked monthly conversion rate of euro vs. U.S. dollar (see working paper XX) [not included in this guide]

Reviewed the Young fashion website

Searched on Internet for relevant articles in Apparel News

Read report of CS Inc. (stockbroker) on apparel industry

Read annual reports for key customers

Changes to Our Understanding in the Current Period

As a result of performing the procedures indicated, we noted the following changes in external matters that have occurred since the prior engagement and that may affect the current period audit:

Decline in the dollar versus the euro has resulted in increased prices for finished goods and piecework performed in Europe. Recent elections in Italy and changed political climate have resulted in increases in wages paid to employees, increasing prices for Italian goods.

Amalgamated Federated acquired BergmanGoodall luxury department store during the year, continuing a general industry trend toward consolidation.

Unusually long and harsh monsoon season in Southeast Asia severely disrupted shipping to and from Asian suppliers.

Nature of the Client

In obtaining our understanding of the client and other internal factors, we considered the following matters:

Business operations

Investments

Financing

Financial reporting

Understanding Obtained in Prior Engagements

The company has been in business for over 50 years and has been a client of our Firm for 10 years. It was founded by Joseph Young (who died 5 years ago) and is now owned and managed by his children, Josh and

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Jane, who each own 30 percent of the company. Mr. Young's widow owns 20 percent and is not active in the business. Trusts for various grandchildren own the remaining 20 percent.

The company's main wholesale customers for the J Young Couture line are: NewmanMacLachlin, and Bernard's (a wholly owned subsidiary of Amalgamated Department Stores). The main wholesale customer for JY Sport is Amalgamated Department Stores, which includes Ford & Mailer, Mandelbaum's, Grosvernor's, and Daniel Fleisher's.

All the company's products are manufactured by independently owned, foreign manufacturers under long term contracts. The company has two basic approaches to production:

Purchase finished goods. Young Fashions buys finished products from the supplier, who is responsible for the purchasing and carrying of raw materials, in addition to the manufacture of the product.

Cut, make, and trim. Young Fashions buys raw materials and piece goods and then moves these to finished product assemblers who send the product to Young's warehouse or directly to the customer. The ending inventory is expected to be about 40 percent purchased finished goods, 40 percent finished goods under the cut, make, and trim program, 10 percent raw materials, and 10 percent work in progress at the assemblers.

The company has two warehouses, one in San Diego and another in Philadelphia. As a way to prevent costly "stock outs," the company maintains a high level of "basic" products, such as shirts and blouses. Customers can order these products at any time, and they will be shipped within five business days.

The company does not undertake any research and development in the traditional sense of the term. However, they actively search for new fabrics for their designs.

The company owns its own headquarters. It finances its inventory and other operations primarily through cash and a revolving line of credit, secured by receivables and inventory.

Procedures Performed

We performed the following procedures to assess the continued relevance of the audit evidence obtained in previous engagements and to identify changes in the nature of the client:

Discussion with Jane Young Ching (8/15), Josh Young (8/15), Lori Feldman, Finance Manager (8/16), and Bob Maguire, Operations Manager (8/22)

Changes to Our Understanding in the Current Period

As a result of performing the procedures indicated, we noted the following changes in the nature of the client that have occurred since the prior engagement and that may affect the current period audit:

As a result of its acquisition by Amalgamated Federated, BergmanGoodall is now a major customer of Young Fashions. This company has a strong balance sheet but is known in the industry as being a tough negotiator on returns, disputes, and markdowns. We will address this issue in our tests of markdowns.

In June, the company hired a fulltime IT director, Robert Haner. (Previously, the function was performed by Lori Feldman, Finance Director, and one IT assistant. Most IT functions were outsourced.)

Company is considering changing suppliers for some goods from Italian companies to those located in Romania or Poland.

Objectives, Strategies, and Business Risks

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In obtaining our understanding of the client's objectives, strategies, and related business risks, we considered the following matters:

How the entity addresses industry, regulator, and other external factors that affect it

Effects of implementing a strategy, including any effects that will lead to new accounting requirements

Understanding Obtained in Prior Engagements

The company's main objectives are [principle 6]

continued growth.

repositioning of the brand as a valuepriced luxury brand, competing against other luxury brands (for example, Giorgio Pirandello, Bosch, L'Estrada) on the basis of price. This positioning is different from its traditional position as a high quality, bridgeline brand competing against other bridgeline brands (Barry Ferris, Brutini, Amy Thomas).

The main strategies for achieving these objectives include

expanding the line of women's and men's wear across the J Young Couture line, which generally has higher margins than the JY Sport line.

expanding its retail outlet network.

deemphasizing sales to Amalgamated Federated to concentrate more on the luxury retailers (although still selling to Amalgamated Federated).

maintaining a high quality IT system as a way to decrease the long lead time between the design of new garments and their sale. Decreased lead times allow the company to be more responsive to customers, reducing endoftheseason markdowns and inventory carrying costs.

The main business risks associated with the company's strategies include [principle 7]

there are fewer customers for the J Young Couture line than for the JY Sport line. Additionally, couture customers tend to be more loyal to their longtime brands, creating a barrier for expanding into this market.

marketing costs for luxury brands are higher than the marketing for bridgeline brands. Additionally, competing successfully against other luxury brands will require significant image marketing.

Amalgamated Federated is one of the company's main customers, and there is the risk that increased income from sales to luxury retailers will not offset any decrease in income from sales to Amalgamated Federated.

constant upgrading of IT systems carries the risk that the new systems will not work as planned, will take longer than expected to implement, or will cost more than anticipated.

Company Responses: The company has developed the following strategies and controls or dealing with these risks: [principles 4, 10]

Hired a new IT director to attempt to reduce the IT systems risks

Changed the commission structure to offer higher commissions for sales of the Couture line

Significantly increased the advertising budget and the coCEOs review the results of advertising

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CEO meetings with key customers

Procedures Performed

We performed the following procedures to assess the continued relevance of the audit evidence obtained in previous engagements and to identify changes in the client's objectives and strategies and related business risks:

Discussion with Jane Young Ching (8/15), Josh Young (8/15), Robert Haner, IT Director (8/24), and Bob Maguire, Operations Manager (8/22)

Read letter from Josh and Jane dated 5/17/03 announcing launch of women's accessory line for spring/summer to its customers

Read minutes of quarterly Board of Directors Meeting, 1/20, 7/18 and 9/05

Changes to Our Understanding in the Current Period

As a result of performing the procedures indicated, we noted the following changes in the client's objectives and strategies and the related business risks that have occurred since the prior engagement and which may affect the current period audit [principle 9]:

Upgraded versions of order management application.

Added a midrange AS 400 computer to its configuration.

Working to install a reportwriting application that will provide management with more and better reports to help plan operations and manage the business.

Expanded line of both men's and women's lines of J Young Couture. Launched a new line of women's accessories in Q4 (J Young Couture).

Have not fully integrated new accessories line with the inventory management system, which has prevented management from monitoring inventory levels for accessories sold through wholesale customers. This condition creates a risk of material misstatement of the financial statements—see part III, risk #3, for additional comments and followup.

Did not actively pursue repositioning of brand or deemphasis of sales of JY Sport to Amalgamated Federated, due to higher labor and materials costs for Italian goods.

Measurement and Review of Financial Performance

In obtaining our understanding how management measures and reviews the entity's financial performance, we considered the following matters:

Key ratios and operating statistics

Key performance indicators

Employee performance measures and incentive compensation policies

Trends

Use of forecasts, budgets, and variance analysis

Analyst reports and credit rating reports

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Competitor analysis

Periodonperiod financial performance (revenue growth, profitability, and leverage)

Understanding Obtained in Prior Engagements

Company management uses the following measures to monitor the company's financial performance:

Cash on hand, receivables, and payables. This gives management a quick assessment of liquidity.

Total inventory balance. These balances will fluctuate depending on the season. Total receivables plus inventory compared with loan balance—these assets are pledged as collateral for loan. Loan agreement requires receivables and inventory to be at least twice the loan balance at end of each month.

Budget to actual comparisons for sales and gross margins by product line and for the company as a whole, operating expenses, net income, cash on hand, receivables and payables.

Sales, gross margins, inventory turnover, and receivables by product line. This is a primary measure of company performance. It is used to determine whether Company is meeting its financial goals. Markdowns and other credits are monitored by product line, since this is a risk area.

Sales by product line by customer. Report provides information on sales channel inventory levels, which is necessary to estimate endofseason markdowns.

Net income. Also used as the internal primary measure of company performance.

Note: Data in most reports is summarized at a highly aggregated level. See evaluation of entitylevel controls (appendix K2) for further consideration.

Procedures Performed

We performed the following procedures to assess the continued relevance of the audit evidence obtained in previous engagements and to identify changes in the way management measures and reviews the entity's financial performance:

Discussion with Jane Young Ching (8/15), Josh Young (8/15), Barry Gregg, Sales Manager (8/16), and Lori Feldman, Finance Director (8/16).

Read minutes of quarterly Board of Directors meetings: 1/20, 5/05, 7/18 and 9/05.

Read the following reports: Quarterly financial statements for quarters ended 6/30 and 9/30; quarterly budget to actual worksheets for 6/30 and 9/30; Sales Analysis Report 6/30 and 9/30.

Email thread from Barry Gregg, Sales Manager, to Bret Jensen, Salesman, and Lori Feldman, Finance Director; subject: "second quarter results." Thread was started 7/12 and asks for explanation of variances between budget and actual for sales to NewmanMacLachlin.

Changes to Our Understanding in the Current Period

As a result of performing the procedures indicated, we noted the following changes in management's measurement and review of the company's financial performance that have occurred since the prior engagement and that may affect the current period audit:

Management is monitoring companywide technology expenditures and marketing costs by product line

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Other reports that management will receive with new reporting application include

orders from customers, by customer and product line. This helps develop expectations of sales for the next month and also alerts management to possible stock outs.

supplier reports. These reports show orders placed with suppliers, the status of shipments, the amounts paid and owed.

sales, gross margins, and receivables by customer.

Part II

Planning Analytical Procedures

Observations and Suggestions

The information you obtain by performing risk assessment procedures will help you perform more effective analytical procedures in planning the audit. This information about the client and its industry can help you form an expectation and then determine whether actual results are consistent with that expectation.

In this example, the auditor used the client's budget for 'X4 as a basis for the expectation, which was then compared to actual results. Significant differences between expected and actual amounts were discussed by management and will be tested during the audit. When analytical procedures are used as risk assessment procedures, these differences can help identify risks of material misstatement. They also may confirm or disconfirm information obtained through other procedures, such as inquiry.

For example, through inquiry and other procedures (as described in part I) the auditor learned that labor and materials costs for the J Young Couture line increased significantly during the year. The results of the analytical procedures confirmed this understanding. Had the analytical procedures indicated that labor and materials costs for J Young Couture were comparable to prior years, amounts, this difference between the expected trend and that reported by the client could indicate a risk of material misstatement.

Overall Company (in thousands)

Budgeted YearEnd Reported Amounts 20X4 20X4 20X4

Wholesale sales, net

(basis of analytical expectation)

(estimated from 3rd quarter results) Actual

J Young Couture 41,000 $35,063 27,597 JY Sport 68,000 70,126 70,965 Total wholesale sales 109,000 105,189 98,562 Retail sales, net 7,000 9,220 4,436 Total sales, net 116,000 114,409 102,998 Cost of goods sold J Young Couture 16,000 16,830 11,591 JY Sport 38,000 37,868 39,111 Retail 3,000 4,942 2,301 Cost of goods sold 57,000 59,640 53,003

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Budgeted YearEnd Reported Amounts 20X4 20X4 20X4 Gross profit 52,000 54,769 49,995 Marketing 12,000 10,414 8,025 General and administrative 26,000 30,989 28,460 Income from operations 14,000 13,366 13,510 Provision for income taxes 4,000 4,867 5,066 Net income 8,000 $ 8,499 8,444 Cash and cash equivalents 11,000 $ 15,538 13,008 Accounts receivable, net 34,000 35,988 32,902 Inventory 31,000 32,920 32,072 Other assets 9,000 9,757 9,354 Total assets 85,000 $ 94,203 87,336 Current liabilities 21,000 $ 24,930 22,886 Longterm liabilities 14,000 14,752 15,763 Total liabilities 35,000 39,682 38,649 Stockholder's equity 50,000 54,521 48,687 85,000 $ 94,203 87,336

Inventory Levels by Product Line

Year J Young Couture JY Sport Yearend inventory balance $ 12,688 $ 19,384 X3 Percentage of total inventory

balance 40% 60% Inventory turnover 2.2 3.7 Yearend inventory balance $ 20,752 $ 12,168 X4

(3rd Q estimate)

Percentage of total inventory balance

63% 37% Inventory turnover 1.7 5.8 Yearend inventory balance 13,000 18,000

Budget

(basis for expectation)

Percentage of total inventory balance

42% 58% Inventory turnover 3.2 3.8

Note: We based expectations primarily on the X4 budget. See XXX for an understanding of the budget process and our walkthroughs of that process.

Analysis

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Overall Company

J Young Couture sales were budgeted for a significant increase over previous year. Actual sales were less than budgeted, though still 30 percent greater than the prior year. Because of significant changes in the cost of Italian labor and supplies, the division spent much of the year finding alternative, cheaper sources, which resulted in a lack of resources to pursue the repositioning of the brand. Because of this lack of marketing, JY Sport sales were flat. This change in product mix is consistent with the company's strategy of improving couture sales by expanding the line and introducing a new line of women's accessories products.

Retail sales increased by approximately $5 million (100 percent). Approximately $3.5 million was due to women's accessory line. The company also increased its sales of J Young Couture due to expanded product line which accounted for the remaining difference.

Margins on J Young Couture decreased from 58 percent in X3 to 52 percent in X4. Expected margins for X4 were expected to increase to 60 percent as a result of repositioning the brand. This variance from expected results is attributable to higher labor costs in Italy, which is the source for nearly all of the J Young Couture products. During the audit, we will quantify the cost increase in Italy and determine whether it accounts for all the difference.

Margins for JY Sport line remained relatively constant at approximately 55 percent, which is in line with expected margins and consistent with historical levels. JY Sport is manufactured in Southeast Asia using fabric from Hong Kong—not affected by Italian price increases.

Increase in marketing costs due to launch of new accessory lines and expanded marketing efforts of J Young Couture.

Increases in cash, receivables, and inventory commensurate with increase in sales. However, these amounts were not consistent with the budget. To be investigated—see XX.

Inventory

Relative inventory levels of J Young Couture varied significantly from anticipated levels. Inventory turnover was significantly less than budget. These variances are due to

higher labor costs for Italian goods.

significant decrease in inventory levels for JY Sport items.

The effect will be further measured during the audit—See XX.

For JY Sport, the company still has not been able to restore its inventory levels to normal levels after the disruption in the manufacture and shipping of goods from Southeast Asia (caused by unusually difficult monsoon season). This decrease in inventory levels has resulted in lower sales and a higher inventory turnover rate.

Subsequent to yearend this information will be updated for actual '03 amounts.

Part III

Summary of Identified Inherent Risks

Observations and Suggestions

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This section of the form summarizes the inherent risks identified in parts I and II. You should assess all identified inherent risks so you can develop an appropriate audit response.

The inherent risks #1 and #3 in following table have been carried forward to appendix K5, where they will be assessed with all other identified risks of material misstatement (which in this example, have been identified in appendixes K2, K3, and K4). Because this example focuses only on sales transactions, risk #2 and the inventory part of risk #1 in following table have not been carried forward to appendix K5. However, in practice, this risk would still need to be assessed in the same manner that all other identified inherent risks should be addressed.

Relevant AssertionLevel

Risks

No. Description of Risk

Overall Fin StmtLevel Risk?

Acct. Trans or Disclosure Assertion(s) Ref.

General downward pressure on prices and endofseason markdowns may result in over or underreporting sales and receivables due to a poor estimate of markdowns owed to customers.

No Revenue Receivables

Valuation w/p XXx

Overvaluation of inventory. Inventory Cost of Sales

Valuation XXx

2 Reduced margins on J Young Couture line, combined with higher inventory balances and increase in competition for couture apparel, may result in over valuing inventory.

No Inventory and Cost of Sales

Valuation w/p XXx

3 Lack of integration of new accessories line with the inventory management system has resulted in a lack of information about inventory of accessories held by customers. Lack of information, together with lack of historical data about markdowns of this new product, may result in the inability to make a reliable estimate of markdowns for this line.

No Revenue Receivables

Accuracy Valuation

w/p XXx

Regarding controls: The previously mentioned risks are before considering controls. See referenced working papers where we consider controls in these areas and conclude on risk of material misstatement.

APPENDIX K11

Young Fashions: Audit Strategy

Observations and Suggestions

As described in paragraph 3.02 of this guide, you should establish an overall audit strategy that includes

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determining the characteristics of the engagement that define its scope.

understanding the reporting objectives of the engagement to plan the timing of the audit and the nature of the communications required.

considering the important factors that determine the focus of the audit teams efforts.

As described in paragraph 3.141 of this guide, in addition to your preliminary overall audit strategy, you also should document significant revisions to that strategy to respond to changes in circumstances. This example documents such revisions.

In addition, you should determine materiality and performance materiality. Part II of this example documents this determination for Young Fashions.

All information that appears in this font style illustrates information completed by the auditor.

Instructions for Preparation

This form documents your audit strategy, including your determination of materiality and performance materiality.

Part I of this form should be used to document your audit strategy as well as any revisions to your preliminary audit strategy. Use part II of the form to document your determination of materiality and performance materiality.

Part I—Audit Strategy

Preliminary Audit Strategy—Prepared August 31, X4

Characteristics That Define Scope of Audit Basis of reporting Generally accepted accounting

principles

Industryspecific reporting requirements None

Client locations Headquarters: Los Angeles

Warehouses: San Diego and Philadelphia

Timing of the Audit and Required Communications Reporting deadlines March 15, 20X5

Physical inventory observation December 31, 20X4

Confirmation of sales transactions December 31, 20X4

Risk assessment procedures Most risk assessment procedures will be performed at various dates in August and September and October and updated near year end.

Dates for expected communications with management and those charged with

Communications of control deficiencies and misstatements will be

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governance made during the course of the audit, letter on controls targeted for May 15, 20X5.

Factors That Determine Audit Focus High risk audit areas Revenue and receivables, including

markdowns and chargebacks

Inventory

Material locations and account balances fn 1 Inventory is kept at San Diego and Philadelphia warehouses, but all accounting is performed at headquarters in Los Angeles.

Material accounts include cash, receivables, inventory and debt.

Plans to test controls None because of weakness in IT access and security for most of X4.

Entity's use of IT and the need for an IT specialist as part of the engagement team

IT is used to process orders, track inventory, and process financial reporting information.

For major customers, company’s IT system integrates with customers IT system.

Use of IT specialist is warranted, since this is a complex IT environment.

Recent developments [See appendix K1]

Direction of Overall Inherent Risk

We believe the overall risk is overstatement of income. We based this on managements need to show growth (for example, growth in revenues) to the bankers, creditors, and customers and show profits to other owners. In addition, the bonus plan provides management with some incentives to overstate income. Accordingly, we will focus many of our tests on the risks of overstatement of income.

We did note deficiencies related to controls over spreadsheets. These deficiencies indicate misstatements are possible in either direction. Accordingly, we will test current spreadsheets for both overstatement and understatement of income. In addition, because this year was very profitable we will watch for understatement of income (the creation of excess reserves).

Subsequent Changes to Audit Strategy

Since the development of the initial overall audit strategy, the company made significant changes to its IT system, including hiring a new IT director, upgrading to a newer version of the order management system, and installation of more formal logical access controls and security. Because this is a sophisticated system, we will again include an IT specialist on the engagement team and, based on the findings of the specialist, reconsider the decision to rely on IT application controls for certain classes of transactions. In addition, we

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assessed there continued to be poor IT access and security controls for the first nine months of the year. Based on the advice of the IT specialist, we have assessed control risk for the first nine months of the year as high for all ITrelated controls. We have changed our testing approach to extensively test transactions substantively. We already do most balance sheet testing at year end. See XXX. Note: The impact of the deficiency noted for the ninemonth period may also preclude the determination of control risk for other (nonITrelated) controls as anything below high. However, for the purpose of this case study, that consideration has not been contemplated.

Part II—Determination of Materiality and Performance Materiality

Observations and Suggestions

As described in paragraph 3.06 of this guide, you should determine a materiality level for the financial statements as a whole to help you plan your audit. The determination of materiality is a matter of your informed professional judgment, which depends on a number of factors, including

the nature of the client and circumstances, such as their financial position or results of operations.

how the financial statement users use the company's financial statements. This consideration would include trends, such as profitability, key financial statement ratios, including working capital, and the potential impact on loan covenants.

After assessing the users and their likely perspective on what level of materiality might be influential to their use of the financial statements, one of the steps used to determine materiality is to apply a percentage to an appropriate benchmark, such as total revenues, net income, or net assets. In governmental entities, a measure such as expenditures may be more appropriate.

This example memorandum documents the auditor's thought process in determining the materiality for Young Fashions. In this example, the auditor has chosen to document materiality and performance materiality in a memorandum to the file.

Application of Percentage to a Benchmark

To help determine materiality for Young Fashions, we computed amounts using various benchmarks and estimates of company financial results.

Base Estimated Amount Illustrative Percentage Total revenues $ 114,000,000 0.5% 1 $ 570,000 Pretax income $ 13,300,000 7% $ 931,000 Net income $ 8,500,000 5% $ 425,000 Total assets $ 94,000,000 0.5% $ 470,000 Equity $ 54,000,000 2% $ 1,080,000 1 For some entities, auditors may consider a range based on revenues (for example, 1/2% to 1%) or expenses (for example, 3% to 5%) if these measures are the "drivers" in the business and relevant to the financial statement users' interests. Some government audit engagements may follow more tailored guidance as to a target materiality base and percentage relevant to these engagements, such as basing the audit benchmark on expenditures.

Determination of Materiality and Performance Materiality

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Observations and Suggestions

The determination of materiality is not simply a mathematical calculation or an averaging of several calculations. Rather, materiality is determined based on auditor judgment, which typically includes—but is not limited to—the consideration of calculations such as the previous one.

An important element of the determination is the consideration of the users of the client’s financial statements and how they might use them and their expectations of materiality. The base used from which to assess materiality should align with the user’s expectations and needs. In this section, the auditor describes the consideration of financial statement users and the overall thought process for determining materiality.

To illustrate the application of the guidance in the standards to this critical judgment, the documentation of the auditor thought process in this example may be more extensive and detailed than typical for such circumstances. A sentence or two identifying the users and the logic in selecting the relevant base and percentage or dollar amount may be appropriate.

In determining materiality for Young Fashions, we considered the intended users of the company's financial statements, which we believe are the following:

Lenders. The company has a revolving line of credit, secured by receivables and inventory. Restrictive covenants also must be met. See XXx.

Major customers. Most of the company's major customers annually review the company's financial statements and other business information before committing to significant purchases from a supplier such as Young Fashions.

Major suppliers also assess the company's overall financial condition to determine whether the company is capable of fulfilling their purchase order commitments, which also is a function of cash flow, working capital, and profitability.

Other owners. This group is focused on profitability.

All of these main user groups use the company's financial statements primarily to assess cash flow and, to a lesser degree, profitability. We note that as a privately held company, the owners have wide discretion over the amount of cash to distribute to owners, primarily in the form of compensation. As a result, assets, equity, and expenses may not be reflective solely of business operations but may include factors such as the owners' desire to retain or distribute cash in or from the business.

Accordingly, we determined that total revenues were the most appropriate benchmark for determining materiality as they more effectively represented business cash flows. The 0.5 percent is based on our assessment of the financial statement users and our judgment about the magnitude of a misstatement that could influence their decision making process.

Given the previously mentioned considerations, we have determined materiality for the financial statements as a whole to be $500,000, which is based primarily on revenues ($114 million), but has been reduced slightly after considering that users may also use net income as a secondary base for assessing company performance.

We will consider the low past level of audit misstatements as well as the past practice of Young to adjust misstatements and Firm policy to use PPSbased sample sizes for substantive sampling.

Based on that determination of materiality for the financial statements as a whole, we determined performance materiality to be $350,000. The amount under which misstatements are considered trivial is

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$3,500 for this engagement.

We will ask management to adjust all factual (known) misstatements and investigate and consider the effects of all judgmental and projected misstatements. In addition, the bank is especially interested in receivables and inventory since these accounts are the basis for the restrictive covenants. Thus, we will exercise care in waiving any proposed adjustments to those accounts.

We will use tolerable misstatement in determining extent of testing using PPS samples, in identifying accounts that are less than significant, and in performing substantive analytical procedures.

See appendix K5 for audit approach for revenue and receivables (after analyzing risk of material misstatement) and for overall issues of concern to the partner. See XX for audit approach for other cycles (not shown).

Footnotes (APPENDIX K11 — Young Fashions: Audit Strategy):

fn 1 This illustrative case study does not consider implications of AUC section 600, Special Considerations— Audits of Group Financial Statements (Including the Work of Component Auditors) (AICPA, Professional Standards), related to group audit considerations.