Today . . .

1. Today . . . • Three audit documents and expectations • Two audit parameters • Engagement Risk Model introduction • Case 7 • EXAM 1 discussion

2. The Audit Contract: Sample Engagement Letter Alex and Louis, CPAs, L.L.P. October 25, 1999 related information available to us, and (4) providing to us at the conclusion of the engagement a representation letter that, among other things, will confirm management’s responsibility for the . . . financial statements. Assistance to be supplied by your personnel . . . is described on a separate attachment. Timely completion of this work will facilitate the completion of our audit. Our fees will be billed as work progresses and are based on the amount of time required . . . Our initial estimate of total fees of $150,000. If this letter correctly expresses your understanding, please sign the enclosed copy and return it to us. We appreciate the opportunity to serve you. Sincerely, ___________________ Partner’s signature Alex and Louis CPAs, L.L.P. Accepted and agreed to: ___________________ Client representative’s Signature Title: _______________ Date: _______________ LJ Appliances, Inc. Iowa City, IA Dear Ms. Jo: We will audit LJ Appliances, Inc.’s financial statements of the year . . . for the purpose of expressing an opinion on the fairness with which they present, in all material respects . . . in conformity with generally accepted accounting principles. We will conduct our audit in accordance with generally accepted auditing standards. Those standards require that we obtain reasonable, rather than absolute, assurance that the financial statements are free of material misstatement, whether caused by error or fraud. Accordingly, a material misstatement may remain undetected. While an audit includes obtaining an understanding of internal control sufficient to plan the audit and to determine the nature, timing and extent of audit procedures to be performed, it is not designed to provide assurance on internal control or to identify reportable conditions. However, we are responsible for ensuring that the audit committee (or others with equivalent authority or responsibility) is aware of any reportable conditions that come to our attention. The financial statements are the responsibility of LJ Appliances, Inc.’s management. Management is also responsible for (1) effective internal control over financial reports, (2) the company complies with the laws and regulations applicable, (3) making all financial records and

3. Illustrative Representation Letter 6. The company has no plans or intentions that may materially affect the carrying value or classification of assets and liabilities. 7. The following have been properly recorded or disclosed in the financial statements: a. Related party transactions . . . b. Guarantees, whether written or oral, under which the company is contingently liable. c. Significant estimates and material concentration known to management that are required to be disclosed in accordance with the AICPA’s 94-6 . . . 8. There are no-- a. Violations or possible violations of laws or regulations whose effects should be considered for disclosure in the financial statements or as a basis for recording a loss contingency. b. Unasserted claims or assessments that our lawyer has advised us are probable of assertion and must be disclosed in accordance with SFAS No. 5. . . c. Other liabilities or gain or loss contingencies required to be accrued or disclosed by SFAS No. 5. 9. The company has satisfactory title to all owned assets, and there are not liens or encumbrances on such assets nor has any asset been pledged. 10. The company has complied with all aspects of contractual agreements that would have a material effect on the financial statements in the event of noncompliance. To the best of our knowledge and belief, no events have occurred subsequent to the balance-sheet date and through the date of this letter that would require adjustment to or disclosure in the aforementioned financial statements. Jo Anne Linda Jo Chief Financial Officer Chief Executive Officer LJ Appliances, Inc. February 10, 2000 (Date of Auditor’s Report) To Alex and Louis CPAs, LLP We are providing this letter in connection with your audit of the financial statements of LJ Appliances, Inc., as of . . .in conformity with GAAP. We confirm that we are responsible for the fair presentation in the financial statements of financial position, results of operations, and cash flows in conformity with GAAP. Certain relations in this letter are described as being limited to matters that are material. Items are considered material, regardless of size, if they involve an omission or misstatement of accounting information that, in the list of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would be changed or influenced by the omission or misstatement. We confirm, to the best of our knowledge and belief, as of February 10, 2000, the following representation made to you during your audit.. 1. The financial statements referred to above are fairly presented in conformity with generally accepted accounting principles. 2. We have made available to you all-- a. Financial records and related data. b. Minutes of the meetings of stockholders, directors, and committees of directors . . . 3. There have been no communications from regulatory agencies concerning noncompliance with or deficiencies in financial reporting practices. 4. There are no material transactions that have not been properly recorded in the accounting records underlying the financial statements. 5. Fraud involving others that could have a material effect on the financial statements

4. Auditor’s Standard Report Report of Independent Accountants To LJ Appliances, Inc. We have audited the accompanying balance sheet of LJ Appliances, Inc., as of December 31, 1999, and the related statements of income, retained earnings, and cash flows for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of LJ Appliances, Inc. as of December 31, 1999, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles. Alex and Louis, CPAs Iowa City, Iowa February 10, 2000 (responsibilities) (scope) (opinion)

5. Auditor’s Standard Report • Responsibilities – statements are management’s . . . we express an opinion based on our audit • Scope – audit according to GAAS to obtain reasonable assurance that . . . statements are free of material misstatement (test checking, assess accounting principles used and estimates) • Opinion – in our opinion, statements comply with GAAP in all material respects

6. Audit benefits • Management gets: • lower cost of capital, production, distribution • higher credibility in market place • independently benchmarked against others • Auditor gets: • audit fee • overview of corporate operations, financing, (strategy?), and inside knowledge about problems • access to CEO, CFO, corporate board • . . . and conflict between advice and audit objectivity

7. Audit Risk, Reasonable Assurance and Materiality AuR = risk of materially misstated financial statements given pass GAAS audit = 1 - Reasonable Assurance Mathematically: P( SM > M* | GAAS audit) < AuR* Practically: P( SM > .005 Rev. | GAAS audit) < .005

8. Reasonable assurance(SECPS (AICPA)) 10,000 audits per year (approximate) 100 “complaints” filed with SECPS per year 50 found to be GAAS violations 50 complaints when GAAS met GAAS audit failed to find M* when it existed AuR < 50 / 10000 = .005

9. Materiality Discovery vs. Disclosure - what size misstatement could you miss or waive and still satisfy GAAP? 5% to 10% of net income (adjusted for accounting method, small firm, losses or close to zero problem) .5% of revenue of large firm (+/- .25%) 1% of revenue of small firm (+/- .5%)

10. Management responsible for financial statements and has discretion to • choose transactions in which to engage • choose methods to account for transactions and events • choose how carefully to apply chosen methods (precision and bias of estimates and judgments) • choose to misapply methods (non-GAAP)

11. Example of judgment: AstroGamas • Holds $4 million in Trasher games ( 500K units, cost = $8, net selling price = $5 to $8 (loss up to $3) • Customers hold $7.5 million to $12.5 million Trasher • Materiality = $750,000, based on Net Income and Sales • Lower of cost or market correction (adj.) needed? Others say: $0 to $1,500,000 write down needed for GAAP Actual = f(contract, auditor reputation, ERM . . . auditing standards)

12. Five Common Conditions Accompanying Management Misrepresentation Fraud 1. Overstate revenues (including early recognition) 2. Understate expenses (including delayed recognition, non-recognition of obsolescence or impairment, and accounting estimate manipulation) 3. Accounting method changes that increase current year earnings and net assets 4. Declining business prospects for the industry (need accounting manipulation to maintain earnings trends) 5. Management compensation based on accounting measures (personal motivation for misstatement)

13. The Auditor’s Engagement Risk (from being associated with entity as its auditor) Client Business Risk (Future decline in client performance) Audit Risk (Unknowingly certify material misstated financial statements) Auditor’s Business Risk (Management fraud, lawsuits, reputation loss, client noncompliance) Note: GAAS and GAAP measurement and disclosure criteria apply.

14. Auditor Business Risk (ABR) Assess Management Integrity and Context ABR Acceptable ? No Resign/ Decline engagement Yes Client Business Risk (CBR) Assess Strategy Viability and Risks CBR Acceptable ? No Advise client/ Resign engagement Yes Audit Risk (AuR) Assess OR and Conduct Auditing Procs. Resign/ Issue modified audit report AuR Acceptable ? No Yes Issue Standard (Three Paragraph) Audit Report Engagement Risk Approach to Financial Statement Audits

15. Valuation using Net Income review: P/E ratio = earnings multiple = Price12/00 / Net Income00 = 1 / cost of equity capital = 1 / k = S ( 1 + k )n n Price12/00 = earnings multiple x Net Income00 = (P/E) x Net Income00

16. Northern Frontier Parks, Inc. Value* = expected NI / cost of capital = $2 million / .2 = $10 million What is expected NI for 2001 through 2010? Is NI for 2000 a good approximation? * assuming GAAP for NI and no growth

17. Issues in Case 7 - NFP, Inc. • management buyout – what is it and how does it affect audit and risks? • relevance of GAAP and 2000 for valuation of the business? • what risks can a GAAS audit control? • what are audit risks for NFP 2000 audit? • what special risks for auditor/ buyer?