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The purpose of the note to reflect the changes on the audit of Do-It-Yourself Inc. for the year ended December 31, 2011 because of the fire occurred on December 7, 2011. Our preliminary audit plan will be re-assessed and the following sections need to be updated.
Updated Risk Assessment:
Inherent Risk: * Because of the fire to the largest store, there is difficulty in measuring the insurance receivable, inventory value, building and other fixed assets. There is potential for contingent liabilities such as asset retirement obligations and potential lawsuits from the victims of the fire. Thus, increased difficulty and significant amount of judgment required in the audit engagement increases the inherent risk. * DIY has tight deadline to submit their audited financial statement to the bank in order to refinance the line of credit. However, as discussed in the procedure section, the additional amount of work to be performed increases inherent risk. * The inherent risk for the other 24 stores combine would not have any changes, while the largest store individually has high inherent risk. Overall impact of the inherent risk of the engagement depends on the magnitude of the burned down store, which could be potentially assessed to be high. * We would perform additional analysis on the size of the impacted store before forming a final conclusion of the overall inherent risk.
* It is discovered that DIY did not perform frequently backup and DIY does not have any disaster recovery plan in place. The lack of control in the affected store indicated that the IT controls are poor, which will increase control risk. * To ensure whether the control is effective in other stores, we would need to assess the control on data backup in the other 24 stores and judge whether it is an isolated case. If the control in all other stores are designed and operated properly, we would still rely on the control in place and not adjust our assessment of control risk for all the other 24 stores. * However, the control risk for the impacted store, i.e., the burned down store, is assessed to be high. * We would conclude on the overall control risk when the assessment is completed for the other 24 stores. Business Risk:
* Business risk of the engagement is higher because of the death and injuries caused by the fire. Though there is insurance coverage, reputation of the business will be significantly impact, which will impact its ability to achieve its objectives and obtaining the refinanced line of credit.
* Because of the deficiency of data backup and disaster recovery plan, our detection risk is increased since we may not be able to obtain enough evidence. Thus, detection risk increases * We would need to perform more testing and increase the extent of our substantive testing during the execution stage.
Overall Audit Risk:
* Overall audit risk of the engagement increased because of the significant amount of judgment required, the deficiency in the Information system and the incentive of management to meet the deadlines, risk of material misstatement is high for the burned down store. Audit risk for the impact store is higher. * Accounting staff’s tight deadline to prepare the financial statement could potentially increase the number of errors in the financial statements of the other 24 stores. The risk of material misstatement is higher as well. * Thus, overall audit will be assessed to be moderate to high.
Updated Audit Approach:
* We would need to obtain more information on the control environment of all the other 24 stores before deciding whether to perform additional substantive testing and picking more samples for the stores. * Since accounting records are available before November 7, 2011, we would need to perform both control testing (if we are planning to rely on the controls) for the previous accounting transactions, and perform purely substantive testing from November 7, 2011 to December 7, 2011.
* Since the situation for the burned down store significantly differs from the rest of the stores, we would need to separately calculate the materiality for the other 24 stores overall and the burned down store. * Since the burned down store is more risky and the amount of income is significantly different from the previous years, normalized average income after taxes for the past five years can be used as the base for the materiality of the burned down store. 5% is chose as the base, since the bank significantly relies on the financial statements to make their decision on refinancing the loan. * Materiality of the other 24 stores will be calculated using 5% of the total income after tax for the 24 stores. The base will not be impacted by the fire.
Contingent Liability: * We would need to perform additional procedures on the potential contingent liability was resulted from the fire. Since two people dead during the fire and there are other people injured during the fire, it is highly possible that DIY will be sued by the victims. * To ensure contingent liability is properly recorded and disclosed in the financial statements, we would need to review all the board meeting minutes to discover whether there is any discussion of the contingent liability * In addition, we would need to discuss with management on the possibility of the victims suing, since it is management’s responsibility to make judgment on the contingent liability. Our auditor’s responsibility is to obtain sufficient appropriate audit evidence to validate their assumptions. We also need to send legal letters to DIY’s lawyers and obtain their opinion on the contingent liability. * Before the financial statement is issued, we need to ensure that the contingent liability is properly disclosed in the notes and recognized in the financial statement if it is probable and measurable.
* There is potential going concern issue because of the potential for huge losses from the fire. Though there is insurance coverage on the burned down inventory and fixed assets, whether DIY can recover from the other losses (such as contingent liability) should be considered to evaluate management’s assumption on going concern. * We would need to discuss with management on their assumptions on the going concern, since it is management’s responsibility to closely monitor the indications on going concern and make a reasonable judgment. Our auditors’ responsibility is to assess their assumptions and ensure the financial statements are presented and disclosed based on reasonable assumptions. * As auditors, we would need to closely monitor other indications (such as the potential lawsuit and refinance of the loan) and be updated on the issue. If DIY will not be able to obtain the line of credit to do their business or other pervasive issues exists, we would need to ensure management properly record the impact and disclose it in the financial statement.