Auditing A Practical Approach First Canadian Edition by Robyn Moroney, Fiona Campbell, Jane Hamilton

Auditing A Practical Approach First Canadian Edition By Robyn Moroney, Fiona Campbell, Jane Hamilton, and Valerie Warren

Email: Richard@qwconsultancy.com

Moroney, Campbell, Hamilton, Warren

Auditing: A Practical Approach, Canadian Edition

Solutions Manual to accompany

Auditing: a practical approach by

Robyn Moroney Fiona Campbell Jane Hamilton Valerie Warren

CHAPTER 1 Introduction and overview of audit and assurance

John Wiley & Sons Canada, Ltd. 2012

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Chapter 1 – Introduction and overview of audit and assurance

SOLUTIONS TO REVIEW QUESTIONS REVIEW QUESTION 1.1 LO 1 According to the CICA Handbook, an assurance engagement is an engagement where a practitioner issues a written report and concludes on a subject matter for which the accountable party is responsible. Therefore, a prerequisite for an assurance engagement is the existence of an accountability relationship, where one party is answerable to another for the subject matter (s. 5025.0304).

In the financial reporting context ‘assurance’ relates to the audit or review of an entity’s financial statements.

An audit provides reasonable assurance about the fair presentation of the financial statements, and a review provides limited assurance. The audit contains a positive expression of opinion (e.g. ‘in our opinion the financial statements are in accordance with (the Act) including giving a true and fair view…), while the review contains a negative expression of opinion (e.g., ‘we have not become aware of any matter that makes us believe that…the financial statements are not in accordance with Canadian GAAP .. including giving a true and fair view..’).

An auditor may also perform agreed upon procedures for a client, but these do not provide any assurance. The client determines the nature, timing and extent of procedures and no opinion is provided to a third-party user.

The assurance practitioner is an auditor working in public practice providing assurance on financial statements of publicly listed companies, or other entities.

Intended users are the people for whom the assurance provider prepares their report (e.g., the shareholders). The responsible party is the person or organization (e.g., a company) responsible for the preparation of the subject matter (e.g., the financial statements).

An assurer must have the knowledge and expertise to assess the truth and fairness of the information being presented by the preparers. Auditors of financial statements need to be trained accountants with detailed knowledge about the complex technical accounting and disclosure issues required to assess the choices made by the financial statement preparers. When undertaking an audit, the auditor should use professional scepticism, professional judgement and due care.

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Auditors should be independent of the client. Independent auditors have no incentives to aid the entity in presenting their results in the best possible light.

They are concerned with ensuring that the information contained in the financial statements is reliable and free from any significant (material) misstatements (error or fraud). A user needs to believe that the auditor is acting independently.

This means that not only should auditors be independent (i.e., not have any undue personal or financial incentive to protect the client), auditors should avoid doing anything that would cause a reasonable person to doubt their independence.

REVIEW QUESTION 1.2 LO 2 The arguments in favour of audit firms providing other services to their audit clients relate to the benefits to be derived by all parties. The audit firm has very detailed knowledge about the client and can use that knowledge to recommend actions or products that would suit the client’s needs. In some cases, the auditor could identify a potential problem that the client had not identified. To the extent that the audit firm uses its knowledge to provide better advice than could be provided by an external consultant, the client will benefit. Shareholders of the client and other interested parties will benefit from improvements to the client’s business. Finally, the auditors will benefit from additional revenue which can be used to subsidise the audit firm’s investments in knowledge and systems, and streamline the audit.

The main disadvantages of audit firms providing services to their audit clients relate to potential adverse effects on the auditor’s independence. The auditor could be unwilling to provide services which would reduce their audit fees or cause the client to seek another auditor. The auditor could be unwilling to criticise something to the client which was provided by their consulting division. The auditor could be ‘blind’ to potential adverse impacts on the client’s accounting systems from products and services provided by their consulting division. Even if the consulting provided unquestionable benefits to the client, the relationship between the audit firm and the client could become ‘too cosy’, and discourage the client from considering other auditors. Finally, the auditor could be reluctant to qualify the audit report for fear of losing lucrative fees from consulting services.

If this occurs, the audit is less valuable because the auditor is less independent.

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REVIEW QUESTION 1.3 LO 3 An auditor evaluates the contents of a financial statement against the standards and laws that apply to that type of financial statement. According to CAS 200 Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with Canadian Auditing Standards, the objective of a financial statement audit is for the auditor to express an opinion about whether the financial statements are prepared in all material respects in accordance with a financial reporting framework (CAS 200, para. 11). Within a Canadian context, this means that the financial statements have been prepared in accordance with Canadian generally accepted accounting principles (GAAP) and any relevant legislation, such as the Canada Business Corporations Act. Listed public companies must abide by the appropriate Corporations Act, the Canadian Institute of Chartered Accountants (CICA) Accounting Standards Board (AcSB), the Canadian Securities Administrators (CSA), and the listing rules of the public stock exchange (for instance, the TSX – Toronto Stock Exchange) and report their financial statements using IFRS. Certain companies must also abide by additional specific legislation, depending on their industry or legal status. In addition, if a company is listed in another country, foreign exchange listing rules and laws could apply to the financial statement. Private companies in Canada may report their financial statements using IFRS or Accounting Standards for Private Enterprises.

Auditing standards control the way an audit is conducted, they are not the criteria against which the financial statement is evaluated.

REVIEW QUESTION 1.4 LO 2 An operational audit (performance audit) is an assessment of the economy, efficiency and effectiveness of an organization’s operations. It can be conducted internally (by internal audit) or externally (by an audit firm) and across the entire organization or for part of an organization.

Management may request an operational audit (performance audit) of its own company (or part thereof) in order to assess the economy, efficiency and effectiveness of the organization. Ideally, the audit would identify issues that need to be addressed in order to increase the performance of the division or company. For example, the audit could examine a logistics department. It would assess the cost of running the department, the number of deliveries per input (such as labour hours, vehicle hours, etc), and indicators of delivery on time to the correct address.

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An operational audit (performance audit) could be conducted on a government department or agency as part of the process of accountability to the public.

Stakeholders of government entities are usually seen to be more interested in economy, efficiency and effectiveness than in profit, or surplus. Operational (performance) auditing can expose poor practices, or even corruption, in an organization. Operational (performance) auditing can provide information on the implementation of government policies. Regular operational (performance) auditing of government entities can help build trust between the government and the citizens.

REVIEW QUESTION 1.5 LO 2 Internal auditors are employees of the company, and therefore cannot be completely independent of the company. However, it is possible to increase the independence of the internal audit department through means such as funding, terms of reference, and lines of reporting.

A well-funded internal audit department can investigate more issues and spend more time on each investigation, potentially increasing the chance of discovering fraud and other problems. An internal audit department with a small budget is likely to have fewer staff and less qualified staff (because they will be lower paid), and will have to make compromises on the issues to be investigated.

An internal audit department with wide terms of reference has the freedom to pursue the issues which the audit staff believe are most important or create the most risk for the organization. A department with narrow terms of reference could be limited to investigating only certain matters, or must seek the approval of higher levels of management before commencing any investigation.

If the internal audit department reports to the CFO it is possible that the CFO will prevent some issues from reaching other members of the management team, or the board of directors. Often, the problems will be within the CFO’s department, creating a conflict of interest for the CFO when deciding whether to report the issue more widely. An internal audit department that reports directly to the audit committee is outside the normal lines of management and reporting. The audit committee is part of the board of directors. Therefore, reporting to the audit committee increases the chance that the highest level of the organization is aware of the problems and will approve the investigation. The audit committee also deals with the external auditor. If the internal auditor reports directly to the audit committee it can communicate the issues to the external auditor and ask them to consider them, where relevant, as part of the financial statement audit.

Not all companies have an audit committee. Where the audit committee does not exist, the internal auditor could report directly to the full board of directors.

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REVIEW QUESTION 1.6 LO 4 As defined in CAS 706 (CAS 706 (5)): Emphasis of Matter paragraph means a paragraph included in the auditor’s report that refers to a matter appropriately presented or disclosed in the financial statements that, in the auditor’s judgement, is of such importance that it is fundamental to users’ understanding of the financial statements.

The emphasis of matter paragraph is included in the audit report immediately after the opinion paragraph.

An emphasis of matter paragraph draws the attention of the reader to an issue that the auditor believes has been adequately and accurately explained in a note to the financial statements. The purpose of the paragraph is to ensure that the reader pays appropriate attention to the issue when reading the financial statements. The audit report remains unqualified and the user of the financial statements can still rely on the information contained in the financial statements (CAS 706; ISA 706).

The emphasis of matter paragraph is not used when the entity has not disclosed the issue in its report. The auditor can use an ‘other matter’ paragraph to introduce another matter that the auditor believes should be disclosed.

The usual circumstance which would warrant an Emphasis of Matter paragraph in the auditor’s report is the existence of a significant uncertainty, the resolution of which may materially affect the financial statements.

From CAS 706: A1. Examples of circumstances where the auditor may consider it necessary to include an Emphasis of Matter paragraph are: - An uncertainty relating to the future outcome of exceptional litigation or regulatory action.

- Early application (where permitted) of a new accounting standard (for example, a new Canadian generally accepted accounting principle) that has a pervasive effect on the financial statements in advance of its effective date.

- A major catastrophe that has had, or continues to have, a significant effect on the entity’s financial position.

CAS 706 stresses that the inclusion of an Emphasis of Matter paragraph in the auditor’s report does not affect the auditor’s opinion. An emphasis of matter can be included in an unqualified auditor’s report or a qualified auditor’s report (see example in CAS 706).

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REVIEW QUESTION 1.7 LO 6 The users of the financial statements issued by a large listed public company include shareholders, customers, suppliers, employees, lenders, competitors, and government agencies. They need information which will help them evaluate the future financial performance of the company (including profitability, liquidity and solvency), whether the company has overseas operations and the nature of their activities in those countries (to evaluate exposure to foreign exchange risk, risk to the company of a change in economic conditions in those countries, and whether it is apparently supporting countries with dictators), likely lack of compliance with various laws and regulations, whether the company (and its industry) need government support. Investors are concerned with the value of their investment, employees with their job security, customers with whether the company is likely to remain in business long enough to honour warranties, suppliers with whether they will be paid, lenders with the risk to their loans, competitors with the health of their rivals, and government agencies will be interested in taxes, tariffs, industry support, and economic growth.

Users of a sporting team’s financial statements are likely to be interested in the financial condition and performance of the team (its solvency) and whether it is investing in physical facilities, player payments, etc. They might be interested in whether the sporting team supports local businesses and community groups.

Although sports teams are often companies limited by guarantee and have members, the members are usually unable to trade their interest in the team.

Therefore, users of a sporting team’s financial statements are not concerned about profitability for its own sake, but whether it helps the team pay its players and expand its facilities. Creditors and lenders will be interested in the likelihood that they will be repaid. Government will be interested with sporting and community concerns.

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REVIEW QUESTION 1.8 LO 6 In addition to the auditing standards (CAS), the Canadian Auditing and Assurance Standards Board (AASB) issues Canadian Standards on Assurance Engagements (CSAE). The IAASB provides an equivalent set of ISAE. CSAE 3000 (ISAE 3000) establishes requirements and provides explanatory guidance for undertaking and reporting on assurance engagements other than audits or reviews of historical financial information covered by Canadian Auditing and Assurance Standards or Standards on Review Engagements. For example, assurance engagements regarding: • • •

Environmental, social and sustainability reports; Information systems, internal control, and corporate processes; and Compliance with grant conditions, contracts and regulations.

governance

In addition, the IAASB is currently undertaking a project on the Assurance of Greenhouse Gas Emissions (GHG). The IAASB believes that with the increasing attention given to the link between GHGs and climate change, many entities are quantifying their GHG emissions for internal management purposes, and an increasing number are also preparing a GHG statement: • As part of a regulatory disclosure regime; • As part of an emissions trading scheme; or • To inform investors and others on a voluntary basis. Voluntary disclosures may be, for example, published as a stand alone document; included as part of a broader sustainability report or in an entity's annual report; or made to support inclusion in a "carbon register."

The IAASB states that the focus of this project is on an entity's GHG statement, it does not include requirements or guidance on assuring emissions offsets. The ISAE will also likely be of assistance to financial statement auditors when considering the carrying value of emission trading rights in a financial statement audit. It is the intent of the Accounting and Assurance Standards Board (AASB) to adopt this standard. (see http://www.ifac.org/IAASB/ProjectHistory.php?ProjID=0081 for further information) The AccountAbility organization also provides guidance for sustainability assurance. AccountAbility issues AA1000AS (2008), which is an assurance standard for management, performance and reporting on sustainability issues by evaluating the adherence of an organization to the AccountAbility Principles. (see http://www.accountability.org/ for further information).

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The International Organization for Standardization (ISO) issues quality control standards in several areas. The 14000 series addresses various aspects of environmental management. These include the requirements and guidelines for environmental management systems (EMS). They also address specific environmental aspects, including labelling, performance evaluation, life cycle analysis, communication and auditing.

ISO 19011:2002 provides guidance on the principles of auditing, managing audit programmes, conducting quality management system audits and environmental management system audits, as well as guidance on the competence of quality and environmental management system auditors.

It is applicable to all organizations needing to conduct internal or external audits of quality and/or environmental management systems or to manage an audit programme.

The application of ISO 19011 to other types of audits is possible in principle provided that special consideration is paid to identifying the competence needed by the audit team members in such cases.

(See http://www.iso.org for further information).

REVIEW QUESTION 1.9 LO 8 The audit expectation gap occurs when there is a difference between the expectations of assurance providers and financial statement users. The gap occurs when user beliefs do not align with what an auditor has actually done. In particular, the gap is caused by unrealistic user expectations, such as: • the auditor is providing complete assurance • the auditor is guaranteeing the future viability of the entity • an unqualified (clean) audit opinion is an indicator of complete accuracy • the auditor will definitely find any fraud • the auditor has checked all transactions.

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The reality is that: • an auditor provides reasonable assurance • the audit does not guarantee the future viability of the entity • an unqualified opinion indicates that the auditor believes that there are no material (significant) misstatements (errors or fraud) in the financial statements • the auditor will assess the risk of fraud and conduct tests to try to uncover any fraud, but there is no guarantee that they will find fraud, should it have occurred • the auditor tests a sample of transactions.

The audit expectation gap can be reduced by: • auditors performing their duties appropriately, complying with auditing standards, and meeting the minimum standards of performance that should be expected of all auditors • peer reviews of audits to ensure that auditing standards have been applied correctly • auditing standards being reviewed and updated on a regular basis to enhance the work being done by auditors • education of the public • enhanced reporting to explain what processes have been followed in arriving at an audit (reasonable assurance) or a review (limited assurance) opinion (significant improvements have been introduced by standardsetters improving assurance reporting) • assurance providers reporting accurately the level of assurance being provided (reasonable, limited, or none).

The audit expectation gap is represented graphically in figure 1.7 of the text.

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REVIEW QUESTION 1.10 LO 7 The two main bodies that regulate auditors are Canadian Securities Administrators (CSA) and the Canadian Public Accountability Board (CPAB).

CPAB registers auditors for public companies, processes annual statements from registered auditors, enforces independence requirements and provides a whistle blowing facility for the reporting of contraventions of the appropriate Corporations Acts. CPAB conducts an audit inspection program to report on audit quality and make recommendations for continued improvement. CPAB visits a selection of firms annually to gain an understanding of their policies and procedures in relation to their independence, audit quality, methodologies and training programs.

The CPAB also responds to allegations that an auditor has breached the appropriate Corporations Act or the standards set out by the Accounting and Assurance Standards Board (AASB). The CPAB, AASOC, and AASB will be involved when it is believed an auditor has not carried out their duties properly, is not a fit and proper person, is subject to disqualification or should not remain registered for some other reason. In response, they may cancel or suspend the individual’s registration, give the individual a warning or ask them to make an undertaking to improve their conduct.

The inspection process concentrates on an audit firm’s compliance with auditing standards, and their independence and quality control systems. The process includes: - reviewing and undertaking limited testing of the firm’s independence and quality control systems - interviewing the leaders of the audit firm, human resources personnel and selected partners and staff - examining the firm’s audit methodology for compliance with auditing standards - reviewing the conduct of aspects of selected audit and review engagements.

The program finishes with an exit meeting and CPAB sends the audit firm a confidential report of their findings. CPAB publishes a public report summarising all their findings.

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CPAB - Practice Inspections • In accordance with CPAB's mission, they have developed a program of quality inspections which covers all firms who audit reporting issuers who issue securities to the public in Canada and are subject to the rules of provincial or territorial securities commissions.

• Registered firms who audit reporting issuers are subject to inspection by CPAB. Their current practice inspection program selects firms for inspection on a cycle ranging from one to three years according to certain criteria. Annually, CPAB monitors the ongoing effectiveness of its practice inspection program and publishes a report highlighting inspection findings from the current year as well as trends relating to audit quality.

• As part of their inspection process, CPAB has the right to take a disciplinary action against firms or individuals that CPAB has determined did not perform audits in accordance with professional standards.

(see http://www.cpab-ccrc.ca/ for further information)

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SOLUTIONS TO PROFESSIONAL APPLICATION QUESTIONS PROFESSIONAL APPLICATION 1.1 – Audit reports LO 2, 3, 4, 5, 8 (a) These paragraphs highlight to readers that the directors of the company and the auditors have separate and distinct responsibilities. The directors are responsible for maintaining the accounting systems and preparing the reports, and the auditors are responsible for conducting an audit of these reports by evaluating their contents against the criteria of the accounting standards and relevant legislation. The auditor’s responsibilities do not include preparing the reports and the auditor must use judgement when choosing procedures and evaluating the evidence. (b) In an independent auditor's report, the paragraph is headed ‘Opinion’. It states that in the independent auditor’s opinion the reports are consistent with the relevant standards and legislation including a fair presentation of the financial position and performance of the company. This means that the opinion is unqualified and unmodified. (c) In a review engagement report, the auditor expresses a conclusion, not an opinion, in the review report. It is not an opinion because they did not conduct an audit. The statement is a negative one – ‘we have not become aware… is not, in all material respects, in accordance with ...’. (d) Other differences include: • Audit report indicates that the audit included the financial statements and the notes to the financial statements, whereas the review engagement report only indicates that the financial statements have been reviewed (no reference to the notes to the financial statements).

• Audit report outlines the responsibilities of management and the responsibilities of the auditor, whereas the review engagement report makes no reference to these responsibilities.

• Close reading of the description of the work done by the auditor will reveal that the procedures used for the review engagement are less comprehensive than those done for the audit. This is the main difference between the reports and why the audit report contains an opinion and the review report expresses a conclusion rather than an opinion.

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PROFESSIONAL APPLICATION 1.2 – Corporate sustainability reporting assurance LO 2, 3, 5 (a) InterPraxis Consulting wrote the report. (b) In the paragraph ‘Introduction’, ‘The Vancity Credit Union has commissioned InterPraxis to provide it with external assurance of its Accountability Report and the supporting web-based material...’

A ‘limited assurance’ conclusion is provided. However, InterPraxis states that in their opinion the Vancity’s report ‘presents a balanced and fair representation of its social, economic, and environmental performance’. Therefore, although the assurer provides an ‘opinion’ expressed in a positive form, there is only limited assurance. This is further shown by the limited scope of work and the limited set of procedures conducted. (c) AA1000AS (2008) is published by the AccountAbility organization, and provides guidance for sustainability assurance. AA1000AS (2008) is an assurance standard for management, performance and reporting on sustainability issues by evaluating the adherence of an organization to the AccountAbility Principles. (see http://www.accountability.org/ for further information). (d) The AA1000 Assurance Standard is based on assessment of reports against three Assurance Principles: • Materiality: does the sustainability report provide an account covering all the areas of performance that stakeholders need to judge the organization's sustainability performance?

• Completeness: is the information complete and accurate enough to assess and understand the organization's performance in all these areas?

• Responsiveness: has the organization responded coherently and consistently to stakeholders' concerns and interests?

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From the text discussion of financial reporting: • Relevance: Information will be relevant if it has an impact on the decisions made by users regarding the performance of the entity.

• Reliability: Information will be reliable when it is free from material misstatements (errors or fraud).

• Comparability: Users need to be able to trace an entity’s performance to identify any trends that may influence their perception of how well the entity is doing.

Users also need to be able to benchmark the performance of the entity against other similar organizations to assess its relative performance.

• Understandability: Users need to understand the information presented in order to make appropriate decisions.

• Presents fairly: ‘Presented fairly’ refers to the consistent and faithful application of accounting standards when preparing the financial statements.

Conclusions: • AA1000AS does not require the information to be reliable, but it does require enough accuracy for users to assess and understand the organization’s performance in these areas.

• AA1000AS does not require the information to be comparable across years and organizations, but does require the organization to respond consistently to stakeholders’ concerns.

• AA1000AS does not require the information to be understandable, but does require the organization to respond coherently to stakeholders’ concerns.

• AA1000AS does not require the report to be a fair presentation, but in financial reporting this is often interpreted as consistent application of the financial accounting standards. There are few standards in sustainability reporting and those that do exist are not mandatory.

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PROFESSIONAL APPLICATION 1.3 – Assurance providers LO 5, 6 Required: (a) The solution will depend on the accounting firm chosen and the date of the analysis. However, the answers should show for the Big 4: greater geographic coverage, larger numbers of staff and broader range of skills offered, greater claims to specialization and industry coverage, more publications available (particularly from the international offices), more consistent and sophisticated marketing. (b) Financial statement audits are mandatory for most companies, so overall demand is largely fixed or determined by economic conditions affecting the number of companies. However, for organizations that are not required by legislation to have an audit, there are two opposing pressures in times of economic recession. First, cost-cutting would result in fewer audits. Second, organizations with less credible financial statements will face most difficulty in borrowing during a credit squeeze. This suggests that demand for auditing will increase in difficult times, because an audit will increase the credibility of the statements and thus increase access to external finance.

Also, shifting from a national auditor to a Big 4 auditor would increase both costs and financial reporting credibility for a company. Therefore, it can be argued that firms with greater need to reduce costs will shift ‘down’ from Big 4 auditors to national auditors, but firms with greater need for credibility (and financial advice) will shift ‘up’ from national auditors to Big 4 auditors.

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PROFESSIONAL APPLICATION 1.4 – Canadian designations LO 6 Certified General Accountants (CGA) Education Requirements • CGA students must complete 19 required courses plus 2 comprehensive business cases and one public speaking course. o Students are able to complete these courses through CGA or by way of transfer credit.

• Bachelor’s degree is required before certification but it is not an entrance requirement to the CGA program. The degree may be from any approved post-secondary degree-granting institution and may be obtained in any field of study.

• Students then proceed to the PACE (Professional Applications and Competence Evaluations) courses. o There are four PACE level courses the students must complete.

These consist of 2 electives and two mandatory capstone courses.

Students apply technical knowledge and professional skills to solve problems in real-world situations. Competencies are developed through online teamwork, in-depth case studies, and simulations of real-world business projects or engagement.

Work Experience Students must obtain a minimum of 24 months of practical work experience at a professional level, however often it takes candidates three years of work in positions of increasing responsibility to demonstrate the competencies necessary for certification. Most candidates are employed in an accounting or related field while taking the PACE courses Certified Management Accountant (CMA) Educational Requirements • 4 year Bachelor’s degree.

• Students are required to pass an entrance exam that tests technical skills focusing mainly on management accounting, financial accounting, financial management and taxation of knowledge gained through university studies.

• After successfully completing the Entrance Examination, students progress through the two-year Strategic Leadership Program concurrent with full-time employment. o The Strategic Leadership Program combines individual and group work, as well as written assignments and oral presentations. o It consists of two phases — Development and Application — each lasting one year. Both phases each have three modules designed

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to develop the competencies.

Auditing: A Practical Approach, Canadian Edition

integrated

CMA

functional

and

enabling

Work Experience CMA students are required to obtain a minimum of 24 months of relevant full-time or equivalent, progressive practical experience concurrent with the Strategic Leadership Program.

Chartered Accountant (CA) Educational Requirements • Students must have a university degree with specific business course credits the professional program in your province or territory: o Western Canada, its universities and its CA School of Business (CASB) o Ontario, its universities and the Ontario Institute's School of Accountancy o Québec, it's universities and the Ordre's Professional Education Program (PEP) o Atlantic Canada, its universities and the Atlantic School of Chartered Accountancy (ASCA) • Once the educational requirements of the provincial institute are met, all CA candidates must sit the Uniform Evaluation (UFE). The UFE is a three three-day evaluation testing the student’s competencies using case based questions.

Work Experience Once the educational requirements are met, students are required to work in a CA Training Office, which include CA firms, corporations and government organizations that have approved training programs in place. Minimum hour requirements vary by province.

Over the years, there have been many discussions as to a potential merger between the professional accounting organizations in Canada. At the time of publication the three accounting bodies are currently in merger talks.

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PROFESSIONAL APPLICATION 1.5 – Demand for assurance LO 6 The three theories discussed in the chapter are agency theory, the information hypothesis and the insurance hypothesis.

Agency theory suggests that there are incentives to hire an auditor to assess the fair presentation of the information contained in the financial statements. The auditor reports to the members on the fair presentation of the financial statements prepared by the manager. The good quality managers are willing to have the audit of their reports because it allows them to distinguish themselves from poor quality managers. Shareholders are willing to pay the audit fee (i.e. the audit fee is paid by the company, reducing the profit available to distribute to the shareholders) to monitor the managers (who are their agents). Good quality auditors are more highly valued for this monitoring function than poor quality auditors. Andersen’s lowered their quality through their involvement with Enron, leading some companies to prefer another auditor. It has been suggested that companies taking early action to dismiss Enron could have protected their share price by retaining their financial reporting credibility. Ultimately, all Andersen’s clients had to find another auditor.

The information hypothesis suggests that financial statement users value higher quality information. Higher quality auditors are associated with higher quality financial statements. Therefore, when Andersen’s quality was called into question by their association with Enron, their client companies that valued higher quality auditors switched to another auditor.

The insurance hypothesis suggests that investors insure against their losses from company failure by purchasing an audit. When Andersen’s credibility was damaged by the Enron affair, there was doubt about their ability to survive and provide the insurance for such losses. The insurance factor is ‘impounded’ into share prices, so when the insurance cover is lost the share price should fall. This means that companies that were more sensitive to the loss of the insurance cover were more likely to dismiss Andersen early.

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PROFESSIONAL APPLICATION 1.6 – Being an auditor LO 3, 5, 8 (a) There is a gap between Kim’s expectations and the level of auditor performance.

An audit provides reasonable assurance, not absolute assurance. The audit enhances the reliability and credibility of the information included in a financial statement but is not a guarantee that the financial statements are free from error or fraud, or that the company will not fail. Partly, this is because of the nature of financial reporting. It requires judgements about accounting estimates and the choice and application of various accounting methods. There is usually not one ‘right’ answer for a company’s profit. The auditor cannot guarantee the profit reported by the company is ‘right’, only provide assurance about the appropriateness of the accounting method selection and application and the accounting estimates. Another reason the assurance is not absolute is the nature of the audit process. Auditors cannot review every transaction and account balance so use sampling (which could mean that representative items are not selected for testing), some transactions and balances are difficult to gather reliable evidence about, clients can conceal evidence, and auditors have a limited time frame in which to complete the audit. (b) Professional scepticism is required of an auditor. It is an attitude that requires the auditor to remain independent of the client and its staff. The auditor has a questioning mind and thoroughly investigates all evidence presented by their client. This does not mean that they regard the client as a liar, but that they need to do more than simply take the client’s word about anything. Usually, there will be confirming evidence which supports the client’s statements (e.g. copies of contracts, minutes of meetings, etc). Evidence gathered from independent third parties is generally regarded as more reliable than that gathered from the client.

Managers will not always try to deceive auditors, but auditors must take the responsibility of gathering evidence to verifying managers’ statements. The auditor needs to be alert to the fact that some managers will try to deceive auditors sometimes.

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PROFESSIONAL APPLICATION 1.7 – CPAB LO 7 Refer to review question 1.10 for a discussion of review of audit quality and its role in inspecting auditors with respect to the CPAB. PROFESSIONAL APPLICATION 1.8 – Types of assurance engagements LO 1 A review provides limited assurance. The auditor does adequate work to report whether or not anything came to their attention, which would lead them to conclude that the information being assured is not true and fair.

To be able to comment on the appropriateness of a review for financial statements, the differences between an audit and a review should be identified.

• Assurance: reasonable vs limited • Opinion: positive vs negative • Procedures: nature, timing and extent – review procedures are a subset of those performed for an audit • Reports: annual reports – both audits and review engagements are appropriate for annual reporting as long as they achieve the desired level of assurance for the stakeholders.

• Conclusion: Review engagement reporting is more limited than auditing and thus a lower level of assurance is appropriate as long as it is understood and agreed to by the stakeholders.

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PROFESSIONAL APPLICATION 1.9 – Expectations gap LO 8 The expectations gap is the difference between the expectations of financial statement users and the auditor’s performance.

Special users for Securimax could include: • Government agencies, including Department of Foreign Affairs and Trade, who would be interested in the purchases by foreign governments and individuals of this type of security vehicle.

• Competing companies and/or governments who would be interested in sensitive information about the construction of the vehicles and the identity of the purchasers.

• Waterloo local government and Ontario Provincial Government, who would be interested in the financial viability of the business and its impact on local employment and economic activity.

• Suppliers of technological equipment – it is possible that the Terrain Master uses specialized components. These suppliers would be interested in the financial viability of the business and the likelihood of its timely payment for goods purchased on credit. Such equipment could be made to specialized order with limited alternative customers. The suppliers would have large investments to support the manufacture of these specialized components.

• Other potential customers.

• Usual relationships would exist with lenders, shareholders, employees.

Discussion: Consider how well would Securimax’s financial statements provide the information that these users would require, given the highly sensitive and confidential nature of the manufacturing process. Management is responsible for preparing the reports, but the users may look to the auditors to make sure that the required information is provided. Also consider how well would the audit process be able to meet the users’ needs for this information.

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PROFESSIONAL APPLICATION 1.10 – Performance and compliance audits LO 2 TLCL must comply with the Ministry of Health’s Guidelines for Procurement of Medical Equipment’ when purchasing the accelerator. We are not provided with this document, but it is likely to contain rules about approved suppliers, the tendering/purchasing process (including the type of supplier/equipment documentation required), and so on. The auditor will gather evidence about TLCL’s purchases of the linear accelerators and assess whether the guidelines were followed. If the guidelines are specified with a great deal of detail, the audit will focus on ensuring that these guidelines were followed as specified. If the guidelines are expressed loosely (e.g., ‘the firm should obtain a number of quotes’), the auditor will need to use more judgement to assess compliance than if the guidelines are expressed precisely (e.g., ‘the firm will obtain 3 quotes’). The auditor will have to decide if the number of quotes obtained in those circumstances is sufficient to satisfy the loosely expressed guidelines. Are two quotes sufficient? If three quotes are required, the auditor could decide that two quotes are not sufficient, unless there are extenuating circumstances (e.g., there are only two possible suppliers worldwide).

PROFESSIONAL APPLICATION 1.11 – Types of assurance engagements LO 3 (a) A review engagement is required because the bank requires a certain level of assurance, but it has already been agreed that an external audit will not be required. (b) The title of the report or communication that Cicak & Jones will prepare is a "Review engagement report". (c) The types of procedures that Cicak & Jones would be required to conduct in this review engagement would be inquiry, analysis, and discussion.

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PROFESSIONAL APPLICATION 1.12 – Audit opinions LO 1, 4 (a) Unqualified with Emphasis of Matter. (b) A denial of opinion. (c) Unqualified with Emphasis of Matter. (d) Either an adverse opinion or a qualified opinion. (e) Either a denial opinion or a qualified opinion. (f) A denial of opinion. (g) A qualified opinion. (h) A qualified opinion.

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PROFESSIONAL APPLICATION 1.13 – The expectation gap LO 1, 6, 7 (a) The auditor is responsible to provide an opinion on the fair presentation of the historical financial statements in accordance with Canadian GAAP, unless they are engaged to provide assurance on other information. Therefore, auditors do not review press releases and other information that may be distributed to the users and other stakeholders. Auditors do have a responsibility to ensure offering documents provided by the company are consistent with the financial statements but they do not provide assurance over that information. (b) The audit expectation gap occurs when there is a difference between the expectations of assurance providers and financial statement users.

In this case, the users seem to believe the auditor should have provided more information with respect to the future success of the company. This demonstrates the “expectation gap”, where users tend to blame the auditor when companies fail. Users tend to believe that the auditor should have done more (i.e., provided assurance over the success of research expenditures). Auditors however, tend to avoid opinions over such subjective information, therefore, research costs are expensed as whether they will lead to a future benefit is too difficult to verify. (c) The audit expectation gap can be reduced by: • auditors performing their duties appropriately, complying with auditing standards and meeting the minimum standards of performance that should be expected of all auditors, • peer reviews of audits to ensure that auditing standards have been applied correctly, • auditing standards being reviewed and updated on a regular basis to enhance the work being done by auditors, • education of the public, • enhanced reporting to explain what processes have been followed in arriving at an audit (reasonable assurance) or a review (moderate or limited assurance) opinion (significant improvements have been introduced by standard setters improving assurance reporting), • assurance providers reporting accurately the level of assurance being provided (reasonable, limited, or none).

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PROFESSIONAL APPLICATION 1.14 – Types of audit reports LO 4 Situation 1 (a) Unqualified, qualified or disclaimer of opinion. (b) The client has, in effect, imposed a scope limitation on Aschari and Di Tomaso.

The type of report issued depends upon the materiality of accounts receivable and the likelihood that a potential error would be material or significantly material.

If the account receivable balance were insignificant and immaterial, then an unqualified report could still be issued. If the likelihood that a potential error would be material, but not pervasive, then an opinion qualified as to scope would be appropriate. If the likelihood that a potential error would be material and pervasive, then a disclaimer of opinion would be warranted.

Situation 2 (a) Qualified or adverse opinion. (b) By not including the probable need to pay $3,000,000 as a result of the lawsuit in the financial statements, they are likely materially misstated. If the financial statements are considered to be materially misstated but not pervasive, a qualified opinion would be appropriate. If the statements are considered to be both materially and pervasively misstated, an adverse opinion would be appropriate.

PROFESSIONAL APPLICATION 1.15 – Different audit opinions LO 4, 5 Khaled Nersesian should review the completed financial statements and the working papers to satisfy himself that: • the financial statements are not materially misstated; • they present fairly the financial position of the company; and • the information provided is in accordance with Canadian GAAP.

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Case Study — Cloud 9 (a) The objective of an audit is to obtain reasonable assurance by gathering sufficient evidence upon which to form a positive expression of an opinion regarding whether the information being assured is presented fairly. This means that the auditor has done adequate work to report with reasonable certainty that the information being assured is, or is not, reliable. This does not reflect absolute assurance, as an auditor can never be 100% certain that there are no errors or omissions. For example, an auditor is in the position to say whether in their opinion the financial statements are in accordance with relevant laws and accounting standards and they present fairly the financial position of the reporting entity. Auditors can only make such a positive statement if they are reasonably sure that the evidence gathered is sufficient. The audit of a company’s financial statements is one example of a reasonable assurance engagement. CAS 700 Forming an Opinion and Reporting on Financial Statements provides guidance on the form and elements of the audit report. The audit opinion will depend upon the auditor’s findings while conducting the audit. Reasonable assurance is the highest level of assurance provided; again, note that it is high but not absolute assurance.

The objective of a review engagement is to obtain moderate assurance by gathering sufficient evidence upon which to form a negative expression of an opinion regarding the reliability of the information being assured. This means that the auditor has done adequate work to report whether or not anything came to their attention that would lead them to believe that the information being assured is not worthy of belief. The auditor is not in a position to say that in their opinion the financial statements are in accordance with the relevant law and accounting standards, and does present fairly the financial position and performance of the reporting entity. The auditor is only able to say that the information is plausible, in that nothing makes them believe otherwise. To make a negative statement, auditors do not need to be as sure about the evidence as they must be to make a positive statement. The review of a company’s financial statements is called a review engagement. A review engagement may be requested when the client requires some assurance over the financial statements but does not require an audit level of assurance. CICA Handbook sections 8100–8600 provide guidance on review engagements and the form and elements of the review report. Th e review report highlights the responsibilities of the auditor to comply with Canadian generally accepted standards for review engagements and that the financial statements comply with Canadian GAAP or another appropriate financial reporting framework. An explanation of the procedures used in conducting the review is provided. The report states explicitly that an audit was not performed and therefore an audit opinion is not being expressed. Finally, the review report includes the conclusion of the auditor that they were not aware of any matter that made them believe that the financial statements were not in all material respects in accordance with GAAP (negative assurance).

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In conducting a review, an auditor will obtain an understanding of the entity under review; identify potential material misstatements where effort should be concentrated; and conduct analytical procedures, enquiries of entity personnel, and other tasks to aid in the formulation of their opinion. The work done when conducting a review is less extensive than the work done when conducting an audit. Specifically, an auditor will make enquiries of key personnel, apply analytical procedures, and hold discussions with client staff. That is why an auditor can provide only moderate (limited) assurance after completing a review.

It is also why this engagement is less time-consuming and therefore less costly.

For a compilation engagement, an auditor compiles a set of financial statements based on the information provided by the client, ensuring mathematical accuracy but does not perform any procedures to assure that the information is not materially misstated, and therefore no expression of assurance is provided.

However, the auditor must ensure that they are not associated with information that may be false or misleading. To ensure that users are aware that no assurance is being provided, the auditor attaches what is called a Notice to Reader report to the financial statements. The Notice to Reader report explicitly states that no assurance is being provided. For a compilation engagement, Canadian GAAP is not required as the financial reporting framework (however, it is the required framework for audits and review engagements).

(b) Reasonable assurance is the highest level of assurance. It means that the auditor has conducted audit procedures and gathered sufficient and appropriate evidence to provide an opinion on the fair presentation of the financial statements. The auditor states, in an unqualified opinion, that they believe that the statements do provide a fair presentation of the financial position and performance of the client. Limited assurance is a lower level of assurance. The auditor performs a more limited set of audit procedures and gathers less evidence. The auditor provides an opinion stated in the negative form. They state that they have found no evidence which makes them believe that the financial statements do not provide a true and fair view of the financial position and performance of the client. Reasonable assurance is provided in an audit, limited assurance is provided in a review engagement.

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(c) Chip would ask that Ron have the financial statements for McLellan’s shoes audited rather than reviewed because the audit provides a higher level of assurance that the financial statements give a fair presentation of the financial position and performance of the business. The risk that the audit opinion is inappropriate is lower than the risk that a review conclusion is inappropriate. Chip would feel more confident about the information being provided if it is audited rather than reviewed.

(d) Ron would be purchasing a service from an audit firm. Therefore, Ron would consider the benefits being offered by each firm and the price being charged.

Auditors generally charge based on the amount of work being done (which would be affected by the size of the business and its complexity) and the difficulty in performing the work. For example, if the auditor was unable to use their normal audit software because it was incompatible with the business’s systems, they might be forced to use more expensive techniques to conduct the audit. The audit firm would evaluate the type of business and the type of accounting records being kept before quoting their price. Ron should consider how well he is likely to be able to work with the auditors, how easy they are to contact and whether he believes they understand his requirements, and how much time they would require at his business. Many clients would like the audit to be conducted as quickly as possible so that it doesn’t interfere too much with their normal operations. Ron might also consider whether he is likely to be given useful advice by the auditors, although as he is trying to sell the business he is unlikely to seek advice on how to improve his systems. Some clients try to ‘purchase’ the right opinion. Auditor’s professional ethics prevent them from being involved in ‘opinion shopping’, which is the practice of clients going to a number of audit firms seeking the opinion which would be most favourable.

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Research Question 1.1 – Chong & Pflugrath (a) The question asks for the student’s view. The student should propose a standard audit report format with justification for each section. The factors to be considered include: report length, location of the audit opinion, plain or technical language. If the student regards the current audit report as the most appropriate, justification should still be provided and the student should discuss how the report conveys realistic expectations of the auditor’s role and the level of assurance provided.

The students should provide evidence of different possible audit report formats as part of their discussion.

(b) The arguments supporting auditors’ current practices and the users’ alternative expectations should be researched and discussed. Are there any arguments to support the auditors’ position that could not be regarded as merely defending existing practices? Are there any arguments to support critics who suggest that auditors should be doing more? Recent changes to the law suggest that regulators are willing to reconsider the auditor’s role (e.g. banning certain nonaudit services, requiring an independence declaration, requiring audit partner rotation). If auditors proactively adopt these types of changes, is it possible that more draconian regulatory changes could be avoided?

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Research Question 1.2 – Access the CICA Handbook ... (a) CAS 230 Audit Documentation.

(b) Each CAS has a different number of sections, depending on the volume required to express the standard. However, it is important to note the general structure that is present in each CAS as they all have the following sections (if that particular section is relevant to that CAS): • introduction • scope • effective date • definitions • requirements • application and other explanatory material • appendices • basis for conclusions.

(c) The name of CICA Handbook, Section 5025 is "Standards for assurance engagements other than audits of financial statements and other historical financial information".

(d) The sections of the CICA Handbook that relate to review engagements are Sections 8100–8600.

(e) The wording for the Notice to Reader can be found in the CICA Handbook, Section 9200 "Compilation Engagements", para. 26.

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Legal Notice Copyright

Copyright © 2012 by John Wiley & Sons Canada, Ltd. or related companies. All rights reserved.

The data contained in these files are protected by copyright. This manual is furnished under licence and may be used only in accordance with the terms of such licence.

The material provided herein may not be downloaded, reproduced, stored in a retrieval system, modified, made available on a network, used to create derivative works, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise without the prior written permission of John Wiley & Sons Canada, Ltd.

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Solutions Manual to accompany

Auditing: a practical approach by Robyn Moroney Fiona Campbell Jane Hamilton Valerie Warren

CHAPTER 2 Ethics, legal liability, and client acceptance

John Wiley & Sons Canada, Ltd. 2012

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Chapter 2 – Ethics, legal liability, and client acceptance SOLUTIONS TO REVIEW QUESTIONS REVIEW QUESTION 2.1 LO 1 The fundamental ethical principles that apply to all members of the professional bodies are to act with integrity, objectivity, professional competence and due care, confidentiality and professional behaviour.

The requirement to act in the public interest means that auditors should consider how their actions impact the client and their employer. They must also consider the impact of their actions on others such as the client’s employees, investors, credit providers, and those without direct financial interests in the client such as the broader business and financial community and members of the public. All these people could be reliant on the quality of the auditor’s work, even though they are not party to the contract between the client and the audit firm.

The reliability of the financial statements and the audit report is potentially damaged if the auditor does not act with integrity (honesty), objectivity (being independent), with professional competence and due care (executing the work with the required level of skill and attention), confidentiality (discussing the client’s affairs with others inappropriately), and professional behaviour (protecting their reputation and the profession’s reputation). A dishonest auditor could knowingly help publish a materially false, misleading, or reckless financial statement. Auditors who compromise their objectivity could be biased or unduly influenced to publish an inappropriate audit opinion. Auditors who do not uphold professional competence and due care principles could give incompetent professional service or fail to act diligently in accordance with the applicable technical standards. Disclosures of the client’s confidential information with proper or specific authority from the client or without a legal duty to disclose could disadvantage the client in the conduct of its affairs.

Unprofessional behaviour brings discredit to the profession.

REVIEW QUESTION 2.2 LO 2 Both aspects of independence are important. If an auditor has independence of mind the auditor will act independently. Acting independently means that the auditors are free of the clients’ influence and will perform their duties as required by the auditing standards and codes of ethics, even if the clients do not agree. Acting independently is essential for a high quality audit.

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However, despite how independently the auditors may act, the audit reports will not be credible if the outside parties do not believe that the auditors acted independently. That is, the outside parties do not believe the audit reports have any credibility because they believe that the clients have influenced the auditor. Therefore, the auditor must be seen to be independent by outside parties. That is, the auditor must be independent in appearance for the audit report to be believed.

If the auditor is seen to be independent but is really not independent, then the audit reports will have credibility, but if later events reveal that the auditor did not act independently, the outside parties could suffer a loss from relying on an inappropriate audit opinion. Therefore, both independence of mind and independence in appearance are required for effective auditing.

REVIEW QUESTION 2.3 LO 2 An auditor has a self-interest problem if the outcome of the audit (and/or the success of the company) affects the auditor’s (i.e. the audit firm or the auditor as an individual) financial interests. The closeness in this case is manifested through the auditor’s share ownership in the client, the client producing a very large part of the audit firm’s audit or other services revenue, or the existence of loans or other financial interests between the auditor and the client. It is a problem for the audit’s value because the auditor knows that a qualified audit report could adversely affect the client’s share price, or a tough audit decision (e.g. requiring the client to write down the value of its assets) could encourage the client to seek another auditor. These concerns could prompt the auditor to act inappropriately during the audit.

The self-review problem arises when the auditor, as part of the audit, has to test transactions or systems that were recorded or provided by another part of the audit firm or by a previous employee of the audit firm, or the testing is performed by a previous employee of the client. The closeness is manifested by the fact that self-review means that there is too little separation between the client and the auditor with respect to that part of the audit, that is, the auditor is testing or reviewing itself. It is a problem for the audit because selfreview impairs the primary source of value of a financial statements audit, that is, the independence of the auditor from the client. The lack of independence could mean that the auditor acts inappropriately during the audit.

Familiarity refers to a general closeness between the auditor (including the whole audit team) and the client. The closeness in this case is manifested in a relationship that is more one of friendship than that between independent auditor and client. The auditor could lose their objectivity during the audit and act inappropriately.

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REVIEW QUESTION 2.4 LO 3 The audit report is addressed to the shareholders of the audited company.

However, there is very little contact between an auditor and the shareholders.

One exception is that the auditor is required to attend the company’s Annual General Meeting where there could be some dialogue between the members and the auditor. In addition, the auditor could meet large shareholders, for example those on the board of the directors or who work for the company.

Shareholders are responsible for the appointment and removal of the auditor, but in practice the selection of the auditor is done by the board who then recommend the appointment to the shareholders for their approval. It would be more realistic to regard the board of directors as the auditor’s client because they are in charge of the company’s governance. The CEO or CFO will be in charge of the client’s financial reporting process and the auditor may have most contact with them and the finance department, but they are not the client to whom the auditor reports.

REVIEW QUESTION 2.5 LO 3 Executive directors are employees of the company who are also members of the board of directors. Non-executive directors are members of the board who are not employees of the company, but they could be ex-employees and/or major shareholders. Executive directors are generally regarded as being less independent with respect to the audit because they are part of the subject of the audit. That is, the executives, such as the CEO or CFO are in charge of the company’s operations and financial statements and so their work is being audited.

The audit committee is a sub-committee of the board of directors and its responsibilities include selection of the company’s auditors and overseeing the contract with the external auditors (and sometimes the internal audit department). The external auditors need to feel confident about bringing issues and difficulties they encounter during the audit to the attention of the audit committee. The auditors need to believe that the audit committee will not attempt to cover up the problems and will not try to persuade the external auditors to drop any major issue. If an executive director is on the audit committee they are regarded as being more likely to try to cover up any problems because such problems would reflect badly in the executive director’s performance as an employee. Not allowing executive directors to be part of the audit committee avoids such potential conflicts of interest.

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REVIEW QUESTION 2.6 LO 3 Outsourcing an internal audit function could provide the advantages of potentially better qualified auditors and a better resourced auditing function. It also allows small companies that would not be able to justify the establishment of a fully functioning internal audit department to have an internal audit function. An outsourced internal audit function is also likely to be more independent because they are not employees of the company and will not have the familiarity problems that could arise when one employee of a company is required to audit another employee’s work.

Outsourcing has the disadvantage that the internal auditors would have less knowledge about the company and its systems. Such lack of knowledge may mean that employees could find it easier to hide problems from the internal auditors. Outsourced internal auditors are removed from employee social networks and thus may not be alert to problems known by employees. For example, employees may know of another employee’s gambling problems which could tempt them to steal from the company.

REVIEW QUESTION 2.7 LO 4 A client may bring an action against an auditor under contract or tort law. The contract is between the client and the auditor. Damages under a breach of contract can only be claimed by a party to the contract.

Tort law allows any party to bring an action for negligence, provided the following three conditions are established: • a duty of care was owed by the auditor •

there was a breach of the duty of care

•

loss was suffered as a consequence of that breach.

Therefore, tort law allows another party to bring an action (not just a party to the contract) if it can be shown that there was a duty of care to that party. This means that the client and other parties could potentially bring an action for negligence. The first condition appears to be the most difficult to prove.

For example in the Pacific Acceptance case report, it was noted that the auditor could owe a duty of care to the client and its shareholders. The report discusses the problems facing plaintiffs when seeking to establish that the client or shareholders had suffered a loss as a result of the auditor’s negligence. To ascertain a causal relationship between the negligent act and the loss suffered, reasonable forseeability must be proven. This means that the auditor must have been aware that any negligence on their part could cause a loss to the client or their shareholders.

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In Hercules Management Ltd. (1997) the courts ruled that for a third party to be able to establish that an auditor owes them a duty of care, they would need to show the following: • The report was prepared on the basis that it would be communicated to a third party.

•

The report was likely to be relied upon by that third party.

•

The third party ran the risk of suffering a loss if the report was negligently prepared.

The judgement in the Hercules case provided some relief for auditors as it made it far more difficult for a third party to establish that a duty of care was owed by the auditor. Today, it is advisable that a third party take steps to establish proximity before using an audited report to make a decision. They can request that an auditor provide them with a privity letter, which can be used to prove that a duty of care was owed to them.

The plaintiff must also show that the auditor breached its duty of care, for example, by conducting a poor quality audit. Mere non-compliance with auditing standards may not be sufficient to show a breach of the duty of care.

Finally, the plaintiff must establish that they suffered loss as a result of the breach of the duty of care. For example, the plaintiff must show that they relied on the audit report to make their investment which subsequently lost value.

REVIEW QUESTION 2.8 LO 4 For a case brought by a client or another party to succeed against an auditor it must be shown that they breached the terms of the contract and/or were negligent. An auditor will use internal documentation to show that all duties were conducted to a reasonable standard. Failure to follow auditing standards would imply that the work was not conducted to a reasonable standard, but it is still possible that an auditor could be found to be negligent even if the strict letter of the auditing standards was followed. This is because the test is not whether or not the standards were followed, but whether it was reasonable to expect an auditor to act in a particular way. All circumstances must be examined on a case-by-case basis, and there could be conditions which would create a reasonable expectation that the auditor would have performed additional procedures or acted differently in some way. Therefore, compliance with auditing standards is generally regarded as a minimum, not a maximum, requirement to avoid legal liability.

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REVIEW QUESTION 2.9 LO 5 Client acceptance and continuance procedures are performed for the purpose of evaluating whether the auditor can service the client and still meet the relevant ethical and legal requirements. This is to protect the client and the auditor as well as those who will rely on the audit report. The client needs to be assured that the auditor has the appropriate skills and capacity to provide the audit at the appropriate level of quality and within the required time frame.

The auditor needs to be sure that it can service the client in this way and protect itself from any conflicts of interest that could arise during the engagement. The public and other parties need to be assured that the audit was conducted appropriately and the auditor was able to exercise the required level of independence.

An auditor will not accept every client, even if it has capacity, because they would not be able to provide the required level of expertise to service the client’s needs. Refusal to accept a client (or continue with an existing client) does not mean that the client is not auditable or lacks integrity. Another auditor could be better able to service the client because of capacity or expertise issues. However, the auditor’s right to refuse a client means that the more difficult to audit clients find it hard to get an auditor and so have the incentive to either improve their systems and/or integrity, or go out of business. As such, the quality of financial reporting across the economy is likely to be higher.

REVIEW QUESTION 2.10 LO 5 An engagement letter is the contract between the client and the auditor. It contains clauses that make the responsibilities of each party clear, and can provide a method of handling disputes. CAS 210 Agreeing the Terms of Audit Engagements provides guidance on the preparation of engagement letters.

An engagement letter is prepared by an auditor and acknowledged by a client before the commencement of an audit.

The purpose of an engagement letter is to set out the terms of the audit engagement, to avoid any misunderstandings between the auditor and their client. The letter will confirm the obligations of the client and the auditor in accordance with the various standards. While the engagement letter can expand upon the requirements that appear in legislation and standards, it cannot limit or contradict those requirements.

An engagement letter includes an explanation of the scope of the audit, the timing of the completion of various aspects of the audit, an overview of the client’s responsibility for the preparation of the financial statements, the requirement that the auditor have access to all information required, independence considerations and fees.

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SOLUTIONS TO PROFESSIONAL APPLICATION QUESTIONS PROFESSIONAL APPLICATION 2.1 – Ethical principles LO 1 The fundamental ethical principles that apply to all members of the professional bodies are to act with integrity, objectivity, professional competence and due care, confidentiality and professional behaviour (according to the code of professional conduct for the appropriate professional body).

Charles overstates his importance at the audit firm – he states that he is a partner but he is a ‘senior’ (which is less senior than a partner). This is a breach of integrity.

Charles tells William that the patriarch (male leader of the family) is having an affair with his personal assistant – this is gossip. Even if it is true, it is not professional behaviour to reveal private matters about a client to another party. Charles also states that he has his ‘doubts’ about this person – this apparently means that Charles believes that the person is dishonest or unethical or incompetent (it is not clear what he means but he is saying something negative). Once again, this is not professional behaviour.

Charles tells William that the family has increased its shareholding in another company, with potential benefits to the company. This information appears to have been gained as part of the audit so revealing it to William is a breach of confidentiality. It is not relevant that William works for a bank which lends to the client, Charles does not have the client’s permission to discuss this matter.

PROFESSIONAL inheritance LO 2, 3, 4

APPLICATION

2.2

–

Receiving

shares

through

Most professional accounting bodies have similar rules of professional conduct. As an illustration, The Institute of Chartered Accountants of Ontario (ICAO), in their Member's Handbook, has the following interpretation to provide guidance to its members about auditor independence.

ICAO Council Interpretations to Rules 204.1 to 204.6 – Independence in Assurance and Specified Auditing Procedures Engagements: para. 65: "When a person on an engagement team, or any of the person’s immediate family, receives, for example, by way of gift or inheritance or as a result of a merger or reorganization, a direct financial interest or a material indirect financial interest in a particular assurance client, or a related entity of the client in the case of an assurance client that is an audit or review client, one of the following actions should be taken to comply with Rule 204.4(1):

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•

dispose of the financial interest at the earliest practical date but no later than 30 days after the person has knowledge of the financial interest and the right or ability to dispose of it; or • remove the person from the engagement team.

During the period prior to disposal of the financial interest or the removal of the person from the engagement team, consideration should be given to whether additional safeguards are necessary to reduce the threat to independence to an acceptable level. Such safeguards might include: • discussing the matter with the audit committee; or • involving another member of the firm who is not, and has not been, on the engagement team to review the work done by the person, or advise as necessary.

Members are reminded that Rule 204.5 requires a member who has an interest that is precluded by this Rule to advise in writing a designated partner of the firm of the interest." para. 69.

An inadvertent breach of the principles in this Council Interpretation as they relate to a financial interest in an assurance client, or an related entity of the client in the case of an assurance client that is an audit or review client, would not impair the independence of the member of the firm or the firm when: • the firm has established policies and procedures that require a network firm and all members of the firm to report promptly any breaches resulting from the purchase, inheritance or other acquisition of a financial interest in the assurance client; • the firm promptly notifies the network firm or the member of the firm that the financial interest should be disposed of; and • the disposal occurs at the earliest practical date after identification of the issue, but no later than 30 days after the person has both the knowledge of the financial interest and the right or ability to dispose of it, or the person is removed from the engagement team.

Prior to the uncle’s death, the shares were not held by Kerry or his wife – the connection through her uncle is too remote for a self-interest threat to have existed prior to his death.

After the uncle’s death, Kerry’s wife is the owner of the shares, which appears to give her material ownership in the client, creating a potential self-interest threat for Kerry.

ICAO Council Interpretations to Rules 204.1 to 204.6 – Independence in Assurance and Specified Auditing Procedures Engagements para. 65 and para. 69 suggests that the shares should be disposed of, or Kerry removed from the audit. If Kerry stays on the audit the shares should be sold and the additional safeguard of discussing the matter with the client’s audit committee should apply if the disposal of the shares would take some time.

Kerry will not get fired from the audit firm provided he follows the above procedures.

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PROFESSIONAL APPLICATION 2.3 – Provision of non-audit services to audit clients LO 2, 3, 4 Most professional accounting bodies have similar rules of professional conduct. As an illustration, The Institute of Chartered Accountants of Ontario (ICAO), in their Member's Handbook, has the following referenced interpretations to provide guidance to its members about auditor independence in the "ICAO Council Interpretations to Rules 204.1 to 204.6 – Independence in Assurance and Specified Auditing Procedures Engagements". (a) It is possible that increasing the profitability of the audit firm would increase Elise’s reputation within the firm. However, if the growth in revenue creates any conflicts of interest or other ethical problems it could damage Elise’s reputation. See ICAO Council Interpretations to Rules 204.1 to 204.6 paragraphs 40, 123, 125, 133 and 195 relating to providing "non-audit services" – if the provision of non-assurance services creates a threat to the auditor’s independence, safeguards would need to be applied to eliminate or reduce the threat. (b) See ICAO Council Interpretations to Rules 204.1 to 204.6 – Independence in Assurance and Specified Auditing Procedures Engagements for a guide to which services to avoid. These interpretations state that the auditor should avoid acting as an executive of the client company. The auditor should not be involved in transactions, making decisions about the audit firm’s recommendations, management reporting to directors, or acting as manager of the client within the previous two years.

The interpretations also discuss less significant threats, which should only be offered after careful consideration because they could create self-review or self-interest threats. These include having custody of a client’s assets, supervising client employees, and preparing source documents. The section also discusses examples of safeguards, such as making arrangements so that personnel providing such services do not participate in the audit, and gaining additional advice on the impact of such services. (c) Yes. Auditors can provide more non-audit services to a private company than to a listed public company.

ICAO Council Interpretations to Rules 204.1 to 204.6 – Independence in Assurance and Specified Auditing Procedures Engagements, para. 140 states that a Member, Firm, or a Network Firm, may provide an Audit Client that is not a Listed Public Entity with accounting and bookkeeping services, including payroll services, of a routine or mechanical nature, provided any self-review threat created is reduced to an acceptable level.

Examples of such services include:

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• Recording transactions for which the Audit Client has determined or approved the appropriate account classification; • Posting coded transactions to the Audit Client's general ledger; • Preparing Financial Statements based on information in the trial balance; and • Posting the Audit Client approved entries to the trial balance.

The section continues by explaining that the significance of any threat created should be evaluated and, if the threat is other than Clearly Insignificant, safeguards should be considered and applied as necessary to reduce the threat to an acceptable level.

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PROFESSIONAL APPLICATION 2.4 – Unpaid audit fees LO 2, 3, 4 If fees are outstanding the auditor could be perceived to have a conflict of interest because the auditor is more likely to be paid if the client survives and is happy with the auditor. In these cases, the auditor could be perceived as being more interested in the client’s survival than an accurate audit report.

The auditor should take steps to have the fees paid before the next audit or remove itself from the audit.

ICAO Council Interpretations to Rules 204.1 to 204.6 – Independence in Assurance and Specified Auditing Procedures Engagements, para. 191 states that a self-interest threat may be created if fees due from an Assurance Client remain unpaid for a long time, especially if a significant part is not paid before the issue of the assurance report for the following year. Generally the payment of such fees should be required before the report is issued. The following safeguards may be applicable: • Discussing the level of outstanding fees with the audit committee or others charged with governance.

• Involving an additional professional accountant who did not take part in the Assurance Engagement to provide advice or review the work performed.

The Firm should also consider whether the overdue fees might be regarded as being equivalent to a loan to the Client and whether, because of the significance of the overdue fees, it is appropriate for the Firm to be reappointed.

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PROFESSIONAL APPLICATION 2.5 – Using the work of internal auditors LO 5 The internal audit department focuses on efficiency and effectiveness of production (i.e. operational or performance auditing) and compliance with government regulations (compliance auditing). The head of the internal audit department is a Chartered Accountant and a member of the Institute of Internal Auditors and the other members of the department have performance auditing and compliance relevant experience and qualifications. The internal audit department is highly regarded within the business, reports to the board of directors as well as the CEO, and the reports appear to be acted upon. All these factors suggest that the internal audit department is well run and effective. However, they also suggest that it does not concentrate on issues directly relevant to financial reporting and auditing.

The external auditors are likely to review the internal audit department’s work, particularly where it is relevant to operational indicators which are reflected in the accounts. They are likely to review the internal auditor’s reports and their evaluations of internal control systems, particularly in production and inventory issues and general management issues. However, most of the internal audit department’s findings on waste regulations and efficiency matters will not be directly relevant to the external auditors’ audit of accounting transactions and balances.

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PROFESSIONAL APPLICATION 2.6 – Legal implications of client acceptance LO 6, 7 (a) Steps to take to avoid the threat of litigation (in addition to the client continuation decision issues in part (b) below) include: ▪ hiring competent staff ▪ training staff and updating their knowledge regularly ▪ ensuring compliance with ethical regulations ▪ ensuring compliance with auditing regulations ▪ Implementing policies and procedures that ensure: o appropriate procedures are followed when accepting a new client (or client continuance) o appropriate staff are allocated to clients o ethical and independence issues are identified and dealt with on a timely basis o all work is fully documented o adequate and appropriate evidence is gathered before forming an opinion ▪ meeting with a client’s audit committee to discuss any significant issues identified as part of the audit ▪ following up on any significant weaknesses in the client’s internal control procedures in a previous year’s audit. (b) The client continuation decision is critical. Rebecca should evaluate and document the firm’s ability to service the major client, Carolina Company Ltd., and any other major clients for the coming year. Canadian Standard on Quality Control (CSQC 1) "Quality control for firms that perform audits and reviews of financial statements, and other assurance engagements" and CAS 220 Quality Control for an Audit of Financial Statements provide guidance on the procedures to be followed when making the client acceptance or continuance decision.

The key factors to be evaluated are client integrity and any threats to the auditor’s compliance with the fundamental principles of professional ethics (integrity, objectivity, professional competence and due care, confidentiality and professional behaviour). Although Carolina Company Ltd. has been a client of the firm for several years, its integrity must still be re-evaluated. Rapid growth can create pressures within the client that could compromise its integrity. This is particularly so in the case of Carolina Company Ltd. because there is already evidence of difficulties in its financial systems.

A major problem confronting the audit firm is its ability to comply with the fundamental principles of professional ethics.

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Rebecca should be particularly concerned with the firm’s ability to be objective given its dependence on the large client’s fees. Although, Carolina Company Ltd. is only one of the major clients experiencing rapid growth, fee dependence arises when a client’s fees form a significant proportion of the audit firm’s overall revenue. Many professional accounting bodies' rules of professional conduct provide guidance about safeguards when this proportion reaches 15%.

Rebecca should also be concerned about the firm’s ability to use professional competence and due care in audits for rapidly growing clients at a time when the audit firm is growing rapidly and the client is undergoing major changes to its reporting requirements. Does the audit firm have the expertise to audit listed clients? What sort of auditing difficulties are likely to be created by the stretched financial systems at Carolina Company Ltd.?

The client continuation decision must be properly documented and the engagement letter drafted to reflect the responsibilities of both parties.

PROFESSIONAL safeguards LO 3, 4

APPLICATION

2.7

–

Independence

threats

and

(a) Personal relationships between a partner of the audit firm and the two directors – familiarity threat. This applies even if the partner is not part of the engagement team because the partner is a senior member of the audit firm.

ICAO Council Interpretations to Rules 204.1 to 204.6 – Independence in Assurance and Specified Auditing Procedures Engagements, para. 43 states that examples of circumstances that may create familiarity threats include, but are not limited to: • a person on the engagement team having an immediate or close family member who is director or officer of the assurance client;.

• a person on the engagement team having an immediate or close family member who, as an employee or shareholder of the assurance client, is in a position to exert direct and significant influence over the subject matter of the assurance engagement; • a former partner of the firm being a director, officer or employee of the assurance client in a position to exert direct and significant influence over the subject matter of the assurance engagement; • the long association of a senior person on the engagement team with the assurance client; and • the acceptance of gifts or hospitality from the assurance client, its directors, officers or employees, unless the value thereof is clearly insignificant.

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(b) Many accounting bodies rules of professional conduct, in particular ICAO Council Interpretations to Rules 204.1 to 204.6 – Independence in Assurance and Specified Auditing Procedures Engagements, suggests that the audit firm should document the policies that relate to this type of threat to independence, the evaluation of the threat and the safeguards to reduce the threats. They should also have policies and procedures to prevent that partner from inappropriately influencing the outcome of the assurance engagement.

The firm should not use that partner on the Featherbed engagement, and should not accept the audit if that partner is required on the audit.

For example, the following are some of the points that have been suggested: • For Firms that perform Assurance Engagements, documented Independence policies regarding the identification of threats to Independence, the evaluation of the significance of these threats and the evaluation and application of safeguards to eliminate or reduce the threats, other than those that are clearly insignificant, to an acceptable level.

• Documented internal policies and procedures requiring compliance with the fundamental principles.

• Policies and procedures to prohibit individuals who are not members of an Engagement Team from inappropriately influencing the outcome of the Engagement.

PROFESSIONAL safeguards LO 3, 4

APPLICATION

2.8

–

Independence

threats

and

Issues raised in the case: ISSUE # 1 (a) The client’s internal audit department is headed by an ex-partner of KFP. The rules of professional conduct generally place restrictions on audits where a former audit partner has a senior role within the client. The restrictions include a cooling off period, which is usually a two to five year period after the leaving the audit form and the current audit. On this basis, there does not appear to be a contravention of the rules of professional conduct. In addition, the restriction sometimes applies to ex-auditors who become an officer of the company. In the case of Securimax, Rydell Creek does not appear to be an officer of the company (e.g., a director or senior manager) – he is the head of the internal audit department. This would certainly include the CFO or CEO, but it is unlikely to include the head of the internal audit department. (b) Safeguards: • Ensure that Rydell Creek is not regarded as able to exert direct and significant influence over the subject matter of the external audit.

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• Ensure that there wasn’t a significant and personal relationship between Rydell Creek and the other members of the audit team based on their previous association as colleagues (to deal with the general familiarity threat).

An excerpt from the rules of professional conduct states that examples of circumstances that may create familiarity threats include, but are not limited to: • A former Partner of the Firm being a Director or Officer of the Client or an employee in a position to exert direct and significant influence over the subject matter of the Engagement.

ISSUE # 2 (a) Clarke Field has been the partner for 5 years and will remain as review partner when Sally Woodrow is appointed as partner for the audit.

CPAB and many rules of professional conduct with respect to independence require rotation of senior audit personnel as follows stating that using the same: • Lead Engagement Partner, or • Audit Review Partner (if any), or • Engagement Quality Control Reviewer on an audit over a prolonged period may create a familiarity threat.

This threat is particularly relevant in the context of a Financial Statement audit of a Listed Public Entity and safeguards should be applied in such situations to reduce such threat to an acceptable level. Accordingly in respect of the Financial Statement audit of Listed Public Entities: (a) The Lead Engagement Partner, the Audit Review Partner (if any) and the Engagement Quality Control Reviewer should be rotated after serving in any of these capacities, or a combination thereof, for a pre-defined period, no longer than five financial years within a seven year period; and, (b) Such an individual rotating after a pre-defined period should not participate in the Audit Engagement until a further period of time, no less than two years, since the end of the financial year following the end of the pre-defined period has elapsed. (b) Safeguards: Clarke Field should not participate in the audit for two years.

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ISSUE # 3 (a) Appointment of Sally Woodrow to position of partner and as partner in charge of the Securimax audit.

Is Sally Woodrow experienced enough to lead the audit? She is being promoted to partner to enable her to take over the audit. If she is not sufficiently experienced and qualified to lead the audit there is a risk that the independence of the audit will be compromised. (b) Safeguards: An independent (i.e., not previously involved with Securimax) senior audit partner should be appointed as review partner to assist Sally Woodrow.

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PROFESSIONAL APPLICATION 2.9 – Ethics of accepting engagements LO 1 The fundamental principles of professional ethics include integrity (being straightforward and honest), objectivity (not allowing personal feelings or prejudices to influence professional judgment), professional competence and due care (maintaining knowledge and skill at an appropriate level), confidentiality (not sharing information that is learned at work), and professional behaviour (upholding the reputation of the profession).

The CEO of TCCL has requested the auditor provide an opinion that the laser machines are fit for use without charging a fee as a gesture of goodwill, in the context of the future negotiations about the audit tender. There is an implicit invitation to provide a favourable opinion to ensure that the audit tender is awarded to Fellowes and Associates again.

If Tania provides the opinion without obtaining appropriate and sufficient evidence she would be compromising her integrity because the favourable opinion would not be honest, and her objectivity because her professional judgement would be influenced by the desire to win the tender again. There does not seem to be any threat to confidentiality, although her professional competence and behaviour on this particular engagement would be compromised because she would not be exercising her skill at an appropriate level (and she may not be qualified to provide the opinion on the lasers ) and her actions could damage the profession’s reputation.

Accepting an engagement without appropriate remuneration is also likely to create a conflict of interest. Fees should reflect the work involved and be set at a level that ensures that adequate staffing are assigned to the engagement and sufficient work done to complete the engagement.

PROFESSIONAL APPLICATION 2.10 – Independence issues in accepting engagements LO 1, 2, 3, 4 One of the accountants intended to be part of the 2011 audit team owns shares in HCHG. The accountant’s interest is not material to him.

Most rules of professional conduct and independence guidelines state that a financial interest in a client may create a self-interest threat. Owning shares in an engagement client creates a direct financial interest. Independence rules generally require the auditor to consider the nature of the financial interest in order to determine the significance of the threat and the appropriate safeguards. Matters to consider are whether the shareholding is direct or indirect, how material is the holding, and the role of the member of the assurance team.

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Therefore, what duties does the member of the assurance team perform?

How senior is his role? How much judgement will he be required to exercise?

If the person is very junior and/or the amount of the financial interest is very small, the threat is lower and fewer safeguards are required. However, if the person is more senior and/or the amount of the financial interest is greater, the safeguards would need to be more significant.

Most independence rules also state that if a member of the assurance team has a direct financial interest, as in this case, the only safeguards available to eliminate the threat are to dispose of the direct financial interest prior to the individual becoming a member of the assurance team, or to remove the member of the assurance team from the engagement.

"Self-Interest Threat" occurs when a firm or a member of the assurance team could benefit from a financial interest in, or other self-interest conflict with, an assurance client.

Examples of circumstances that may create this threat include, but are not limited to: • a direct financial interest or material indirect financial interest in an assurance client; A financial interest in an assurance client may create a self-interest threat. In evaluating the significance of the threat, and the appropriate safeguards to be applied to eliminate the threat or reduce it to an acceptable level, it is necessary to examine the nature of the financial interest. This includes an evaluation of the role of the person holding the financial interest, the materiality of the financial interest and the type of financial interest (direct or indirect).

Most independence rules also state that if a member of the assurance team, or their immediate family member, has a direct financial interest, or a material indirect financial interest, in the assurance client, the self-interest threat created would be so significant the only safeguards available to eliminate the threat or reduce it to an acceptable level would be to: (a) dispose of the direct financial interest prior to the individual becoming a member of the assurance team; (b) dispose of the indirect financial interest in total or dispose of a sufficient amount of it so that the remaining interest is no longer material prior to the individual becoming a member of the assurance team; or (c) remove the member of the assurance team from the assurance engagement.

Fellowes and Associates was previously engaged by HCHG to value its intellectual property. The consolidated balance sheet (statement of financial position) as at June 30, 2011 includes intangible assets of $30 million, which were valued by Fellowes and Associates on 1 March 2011 following HCHG’s acquisition of the subsidiary Shady Oaks Centre. The intangibles are considered material to HCHG.

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Independence rules generally address the issues surrounding the provision of valuation services to an assurance client. The problem arises because in a financial statement audit the auditor is required to gather evidence about the client’s valuation of the assets. If the auditor provided the valuation to the client, then the auditor has to audit their own work.

A self-review threat may be created when an audit firm performs a valuation for an audit client that is to be incorporated into the client’s financial statements. This is generally a problem if the valuation service involves the valuation of matters material to the financial statements and the valuation involves a significant degree of subjectivity. In this case, the self-review threat created could not be reduced to an acceptable level by the application of any safeguard, and the valuation services should not be provided, or alternatively, the auditor should withdraw from the audit engagement.

Therefore, the key questions are whether the item is material, whether there is a significant degree of subjectivity in the valuation service. The intangibles are stated to be material. Valuation of intangible assets is likely to be subjective, or at least more subjective than valuation of real property (land and buildings).

This implies that Fellowes and Associates should withdraw from the audit or the client should obtain another independent valuation for the intangibles.

However, the question appears to state that the valuation services were provided prior to the audit engagement being accepted. If so, at this time, there was no conflict between Fellowes and Associates duties as valuator and auditor. However, now, as auditor, Fellowes and Associates is required to provide an opinion on the valuation which it previously provided.

Other safeguards that could apply to valuation situations include: - involving an additional professional accountant who was not a member of the assurance team to review the work done or otherwise as necessary; - confirming with the audit client their understanding of the underlying assumptions of the valuation and the methodology to be used and obtaining approval for their use; - obtaining the audit client’s acknowledgement of responsibility for the results of the work performed by the firm, and - making arrangements so that personnel providing such services do not participate in the audit engagement.

At a minimum, Fellowes and Associates should apply the safeguards with respect to the intangible assets valuation. The valuation should be reviewed by an additional professional accountant, who is outside the audit team, they should obtain the client’s acknowledgement of responsibility for the valuation, and should not use the personnel involved in the valuation of the financial statement audit. However, it is likely that these safeguards would not be enough, given the high level of subjectivity in the intangible assets valuation.

Therefore, the client will either have to obtain another independent valuation or Fellowes and Associates should withdraw from the audit.

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In the future, the audit firm should not perform valuations for audit clients that are likely to be the subject of a financial statement audit, unless they are immaterial and/or have a very low degree of subjectivity.

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PROFESSIONAL APPLICATION 2.11 – Principles and rules of the code of professional conduct LO 1, 2 (a) This case indicates a violation of the confidentiality principle. An auditor should not disclose client information to others outside the organization.

Joan has bought shares in her client, there may also be a self-interest threat (impairment of independence). Furthermore, she used insider information to buy these shares, which is not legal. (b) There is a violation as the advertising is making an unsubstantiated claim in indicating the firm is the “premier” accountants. There is also a fee issue as contingency fees based on the outcome of the engagement are not appropriate. Fees are to be based on an estimate of the work to be performed. (c) This scenario presents a self-review threat, as Sue is planning to prepare the tax provision and then audit it, therefore she would be providing assurance over her own work. Also, there is a prohibition on providing bookkeeping services to reporting issuers. (d) In this case the client is a private company and therefore it may be possible for Sue to propose adjusting journal entries and remain independent. Sue must be careful to ensure that the preparation of the journal entries does not cause a self-review threat where she is auditing her own work.

If the journal entries are for simple bookkeeping entries, the self-review threat would not be significant. However, Sue should review the entries with management and ensure management understands them. Management should sign their approval of the entries and this documentation should be kept in the audit file.

If however the entries involved complex accounting issues requiring significant judgement, the self-review threat would be significant. Sue would then have to ensure safeguards were in place to reduce the self-review threat to an acceptable level. She could do this by consulting with another professional accountant to confirm the accounting treatment proposed is appropriate, thereby reducing the self-review threat to an acceptable level.

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(e) For compilation engagements, the preparation of routine journal entries or the provision of routine bookkeeping services do not create a self-review threat.

As best practice, Sue should, review the journal entries with management and obtain their written approval. However, the absence of management approval does not create an independence issue — except in Quebec. In Quebec this situation would need to be disclosed, unless the entries were basic mechanical and posting type entries. (f) There is no self-interest threat provided the loan is within the bank’s normal lending terms. (g) This presents a familiarity threat where with a close relative (Jack’s father-inlaw) holds a senior position as CEO at Canada Bank. (h) This may represent a threat if the fees are significant. If the fees are significant, they may be considered in substance a loan to the client and therefore create a self-interest threat for Frank. (i) There are many issues with this scenario.

• The first is the referral fee, as referral fees are not permitted.

• Second, she must ensure she exercises due care and conducts the engagements in accordance with the current standards. As she has not performed any audit engagements in the last four years, it is unlikely she is up to date with generally accepted auditing standards (GAAS), as new auditing standards were introduced in 2010.

• Alison also failed to demonstrate due care when she accepted the client without performing any of the required client acceptance procedures.

• She did not exercise due care when she concludes she will perform a substantive based audit and therefore ignore controls altogether. (j) Independence is not required for compilation engagements, but Matt should disclose the fact that he is not independent in his written report accompanying the financial statements. The disclosure should indicate the nature of the relationship.

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PROFESSIONAL APPLICATION 2.12 – Auditor legal liability LO 4 (a) Since there is no contract with Xing Investments Inc. it is questionable if the auditor owes this third party user a duty of care. Especially since Ahmad & Partners were not aware that Xing Investments Inc. was a user of the financial statements. However, Ahmad & Partners did have a contract with Canada Bank, therefore they did owe the bank a duty of care. (b) Defences that Ahmad & Partners could use are: • They did not owe Xing Investments a duty of care as they were not a foreseen user.

• They conducted their audit in accordance with generally accepted auditing standards (GAAS), therefore there was no negligence on their part.

• They could question whether the Xing Investments actually relied on the statements before investing in Chan Corporation.

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PROFESSIONAL APPLICATION 2.13 – Breaches to the principles and rules of the code of professional conduct LO 1, 2 (a) No violation. Susanne is free to set the audit fee based on the amount of audit work required and there are no restrictions on the performance of taxation services for the client or the client’s key executives. (b) No violation. Aziz has acted appropriately in designing the audit plan for this client. Exceptionally high revenue growth may well suggest that the financial statements are being manipulated by management to increase reported profit.

Also, Aziz is correct in his assessment that overstated profit may be accomplished through an overstatement of asset values and/or an understatement of recorded liabilities. Finally, Aziz is justified in considering resigning from the engagement if evidence of fraud is discovered during the audit. (c) Violation. There is no problem with Mandip compiling the financial statements for this closely held company, nor do the compiled financial statements need to include footnotes or other disclosures (GAAP is not required for compiled financial statements). However, by agreeing to receive company shares as payment for his services, Mandip is not independent of the company. While a professional accountant (for example, consider Mandip to be a CGA) who is not independent can still perform compilation services for a client, the lack of independence must be disclosed in the notice to reader communication.

Finally, Mandip should not perform a ratio analysis in conjunction with his compilation. Ratio analysis and related inquiries of management are a major part of a review of financial statements, which is designed to provide a moderate level of assurance that recorded amounts are not materially misstated. In a compilation, no assurance is provided and a professional accountant (for example, a CGA in this illustration) should not be trying to determine that recorded amounts are plausible. Doing so serves to distort the nature of the service being provided to the client.

Note that Mandip cannot ethically perform a review for this client since a review requires that Mandip be independent — he cannot be a shareholder in the firm.

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PROFESSIONAL APPLICATION 2.14 – Auditor legal liability LO 4 The elements of negligence would apply to this case as follows: 1. There must be a duty of care owed to the party suing the auditor. In this case, HHH Corporation hired the auditors, therefore the auditors owe duty of care to the shareholders.

2. There must be a breach of duty of care (failure to follow GAAS which would lead to a negligent audit). In this case, the shareholders would have to show that the auditors were negligent in their audit, that is, the auditor issued an unqualified report even though there is a misstatement in the financial statements.

3. There must be proof that the party suffered a loss or damage. In this case, HHH Corporation lost its investment in the commodities. The loss must be the direct result of the breach of the duty. In this case, HHH Corporation shareholders would have to show that they suffered the loss due to the auditor’s negligence.

PROFESSIONAL APPLICATION 2.15 – Quality assurance LO 2 (a) Most firms use their last names to ensure they are not misleading or self lauditory. They must also be in good taste. (b) Advertising must be in good taste. It cannot be false or misleading or make unsubstantiated claims. Some suggestions for advertising may include: • word of mouth – referrals • friends and family • signage on office property • advertising that is in good taste, identifying services offered • networking and joining organizations such as the Board of Trade, Chamber of Commerce, or local Business Improvement Associations (c) A sample table of contents for a quality assurance manual would be: 1. Leadership Responsibility to promote a culture of quality • Tone at the Top 2. Ethical requirements, independence, and privacy 3. Client Acceptance and Continuance to ensure firms perform engagements within their competencies and that they have adequate resources available 4. Human Resource policies to ensure personnel are capable, competent, and ethical • Hiring/ Staffing/ Supervision Solutions Manual 2-27 Chapter 2 Copyright © 2012 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of this page is strictly prohibited.

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• Confirmation of independence re: Client list • Professional Development Requirements 5. Engagement Risk • Client acceptance and continuance • File Documentation • Performing and documenting Engagement Quality Reviews 6. Monitoring.

• Internal-ongoing compliance • External (d) File quality reviews are more commonly known as second partner reviews.

They are required for all listed public entities. For non-listed entities, firms need criteria to assess the need for a file quality review. Common factors used to determine if a file quality review is required are: 1. assurance fees greater than $10,000, 2. more than 10 stakeholders, and 3. the engagement is assessed as high risk.

File quality reviews involve a review of the financial statements, the work performed, and an evaluation of the opinion formed.

There are two requirements a firm must meet with respect to monitoring. First, a firm must perform an ongoing assessment of its compliance with the policies and procedures set out in its quality assurance manual. Second, every one to three years, a firm should have a “Monitor” (someone not involved in the engagements) review a selection of assurance files as well as assess the quality control activities of the firm. A report should be issued identifying any weaknesses or deficiencies.

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Case Study — Cloud 9 (a) Client acceptance decision issues: • The relationship between David Collier and P.S. Nethercott is described as distant. Rules of professional conduct and independence rules discuss familiarity threats which can occur because of a close relationship, such as a member of the assurance team having an immediate family member or close family member who is a director or officer of the assurance client, or an employee in a position to exert direct and significant influence over the subject matter of the assurance engagement. In this case, P.S. Nethercott is not on the assurance team (and is not likely to be), and although the relationship is with a person in a position to be involved in the subject matter of the audit, the relationship is distant. There would be no threat to independence.

•

The potential consulting fees are twice the size of the audit fee, creating a significant business relationship between the audit firm and the client, and potentially an undue dependence on the fees from this client (relative to total fees from all clients). According to rules of professional conduct and independence rules a self-interest threat to the auditor’s independence could arise from this relationship. In general, firms would limit the size of non-assurance service fees relative to the size of assurance fees for any one client, through either limiting the amount of non-assurance services provided or refusing to perform both for the same client. In addition, it is possible that a self-review threat could arise if the IT installation was relevant to the financial data that would be the subject matter of the audit in future periods. The non-assurance service (IT installation) in itself should also give risk to consideration of the threats to independence. In general, the self-review threat is likely to be too significant to allow both services to be provided by the same firm, except if the audit client clearly takes all management decisions with respect to the installation of the IT project, and non-assurance and assurance staff at the audit firm are kept separate.

•

Purchases of products in the normal course of business and on an arm’slength basis, such as shoes from stores, is acceptable and is not an independence threat.

•

Members of the IT department at the audit firm could be involved in the audit. As such, their financial interests need to be considered. In this case, the shareholdings are in retailers that sell the audit client’s products, and the shareholdings are material and have been disclosed to the audit firm.

The shareholdings are not in the audit client, and the relationship does not allow the members of the IT department to influence management decisions at either the retailers or the audit client. There is no independence threat to the audit of Cloud 9.

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This point does not relate to independence issues. In this case, the newspaper article suggests that the management of Cloud 9 Inc, the parent firm of the audit client, is engaged in illegal and/or unethical behaviour. The auditor is required to consider client integrity in the client acceptance decision (CSQC1 and CAS 220 Quality control for an audit of financial statements). In addition, the auditor is required to consider any threats to the fundamental principles. Such a threat could occur if the prospective client is dishonest or involved in illegal activities. The management of Cloud 9 Inc have denied the allegations and invited international human rights groups to visit their factories. Cloud 9 Inc is not the prospective client of W&D Partners, so it could be argued that the auditors are not concerned with this issue. However, a lack of integrity at the parent company could indicate a lack of integrity at the local level, and/or create other issues for the auditors related to dealings between the companies. The auditors could raise the issue with Cloud 9 Ltd management, and if still concerned, also visit the factories.

(b) Other issues to be considered in making the client acceptance decision include: • Other issues relating to client integrity, such as reasons for the audit switch, client attitudes to risk, internal controls, accounting standards, full access to information, and payment of fees.

• Obtaining permission from the client to communicate with the previous auditor, third parties such as bankers and lawyers, and client personnel.

• Review press articles and other company disclosures.

• Any potential threats to other fundamental principles, such as professional competence and due care through lack of auditor expertise in the client industry or insufficient audit staff. (c) Prepare client engagement letter as per example in text (figure 2.4).

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Research Question 2.1 – Accounting expertise on audit committees (a) Arguments for and against allowing former audit firm partners and/or employees to join audit committees: Advantages: • expertise of former auditors being available to client, should lead to an improvement in their financial statements which benefits the client, its stakeholders, and the general public (through a general increase in reporting quality), • ex-auditors understand the problems facing the auditors and can help their new colleagues at the client respond appropriately to the auditor’s requests.

Disadvantages: • loss of auditor independence arising from close personal relationships between these former auditors and their former colleagues in the audit firm, • audit committee might lose its independence when selecting audit firms (preference for their old firm) and in dealing with disputes (b) Former audit partners might be recruited by the client in order to help the audit process by: • improving their systems and financial statements based on the exauditor’s intimate knowledge of good control systems and financial reporting.

However, they could also be recruited and hinder the audit process by: • encourage the audit firm to be ‘soft’ on their friends, • use the expertise of the former auditors to ‘get around’ the system, that is, they know what the auditors will be looking for in terms of ‘red flags’ and thus better able to hide the problems, • share their knowledge of audit sampling methods could be used to hide errors in items that are not likely to be sampled.

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Research Question 2.2 – Professional accounting bodies and their rules of professional conduct (a) Certified General Accountants Association of Canada (CGA-Canada) Locate the Independence Standard and Code of Ethical Principles and Rules of Conduct.

What are the six principles listed under the “Code of Ethical Principles” 1. Responsibilities to Society 2. Trust and Duties 3. Due Care and Professional Judgement 4. Deceptive Information 5. Practice of the Profession 6. Responsibilities to the Profession What are the requirements of the “Rules of Conduct” for the following: rules 201, 202.4, 301, and 402?

Rule 201 “A member shall not disclose or use any confidential information acquired as a result of professional or business relationships without proper and specific authority.”

Rule 202.4 Compilation Engagements “A member may issue a compilation engagement report as long as appropriate disclosure of any interest, influence, or relationship between the member and the client is made in the compilation engagement report.”

Rule 301 Competence “A member shall sustain professional competence by keeping informed of, and complying with, developments in the acknowledged standards of the profession in all areas in which the member practices or is relied upon because of the member’s profession.”

Rule 402 Association with Financial Information A member shall not be associated with any letter, report, statement, representation, financial statement, or tax filing, whether written or oral, which the member knows, or should know, is false or misleading, regardless of any disclaimer of responsibility.

Rule 402.1 Employer/Employee Conflicts It is recognized that under exceptional circumstances, compliance with Rule 402 may place a member in a difficult position vis-à-vis the member’s employer. Nevertheless, professional duty is failed if the member fails to comply with Rule 402.

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(b) Certified Management Accountants of British Columbia (CMA BC) What are the requirements of the rules of conduct for the following: rules 201, 211, 302, 403?

Rule 201.1 “A Member shall conduct himself/herself at all times in a manner which will maintain the good reputation of the profession and its ability to serve the public interest.”

Rule 211 “A Member shall bring to the attention of the Professional Conduct Enquiry Committee any apparent breach of these Rules or any instances involving doubt as to the competence, reputation or integrity of a Member or applicant, provided that this Rule shall not apply to: (a) a trivial matter, (b) a Member exempted from this Rule for the purposes and to the extent specified by the Board, or (c) a Member who is under a specific legal requirement imposed by or pursuant to statutory authority which would preclude the disclosure of confidential information.”

Rule 302 “A Public Practicing Certified Member shall not directly or through a party acting on behalf of and with the knowledge of such member solicit any professional engagement which has been entrusted to another professional accountant engaged in the Practice of Public Accounting or who carries on a business or practice which constitutes a related function.”

Rule 403 (1) “A member or, where permitted, an incorporated professional, shall engage in the practice of public accounting, or in the public practice of any function not inconsistent therewith, only under a name or style which: a) is not misleading; b) is not self-laudatory; b) does not contravene professional good taste, and d) has been approved in a manner specified by the Public Practice.”

Rule 403 (2) “A sole practitioner or a firm which was licenced to be in public practice as at October 27, 1991, and whose name at that date included the phrase "& Co." or other similar wording as permitted by Rule 403(1) as it read prior to that date, may continue to use such name for as long as that sole practitioner or firm carries on the Practice of Public.”

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(c) Institute of Chartered Accountants of Ontario (ICAO) Locate the Institute’s Rules of Professional Conduct. What are the requirements of the rules of conduct for the following: rules 102.1, 209, 303, 402?

Rule 102.1 – Conviction of criminal or similar offences “A member, student or firm who has been: (a) convicted of an offence of fraud, theft, forgery or tax evasion, or is convicted of an offence of conspiring or attempting to commit such offences; or (b) found guilty of violating the provisions of any securities legislation; or (c) convicted of any criminal or similar offence for conduct in or relating to their professional capacity, or for conduct in circumstances where there was reliance on their membership in or association with the Institute; or (d) discharged absolutely or upon condition after pleading guilty to or being found guilty of an offence described in (a), (b) or (c) above shall promptly inform the Institute of the fact of the conviction, finding of guilt or discharge, as the case may be, when the right of appeal has been exhausted or expired.”

Rule 209 – Borrowing from clients 209.1 “A member, student or firm shall not, directly or indirectly, borrow from or obtain a loan or guarantee from a client unless either (a) the loan or guarantee has been made under normal commercial terms and conditions, and (i) the client is a bank or similar financial institution whose business includes lending money to the public; or (ii) the client is a person or entity, a significant portion of whose business is the private lending of money; or (b) (i) in the case of a member or student, the client is a family member or an entity over which a family member exercises significant influence; or (ii) in the case of a firm, the client is a family member of a partner or shareholder of the firm or an entity over which a family member of a partner or shareholder of the firm exercises significant influence.”

209.2 “Rule 209.1 does not apply to: (a) the financing of a bona fide business venture between a member, student or firm and a client that is not an assurance client (b) amounts received from a client as a retainer or as a deposit on account of future services to be provided by the member, student or firm; or (c) a loan received from a member’s or student’s employer.”

209.3 “For purposes of Rule 209.1, a client includes a person or entity who has, within the previous two years, engaged the member or firm to provide a service and who relies on membership in the Institute as giving the member or firm particular competence to provide that service.”

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Rule 303 – Co-operation with successor “303.1 A member or firm shall upon written request of the client supply on a timely basis reasonable information to the member's or firm's successor about the work done or being assumed.

303.2 A predecessor member or firm on an engagement shall co-operate with the successor on the engagement, recognizing the client's interests are paramount, and shall transfer promptly to the client or, on the client's instructions, to the successor, all books, documents, and other property belonging to the client which are in the predecessor’s possession.”

Rule 402 – Use of descriptive styles “402.1 The practice of public accounting shall be carried on under the descriptive style of either "chartered accountant(s)" or "public accountant(s)", unless it forms part of the firm name. Regardless of the functions actually performed, the use of either "chartered accountant(s)" or "public accountant(s)" as part of the firm name or as a descriptive style, in offering services to the public, shall be regarded as carrying on the practice of public accounting for the purposes of these rules of professional conduct.

402.2 Notwithstanding Rule 402.1, each office in Ontario of any firm engaged in the practice of public accounting and composed of one or more members sharing proprietary interest with other public accountants who are not professional colleagues* shall not practise under the style of "chartered accountants".” * Members are referred to the bylaws definition of "professional colleague" as a member or a member of a provincial institute.

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The material provided herein may not be downloaded, reproduced, stored in a retrieval system, modified, made available on a network, used to create derivative works, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise without the prior written permission of John Wiley & Sons Canada, Ltd.

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Solutions Manual to accompany

Auditing: a practical approach by Robyn Moroney Fiona Campbell Jane Hamilton Valerie Warren

CHAPTER 3 Audit Planning I

John Wiley & Sons Canada, Ltd. 2012

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Chapter 3 – Audit Planning I

SOLUTIONS TO REVIEW QUESTIONS REVIEW QUESTION 3.1 LO 1 Planning is an ongoing process during the audit because the plan is modified if required. Whether the plan is modified or not depends on the results of the audit procedures performed during the execution stage. If during the execution stage the auditor comes across something unexpected, the audit plan may be modified to do more or less work that originally planned in a certain area. For example, if when planning the audit, the auditor assesses the fraud risk as low but fraud is unexpectedly found during the execution stage, the audit plan will be modified to perform more fraud related procedures. However, planning usually precedes the execution stage, and the reporting stage is last the stage of the audit.

The planning stage includes gaining an understanding of the client, identifying significant accounts and transactions, setting planning materiality, identifying the factors that can go wrong in the audit, gaining an understanding of key internal controls and developing an audit strategy. Risk identification is a key part of the planning stage because CAS 300 Planning and Audit of Financial Statements requires that an auditor plan their audit to reduce audit risk to an acceptably low level. Therefore, the auditor must identify the risks to the audit so that the auditor can plan to gather the evidence required to reduce those risks. Effective and efficient planning ensures that sufficient appropriate evidence is gathered for those accounts at most risk of material misstatement.

REVIEW QUESTION 3.2 LO 1 The planning stage of a financial statement audit is important because it involves determining the audit strategy to reduce audit risk to an acceptably low level. The audit strategy sets the scope, timing and direction of the audit. It also aids the audit team identify the audit procedures that are most appropriate to the client’s characteristics and situation. An effective audit plan shows that a suitable amount of time is spent testing each major account and class of transaction. The audit procedures detailed in the plan are guided by the audit strategy chosen to suit the client’s risk factors and reporting requirements.

The audit plan also is useful as a communication tool to facilitate cooperation between the members of the audit team, ensuring that each member understands the work required. The plan is also useful for communicating with

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other members of the audit firm to ensure that the appropriate resources are provided to the audit team. The plan is used to guide the execution stage of the audit and is used as a framework to guide the audit conclusion and reporting stage.

REVIEW QUESTION 3.3 LO 2 Customers: Auditors are interested in the relations between the audit client and its customers because this could affect the reliability of cash inflow and the collectability of accounts receivable . If relations are poor, customers could withhold payment, reducing the value of the accounts receivable . If the relations are poor because of poor quality goods, the audit client could be liable for warranty claims, affecting expenses and liabilities. Auditors are also interested in the risk associated with the client’s reliance on a few major customers because of going concern issues.

Suppliers: Poor relations between the audit client and its suppliers could be indicators of cash flow problems for the client. The supplier could be supplying faulty goods, leading to issues with customers and problems with warranty claims. The audit client could be locked into unfavourable contracts with suppliers, affecting its ability to survive as a going concern. If the client is not paying its suppliers on a timely basis, it might lose access to that supplier, affecting its ability to continue to trade.

In both cases, the auditor would be interested in whether the other parties are located overseas because of the additional risks associated with international transactions and foreign exchange (which could apply to domestic trading partners as well).

REVIEW QUESTION 3.4 LO 3 Figure 3.2 shows the key factors considered in preliminary risk identification.

Understanding the client — consider issues at the entity, industry, and economy level. What does the client do? How does the client function? What is its ownership structure and sources of finance? Who are its customers and suppliers? Does it import or export? How does the client adapt to changes in technology? Is it liable for warranties? What are its operations? Who are its employees? What industry does it operate in? What are the industry’s issues – competition, government support, demand and supply constraints? How does the economy’s health affect the client?

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Fraud risk — factors indicating high risk of fraud, identify incentives, pressures, and opportunities for fraud, management attitudes.

Going concern — risk and mitigating factors Corporate governance — board structure, listing status, audit committee Information technology — risks to processes, security, changes, controls Closing procedures — types of procedures, monitoring, pressure on results

REVIEW QUESTION 3.5 LO 4 Incentives and pressures are the motivating factors for the client’s personnel to commit a fraud. For example, a regional manager could be under pressure to achieve a sales target to keep their job or to receive a bonus. This motivates the manager to consider fraud possibilities.

The manager would be able to commit a fraud only if there is an opportunity to do so. An example of an opportunity would be an unlocked storeroom (for asset misappropriation) or loose controls over cut-off (to push a sale from one period to the next to create fraudulent financial reporting). If the manager did not have the incentive or pressure to commit the fraud, the opportunity would not lead to a fraud.

Attitudes refer to the ethical beliefs about right and wrong of the manager and the more senior management of the client. If there is an attitude at the top that achieving sales targets is more important than following policies and procedures, then the manager could use this attitude to justify misstating sales for the period.

Rationalization refers to the ability to justify the act for example “They push me very hard and I work a lot of weekends, I am entitled to this bonus.”

An auditor must consider client systems relevant to all three because they would be more likely to detect fraud by doing so. Perpetrators of fraud are likely to take great care to conceal the fraud, and considering only one set of indicators increases the risk that the auditor will not detect a material misstatement resulting from fraud.

REVIEW QUESTION 3.6 LO 4 As a part of the risk identification process during the planning stage of the audit, an auditor will assess the risk of a material misstatement due to fraud (CAS 240).

When assessing fraud risk, an auditor will adopt an attitude of professional scepticism to ensure that any indicator of a potential fraud is properly investigated. This means that the auditor must remain independent of their client,

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maintain a questioning attitude, and search thoroughly for corroborating evidence to validate information provided by the client.

The responsibility for preventing and detecting fraud rests with those charged with governance at the client. Prevention refers to the use of controls and procedures aimed at avoiding a fraud. Detection refers to the use of controls and procedures aimed at uncovering a fraud should one occur. It is the responsibility of the auditor to assess the risk of fraud and the effectiveness of the client’s attempts to prevent and detect fraud through their internal control system. When assessing the risk of fraud, an auditor can consider incentives and pressures to commit a fraud, opportunities to perpetrate a fraud, and attitudes and rationalizations used to justify committing a fraud (CAS 240, App. 1).

Besides assessing the fraud risk factors noted above, the following are the specific procedures the auditor should perform to comply with CAS 240: 1. The auditor should ask management and those charged with governance if they are aware of a known fraud or suspect there has been a fraud. If the company being audited has an internal audit department, it should also be asked this question. The results of these enquiries should be documented.

2. All members of the audit team, including the partner, should attend a team planning meeting. During this planning meeting, the significant fraud risk factors and where the financial statements may be particularly susceptible to fraud should be reviewed. This allows the more experienced team members to share their knowledge with the less experienced members.

3. The auditor should perform preliminary analytics (these are discussed in more detail in chapter 4) to identify any unusual relationships that may indicate fraud and thus require further investigation during the audit.

4. The auditor must consider the risk of management override. As management is in a position to manipulate the accounting records or override the controls designed to prevent such fraud, the auditor should test a sample of journal entries, review accounting estimates for reasonableness, contemplate the risk of earnings management (particularly in the area of revenue recognition), and carefully examine unusual business transactions to ensure that they have business substance.

If during the course of the audit, the auditor finds fraud, then they should contemplate their legal and professional responsibilities. As the auditor remains bound by confidentiality, they should seek legal advice to determine if there is a requirement to report the fraud to an outside third party. The auditor may also consider withdrawing from the engagement. Finally, the auditor must report the fraud to the level of management above that under which the fraud occurred and report the fraud to the audit committee.

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REVIEW QUESTION 3.7 LO 5 CAS 570 Going Concern states that under the going concern assumption, an entity is viewed as continuing in business for the foreseeable future. It also notes that general purpose financial statements are prepared on a going concern basis, unless management intends to liquidate the entity or to cease operations, or has no realistic alternative but to do so. When the going concern assumption is appropriate, assets and liabilities are recorded on the basis that the entity will be able to realise its assets and discharge its liabilities in the normal course of business.

Therefore, if the going concern basis is not appropriate, management should prepare a special purpose report which reflects that state. ‘Going concern issues’ means that there is doubt about the going concern assumption’s applicability to the client’s financial statements, and if these doubts are serious enough, the entity should prepare a special purpose report.

The auditor must consider evidence about the appropriateness of the going concern assumption for the client in order to express the appropriate audit opinion. If there is not sufficient evidence to support the assumption, the auditor cannot provide an unqualified opinion on general purpose financial statements. If the circumstances are appropriately disclosed by the client’s management and those charged with governance in the financial statement, the auditor can issue an unqualified audit opinion with an emphasis of matter. If adequate disclosure is not made in the financial statements, the auditor shall express a qualified or adverse opinion.

REVIEW QUESTION 3.8 LO 5 Mitigating factors are those factors that reduce the risk that the going concern assumption may be in doubt. For example, if the client has lost a key customer, this could raise doubt about its ability to continue as a going concern. However, this doubt would be mitigated by ongoing negotiations with a potential new customer.

Other potential mitigating factors include: -letter of guarantee from a parent company -availability of non-core assets which can be sold without impacting the company’s ongoing operations -ability to raise additional funds through the sale of sales -ability to raise additional funds through borrowings -ability to sell an unprofitable segment of the business.

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If the client is in a loss position, doubt about its ability to continue in business could exist. This doubt could be mitigated by: - plans to introduce new profitable products - management planning to merge with another company - plans and progress towards expansion into another market - financial support from a parent (or any other factor indicating that the losses can be borne for some time without defaulting on debts etc) - restructuring, retrenchment, downsizing plans (to cut costs)

REVIEW QUESTION 3.9 LO 7 Information Technology (IT) is a critical part of a company’s accounting process..

This typically includes transaction initiation, recording, processing, corrections (when needed), transfer to the general ledger and compilation of the financial reports.

CAS 315 requires the auditor gain an understanding of each client’s IT systems and the associated risks (para 18). Paragraphs A53-A59 (Application and other explanatory material) explain how IT benefits an entity’s internal controls but also poses specific risks to that internal control. For example, IT allows an entity to consistently perform complex calculations in processing large volumes of transactions or data. However, if that processing is inaccurate, reliance on those systems would be inappropriate because of the risk of material misstatement in the entity’s financial statements. The auditor needs to understand where the risk of inaccurate processing lies within the IT system and whether the client has other controls (e.g., manual controls or other automated controls) over processing systems which would provide greater assurance that the reported figures are accurate.

REVIEW QUESTION 3.10 LO 8 Examples of client closing procedures include: • Depreciation or amortization of assets • Accruals — e.g. salaries, interest • Prepayments — e.g. insurance, rates, registration of motor vehicles Other closing procedures include procedures to test the identification of revenues and expenses which belong in the current reporting period or the next and to include the item in the correct period (i.e., client’s entries to ensure correct cutoff).

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For each example, state the accounts affected: • Depreciation/amortization – if not done, expenses are understated and net assets are overstated (accumulated depreciation is understated) • Accruals: if not done, expenses are understated and liabilities are understated • Prepayments: if debit initially made to the asset and the prepayment closing entry is not done, expenses are understated and assets are overstated.

However, if debit is initially made to the expense and the prepayment closing entry is not done, expenses are overstated and assets are understated.

Cut-off entries are required to ensure that late expenses (e.g., invoice for goods or services received) are identified as belonging to the current financial year. If this is not done, expenses are understated and liabilities are understated. If it is a revenue item, ensure that revenue is not recognised until goods are despatched or delivered (depending on the terms of sale). If this is not done and the sale is recorded in the current financial year instead of the next financial year, revenue in the current year is overstated and assets (accounts receivables) are overstated.

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SOLUTIONS TO PROFESSIONAL APPLICATION QUESTIONS PROFESSIONAL APPLICATION 3.1 – Audit planning LO 1, 2 What work has been done to provide evidence that there are no related parties and that there are no issues with the client’s corporate governance structure?

Is the risk of misstatement the same for a dollar of rental revenue as a dollar of retail revenue? The risk of material misstatement should drive the audit plan.

The client is new, what work has been done to understand the client, its industry (both rental and retail elements) and the effect of the economy factors on the client?

What are the significant transactions and accounts?

Is the risk of fraud directly proportional to revenue? If not, how should the work on fraud be allocated?

What impact would IT have on the risks associated with the two segments of the business? How does IT relate to the rest of the client’s internal controls?

Are closing procedures the same for the two segments of the business?

Is there any going concern risk? What are the risks and mitigating factors that are likely to occur in a rental and retail company?

PROFESSIONAL APPLICATION 3.2 – Understanding the client and its governance LO 2, 5 (a) (i) Entity level (Refer to para. A23-A27 of CAS 315) Team will be trying to gain an understanding of: • Complexity of the client’s structure (subsidiaries, locations, investments, financing sources) • Ownership and relations between owners and other people or entities (related party issues) Factors to consider include: • Business operations – revenue, products, markets, production, outsourcing, geographic dispersion, segmentation on industry lines, location of facilities and

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inventories, key customers, major suppliers, employment arrangements, research and development activities, warranties, technology changes, transactions with related parties.

• Investments – new or planned acquisitions or divestitures, investments in securities and loans, capital investment, non-consolidated entities.

• Financing – major subsidiaries, debt, beneficial owners, derivatives.

• Financial reporting issues such as principles and practices usually applied, revenue and cost recognition, fair value accounting, foreign currency items, complex transaction accounting, • Changes from prior periods in any of these factors. (ii) Industry and economic effects (Refer to para. A17-A22 of CAS 315) Factors to consider include: • Competitive environment, product demand, supplier and customer relationships, technological developments, cyclical or seasonal activities, energy supply and cost, nature of regulation, including accounting practices, specific regulations affecting industry, taxation, government policies, environmental requirements, economic conditions, interest rates, availability of financing, inflation, currency revaluations. (b) The Canadian Securities Administrators (CSA) recommendations refer to safeguarding the integrity in the entity’s financial reporting (see figure 3.4). The CSA recommends that the entity establishes an audit committee which is comprised only of non-executive directors, with a majority of independent directors, and chaired by an independent chair who is not chair of the board. The committee should have at least 3 members, and operate with a formal charter.

The question states that there are four members of the audit committee, who are all independent directors. In addition, the chair of the committee is an independent director. However, we do not know if the chair of the committee is also the chair of the board, nor if the committee has a formal charter. If both these conditions are satisfied (and the appropriate disclosures are made), we could conclude that the entity complies with the CSA recommendations, but without this information we could not make this conclusion. Note reporting issuers must disclose their corporate governance practices and why they believe they are appropriate.

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PROFESSIONAL APPLICATION 3.3 – Understanding the client and its risks — audit planning LO 1, 2 (a) Issues: Change from good economic conditions (solid employment growth, rising oil prices, easy access to credit for consumers) to financial crisis (recession with lower employment growth, falling oil prices, difficult access to credit).

Changing conditions such as lower oil prices and lower employment growth have slowed consumer demand for scooters. Consumer demand is also likely to be affected by less access to consumer credit for scooter purchases.

The changed economic conditions also likely adversely impact Scooter Ltd’s access to financing (tighter finance market, slower cash flow to service debt). (b) Impact on audit plan: Greater risk of fraudulent financial reporting because of pressure on Scooter Ltd management to meet performance targets (either for bonuses or to satisfy bank covenants) Likely impact on profit: • Sales revenue. Consider risk of fraudulent transactions, cut-off (sales from future period back-dated to the current period), revenue recognition issues (e.g., scooters loaned to potential customers recorded as sales despite generous rights of return) • Risk associated with finance company – scooter price inflated to be above $10,000 with ‘allowance’ granted later to customer.

• Expenses: Consider risk that expenses post-dated to next period to improve current period profit.

Going concern risk – is business able to pay its debts as they fall due? What are the terms of financing between Scooter Ltd and its banks? Is Scooter Ltd locked into a lease on premises that are now too large?

Risk associated with staff layoffs – poor sales could lead to staff layoffs and increase the risk of successful cases for unfair dismissal.

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PROFESSIONAL APPLICATION 3.4 – Financial reporting fraud risk LO 4 (a) Incentives: The board has shown through their selection of a new CEO with a reputation for ‘toughness’ and turning around businesses that they want a change in the company’s results. The board has given the new CEO a 5 year contract with incentives for growth, profit and share price. The CEO also has the incentive to preserve his reputation.

Opportunities: The new CEO has a bonus that is tied to profit from continuing operations. This means that any write-offs that can be labelled as ‘discontinuing operations’ will not affect his bonus. There is the opportunity to ‘take a bath’ by writing down assets more than is required without affecting the bonus. In future periods, bonus payments will be higher because a lower amount of depreciation will be charged to continuing profits. In addition, selling off certain divisions reduces recurrent depreciation charges and provides a cash resource to invest in other areas that are favoured by the CEO. The new CEO also has a 5 year period to make these changes without risking termination.

Attitudes/rationalizations: The focus is now on maximising profits through boosting sales and cutting costs. There is less emphasis on compliance and more on pleasing the CEO. This suggests that efforts to boost profit will be received favourably and any attempt to obstruct the CEO, such as questioning accounting policies or business decisions, will not be received favourably.

Increasing share prices also seem to say that the market approves the new actions. The CEO has been rewarded by the board, further encouraging this type of behaviour. (b) Potential frauds – consider if the risk of fraudulent financial reporting is greater than the risk of asset misappropriation.

Examples: - Backdating sales to current period, post dating expenses to next period (consistent with reported growth in sales, lower costs in latest results) - Reclassifying assets and expenses as part of discontinued operations, overstating asset impairments, overstating losses on disposal of discontinued operations - Inappropriate classification of revenues and expenses in current period to accentuate reported growth in profit, greater capitalization of expenses in current period as assets (also to increase profit), understating liabilities (nonrecognition of accruals, etc)

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(c) Besides assessing the fraud risk factors noted above, the following are the specific procedures the auditor should perform to comply with CAS 240: 1. The auditor should ask management and those charged with governance if they are aware of a known fraud or suspect there has been a fraud. If the company being audited has an internal audit department, it should also be asked this question. The results of these enquiries should be documented.

2. All members of the audit team, including the partner, should attend a team planning meeting. During this planning meeting, the significant fraud risk factors and where the financial statements may be particularly susceptible to fraud should be reviewed. This allows the more experienced team members to share their knowledge with the less experienced members.

3. The auditor should perform preliminary analytics (these are discussed in more detail in chapter 4) to identify any unusual relationships that may indicate fraud and thus require further investigation during the audit.

4. The auditor must consider the risk of management override. As management is in a position to manipulate the accounting records or override the controls designed to prevent such fraud, the auditor should test a sample of journal entries, review accounting estimates for reasonableness, contemplate the risk of earnings management (particularly in the area of revenue recognition), and carefully examine unusual business transactions to ensure that they have business substance.

If during the course of the audit, the auditor finds fraud, then they should contemplate their legal and professional responsibilities. As the auditor remains bound by confidentiality, they should seek legal advice to determine if there is a requirement to report the fraud to an outside third party. The auditor may also consider withdrawing from the engagement. Finally, the auditor must report the fraud to the level of management above that under which the fraud occurred and report the fraud to the audit committee.

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PROFESSIONAL APPLICATION 3.5 – Going concern LO 5 (a) Going concern issue factors: • Hotel occupancy fees are lower due to reduced business, shopping, and sport related travel.

• Rent from coffee shop has stopped due to the shop’s closure, uncertainty about recovery of penalty fees or new lease.

• Short term finance for renovations will not be renewed. (b) Mitigating factors: • Hotel occupancy could increase if sport related travel is realized as predicted.

• If penalty fees are recoverable, this could repay the short term debt.

• Long term debt is not due, although repayments must be made.

Other, not discussed in question: • Refinance short term debt through seeking a new bank for both the long term and short term debt • Coffee shop could be leased to a new tenant.

• Global financial crisis could be less severe due to government stimulus package, increasing business related travel.

• Renovations are complete and could help boost occupancy.

• Consider likely success of sale of property.

Auditor should consider evidence for each risk and mitigating factor. For example, review correspondence with the existing and any new bank with respect to both loans, discuss the case against the coffee shop tenant with the client’s solicitor (with the client’s permission), review advance bookings for travel associated with the hockey games, review correspondence (if any) with potential new coffee shop tenants, read minutes of board of directors where the issues have been discussed, obtain independent evidence on travel to the city and retain spending, obtain valuations of property (should be higher following the renovations).

The auditor’s conclusion should be based on the strength of the evidence supporting the mitigating factors and the going concern issues, and professional judgement about the likelihood of the events occurring.

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PROFESSIONAL APPLICATION 3.6 – Assessing the risks associated with information technology LO 7 The installation of a new IT system means that results of previous audits do not necessarily apply to the new audit. Shane Whitebone needs evidence that the new IT system operates as it was intended before he can place reliance on it.

Although the new IT system was not part of the audit in the last period, there could be evidence of its testing in a preliminary phase. This issue should be discussed with the previous audit partner. In addition, there could be evidence of the process surrounding the order of the new system, including its customization to the client’s requirements.

Risks in the new system include those associated with accurate initiating, recording, processing and reporting of inventory transactions (including nonroutine transactions), whether the system can be overridden or bypassed by management or staff, whether there are sufficient controls over program changes, whether the information in the old IT system has been transferred to the new system appropriately, whether the new system produces sufficient management reports (e.g., exception reports) to show that the client is monitoring its performance.

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PROFESSIONAL APPLICATION 3.7 – Audit planning in an EDP environment LO 7 • There might be more stress on evaluating the internal controls of the IT department.

• The auditor will have to determine if an IT specialist needs to be brought into the audit team and how this will affect the nature, extent, and timing of audit procedures.

• Make planning decisions regarding other resources that will be needed for the audit, such as the use of computer assisted audit techniques.

• There will be a change to the organizational structure as the implementation of computer systems requires additional resources for the systems to function properly. These resources include qualified personnel and investment in capital assets (appropriate computer equipment). The risk is that appropriate internal controls lacking in computerized environment. Management is responsible for establishing internal controls, regardless of the environment in which the company operates (computerized or non-computerized).

Therefore, implementation of computer systems forces management to ensure that: (1) adequate procedures are in place and computer systems are properly documented, (2) an adequate audit trail for significant classes of transactions exists, and (3) knowledgeable personnel are in place to support the computer system and assist management and auditors.

• Centralization and the resulting efficiencies are usually the reasons why the company implements computer systems. Rather than having separate accounts payable or accounts receivable departments doing the data processing independently, for example, more data processing is done through one department — the computer centre or computer processing department. There is a greater risk of losing large amount of data in case of breakdown of computer system. Internal controls, policies and procedures must be in place to make sure that data can be recovered in case of an accident. (The users of the computer processing department, such as the accounts receivable and accounts payable departments, become more dependent on centralized processing).

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• The use of computer systems will undoubtedly reduce the amount of physical documentation available for the auditor. Additional controls are necessary to achieve the objectives of validity, authorization, and completeness that are traditionally supported by documentation. Documentation deficiencies can take the following forms: (1) input documentation, such as batch entry sheet and purchase invoices, which normally contains evidence of authorization and validity, does not exist; (2) audit trail documents, such as ledgers, reports, and records, are not available, except for machine readable documents; and (3) output documentation providing evidence of transactions, including trial balances and invoices, is not produced by the computer system. In addition, data may be input into the system without leaving an audit trail of transactions.

• The auditor must ensure that there are controls to prevent unauthorized access and that there are procedures to secure restricted or sensitive areas throughout the organization. Such controls include but are not limited to: (1) password controls; (2) physical restrictions to computer equipment; and (3) activity logs regarding all access and attempted access to data files or programs.

• With respect to system design, properly designed systems enable data to be processed consistently and correctly with little human intervention. However, computer systems may produce errors that a human would never make; usually, the fault is in the system. With manual processing, humans usually recognize absurd transactions and correct them; computer systems do not, unless they are programmed to do so. to mitigate this risk, a computer may prompt the user each time a transaction is out of the ordinary before continuing the process.

• Vulnerability of hardware, software, and data files — What if there is a fire?

Computer systems tend to centralize programs and data. In case of fire, files and computersmay be destroyed. What if it’s not possible to reconstruct the information files from another source? If it is not possible to reconstruct the information files from another source, the company could be in serious difficulties. From an audit standpoint, there may even be a denial of opinion, because nothing can be verified without proper access to records. Internal controls must be in place to make sure that data can be recovered in case of an accident. The auditor would have to ensure that there are policies and procedures to back up and recover data, as well as adequate insurance coverage for business interruption and for hardware replacement should it be destroyed or stolen.

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PROFESSIONAL APPLICATION 3.8 – Impact of closing procedures on performance LO 8 (a) The auditor is required by CAS 315 to understand the aspects of the client’s business risk that increase the likelihood of material misstatement. Dunks has experienced consistent growth but there are doubts about its ability to continue to grow in the current economic climate. There is a risk that these conditions could place financial stress on the company through falling revenue and cash collections from customers and increased costs from adverse currency movements. There could also be difficulty sourcing products from other companies in financial stress. There is increased risk of bad debts, and improper revenue recognition. If currency exchange rates are more volatile because of the recession there is increased risk of incorrect purchase costs and exposure to foreign currency exchange risk (which could be hedged).

Senior managers remunerated through bonuses could be under pressure to find ways to increase revenues and cut costs. These pressures could increase the risk of fraudulent financial reporting. Also, the general attitude within the company towards profit targets could be interpreted as a poor attitude towards preventing fraudulent financial reporting.

The slower monthly reporting is a concern. It increases the risk that exceptions and performance evaluation are not being dealt with on a timely basis. It also suggests that the reporting system is under pressure for some reason, increasing the risk that the reports are not accurate, particularly with respect to monthly closing entries. (b) Given the above risk statements, specific focus would be on making sure that revenues are not overstated and expenses are not understated. This means that there would be a search for backdated revenues and post-dated expenses.

Documents (invoices, cash receipts and payments) related to sales for the first weeks of the new year and expenses for the last few weeks of the old year would be inspected. The auditor would vouch sales journal entries for the old year and trace expense documents to the journals for the new year.

Interim audit procedures would be directed towards investigating monthly closing procedures. Although these monthly closing entries will not impact on the overall profit for the year (except the first and last month entries), they provide a guide to the management’s attitude towards closing entries in general and the adequacy of the closing entry system controls.

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PROFESSIONAL APPLICATION 3.9 – Gaining an understanding of a new client LO 2 The information could be used to calculate ratios and trends (i.e., analytical procedures). The auditor would gain an understanding of the client’s main categories of revenue and expenses, and the relative importance of various assets and liabilities. The auditor can compare the firm to other firms in the industry. How similar is the client to other businesses in this industry? What are the major trends developing in the industry, particularly as economic conditions change? Does this client show the same trends? Why/why not? The auditor should focus on areas that will be given additional attention during the audit.

Anticipated results could be analysed to understand the client’s expectations regarding growth (or decline) and also reveal shifts in revenue and expense patterns. The auditor would consider whether actual changes in business are reflected in the accounts (e.g. has the bank given the business a new loan to finance an expansion or new purchase of equipment?). The auditor would also use the reports to understand the difference between peak and off-peak periods and how they affect the business’s profits. Specific issues include provision for annual and other leave (apparently some staff never take holidays) and the most senior staff’s retirement-related provisions.

The auditor should also obtain information about occupancy rates, visitor numbers, staff numbers, and compare these to the financial data. For example, does accommodation revenue vary proportionally with occupancy rates, tour revenue with visitor numbers, payroll expense with employee numbers? Why/why not?

PROFESSIONAL APPLICATION 3.10 – Assessing fraud risk LO 4 (a) Fraud risk factors: Justin and Sarah Morris have effective control, but not 100% ownership of the business. This creates a risk that related party transactions are not properly at arms’ length or disclosed in the Featherbed reports. The presence of a new equity investor and the involvement of the bank increase the demand for credible reports. The management have a ‘laid back’ style, suggesting there is not effective control. There is also the question of effective control over assets because the CFO is in control of financial statements and a major investor in both companies. The chairman of the board is the husband of the CFO, the CFO is a director – is there good oversight, i.e., good corporate governance?

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The accounts have not been audited before, meaning that an independent external party has not previously reviewed the business’s internal control and financial reports. Opening balances are particularly at risk.

Accounting staff rarely take leave, suggesting that there has not been an opportunity to independently review their work. Are they hiding anything? There appear to be issues with segregation of duties and effective supervision. For example, they help each other with journal entries, it is not clear whether the custody of the cash is kept separate from the bank reconciliation (these issues relate to opportunity to commit fraud).

Peter Pinn is close to retirement and thus has a short ‘horizon’ in the business. Is there an attitude that they work so hard in the accounting department that they are ‘owed’ something (i.e., an attitude/rationalization issue).

Is there effective supervision of the casual workers? They are people likely to have incentives for asset misappropriation due to their low wages. They could have an attitude that fraud is reasonable due to the poor working conditions and low wages. Does the accounting staff have proper procedures for processing these short-term employment contracts? Who handles the human resource (HR) duties?

Overall, the small size of the business means that it is unlikely that the client has fully effective internal control systems. A great deal of reliance is placed on management supervision and there are factors that indicate that this supervision might not be totally effective. (b) Each fraud risk factor would require more time in the audit plan to gather evidence about the assertions relating to relevant accounts and transactions.

The plan would include time on understanding the client’s system of internal control, but additional control testing would only be warranted where the auditor intended to place reliance on the controls. The fraud factors appear to suggest that greater substantive testing would be required, particular for accounts relating to payroll, bank, related parties, revenue recognition and expenses, and closing entries.

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PROFESSIONAL APPLICATION 3.11 – Fraud risk LO 4 (a) The collusion resulted in reduced fees for patients. This means that revenue is understated for various medical and other services as well as room charges (completeness of revenue). It is possible that accounts receivable are understated – either amounts are too low or some accounts are not recorded (valuation of accounts receivable)

(b) Discussion of effect of this fraud on Gardens Nursing Home's business Revenue and cash receipts are reduced by the fraud. This means that Gardens Nursing Home appears less profitable than it is. Consider the impact of this on staffing decisions (i.e., the business has to cut back staff because of reduced profits?), equipment purchases, loan covenants (are covenants breached due to reduced profitability?). Have management taken other action to deal with declining profitability?

Consider control environment. What conditions led to this fraud? What other controls are inadequate? What is the prevailing attitude within the business to fraud? Are personnel upset by the fraud? How effective is Gardens Nursing Home’s management and supervision?

Discussion of effect of this fraud on the external auditor The external auditor will focus on how the fraud affected the financial statements – where are the likely misstatements? How has the poor control environment and systems affected the quality of the accounts?

The internal auditors will focus on the wider implications of the internal control system breakdown for the business. How are management objectives being achieved if controls are weak? Are there any implications for future business plans or operations not directly related to the financial statements?

PROFESSIONAL APPLICATION 3.12 – Motives and opportunities to commit fraud LO 4 Items that would be considered as: 1) a motive for fraud: a, b, f, g, h, i, l

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2) an opportunity for fraud: c, d, e, f, j, k, l, m PROFESSIONAL APPLICATION 3.13 – The fraud triangle LO 4 Pressure — The company needs the bank loan to expand.

Opportunity — The president of the company has a great deal of authority in the company. Internal controls, if they exist, may not prevent the president from recording sales revenue early.

Rationalization — "We will never notice the loss of these sales next year, because when we build the new manufacturing facility our sales revenue will dramatically increase."

CASES 3.14 – Cool Look Limited (a) Going concern There is a need to assess the going concern assumption in the 2012 audit of CLL. CLL s bank has extended CLL s credit up to February 28, 2012, at which time it reserves the right to call its loan if the covenants are not met. Being in breach of covenants in and of itself does not automatically result in CLL not being a going concern. However, there are a number of other factors that do suggest CLL is not a going concern. CLL has lost money for at least the last two years. It also has stretched its accounts payable from just under $1 million a year ago to almost $2.5 million. It currently cannot afford to upgrade and refit its equipment, and is not maintaining its equipment or maintaining its insurance coverage.

Furthermore, the board passed a resolution to temporarily delay remitting taxes until cash flows improved. These points indicate serious liquidity problems.

The financial ratios are not currently met by CLL. Before making any adjustments for audit findings, the November 30, 2012 statements show CLL is onside on one of the two ratio requirements. The current ratio is 1.64:1, which is more than the minimum 1:1 allowed. However, reclassifying the long-term debt as a current liability (a possibility discussed later in my memo) would reduce the current ratio to 0.42: 1 and it would fall under the bank s requirement. It is also possible that the bank will not consider the $500,000 loan to Martin Roy in its current-ratio calculation, which would reduce the ratio further. In addition, the debt-to-equity ratio is 85.8%, while the bank is asking for a maximum debt-to-equity ratio of

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80%. This ratio will require improvement in order to meet the covenants set out by the bank in its November 1 letter.

We need to discuss the extent of the problem with management. Evidently management and the board are concerned about the cash position since they have taken steps to reduce spending. But they also increased their risk exposure by delaying payments and cancelling the insurance. We need additional information before concluding on the validity of the going-concern assumption.

For example, we need to see future cash flow forecasts, sales forecasts, and future sales contracts.

There are a number of positive factors that suggest CLL is a going concern. CLL has $1,094,000 cash on hand as of November 30. If the equipment can be refitted using that cash in the next three months, CLL may remain a going concern. Also, CLL still has a positive equity, and our review of the minutes shows that the company has a new, large contract. These factors suggest that CLL remains a going concern, despite the possibility of the bank calling its loan any time after February 28, 2012.

If CLL proves not to be a going concern it will be necessary to restate the balance to liquidation values. Although further investigation is required, it is likely that restatement is unnecessary given the positive factors identified. However, the possibility that CLL is not a going concern will have to be disclosed in the notes to the financial statements. If disclosure is deemed adequate, we will be able to issue a clean audit report.

(b) Shareholder loan The shareholder loan is a related party transaction. Related Party Transactions tend to increase audit risk as there is a risk they may not be appropriately identified and disclosed. It is also important in that related party transactions may not be in the normal course of business. This increases the susceptibility of the financial statements to a material misstatement due to fraud and error, and it may impact the overall financial statement results. Financial statement users need sufficient information to assess the impact of these transactions on the financial statements overall. (c) If the client refuses to disclose the related party transaction, there is a GAAP departure. Therefore, an unqualified audit opinion should not be issued and the auditor should issue either a qualified or an adverse opinion. A qualified opinion is appropriate if there is a material departure from GAAP, but the effect of the error is not pervasive throughout the financial statements. An adverse opinion

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would be appropriate if there is a material departure from GAAP that is pervasive to the financial statements.

In this case, as the impact of the shareholder loan is not pervasive to the overall financial statements, it is likely a qualified opinion. (d) CLL Board members have increased their risk exposure of the company. There could be some safety issues the CCL could be subject to lawsuits in this situation, which would be damaging to the company. The board has also decided to discontinue insurance coverage. This puts CLL at significant risk. If there is a major fire CLL is out of business. The potential risk is highlighted by the recent fire that occurred. The cancellation of insurance is negligent and, therefore, the directors could be personally liable to the shareholders and other key stakeholders for any losses. The insurance coverage should be reinstated at once.

The board passed a motion to allow Martin Roy to postpone repayment of his interest-free shareholder loan by another six months to May 31, 2013. He owes CLL $500,000. Considering the financial situation of CLL, this $500,000 would help CLL considerably. The bank may not be aware of this postponement, and CLL could be in breach of another bank requirement.

The board has decided to defer payment of taxes and withholdings to the federal government. If the payments are not made by CLL, the Canada Revenue Agency (CRA) can go after CLL and its directors for payment of the taxes and withholdings.

Therefore the Board is not in compliance with National Policy 58-201 which requires it to identifying the key risks to the business, and ensure there are appropriate systems in place to manage these risks.

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Case Study — Cloud 9 Your task is to research the retail and wholesale footwear industries and report back to the audit team. Your report will form part of the overall understanding of Cloud 9’s structure and its environment.

You should concentrate your research on providing findings from those areas that have a financial reporting impact and are considered probable given Cloud 9’s operations. In conducting your research, you should consider the following key market forces, as they relate to Cloud 9’s operations.

• General and industry-specific economic trends and conditions • Competitive environment • Product information • Customer information • Supplier information • Technological advances and the effect of the internet • Laws and regulatory requirements

Solution Students may have identified some of the following key market forces based on their research.

Economic characteristics/Supplier information/Regulatory The Canadian footwear market is expected to grow at an average of approx 2% each year to 2012: • Household consumption expenditure has decreased over the last few years with gasoline and housing prices increasing. Expenditure is mostly going towards travel and leisure rather than clothing or footwear.

• Tariff reductions have led to a decrease in prices for consumers.

• Lower pricing levels and improved quality of Chinese imports have resulted in large volume increases. Cloud 9 has responded well to this shift by obtaining the majority of its good from their China distribution plant.

• The strength of the Canadian dollar against the US dollar has improved the foreign currency exchange issues.

• Having a retail outlet/store increases the risk of theft (and has been proven) and need for skilled or at least consistent labour.

• Consider effect of recent events — e.g., Global financial crisis.

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Competitive environment/Product information/Customer information Competition is high and increasing, with price and quality the deciding factors: • The ability to supply footwear retailers with products in a timely manner is an important success factor against competitors. Footwear is subject to fashion trends.

• Image and functionality are two of the most important characteristics consumers use to differentiate footwear. An aggressive marketing campaign, often using sports and fitness preferences are key to establishing brand recognition.

• The industry is relatively capital intensive – need for warehousing, transportation, inventory/stock – is high and may create barriers to entry.

• While entry from new wholesalers can be difficult based on agreements between existing wholesalers and retailers, the trend in the industry is for the customer to buy directly from the manufacturer. Cloud 9 has responded well to this trend by opening its own store, thereby taking out the wholesaler.

• Discount stores are surpassing department stores – this may impact Cloud 9’s current customer base and sales opportunities.

• To boost repeat customer visits, retailers are developing loyalty programs.

While Cloud 9 started a program this year, it remains to be seen if the benefits will be achieved given the low regularity of consumers purchasing athletic footwear.

Technology and Systems Technological advances in this industry have mainly been in the areas of replacing the need for skilled labour with computerized automation of inventory control: • Computers allow inventory to be stored on an international basis; allowing for more efficient transportation and distribution.

• Distribution management software allows advanced order management, inventory management, and delivery systems to be combined in one seamless supply chain.

• An on-line presence will provide a competitive advantage through increased marketing power and the ability to provide product information.

By considering these factors, the auditor would identify key business risks that would have a material effect on the financial statements. These risks are inherent to the business operations. Based on the research above, the Cloud 9 audit team have identified the following audit risk areas:

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Growth of revenues given industry outlook and management incentive Risk Description Consumer discretionary spend is low and expected to grow by only 2% for the year. Management receive bonuses based on revenue targets, which was set at 3%. General economic conditions will also impact retail businesses with their recoverability of debt and valuation of assets.

Use of IT for inventory management system Risk Description Retail businesses are reliant on a smooth supply chain process. Where a business uses products with a long lead time, there is significant pressure to ensure that the correct type and quantity of inventoryis ordered to meet the requirements of customers.

Level of competition Risk Description Most sectors of retailing are relatively mature and continue to compete on the traditional basis of price, brand strength and level of market power. Price remains important in most mass market areas of retailing.

Merchandise cycle and fashion trends Risk Description Rapidly changing fashion trends and slow sales outlooks can result in obsolete inventory/stock.

Misappropriation of inventory and cash Risk Description Retail business selling highly desirable and moveable products (e.g., PC games, CDs, designer sunglasses) will be exposed to an increased risk of theft. In addition, employees handling cash at store locations increases the risk of fraud through theft also.

Rebates/Discounts to retailers Risk Description For the wholesale business, there is significant pressure from retailers to receive generous rebates or volume discounts. Retailers are heavily influenced by landlords and consumers; therefore they control their profits through the supply chain, thus impacting the wholesaler.

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NOTE TO THE LECTURER: From a big picture perspective, you may want to highlight the key risks in respect of understanding the wholesale/retail industry. This does not directly affect the outcome of the case study for Cloud 9 given the limited company background provided.

• How does the company control the suppliers/manufacturers? Are they onshore or offshore?

• How do they determine the quantity/style for their purchases from the manufacturer? Ultimately, the wholesaler inherits some of the risk when determining inventory/stock balances to effectively service the retailers.

• What are the terms and conditions with the retailers? What rebates or discounts are provided? As price is the key driver in retail, this will be the area of concern when dealing with retailers.

Research Question 3.1 – The auditor and the Ponzi Scheme (a) Students should conduct a literature review and write a report of the current state of the legal case.

There are several useful texts explaining the Madoff affair including: • Markopolos, H., No one would listen, Wiley (2010) • Arvedlund, E., Too Good to Be True: The Rise and Fall of Bernie Madoff, Penguin (2009). (b) A summary of the allegations again Friehling from the most recent court documents and media reports should be tested against relevant provisions of the rules of professional conduct (e.g., lack of independence, competence, professional behaviour and due care allegations), and standards. These are likely to include CAS 200 (conduct of an audit), CAS 220 (quality control), CAS 230 (was there appropriate documentation?), 240 (fraud factors - were they properly identified?), CAS 315 (understanding the client and assessing risk – did the auditor understand the business of hedge funds and assess Madoff’s control systems?), CAS 330 (responding to assessed risks – did the auditor respond appropriately to any risks identified?), CAS 500 (audit evidence – was it sufficient and appropriate?).

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Research Question 3.2 – Public Company Financial Statements The solution to this research question will depend on the company selected by the student. However, some general references and guidance are provided. (a) Entity level factors Knowledge about the entity is gained through interviews with client personnel, including those charged with governance. The student should ask questions about what the client does, how it functions, how its ownership is structured, and what its sources of financing are. By gaining an understanding of the client, the student is in a stronger position to assess the entity-level risks and the financial statement accounts that require closer examination. The following points outline some of the procedures the student should consider to gain an understanding of the client at the entity level: • Who are the Major customers? Do they have a good reputation? Are they on good terms with the client (that is, likely to remain a customer in future)? Are likely to pay the client on a timely basis?

• Dissatisfied customers may withhold payment, which affects the allowance for doubtful accounts and the client’s cash flow, or they may decide not to purchase from the client in the future, which can affect the going concern assumption. If a client has only one or a few customers, this risk is increased.

• Who are the Major suppliers? Are they reputable? Do they supply quality goods on a timely basis? Are significant levels of goods are returned to suppliers? What are the terms of any contracts and terms of payment with suppliers? . Does the client pays its suppliers on a time?

• If the client is having trouble paying its suppliers, it may have trouble sourcing goods as suppliers may refuse to transact with a company that does not pay on time.

• Does the entity import or export goods? . If so, is the country (or countries) the client trades with, stable? Is the foreign currency (or currencies) the client trades in stable? Are the risk management policies effective (such as hedging policies)?

• Is the entity able to adapt to changes in technology and other trends?

• Ifnot, it risks falling behind competitors and losing market share, which in the longer term can affect the going concern assumption. If the client operates in an industry subject to frequent change, it risks significant losses if it doesn’t keep abreast of such changes and “move with the times.”

• What is the entities policy regarding warranties? . What is the risk that the client has underprovided for that rate of return (adequacy of the warranty provision)?

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• Are discounts given by the client to its customers and received by the client from its suppliers. Are discounting policies are putting profit margins at risk, which may place the future viability of the client at risk?

• What is the client’s reputation with its customers, suppliers, employees, shareholders, and the wider community?

• A company with a poor reputation places future profits at risk. It is also not in the best interests of the auditor to be associated with a client that has a poor reputation.

• What does the client do? Where does it perates? How many e locations are there and how geographically dispersed are they?

• The more spread out the client’s operations are, the harder it is for the client to effectively control and coordinate its operations, increasing the risk of errors in the financial statements. • Are there f employment contracts? What is the client’s relations with its employees.? Is the workforce unionized? Are employees paid hourly? Are there bonuses? , o The more complex a payroll system, the more likely that errors can occur. When staff are unhappy, there is greater risk of industrial action, such as strikes, which disrupt client operations.

• Does the entity have debt? What are the sources of financing available to the entity? Can they meet theinterest payments on funds borrowed and repaying funds raised when they are due? Are there covenants with a debt provider? If so, what are the terms of the covenants and the nature of the restrictions it places on the client?

• What is the client’s ownership structure? What is the amount of debt funding relative to equity? Are there, diff erent forms of shares? What are the rights of the shareholder groups? What is the client’s dividend policy? Can it meet dividend payments out of operating cash flow

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Industry level factors At the industry level, the student should consider the entity’s position within its industry, the level of competition in that industry, and its size relative to its competitors. What is its reputation among its peers? How much government support is there for companies operating in that industry? What is the level of regulation for this industry? What is the level of demand for the products sold or services supplied by companies in that industry? What factors affect that demand?

Economy level factors Finally, the student should consider how economy level factors affect the entity.

This includes a consideration of how economic upturns and downturns, changes in interest rates, and currency fluctuations will affect the entity. .

(b) The student should identify the related parties disclosed in the notes of the financial statements. This will include parent companies, subsidiaries, joint ventures, associates, company management, and close family members of key management. The student should recognize that the number of related party transactions impacts the susceptibility of the financial statements to material misstatement due to fraud and error, and potentially the overall financial statement results. Is there sufficient information to assess the impact of these transactions on the financial statements overall?

(c) The solution to this research question will depend on the company selected by the student.

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Solutions Manual to accompany

Auditing: a practical approach by Robyn Moroney Fiona Campbell Jane Hamilton Valerie Warren

CHAPTER 4 Audit planning II

John Wiley & Sons Canada, Ltd. 2012

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Chapter 4 – Audit Planning II

SOLUTIONS TO REVIEW QUESTIONS REVIEW QUESTION 4.1 LO 1 Audit risk is the risk that the auditor gives an inappropriate opinion on the financial statements. The auditor tries to keep this risk to an acceptably low level by planning the audit according to the key risks faced by the client and allocating more audit time where the risk of material misstatement is highest.

This means that the auditor tailors the audit work to the client’s characteristics.

If the client has characteristics which suggest that the greater risk of material misstatement is in a particular account or transaction cycle, the auditor will plan to do more audit work on that account or transaction cycle than would be done for another client with different characteristics and lower risk in that area.

The auditor identifies the specific accounts that are most at risk, and how those accounts are likely to be misstated. For example, one client may have a greater risk that fictitious credit sales are included in the balance of accounts receivable, while another client may have a greater risk that accounts receivable balance includes balances that are not likely to be collected. The first client has ineffective controls over processing credit sales and the second client has ineffective controls over granting credit to customers. The auditor would spend more time gathering evidence over the validity of credit sales transactions for the first client, and more time gathering evidence about the collectability of accounts receivable for the second client.

REVIEW QUESTION 4.2 LO 2 The auditor’s preliminary assessment of materiality is made early in the audit and is used to guide planning of the audit and the audit testing based on the plan. In making this assessment, the auditor considers the financial statement users and their needs. This is considered independently from audit risk.

A low preliminary assessment of materiality means that the auditor must plan to detect misstatements of low materiality. A high preliminary assessment of materiality means that the auditor plans to detect misstatements that have a high level of materiality. It takes more audit work to be reasonably sure that smaller misstatements are detected, than the amount of audit work required to be reasonably sure that larger misstatements are detected. This is because the lower the materiality level set, the more items will fall into this definition. In addition, because the auditor will be combining all testing results together, a lower materiality level is more sensitive to a potential material misstatement.

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REVIEW QUESTION 4.3 LO 2 The Canadian Professional Engagement Manual (C•PEM) guides auditors in the choice of base for materiality calculations. The base must be ‘appropriate’, which means that the potential misstatement should be considered in the context of its effect on the client’s financial performance or position. This judgement is made based on the auditor’s knowledge of the client and the auditor’s experience. For example, a publicly listed client is primarily assessed on its ability to generate profits, so an auditor is likely to consider profit before tax as an appropriate base. However, a non-profit entity is less likely to be evaluated on profit, so either assets or revenue would be more suitable as a base. However, a publicly listed client could be reporting a loss or have variable profits. In this case the auditor is more likely to use revenue or assets as a base. If the client is newly established, and thus with little revenue, equity or total assets would be more suitable as the base. The overall consideration is how the impact of the potential misstatement is likely to affect users’ decision-making.

REVIEW QUESTION 4.4 LO 3 The two types of audit strategy outlined in CAS 300 Planning an Audit of Financial Statements are the predominantly substantive approach and the combined audit approach. The auditor bases the strategy decision upon their assessment of the client’s control risk. If control risk is assessed as high, the auditor will reduce control testing and increase reliance on substantive tests of transactions and account balances. In some cases, there may be no tests of controls when the predominantly substantive approach is adopted. However, the auditor is still required to gain an understanding of the client’s control systems (CAS 315), i.e., consider the controls, document them, and perform walk-throughs. The auditor is also required to gain an understanding of their client’s controls relevant to any ‘significant risks’ (CAS 315). For example, the auditor will review processes used by management to make estimates of significant balances or transactions.

If the auditor adopts a combined approach, there will be increased reliance on tests of controls and reduced reliance on substantive tests of transactions and account balances. In this case, the auditor has assessed the client’s control risk as low and detection risk as high. However, an auditor can never completely rely on a client’s system of internal controls and will always conduct some substantive procedures to gather independent evidence about the amounts in the client’s financial statements.

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REVIEW QUESTION 4.5 LO 3 No. There are many reasons that the valuation assertion for inventory could be at risk, i.e., the risk that the inventory is shown at an incorrect value in the balance sheet. Locking the warehouse would reduce the risk of theft, but does not address all the valuation risks. For example, the inventory could be physically present in the warehouse, but the valuation is incorrect because there are errors in the costing procedures used to value inventory. If the client is using FIFO, there could be errors in identifying the inventory movements and associated costs. There could be errors in calculating inventory costs because of mathematical mistakes in the invoices or inventory records. There could be errors in updating the inventory records so that they misstate the amount and value of inventory in the warehouse. There could be inappropriate procedures for identifying obsolete or damaged inventory so that these items continue to be carried at full cost instead of being written down to NRV. There could be errors in cut-off, so that inventory purchases made prior to the end of the financial year are not recorded in the inventory records as at the end of the year.

The auditor would need to explicitly address all of the risks to the inventory balance and how these would be prevented or detected by the client’s controls before concluding that inventory was not likely to be misstated.

REVIEW QUESTION 4.6 LO 5 Analytical procedures that could be useful to assess the risk of misstatement of sales revenue include: • Comparisons between this year’s sales (interim or final data) and previous years (for the same months) • year by year comparison • Trend analysis (across time periods) • Common size statements and analysis (sales to every other item in the accounts) • Comparison between this year’s actual sales and budgeted sales • Comparison between sales for this client and industry averages or peers • Calculation of gross margins for this year and comparison with other periods and entities (year by year, trend analysis, common size analysis) • Consideration of sales and margins by product line, region, store (and comparison with other periods and entities) • Comparison of sales commissions and revenues and margins, by entity, region and sales person

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REVIEW QUESTION 4.7 LO 5 A gross profit margin is the gross profit divided by net sales. Fully understanding this margin, and the reasons for any change, requires an understanding of the components of the margin.

Gross profit = sales – cost of goods sold.

If the gross profit margin increases, profit as a proportion of sales increases, which means that cost of goods sold as a proportion of sales decreases.

Cost of goods sold = opening inventory plus net purchases minus closing inventory. This means that any change in cost of goods sold could be due to changes in opening inventory, net purchases (i.e., purchases less purchases returns), or closing inventory. Opening inventory can be verified by comparing with closing inventory in the previous period. Net purchases can be verified through detailed testing of transactions. Closing inventory can be verified through inventory testing procedures.

Increases in the gross profit margin are likely caused by either: • Increasing selling prices (at least increasing faster than cost of sales are increasing) • Decreasing cost of sales (at least decreasing faster than sales prices are decreasing) Increasing sales are possibly caused by: • Cut-off errors (sales in next period backdated to current period). Auditor will verify dates of sales around the end of the financial year.

• Fictitious sales. Auditor will seek evidence of sales, and test for sales returns to determine if sales and sales returns are being used to eliminate fictitious sales and accounts receivables . Auditor will seek evidence of inventory movement to customers.

• Increasing selling prices. Auditor will check for evidence of increased prices on approved price lists.

• Errors in accuracy of sales. Auditor will test for correct calculations in sales invoices and accounting records.

Decreasing cost of sales are possibly caused by: • Lower cost of purchases, e.g., buying goods for lower prices because of better purchasing agreements, buying in bulk, favourable exchange rate movements for imported goods etc. This can be verified through examining purchase agreements, invoices, foreign exchange agreements and transactions.

• Higher cost items being held as closing inventory and lower cost items being sold (higher closing inventory reduces the cost of goods sold).

This implies a change in the product sales mix without lower selling prices. Auditor will analyse changes in product mix.

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Auditing: A Practical Approach, Canadian Edition

Overstatement of closing inventory – auditor will use inventory testing to verify.

Failure to update inventory records for sales. Auditor will test details of inventory movements.

Decreases in the gross profit margin are likely caused by either: • Decreasing selling prices (at least decreasing faster than cost of sales are decreasing) • Increasing cost of sales (at least increasing faster than sales prices are increasing) Decreasing sales are possibly caused by: • Cut-off errors (sales in this period post-dated to next period). Auditor will verify dates of sales around the end of the financial year.

• Omitting sales. Auditor will trace sales orders and invoices to accounting records, evidence of sales returns made in error.

• Decreasing selling prices. Auditor will check for evidence of lower prices on approved price lists.

• Errors in accuracy of sales. Auditor will test for correct calculations in sales invoices and accounting records.

Increasing cost of sales are possibly caused by: • Higher cost of purchases • Lower cost items being held as closing inventory, higher cost items being sold • Understatement of closing inventory.

The auditor is likely to be more concerned about a potential misstatement which overstates gross profit and closing inventory than one which understates gross profit and closing inventory.

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REVIEW QUESTION 4.8 LO 4 Liquidity is the ability of a company to meet its short term debt obligations.

Solvency is the long-term viability of a company. Both liquidity and solvency can be analysed using ratios. Liquidity ratios tend to take a short-term view of a company; solvency ratios have a long-term perspective.

An auditor is interested in both its client’s liquidity and solvency. If the client cannot pay its short-term obligations, it could lose key employees, relationships with suppliers, and have to pay back borrowed funds. These circumstances could place the fair presentation of the financial statements at risk, and disrupt the client’s ability to continue to trade effectively. Analysing a client’s liquidity situation can alert an auditor to potential going concern issues.

The longer term focus of solvency means that an auditor can use a solvency analysis to alert it to future going concern issues at the client. High debt relative to equity or high financing costs relative to profit cannot be sustained indefinitely and alert the auditor to growing pressures on borrowing costs or access to finance.

REVIEW QUESTION 4.9 LO 1 The statement is based on the audit risk model. Audit risk (AR), the risk of giving an inappropriate audit opinion, is a function of the client’s inherent risk (IR), control risk (CR) and the auditor’s detection risk (DR).

[Recall that AR = IR × CR × DR.] The auditor chooses a desired level of AR. The auditor cannot control IR and CR, so the only way they can achieve the chosen level of AR is by altering DR. High levels of IR and CR increase AR, so the auditor must plan for a low DR to reduce AR to the required level. Low levels of IR and CR decrease AR, so the auditor can plan for a higher DR before AR becomes unacceptable.

The mere act of setting DR low does not reduce actual AR. The auditor must perform the appropriate audit procedures to have reasonable assurance of achieving the chosen DR. The lower the DR, the more effective and extensive the audit procedures required.

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REVIEW QUESTION 4.10 LO 1, 2 The figures in the chapter show that there is an inverse relationship between detection risk (DR) and the risk of material misstatement, i.e. inherent risk (IR) and control risk (CR). If both IR and CR are high, DR is low (table 4.1). If both IR and CR are low, DR is high (table 4.2).

There is a relationship between CR and audit strategy. Where CR is high, there is a predominantly substantive approach strategy (increased reliance on substantive tests, no or very little tests of controls) (table 4.3). Where CR is low, there is a lower assessed level of control risk strategy (increased reliance on tests of controls, reduced reliance on substantive tests) (table 4.4).

The evidence gathered when DR is low is more likely to be from tests of controls than from substantive tests. The evidence gathered when DR is high is more likely to be from substantive tests than from tests of controls.

Setting a lower materiality level (lower PM) is likely to increase the number of items that are material because more items will be above the threshold. For example, if PM is set at $1,000, any error of more than $1,000 is deemed to be material. However, if PM is set at $100,000 there are likely to be fewer errors of this size (and therefore material errors) than there would be errors of the magnitude of $1,000.

Setting a lower PM also increases the evidence requirements because more evidence, or at least more appropriate and convincing evidence, is required to provide the required level of assurance that the financial statements are not materially misstated by that amount. That is, we need more evidence that the reports are not misstated by $1,000 than we would need to be assured that the reports are not misstated by $100,000.

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SOLUTIONS TO PROFESSIONAL APPLICATION QUESTIONS PROFESSIONAL APPLICATION 4.1 – Audit risk and revenue LO 1 Ajax generates one type of revenue by lending to customers. The finance charges paid by the customers (i.e., interest and fees) are Ajax’s revenue.

Ajax must pay interest and fees when it raises the funds on the wholesale money market. In addition, Ajax earns revenue through credit card sales. Ajax is paid an amount per credit card and a proportion of the interest charges paid by the customers to the credit card company.

The difference between the revenue earned by lending to the customers and the cost of raising the money paid to the money market participants, plus the credit card commission and interest, pays Ajax’s running costs and contributes to its profit.

The major risks with Ajax’s revenue relate to the style of its business. Loans are made by mobile lending officers who are paid on a commission basis. The lending officers appear to be alone when they visit clients, and we do not know what controls exist over the loan applications when the lending officer returns to the office (or submits the paperwork electronically). These factors suggest control risk will be higher over the validity of the loans and credit card applications. There is also a possibility that some loans or card applications will not be processed at all, or processed in a timely fashion. The facts also suggest that there could be a high risk of selling loans to customers who will not pay their debts. There is the possibility that the ‘little person’ who is the foundation of Ajax’s business are not likely to pay their obligations as much as the people who have good relationships with their banks. In addition, the selling techniques used by the mobile lending officers could be unscrupulous because of the pressure on the lending officers to make sales. These factors increase the inherent risk surrounding Ajax’s revenue from collecting on their debts and interest payments.

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PROFESSIONAL APPLICATION 4.2 – Audit risk components and materiality LO 1, 2 (a) Inherent risks for inventory for Carl’s Computers include: 1.

Likelihood of rapid obsolescence of computer hardware and accessories – risk of incorrect valuation of obsolete product.

2.

Foreign exchange transactions – are contracts written in US$, CDN$, etc, are the transactions hedged against adverse movements in exchange rates? – leading to difficulty ascertaining cost of purchase and incorrect creditor liability.

3.

Competition from aggressive discounters, risk that inventory will not be held on hand to meet fluctuating sales, risk that inventory will be unsold because of competition – increasing risk of obsolescence, valuation problems.

4.

Rapidly changing product lines – risk that suppliers will change and products will not meet the required standard, leading to valuation problems.

5.

Risk that correct inventory will not be received from suppliers due to inability to meet orders, confusion between Canadian importers and foreign suppliers – purchase orders unfilled or incorrectly filled, payment for inventory not received.

6.

Dealing with multiple transport companies – ship from overseas and truck from ports – could increase risk of goods not being received, or not received in a timely manner, missing inventory.

7.

Many different products, wide range of value per item – incorrect calculations of inventory on hand.

8.

Risk of theft (either during transport or from the stores) would vary across products – inventory account would be overstated if thefts were not identified. (b) Strengths in inventory control system: • Branch manager in each store and permanent staff who can receive consistent training in inventory control.

• Permanent staff used to supervise casual staff at stores.

• Inventory held at central warehouse under control of specialist inventory supervisors.

• Requisition required for transfer from central warehouse to branch store.

Weaknesses in inventory control system: • Casual staff may not be sufficiently trained or supervised despite procedures requiring this.

• Inventory requisition authorised by branch manager rather than central manager.

• Passing through central warehouse could delay receipt of product at branch, leading to overriding system to increase speed of delivery.

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Questions about inventory control system: • Who chooses and approves suppliers?

• Is there segregation between inventory staff and those keeping inventory records? (c) Inventory would be a material balance because the company is an importer and retailer of computer hardware and accessories. Inventory is likely to be the largest asset after property, plant, and equipment. It is likely that the majority of sales are made for cash, so accounts receivable is unlikely to be a large balance (except for balances owing from credit card companies for card transactions). The inventory is also qualitatively material because the business model requires expert inventory management to deal with obsolescence and competition issues. Users of financial statements would be very interested in data such as inventory turnover.

The auditors would adopt different approaches for different types of inventory.

They would focus more on larger value items with greater risk of obsolescence or product specification problems. They would also focus on products with greater risk due to more likely supplier problems, such as new suppliers for consumables, or complicated foreign transactions which create valuation issues. Focus would also be given to items with greater risk of being stolen, to ensure that the inventory balances are not overstated, and those items with greatest competition pressure, to ensure sales are valid.

PROFESSIONAL APPLICATION 4.3 – Inherent risk assessment LO 1 Some of the factors that indicate high inherent risk include: • Management integrity is in question as the president is unwilling to provide information.

• The client’s motivation is to secure an audit opinion that will assist it in getting a bank loan to pay for existing debt in arrears. This suggests high inherent risk as the client has financial problems, which could motivate management to make misstatements to make the financial statements look better.

• There is high inherent risk due to the fact that the previous audit appears to have resulted in a qualified opinion.

• This would be an initial engagement for your firm, therefore inherent risk would be higher than usual.

• The audited financial statements would be used by the bank and potential shareholders, therefore there is a wide group of users who could potentially sue the auditor for negligence.

• The company is planning on borrowing funds to build a prototype of an experimental plane, which would likely involve unusual and complex calculations and accounting policy issues.

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PROFESSIONAL APPLICATION 4.4 – Audit risk LO 1 The level of overall audit assurance should be high because of the following factors: • Heavy reliance will be placed on the financial statements (the bank and potential investors will be relying on the audited financial statements).

• The nature of the business is considered to be risky (the company’s only revenue source is expiring in 5 years and the new drug is not yet ready for market).

PROFESSIONAL APPLICATION 4.5 – Materiality LO 2 (a) Some examples of a base for a materiality calculation include: • 5 – 10 % of normalized pre-tax income • 1/2% – 2% of assets • 1% – 5% of equity • 1/2% – 2% of revenues or expenditures (b) No. Even if individual account transactions are below materiality, the auditor has to consider the cumulative effect; for example, five misstatements of only $15,000 each could total more than the overall materiality level of $70,000. As well, there is a possibility that recorded values are understated. Auditors may use performance materiality (60-85% of planning materiality) to help reduce this risk.

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PROFESSIONAL APPLICATION 4.6 – Planning, performance, and specific materiality LO 2 (a) The users of the financial statements and their user needs are as follows: The Bank: As the bank is considering making a loan to Claytonhill Beverages, they are most interested in Claytonhill’s ability to repay the borrowed funds in the future. Therefore, they are most interested in the profitability of Claytonhill Beverages as this indicates Claytonhill’s ability to repay the loan.

Buzz Bottling- As current owners of the entity, they are looking for a good return on their investment. If this does not materialize, they will sell Claytonhill Beverages.

Future Purchaser of the entity- anyone looking to purchase Claytonhill Beverages will want to ensure it is profitable andrealize a good return on their investment. (b) Given the user needs identified in (a) above and the fact that this is a for profit entity, net income is likely the most appropriate base. This is because the financial statement users will be most sensitive to variances in net income. ( c) Planning Materiality Net Income Before tax = Add management bonuses = .

(163,844) 100,000 (normalizing item) (63,844)

After normalizing net income before tax, the company remains in loss position, therefore we will need to use another base to determine materiality.

Other possible bases include .05-2% of assets 0r .05-2% of revenues.

If materiality is based on revenues= 1%* 2,057,505= 20,575 If materiality is based on assets= 1%* 4,808,980= 48,089 Qualitative Considerations: There are no facts indicating qualitative factors would impact materiality. Qualitative items that would impact materiality are such things as fraud, change in accounting methods, or related party transactions.

Conclusion: An appropriate range for materiality is $20,000-48,000. Since the users are concerned with the entity’s ability to make a profit, and this is directly affected by revenue levels, we will use revenues as a base and conclude materiality will be $20,000 (rounded).

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Performance materiality is an amount less than planning materiality set by the auditor to reduce the likelihood that any uncorrected and undetected misstatements exceed overall planning materiality. It is usually calculated as 60-85% of overall materiality.

Conclusion: Performance materiality will be $20,000* 60%= $12,200.

Specific Materiality: This level of materiality is determined for specific account balances, transactions, and disclosures that may influence the economic decisions of users. In this case, the bank has indicated that it is interested in whether the entity has a 2:1 current ratio. Based on the above unaudited financial statements, the current ratio as at December 31 is exactly 2:1.

Therefore any error impacting current assets or current liabilities may impact the banks decision. Therefore, we will set specific materiality for current assets and liabilities at $2,000, as this is the amount needed to impact the current ratio. (d) The audit risk did not impact materiality as audit risk is the risk the auditor may issue an inappropriate opinion, while materiality is based on user needs.

PROFESSIONAL APPLICATION 4.7 – Determining an audit strategy LO 1, 3 (a) Factors affecting preliminary assessment of inherent risk include: • Cheese is perishable, suggesting high risk of spoilage, affecting inventory valuation • Boutique cheese operation – highly skilled processes requiring skilled staff, reliant on few customers?

• Export sales, foreign exchange transactions – complicated transactions with risk of incorrect pricing, risk assessment • Tourism based sales at shop and café – fluctuating demand?

• Competing incentives for export sales and café consulting businesses • Heavy reliance on export sales increases vulnerability of business to this source of revenue, and making product available to meet this demand Factors affecting preliminary assessment of control risk include: • Effectiveness over quality control over cheese operations, affecting saleability of product (although quality control is apparently high) • Risk of product spoilage, affecting value of inventory • Controls over sales made by Jim, documentation, pricing, sales allowances • Lack of communication between Jim and brother Bob and other staff – affecting efficiency and effectiveness of management (b)

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A combined audit approach is appropriate when control risk is assessed as low, predominantly substantive approach is appropriate when control risk is assessed as high, or it is more efficient to not rely on controls.

The poor communication between Jim and other management and staff, plus his competing incentives and the lack of control over his actions means that control risk in these areas would be considered high. The validity of sales transactions, including the amounts and terms of the sale, is at risk. There is also a risk that sales made to customers are not entered correctly in the accounts. Adjustments to accounts receivables do not appear to be adequately controlled. Control risk for sales and accounts receivables is high, meaning that the predominantly substantive approach would be adopted in these areas.

Control over production appears to be good, and inventory quality seems to be high. However, the inherent risk of inventory spoilage is great. This suggests that a combined approach could be adopted for inventory. Testing the controls over inventory, and obtaining satisfactory results, would mean that less substantive testing would be required.

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PROFESSIONAL APPLICATION 4.8 – Planning analytical procedures using profitability ratios LO 4, 5 Possible explanations for the increasing gross profit margin (a) and the declining profit margin, and impact on audit work (b), include: • Cost of goods sold being misclassified as operating expenses (reducing cost of goods sold, increasing gross profit, increasing other expenses) – this suggests verify classification of expenses, trace cost of goods on sales invoices through to cost of goods sold account, trace supplier invoices to purchases account, vouch other expenses to underlying invoices and documentation • Understated purchase costs – test for purchases cut-off, subsequent payments testing to identify creditors that could be understated (that are not recognized in accounts at year end), test for inventory movements inwards • Overstated closing inventory (reducing cost of goods sold, increasing gross profit, but also increasing profit margin which could be offset through other increased expenses) – audit client’s inventory quantity and cost records, test procedures for identifying and valuing obsolete and damaged closing inventory • Overstated sales this period – test for sales cut-off, subsequent receipts testing to identify accounts receivables that could be overstated (credit clients that have not paid their accounts), test for inventory movements to match sales to customers • Increased advertising costs, reducing overall profit but generating more sales and higher sales prices – analyse expenses to determine if this is a likely explanation • Increased other costs, e.g., interest costs, salaries etc, which have impacted adversely on overall profit but not on gross margin – analyse expenses to determine if this is a likely explanation

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PROFESSIONAL APPLICATION 4.9 – Analytical procedures for liquidity and solvency issues LO 4, 5 (a) In the short term, Bright Spark Fashion faces liquidity issues because the long term debt is due for repayment in two months. The business has just experienced the winter season, where sales are lower, and it is unlikely to have significant cash receipts from sales until the summer season. The summer inventory is ordered on a pre-paid basis, which suggests that these orders have been paid by the time the long term debt is due for renewal.

Unless the debt is renewed the business will not have any funds until the summer period to pay for salaries, rent, and other commitments.

In the longer term, it appears that renewing the long term debt for a further two year period will not be sufficient to ensure that the business avoids future cash problems. Renewal every two years means that the business is in almost constant renegotiation talks with its banks. Greater certainty for the business would flow from a longer term debt agreement. In addition, the likely interest rate rise will adversely impact profit over the term of the loan.

Liquidity ratios include: • Current ratio (CA / CL) • Quick ratio ((cash + ST investment + net receivables) / current liabilities) • Inventory turnover (cost of sales / average inventory) • Receivables turnover (net credit sales / average net receivables) Solvency ratios include: • Debt to equity (liabilities / equity) • Times interest earned (EBIT / interest expense) If the debt is not renewed, it will have to be repaid from other sources. It is possible that another bank would make a loan (no impact on the ratios except in reclassifying a current liability as a non-current liability if the new debt has a longer term). It is possible for the owner of Bright Spark Fashion could inject more capital into the business (replacing debt with equity, which would reduce total liabilities and increase equity). Another possibility is that some assets could be sold to repay the debt (reducing both assets and liabilities). This course of action would likely require sales at less than book value, creating a loss which would reduce equity. (b) The major risk is that Bright Spark Fashion will not be able to pay its debts as they fall due if the loan is not renewed. This means that it has a going concern issue until the debt is renegotiated. Unless this is disclosed correctly in the financial statements, the auditor should qualify the audit report.

There is a risk that the bank will not process payments to suppliers because of the outstanding debt. There is a risk that suppliers will not deliver goods to Solutions Manual 4-17 Chapter 4 Copyright © 2012 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of this page is strictly prohibited.

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Bright Spark Fashion, meaning that the clothing will not be in the shops in time for the summer season, adversely impacting sales.

There is a risk that the owner of the business will have to obtain funds elsewhere at penalty rates, adversely impacting profit and exposing the business to the risk of even shorter loan terms. This also creates a going concern risk because there is the risk that the funds will not be available for the next 12 months.

Jenna should plan to investigate the progress of the funding renegotiations and obtain evidence that any loans that Ray Bright claims to negotiate are certain to be received. Jenna should obtain confirmation from the bank about the state of the loan, and plan to obtain expert legal advice about the bank contracts.

Jenna should also gather evidence about delivery of goods into the stores during the period between the year end and the audit report date.

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PROFESSIONAL APPLICATION 4.10 – Risk assessment LO 1 The risk assessment is based on the audit risk formula. Therefore, DR is determined by the inherent risk (IR) and control risk (CR) assessments. If IR and CR are higher, DR is lower.

The factors that would impact IR and CR, and thus DR are: • Several revenue streams – leisure activities plus different classes of accommodation - hostel, hotel, resort – creating a variety of inherent risks over sustainability of revenue streams (e.g., customers of each part of company could be affected by different factors). Husband and wife own majority of shares of parent company of client. Husband is chairman of both, wife is director of both companies and client’s CFO – creating conflicting incentives and confused lines of reporting and authority – is there effective control? Suggests higher risk. Client has not been audited before – risk associated with opening balances; cannot rely on previous audit results –New private equity investor group has 20% of client – creating additional demand (together with request from bank for audit) for financial statements. Increases audit risk.

• Use of part-time and casual workers, as well as permanent staff – suggesting variation in work force, problems in payroll and HR – suggests greater risk. Also consider effectiveness of controls requiring segregation of staff if workforce is fluctuating.

• Laid-back management style – suggests greater control risk from ‘tone at the top’ issues.

• Lack of regular annual leave – control risk from ineffective supervision and segregation of duties, no opportunity to use another staff member in key roles.

• Peter Pinn close to retirement, consider incentives for fraud and effectiveness of supervision of accounts staff, seems inadequate segregation of duties (i.e., they ‘help each other’ during busy times).

However, one staff member is a graduate, suggesting accounting expertise.

• Company is facing increased risk to its viability given changing climatic conditions in the area. Consider effects on going concern issues.

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Overall, there appear to be a number of problems with the business, particularly in its governance and staffing. These issues create questions about specific control risks which would be assessed in greater detail. Greater control risks suggest lower detection risk would be appropriate.

These risks are most relevant to: • Board of director decisions - because of husband/wife control of both companies and recent acquisition of significant percentage of the company by a new private equity investor, possibility of related party transactions.

• Control in accounts department – staff shortages, inappropriate delegation, inadequate segregation of duties, closeness to retirement and lack of annual holidays by head of department, laid-back attitude of CFO. • Staffing issues – use of part-time and casual staff, variation in staffing according to seasons, questions about adequate training and supervision of casual staff.

PROFESSIONAL APPLICATION 4.11 – Assessing inherent risk LO 1 Industry level: - defence - high sensitivity of product information, customer information - Risk of selling to allies which later become enemies, or on-sale of products to others - competitive market tendering to win government contracts Entity level: - high reliance on one product, specialized nature of product and reliance on export customers creates risk to revenue stream - pricing of sophisticated product designed to meet customer specifications - adequate security over designs, customer details – effect on personnel (e.g. security clearances required?), inventory management (secrecy over product components?), etc - new inventory costing system, replacing in-house system – does new system provide comparable information, has it been tested, integration with other client systems - sophisticated nature of product design and costing information, questions about standard costing, inventory movements - adequate documentation for tendering - sufficient accountability of waste – is any waste controlled substances e.g., dangerous chemicals used? How are damaged items and wastes disposed of?

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PROFESSIONAL APPLICATION 4.12 – Assessing preliminary materiality LO 2 Preliminary materiality assessment is based on user needs.

1. Management – Management uses the financial statements to determine if the business is profitable. They also assess business performance and identify areas where there is room for improvement.

2. Government- The government will want to see the financial statements to ensure the entity is a going concern and has the financial strength to support the project Securimax is bidding on.

As this is a for-profit entity and both financial statement users are interested in assessing profitability, the most appropriate base for materiality is net income before tax.

PROFESSIONAL APPLICATION 4.13 – Planning in context of IT system changes LO 1, 2 Staff feedback comments suggest the following issues with the new IT system: - Not using a unique identifier for patients, such as a patient number.

New patients were occasionally confused with old patients in the system. There should be a method of identifying new patients at the point of admission and assigning a unique identifier to their file at that point, to be used for all future transactions, services etc relating to the patient. (Risk that patient database contains errors.)

- Not having a system of approving room rates billed to patients. Room rates should be charged based on an approved room rate list using a code for the relevant room rate. The system appears to accept different room rates. (Risk that rates database contains errors and applied to billing system with error.)

- Software program change approval system does not appear to have procedures to prevent billing calculation changes to client files to allow charges that depart from medical fund and pensioner subsidy rates.

Any charges that differ from approved rates should require specific authorization. (Risk that billing system contains errors.)

- Power surge resulted in loss of patient invoice data. Backups do not appear to be used to prevent loss of data. (Risk that billing system contains errors.)

The issues raised by staff relate to controls over data entry and processing in the new IT system. The problems suggest that control risk is high, especially in relation revenue and accounts receivables.

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PROFESSIONAL APPLICATION 4.14 – Determining audit strategy LO 3 The audit strategy is affected by the assessment of control risk. The errors in the new patient revenue system suggest that control risk is high (see professional application question 4.13 for further discussion). Therefore, a predominantly substantive approach is required because it is unlikely that control testing will produce results which allow the use of the combined audit approach. See CAS 315, where the control risk is assessed as high, the auditor will gain the minimum necessary knowledge of the client’s system of internal controls, but generally conduct no tests of those controls. If a client’s system of internal controls is very poor, there is generally no point in testing the internal controls as the auditor will not be planning on relying on them.

Instead an auditor will increase their level of reliance on detailed substantive procedures, which involves intensive testing of year-end account balances and transactions from throughout the year. The failure of the patient revenue system could be regarded as a significant risk, and a noteworthy deficiency in a client’s system of internal controls.

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PROFESSIONAL APPLICATION 4.15 – Audit risk and materiality LO 1, 2 (a) Factor Public company and financial statements used by the bank Chairman and CEO is well regarded in the Canadian mining industry

Property, plant, and equipment make up a major part of total assets, but valuation is subject to management estimates for useful life and salvage values Your firm has audited the company for the past eight years Previous audits have uncovered few errors

Type of Impact Explanation Risk Audit Risk Decrease Wider distribution of financial statements to more users will require increased assurance (1 – AR) that the audit opinion given is appropriate.

Inherent Decrease A well-regarded management Risk team, reputed to have integrity, decreases the risk that management will misstate the financial statements and increases the auditor’s ability to rely on management’s representations.

Inherent Increase Transactions that require Risk management judgment to determine valuation have higher inherent risk due to the subjective nature of such judgments.

Inherent Risk

Inherent Risk

Large, nonInherent routine $1.1 billion Risk writedown of goldrelated assets just prior to year end

Gold inventories susceptible to theft

Inherent Risk

Decrease A repeat audit engagement has less inherent risk due to the auditor’s enhanced knowledge of the entity’s business, its internal controls, and the industry.

Decrease Given this, the auditor would be justified in reducing inherent risk, provided no changes in relevant circumstances have occurred.

Increase Transactions that are unusual for the client are inherently more likely to be incorrectly recorded by the client than routine transactions because the client lacks experience in recording them.

Increase Gold is an asset which is highly susceptible to misappropriation; therefore, the inherent risk of

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Mining operations give rise to environmental concerns

Inherent Risk

Operations in six countries

Inherent Risk

Stable, dedicated workforce

Control Risk

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companies in the industry is high.

Increase The nature of the business may lead to material environmental costs, including clean-up costs and costs to comply with environmental regulations; therefore, inherent risk is high.

Increase Foreign operations give rise to foreign currency transactions.

The requirement for foreign currency translation increases the risk of misstatements.

Decrease Long-term employees will be familiar with internal control systems. Dedicated employees will be less likely to attempt to circumvent the internal controls to defraud their employer.

(b) Materiality determination: Gross profit figures will be the most appropriate basis for determining materiality as they will have been least affected by changes this year. Given losses this year, the income before taxes basis is not appropriate. Given variability in revenues based on commodity price fluctuations, the revenue basis for calculating materiality is not appropriate. Given the recent share-forshare merger, shareholders’ equity is also subject to significant fluctuations and is not appropriate as a basis for calculating materiality. The asset basis for calculating materiality will not be appropriate given the substantial writedown in the asset value.

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CASES 4.16 – Integrative case study—AutoCare Ltd. (a) Five procedures the auditor should perform before deciding to accept ACL as a client could include: • Assess independence.

• Contact predecessor auditor.

• Assess management integrity — Do background check or a web search.

• Review prior period financial statements.

• Contact bankers, lawyers, and others that provide services to the entity. (b) Four factors that impact the audit risk assessment for the current year and how these factors influence audit risk (i.e., increase or decrease audit risk) could include: • New term loan to support expansion into new market and facilities (increases audit risk).

• Public company and hoping to extend share issue in the future (increases audit risk).

• Entering a new market as they are is targeting commercial businesses in western Canada (increases audit risk).

• First time audit and appears previous auditor resigned due to issues with management due to aggressive accounting (increases audit risk). (c) The overall audit risk and the impact how this will impact the audit planning may include the following: • Due to the above (in parts (a) and (b)), audit risk is assessed as high. This means we will plan to do more audit work.

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(d) Some examples of a base for a materiality calculation include: • 5 – 10 % of normalized pre-tax profit In this case, annual net income is not provided, but it states that ACL has incurred substantial losses in the past three fiscal years.

• 1/2% – 1% of assets For 2012: 1/2% – 1% of assets of $6,843,000 = range of $34,215 – $68,430.

For 2011: 1/2% – 1% of assets of $3,078,000 = range of $15,390 – $30,780.

• 1/2% – 5% of equity For 2012: 1/2% – 5% of equity of $1,244,000 = range of $6,220 – $62,200.

For 2011: 1/2% – 5% of equity of $1,392,000 = range of $6,960 – $69,600.

• 1/2% – 2% of revenue For 2012: 1/2% – 2% of revenue of $6,200,000 = range of $31,000 – $124,000.

The range of planning materiality as shown in the above calculations is a low of $6,220 to a high of $124,000. Given the financial statement users we will set materiality at the mid-range and increase the amount of testing. An appropriate amount for planning materiality would be $30,000. (e) Perform planning analytics and identify at least three accounts with unusual fluctuations. For each of the “risky” accounts you identify, indicate a possible client error that may have caused this significant fluctuation as well as a possible business reason for the change.

Significant Account Change Inventory

Possible Error Inventory incorrectly counted and valued

Capital Assets

Capitalized repairs and maintenance in error Research costs are capitalized

Deferred Development Costs

Possible Business Reason Significant inventory on hand in anticipation of entering new market Purchased new assets

Developing new products

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Case Study — Cloud 9 Part 1 – Materiality (a) Planning Materiality (PM) Students should select Revenues as the basis for calculating PM. This is the preferred method because: • Cloud 9 is currently in, and projecting, a loss result for the year ended December 31, 2011 therefore profit is not an appropriate basis.

• The parent entity (main users of the accounts) is concerned with increasing the brand’s share of the Canadian market – essentially revenue share.

• Management have an incentive to manipulate revenue recorded based on growth targets expected and compensation attached to meeting those targets.

The revenues used should be the aggregate of store and wholesale revenues as this drives the normal operations of the business. However, as the other revenues are immaterial, their inclusion in the base figure would not materially impact the PM calculation. Revenues should be annualized to represent a full year of operations.

To decide where within the range PM should be set, students should consider: • Cloud 9 is part of a TSX listed entity therefore subject to strict regulations.

• Cloud 9’s business has changed in terms of the opening of the retail store and high reliance on new inventory management systems.

• Evidence of theft at the stores – risk of fraud with merchandise.

Based on the factors, PM should be set at 5%.

Revenue – stores Revenue – wholesale

$

Total revenue from normal operations

$ 27,896,199

Annualized revenue

$ 37,194,932

PM at 5%

$ 1,859,747

640,782 27,255,417

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(b) Risks The following risks were identified as part of case study question in chapter 1.

Financial accounts are as follows: (assertions are also provided for completeness even though not required in the question).

Growth of revenues given industry outlook and management incentive Risk Description Consumer discretionary spending is low and expected to grow by only 2% for the year. Management receive bonuses based on revenue targets, which was set at 3%. General economic conditions will also impact retail businesses with their recoverability of accounts receivable and the valuation of assets.

Risk Assessment This inherent risk is “High” and impacts the Sales – Occurrence, Accounts Receivable – Valuation, Inventory – Valuation, Fixed Assets – Valuation, Bonus Provision - Existence assertions.

Use of IT for inventory management system Risk Description Retail businesses are reliant on a smooth supply chain process. Where a business uses products with a long lead time, there is significant pressure to ensure that the correct type and quantity of inventory is ordered to meet the requirements of customers.

Risk Assessment Where there is a high reliance on timing of supply or one supplier, this can affect the level of sales, making the assessment “High”. The company’s early implementation issues of the JIT system and FOB Shipping Point terms also contribute to the higher assessment. This impacts the Inventory – Existence, Completeness and Valuation, and Cost of Sales – Completeness and Accuracy assertions.

Level of competition Risk Description Most sectors of retailing are relatively mature and continue to compete on the traditional basis of price, brand strength and level of market power. Price remains important in most high volume areas of retailing.

Risk Assessment This inherent risk is “Medium” and impacts the Accounts Receivable – Existence and Valuation, Inventory – Valuation, Sales – Occurrence and Accuracy assertions.

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Merchandise cycle and fashion trends Risk Description Rapidly changing fashion trends can result in obsolete inventory.

Risk Assessment Based on the stability of the athletic footwear market, this inherent risk is “Low” as the fashion trends are not as exaggerated as with other footwear.

Misappropriation of inventory and cash Risk Description Retail business selling highly desirable and moveable products (e.g., PC games, CDs, designer sunglasses) will be exposed to a risk of theft. In addition, employees handling cash at store locations increases the risk of theft of case.

Risk Assessment This inherent risk is “High”, especially given the recent known thefts at the store location. This impacts the Inventory – Existence, Cash – Existence, and Cost of Sales – Accuracy assertions.

Rebates/Discounts to retailers Risk Description For the wholesale business, there is significant pressure from retailers to receive generous rebates or volume discounts.

Retailers are heavily influenced by landlords and consumers; therefore they control their profits through the supply chain, thus impacting the wholesaler.

Risk Assessment This inherent risk is “High” given the risks identified around the growth outlook and customer base. Cloud 9 will be pressured to offer rebates and/or discounts to the larger retailers. This will impact the Cost of Sales – Accuracy and Completeness, and Accrued Expenses – Accuracy and Completeness.

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Part 2 – Analytical procedures (a) and (b)- For Financial Statements- See Chapter 9 solution where common sized Financial Statements are provided Notes:

All provisions are treated as CL and interest bearing as non-current liabilities All P&L items are annualized (*12/9) Averages are used for the current year only, they are not available for the previous year.

2011

Liquidity ratios

Current Ratio

Current Assets Current Liabilities

2010

22,303,997.00 10,884,709.00

2.05

23,459,330.00 8,890,292.00

2.64

Quick Ratio Liquid (exclude invent and prepaids)

10,798,074.00 10,884,709.00

0.99

12,454,829.00 8,890,292.00

1.40

Inventory Turnover

Cost of Sales Ave Inventory

17,094,176.00 6,093,689.00

16,453,394.67 6,263,242.00

2.63

AR Turnover

Net Credit Sales Ave AR

37,194, 932 10,626,587

33,897,595 6,263,242

5.43

2.81

3.50

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Solvency ratios

Debt/Equity

Total Debt Total Equity

20,105,192.00 3,995,084.00

EBIT Int Expense

-

972,369.00 1,064,815

Profit Margin

Profit Net Sales

- 2,406,616.00 37,194,932.00

Gross Profit Margin

GM

20,100,756.00 37,194,932.00

ROA

Profit Ave Total Assets

- 2,406,616.00 24,345,065.00

Profit

- 2,406,616.00

Times Interest Earned

5.03

- 18,800,667.00 - 5,789,187.00

3.25

-

0.91

2,177,291 748,106

2.91

-

0.06

1,643,609.33 45,316,793.00

0.04

0.54

23,458,934.00 45,316,793.00

0.52

0.10

1,643,609.33 24,589,854.00

0.07

0.46

1,643,609.33

-

Profitability ratios

R on SE

-

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0.35 Ave SE

- 5,269,246.00

- 4,737,446.00

Memo to include the following: • 2011 data based on annualising 9 months of interim results to 12 months, this could distort figures if transactions in last three months of the year differ from those in the first 9 months.

• Decline in both current and quick ratio suggest tightening of liquidity • Accounts receivable turnover is based on treating all sales as credit sales. This would not be correct – need to separate cash from credit sales.

• Large increase in debt to equity and less interest coverage (due to loss).

• Slight improvement in gross profit ratio, but other ratios show effects of loss. Analysis of reasons for loss reveals that large increases in promotion expenses.

• Overall liquidity and solvency and profitability have all worsened, although the company is still in a sound position. Verify conditions of loans.

• Analysis suggests difficulties arising from opening new stores and associated inventory situation. Greater focus on inventory required. Also need focus on validity of sales.

Further analysis could include common size statement – see solution to chapter 9.

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Research Question 4.1 – Executive renumeration The solution to this research question will depend on the company selected by the student.

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Research Question 4.2 – Public company financial statements The solution to this research question will depend on the company selected by the student.

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Solutions Manual to accompany

Auditing: a practical approach by Robyn Moroney Fiona Campbell Jane Hamilton Valerie Warren

CHAPTER 5 Audit evidence

John Wiley & Sons Canada, Ltd. 2012

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Chapter 5 – Audit evidence

SOLUTIONS TO REVIEW QUESTIONS REVIEW QUESTION 5.1 LO 2 Evidence is higher quality when it is more relevant and/or more reliable.

Evidence is obtained by performing audit procedures. Auditors choose procedures which will give them reasonable assurance about management assertions at the transaction, account balance, or disclosure level. If auditors choose procedures to gather evidence about the occurrence assertion (for example, occurrence of sales), the evidence is relevant to the occurrence assertion but will not be relevant to the completeness assertion. This is because the evidence shows whether recorded sales occurred, but not whether all sales that occurred are in the records. Therefore, the evidence is likely to be of high quality for the occurrence assertion, but low quality for the completeness assertion.

REVIEW QUESTION 5.2 LO 2 A legal representation letter could be provided by a lawyer to the auditor on the auditor’s request to confirm the lawyer’s opinion about a matter, such as the likely outcome of a court case.

A legal representation letter is different to a confirmation because the confirmation letter asks about matters of fact, but the representation letter asks about matters of legal opinion.

The auditor could send a confirmation letter to any third party, to ask them to respond to the auditor on the matter(s) included in the letter. For example, the auditor could ask the client’s bank to confirm the amount of cash held in the bank, details of any loans and interest rates charge.

An auditor will ask the client’s management to provide a representation letter to confirm their discussions or other matters relevant to the audit. The contents would normally include an undertaking that laws and regulations have been complied with, a statement that there have been no material frauds or errors that would impact the financial report, and that internal controls are effective.

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REVIEW QUESTION 5.3 LO 2 When an auditor inspects a client’s tangible assets they can see that the assets physically exist, and that they appear to be in good working order.

In order to gather evidence about the completeness assertion for the assets, the auditor would trace the details of the assets, gathered from the physical inspection, to the client’s accounting records. For example, if the auditor inspects 10 motor vehicles and makes a note of their registration details and physical characteristics, the auditor would then inspect the asset register to determine if all the motor vehicles were present in the register with the appropriate registration information and details about model, year, colour, make, etc. The focus for this test is that all the physical assets are in the accounting records.

In order to provide evidence about the existence assertion for the assets, the auditor would start with the asset register and then inspect the physical assets to determine if they existed as described. The focus for this test is that the assets in the accounting records physically exist.

REVIEW QUESTION 5.4 LO 2 Electronic processing of transactions leaves no paper trail when the documents are initiated and stored electronically. To access the details of these transactions, an auditor must access their client’s computer system, where details are kept.

For example, the contact between the client and its supplier to create a purchase order could be done electronically, such as through an email. The client emails the supplier with purchase order details, and the supplier confirms the placement of the order via return email. The return email confirms the order and also provides detailed information about the estimated delivery date and the amount to be invoiced upon delivery of the goods. When the goods are received, the receiving department advises the accounting department which then initiates an electronic transfer of funds from the bank account to the supplier’s bank account.

The client can provide the information about electronically processed transactions to the auditor via email. The auditor then searches for corroborating evidence to verify the details of the files. The extent to which the auditor can rely on electronic evidence from the client’s computer system depends on the strength of the client’s internal control system.

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REVIEW QUESTION 5.5 LO 3 Corroborating evidence is evidence that supports the client’s records in terms of accuracy. Corroborating evidence can be internally generated by the client, such as copies of documents, externally generated evidence held by the client, such as bank statements and supplier invoices, or externally generated evidence sent directly to the auditor, such as lawyers’ representation letters or debtors’ confirmations.

The auditor must consider the persuasiveness of corroborating evidence to help them judge how much weight to place on each piece of evidence. The auditor needs to gather sufficient appropriate evidence about the assertions and the financial statements as a whole. If the evidence is very persuasive the auditor would need to gather less of it. If the evidence is not very persuasive the auditor might judge that there is not sufficient appropriate evidence to support their audit opinion, and try to gather more persuasive evidence.

The most persuasive evidence, generally, is the externally generated evidence sent directly to the auditor, and the least persuasive evidence is, generally, the internally generated evidence.

REVIEW QUESTION 5.6 LO 4 The auditor can use an expert to provide sufficient, appropriate evidence when the auditor does not have the requisite skills and knowledge to assess the validity of an account or a transaction. The expert could be from within or external to, the audit firm.

The auditor must decide if an expert is required and the scope of the work to be done by the expert. The auditor must assess the capacity of the expert to do the job and the expert’s level of objectivity. The auditor must assess the expert’s completed work and draw a conclusion. Ultimate responsibility rests with the auditor.

The auditor does not usually have the same level of expertise as the expert, but is able to assess the capacity and the objectivity of the expert based on their qualifications, experience, and association with the client.

The auditor is able to make a judgement about the validity and usefulness of the expert’s report based on their reading of the report and the consistency of the expert’s conclusions with other evidence gathered during the audit.

The expert should write the report in such a away that an auditor can understand the technical content of the report. This means that the expert should details each stage of the process used in arriving at the overall opinion

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or conclusion in the report. The auditor should be able to understand the process and how the expert reached the conclusion.

The expert should explain the data sources or estimation models used or calculations conducted. The auditor would be able to check the data and reperform the calculations. The auditor will assess the consistency of any assumptions made with those in prior years and with other known information.

The auditor also assesses the consistency of the expert’s report and conclusions with other information they have gathered about the client, and with other corroborating information gathered by the audit team.

REVIEW QUESTION 5.7 LO 5 A component auditor is another independent auditor who performs work related to a component of a group audit. The group engagement partner is responsible for signing the audit report and asks the component auditor to perform work as part of the group audit. The engagement auditor has to assess the capacity of the other auditor to undertake the work, as well as the component auditor’s reputation and professional standing. The engagement partner is also responsible for ensuring that the work completed by a component auditor meets the group engagement partner’s requirements and standards.

The group engagement partner does not do all of the work where the physical circumstances make it impracticable and/or more costly for the group engagement partner to do the work. These circumstances include: the client operates in a number of locations, has divisions or subsidiaries spread around the country or the globe, or has significant assets in other locations. In addition, the component could be a listed company which has separately appointed an independent auditor that differs from the auditor chosen by the parent company.

The group engagement partner retains responsibility for the audit report and must consider whether they are able to do the majority of the client’s financial report and be sufficiently knowledgeable about the components of the financial report that they do not audit themselves.

REVIEW QUESTION 5.8 LO 6 The main evidence gathering procedures are: • Inspecting – viewing documents or tangible assets • Observation – watching • Enquiry – asking • Recalculation – checking mathematical accuracy • Re-performance – redoing client process • Analytical procedures – studying plausible relationships among data Solutions Manual 5-5 Chapter 5 Copyright © 2012 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of this page is strictly prohibited.

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These evidence gathering procedures can be done at different stages of the audit. For example, analytical procedures are used in the client evaluation process, gaining an understanding of a client’s system of controls in planning, as evidence gathering procedures such as testing controls, and in reviewing the audit evidence in the final stages.

Documents and assets can be inspected during the audit, and can be used to provide evidence of controls as well as substantive testing, such as existence of inventory.

Client staff can be observed performing their duties during the period or at specific times such as when taking inventory counts.

Enquiry is appropriate at all stages; management can be asked about their reasons for actions taken during the year and external parties, such as solicitors, can be asked about progress of court cases.

Recalculation can be used to check any client records, such as pricing on invoices and sub-totals for receivables ledger.

Re-performance can be used to check any client process, e.g., a bank reconciliation.

In general, re-performance and recalculation provide more reliable evidence than observing or enquiring. Client staff may perform their duties more diligently when they are being observed than at other times, so observation provides evidence only for the time that the staff are being observed. Verbal evidence obtained by asking client management about the reasons for their actions is not very reliable until it is corroborated by other evidence. Reperformance allows an auditor to gain a deeper understanding of how a task is performed by client staff and to confirm that the items in question are being dealt with appropriately. Recalculation allows an auditor to confirm mathematical accuracy, but does not in itself, confirm the data being used in the recalculation.

Analytical procedures are limited as evidence by the validity of the underlying data (which could be unaudited client data). Inspecting provides useful reliable evidence to the extent that the auditor understands what they are inspecting (e.g., an auditor may not understand the usefulness and appropriateness of specialized computer hardware), and in same cases needs to be confirmed by other data (e.g., inspecting a vehicle provides evidence that a particular vehicle exists, and in what condition, but documentary evidence is needed to confirm that the particular vehicle is owned by the client).

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REVIEW QUESTION 5.9 LO 6 Recalculation involves checking additions and computations.

Re-performance means following a process used by a client.

For example, reconciling the bank account in the client’s ledger with the bank account balance as per the bank records through preparing a bank reconciliation statement is a client process. The auditor could re-perform the bank reconciliation by confirming the opening balance, tracing unpresented cheques and deposits in transit, and identifying fees, charges and other items that are on the bank statement, and ensuring that the bank ledger balance can be reconciled to the bank statement balance. Recalculation in this context would involve only checking the accuracy of the sub-totals and totals, such as the total of unpresented cheques.

This means that re-performance is a more involved procedure than recalculation and produces more reliable and comprehensive evidence.

REVIEW QUESTION 5.10 LO 8 The main advantage of using electronic working papers is the ability to share files easily between the members of the audit team. The electronic working papers can also track changes made by each member of the team and identify the member responsible for each entry. The various files can be linked electronically, e.g., worksheets supporting entries in word documents can show detailed calculations which are accessible from the word file. The references can be used to support and justify conclusions made in reports.

In addition, the working papers are stored electronically and can be archived easily, with easy retrieval in future years as required.

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SOLUTIONS TO PROFESSIONAL APPLICATION QUESTIONS PROFESSIONAL APPLICATION 5.1 – Identifying audit assertions LO 1 (a) Valuation (b) Rights and Obligations (c) Completeness (d) Completeness (e) Cut-off (f) Rights and Obligations (g) Cut-off (h) Valuation (i) Existence (j) Completeness PROFESSIONAL APPLICATION 5.2 – Confirmations LO 2 (a) Factors that make audit evidence reliable: • It is obtained through the auditor’s direct personal knowledge.

• It is obtained through an independent provider.

• It has a high degree of objectivity.

• The provider has adequate qualifications.

• The system of internal control producing the information is effective. (b) Positive confirmations request a response even if the customer agrees with the recorded balance. Negative confirmations request a response only if the customer disagrees with the recorded balance.

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PROFESSIONAL APPLICATION 5.3 – Types and persuasiveness of audit evidence LO 1, 2, 3 (a) Jenna has gathered the following evidence: • external confirmations – 30% of which were positive confirmations and 70% negative confirmations • documentary – invoices, cash receipts and sales returns vouchers • verbal – interviews with accounts receivable manager, CFO and accounts receivable department (b) The external confirmations provide evidence about the existence of accounts receivable when the customers reply and confirm that they owe the client money for goods or services. Negative confirmations provide more limited evidence about existence when the customer does not reply to state that they do not owe the client money. The confirmations also provide evidence about rights and obligations assertion because the customer confirms that they owe the client.

The documentary evidence relates to the existence and valuation and allocation assertions for accounts receivable when Jenna vouches the balances back to the underlying sales documents. It relates to the completeness assertion when Jenna traces the sales transactions to the accounts receivable balance. In addition, the vouching of accounts receivable back to sales returns and cash receipts documents provides evidence about the occurrence of these transactions, and thus the completeness of the accounts receivable balance. The tracing of these transactions to accounts receivable provides evidence about the completeness of the record of these transactions, and thus the existence of the accounts receivable balance. The review of subsequent cash receipts also provides evidence about existence and valuation and allocation because when a customer pays their account they are confirming that they owed the balance on the balance date and they were in a position to make a payment.

The verbal evidence could relate to all assertions, depending on the topic of conversation. The auditor is likely to ask about procedures used to identify potential bad debts (valuation and allocation), about credit control (valuation and allocation), segregation of duties (primarily existence, rights and obligations, completeness), about control systems in general (which would relate to all assertions).

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PROFESSIONAL APPLICATION 5.4 – Communication with lawyers LO 1, 2, 6 (a) A legal letter is sent by the client to its lawyers asking them to complete the letter for the information required and send it directly to the auditor. In this case, the auditor would ask Acme Ltd. to write to three legal firms. The client would be requested to ask each solicitor to advise if there are any legal matters involving the client, the lawyer’s opinion on the client’s description of any outstanding legal matters and whether the client’s evaluation of those matters appears reasonable, and for any details of any legal matters that the lawyer is in disagreement with the client. Angelo would expect that each firm would respond in detail about the type of work being done by that firm for the client. (b) Angelo should perform procedures to detect if any other legal firms have performed work for Acme during the financial period because there could be additional matters relating to claims against the client. Angelo should: • Review the minutes of the board of directors, specifically seeking references to any claims against the client or complex legal matters, such as new enterprise bargaining agreements, property purchases, proposed mergers, major new contracts, new regulations on which they may be seeking legal advice, etc.

• Hold discussions with senior staff, audit committee members, board members, about new developments at the client • Review trial balance for major transactions which could be linked to legal matters (property purchases, new loans, etc) • Review press coverage of the client • Review cash payments for large payments to legal firms

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PROFESSIONAL APPLICATION 5.5 – Bank reconciliations LO 1, 2, 4 (a) There is a hierarchy of evidence persuasiveness. The most persuasive is externally generated evidence sent directly to the auditor, then externally generated evidence held by the client, then the least persuasive evidence is internally generated evidence. None of the documents held in Mohammad’s files is in the most persuasive category because it is all held by the client.

Therefore, the more persuasive evidence held by Mohammad is the externally generated evidence such as bank statements, correspondence from banks, and other bank initiated documents. The least persuasive evidence is Mohammad’s documents, including bank reconciliations and copies of letters sent to banks and other parties. (b) The auditor would obtain more persuasive evidence by obtaining documents directly from the bank. For example, the auditor could ask the bank to confirm in writing (via a bank confirmation) the balances of the client’s various accounts at specific dates, the interest rates and fees that apply to the client’s bank accounts and amounts payable for the period, the state of any disputed transactions, etc. This evidence would be more persuasive because it has not passed through the hands of the client and therefore could not have been altered by the client.

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PROFESSIONAL APPLICATION 5.6 – Using an expert LO 4 Ken must consider the requirements of CAS 620 Using the Work of an Auditor's Expert when making his choice of expert. Once it has been decided that the services of an expert are required, the main factors to consider are: • Scope of the work: The auditor must specify the scope of the work to be carried out by the expert. It is possible that the two experts being considered, as well as any others, would not be interested in completing all the work required. Ken has to consider how to communicate the scope of the work, and whether he could use more than one expert to complete the work required.

• Capability of the expert: What qualifications do Manfred and Lily possess? Are they a member of a relevant professional body (e.g., Institute of Engineers), and what tertiary qualifications do they have in the relevant scientific field? What experience do they have – both appear to have been working in the industry for many years?

• Objectivity of the expert: This appears to be the most contentious point in this case. Fritz is not in favour of using Manfred because he believes that Manfred would have a negative attitude. However, Ken should be cautious about taking Fritz’s advice to employ Lily because it appears that Lily could be too positive towards Fritz. A third choice of expert might resolve the deadlock, although in such a specialised field it is likely that there would be personal relationships or views on reputation of most of the leading experts.

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PROFESSIONAL APPLICATION 5.7 – Gathering evidence LO 2, 6 (a) Susan has been gathering the following types of evidence: • Oral: Susan has been holding conversations with staff. During these conversations she will be discovering how they perform their duties, whether there are staff shortages in certain areas at various times, how management are communicating their attitudes towards control systems and profit targets, whether controls are overridden at various times.

• Physical evidence: Susan has inspected physical assets of the company during her tours. She can see if assets exist, whether they are being protected, their condition, how they are used. For example, she can see if construction equipment appears to be new or well maintained. She can also observe staff performing their duties, both on the construction sites and in the offices.

• Computational evidence: Susan is calculating ratios and reviewing the trial balance. She is looking for indicators of problems, such as unusual fluctuations, and whether the data appear to reflect the state of the business as described by management. (b) The spreadsheets are reviewed to identify unusual patterns which could indicate problem areas for further investigation, and to calculate trends and ratios, including common size statements, to quantify the fluctuations. Susan will use the results of the analytical procedures to justify increased or decreased focus on specific areas, and the nature, timing and extent of further procedures.

For this type of business Susan will be using the data to determine if profitability is comparable to previous periods and with other similar clients.

She will analyse the specific movement of physical materials used in construction and whether this is consistent with the financial data. For example, if the quantities of physical materials delivered to a site are lower because of slower construction progress, is the cost of materials also lower?

Is the progress of the build consistent with the use of labour and machinery?

Is revenue recognized on building in progress consistent with the progress and cost of the construction?

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PROFESSIONAL APPLICATION 5.8 – Documentation LO 7, 8 (a) CAS 230 Audit Documentation requires that the auditor prepares documentation of the audit on a timely basis that provides a sufficient appropriate record of the basis for the auditor’s report and evidence that the audit was planned and performed in accordance with CASs and applicable legal and regulatory requirements.

The audit documentation of audit procedures must record the (a) identifying characteristics of the specific items or matters tested (b) who performed the audit work and the date such work was completed, and (c) who reviewed the audit work performed and the date and extent of such review.

Essentially, the documentation should allow another experienced auditor to understand the work done and the results obtained, and any significant matters that arose during the audit. The conclusions reached should also be understandable given the audit work documented. (b) The audit assistant has documented that there were no replies to certain accounts receivable positive confirmation letters. Jennifer’s review has shown that the decision to take no further action is not appropriate. According to CAS 505 External Confirmations para 12, ‘in the case of each non-response, the auditor shall perform alternative audit procedures to obtain relevant and reliable audit evidence’.

Jennifer should note that further audit work is required, and the specific audit work to be done. These include (para A18-A19 CAS 505) examining specific subsequent cash receipts, shipping documents and sales near the period end (i.e., for the non-response customers), and specific consideration of the implication of the non-responses for audit risk for accounts receivable. These conclusions would also be documented (see paras 8-12 of CAS 230).

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PROFESSIONAL APPLICATION 5.9 – Documenting the audit LO 8 Paragraph 9 of CAS 230 Audit Documentation requires specific documentation of the procedures performed in relation to the bad debt. The auditor would document the analysis of the aging of the accounts receivable balance. For example, which accounts receivable balances were included in the analysis, and the date the balances of accounts receivable were extracted; who conducted the analysis, and on which date; and who reviewed the analysis, and on which date, including the items reviewed and the conclusions drawn.

In addition, the notes (or transcript of interview) for the consultations with Julie and Kristen from Featherbed’s accounts department, would be documented; the date of the interview and the personnel involved; who conducted the interview; and who reviewed the contents of the interviews.

Any other audit procedures relevant to the matter would also be documented.

For example, a review of subsequent receipts and other transactions with this debtor in the period following the financial year end.

Paragraph 10 requires the auditor to discuss significant matters with the management, those charged with governance, and the nature of the significant matters discussed, with whom and when. In this case, the Wave Travel Agency’s account is large and material, and is more than 60 days overdue, yet there is no provision made. The auditor would discuss with management the attempts made to recover the debt, and the progress of those attempts. They would also discuss the reasons why management has not yet made a provision for this account. If the auditor was not satisfied that repayment was likely (particularly if there were no receipts during the subsequent period), the auditor would ask management to make a provision.

In the event that management would not make a provision which the auditor required, the auditor would discuss the matter further with the board of directors. If management do make a provision that was acceptable to the auditor, the auditor would inform the board of directors of the decision and the provision. All such discussions would be documented as required by paragraph 10.

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PROFESSIONAL APPLICATION 5.10 – Considering the work of other auditors LO 5 CAS 600 Special Considerations — Audits of Group Financial Statements (Including the Work of Component Auditors) requires a group engagement partner to consider the work of component auditors. A component is defined as an entity or business activity for which a group or component manager prepares financial information that should be included in the group financial report. A component auditor means an auditor who, at the request of the group engagement team, performs work on financial information related to a component for the group audit. The engagement partner retains responsibility for the audit and signs the audit report. The component auditor must meet the independent requirements that are relevant to the group audit. This means that the component auditor must meet the same independence requirements as the engagement auditor (see para A37).

There is no mention in the case of a group of companies, but CAS 600 also applies where an auditor involves other auditors in the audit of financial statements that are not group financial statements, so CAS 600 could apply to Securimax’s audit.

In this case, Rydell Creek heads the internal audit department at Securimax.

As such, Rydell Creek and the department could not meet the independence requirements for the external auditor, and thus CAS 600 would not allow their work to be treated as though it is done by a component auditor.

CAS 610 Using the Work of Internal Auditors gives an external auditor guidance on using the work of an internal auditor, and would govern the use of the internal audit department’s work at Securimax.

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PROFESSIONAL APPLICATION 5.11 – Confirmation evidence LO 2, 3, 6 Accounts receivable confirmations would provide evidence about the existence assertion for accounts receivable at HCHG. If the accounts receivable customer replies with an affirmative answer, they provide external evidence that they owe HCHG for services rendered.

Debtor confirmations also provide evidence about the rights and obligations assertion, because they give evidence about whether the amounts were owed to HCHG companies. They do not provide reliable evidence about the valuation and allocation assertion because the customer does not provide any more assurance that they intend to pay the account, although they may note that there is an error in the account balance.

The balance of receivables for Shady Oaks is material, and although payment terms are 14 days, many of the smaller accounts are more than 60 days overdue. This suggests that procedures at Shady Oaks for approval of credit and collection of accounts receivable are not very effective.

Accounts receivable confirmations could be sent to the large balances (60% is owed by 5 medical practitioners) to obtain evidence about their existence.

However, further procedures would be required to gather reliable evidence about their valuation. It is not stated how long these accounts have been outstanding. If they are within 14 days, it is less likely that there are significant doubts about their eventual recovery. However, a subsequent receipts review would provide additional evidence which would be necessary because of the material nature of the accounts.

The smaller accounts, 40% of the balance, appear to be more likely to be in doubt because most are well over the allowed 14 days. Accounts receivable confirmations would provide evidence about their existence, but other procedures would be required for the valuation assertion. As the allowance for doubtful accounts is taken directly against the trade receivables account, the auditor would need to review the transactions and assess their reasonableness in light of the apparently poor credit control. Subsequent receipts review and analysis of the characteristics of the accounts receivable customers would also provide evidence about their valuation.

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PROFESIONAL APPLICATION 5.12 – Adequacy of documentation and audit evidence LO 2, 6, 7, 8 CAS 230 Audit Documentation requires that the auditor prepares documentation of the audit on a timely basis that provides a sufficient appropriate record of the basis for the auditor’s report and evidence that the audit was planned and performed in accordance with CASs and applicable legal and regulatory requirements.

Paragraph 9 of CAS 230 requires specific documentation of the procedures performed in relation to the bad debt. The auditor would document the analysis of the ageing of the accounts receivable balance. For example, which accounts receivable balances were included in the analysis, and the date the balances of accounts receivable were extracted; who conducted the analysis, and on which date; and who reviewed the analysis, and on which date, including the items reviewed and the conclusions drawn.

It is not likely that using only accounts receivable confirmations in this case would provide sufficient basis for the auditor’s report. The accounts receivable balance is material, and there is evidence that many smaller debtors balances are overdue. Performing accounts receivable confirmations would not provide sufficient evidence of the valuation and allocation assertion for accounts receivable. It would necessary to conduct further procedures for the valuation and allocation assertion. In particular, it would be necessary to discuss with management their approach to recognizing doubtful debts. The auditor would need to consider the assumptions, data, and methods used by management and consider their reasonableness, as well as the reasonableness of the adjustment to the accounts. In addition, the large outstanding balances from 5 practitioners would have to be considered specifically with respect to their collectability. Additional procedures for all accounts receivable balances would include analysis of subsequent receipts and further invoices to these accounts receivable customers.

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PROFESIONAL APPLICATION supporting evidence LO 1

Auditing: A Practical Approach, Canadian Edition

5.13

–

Identifying

assertions

and

The audit assertions applicable and description of the relevant evidence that needs to be obtained to support them for the audit of investments in securities at December 31 is as followed: 1. Existence. Obtain evidence that the securities are legitimate and held by Lawson.

2. Occurrence. Obtain evidence that the loan transaction and securities purchase transactions actually took place during the year under audit.

3. Completeness. Obtain evidence that all the securities purchase transactions were recorded.

4. Ownership Rights. Obtain evidence that the securities are owned by Lawson.

5. Obligation. Obtain evidence that $250,000 is the amount actually owed on the loan.

6. Valuation. Obtain evidence of the cost and market value of the securities held at December 31. Decide whether any writedowns to market are required.

7. Presentation and Disclosure. Obtain evidence of the committed nature of the assets, which should mean they should be in a non-current classification like the loan. Obtain evidence that restrictions on the use of the assets are disclosed fully and agree with the loan documents.

PROFESIONAL APPLICATION 5.14 – Identifying types of audit evidence LO 2 The type of audit evidence being used in each situation is: (a) Computational, Documentary. (b) Documentary, Computational. (c) Physical, Confirmation, Computational. (d) Computational, Documentary, Electronic.

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CASE 5.15 – IndaCar—Integrative Case Study (a) The costs and benefits of upgrading from a review engagement to an audit engagement would include: • more assurance is provided with and audit than a review, which requires more evidence on the part of the auditor; however, users of the financial statements may find the increased level of assurance more satisfactory • an audit would result in a higher fee cost to the client, as opposed to the review (b) In planning the audit, the auditor must consider audit risk. Using the above case facts, we can make the following risk assessment.

Risk is higher high due to the following: • the more complex accounting transactions that need to be accounted for properly, • the potential use of the financial statements to obtain new equity financing, and Jake’s stated objective of maximizing equity and minimizing liabilities reported on the fiscal 2012 financial statements creates a strong management bias • May be fraud • This would be a first year audit engagement, therefore, the risk is increased but the fact that we have experience IC and that we have had no issues with it decreases this risk. (c) If the Control Risk is assessed as high, then the auditor will adopt a primarily substantive strategy. This means the auditor will perform the minimum required work on controls and they will increase the reliance on substantive tests of transactions and account balances. (d) Calculate and conclude on the most appropriate materiality, and include a detailed explanation supporting your decision.

• The users of the financial statements are the bank (that is primarily concerned with whether the entity can repay the borrowed funds) and the potential shareholders (who will want a good return on their investment).

• Possible bases for the materiality calculation are percent of revenue, percent of assets or percent of net income. Due to the users being most interested in a return on investment, and this is a for profit entity, the most likely applicable base is percent of net income. (Other conclusions are reasonable provided they are tied to user needs).

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Suggested calculation for materiality: • Current year before tax net income (unaudited) = 5% × $9,930,000 = $496,500. Prior year materiality based on audited before tax balance = 5% × $2,430,000 = $121,500.

• Qualitative factors indicate there may be a high risk of fraud as Jake suspects employee theft, therefore we should use a lower materiality.

Also due to Jake’s bias and the fact that many of the balances have changed significantly over prior year, we will choose a lower materiality by using an average of the above = $309,000 [= ($496,500 + $121,500) ÷ 2].

• Conclusion: Planning materiality is $300,000. (e) For the following accounts what assertions will the auditor be most concerned with? What evidence should the auditor gather to verify the management assertions?

1. Accounts Receivable • Existence – Evidence- Accounts receivable confirmations • Valuation – Discuss the aging balances with the client, recalculate the allowance for doubtful accounts • Therefore documentary, verbal and computational evidence 2. Property, plant, and equipment • Existence – Go look at the equipment • Valuation – when inspecting the equipment, note the condition of the equipment • Therefore physical evidence is crucial 3. Accounts payable • Completeness – Accounts Payable Confirmations • Therefore documentary evidence 4. Long-term debt • Completeness – Evidence = Confirmation • Therefore documentary evidence 5. Car rental sales • Occurrence – Vouch to sales invoices • Therefore physical evidence

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Case Study — Cloud 9 (a) The procedures for engaging component auditors to perform the work on the inventory in China and the US are covered in CAS 600 Special Considerations — Audits of Group Financial Statements (Including the Work of Component Auditors). The standard (and the codes of ethics for professional accountants) requires the auditor responsible for signing the audit report to consider the issues with using another auditor when accepting the client, be responsible for performing the majority of the work, and be knowledgeable about the other components that they do not audit themselves. When engaging the component auditor W&S Partners should consider the reputation of the component auditor and ensure they are the member of a reputable professional body. W&S Partners are also responsible for ensuring the work done by the other auditor meets the required standards.

The procedures include: • The engagement partner sets out the work to be done – in this case auditing the inventory in another location • Discussing the detailed procedures to be used between the engagement partner and the component auditor – such as inventory procedures • Reviewing the conclusions drawn in the working papers by the other auditor • Discussing the results, particularly if there are any problems or there is a lack of understanding between the auditors (b) Engagement of the derivatives expert is covered by CAS 620 Using the Work of An Auditor's Expert. In this case, Suzie is engaging an expert in valuing derivatives. Derivatives are specialised assets and can be difficult to value because of the risks involved. Suzie must decide the scope of the work to be carried out by the expert. Suzie has to advise the expert of the nature timing and extent of work to be completed by the expert, but will consult with the expert in order to make sure that the instructions are appropriate. All instructions will be communicated in writing to ensure that there are no potential misunderstandings about the scope of the work and the use of the findings in the financial statement audit. Suzie will require the expert to report on specific details about the derivatives, explain the assumptions used to value the derivatives, show the computations in detail, and explain any issues in reaching the conclusion.

Suzie must also consider the choice of expert – are they appropriately qualified, experienced, independent, and do they have sufficient time to complete the work?

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Once the report is received from the expert, Suzie will need to be able to read the report and understand the findings even though she is not an expert in the subject. The technical content of the report has to be explained clearly. Suzie will then need to assess the conclusions, based on the assumptions and calculations, whether they are consistent with previous periods and with the instructions given, and whether it is appropriate to rely on the report in the audit. The audit partner retains ultimate responsibility for the expert’s work as part of the audit. (c) Working papers: Students are to create a document with a heading including the details of the audit client, preparer and reviewer of the document, date prepared and reviewed, reference number. Each working paper would include instructions to the other party (component auditor or expert). Instructions would include information about why the auditor/expert is being engaged, that their work would be relied upon as part of the financial statement audit, that the engagement auditor retains responsibility for the conclusion. Each paper would ask the third party to confirm their qualifications and independence to perform the work. It would include a list of detailed steps to be undertaken by the third party, including that they must report the work done in a manner that the engagement partner can review the adequacy of their work.

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Research Question 5.1 – Annual report of a large multinational Canadian company The solution to this research question will depend on the company selected by the student.

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The material provided herein may not be downloaded, reproduced, stored in a retrieval system, modified, made available on a network, used to create derivative works, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise without the prior written permission of John Wiley & Sons Canada, Ltd.

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Solutions Manual to accompany

Auditing: a practical approach by Robyn Moroney Fiona Campbell Jane Hamilton Valerie Warren

CHAPTER 6 Overview of tests of controls, substantive procedures, and sampling

John Wiley & Sons Canada, Ltd. 2012

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Chapter 6 – Overview of tests of controls, substantive procedures and sampling

SOLUTIONS TO REVIEW QUESTIONS REVIEW QUESTION 6.1 LO 1 Tests of controls are audit procedures designed to evaluate the operating effectiveness of controls in preventing, detecting and correcting, material misstatements at the assertion level.

Substantive procedures are audit procedures designed to detect material misstatement at the assertion level.

Therefore, the difference between the two types of audit procedures is whether they provide evidence about the effectiveness of the control systems at preventing or detecting material misstatements from entering the accounts, or about the existence of material misstatements in the accounts.

The results of the tests of controls indicate how likely it is that material misstatements exist in the accounts. If it is unlikely that these misstatement exist (i.e., control risk is low), then the auditor has gained some assurance from the control tests about the fair presentation of the financial statements.

The auditor then needs to gather only a limited amount of evidence from substantive tests and can use less expensive and less extensive substantive procedures. If it is likely that misstatements exist in the accounts (i.e., control risk is high), then the auditor has only limited assurance from the control tests about the fair presentation of the financial report. The auditor must gain more assurance from substantive tests and therefore is required to use more effective and extensive substantive procedures. The auditor makes decisions about the nature, timing, and extent of substantive procedures to achieve the required level of quality and quantity of evidence from substantive testing.

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REVIEW QUESTION 6.2 LO 2 Analytical procedures can be used at various stages of the audit. CAS 315 Identifying and Assessing the Risks of Material Misstatement Through Understanding the Entity and Its Environment requires an auditor to obtain an understanding of the entity’s internal controls, and design appropriate responses to the assessed risk of material misstatement. The auditor could perform substantive procedures or tests of controls concurrently with risk assessment procedures when it is efficient to do so. Paras A7-A9 of CAS 315 discuss the use of analytical procedures to help identify risks, such as those revealed by unusual transactions or events and amounts, ratios or trends. For example, the auditor could use the client’s interim trial balance to analyze relationships between data such as cost of sales and sales, between nonfinancial data such as employee numbers and financial data such as payroll expense, to identify areas or risk that would require further testing.

CAS 330 The Auditor’s Responses to Assessed Risks requires the auditor to gather sufficient appropriate audit evidence through designing and implementing the appropriate responses to the assessed risk of material misstatement. For example, an auditor could use a combination of procedures to gather evidence about the effectiveness of controls. The auditor could make enquiries of management to obtain explanations about the results of analytical procedures which indicate there is unusual variance between budgeted and actual amounts.

CAS 520 Analytical Procedures explains how analytical procedures are used as substantive tests. It notes that substantive analytical procedures are generally more applicable to large volumes of transactions that tend to be predictable over time (para A6). These types of transactions could include expenses such as insurance, rent, power related to asset values, building size, and production activity, respectively.

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REVIEW QUESTION 6.3 LO 2 Test data are transactions created by an auditor to tests controls embedded in their client’s computer programs. The auditor creates transactions with valid and invalid items to determine how they are processed by the client’s programs. The auditor knows what the results of the processing should be, and tries to use the data to ‘trip up’ the programs. For example, the auditor could create transactions with invalid prices or quantities which should be detected and rejected by the programs. If the program is well designed it should detect all types of invalid entries.

Reading client procedure manuals gives the auditor an understanding of the design of the control system, or programs. The manuals explain how the programs work and what type of results are expected. The manuals would also explain the error messages or results that will be produced if invalid data is entered into the system. However, the program designers and manual writers may not have anticipated all possible invalid entries. Testing the system using auditor created transactions will provide direct evidence of how the systems work in practice.

REVIEW QUESTION 6.4 LO 3 High risk clients are more likely to have material misstatements in their accounts. Auditors are not as able to rely on these client’s internal controls to detect or prevent material misstatements. If an auditor gathers evidence which shows that the internal control systems work effectively, there is a low risk that material misstatements will occur between the date of the testing and the year end. However, if the evidence shows that the internal control systems do not work effectively (i.e., a high risk client), there is a high risk that material misstatements will occur between the date of the testing and the year end.

This means that the auditor must gather evidence up to the year-end and just after year-end for high risk clients.

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REVIEW QUESTION 6.5 LO 4 Sampling risk relates to the chance that the sample is not representative of the population. If the sample is representative of the population, both the sample results and the results from testing the entire population would lead to the same conclusion.

Overreliance on an ineffective system of internal controls occurs when the sample results indicate that internal controls are effective, but they are not. In this case the auditor concludes, based on testing the sample, that the control risk is lower than it really is. The auditor will not perform more testing and will rely on the controls. The auditor faces the risk that they will not detect a material misstatement and provide an inappropriate audit opinion.

Under-reliance on an effective system of internal controls occurs when the sample results indicate that internal controls are not effective, but they really are. In this case, the auditor concludes that the control risk is higher than it really is, and performs more testing or decides not to rely on the internal controls. The auditor will eventually realize that the controls are better than first thought, but additional time and money will be spent on testing which was not necessary.

Both overreliance and under-reliance are problems for the auditor. The first exposes the auditor to a higher audit risk that they planned, and the second exposes the auditor to greater expense. The implications for the auditor depend on the extent of the problem (i.e., whether the over or under reliance was extreme) and chance. For example, just because internal controls are not as effective as they appear doesn’t mean that a material or pervasive error will definitely occur in the client’s financial statements.

REVIEW QUESTION 6.6 LO 4 Non-sampling risk is the risk that the auditor reaches an inappropriate conclusion for any reason not related to sampling risk. For example, the auditor could misinterpret the evidence or draw the wrong conclusion from the results because they didn’t understand them. The auditor could have chosen the wrong type of test, or applied the test to transactions from the wrong period. The auditor could have been given incorrect information by management to conceal a fraud, which they didn’t detect using other techniques. When testing controls, the auditor could choose to test a control that was not critical to the integrity of the data. When gathering substantive evidence, the auditor could make a mistake when recalculating a subtotal of a subsidiary ledger, or compare the subtotal with the control account at the wrong date.

Non-sampling risk is determined by the auditor’s expertise, experience and understanding of the client. It differs from sampling risk which is created by Solutions Manual 6-5 Chapter 6 Copyright © 2012 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of this page is strictly prohibited.

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using sampling from a population, rather than examining every item. Even when examining every item in a population, an auditor still faces non-sampling risk.

REVIEW QUESTION 6.7 LO 5, 6 Non-statistical sampling does not involve random selection and probability theory to evaluate the results.

Non-statistical sampling is easier to use than statistical sampling and generally lower cost. The auditor selects a sample that they believe is appropriate, and is used when the auditor believes the account is low risk and the auditor has access to adequate corroborating evidence from other sources.

Main methods are: • Haphazard selection: selection of a sample by an auditor without using a methodical technique. The auditor could introduce human bias (e.g., select items that are easier to reach).

• Block selection: select items that are grouped together. Bias can be introduced where the items are sorted in a sequence (e.g., date order).

• Judgemental selection: auditor uses judgement to select items that they believe should be included in the testing (e.g., just after a new computer system is installed).

REVIEW QUESTION 6.8 LO 7 (1) If the auditor believes that the control is likely to be more effective, the auditor will seek to rely on that control and reduce substantive testing.

This means that the auditor will need greater assurance and gather more appropriate audit evidence that the control does work effectively. Greater assurance is provided by increasing the sample size.

(2) The acceptable, or tolerable, rate of deviation refers to the number of deviations (or control errors) that the auditor will accept or tolerate. If the auditor is prepared to accept more deviations, less audit evidence is required, and thus a smaller sample size is required.

(3) The expected rate of deviation is the actual level of deviations that the auditor expects to find in the population from the control, not the level that the auditor is prepared to tolerate. If the auditor expects a higher rate of deviation than in the past, for example because the client has changed its systems, the auditor will need to gather more evidence on which to base their conclusion. This means that the sample size will be increased.

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(4) The auditor’s confidence in the test results is greater when there is more evidence on which to base their conclusions. This means that if the desired level of assurance, or confidence, that the tolerable rate of deviation is not exceeded by the actual rate of deviation in the population is higher, the sample size must be larger.

(5) The number of units in the population has only a negligible effect on the sample size. If the sampling is representative, a larger population should have little effect on the ability of the auditor to draw a conclusion.

REVIEW QUESTION 6.9 LO 8 Stratification is the process of dividing the population into groups and then selecting items from each group. The groups are based on some particular characteristics of the items in the population. For example, the dates of the transactions, the size of the item, the branch or department, etc. Stratifying the population before taking the sample ensures that the auditor obtains sample items from each group of interest. The auditor would have to take a larger sample to have a reasonable chance of selecting items from each group if the auditor used random sampling from the entire population. By using stratification, the auditor can also ensure that sample items come from the riskier sections of the population, increasing the auditor’s confidence that the results reflect the risk in the population. Because confidence is increased by using stratification, the auditor can reduce the size of the sample that would otherwise be required to obtain such a level of confidence.

Stratification would be appropriate in many cases, some examples include partitioning the population by: • Dates • Location • Staff identity (e.g., sales for each salesperson, authorisations for each supervisor) • Transaction characteristics including size, cash vs credit, supplier, product.

REVIEW QUESTION 6.10 LO 9 The auditor must consider whether an error is likely to be unique, and thus not likely to be repeated throughout the population being tested. The auditor would also consider whether the population was stratified before sampling. If neither of these circumstances applies, the auditor would project the error to the population of sales invoices.

If the sample error is $25,300, it would not be appropriate to conclude that sales are misstated by the same amount because this error was discovered in a sample of sales invoices. In this case, we are not told the total of sales Solutions Manual 6-7 Chapter 6 Copyright © 2012 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of this page is strictly prohibited.

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invoices in the sample or the total of sales invoices in the population, so an estimate of the projected error cannot be made. However, to make the estimate the auditor would consider the size of the error in relation to the sample size (sample error / sample size), and then the sample error rate in relation to the population size (by multiplying sample error/sample size by the population size).

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SOLUTIONS TO PROFESSIONAL APPLICATION QUESTIONS PROFESSIONAL APPLICATION 6.1 – Testing accounts receivable LO 1, 2 (a) Emma will be testing the controls over accounts receivable to support her preliminary assessment that the control risk is low. Evidence of low control risk allows Emma to reduce the reliance on substantive testing for accounts receivable. She will be seeking evidence that the controls over transactions and balances in the accounts receivable area are effective and consistent.

Effective controls mean the entity has a low risk of violating the assertions: occurrence, completeness, accuracy, cut-off, classification, existence, rights and obligations, and valuation and allocation.

(b) If Emma is successful in obtaining evidence that controls are effective and consistent, she will reduce the reliance on substantive testing. This means that she can use less effective substantive techniques (e.g., rely more on observation and enquiry and less on inspection of documents), vary the timing (e.g., conduct more interim testing and less balance date testing), and reduce the extent of testing (e.g., inspect fewer documents).

Emma could use these common procedures to test the controls: 1. Inspection of documents for evidence of authorization (e.g., of prices, extending credit to new customers, sales returns) 2. Inspection of documents for evidence that details included have been checked by appropriate client personnel (e.g., that variations to prices have been authorized by the sales director, etc) 3. Observation of client personnel performing various tasks (e.g., opening mail, reconciling receipts with customer statements) 4. Enquiry of client personnel about how they perform their tasks (e.g., following up on outstanding accounts, making adjustments to client accounts) 5. Re-performing control procedures to test their effectiveness (e.g., bank reconciliations, customer statement reconciliations)

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PROFESSIONAL APPLICATION 6.2 – Sample selection in practice LO 6 (a) Using a random number generator in Excel or on your calculator, any number between 1-12 may be selected. This corresponds to the appropriate month.

For example, if the random number generator produces the following items 5, 12, 6, and 4 – then May, December, June, and April will be tested. (b) Systematic selection — 12 months ÷ 4 months required in sample = 3. Thus, pick every third month.

Assuming the sample started at month number 1 (January), the systematic sample months selected would be January, March, June, September, December. (c) Haphazard selection — Pick any 4 months. (d) Block selection — Pick any starting point within the sample, and then pick four consecutive months.

PROFESSIONAL APPLICATION 6.3 – Sampling and non-sampling risk for control testing LO 2, 3, 4 (a) Fred is gathering evidence over cash payment controls. This means that the population definition must relate to the controls over cash payment transactions. Fred would need to gain an understanding of controls over cash payments and identify the controls for each type of potential misstatement, or ‘what could go wrong’ (WCGW). Fred would then sample from the instances of each control, as required. For example, the cash payments are authorized by a senior accountant in order to prevent unauthorized payments being made. Fred would need to consider all authorizations as a population from which to sample. All cash payments are based on a set of documents assembled and checked by the accounts staff; Fred would need to regard all these sets of documents as a population and would sample a number of sets of documents to test if the documents were assembled correctly and checked as required. Fred would also sample from the processed cash payment transactions and test the documents and authorizations on which the transactions are based. In this case, the population is the processed cash payments.

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(b) Sampling risk refers to the possibility of drawing an incorrect conclusion about the population based on the sample results. There is a possibility that the sample is not representative of the population, and the sample deviation rate (departure from controls in the sample items) differs significantly from the population deviation rate (departure from controls in the population).

Sampling risk could lead to the auditor concluding that the population contains more control deviations than it actually does. In this case, the sample deviation rate is higher than the population deviation rate. In this case the auditor would under-rely on the controls and conduct further testing which was not necessary.

Sampling risk could lead to the auditor concluding that the population contains fewer control deviations than it actually does. In this case, the sample deviation rate is higher than the population deviation rate. In this case the auditor would over-rely on the controls and conclude that the control is working effectively. The auditor would not conduct further testing and has a higher risk of providing an inappropriate audit opinion. (c) Non-sampling risks always exist. The non-sampling risk is the risk that the auditor will make an inappropriate conclusion based on anything other than sampling risk. That is, the auditor misinterprets the evidence or misapplies the audit techniques. For example, in this case, the auditor could fail to detect that cheques were countersigned by the chief accountant by being careless when reviewing the documents. The auditor could fail to understand the significance of certain cash payment entries being authorized for maintenance on items which were not owned by the client (i.e., the maintenance was for a staff member’s private assets). The auditor could fail to ask the chief accountant about their annual leave (vacation) and the arrangements for counter-signing cheques whilst away.

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PROFESSIONAL APPLICATION 6.4 – Sampling methods LO 3, 4, 5 (a) Bob is conducting substantive testing of sales invoices. In order to gather evidence about existence, Bob would need to sample the entries in the sales journal and then vouch to the underlying documents. This would also allow evidence to be gathered about the details of the sales transactions that is relevant to the accuracy, classification and cut-off assertions.

In order to gather evidence about completeness of the accounting records, Bob would sample the invoices, and then trace the details of the transactions to the sales journal. This would also provide evidence relevant to the accuracy, classification and cut-off assertions. In this case, Bob has to be careful about which invoices he samples. The conditions in which the boxes of sales invoices are stored appear to be unsatisfactory. He will have difficulty identifying the boxes of sales invoices relevant to the current year. He will also have to be careful not just to sample the invoices that are in boxes near the door or otherwise easy to access, because this would introduce bias to his sampling and potentially invalidate his conclusions. (b) As noted above, there is an issue about identifying and accessing the sales invoices because of the unsatisfactory conditions in the storage shed. Other information relevant to sampling is the difficulties in the administration department. There have been periods of staff shortages. The auditor should consider stratifying the sample and making sure that they sample from the periods where staff conditions were different. This would provide evidence about the effectiveness of controls under different conditions. The auditor would consider the patterns in customer complaints – do they relate to specific periods, or specific types of sales? Do the complaints suggest greater risk would apply to different parts of the year? Overall, controls over sales invoices appear to be poor and substantive testing should be extensive.

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PROFESSIONAL APPLICATION 6.5 – Determining sample size for control testing LO 7 • •

•

• •

The number of accounts payable has increased by 50% since last year.

An increase in the population has a negligible effect on sample size.

Bunns and Major has changed some of its suppliers. This changes the conditions affecting accounts payable because the change has been from large corporate wholesalers to direct dealing with manufacturers.

There is a possibility that the two groups of suppliers would have different levels of quality control over their supplier statements. The auditor would need to consider if there was a decrease (increase) in quality, and if so, increase (decrease) the sample size because there is potentially a greater (lower) degree of error in the supplier statements (an increase/decrease in the expected rate of deviation of the population to be tested).

Belief that controls in accounts payable are likely to be operating more effectively than in previous years because of additional staff, expecting a reduction in control deviations. An expected reduction in control deviation leads to a lower sample size.

A lower tolerable rate of deviation because of the increased importance of accounts payable to the solvency analysis would lead to an increased sample size for control testing.

An increased reliance on controls to justify less substantive testing means that the sample size for control testing will increase (an increase in the extent to which the auditor’s risk assessment takes into account relevant controls leads to increase in sample size).

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PROFESSIONAL APPLICATION 6.6 – Evaluating substantive testing results LO 7, 8, 9 (a) Completed table of projected errors:

Stratum

Sample total Error found value

Stratum total value

Projected error

(1)

(2)

(3)

(4)

(2)/(3) × (4)

1

$7,930

$101,170

$128,660

$10,085

2

$3,290

$41,990

$76,830

$6,020

3

$8,600

$62,840

$162,280

$22,209

Total

$19,820

$206,000

$367,770

$38,314

Projected error ($38,314) is not material if tolerable error is set at $40,000; however, because this amount is quite close the auditor may want to consider additional testing. However, it is material if tolerable error is set at $30,000 and the auditor will need to do more testing. (b) Consider results of testing controls for those three months. If results are not consistent across the year and show that controls are weaker in that period, the auditor would need more substantive testing for weaker control period, or change the tolerable error for that period to reflect the weaker controls.

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PROFESSIONAL APPLICATION 6.7 – Sampling methods and risk 3 4 5 LO 2, 3, 4, 5, 6 The population for the tests of depreciation expense is the depreciable items included in PPE. This includes both new items and existing items. The auditor should ensure that disposals are removed from the asset register before the sample is taken.

Sampling PPE for the tests of depreciation expense should reflect the changed conditions and the materiality of PPE to the balance sheet. The changed conditions relate to the large investment in a new manufacturing process and the associated increases in PPE acquisitions. The sampled items should include new acquisitions of PPE (because these have not been tested before for depreciation), plus the larger items (because the depreciation expense would likely be higher for these items).

Other considerations include the location of items (does FH have different branches?), and types of equipment (are some pieces of equipment harder to value and make estimates about useful life and depreciation rates?), and history (does management made predictable types of misjudgements about useful life?).

The auditor could formally stratify the sample to select samples of new items and old items, and different value items, or select a large enough sample to be reasonably sure that the sample includes all types of items that are likely to be most at risk.

A random sample (either with or without stratification) would allow the auditor to make conclusions using probability theory. The auditor could supplement the formal conclusions based on a random sample with evidence obtained from samples of items considered ‘important’ in the auditor’s judgement. This judgement would relate to the consideration of which items are more likely to be depreciated inappropriately.

The assertions most at risk are the accuracy of depreciation expense and the valuation and allocation for PPE (shown as cost less accumulated depreciation).

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PROFESSIONAL APPLICATION 6.8 – Projecting errors for PPE LO 8, 9 In order to project the error in the sample of $48,500 back to the population we use information on the sample total value ($1,145,000) and the population total value ($11,345,000). The projection shows: projected error = errors found ÷ sample total value × stratum total value = $48,500 / $1,145,000 × $11,345,000 = $480,552.

This means that PPE items with a value of $480,552 have inappropriate depreciation rates. This error equates to approximately 4% of gross PPE, which is usually not considered material. In this case, the auditor would conclude that the valuation and allocation assertion for PPE was not violated.

Although we are not given the depreciation rate, the effect on profit before tax is likely to be less than 4% (i.e., assuming 10% depreciation, the error in the expense is $48,055 which is 2.5% of profit before tax).

However, given that PPE is considered to be one of the most material balances, the auditor might consider further testing or asking management to adjust the depreciation.

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PROFSSIONAL APPLICATION 6.9 – Substantive testing and assertions LO 1, 2, 8 (a) The sales team are remunerated in two ways; a base salary plus a bonus based on the dollar values of sales. The bonus payment increases if the sales person increases recorded sales. An inappropriate way of increasing sales is to record sales during the year for samples given to customers, or to record sales to existing customers at year-end when not ordered and then to reverse immediately after year-end, or to record a sale prematurely (for example, before shipment to customer). When the sample is returned following the year-end the sale is reversed or adjusted with a sales return or allowance.

Another way of increasing sales is to falsify sales by recording a sale to a fictitious customer. The account balance is eventually written off for nonpayment of the account. The sales and accounts receivable account balances are at risk because of these practices. The assertions at risk are occurrence and existence for the sales transaction and accounts receivable balance. In addition, the valuation and allocation assertion for accounts receivable is at risk because the balance does not represent the amount that is reasonably expected to be received from customers. (b) The substantive test described in the question is to take a sample of payments received by the hospital (i.e., cash receipts) and trace back to the general ledger and customer account balance. Performing this test will provide evidence about the existence/occurrence assertion for the accounts receivable and sales balances, and the valuation and allocation assertion for accounts receivable. If the client receives cash for the credit of an accounts receivable this is reliable evidence that the recorded sale did occur and that the balance of accounts receivable was fairly stated at the year-end.

The reference to the bonus structure is to reinforce the risk to the occurrence assertion for sales and the valuation and allocation assertion for accounts receivable.

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PROFESSIONAL APPLICATION 6.10 – Substantive testing versus control testing 1 8 LO 1, 8 (a) Test 1: This is a substantive test. The test gathers evidence about the balance of trade creditors at year end and the total of purchases. In particular, the test is gathering evidence about the date the goods were received and the date the entry is posted.

Test 2: This is a test of controls. The test is gathering evidence about the process of reviewing and authorising the pricing and discount terms. (b) Test 1: Cut-off assertion for purchases, valuation and allocation assertion for trade creditors. The dates are being verified to ensure the transactions are recorded in the correct financial period.

Test 2: Controls over pricing and discounts are relevant to the valuation and allocation assertion for trade creditors, and the accuracy assertion for purchases. (c) Test 1: The test does not address the issue of completeness for trade creditors or fully address the cut-off assertion for purchases. The key risk for creditors is understatement. By taking a sample from the list of trade creditors the auditor is not able to detect unrecorded liabilities. The conclusion is not appropriate.

Test 2: The initial test reveals that 3 out of 20 invoices had not been authorized and incorrect discounts were recorded. The follow-up shows no pattern. The conclusion refers to the amount of the discount. This is not appropriate for a test of controls. The issue is whether the rate of deviation in the control is tolerable. If the deviation rate in the sample is tolerable when projected to the population, especially given the additional testing, then the auditor could conclude that there is no significant deviation in the control. The auditor cannot conclude the valuation of suppliers is fair based on the control tests alone. (d) Further procedure for test 1: The auditor should examine suppliers’ invoices and goods received relating to the period following year-end. These documents could reveal an unrecorded liability, that is, goods recorded as received after the year-end that were actually received by the client prior to the year-end.

Further procedure for test 2: As outlined in part (c), the conclusion about the deviation in controls should be considered in light of the tolerable deviation rate. The substantive testing needs to be designed given the control risk as revealed by the control tests. Further procedures would include selecting a sample of suppliers invoices, given the control risk, and testing of pricing and discounts.

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PROFESSIONAL documentation LO 4, 9

APPLICATION

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6.11

–

Interpreting

sampling

(a) The test of controls is Test A (Test B is a substantive text). The attribute being tested is to verify the accounting supervisor’s initials indicating approval. (b) Yes. Since the sample was selected randomly from the entire population, then it can be used to project a value for the entire population. (c) Test A is a test of controls, not a substantive test; therefore, it could not be used to project a value for the population. (d) Sampling risk in substantive testing refers to the probability that the auditor will form an incorrect conclusion about an account balance (that is, reject a correct balance or accept an incorrect balance) based on the sample results.

PROFESSIONAL APPLICATION 6.12 – Types of audit sampling and sampling risk LO 4, 5 1. D – Non-sampling risk 2. C – Sampling risk 3. A – Statistical sampling

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PROFESSIONAL APPLICATION 6.13 – Benefits of statistical sampling LO 5 Statistical sampling enables the auditor to use the most efficient sample size and to quantify the sampling risk for the purpose of reaching a statistical conclusion about the population.

The major advantages of statistical sampling versus non-statistical sampling are that it helps the auditor: (1) design an efficient sample, (2) measure the sufficiency of evidence obtained, and (3) quantify sampling risk.

Disadvantages of statistical sampling to be overcome include the additional costs of: (1) training auditors in the proper use of sampling techniques, (2) designing and conducting the sampling application, and (3) the potential lack of consistent application across audit teams due to the complexity of the underlying concepts.

Fortunately, this audit includes an auditor with training in statistical sampling, which will mitigate these disadvantages.

PROFESSIONAL APPLICATION 6.14 – Potential impact of sampling risk LO 4, 6 No, Alexei cannot safely conclude that no additional work is needed, as he has not considered sampling risk. He has only sampled 30 transactions, which amounted to less than 1% of the sales balance. Because this is a small sample, the risk that the sample is not representative of the population is significant. If the true misstatement rate in the remainder of the population is higher, total misstatement could easily exceed the tolerable error of misstatement.

The approach that should be taken is to project the misstatement (i.e., calculate the best estimate of total misstatement in the population) and incorporate an amount in consideration of sampling risk. There is an inverse relationship between sample size and sampling risk. Without statistical methods, judgments about sampling risk are difficult to make. Thus, sampling risk must be considered.

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PROFESSIONAL APPLICATION 6.15 – Sample size selection LO 7 Patrizia should select a larger sample size in Case B as all the factors point to more sampling risk in Case B.

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Case Study — Cloud 9 (a) As discussed elsewhere in the solutions, opening a retail store creates new risks for inventory and receivables (if sales are made on credit). For example, the risk of theft. The store also requires exposure to risk associated with leasing premises and equipment. Sales through a store are directly affected by matters impacting on consumers, e.g., weather conditions, transport etc, that are absorbed by retailers when Cloud 9 makes wholesale sales. There would be additional issues around cash because cash would be held in the premises and staff would be required to bank cash at the end of each day. (b) Recall that Audit Risk = Inherent Risk × Control Risk × Detection Risk. Audit risk (AR), the risk of giving an inappropriate audit opinion, is a function of the client’s inherent risk (IR), control risk (CR) and the auditor’s detection risk (DR). The business change would increase inherent risk, thereby increasing audit risk. (c) Inventory will be affected by the need to hold inventory in the store to meet daily sales. There will be a larger volume of smaller sales made (consumer sales would be smaller than wholesale sales). There will be movements of inventory from the warehouse to the store. There could be issues with sales returns as customers return items that do not fit etc, and risk of damage to inventory held in the store. (d) Assertions that are likely affected by the opening of the store include: occurrence of sales, existence of inventory (theft issues), valuation of inventory (risk of obsolescence, damage of goods in store). (e) The population would include: inventory items held in the store and warehouse – sample for inventory; sales made – sample for testing validity or occurrence of sales; cash receipts made by the store – testing for completeness of cash. The sampling approach would be to select key items for testing – large sales transactions, inventory items that make up the largest part of the inventory balance (e.g., high value items), and take representative samples of the other items. The auditor would be concerned with completeness of cash receipts and would test controls over cash at the store.

Control testing of inventory would focus on movements of inventory, either from the warehouse to wholesale customers or to the store, and goods in transit controls. Further details are provided in chapter 7 solutions.

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Research Question 6.1 – McKesson & Robbins fraud research The solution to this research question will depend on the sources selected by the student and the information gathered.

However, some background on the scandal follows and is intended only as a brief primer.

McKesson & Robbins scandal (1938) "The McKesson & Robbins, Inc. scandal of 1938 was one of the major financial scandals of the 20th century. The company McKesson & Robbins, Inc. (now McKesson Corporation) had been taken over in 1925 by Phillip Musica, who had previously used Adelphia Pharmaceutical Manufacturing Company as a front for bootlegging operations. Musica, a twice-convicted felon, used assumed names to conceal his true identity in taking control of the two companies: Frank D. Costa at Adelphia Pharmaceutical and F. Donald Coster at McKesson & Robbins. Although he was successful in expanding the company’s legitimate business operations, Musica recruited three of his brothers, also working under assumed names, one outside the company and two inside it, to generate bogus sales documentation and to pay commissions to a shell distribution company under their control. Eventually, McKesson & Robbins treasurer Julian Thompson discovered the distribution company was bogus. It was eventually determined that about $20 million of the $87 million in assets on the company’s balance sheet were phony.

In December 1938, the Securities and Exchange Commission (SEC) opened an investigation and Musica was arrested. Only after he was booked, fingerprinted and released on bond did the authorities realize that “Coster” was in reality Musica. His bond was revoked and he committed suicide before he could be rearrested.

The McKesson & Robbins scandal led to major corporate governance and auditing reforms. The SEC required that public companies have audit committees of “outside” directors and that the appointment of auditors be approved by the shareholders. The American Institute of Accountants (now the American Institute of Certified Public Accountants) adopted audit standards requiring that auditors verify accounts receivable and inventory." (sources: "http://en.wikipedia.org/wiki/McKesson_%26_Robbins_scandal_(1938)", retrieved October 2011; and "http://www.americanfraud.com/mckesson.aspx", retrieved October 2011)

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The material provided herein may not be downloaded, reproduced, stored in a retrieval system, modified, made available on a network, used to create derivative works, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise without the prior written permission of John Wiley & Sons Canada, Ltd.

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Solutions Manual to accompany

Auditing: a practical approach by

Robyn Moroney Fiona Campbell Jane Hamilton Valerie Warren

CHAPTER 7 Gaining an understanding of the client's system of internal controls

John Wiley & Sons Canada, Ltd. 2012

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Chapter 7 – Gaining an understanding of the client's system of internal controls

SOLUTIONS TO REVIEW QUESTIONS REVIEW QUESTION 7.1 LO 1 CAS 315 Identifying and Assessing the Risks of Material Misstatement Through Understanding the Entity and Its Environment requires the auditor to obtain an understanding of internal control on all audit engagements.

Therefore, even if the auditor intends to take an entirely substantive approach to the audit and not rely on internal controls, the auditor must obtain an understanding of internal control. This is because without gaining this understanding, the auditor will not fully understand the risks of material misstatement of the financial statements. CAS 315 states that gaining an understanding of the entity and its environment, including its internal control, establishes a frame of reference within which the auditor plans the audit and exercises professional judgement throughout the audit.

The standard allows the auditor to use professional judgement to determine the extent of the understanding of internal controls required in each case.

REVIEW QUESTION 7.2 LO 4, 5 Entity-level controls are: 1. the control environment 2. the entity’s risk assessment process 3. the information system, including the related business processes, relevant to financial reporting, and communication 4. control activities 5. monitoring of controls Each of these controls relates to the whole organization.

Transaction-level controls are controls that impact a particular transaction or group of transactions.

Therefore, the difference is that entity-level controls have the potential to impact all of the processes in the organization, including those that have a direct impact on the financial statements and others, while transaction-level controls impact only a specific group of transactions. Transactions make up the financial statements that the auditor is auditing, and can be impacted by both entity-level and transaction-level controls. This is why an auditor would be interested in both types of controls.

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REVIEW QUESTION 7.3 LO 3 The control environment sets the tone of the entity and influences the control consciousness of its people. People, through their actions, determine the effectiveness of internal controls. If the control environment does not encourage ethical behaviour and high quality work, the people within an organization could fail to implement controls or override them when performing their duties. Even the best control system is not 100% effective, and all systems are less effective if the people working with them do not support the systems.

However, all components of an internal control system are important. Having a strong control environment will not be sufficient by itself to ensure that an organization is able to achieve its objectives.

REVIEW QUESTION 7.4 LO 3 An entity’s risk assessment process would consider risks to its achievement of its objectives at all levels. These would include: risks to revenue through product competition, to attracting and retaining staff, exchange rate risks, transportation interruption risks (both freight and passenger transportation delays affecting staff and customers), climate change risk, financing risk (obtaining and servicing loans), supply risks, and risks relating to protection of assets from theft and fraud, etc.

A retailer would have a particular focus on the risk of not being able to buy the appropriate products from reputable suppliers, product quality risks which would lead to sales returns and/or warranty claims, exposure to exchange rate risks if suppliers are located in other countries, transportation risk affecting imports, competitive risks from other retailers in the same location or servicing the same type of customer, staff risks relating to attracting and retaining the right type of staff for all shifts, physical risks including power interruption, shopping centre building issues, financing risks relating to funding product purchases and paying expenses prior to receipt of cash from customers, and protection of assets and the integrity of sales and other transactions in the accounts. The retailer would be interested in identifying and controlling risks to its ability to operate and achieve its objectives.

All uncontrolled risks for the entity could affect the ability of the entity to survive (i.e., be a going concern). Therefore, all risks are of interest to the auditor. However, the auditor is most directly concerned with risks relating to protection of assets and the integrity of transactions in the accounts. The auditor must consider the risk to the accounts so that the audit can be planned with appropriate consideration of the risk of material misstatement.

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REVIEW QUESTION 7.5 LO 3 Segregation of incompatible duties is a part of the control activities of an organization. Control activities are policies and procedures that help make sure management’s directives are carried out. The concept of segregation of incompatible duties is that no one employee or group of employees should be in a position both to perpetrate and hide errors or fraud in the normal course of their duties. If these duties are not segregated, an employee could steal assets (such as cash or inventory) and adjust the records to conceal the theft.

If the duties are segregated, the employee stealing the assets would have to get the cooperation of another employee to adjust the records to hide the theft.

Therefore, it is very important for the effective operation of a control system that incompatible duties are split between different employees.

Within the sales process, the person making the sale is not responsible for recording the sale, and should not be able to process a sales return or other adjustment to a customer’s account balance. If these duties were not segregated, the sales employee could record a sale to a fictitious customer and take the goods for themselves. To conceal the theft, the employee would later process a sales return or adjustment to eliminate the balance in the fictitious accounts receivable account.

REVIEW QUESTION 7.6 LO 3, 4 A client should have processes for monitoring the effectiveness of its internal controls because circumstances and conditions change over time and controls need to adjust accordingly. An out-of-date control system may not be able to alert management to new risks, or control new types of transactions. The monitoring process allows the client to assess the need for changes to internal controls. As such, the auditor will be interested in the effectiveness of the monitoring system and whether the client’s management are able to be sure that internal controls remain current and valid. The auditor will also be able to assess the client’s management attitude to internal control systems through evaluation of the monitoring processes within the client.

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REVIEW QUESTION 7.7 LO 4 List three steps in the sales process. For each step selected, also identify a WCGW and an example control that should be incorporated in the step to mitigate that risk.

Invoicing customers

Invoices are not correct as to the quantity of goods shipped Recording sales Sales are recorded in the and trade wrong period. receivables Processing cash receipts

Cash receipts posted to wrong customer account.

Quantities per shipping

Date recorded is set by date of transaction in software; therefore, invoice dates cannot be changed.

Accounts receivable statements are sent to customers monthly and issues promptly resolved.

This is only a sample of the steps of a simple cost of sales process and a control that should be incorporated into each step. Table 7.1 in the text provide a full analysis.

REVIEW QUESTION 7.8 LO 4 List three steps in the cost of sales process. For each step selected, also identify a WCGW and an example control that should be incorporated in the step to mitigate that risk.

TRANSACTION RISKS (WHAT CAN GO EXAMPLE CONTROL WRONG) Purchasing Purchases are made and Three-way match between not recorded in the general purchase order, receiving ledger for inventory, assets, report, and invoice. expenses, or payables.

Supplier statements reconciled monthly.

Purchases are recorded in Three-way match between the general ledger but the purchase order, receiving goods are never received. report, and invoice.

Regular inventory counts.

Recording Purchases are recorded in Date recorded is set by the

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the wrong period.

Sales tax, HST, discounts, rebates, and other invoice adjustments are posted to the wrong general ledger account.

Purchases are not recorded in the purchase journal.

There are duplicate postings.

date of transaction software; therefore invoice dates cannot be changed.

Application control (driven by approved chart of accounts) within the accounting software used.

Application control within the accounting software used.

Monthly purchases and trade payables reconciliation between the subsidiary ledger and general ledger.

This is only a sample of the steps of a simple cost of sales process and a control that should be incorporated into each step. Table 7.2 in the text provide a full analysis.

REVIEW QUESTION 7.9 LO 5 The four approaches to internal control documentation are: 1. Narratives; the advantage is that the process can be described in full, the disadvantage is that it can take many words to describe a process in full.

2. Flowcharts; the advantage is that the standardized graphics allow a large amount of information to be presented on a single page to represent complex flows of transactions and the key controls. If there is common understanding of the symbols, it is easier to review and understand. The disadvantage is that the reader may not understand the symbols or require additional clarification.

3. Combinations of narratives and flow charts; the advantage is that complex systems can be described using standardized symbols, with additional narrative to explain steps that are hard to chart. The disadvantage is that both the flowchart and narrative have to be prepared and checked for consistency.

4. Checklists and preformatted questionnaires; the advantage is that it is helpful to inexperienced auditors because the checklist guides the process and assists in identifying critical controls. The disadvantage is that it can inhibit an experienced auditor and slow down the process.

The documentation assists the auditor because the process of preparing the documentation prompts the auditor to ask detailed questions in order to gain a full understanding. An experienced auditor would be able to identify departures from the systems used at similar organizations and the graphical forms of documentation reveal quickly the destination of all copies of documents.

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REVIEW QUESTION 7.10 LO 7 CAS 260 Communication with Those Charged with Governance requires the auditor to communicate matters from the audit with those charged with governance, and CAS 265 Communicating Deficiencies in Internal Control to Those Charged with Governance and Management governs communicating deficiencies in internal control to those charged with governance and management. To satisfy the requirements in these standards, the auditor will prepare a management letter to those charged with governance. The auditor will also communicate on a timely basis with management of the entity, where appropriate, the deficiencies in internal control revealed during the audit that are either being communicated to those in governance or are not.

The auditor uses their professional expertise to inform management about deficiencies in the internal control system which could affect the integrity of the financial statements either in the current financial period or in the future.

The feedback is provided in written form so that there is no confusion about the fact of the report or the observations and recommendations being made.

The management of the entity is able to use the written report as a basis for a response. Sometimes, management is able to use a letter written at an interim stage of the audit as a basis for a response before the end of the audit.

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SOLUTIONS TO PROFESSIONAL APPLICATION QUESTIONS PROFESSIONAL APPLICATION 7.1 – Importance of internal control LO 1 (a) Potential problems include: • Problems with communication systems stop emergency reports reaching the response teams in a timely manner • Police or other emergency services are unable to contact Powersys during an emergency because they do not have the required contact information or staff at Powersys are not rostered on to respond to emergencies • Trained staff are not available to respond to emergencies through mismanagement of leave or failure to recruit and train staff • Storms, fires or other emergencies are more extensive than anticipated and not enough staff and equipment are available to respond • Equipment, such as vehicles, diggers and cherry pickers, are not operational due to lack of suitable maintenance • Not sufficient supplies of specialized tools and parts are held in stores • The large warehouse is not accessible in an emergency because the key holder is away sick or on holidays • Too many staff are rostered onto normal maintenance and not enough available for emergency response in a particular geographic location • Changes are made to the electricity distribution system so that different parts are required for maintenance and these new parts are not ordered in time (b) Suggested internal controls include: • Responsibility for maintaining communication systems with emergency services assigned to a senior staff member at Powersys who also has information about staff rosters • HR department is made aware of staffing requirements for emergency response and reports to senior management on achievement of staff targets • HR department oversees policies and procedures for staff training to ensure that sufficient staff within the organization have the required skills and qualifications • Scientific modelling of emergency situations, taking into account population growth and climatic conditions • Schedule of maintenance for equipment coordinated with senior staff responsible for emergency response • Stores report on holdings of various parts, with integration with new equipment purchases • Stores maintain security systems and assign responsibility for staff member to coordinate with emergency response teams

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•

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Staff schedules and rosters approved by senior management with consideration of balance between maintenance and emergency response

PROFESSIONAL APPLICATION 7.2 – Objectives of internal control LO 2 (a) Transactions would include: • Cash receipts from customers for services • Reimbursement from health insurance companies for counselling and massage services • Credit purchases of supplies, such as oils, hair products • Electronic funds transfers to pay wages • Cheque payments for rent, electricity, furniture purchases, insurances, tax remittances, advertising • Depreciation for furniture and equipment (b) Potential problems in transactions if control system does not meet objectives include: • Incorrect pricing used for customer services; services provided but not charged to customers or recorded in the accounts; duplicate receipts recorded • Not all cash receipts are deposited intact in a timely manner • Failure to claim reimbursements from health insurance companies on behalf of clients, or claims for the wrong services • Ordering wrong supplies or sufficient supplies to meet demand • Failure to keep supplies safely locked away, as required • Failure to record purchase of supplies; payment for supplies not received; incorrect cost of supplies recorded • Branch manager approves salary payments for hours not worked by staff, at wrong rates, or for staff that do not work for the business • Failure to control costs such as electricity, through inefficient use of equipment • Equipment and furniture not accounted for, not kept secure at the premises, charging depreciation on furniture and equipment no longer used by the business; failure to record depreciation because equipment not recorded as asset • Repairs to furniture and equipment recorded as new purchases of assets; new purchases recorded as repairs

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PROFESSIONAL APPLICATION 7.3 – Control environment at a large company LO 3 The problems at International Bank (IB) appear to begin at the most senior levels of the foreign currency department, rather than with an individual trader.

The attitude at senior levels was that if the trader was able to make a profit, the official policies and procedures could be ignored, or overridden. This suggests that the control environment in the department did not reinforce integrity and ethical values, and encouraged risk taking in pursuit of profit.

Questions must be asked about more senior levels in IB if senior management of one department has a poor ethical attitude, how was this viewed by higher levels of management and those charged with governance? Did senior levels in the foreign currency department hide their attitudes from their supervisors, or did those supervisors ‘turn a blind eye’ to the issue provided the department was profitable? The press reports suggest that the poor ethical attitudes are not confined to the foreign currency department, adding weight to the view that more senior management were likely to have poor attitudes to ethical conduct. There should have been stronger communication and enforcement of integrity and ethical values through the organization, through measures such as codes of conduct.

The press reports do not suggest that the rogue trader or the supervisors lacked technical knowledge about foreign currency trading.

The organization structure at IB could be deficient if there was not effective supervision of the foreign currency department. In addition, HR policies and practices were either ignored or were nonexistent with respect to inculcating ethical attitudes and behaviour.

Overall the most significant problem was with communication and enforcement of integrity and ethical values.

Other considerations: • The risk assessment processes at IB appear to not have considered the potential problems in the foreign currency department, or at least have addressed them in full.

• The information system should have produced reports to more senior levels of these irregularities.

• Control activities, such as performance reviews, should have detected the common occurrence of the risky trading behaviour, or alerted senior management to excessive profitability based on risky activity.

• Internal audit department of IB should have provided information on the risky trades to those charged with governance.

• Finally, transaction level controls should have prevented or detected the large trades and unbalanced positions.

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PROFESSIONAL APPLICATION 7.4 – Segregation of duties in small business LO 3 (a) The accounts show that the controls over sales, accounts receivables and cash receipts are not good. The accounts are not up to date and client statements have not been issued for four months. These tasks were apparently the responsibility of the junior trainee, Sally, under the supervision of Max. Max appears to have been unaware of the problems, suggesting that he is not monitoring the processes very closely. Overall, this means that the management’s attitudes towards internal controls in general, and the accounts in particular, are not good. The fact that the bank has asked them to meet to discuss their worsening cash position also suggests that they are not managing their cash flow adequately.

Although Betty is responsible for technical issues, such as repairing computers, rather than the administration side of the business, she is also an owner of the business and as such should be involved in setting the tone of the organization. Max and Betty appear to have failed to establish good internal controls and to communicate and enforce the importance of the systems to their staff. There is no evidence of any unethical behaviour by the staff, but they do not appear to have been adequately trained and/or appropriately selected for the positions they hold.

In a small business, such as this, management involvement is a substitute for a large system of formal controls. This means that Max and Betty must be personally involved in authorizing and supervising transactions to a greater extent than if there were more staff.

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(b) Segregation of duties should follow the broad principle that the following duties are segregated: • Authorization or approval of transactions affecting assets • Custody of assets • Recording or reporting of transactions • Control over processing of a transaction should be separated from recording or reporting a transaction Sally is employed to help with administration. The other staff are a computer technician and a sales part-timer. This means that Sally and Max are the only two staff currently with administrative responsibilities. It will be difficult to adequately segregate duties with only two staff in the area. Therefore, Max and Betty must perform additional review tasks, such as separately reviewing all transactions over a certain limit, monthly reports of accounts receivable balances and transactions, bank reconciliations, etc.

In addition, if Sally retains the task of banking, she should not be involved in recording transactions, particularly cash receipts. An alternative would be for Max to do the banking and leave Sally responsible for transaction processing.

Betty could take responsibility for inventory control, so that the sales staff are not involved in maintaining inventory records as well as having access to the inventory for making sales.

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PROFESSIONAL APPLICATION 7.5 – Segregation of duties and documentation LO 3, 4, 5 (a)

Requisition for inventory prepared by stores sent to purchases department Approved vendor available?

No

Yes Funds available?

Refer to purchases manager to source approved supplier

No

Request approval to exceed purchases limit

Request approved?

No

Reject purchase requisition

Yes

Yes Create purchase order and send to vendor

Inventory receipt process

Receiving report, packing list and supplier invoice received Do quantities, unit price and shipping agree to purchase order?

No

Contact supplier to resolve discrepancy

Yes Process purchase in purchase ledger

Supplier payment process

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(b) As indicated on the flowchart, the stores which create the requisition and receive the goods are separate from the purchasing process. The stores manager is not permitted to make purchases directly with suppliers because there needs to be a segregation of the authority to commit the entity to purchasing goods and the custody of the goods. The recording of purchases into the inventory account is separated from the record keeping at the stores.

Also, the payment process is separate from the purchases process. At various points in the process, permission is sought from purchases manager and the accountant for action. The purchases manager arranges for suppliers to be selected and approved. Only approved suppliers are used to ensure that they are reliable and the items meet the entity’s specifications. The accountant gives permission to create purchase orders if the purchases department does not have approved funds available.

Payment is not approved for processing until the purchase order, receiving report and packing list, and supplier invoice are matched and reconciled. Not shown on this flowchart, approval for processing the payment would be required before the supplier is paid.

PROFESSIONAL APPLICATION 7.6 – Categories of controls LO 3 (a) Physical controls (b) Information processing (c) Segregation of incompatible duties (d) Information processing (e) Physical controls (f) Performance reviews (g) Authorization (h) Authorization (i) Physical controls (j) Segregation of incompatible duties (k) Performance reviews

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PROFESSIONAL APPLICATION 7.7 – Categories of controls LO 2, 3, 4 Five possible errors that could result if the controls over the financial reporting cycle with respect to journal entries, and examples of some controls management could implement to mitigate this risk are: Possible Error Unauthorized journal entries are recorded

Journal entries are posted to manipulate results (management override).

Journal entries are recorded twice Unbalanced journal entries are posted Required journal entries are not recorded

Possible Controls • Access to recording journal entries is limited.

• Journal entries must be approved before posting • Journal entries require supporting documentation.

• Accounting system does not allow duplicate journal entries to be posted • Accounting system does not allow unbalanced journal entries to be posted • Financial statements are reviewed for accuracy, classification of accounts and completeness by someone other than the preparer.

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PROFESSIONAL APPLICATION 7.8 – Controls at a small startup company LO 1, 3, 4 (a) Internal controls are the process designed, implemented and maintained by those charged with governance, management and other personnel to provide reasonable assurance about the achievement of the entity's objectives with regard to: • reliability of financial reporting • effectiveness and efficiency of operations • compliance with applicable laws and regulations (b) Four things your friends should do to ensure they create a strong control environment include: 1. Have a code of conduct and ensure all employees are aware of it and follow it.

2. Hire competent ethical employees.

3. Assign responsibility and authority- have job descriptions.

4. Ensure human resource policies are in place over hiring, training, evaluating, counselling, promoting and compensating employees (c) List eight control activities they should have in place. Ensure each activity is relevant to their business.

• Keep cash locked up • Limit purchases to only authorized personnel (management).

• Ensure all cash receipts deposited every day.

• Have security system in place.

• Have monthly financial statements prepared and review them each month.

• Ensure staff take vacations.

• Have all accounts (especially cash) reconciled monthly and reviewed by someone other than preparer.

• Limit access to sales and purchasing modules to only servers and the receiver.

(Students may also include any other relevant and reasonable controls.)

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PROFESSIONAL APPLICATION 7.9 – Strengths and weaknesses of controls LO 1, 2, 3, 4 (a) Internal controls that appear to be effective in GGG's system include: • Inventory is kept in a separate locked area.

• Supplies are kept in a separate area from inventory (this prevents employees from having access to inventory when obtaining supplies).

• Cheques are not prepared without a matching purchase order.

• Cheque preparation and approval are segregated.

• Requisition cards are serially pre-numbered. (b) Examples of weak internal controls in GGG's system include: • The receiving reports are based only on an e-mail.

• The receiving reports are not serially pre-numbered.

• A report could be lost or altered by the accounting department and it would be very difficult to reconcile to goods received or ordered.

• The receiver has online access to the purchase orders. This means that she does not have to actually count the goods being received.

• The receiver has access to edit the purchase order online. The receiver could therefore change the amount on the purchase order, and steal goods that were actually received.

• The controller also relies on an e-mail to authorize a cheque. Staff in the accounting department could prepare a cheque and send an e-mail, and the controller would have no way of knowing if the goods had been ordered or received.

PROFESSIONAL APPLICATION 7.10 – Control weaknesses LO 1, 2, 3, 4 Some weaknesses or problems in WWW's internal controls include: • Absence of appropriate segregation of incompatible duties: The CSC receives the order, approves the order, and authorizes the shipment.

• Absence of review and approval of transactions: No one checks the CSC’s sales invoice. No one checks the sales invoice quantity, prices, and extensions by the CSC. • Management override: Management sent a shipment without a sales invoice.

• The regular use of casual labour may leave the company more susceptible to problems caused by incompetent and/or untrustworthy personnel: A CSC sent goods to a friend at a price below the company’s cost.

• Improper/inaccurate documentation policy: The sales invoice shows a shipping date of 1 day after the order date.

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PROFESSIONAL APPLICATION 7.11 – Internal control components LO 3, 4 (a) Small entities have limitations in their ability to implement a comprehensive control system. There are fewer employees in small entities, which means that segregation of incompatible duties is harder to organize. In addition, small entities usually do not have formal documentation of their control systems, making assessment of their design effectiveness more difficult. However, managers of smaller entities (who are usually also the owners) are able to have a greater personal involvement in all aspects of the business and are therefore able to monitor activities directly. With direct monitoring, many departures from control systems could be detected. The effectiveness of this direct monitoring is dependent on managers’ knowledge and interest in controls, which could be low. Managers may also be tempted to override systems because they do not distinguish between their interests and the interests of the entity. (b) There is little separation between the board and the senior management – Sarah is both CFO and director of both Featherbed and the Morris Group. The control environment would be stronger if the CFO and the director positions were split.

Management philosophy and operating style are ‘laid back’, suggesting that formal control structures are not in place. Although some documentation is now being done, it is being done at a low level rather than being designed by senior management. There is a risk that the documentation will be incomplete, without the necessary review procedures.

Peter Pinn does not appear to be very active in reviewing the performance of the more junior staff, and there is a lack of clear information on whether Sarah is adequately supervising Peter. The lines of accountability should be stronger and because of the small size of the accounts department, should include periodic reviews of transactions authorized and processed at lower levels.

There appears to be a lack of adequate segregation of duties, both Kristen and Julie are involved in opening mail, processing transactions, banking, bank reconciliations, and payroll. These duties should be segregated so that staff handling cash are not also able to record transactions. Bank reconciliations and reviews of journal postings should be done by Sarah or Peter, and they should also be authorizing transactions. There appears to be no separate HR function and there is a danger that payroll is not valid.

Overall, the internal controls appear to have deficiencies. The documentation should be completed by Sarah and she should take more responsibility for overseeing the operations of the accounts department. Peter does not appear to be performing the necessary authorization and supervision roles.

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PROFESSIONAL APPLICATION 7.12 – Communication with management LO 7 The management letter would conform to the example in the text. It would be addressed to the chair of the board of Featherbed (Justin Morris). It would explain the deficiencies in internal control, as outlined in Professional Application Question 7.11, with the appropriate recommendations with respect to segregating duties and completion of documentation of policies and procedures.

PROFESSIONAL APPLICATION 7.13 – Components of internal control LO 3, 4

(1) Control Environment.

The high level of security around information relating to product design, manufacturing and costing, and the client identity and transactions is a key part of the internal control system at Securimax. The secure environment provides the foundation for the successful implementation of the new manufacturing costing system because data are secure and only certain personnel will have access to it.

The highly secure environment indicates that the control environment at Securimax has a focus on clear assignment of authority and responsibility and a formalized organizational structure. It also reflects management’s philosophy and operating style which rates security highly.

Consistent with this approach it would be expected that internal audit have a formal and important role in the organization. Internal audit were involved in all stages of the installation of the new manufacturing costing system. Their role would have been to ensure that the integration with other systems (e.g., sales) is correct. Internal audit will also be interested in maintaining the secure environment and assessing the performance (i.e., efficiency and effectiveness) of the new system.

External audit would focus on understanding the control environment and assessing whether the control environment means that management has positive attitudes towards internal control systems. The auditors would be interested in assessing how well the implementation of the new costing system was executed, and whether the secure environment was maintained.

(2) Risk assessment process.

The risk assessment process refers to management’s processes to identifying and responding to business risks. Securimax has responded to the risk of using inaccurate costing data by installing the new manufacturing costing

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system. However, there are risks involved with the installation and these would need to be managed.

The internal audit department would be involved in assessing how management handle the implementation and other risks.

The external audit department would use the information from the internal audit department’s assessment to evaluate the level of risk to the financial statement accounts from any problems with the manufacturing costing system.

(3) Control activities The information provided does not explain the segregation of duties and physical controls relating to the new manufacturing costing system. However, internal audit would assess the level of segregation and physical controls when determining the success of the implementation process.

External audit would require an understanding of these matters in order to assess control risk for transactions relating to the costing system.

PROFESSIONAL APPLICATION 7.14 – Control environment LO 3, 4 The sales bonus system would impact on the control environment at HCHG because it increases the focus on recorded sales and provides incentives for personnel to take actions to increase their bonus through increasing sales. A bonus structure can work against management attempts to communicate and enforce integrity and ethical values because it implies a reward for ‘cutting corners’ in order to increase sales. When such a bonus system is in place management have to work hard to communicate the core values and show through their philosophy and operating style that there is not a focus on increasing sales at all costs. Management will need to ensure that there is a commitment to competence through mechanisms such as HR recruitment and review policies and practices. Management would also pay attention to ensuring that sales, particularly those on credit to new customers, are authorized by appropriately senior staff, and performance reviews are used to guide sales staff towards the organization’s objectives.

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PROFESSIONAL APPLICATION 7.15 – Control risks in new IT systems LO 3, 4 The internal audit department was required to ‘make sure the conversion worked without any problems’. This means that the internal audit department was primarily focussed on the effectiveness of the conversion, and not just making sure it was completed at the lowest possible cost. Therefore, the potential questions would address the accuracy of information from the new system. Examples include: • How did the performance indicators address the effectiveness of the conversion? Who was responsible for the conversion and how was the effectiveness measured for the purpose of performance review?

• What changes were made to the information processing activities and how was their effectiveness assessed?

• What physical controls are used to prevent unauthorized changes to the patient revenue system?

The external auditor is required to gather evidence to support an opinion about the fair presentation of the financial statements, and its compliance with the relevant accounting standards. The auditor would require evidence that the transactions are processed accurately, meeting the objectives of the internal control system (real, recorded, valued, classified, summarized, posted, timely).

Therefore, the external auditor would have questions to address the control risks in the new patient revenue system, including: • How are duties segregated with respect to approving changes to programs, authorizing transactions, custody of raw materials and work in process, reporting costs, recording sales, cut-offs?

• What controls exist to ensure that all product movements are recorded accurately and that sales are recorded at the proper amounts in the proper periods?

• What controls exist to ensure that invoices to customers are based on correct costs?

• What controls exist to ensure that the correct labour costs are added to the manufacturing costs assigned to products?

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PROFESSIONAL APPLICATION 7.16 – Transaction level controls over the payroll cycle LO 4 The new accountant’s plan does not provide strong internal control over payroll, as is evidenced by the following facts: • The personnel manager has hiring authorization and establishes pay rates for new employees — this is an effective control over these functions.

• The new accountant has incompatible duties, demonstrating a lack of segregation, because he prepares and also distributes the paycheques.

• Overall, there is no strong control because the accountant can prepare a false paycheque and cash it himself.

CASES 7.17 – Controls over restaurant sales

Weakness

Implication

Recommendation(s)

• The restaurant manager does not review the outstanding order file before clearing it at the end of each day.

• Servers have the opportunity to steal cash by not recording cash payments made by customers. This is a serious weakness if the servers are aware of this lack of control exercised by the restaurant manager.

• The system needs to be redesigned to record that a server has instructed the system to prepare the customer bill. This control will prevent a server from presenting a bill to a customer and pocketing the cash.

• The restaurant manager must identify and investigate outstanding orders before clearing the day’s outstanding order file.

• The system needs to be redesigned to generate reports, at least monthly, that detail sales and cost of sales by type (i.e. food, wine and liquor) and the related profit margins.

Taufiq needs to investigate any unfavourable variances.

• There are no controls over recording tips in the system.

• Servers have the opportunity to steal cash designated for tips.

• The system needs to generate reports of tip, by server, at least monthly.

Taufiq needs to investigate

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the recorded tip amounts that are suspiciously low.

• There is no nightly • More tips may be reconciliation of cash distributed than were received to sales actually collected. recorded.

• A nightly reconciliation of cash and credit card slips received to the total sales should be performed before any distribution of tips is made.

• The restaurant manager prepares the deposit which includes cash and there is no check that the amount deposited equals the recorded revenue for the day.

• The restaurant manager has the opportunity to steal cash and deposit the lower amount to avoid detection.

• The part-time accountant should independently agree the amount of the deposit to the revenue reported by the system and report discrepancies to Taufiq.

• The restaurant manager prepares the daily bank deposit. He takes the deposit home and makes the deposit first thing the next morning.

• Increases the risk of theft if someone is aware of this practice.

• HV should arrange for night deposits that the restaurant manager can make on his way home each night.

• The restaurant manager receives monthly statements from the credit card entities that report the amount of the credit card sales processed by the entity. There is no evidence of any reconciliation between the monthly statements, the recorded sales and the bank account.

• Increases the risk of error in the financial statements.

• The part-time accountant should perform a monthly reconciliation of the statements received from the credit card entities, the recorded sales and the bank account. Taufiq should review and approve this reconciliation.

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• The bartender counts and reports the amount of inventory on hand.

• The system needs to be redesigned to track wine sales and sale of other alcoholic drinks, and Taufiq should compare the usage of wine, and other liquor products to expected usage (i.e., beginning inventory plus purchase minus usage equals inventory that should be on hand).

• Independent inventory counts should be performed on a surprise basis.

• He can steal wine and liquor products and avoid detection by overstating the amount of inventory.

• Expected on the basis of revenue (i.e., the ingredients are expected to provide a contribution margin of 40%) and to investigate any significant excessive costs.

• Cheques should be signed by Taufiq after examining the supporting documentation and assessing the appropriateness of the purchase.

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CASES 7.18 – Integrated Management Systems Inc. (a) 1. The Purchase Request (also referred to as PR) is authorized (signed) by personnel with the appropriate level of authority.

• This control ensures that the purchasing activities that result in a purchase transaction are properly authorized. The different levels of authority ensure that sufficiently senior personnel review and approve significant expenditures.

2. Purchase Requests are reviewed and approved by the purchasing manager.

• This control ensures that all requests are authorized by a senior, independent manager before the purchase order is completed, and requests for purchases of unusual items or quantities, etc., can be questioned through the review process.

3. There is a pre-qualified list of suppliers and a bidding process for larger purchases.

• The use of a pre-qualified list and a bidding process ensures that vendors have met the prequalification criteria before being given an order. The criteria used are likely performance-related and size-related and probably include references. The bidding process ensures that all qualified vendors have the opportunity to fill the order and ensures a competitive price, thereby preventing collusion with a particular vendor and price gouging.

4. The purchasing manager reviews the Purchase Orders (PO).

• A review by the purchasing manager acts as a deterrent to any buyer trying to circumvent the control system. The purchasing manager is able to review the details of the purchase order (such as the vendor selected and the prices to be paid). The use of approved purchase orders also ensures that all purchases are authorized.

5. The receiver matches the quantities received against the bill of lading (BL) and signs the bill of lading.

• This control ensures that the company will not pay for goods it did not receive, and that documentation exists for missed items, overshipments, etc. The signature is proof of performance by the receiver.

6. All goods are received in the warehouse.

• Central receiving of goods allows for better control of the goods, thereby safeguarding assets.

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7. The signed copy of the Bill of Lading (receiving document) is matched to the Purchase Request & Purchase Order Authorization.

• This control ensures that the goods that have been received were ordered. The PO commits the company to the transaction. Thus, only goods that have been received are paid for and the correct amount/price is paid. The information provided on the PR and PO, when matched to the BL information, provides control over existence, completeness and accuracy of the transactions. The matching of the three documents initiates the requirement for entries to record Accounts Payable and Inventory.

8. A copy of the BL (receiving document) goes to the user department with the goods, and the user department agrees the quantity it received to the BL copy.

• By receiving a copy of the BL and agreeing the quantities, the person placing the order knows what amount was received in the warehouse and whether it was the actual number he/she received, thus legitimizing the transaction for the payment cycle.

(b) 1. PR authorizing signatures are not confirmed.

Currently, the operating departments are responsible for ensuring that their PR forms are signed by individuals with the appropriate level of authority, and the purchasing clerk is not required to check the specifics of the signatures.

Although the purchasing clerk ensures that an authorizing signature appears on the PR, there is no confirmation that the person signing the PR has the requisite level of authority. It is thus possible for an order to be placed that is beyond that person’s authorization limit, for whatever reason, and it would not be caught. Since the purchasing clerk is not monitoring the specific names, he/she does not know if the limits have been exceeded or if some unauthorized person has placed an order. The company risks being committed to a purchase contract that is not a legitimate company expense.

Corrective action: Provide the purchasing clerk with a list of authorizing individuals based upon the tiered approval process to allow him/her to check for appropriate approval of the PR. Ensure that the list is regularly updated as changes in personnel occur.

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2. The purchase requests are numbered by the purchasing clerk only as filled out.

Because the purchase request forms are not pre-numbered, the clerk could assign the same number to two purchases or skip a number. There is the risk of a false order being processed in the case where two orders with the same number exist.

Corrective action: The forms should be sequentially pre-numbered, and the purchasing clerk should log the assigned numbers to allow for all orders to be tracked through the purchasing and accounting system.

3. Buyer has discretion in selecting vendors.

For items costing between $5,000 and $25,000, buyers currently are permitted to select a vendor from a pre-approved list. There is a risk of the buyer always selecting the same vendor, and he/she could be getting kickbacks for doing so. For items costing less than $5,000, the buyer currently has the discretion not to use the list at all. There is the additional risk that buyers could use smaller increments (e.g., of less than $5,000) to get around using vendors on the pre-approved list. Again, the buyer could be in collusion with a particular supplier for personal gain.

Currently, the buyer can also waive the formal bidding process, if deemed to be cost inefficient, for items costing more than $25,000. This again creates opportunities for buyers and vendors to collude.

Corrective action: Additional procedures should be put in place to ensure that the vendors are fairly selected. Consider a process whereby a purchase automatically defaults to the next vendor of that product for a subsequent purchase. For purchases in excess of $25,000, any waivers of the formal bidding process should be approved by a senior manager, and the reasons for the waiver should be noted. When reviewing the POs, the manager should be looking for tendencies to purchase from the same vendors and should be questioning why it is happening. To make the review easier, reports could be created (if they don t already exist) that sort the purchases by buyer, showing their activity levels and who they regularly deal with. These reports should be reviewed by the manager.

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4. Purchasing manager sends PO back to buyer who delivers it to vendor.

Sending the PO back to the buyer before it is sent to the vendor makes it possible for the buyer to alter the PO before it is delivered. The buyer could, for example, change the order amount to a larger quantity. When the goods are received, the buyer could keep the extra goods, and approve the BL going to the user indicating that more goods were received and that the buyer has agreed to ship them back. The copy of the BL going to accounts payable would show the full shipment amount and would get paid. The buyer could also collude with the vendor since he/she is the one delivering the PO to the vendor.

Corrective action: Once approved by purchasing manager, the PO should be sent directly to the supplier. The buyer would not have the opportunity to modify the PO or collude with the vendor.

5. All employees have access to the warehouse.

IMS manufactures high-end measuring devices. All employees currently have access to the warehouse; access to goods is therefore not restricted. Many of the goods are shipped directly to the users. However, depending on the nature and size of the component parts that are used in the manufacturing process, employees could pilfer some of the inventory that is simply stocked on the warehouse shelves or waiting to be stocked on the shelves. Even the goods that go to the users are subject to theft while in transit from the warehouse to the user department. When there is a freely accessible warehouse, there is also the risk of goods being taken for use in the manufacturing process before being recorded as an inventory withdrawal.

Corrective action: Access to the warehouse should be restricted or monitored, through the use of access cards or keys. Non-warehouse employees should not have unrestricted access to goods. The warehouse should have a secure receiving area.

6. BL is not matched to PO by receiver.

Currently, the receiver checks the bill of lading to ensure it agrees to the goods physically received. There is no check to determine that the goods were ordered. With the other weaknesses noted in the system, the absence of a check could result in goods being accepted and paid for that were not ordered.

Corrective action: The receiver should have a carbon copy of the PO in order to check that goods received have in fact been ordered before accepting the goods from the vendor.

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7. Receiver currently sends BL to user group, which then files it.

Currently, the receiver sends a photocopy of the BL to the user department, where it is filed away. The receiver also sends a copy of the BL to the payables group for settlement. The user department should send the signed copy of the BL to accounts payable rather than file it. The receiver could be pilfering goods and reporting them as short shipments to the user department, while accounts payable receives a copy that indicates everything has been received, thus triggering full payment. This may already be occurring, as the user departments have noted an increasing number of manual adjustments on the BLs. Corrective action: The user department should sign off the BL confirming that the goods were received and forward it to accounts payable rather than filing it. If users want to keep a copy for their records, they could make a photocopy of the signed document.

8. Discrepancy between BL & PR is being resolved by buyer.

The purchasing clerk matches the PR, PO, and BL. If there are any differences between the BL and the PO, the BL is forwarded to the buyer for resolution with the vendor. Depending on the nature of the discrepancy, there is the possibility of a buyer having colluded with a particular vendor. IMS has a system is in place to capture set prices and quantities on the PO. However, if it simply takes the buyer s signature to approve any differences, the control related to using a PO is being overridden and could present an opportunity for fraud. The differences in shipment amounts (over or under) or pricing differences could simply be approved by the buyer with the idea that the buyer would get a kickback for co-operating. The buyer can then simply explain away the differences to the purchasing clerk.

Corrective action: The purchasing manager should be the only person allowed to approve discrepancies. That way, the person initiating the purchase is not the same person who approves the differences. All discrepancies should be well documented by the buyer.

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9. The buyer is asked about the BLs that have no matching PO & PR for follow-up.

How an order can have a BL without a PR and PO is a separate concern, as all orders are supposed to have a PR and PO. (Perhaps the problem is occurring with orders are shipped in two parts: the loose BL might be sent with the second part of the shipment, while the PO/PR was sent with the first shipment and forwarded to accounts payable. These situations should be investigated.) Having the buyer do the follow-up may not be the best control. If operational departments are circumventing the controls by placing orders without a PO/PR, then this situation should be brought to the attention of management. There is no guarantee that the buyer will report his/her findings, particularly if the buyer is doing a favour for someone by approving a nonauthorized order and receiving compensation for doing so.

Corrective action: The purchasing clerk should delay forwarding the BL to accounts payable until after the BL has been approved by a manager from the operating department and the purchasing manager. See note below regarding inefficiency in this area.

10. Unmatched BL is sent to A/P. Accounts payable should not be sent the BL at the same time that the purchasing clerk is following up with the buyer. The purchasing clerk should send accounts payable only approved and matched orders or, in the case of part shipments, the BL should only be shipped after the exception has been approved by the person who placed the order and/or the purchasing manager.

Otherwise, items could be purchased that are not approved, e.g., items of a personal nature or items that do not meet safety specifications, etc.

Corrective action: The BL should be approved by a manager from the operating department and the purchasing manager to indicate the order is authorized. The BL should be sent to accounts payable only after the discrepancy has been investigated and resolved.

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11. Unmatched PRs / POs are sent back to the operational departments on the assumption that the goods must have been received. User group is responsible for follow-up.

If the purchasing clerk is regularly matching all PR, PO and BL documents, it is unlikely that the goods were received and that the paper work was just missed, unless the processing of part shipments is flawed. It is more likely that the order was cancelled or that is the goods are on back-order. However, mismatched information on the outstanding POs / PRs might be indicative of unrecorded receipts. The partial-shipment tracking system should be checked to make sure it is working properly. Ninety days is too long to wait to follow up.

It is much easier to follow up on an order when the information is current. The purchasing clerk should be following up on open orders once a week. In addition, pushing follow-up responsibility to the operational departments can result in processing inefficiencies. This approach relies on the operational departments performing purchasing activities that are not part of their core competence.

Corrective action: The purchasing group should promptly follow up on all issues regarding the timing of receipts and unmatched PRs / POs. (c) An internal audit group is a useful addition to a corporate entity to independently report on the functioning of controls both accounting and nonaccounting related within an organization.

• In order to be most effective, the department should not report directly to the accounting and finance group. The department should report to senior management and should also have access to the audit committee.

• The internal audit group would be responsible for evaluating controls (both financial and non-financial) and adherence to prescribed procedures and policies. Through the completion of operational audits, the department would evaluate the functioning of the controls, monitor adherence to prescribed policies, and consider the effectiveness of those policies. The reporting of their findings and recommendations for improvement is a useful tool for ensuring that an organization is achieving good control, and their recommendations should be acted upon.

• Internal audit staff must have adequate technical training and competence as internal auditors, as well as knowledge of the areas subject to audit. During the hiring process, you should enquire about the background and training of any applicants, as well as their professional qualifications.

• The internal audit group could provide useful assistance in determining whether the company is achieving its corporate governance framework goals. In addition, their work may be used by the external auditors at year end.

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Case Study — Cloud 9 (a) NARRATIVE – Cloud 9 wholesale sales to cash receipts: A sales transaction begins with the receipt of the customer purchase order via the inventory management system, Swift. Swift is a custom-made software package that has an interface through a secured site key to retailer inventory systems. When inventory balances at retailers get below a pre-determined amount (which is established and updated by the customer), the system automatically alerts the customer to complete a purchase order on-line.

Purchase orders are initiated in Swift based on a master price file and the available inventory in the warehouse. Swift does not allow quantities to be ordered greater than the amount on hand in the warehouse. Once the purchase order is completed by the customer, a credit limit check is automatically performed by the system against pre-determined limits maintained in the customer master file. If the customer exceeds their limit, the system will reject the order. Once the credit check is successful, the system will generate the sales order.

Each day, the warehouse manager downloads the outstanding sales orders to hand held computers for his team. Warehouse personnel collect the goods and take them to the packaging staging area. Here, they scan the bar codes of each product with the hand held computer that is linked to Swift. This creates the dispatch note in Swift, which is automatically matched to the sales order. Only when there is match, does the approval box get activated. The Shipping Supervisor electronically signs off on the dispatch note by entering his passcode to approve the dispatch note.

The goods are boxed up and placed in the secure caged areas for the Cloud 9 drivers to pick up the following day. In the morning, drivers print the approved dispatch notes and arrange their delivery schedule. Upon delivery, the customer signs the dispatch note confirming receipt of goods. That copy is sent to the billing team. Any undelivered items are returned to the cage.

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At the end of the day, the warehouse manager reviews the unfilled sales order report and contacts the customer service representative to notify the customer of when the expected delivery for their items would be.

When goods are returned, they are received in the warehouse and scanned.

Once the dispatch report is signed, the system automatically generates the invoice, which is maintained in “draft” status for the billing team. The billing team matches the draft sales invoice to the returned dispatch note. Final invoices are printed in duplicate at 4pm each day and mailed to the customer.

The invoice copy and signed dispatch note are stapled and put on the customer’s file. After the print run, an exception report is generated to catch any shipments for which the final bill was not issued. The signed dispatch note file is checked regularly to catch any unmatched notes.

Once the invoice is printed, the receivables and sales entries are recorded automatically by the system. The system automatically posts the sales in the sub-ledger to general ledger.

Most customers pay by EFT. Each morning, the A/R clerk downloads from online banking the receipts received the previous day. The amounts are applied to the customer’s accounts receivable balance in the sub-ledger system.

Once each receipt is entered, a batch report of postings to Accounts Receivable is generated and reconciled back to the direct banking receipts.

That reconciliation is reviewed and approved by Carla. Any unapplied cash receipts are posted to a dummy account until they can be cleared against a specific customer. The dummy account balance is reviewed weekly for unapplied balances that need follow-up.

Bank reconciliations are prepared on a monthly basis by Carla and reviewed

by David.

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(b) Additional follow-up questions: From the interview transcript, students should ask the following questions for further information or clarification: For the sales manager • How often are prices changed? What is the process for making a change to the master price list? Who has access to the master price lists?

• What are the mechanics of the credit check the system performs?

Who set the limits? What happens if they are over their limits? How are the limits changed?

For the shipping supervisor • How are the goods prepared for delivery – i.e., how are they packaged?

• Do the drivers check their loads against the dispatch notes prior to departing the warehouse or during their deliveries? How is this evidenced?

For the warehouse manager • How do you ensure all sales orders are filled?

• What happens if a product is returned?

For Carla Johnson (to represent finance) • What happens if the batch posting report doesn’t reconcile to the bank report?

• How do you know to what invoice the payment relates?

• Do you ever have cash that you can’t determine what customer or invoice against which it should be applied?

For an IT Manager Overall, there is such a reliance on the IT systems that the audit team would want to get an IT specialist involved to help review the general controls (access, change management, backups) as well as help understand exactly what happens to the data that gets entered.

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(c) and (d): Potential misstatements and assertions The Wholesale Sales to Cash Receipts process includes transactions recorded in Sales, Accounts Receivable and Cash. Students should have identified the following potential errors: Significant Potential Misstatements Process Sales/Accounts Credit memos are not issued Receivable or recorded for returns on a timely basis or at all.

Duplicate/false sales transactions are recorded.

Invoice misstates the quantity of goods shipped or incorrect pricing.

Proper credit authorization is not obtained for wholesaler transactions.

Sales journal/sub-ledger is incorrectly posted to G/L or does not reconcile.

Sales transaction is not recorded upon shipment of goods.

Sales transaction is recorded when goods not shipped.

Cash Receipts

Cash receipts are not recorded when received.

Cash receipts in foreign currencies are incorrectly valued (e.g., by using the incorrect exchange rate).

Cash receipts recorded differ from amounts deposited.

Assertions Sales - Occurrence; Accounts Receivable Existence Sales - Occurrence; Accounts Receivable Existence; Allowance for Bad Debt - Completeness Sales - Accuracy; Accounts Receivable - Valuation; Inventory - Valuation; COGS - Accuracy Allowance for Bad Debt Completeness Sales - Completeness

Sales - Completeness; Accounts Receivable Completeness; Inventory Existence; COGS – Occurrence Sales - Occurrence, Accounts Receivable Existence; Inventory Completeness; COGS Completeness Accounts Receivable Completeness; Cash Completeness Accounts Receivable Valuation; Cash - Valuation

Accounts Receivable Completeness and Existence; Cash Completeness and Existence

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Cash receipts and transfers are recorded in the wrong period.

Duplicate postings of cash receipts are made to the general ledger. This would lead to a discrepancy between the general ledger and the underlying AR subledger.

Totals in cash receipts journal are incorrectly posted.

Accounts Receivable Completeness; Cash Completeness Cash - Existence

Cash - Completeness

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Research Question 7.1 – Alberta oil sands development The solution to this research question will depend on the sources selected by the student and the information gathered.

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Legal Notice Copyright

Copyright © 2012 by John Wiley & Sons Canada, Ltd. or related companies.

All rights reserved.

The data contained in these files are protected by copyright. This manual is furnished under licence and may be used only in accordance with the terms of such licence.

The material provided herein may not be downloaded, reproduced, stored in a retrieval system, modified, made available on a network, used to create derivative works, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise without the prior written permission of John Wiley & Sons Canada, Ltd.

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Solutions Manual to accompany

Auditing: a practical approach by Robyn Moroney Fiona Campbell Jane Hamilton Valerie Warren

CHAPTER 8 Execution of the audit – testing of controls

John Wiley & Sons Canada, Ltd. 2012

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Chapter 8 – Execution of the audit – testing of controls

SOLUTIONS TO REVIEW QUESTIONS REVIEW QUESTION 8.1 LO 1 Controls have two main objectives: to prevent or detect misstatements in the financial statements, or to support the automated parts of the business in the functioning of the controls in place.

The preventive controls are designed to stop fraud or errors from occurring. The preventive controls are applied to each transaction with the objective that all transactions that are entered into the client’s accounting system do not contain any errors.

The detective controls are designed to detect fraud or errors that have occurred. As such, they are applied after transactions have been processed with the objective that any transactions that were entered into the client’s accounting system with error are detected so that they can be rectified.

Ideally, the preventive controls would stop all fraud and error, so that detective controls are not necessary. However, because preventive controls do not work at 100% effectiveness, the detective controls are necessary. Preventive controls are normally expected to be less than 100% effective because of factors such as: • Management override of the controls • Failure to apply the preventive controls due to staff tiredness, busy schedules of staff, or malfunctioning hardware or software Also, the preventive controls may not leave an auditable trail when they are applied.

This means that it is not always easy to verify if the preventive control has worked. For example, there may be a signature of the person authorizing the transaction, but it is not clear if the transaction was carefully checked before it was authorized. Also, the preventive control may not leave any evidence if the transaction is not processed (because it was not correct). An effective detective control will provide additional assurance that the transaction was checked because it shows the errors detected.

The system should not rely solely on detective controls. Preventive controls are necessary to support the detective controls because the detective controls are unlikely to be sensitive enough to detect all errors after they enter the records.

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REVIEW QUESTION 8.2 LO 1 Manual controls differ from automated controls because they do not rely on the client’s information technology environment for their operation. Automated controls can differ in the degree of their reliance on the IT system.

Manual controls include such controls as locked cage for high dollar inventory items, with restricted number of people holding keys to the cage. Manual controls can also include information produced by other parties’ computer systems, such as a computergenerated consignment inventory statement used in a client’s inventory system. Purely manual controls tend to be preventive controls (rather than detective controls).

Automated controls include such controls as controls over software program changes or restrictions to software program access. They can also include fully automated controls that apply to transaction processing.

REVIEW QUESTION 8.3 LO 1 ITGC means Information Technology General Controls. The three types are: 1. program change controls – only appropriately authorized, tested and approved changes are made to applications, interfaces, databases and operating systems 2. logical access controls – only authorized personnel have access to data and applications and can perform only authorized tasks and functions.

3. other ITGCs, including regular and timely back-ups of data, following up and resolving program faults and errors in a timely manner, following up any deviations from scheduled processing on a timely basis, and planning upgrades to programs and applications on a timely basis.

These controls are ‘general’ because they do not relate to a specific program, or type of transaction process. They apply generally to the IT system.

These are important controls because they support the functioning of the IT system.

They are preventive and detective controls, and provide evidence supporting the auditor’s reliance on the electronic audit evidence.

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REVIEW QUESTION 8.4 LO 2 The four types of tests of controls are: 1. Enquiry – this means that the auditor asks an employee of the client about how the control is performed and/or monitored 2. Observation – this means that the auditor observed the control being performed 3. Inspection of physical evidence – this means that the auditor inspects the documents for evidence that the control was performed 4. Re-performance – this means that the auditor re-performs the control to test its effectiveness.

The most reliable evidence is re-performance because the auditor obtains direct evidence on how the control works. However, this test can be very time-consuming and would not be applied to a very large sample. Inspection of physical evidence is the next most reliable test because the auditor gathers evidence about the performance of the controls in detail. However, the evidence may not be conclusive. For example, finding a signature authorizing a document does not mean that the person properly checked the transaction before authorizing it.

Enquiry and observation are limited as evidence gathering techniques because the employee may not tell the truth, or may perform the control more diligently if the employee knows that they are being observed. Although the control may be performed correctly on that occasion, the auditor does not know if the control is always performed the same way. The auditor would supplement evidence from enquiry and observation with the evidence gathered from the other two types of tests.

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REVIEW QUESTION 8.5 LO 3 An auditor does not have to test every control because some controls are redundant or control errors that are not likely to result in material misstatements of the financial statements.

The auditor would select the controls that will provide the most efficient and effective audit evidence (that the controls are working). The auditor selects the controls that they believe are critical to their opinion.

Factors affecting the auditor’s decision about which controls to test include: - type of control - frequency of the controls - level of assurance that the auditor wants to gain Generally, the auditor tests controls that address the WCGWs (what can go wrongs) the most effectively with the least amount of testing. If one control addresses multiple WCGWs, then it would be most likely to be selected for testing.

REVIEW QUESTION 8.6 LO 3 The factors affecting the auditor’s decision about how much control testing to do include: - the frequency of the control’s operation - the level of assurance required (i.e., how much the auditor will rely on the control to reduce substantive testing) - the persuasiveness of the evidence gained from testing the control - the need to be sure that the control operated throughout the period - the existence of a combination of controls address the WCGW (what can go wrong) - the relative importance of the WCGW being addressed - the likelihood that the control operated as intended (i.e., how competent are the staff, the quality of the control environment, changes in the accounting system, unexplained changes in related account balances, the auditor’s prior period experience with the client).

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REVIEW QUESTION 8.7 LO 3 Benchmarking is the audit testing strategy that allows the auditor to carry forward the benefit of certain application controls testing into future periods.

The concept behind benchmarking is the idea that a computer will continue to perform any given procedure in exactly the same way until such time as the program (or application) is changed. This means that if the auditor can show that there has been no change in the program or the application, the auditor can continue to rely on the results of testing the program or application in previous periods.

The auditor is likely to be more successful in showing the absence of change if the overall control environment is strong, the length of time between the original test and the audit test period is shorter, and the specific program or application is more defined and likely to be stable. In addition, the decision to use benchmarking is more likely if the results of other tests are consistent and the consequences of failing to detect changes because of the reliance on benchmarking are less severe.

The benefit to the auditor of benchmarking is that the auditor’s testing is reduced.

Instead of re-testing the program or application, the auditor needs to test only the lack of changes to the program or application.

REVIEW QUESTION 8.8 LO 3, 4 Nature refers to the type of test (enquiry, observation, inspection of physical evidence, re-performance). As discussed in review question 8.4, the types of tests vary in the reliability of the evidence produced.

Timing refers to the date of testing (i.e., interim vs. year-end). Interim testing is common for controls testing because it provides evidence about control risk which influences the nature, timing, and extent of substantive testing to be conducted at or near year-end. Further control testing is conducted during the remainder of the year to provide evidence that the controls continue to operate effectively throughout the financial period.

Extent refers to the number of items tested (i.e., size of the sample). A larger sample provides more reliable evidence about the strength of controls, and would be used if the auditor wishes to gain a higher level of assurance from the controls testing.

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REVIEW QUESTION 8.9 LO 4 If an auditor assesses control risk as being less than high, the auditor must gather evidence from controls testing to support their assessment. If the evidence shows that control risk is less than high, the auditor can tolerate a higher level of detection risk.

Higher detection risk means that the auditor can adjust the nature, timing, and extent of substantive testing such that less evidence is required from these tests.

Therefore, the evidence gathered from tests of controls can provide a reasonable level of assurance that there are no material misstatements in the financial statements. In this case, the auditor will perform only limited substantive testing (perhaps relying on analytical review). If the auditor is able to obtain only limited assurance from tests of controls, the auditor will need to perform more substantive testing. If the auditor is unable to gain any assurance from controls testing, the auditor will perform considerable substantive testing.

REVIEW QUESTION 8.10 LO 5 The auditor would document the results of the control testing, including the purpose of the tests and the deviations found. The auditor must document the action taken, if any, to resolve the exceptions or issues that arose during the controls testing. For example, there could be a compensating control which was working effectively, so that the auditor did not need to do further testing. Alternatively, the auditor would document the additional work done to resolve the issue, or the adjustment to substantive tests to take into account the higher than expected control risk.

The tests are documented in detail: - the actual control being tested - the purpose of the test - the work performed (e.g., the items selected for testing) - the results of testing each item - whether the test results supported overall purpose of the test - details on audit personnel performing the test, date of the tests The documents should allow another auditor to review the working paper, re-perform the steps and reach the same conclusion as the original auditor.

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SOLUTIONS TO PROFESSIONAL APPLICATION QUESTIONS PROFESSIONAL APPLICATION 8.1 – Performance indicators LO 1 The performance indicators appear to be useful to the client. That is, the supervisor of the procurement department uses the performance indicators in the reports to assess the performance of the purchasing team. This means that the client has faith in the quality of the data. As such, the auditor has more confidence in the data.

However, the supervisor also reveals that the performance indicators are not used for follow-up on unexpected results in the financial reporting system. The performance indicators are based on non-financial data. Although the non-financial data are relevant to financial data (e.g., overtime requests would be related to payroll expense classified as overtime payments), the client does not appear to relate the performance indicators to the financial reporting system. This means that the relevance of the indicators to the topic of the financial statement audit is lower.

The auditor could conduct tests of the non-financial data to gain additional assurance about their reliability, including their relation to the financial data, before using them in the audit.

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PROFESSIONAL APPLICATION 8.2 – Preventive controls LO 1 (a) Preventive controls would be designed to stop sales being made to non-creditworthy customers. For example, the software would not allow a sale to be made until the credit manager has approved the sale on credit, or the software could require a credit check authorization number to be included in the sale transaction. The system could require all new customers to be approved before a debtor account can be opened, and the account has to be opened before a sale can be processed to that customer. The system would prevent a sale being made if the sale took the account balance beyond the approved credit limit, unless authorized by the credit manager. (b) The auditor observes that no credit sale has been processed which takes a customer over its credit limit. The two possible explanations are: (1) the preventive control is working effectively; (2) no customer has tried to purchase items which take it over its credit limit. In the second case, there is no evidence that the preventive control is working or not working, because it was not triggered. (c) The transaction could have been authorized by the credit manager (or other senior manager). The authorization could be because the client has security for the balance owing. However, the authorization could be inappropriate and be a case of management override of the control. That is, the manager has overridden the preventive control to make a sale for reasons such as receiving a kick-back from the customer, disregard for company policy against such sales, an effort to reach sales targets in the department, etc. The auditor would consider whether there was evidence of higher level authorization of the transactions, such as reading board minutes, reading correspondence or memos between the managers, reading the customer file for evidence of security for the debt, making enquiries of the relevant sales managers. The auditor would also consider if other similar transactions (same sales manager, same client, same product, etc) are being processed correctly, or if there is evidence of other sales in excess of credit limits being prevented.

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PROFESSIONAL APPLICATION 8.3 – Testing bank reconciliation controls LO 1, 2, 3 (a) The most reliable evidence would be gathered by re-performance of a sample of bank reconciliations. The auditor could judge if all items were dealt with appropriately. In addition, completed bank reconciliations can be inspected for evidence of identification of errors and follow-up. The least reliable evidence would be obtained from observing client staff complete a bank reconciliation or by making enquiries of the client staff (because these procedures would not provide reliable evidence about the bank reconciliation performance at earlier periods when different staff were involved). (b) The auditor would approach discussions with client staff with professional scepticism.

This means that the auditor does not assume the client staff are lying, but the auditor has a questioning mind, being alert to conditions which may indicate possible errors or fraud. The auditor makes a critical assessment of any statements by the staff. For example, do the statements make sense given what the auditor knows about the client and in the context of other evidence gathered? What other evidence could be obtained to support the statements? How much would the auditor expect the staff to know about bank reconciliations performed by other staff at other periods? The auditor cannot assume that staff would lie and not ask them about the audit, but the auditor cannot rely on staff statements alone. (c) The staff changes impact on the controls testing program because the auditor would require evidence that the performance of bank reconciliations was similar in different periods. The auditor would be careful to obtain evidence about the performance of the controls from each period. If there was any evidence that performance was poor during any sub-period, the auditor would seek to obtain additional evidence about control performance, or increase the substantive testing.

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PROFESSIONAL APPLICATION 8.4 – Inventory program controls LO 1, 3 (a) The auditor would expect to find client documentation about the changes to computer programs. If the client made major changes to the computer programs (e.g., install a new system), the matter could be discussed at the board level. Other changes would be authorized by senior management, as appropriate. In all cases, there would be some level of authorization of the changes, including complete documentation of the changes and their effects on the client’s reporting and operations. In addition to documenting the changes to the programs, the auditor would expect to find a log of the changes (including the staff involved, the changes, test data, copies of programs, etc).

The auditor would expect to find some type of segregation of duties. For example, those making the computer changes would not also be those staff involved in maintaining accounting records.

Auditors are concerned about program changes because they potentially introduce errors to programs. In addition, the changes could mean that the auditor is unable to rely on the results of any previous testing by the auditor of the computer system in the audit. (b) The financial statements for the year include the effects of sales and purchase transactions from the entire year. If the computer program is changed at any point during the year, the auditor must consider whether controls should be tested separately for the periods before and after the change. Evidence is not necessarily required from every month of the year, but there should be evidence from before and after the new system was installed in April. Inventory balances as at December 31 can be tested through the end of year inventory system procedures. (c) The results of the interim testing to the end of year inventory balance are appropriate if the testing was performed during the period after the installation of the new inventory control system. However, as noted above, the total purchase and sales transactions also include pre-April transactions which were processed through the old system. The testing of these accounts should include evidence from pre-April dates.

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PROFESSIONAL APPLICATION 8.5 – Control testing results and documentation LO 2, 4, 5 (a) The audit assistant is incorrectly interpreting an absence of evidence of an event as evidence of the absence of the event. There is no evidence of any program changes or overrides, but only limited testing has been done. The auditors need to gather direct evidence that there were no changes or overrides. The auditors will need to conduct further tests to verify the statements. (b) Other options available to the auditor include testing other controls that could perform the same function, that is, what other controls exist to prevent or detect the WCGW (what can go wrong)? Further, would failure of the control being tested necessarily lead to a potential material misstatement in the financial statements? For example, is the control aimed at behaviour which does not impact on the financial statements (e.g., making sure that inventory is sorted correctly by colour on the shelves is not relevant to the financial statement)? If the auditor concludes that the only controls relevant to preventing or detecting an error is likely to result in a material misstatement in the financial statements the auditor would increase substantive testing. (c) Working papers (whether electronic or paper based) are used to provide instructions to audit staff and to record results of testing. As the working papers are completed, more senior staff review the results of the tests in order to assess the adequacy of the evidence. The audit opinion must be based on sufficient, appropriate evidence.

Ultimately, the audit partner must sign off on an audit report using the results recorded in the working papers as justification. Within the audit firm, other partners are often used to review the decisions reached to ensure quality standards are maintained. These other partners are not involved in the audit and must rely on the documentation to understand the nature, timing, and extent of all testing, and the results obtained. The papers must be completed with sufficient detail to allow the review partners to reach a decision. Audit partners from other firms could also review the working papers to provide more independent testing of the audit quality as part of peer review programs within the auditing profession. Regulators, such as the Canadian Public Accountability Board (CPAB), the Canadian Securities Administrators (CSA), and the self-regulatory inspection group of each provincial professional accounting body for each Canadian designation (CA, CMA, CGA), may also review some audit working papers to monitor audit quality and write reports on the overall level of audit quality . Finally, the working papers could be used as evidence in legal disputes between auditors and their clients or other interested parties.

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PROFESSIONAL APPLICATION 8.6 – Technique for testing computerized controls LO 1, 3 Possible tests include: • Test data – the auditor prepares some data to process through the client’s computer system. The data would have valid and invalid types of transactions.

The auditor would try to prepare enough invalid transactions to mimic all types of errors (e.g., if the client does not sell items with values greater than $1,000, the auditor could prepare a transaction with $1,000,000 as the value to test if the client’s system will reject the transaction).

• Process the client’s actual transactions through another software package controlled by the auditor. The auditor would test if the output from the client’s software is the same as the output from the auditor’s software. This would require the auditor to have software that would be similar enough to the client’s systems.

• Interrogation software – the auditor would have special software to interrogate the client’s systems to request reports of transactions with certain parameters.

The audit software could also search for evidence of changes, which could be unauthorized, made to the client’s software. The audit software could also search for certain likely problems with client software.

PROFESSIONAL APPLICATION 8.7 – Understanding types of controls LO 1 Automated application controls apply to the processing of individual transactions. These controls include edit checks, validations, calculations, interfaces and authorizations.

For example: • Only authorized personnel would have access to the costing system – this would be controlled through log-on, password procedures.

• All transactions would have an appropriate level of authorization, through input of an authorization code by a senior manager (once transaction request is input, the manager’s computer would alert the manager to the transaction and request approval, then the transaction would be released for processing).

• Inventory movement transactions entered into the system would require input of an inventory part number which is checked against a master file before the transaction is allowed to proceed.

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PROFESSIONAL APPLICATION 8.8 – Assessing control testing results LO 4 Evidence that the controls are effective increases the auditor’s confidence in the controls and justifies a combined audit approach.

Evidence that the controls are not effective means that the auditor needs to identify and successfully test alternative controls which prevent or detect the WCGWs (what can go wrongs), or increase the reliance on substantive testing.

Specifically, in respect of suggested controls in 8.7: Non-authorized personnel access – a failure of this control would suggest that nonauthorized personnel are able to process transactions. This creates doubt about the validity of all transactions and would be a major control failure.

Authorization – transactions not authorized before entry, creating the possibility that unauthorized transactions have been processed. This is also a major control failure.

Inventory part numbers checked against master file – failure of this control means that part numbers could be incorrect. Inventory movement transactions processed with incorrect part numbers could lead to incorrect inventory balances in the accounting records.

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PROFESSIONAL APPLICATION 8.9 – Preventive and detective controls LO 1 Account at risk A. Payroll expense: overpayment of overtime

B. Accounts payable: payments made twice to the same supplier

a. Assertion at risk Occurrence, accuracy

occurrence

b. Preventive internal control Use different codes for standard shifts and overtime hours; require special authorization of overtime payments Require supplier and invoice code to be input at time of processing payment – system to reject duplicates; Cancel documents used to support payment to prevent reuse

c. Detective internal control Review of overtime payment reports

Reconciliation of supplier accounts each month, detect debit balances or accounts with more payments than invoices

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PROFESSIONAL APPLICATION 8.10 – Preventive controls LO 1, 3 (a) Payment to suppliers before goods are received creates the risk that the payment is for goods that may never be received, or not received in the relevant period at the price quoted. The assertions at risk are the occurrence of the payment of payables. The cheque has been drawn against the bank account, but the payment is not for a liability owing for goods purchased. (b) i, ii, iii Requiring a receiving report before payment (with appropriately verified details of date, amount, unit price, total price and supplier) mitigates the risk of payment before receipt of goods. The receiving department will not prepare the receiving report until the goods are received. The senior staff member will review the package of documents for evidence of receipt, thus ensuring that the receiving report is included, and it matches the other documents.

I would review authorized packages of documents for evidence of the existence of the receiving report and verify that the details on the receiving report match the other documents (i.e., the number of goods received is the same as the number of goods on the supplier’s invoice and purchase order).

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PROFESSIONAL APPLICATION 8.11 – Transaction-level controls over purchases LO 1, 2, 3 (a) Completeness of liabilities • I would compare the supplier invoices and purchase orders in the unmatched supplier invoice file to the company’s unmatched receiver report file. Any invoices that are found to have been received by the balance sheet date would be unrecorded liabilities.

• I would compare the unmatched supplier invoices to the purchase order. If the goods were purchased FOB shipper prior to the balance sheet date, then I would compare the supplier invoice and purchase invoice to the purchase journal. If the supplier invoice or purchase order is not recorded in the purchase journal, then it represents an unrecorded liability.

(b) Completeness of liabilities • I would compare the receiving reports to the purchase journal to find any unrecorded liabilities (the FOB factor is not relevant for this test).

Authorization • Trace receiving reports in the unmatched receiving report file to the purchase orders in the voucher, to verify that the purchasing manager has initialled the purchase orders.

PROFESSIONAL APPLICATION 8.12 – Transaction-level controls over purchases LO 1, 2, 3 (a) • Select a sample of purchase invoices and scan for missing numbers.

• Trace purchase invoices to purchase journal and to subledger accounts.

• Trace subledger accounts to general ledger control account. (b) • Select a sample of receivables and vouch debits to sales invoices and shipping documents.

• Select a sample of receivables and vouch credits to cash receipts journal and approved credit.

• Observe mailing of monthly customer statements.

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PROFESSIONAL APPLICATION 8.13 – Transaction-level controls over sales LO 1, 2, 3 (a) Completeness • Trace bill of lading recorded in shipping department records to sales journal to verify all items shipped have been included in recorded sales.

• Foot the sales journal and compare to sales in the general ledger (G/L) to ensure that all sales recorded in the sales journal have been posted to the G/L. • Analyze the numerical sequence of a sample of sales invoices to ensure that all invoice numbers are accounted for in the sales journal.

• Any other reasonable answer. (b) Accuracy • Compares sales invoice to authorized price list to ensure that sales invoice uses the correct price.

• Recalculate sales invoices to ensure extensions have been prepared correctly.

• Compare sample of sales invoices to sales journal to ensure amounts have been recorded correctly.

• Compare quantities on bills of lading to quantities on sales invoices to ensure correct amounts recorded on sales invoices.

• Any other reasonable answer. (c) Validity • Trace recorded sales from sales journal to sales invoices and bill of lading, to ensure each recorded sale was shipped to a customer.

• Analyze a sample of the bill of lading numerical sequence to ensure that no numbers are duplicated.

• Any other reasonable answer Authorization • Compare the prices recorded in a sample of sales invoices to the authorized price list to ensure that the price was authorized.

• Compare a sample of sales invoices from sales journal to the approved customer list to ensure that the authorized credit limit was not exceeded for any customer.

• Any other reasonable answer.

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PROFESSIONAL APPLICATION 8.14 – Identifying preventive and detective controls LO 1 Required For each of the following controls: a) identify whether it is preventive or detective, and b) indicate whether it relates to the control objective of authorization.

1. The computerized accounting program will not allow a sale to be processed if a customer has exceeded its credit limit.

2. The computer checks the account coding on each purchase order against a table of valid account numbers, and then performs various logic tests.

3. Bank reconciliation and follow-up is conducted of unexpected outstanding items (such as unexpected or large deposits not yet cleared by the bank and cheques presented by the bank but not recorded in the general ledger).

4. Sales invoices are automatically priced using a master pricing file.

5. The computer performs a daily comparison of quantities shipped to quantities billed. If differences are revealed, a report is generated for review and follow-up by the billing supervisor.

6. Amounts cannot be paid to employees without first matching a valid social insurance number to the employee master file.

7. Quarterly reviews are conducted of credit balances in accounts receivable to determine their causes.

8. The sales manager reviews daily shipments, total sales, and sales per unit shipped.

Suggested Solution: a) Preventive: 1,2,4,6 Detective: 3,5,7,8 b) Authorization: 1,2,4,6

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CASES 8.15 – Farmco (a) Factors that would tend to increase inherent risk for accounts payable and accrued liabilities: • Because the managers’ bonuses are based on net income, they would be motivated to understate expenses and accounts payable.

• A significant portion of the business is seasonal, which means that those suppliers’ account balances may not be stable or predictable.

• Because of the terms of payment on the fertilizer and herbicide supplier accounts, a portion of those accounts payable may routinely be left open for long periods of time.

• A temporary employee takes over some of the accounts payable duties for part of the year.

Factors that would tend to decrease inherent risk for accounts payable and accrued liabilities: • The company is stable with key ratios at industry norms.

• There are not many key suppliers. (b) Conclusion: The risk level could be identified as either high or moderate. (c) Control Objective All items are recorded

Control Procedure Pre-numbered purchase orders are used.

All items are recorded

Pre-numbered receiving reports are used.

All items are real (authorized)

The branch manager approves purchase orders.

All items are real (authorized)

The controller approves payment before the cheque is issued.

All items are real (authorized)

The controller and general manager initial (cancel) invoices and purchase orders to prevent reprocessing.

Ernesto matches the

All items are

Test of Control Account for numerical continuity of a sample of purchase orders.

Account for numerical continuity of a sample of receiving reports.

Examine a sample of purchase orders for evidence of approval Examine a sample of cheque requisition listings for Joan’s initials and agree to cheques actually issued that week.

Select a sample of cheques issued documents for controller and general manager initials Agree a sample of

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supplier’s invoice to the signed receiving report.

invoices to receiving reports

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Case Study — Cloud 9 1. Use your worksheet from the case study assignment in the previous chapter to complete this part of the assignment. In column four include the transaction level internal controls Cloud 9 has implemented to prevent and/or detect potential errors.

2. Based on the preliminary assessment of Cloud 9’s control environment obtained in earlier procedures, the audit team has decided to test controls over the sales to cash receipts process. It is expected that there will be no deficiencies in the transaction level internal controls.

Josh has partially completed the testing for selected controls over the sales/accounts receivable and cash receipts processes. He has asked you to complete the testing for him. All information has been provided by the client (refer to the appendix).

Document your findings on the working papers Josh has started (see the tables below) and then conclude with your assessment on the overall effectiveness of the controls tested.

3. Using the results of your control testing, assess the control risk for the following assertions and write your conclusions in the following worksheet. Use the information you provided in the worksheet completed for requirement 1 to focus your controls testing on the significant assertions.

Solution 1. Controls

Significant Potential Process Misstatements Sales/Accounts Credit memos are Receivable not issued or Process recorded for returns on a timely basis or at all.

Duplicate/false sales transactions are recorded.

Assertions Sales - Occurrence; Accounts Receivable Existence

Control Credit memos > $10,000 are approved by receiving manager and finance director. All others are approved by receiving manager.

Bar code scanners used to automatically record sales and returns.

Sales - Occurrence; Sales order automatically matched Accounts Receivable to shipping note in Swift prior to Existence; Allowance for shipment.

Bad Debt Completeness

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Shipping supervisor enters passcode in Swift authorizing each shipment.

System generates draft invoice when shipping note authorized by shipping supervisor.

System automatically posts invoice to sales and AR sub-ledgers.

Invoice misstates the quantity of goods shipped or incorrect pricing.

Sales - Accuracy; Accounts Receivable Valuation; Inventory Valuation; COGS Accuracy

Draft sales invoices are agreed to shipping notes signed by customers.

Sale price taken from master price file.

Sales order automatically matched to shipping note in Swift prior to shipment.

System generates draft invoice when shipping note authorized by shipping supervisor.

System automatically posts invoice to sales and AR sub-ledgers.

Proper credit authorization is not obtained for wholesaler transactions.

Sales journal/subledger is incorrectly posted or does not reconcile.

Allowance for Bad Debt - Completeness

Credit limit check is automatically performed by system against customer master file.

Sales - Completeness

System automatically posts invoice to sales and AR sub-ledgers.

Daily review of the unfilled sales order report.

Sales transaction is not recorded upon shipment of goods.

Sales - Completeness; Accounts Receivable Completeness; Inventory - Existence; COGS – Occurrence

Draft sales invoices are agreed to shipping notes signed by customers.

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Review of exception report listing shipments not yet billed.

Sales order automatically matched to shipping note in Swift prior to shipment.

Signed shipping note file checked regularly.

System generates draft invoice when shipping note authorized by shipping supervisor.

System automatically posts invoice to sales and AR sub-ledgers.

Sales transaction is recorded when goods not shipped.

Sales - Occurrence, Accounts Receivable Existence; Inventory Completeness; COGS Completeness

Draft sales invoices are agreed to shipping notes signed by customers.

Sales order automatically matched to shipping note in Swift prior to shipment.

System generates draft invoice when shipping note authorised by shipping supervisor.

System automatically posts invoice to sales and AR sub-ledgers.

Cash Receipts

Cash receipts are not recorded when received.

Accounts Receivable Completeness; Cash Completeness

Bank reconciliations are prepared and are reviewed timely.

Direct banking receipts are reconciled to Accounts Receivable and reviewed/approved.

Cash receipts in foreign currencies incorrectly valued.

Cash receipts recorded differ from amounts deposited.

Accounts Receivable Valuation; Cash Valuation Accounts Receivable Completeness and Existence; Cash Completeness and Existence

Bank reconciliations are prepared and are reviewed timely.

Bank reconciliations are prepared and are reviewed timely.

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Direct banking receipts are reconciled to Accounts Receivable and reviewed/approved.

Cash receipts/transfers are recorded in wrong period.

Accounts Receivable Completeness; Cash Completeness

Bank reconciliations are prepared and are reviewed timely.

Direct banking receipts are reconciled to Accounts Receivable and reviewed/approved.

Duplicate postings of cash receipts are made to G/L.

Cash - Existence

Bank reconciliations are prepared and are reviewed timely.

Totals in cash receipts journal are incorrectly posted.

Cash - Completeness

Bank reconciliations are prepared and are reviewed timely.

Direct banking receipts are reconciled to Accounts Receivable and reviewed/approved.

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2. Complete testing Cloud 9 Controls Testing - Sales/AR Process December 31, 2011 AIM To test selected controls over the Sales and Accounts Receivable process.

SAMPLE We haphazardly selected 25 sales invoices from the entire year.

RESULTS

Sales Invoice #

Date

Customer Name

Sale Amount (exc GST)

Invoice matches Shipping Note (A)

Shipping Note #

Shippin g Supervi sor authoris ation (B)

1

124874

14/01/2011 David Jones - Moose Jaw

645.87

✓

D00124874

✓

2

125048

23/01/2011 Foot Locker - Ottawa

745.21

✓

D00125048

✓

3

125324

7/02/2011 Rebel Sport - Vancouver Island

905.46

✓

D00125324

✓

4

125542

16/02/2011 Rebel Sport - Sunshine Coast

517.32

✓

D00125542

✓

5

125987

2/03/2011 Myer – Moncton

675.28

✓

D00125987

✓

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6

126067

10/03/2011 Dick's Sports - St. John’s

367.96

✓

D00126067

✓

7

126845

8/04/2011 Foot Locker - Regina

781.62

✓

D00126845

✓

8

127111

27/04/2011 Running Shop - Calgary

457.24

✓

D00127111

✓

For purposes of this case study, sample tests 9-19 have been removed. There were no exceptions noted in the results.

20

132811

13/10/2011 David Jones - Moose Jaw

917.92

✓

D00132811

✓

21

133410

27/10/2011 Rebel Sport - Vancouver Island

723.72

✓

D00133410

✓

22

134063

4/11/2011 Myer – Moncton

752.20

✓

D00134063

✓

23

134104

6/11/2011 Cross Country Sports

229.48

x

D00134104

✓

24

135215

12/12/2011 Wide Road Speciality Retailer

1,192.14

✓

D00135215

✓

25

136947

20/12/2011 Foot Locker - Regina

1,021.60

✓

D00136947

✓

A

To complete this test, we agreed the sales invoice to the shipping note, ensuring it was signed by the customer.

B

To complete this test, we reviewed the shipping note noting the encrypted passcode symbol. As passcodes are not printed, our IT specialists will perform control testing around passcode entry and the generation of the shipping note once entered.

x

It was noted on the shipping note that a customer signature was not obtained. Upon discussion with the billing team, it was determined that the customer was called to verify receipt of the goods. This should have been noted on the shipping note to prove that the goods were received and the control was performed properly.

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CONCLUSION With the exception noted in the testing above, we cannot conclude at this time that the control around matching the sales invoice to the shipping note is working effectively. To be able to rely on this control, we would need to increase our sample size by another 15 (assuming no exceptions found).

The control for the shipping supervisor's authorization does appear to be working effectively.

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Cloud 9 Controls Testing - Cash Receipts Process December 31, 2011 AIM To test selected controls over the Cash Receipts process.

SAMPLE We haphazardly selected 25 workdays from the entire year in order to test the reconciliation of daily bank receipts to A/R. RESULTS

1 2 3 4 5

Date 8/01/2011 18/01/2011 15/02/2011 27/02/2011 11/03/2011

6 7 8

19/03/2011 4/04/2011 22/04/2011

Total Posted to AR 10,548.45 9,587.37 11,486.82 7,456.24 5,836.08

Total Bank Deposit 10,548.45 9,587.37 11,486.82 7,456.24 5,836.08

8,012.74 8,753.91 9,687.45

8,012.74 8,753.91 9,687.45

Evidence of Review ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓

For purposes of this case study, sample tests 9-19 have been removed. There were no exceptions noted in the results.

20

19/09/2011

10,577.23

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10,577.23

✓

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21 22 23 24 25

8/10/2011 23/10/2011 12/11/2011 3/12/2011 19/12/2011

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8,765.49 5,490.61 9,302.20 12,567.33 13,874.85

8,765.49 5,490.61 9,302.20 12,567.33 13,874.85

CONCLUSION Based on the results above, the control appears to be operating effectively throughout the entire period.

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✓ ✓ ✓ ✓ ✓

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3. Assess control risk An exception was found in the testing for the control surrounding matching of sales orders to signed shipping notes. Students should have concluded that the control was not working effectively based on the information provided. In practice, the exception would be investigated and it would be determined if this was a one-off event or if there was a mitigating control that was in place and operating effectively.

Students may also have noted the difference in dates between the invoice date and the shipping date. This is because the invoice, although generated in draft when the shipping note is approved, is not sent until it is properly matched with the signed shipping note.

Assuming no further testing was performed, based on the results the control risk for the relevant account assertions would be assessed as follows: Account Assertion Control Risk Explanation Sales – Occurrence Medium The exception found in the testing provides evidence that the sale was recorded although the shipping note was not signed. Without further testing, it could not be determined that the customer received the goods, thereby triggering the sale to be recorded.

However, the shipping supervisor authorization also covers the Occurrence assertion and was operating effectively.

Sales – Low The matching of sales invoice to the shipping note Completeness provides evidence that the sale is recorded when goods leave the warehouse.

Sales – Allocation Low No exceptions were noted in the matching of quantity between the invoice and shipping note.

A/R – Existence Medium The effects of the sales exception are offset by the successful cash receipts testing. By confirming through testing that the cash is properly posted to the A/R balance, this provides evidence that the customer balance did exist (i.e., they are paid the balance).

A/R – Low The reconciliation testing provides comfort that all Completeness cash received is posted to the accounts receivable balance.

A/R – Valuation Low No exceptions were noted in the matching of quantity between the invoice and shipping note.

Cash – Existence Low By matching the cash receipt journal (through the A/R batch) to the bank statement, the existence of the cash balances is confirmed.

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Cash – Completeness

Low

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Testing shows that cash received in bank is recorded in the general ledger.

The control risk represents the auditors’ assessment of the likelihood that Cloud 9’s internal control procedures would not prevent or detect a material misstatement.

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Research Question 8.1 – Audit of internal controls The solution to this research question will depend on the sources selected by the student and the information gathered.

However, the following brief statement may provide some sort of starting point for discussion of the differences between an audit of internal controls as required by section 404 of the Sarbanes-Oxley Act 2002 (SOX) and the testing of internal controls for the purposes of expressing an opinion on the financial statements as mandated by CAS 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and its Environment.

Section 404 of SOX requires management of SEC (Securities Exchange Commission) registered companies to make an annual assertion concerning the effectiveness of internal control over financial reporting procedures, and for the company’s external auditor to provide assurance on these assertions. Upon passage of SOX, affected companies immediately recognized the substantial effort and costs, including that for IT, needed for complying with Section 404. While CAS 315 does not require documentation of the effectiveness of internal control to the extent SOX does, it does discuss the importance of understanding internal control in a similar fashion. Similar to SOX, CAS 315 utilizes the COSO (Committee of Sponsoring Organizations "COSO" Internal Control framework) framework as a foundation for control evaluation. The IAASB (International Auditing and Assurances Standards Board) also recognizes the need for IT specialists within the audit process to obtain a sufficient understanding of internal controls when clients have significant automation of their systems.

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The material provided herein may not be downloaded, reproduced, stored in a retrieval system, modified, made available on a network, used to create derivative works, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise without the prior written permission of John Wiley & Sons Canada, Ltd.

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Solutions Manual to accompany

Auditing: a practical approach by

Robyn Moroney Fiona Campbell Jane Hamilton Valerie Warren

CHAPTER 9 Execution of the audit – performing substantive procedures

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Chapter 9 — Execution of the audit – performing substantive procedures

SOLUTIONS TO REVIEW QUESTIONS

REVIEW QUESTION 9.1 LO 1 The nature, timing, and extent of audit procedures is determined in response to the risk assessment for the item being tested. The risk assessment includes the auditor’s consideration of inherent risk, control risk, which together are used to determine the level of acceptable detection risk. These assessments are conducted at the assertion level.

If inherent and control risk are assessed as being high, acceptable detection risk is lower. Detection risk is reduced in proportion to the amount of substantive testing performed. Therefore, if acceptable detection risk is lower, a greater amount of substantive testing is necessary.

The nature of a substantive test could affect decisions about when and how much substantive testing is performed because some substantive tests are more appropriate for year-end testing rather than interim testing (and viceversa). For example, verifying the calculation of the split between the amount to be recognized as a prepayment and the amount to be expensed in the income statement is easiest to perform at or after year-end. Also, some tests are easier to conduct over large numbers of items than other tests. For example, verifying the correct authorization for certain transactions could require inspection of the documents, which is more difficult to do for a large number of transactions than recalculating the discount offered to certain types of customers which can be verified by using software to recalculate the discounts for computerized transactions.

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REVIEW QUESTION 9.2 LO 3 Substantive procedures are designed to obtain direct evidence as to the completeness, accuracy and validity of data, and the reasonableness of the estimates and other information contained in the financial statement. That is, they are direct tests of the amounts reported by the client in the financial statements and the relevant disclosures.

The main types of substantive procedures are: inspection (of documents and physical assets), observation (of client employees performing their duties), enquiry (of client employees and directors, client solicitors and other third parties), confirmation (of account balances including customers, creditors and banks), recalculation (of discounts, depreciation expense, etc), reperformance (of bank reconciliations, inventory counts, etc), and analytical reviews (of account data at interim or year-end, comparisons with other periods and entities, etc). Substantive procedures that are not analytical procedures are also known as tests of detail.

REVIEW QUESTION 9.3 LO 3 Analytical procedures consist of evaluations of financial information made by a study of plausible relationships among both financial and nonfinancial data.

Analytical procedures include data comparisons, ratio analysis, trend analysis, preparation of common-size statements, break-even analysis, and pattern analysis and regression analysis.

Analytical procedures can be used as primary tests of a balance, as corroborative tests in combination with other procedures, or to provide at least some minimal level of support for the auditor’s conclusion.

For example, analytical procedures would be a primary test of the balance of the allowance for doubtful accounts. It would be based on analysis of accounts receivable transactions balances for the current period, and comparison with past history for this client. Preparation of common-size statements, ratio and trend analysis would be useful to corroborate other evidence about cost of goods sold and other expenses.

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REVIEW QUESTION 9.4 LO 4 If the auditor is using the analytical procedure to provide primary evidence, controls over financial and non-financial data need to be more reliable. If the auditor is using analytical procedures to provide a general understanding of the client, data quality is not so important. However, if the procedures are designed to provide persuasive evidence, the underlying data should be tested. For example, if the accounts receivable ageing report is being used to test the reasonableness of the provision for doubtful debts, the report should be tested for accuracy.

Another consideration for the auditor is that the analytical procedure could rely on non-financial data, such as quantities of raw materials, numbers of employees or customers, etc. This data is usually not subject to the same controls by the client as the financial data, making it less reliable in analytical procedures. Where the client uses the data for management purposes, the data is likely to be more reliable.

Analytical procedures provide more persuasive evidence when they are able to generate an amount that the auditor believes is a reasonable estimate of what the balance should be, allowing a conclusion about whether it is free from material error. In this case, no further evidence is required.

Analytical procedures provide corroborative evidence if it (1) confirms findings from other procedures, and (2) supports management representations or otherwise decreases the level of audit scepticism. These results limit the amount of evidence required from other procedures.

If the auditor is using the analytical procedures for minimal assurance (i.e., not persuasive or corroborative), the auditor does not need to test the underlying data.

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REVIEW QUESTION 9.5 LO 3 The results of analytical procedures are only as good as the data used in the procedures. Therefore, client data that has not been audited is less reliable than audited data, and less faith can be placed on the results of analysis using unaudited data. Client data can also be unreliable if the client has restructured its operations or reporting lines. The more geographical or segment diversity within the client, the less useful aggregated data (rather than geographical or segment data) will be. Client controls over data, including budget data, affect the quality of the data, and its usefulness in analytical procedures.

Also, industry data that is used for comparisons can be of variable quality.

Industry data could be outdated if the industry is subject to rapid changes, such as economic growth or decline. The industry could be less comparable with the client due to changes in conditions or differences between the client and the average industry member.

REVIEW QUESTION 9.6 LO 1, 3 Vouching a transaction or balance back to supporting documentation primarily gives evidence about existence or occurrence. This is because the documentation is used to verify that the transaction was real and valid.

Vouching involves testing and verifying information already recorded in the accounting records and is used to ensure the balances or transactions are not overstated.

In addition, vouching can provide evidence about valuation and allocation and accuracy. The documentation confirms the amount recorded in the accounts.

Vouching can also provide evidence about rights and obligations because the documents will show the parties to the transaction.

Vouching does not provide evidence about completeness. This is because the auditor is testing information already recorded in the accounting records, and as such, will not normally uncover evidence about transactions and balances that are not in the accounting records.

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REVIEW QUESTION 9.7 LO 1, 3 Key item testing is done by using either a statistical basis or professional judgement to identify and test key items in a balance. The auditor focuses on selecting the largest transactions within a balance to obtain ‘coverage’ over the total. If the auditor tests the largest items in the balance, the auditor is able to reach a conclusion about the entire balance.

Representative sampling aims to take a representative sample from the population (perhaps after key items have been separately tested) for testing.

Every item in the population has an equal chance of selection for the sample.

Audit risk tables are used to determine the size of the representative sample based on the auditor’s expectation of error (which should be low for this type of sampling) and the risk of material misstatement (which should also be low).

This technique is generally used when the primary focus is on overstatement, because items already in the client’s accounts are sampled.

Software is useful for both types of sampling. For example, the software could find the largest items, or the most recent, etc, for key item testing. The software will also calculate if sufficient items are selected to provide a reasonable basis for concluding that sufficient ‘coverage’ is obtained by focusing on the selected key items. Software is also useful to calculate the size of the representative sample and to choose the items for testing. The software uses the audit risk model in the calculations, together with other considerations such as materiality, total key items already tested, and the audit evidence obtained from other substantive procedures.

REVIEW QUESTION 9.8 LO 3 Computer aided audit techniques = CAATs. The two main types of CAATs are: (1) software used to interrogate and examine client data files when the client is automated, (2) software to plan, perform, and evaluate audit procedures, regardless of whether the client is automated or not.

Audit software can be used to perform procedures such as calculations and logic tests, select and print key items and representative samples for testing.

The software makes the audit more comprehensive and efficient because the computer can handle large volumes of data.

CAATs do not remove the need to test client control systems. Client data files are likely to be more useful for audit testing if controls are strong, because the records will be more complete and reliable.

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REVIEW QUESTION 9.9 LO 2 The timing of substantive procedures is directly influenced by the level of control risk. The greater the assurance gained from control testing or the more effective controls are judged to be, the more likely that substantive testing can be done at an interim period. Therefore, clients with stronger internal controls, and accounts with stronger controls, are more suitable for interim substantive testing.

Also, for clients or accounts where there is low inherent risk substantive testing can be conducted at interim periods.

In addition, the accounts that accumulate transactions which mostly remain in the account balance at year-end are more suitable for interim testing. For example, the auditor can test additions and disposals to the property, plant, and equipment register prior to the year-end.

Clients with specific reporting requirements can also be suitable for interim testing. If the client needs to close its accounting records promptly, interim testing is a great advantage.

REVIEW QUESTION 9.10 LO 5 Examples of errors include: • An addition posted to the repairs expense account instead of the property, plant, and equipment (PPE) asset account (and vice-versa) • A transaction posted with the wrong date around year-end • Failure to record theft of equipment • Failure to remove scrapped items from asset register Examples of judgemental misstatements include: • Judgements around capitalization of installation expenses and borrowing costs • Judgement of impairment/revaluation amounts

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SOLUTIONS TO PROFESSIONAL APPLICATION QUESTIONS PROFESSIONAL APPLICATION 9.1 – Designing substantive procedures LO 1, 2 Gaskin and Bryson have approximately the same amount of revenue, but there are substantial differences between the firms. Gaskin is a recently publicly listed manufacturing and wholesaling company. Bryson is a firm that provides marketing and other consulting services, listing status unknown.

The auditing standards require the auditor to gain an understanding of the client and its circumstances. For example, the auditor should gain an understanding of the operating conditions in the client’s industry as well as the economy generally, and the reporting requirements that apply to the firm (which would be influenced by its listing status). The auditing standards require audit plans to be based on the auditor’s assessments of inherent and control risks at the client, and the nature, timing and extent of substantive procedures should reflect these risk assessments.

Therefore, the main problems with using Bryson’s audit program as a basis for designing substantive procedures for Gaskin relate to the fact that by doing so the auditor may not properly work through the effects of Gaskin’s circumstances on the audit program.

Examples of specific problems: - The auditor may use the wrong type of substantive procedures, e.g., not incorporate tests of inventory balances (which would not be on Bryson’s balance sheet) and accounts receivable balances.

- The auditor may not make a thorough assessment of internal controls at Gaskin and therefore not schedule control tests in time to use the results of the control tests to determine the nature, timing or extent of substantive procedures.

- The auditor may not schedule tests of disclosures required by listed firms that are not required for Bryson.

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PROFESSIONAL APPLICATION 9.2 – Data for analytical procedures LO 3, 4 Factors increasing reliability of data include: - Data used for management purposes, suggests that management have faith in its reliability - Data is generated by province and division, allowing new business segments to be removed before comparison with prior years - Well-established business, suggesting good business practices and reliable data being used - Purchasing and billing systems are fully integrated, suggesting data is used consistently through the business - Few changes to production processes in paper business - Minimal changes to new plastics business since acquisition, allowing analysis of this division with data held for prior years (if available) - Takeover was 18 months ago, suggesting that this year would be a full year of data Factors decreasing reliability of data include: - Acquisition of new plastics business makes whole of business reports not comparable with previous years.

- Any changes such as growth could distort comparisons - Could be increased pressures for growth and/or profitability, changing the incentives for accurate reporting (i.e., managers could have incentives to manipulate figures for their division) - Last year’s data was difficult to analyse because of acquisition half-way through the year, making last year’s data not as useful for comparisons

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PROFESSIONAL APPLICATION 9.3 – Persuasiveness of evidence from analytical procedures LO 3, 4 (a) Questions Mathieu could ask include: (1) What acquisitions and disposals have occurred for each depreciable asset class? (These would affect the balance of assets at the end of the period although depreciation expense is for all assets held during the period.)

Are the same rates and depreciation methods used for each asset in the asset class?

Have the closing balances for the assets been verified? Are there any other changes in the business suggesting that asset balances should be different?

Are there any significant changes from last year?

(2) Are sales commissions ever given at non-standard rates? If so, to which salespeople or for which products? Are all sales subject to sales commission?

Has total sales been verified?

Are there any significant changes from last year?

(3) What changes in personnel numbers have there been this year (i.e., new employees or employees leaving?) Are there any changes in pay rates for some employees? Are there any other changes in the business suggesting that employee numbers or payroll expense should be different?

Are there any significant changes from last year? (b) In all cases, the results of the analytical procedures would be more persuasive if the underlying data has been audited and is consistent with other evidence obtained during the audit. Also, in all cases there are reasons to expect the relationship between the data to be consistent if the relevant conditions are similar to those in previous years. The most persuasive tests would be (1) and (2) because they involve more than a mere comparison with the previous year. However, both these tests could be improved. For example, test (1) would require an adjustment for disposals and acquisitions to improve its persuasiveness, and test (2) would be more persuasive if data about product lines and relevant sales commissions were available. Test (3) would be more persuasive if the total payroll expense was calculated on an employee basis before comparing with the previous year. If the test is more persuasive, less further substantive testing would be required. For each of these tests, it is likely that no further testing would be required if all questions are answered satisfactorily and improved as suggested above.

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PROFESSIONAL APPLICATION 9.4 – Tests of details LO 3, 4 (a) The major risk is overstatement of sales. Therefore, we would expect to see substantive procedures in the audit program designed to test the assertions of occurrence and cut-off for sales. This focus drives the sample selection. The audit program would require sampling of recorded sales transactions. Key items would be selected on the basis of size (there are some very large transactions) and date (because those sales recorded as occurring just prior to the year-end are potentially misstated sales that occurred just after the year-end). Depending on the auditor’s assessment of the strength of controls over custom tools and standard tool sales, the sample could sample relatively more of one type of sale transaction. Key item selection and testing would allow the auditor to gain reasonable assurance that the total sales balance was adequately ‘covered’, although the auditor might also require testing of a representative sample of the remaining items.

The vouching procedures would require Marty to inspect documents supporting the sales transactions. Marty would be instructed to start with the items selected as above, and locate the relevant documentation (sales order or contract, shipping documents, sales invoice). Marty would be instructed to verify the date and amount of the sales transaction, plus the details of the items sold. He would be instructed to recalculate the total price by reference to number of units and the agreed price. In the case of custom designed tools, Marty would be able to inspect a contract and obtain the details of price from it, but in the case of standard tools Marty would need to obtain the record of the telephoned sales order and use standard price lists. The number of items shipped to the customer would be verified by inspecting the shipping documents that are reconciled by the client to the sales order and copy of the invoice. (b) CAATs would be useful to Marty (and others in the audit team) in: • calculating the size of the samples • selecting items from the population to include in the sample • searching for electronic records of sales documents • recalculating # unit × unit price • analyzing fluctuations in recorded sales to search for unusual patterns (e.g., by time, customer, product) • interpreting the results of the tests • writing working papers recording the results of the tests

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PROFESSIONAL APPLICATION 9.5 – Timing of substantive tests LO 1, 2, 3, 4 (a) Some substantive procedures could be performed at interim periods. These would be most likely in the following accounts: • Accounts which accumulate transactions which remain in the account balance at year-end (e.g., verify additions to fixed assets).

• Accounts where controls are confirmed as strong (which they appear to be), and high acceptable detection risk (tests could be done up to six months before year-end) • Accounts where controls are believed to be strong, and controls will be tested (tests could be done 2 or 3 months before year-end) • Accounts with limited materiality (e.g., small asset accounts) or low likelihood of errors (i.e., low inherent risk) (b) Roll forward procedures update the findings from the interim tests. For example, analytical procedures could be used to test if the patterns of revenue or expense transactions are similar before and after the interim tests.

A sample of transactions from after the test date could be taken and further tests of details performed. (c) In general, risk assessments affect the timing of substantive procedures. If inherent risk and control risk are low, allowable detection risk is high. This means that the timing of the substantive tests is more flexible. For example, good internal controls over inventory would allow interim physical inventory count testing. In addition, the nature of substantive tests affects the timing of the tests. Some tests are more relevant at year-end than at interim periods (e.g., the auditor would test the completeness of liabilities at year end, but details of individual liabilities could be tested prior to year-end).

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PROFESSIONAL APPLICATION 9.6 – Evaluating substantive testing results LO 5 (1) Error – because the sale is included in the wrong accounting period (unless the date of December 31, 2011 is based on a judgement about the nature of the sales contract). The sale should be included in the next period. The client has incorrectly recorded the sale on December 31 as: Dr accounts receivable, Cr sales (assuming a credit sale, not a cash sale). To correct this error, the adjusting entry would be to reverse the entry for December 31 and record it as January 2 ($1,250,000).

(2) The management underestimated the provision for warranty claims for the year ended December 31, 2011. They estimated $100,000, and (depending on how the information in the question is interpreted) there are already an additional $150,000 in processed claims and a further $200,000 to be processed. Management estimate a provision for the year ended December 2012 of $120,000. The new provision appears to be inadequate, and is a judgemental misstatement. The entry to increase the current year provision would be Dr Warranty expense, Cr Provision for warranty for the amount of the increase ($200,000), since correspondence suggests that an additional $200,000 in warranty claims could result.

(3) Error – the severance costs were charged to the wrong expense account. An adjusting entry should be made: Dr Severance expenses, Cr Rental Expenses ($578,920).

(4) The amount for impairment of assets to be recognized in the accounts is a judgement. In this case, there is evidence that the following entry should be made: Dr Impairment expense Cr Asset, but the amount of the impairment is not given in the question.

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PROFESSIONAL APPLICATION 9.7 – Substantive testing for specific assertions at risk LO 1, 3 (a) Key account balances: (i) Scanning revenue, (ii) Accounts receivable, (iii) Scanning machine (fixed asset account), (iv) Deferred/unearned revenue (since question appears to indicate that all customers pay at time of initial booking). (b) (i) Occurrence - has revenue occurred? Recognizing revenue at time of receipt of cash is not consistent with revenue recognition principles (services has not been delivered) (ii) Existence - does the asset exist because the service has not been delivered? (iii) Valuation and allocation – what is the appropriate value for the scanning machines given the uncertainty around their approval? (c) Read the contracts for use of the scanning machines. Is there anything to support the early recognition of the revenue and the claim against the patient? (e.g., the hospital has the right to deliver an alternative service, the patient does not have the right to a refund). Obtain a legal opinion.

Consider the documentation surrounding the regulation of the scanning machines. Is the Canadian Medical Association the relevant approving body?

If this body withholds approval, is the hospital still able to use the machines legally?

Talk to management. What evidence does management have to support their view that there is an 80% chance of the scanners being approved? Obtain an independent expert’s view of the regulatory situation.

Read the press reports. How extensive is the bad press surrounding the scanning machines? Is it likely to affect patient demand for the services?

Would all these factors affect the value of the machines?

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PROFESSIONAL APPLICATION 9.8 – Using analytical procedures LO 3, 4 Number of patients treated in the facility for this period and prior periods, with details about patient type and length of stay.

Obtain patient data per service during different periods during the year (different wards could have different charges, e.g., physiotherapy vs. massage) Calculate revenue per patient (by ward or other characteristic such as patient type) in past, apply to this period.

Compare revenue per patient to other similar facilities.

Use personnel and other operating data to estimate reasonableness of patient data. (e.g., if number of nurses increases, it is likely that number of patients also increases.)

PROFESSIONAL APPLICATION 9.9 – Planning substantive tests LO 2 (a) A high projected error rate suggests that the controls are not working effectively. The required audit response is to increase the assurance gained from substantive testing. This can be done by using more effective substantive procedures, altering the timing of the substantive procedures to closer to year-end, and/or increasing the extent of the substantive procedures (i.e., increasing sample size). For example, greater reliance on tests of detail and less reliance on analytical procedures would normally provide greater assurance. (b) If all the control deviations can be isolated to a specific period, the increased substantive procedures could be addressed to this period rather than applied to the entire period. The auditor should also consider if the relevant senior person was on leave at other periods, and increase testing during those times as well. In addition, the auditor should consider discussing the issue with management to determine the cause of the problems. For example, are there issues with covering the absence of other staff members? Is there adequate training provided for staff taking on higher duties when colleagues are absent? How does this reflect on general control environment at the client?

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PROFESSIONAL APPLICATION 9.10 – Persuasiveness of evidence LO 4 In general, the analytical procedures would provide less persuasive evidence than the tests of detail. However, the analytical procedures, such as estimating revenue from patient data, would be useful as corroborative tests or general tests. In this case, the auditor would also use tests of detail relating to patient revenue. Revenue from patients is also likely to be very material to the audit, so more than one type of tests would be required to provide the required level of assurance.

The tests of inventory controls showing breakdowns during a three week period would be relied upon to restrict additional substantive testing to that period, and therefore would need to be highly persuasive. Additional testing to provide the highest level of assurance that the controls were effective during other periods would save the auditor completing unnecessary additional substantive tests.

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PROFESSIONAL APPLICATION 9.11 – Analytical procedures LO 3, 5 (a) Analysis is the study and evaluation of the inter-relationships between the elements of financial and non-financial information, the comparison of the relationships with the auditor’s assessments of the expected relationships and balances, and the investigation of significant fluctuations. Analytical procedures are the techniques by which analysis is performed, or “everything else an auditor can think to do” that does not meet the definition of computation, observation, confirmation, structured enquiry, or inspection. (b) Auditors can use analysis at: (i) The planning stage of the audit, (ii) During the execution phase of the audit (field work) as a substantive procedure, and (iii) When doing the final review (final stage) and evaluation of the financial statements before the audit report is issued. (c) The auditor's objective in using analysis, with respect to the stages identified in part (b), are: (i) In the planning stage, analysis assists the auditor in understanding the client’s business and in identifying areas where there is a high inherent risk of material misstatement, as signalled by unusual ratios or relationships. (ii) In the field work, or substantive testing stage, the auditor may obtain substantive assurance directly about financial statement assertion(s). (iii) In the final stage, or reporting stage, the auditor may employ analysis to assist in formulating the overall conclusion as to whether the financial information as a whole is consistent with the auditor’s knowledge of the entity and underlying economic conditions. (d) The reliability of the data used in analytical procedures can be ensured through: 1. The direct knowledge of the auditor, through his or her own mathematical calculations.

2. The use of documentary evidence obtained directly from independent sources (external evidence); for example, industry statistics.

3. The use of internal evidence when produced under satisfactory internal control conditions, that is, where the internal controls are sufficient to ensure client reports are mathematically accurate.

4. The use of prior years’ audited figures in assessing trends or determining ratios.

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Case Study — Cloud 9 Statement of Financial Position

30-Sep-12

COMMON SIZE

31-Dec -11

COMMON SIZE

Cash

$

245,965

1.0

$ 1,753,765

7.1

Receivables

$ 10,552,109

43.8

$ 10,701,064

43.5

Inventory

$

5,924,136

24.6

$ 6,263,242

25.5

Financial assets

$

4,469,759

18.5

$ 4,075,205

16.6

Prepayments

$

1,112,028

4.6

$

666,054

2.7

Deferred tax asset

$

346,949

1.4

$

277,559

1.1

PPE

$

1,449,330

6.0

$

852,965

3.5

Total assets

$ 24,100,276

100.0

$ 24,589,854

100.0

Payables

$ 10,323,185

42.8

$ 8,413,818

34.2

Provisions Interest bearing liabilities Current tax liabilities

$

401,658

1.7

$

268,581

1.1

$

9,021,836

37.4

$ 9,740,091

39.6

$

159,866

0.7

$

207,893

0.8

Deferred tax liabilities

$

198,647

0.8

$

170,284

0.7

Total liabilities

$ 20,105,192

83.4

$ 18,800,667

76.5

NET ASSETS

$

3,995,084

16.6

$ 5,789,187

23.5

Issued capital

$

5,448,026

22.6

$ 5,448,026

22.2

Reserves

$

(247,638)

-1.0

$

(259,498)

-1.1

Retained profits

$ (1,205,304)

-5.0

$

600,659

2.4

Total equity

$

16.6

$ 5,789,187

23.5

3,995,084

Note: assets and liabilities are not split into current and non-current because not enough information given for liabilities. Although loan is repayable over 5 years, the information about payment schedule is not provided.

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Comments: • Total assets have grown slightly, liabilities have grown faster resulting in lower net assets.

• Cash is lower proportion of total assets, despite opening store inventory has not grown proportionately, property, plant, and equipment (PPE) has grown – due to fit-out of store, purchase of trucks?

• Growth in liabilities has come from increase in payables • Total equity lower because of increase in accumulated losses.

Implications: • Lower cash balance, increase in borrowings increase concerns about solvency. However, overall position is still strong.

• Inventory balance is not increased, despite new store, consider reasons.

• Additional testing required for PPE to verify additions and valuations.

• Increase in payables is consistent with new operations, but is not reflected in higher inventory balances. Consider adequate of provisions.

• Special disclosures required for loans and other transactions with directors.

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Statement of Comprehensive Income

COMMON SIZE

30-Sep-12

COMMON SIZE

30-Sep-10

Revenue Revenue - stores Revenue Wholesales

$

640,782

$ 27,255,417

2.3 $ 27,896,199

97.7

$ 12,820,632

44.2

$ 100.0

-

$ 33,987,595

0.0 $ 33,987,595

100.0

100.0

$ 16,393,394

48.2

48.2

less COS COS - Stores

$

COS - Wholesales

$ 12,340,046

480,586

Gross profit

1.7

$ 15,075,567

$ 46.0

-

$ 16,393,394

54.0

$ 17,594,201

51.8

Other revenue Interest from bank

$

45,432

0.2

$

28,642

0.1

FX Gain/Loss Proceeds on disposals

$

35,467

0.1

$

29,568

0.1

$

-

$

7,714

Other Revenue

$

188,590

$

246,523

Storage - rent expense store

$

125,000

0.4

$

-

0.0

Storage - Rent expense warehouse

$

2,219,443

8.0

$ 2,959,257

8.7

Distribution expenses

$

1,551,191

5.6

$ 2,008,015

5.9

Advertising and Promotion - Print

$

1,564,359

5.6

$ 1,046,668

3.1

$

269,489

0.7

1.0

$

312,447

0.7

Selling expenses

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0.9

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Trade shows

$

245,765

0.9

$

384,934

1.1

Advertising and promotion - TV

$

1,306,426

4.7

$

496,996

1.5

Advertising and Promotion - Sponsorships

$

1,284,756

$

-

Salaries and employee benefits

$

3,813,345

13.7

$ 4,842,343

14.2

Telephone Computer and IT costs

$

75,654

0.3

$

152,324

0.4

$

189,352

0.7

$

298,583

0.9

Rent expense - office

$

231,877

0.8

$

309,170

0.9

Depreciation - Furniture and equipment

$

525,890

1.9

$

339,852

1.0

Depreciation - leasehold improvements

$

150,982

0.5

$

96,326

0.3

Entertainment

$

165,432

0.6

$

320,703

0.9

Professional fees

$

238,654

0.9

$

458,903

1.4

Insurance expense

$

2,065,096

7.4

$ 1,597,463

4.7

Recruitment

$

264,327

Bad debt expense

$

56,784

Interest expense - loan from bank

$

763,187

Interest expense - directors

$

35,424

$ 8,296,940

4.6

29.7

$ 6,895,870

0.0

20.3

Administration expenses

$ 7,720,609

0.9

27.7

$

297,190

$

120,000

$

701,576

$

46,530

$ 8,712,857

0.9

25.6

Finance Expenses

Profit before income tax Tax expense Profit after tax

$

0.2 2.7 $

855,395

0.1

3.1

0.4 2.1 $

868,106

0.1

2.6

$ 16,603,455

59.5

$ 16,164,386

47.6

$ (1,527,888)

-5.5

$ 1,429,815

4.2

278,074

1.0 $ (1,805,962)

$ -6.5

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378,074

1.1 $ 1,051,741

3.1

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Comments: • Income (revenue and expense) figures are for 9 months only, so care should be taken when comparing with previous year. However, common size statements allow valid comparisons because individual items are expressed as a proportion of the total revenue.

• Cost of sales as a proportion of revenue has fallen, increasing gross profit as a proportion of revenue.

• Significant increases in selling expenses, mainly the new sponsorship costs and other advertising costs.

• Administration expenses have increased. There is additional insurance, likely related to the new stores.

• Finance expenses are greater, due to loan from bank.

• Overall, increasing costs are contributing to a net loss for the period.

Total operating expenses have increased from 48% of sales to 60% of sales.

Implications • Consider reasons for reduction in COS. • Advertising is a new large expenditure item; consider authorizations and classifications of expenses. Insurance is larger – why?

• Employee costs are lower despite new stores opening, consider reasons.

• Bad debts and warranty – consider adequacy of provisions.

• Expense growth – consider whether any items should be capitalized.

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Research Question 9.1 – Love and Lawson, "Auditing in Turbulent Economic Times" The solution to this research question will depend on the sources selected by the student and the information gathered.

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Legal Notice Copyright

Copyright © 2012 by John Wiley & Sons Canada, Ltd. or related companies.

All rights reserved.

The data contained in these files are protected by copyright. This manual is furnished under licence and may be used only in accordance with the terms of such licence.

The material provided herein may not be downloaded, reproduced, stored in a retrieval system, modified, made available on a network, used to create derivative works, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise without the prior written permission of John Wiley & Sons Canada, Ltd.

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Solutions Manual to accompany

Auditing: a practical approach by

Robyn Moroney Fiona Campbell Jane Hamilton Valerie Warren

CHAPTER 10 Substantive testing and balance sheet accounts

John Wiley & Sons Canada, Ltd. 2012

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Chapter 10 — Substantive testing and balance sheet accounts

SOLUTIONS TO REVIEW QUESTIONS

REVIEW QUESTION 10.1 LO 1 The auditor designs the nature, timing, and extent of audit procedures to provide reasonable assurance of detecting material misstatements at the assertion level and thereby provide the basis for reasonable conclusions on which to base the auditor’s opinion. The auditor is required to choose substantive procedures in response to the risk assessment for each significant account or disclosure for the client. Because these risk assessments would vary from client to client, the combination of audit procedures would also vary.

However, there normally would be a high degree of overlap in the nature, timing, and extent of audit procedures for the same accounts for clients with similar characteristics (size, industry, listing status, etc).

REVIEW QUESTION 10.2 LO 1 Figure 10.2 shows that interim testing is more likely for accounts with low overall risk assessments, and year-end testing is more likely for accounts with high overall risk assessments. A low overall risk assessment means that planned detection risk is high, which in turn means that less work needs to be performed. Most evidence from this work is likely to be obtained from controls testing during the year, with a small amount of substantive testing. A high overall risk assessment means that detection risk is low, which in turn means that more work needs to be performed. This work is less likely to be obtained from controls testing during the year and more likely to be obtained from a variety of substantive tests performed near or at the reporting date.

An auditor has some opportunities to perform some substantive procedures prior to year end.

Some events or transactions occur prior to year-end and then stay in the balance, for example, major acquisitions or disposals. These could be audited prior to year-end.

Events or transactions that occur throughout the year could be reviewed prior to year-end and then updated at year-end.

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Some general audit procedures could be performed during the year, such as reviewing board minutes and some statutory records. These are updated at year-end.

Provisions can be reviewed prior to year-end, then updated and checked to see if the final balances agree with the auditor’s expectations formed at the interim date.

The external auditor could use results from the internal audit function to increase their understanding of internal controls.

REVIEW QUESTION 10.3 LO 1 During the control risk assessment phase the auditor gathers evidence about the design and performance effectiveness of the client’s internal controls. This evidence provides a basis for the control risk assessment for each account, and the subsequent design of the substantive procedures. If a high control risk is identified, it is important that the auditor designs the nature of substantive testing to provide more persuasive evidence. If a low control risk is identified, the auditor need not obtain as persuasive evidence from substantive tests (there may even be no substantive testing performed). The nature of substantive testing must be appropriate and fully reflective of the control risk (and inherent risk) assessment and the expectation of the likelihood of errors of audit importance occurring.

REVIEW QUESTION 10.4 LO 2 The processes impacting the cash balance are the cash receipts and cash payments processes. If the auditor has performed controls testing for these processes and concluded that the controls are effective and can be relied upon, it is unlikely that any additional tests related to the processes would be performed. The auditor would rely on substantive testing of the cash balance at year-end. However, if substantive testing of the significant transactions is required (because control testing did not provide sufficient evidence or it is considered more efficient to test the transactions), examples of the procedures are listed in table 10.2.

Substantive testing of cash balance at year-end is focused on existence, completeness, and classification of the cash balance. Existence is normally tested through a bank confirmation. Completeness tests focus on testing the client’s bank reconciliation and cut-off of cash transactions. Further examples of substantive tests for year-end cash balances are provided in Table 10.3.

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REVIEW QUESTION 10.5 LO 4 The auditor would compare the dates for posting of purchases, production, transfers, acquisitions, disposals, and shipments of inventories with the inventory records and the general ledger accounts. This would involve both vouching the inventory records and ledger accounts to the supporting documentation (occurrence), and tracing the documents to the inventory records and ledger accounts (completeness). The auditor would also reconcile the document numbers for internally generated documents (including receiving reports, sales invoices, inventory count tags, etc). Establishing the last document number for the financial period assists the cut-off verification process. Any documents with lower numbers than the last document number should be recorded in the current financial period, those with higher numbers should be recorded in the next financial period.

REVIEW QUESTION 10.6 LO 4 Some clients conduct inventory counts once a year, while other clients perform inventory counts on a cyclical basis. A cyclical inventory count is performed by counting a small number of items on multiple days throughout the year. For both types of counts, the number of items obtained by counting is compared with the number of those items recorded in the inventory records.

The inventory count should also consider the condition of the inventory (i.e., damaged or obsolete inventory should be removed from the record of saleable items).

Cycle counting is easier to implement when the company has better controls over inventory because the inventory records are constantly updated. If the company has a periodic inventory control system, there is no current record for the number of items held by the client. Another factor which affects the choice between annual and cyclical inventory counts is the physical conditions in which the inventory count has to be performed. If conditions are difficult, annual counting is preferred.

REVIEW QUESTION 10.7 LO 3 Subsequent receipts testing is vouching the trade receivables at year-end to the subsequent receipt of cash from the customer. This provides evidence about valuation at year-end because the customer has subsequently paid the account. If it is paid after year-end, it is valued appropriately at year-end. If an account is not paid, there is some doubt about its valuation at year-end. The customer might pay at a later date, or there could be a dispute or a bad debt.

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REVIEW QUESTION 10.8 LO 5 Misclassification of repairs and maintenance potentially affects both the expense account and the PPE (property, plant, and equipment) asset account. The accounting standards require capitalization of some expenditures into the PPE asset account (e.g., improvements such as extensions, upgrades) and other items must be treated as expenses (e.g., repairs due to damage, replacing worn out parts). Therefore, the auditor is interested in examining debits to both accounts to assess whether they are correctly classified as capital (which should be a debit to the PPE asset account) or expense (which should be a debit to the repairs and maintenance account) items.

If capital items are misclassified as expenses, the PPE completeness (separate asset missing from the account) or valuation and allocation (improvement to asset not recognized in the balance) assertions are at risk, and the repairs and maintenance occurrence assertion is at risk. If expenses are misclassified as capital items, the PPE existence (a separate asset which does not exist is included in the account) or valuation and allocation (repair treated as an improvement to asset) assertions are at risk, and the repairs and maintenance completeness assertion is at risk.

REVIEW QUESTION 10.9 LO 5 If an item of PPE (property, plant, and equipment) is not currently being used (or will become idle in the near future), it could be evidence of the item’s obsolescence. An obsolete item of PPE would likely have an impaired value, which should be recognized in the accounts as an asset impairment charge (valuation and allocation assertion). An idle asset could also be evidence of a significant drop in production, or a change in production. Significant production changes could lead to more items being recognized as obsolete, and could be an early indicator of going concern problems.

An auditor would review directors’ board minutes to gather evidence about production plans and asset disposal plans for the foreseeable future and for any specific discussion of asset values. This evidence would form part of the basis for conclusions with respect to asset valuations.

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REVIEW QUESTION 10.10 LO 6 The completeness assertion relates to the objective of ensuring that the balance sheet accounts are not understated. Although this is important for assets, it is generally more important for liabilities because the consequences are likely to be more serious. If assets have to be revised upwards at a later date, shareholders' equity becomes greater. If liabilities have to be revised upwards at a later date, shareholders equity becomes smaller, potentially negative, which could result in the client’s liquidation.

Typical procedures used to address the completeness assertion for payables include: • Testing the occurrence of cash payments (to ensure that a payable is not incorrectly recorded as paid) • Testing the completeness of purchasing (to ensure that a payable is not incorrectly omitted from the balance sheet) • Testing the accuracy and cut-off of purchases and cash payments • Subsequent payments testing (to detect payments of payables which were not recorded at year-end) • Reviewing payables ledger and cash payments ledger for unusual items • Search for unrecorded liabilities at inventory count date and/or year end • Compare a list of payables with those of prior periods, investigate any unexpected changes (or absence of changes), such as suppliers, ageing, pattern of purchases • Compare payables in subledger with general ledger account • Review board minutes for discussion of major suppliers.

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SOLUTIONS TO PROFESSIONAL APPLICATION QUESTIONS PROFESSIONAL APPLICATION 10.1 – Designing audit procedures for cash LO 1, 2 (a) • • • • • • •

Controls should include: Separate bank deposit books and cheque books for each cash account Bank reconciliations for each bank account Segregation of duties – banking, reconciliations, cheque authorization, posting to customer ledger accounts, and segregation of these duties from staff performing tenancy search and management services Accountability/reconciliation of numerical sequence of all forms (cheques, deposits, vouchers) Mail opening procedures (for any amounts received by post) – two people, listing, reconciliation with bank deposits Supervision of customer ledger postings Specific procedures for dealing with trust account – additional authorization procedures

(b) Cash is a significant account balance for this business Substantive procedures include: • Bank confirmations – all bank accounts, liens • Testing bank reconciliations • Confirm signatures on cheques for correct authorization • Testing cut-off for cheques remitted to customers (reconcile with customer accounts) and transfers between cash accounts (especially to ensure that withdrawals and deposits for account transfers are recognized on the same day) • Correlate cash receipts and cheques to movements in customer accounts • Compare paid cheques and supporting documents with cash payments ledger – confirm dates, payees, amounts, account classifications, and cancelling of supporting documents • Compare entries in cash payments ledger with paid cheques and supporting documents to confirm dates, payees, amounts, account classifications, and cancelling of supporting documents • Compare entries in cash receipts ledger and supporting documents to tenants accounts • Test calculations of commission before remittance of rental payments to landlord customer • Investigate for any unusual delays in remitting rental payments to landlord customers • Test mathematical accuracy of cash receipts, cash payments ledger • Test supervision reports for evidence of timely review, authorization, and evidence of follow-up of differences Solutions Manual 10-7 Chapter 10 Copyright © 2012 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of this page is strictly prohibited.

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PROFESSIONAL APPLICATION 10.2 – Accounts receivable confirmation LO 1, 3 (a) The change in credit terms means that there are less strict controls over accounts receivable (debtors). In the past, Albert required a security deposit from smaller retailers and did not give credit until a satisfactory credit check was completed for each new retailer. In addition, terms of payment were seven days. The new credit terms still mean that a credit check is performed for new retailers, but security deposits are no longer required and the customers have 30 days instead of 7 days to pay their accounts.

Previously, an account that was unpaid after 7 days was in arrears, creating doubt about its recoverability. In these cases, Albert would take action to recover the account (including using the security deposit to repay the balance due and refusing to advance further credit). Now, Albert does not know if an account that is unpaid after 30 days is in doubt. The additional time delay before Albert can take action increases the likelihood that the full amount will not be recovered. In addition, the lack of a security deposit means that there is not such an easy way to recover outstanding accounts.

Overall, the valuation and allocation assertion for accounts receivable is at greater risk because it is more likely that there are amounts owed to Albert from its customers that will not be paid in full. (b) The change in credit terms should be recognized in the audit program for accounts receivable. Additional testing should be done over the new control system, such as the credit checks. Additional substantive testing is required to assess the valuation and allocation assertion.

These procedures include: • Additional confirmation of accounts receivable (larger sample – see below) • Substantive receipt testing for the following 30 days • Vouching of invoices remaining in accounts receivables’ balances at year-end to underlying documentation • Reading correspondence with credit customers , including attempts to recover balances owing that are paid late and any disputes relating to product quality • Ageing of accounts receivable – review reports and follow-up actions by supervisor • Analysis of new credit customers – history of making timely payments • Additional testing of sales returns • Greater testing of cut-off for sales invoices and cash receipts • Review of allowance for doubtful accounts – underlying assumptions need to be changed from previous year to recognize changed credit terms • Test mathematical accuracy of the accounts receivable ledger – likely to be a larger balance than in previous years.

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(c) The sample of accounts receivable should focus on the greater risk of misstatement. The assertions most at risk are valuation and allocation and existence. Select large accounts at year-end for testing as these contain most risk. Additionally, select a random sample from smaller balances. There could be an additional sample based on new customers – those attracted by the new relaxed credit terms are more likely to have difficulty paying accounts.

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PROFESSIONAL APPLICATION 10.3 – Accounts receivable ledger LO 1, 3, 8 (a) Internally generated documents are often numbered consecutively. The numbers provide a convenient reference for the audit trail. For example, the sales invoice number is used to identify the document underlying the transaction entered into the sales journal. In addition, the numbers reveal if a document has been omitted from the records, or duplicated in the records.

The control is stronger if the numbers are preprinted on the forms or automatically numbered by the software program when the invoice is generated (because they cannot be duplicated). For example, the sales invoices should be entered consecutively in the sales journal. If a number appears twice, there is an error because two valid invoices cannot have the same number. If the sales invoices in the sales journal omit a number, the original document should be accounted for (i.e., the document is cancelled and filed in a cancelled document file).

The numerical sequence is also useful for cut-off testing. The auditor should establish the last valid number for the current financial year and ensure that all documents for previous numbers are recorded for the current year, and all subsequent numbered documents are recorded in the next financial year.

All documents mentioned are internally generated documents and should be preprinted (for forms that are completed by hand) or numbered by the computer software when the electronic form is generated. (b) Credit memos are the documentary basis for a credit to accounts receivable (debtors) and a corresponding debit to sales returns and allowances. These entries result in a lower balance for accounts receivable and an increased expense (or reduced revenue). They are used to reverse a recorded sale. The greater audit risk for accounts receivable and sales relates to their overstatement, thus the auditors are particularly interested in any evidence that a recorded sale was not valid.

Victoria would be worried that credit memos and the resulting credits to accounts receivable and debits to sales returns and allowance are made following the year-end to reverse invalid sales recorded in the current financial year. These reversals could be processed after year-end. Therefore, Victoria wants evidence about the validity of sales returns in July, to provide evidence about the validity of sales prior to year-end.

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(c) Victoria would undertake some substantive testing herself because the audit assistants are inexperienced; they would be less likely to detect ‘unusual’ relationships because they are not familiar enough with what is ‘usual’. In some cases, a lack of fluctuation in an account can raise more questions than a fluctuation because other evidence suggests that the account balance should be different. A more senior auditor would have a better understanding of how non-financial information relates to financial data.

Other tasks usually performed by more senior auditors would be interviewing senior client personnel, including directors, obtaining access to confidential documents and board meeting minutes (where a junior auditor would not understand the discussion), communicating with external parties such as solicitors about complex matters, making judgement estimates, such as the allowance for doubtful accounts , speaking to experts about valuations, auditing complex accounts, such as derivatives, auditing disclosures such as related parties, reading contracts between the client and its customers/suppliers/employees, reading contracts for leasing of property, plant, and equipment (PPE).

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PROFESSIONAL APPLICATION 10.4 – Valuation of PPE, additions, and disposals LO 1, 5 (a) Mothballing is a process of removing property, plant, and equipment (PPE) from active use and making it safe for storage until it is required again. Some equipment requires modification for storage (draining fuel, removing parts), and must be stored under cover. Other equipment can be stored in a safe external environment. In some cases, a caretaker is employed to ensure that conditions remain safe.

The implication for auditing is to consider whether there are sufficient controls over the safety of equipment such that its existence and value are protected.

Are the measures in place going to protect the equipment from damage or theft? Are disposals correctly recorded during this period? How will an auditor physically sight assets that are mothballed at a remote mine site?

There would be questions over the equipment’s valuation – should an asset impairment be recognized in the financial statement accounts to reflect the cost of restoring the equipment to production? Should depreciation continue to be charged if the asset is idle? Are rights and obligations for the assets protected – what duties do the lease contracts or lending contracts impose upon the client? (b) The mothballing process would require the auditor to reconsider the controls over PPE because conditions are changing significantly. If a substantive approach is adopted, the auditor would inspect documents authorizing the process. In addition, the following procedures could be adopted: • Test assumptions underlying PPE valuation and impairment charges and review charges for reasonableness • Test mathematical accuracy of any depreciation charges for the period • Inspect mothballed assets • Review cash receipts journal for evidence of PPE disposals • Examine underlying documents for any asset acquisitions during the period • Review repairs and maintenance account for reasonableness in the new conditions • Review tax returns for claims relating to mothballing assets • Review board meeting minutes and any relevant legal documents for authorization of mothballing assets • Examine financing contracts and consider the reasonableness of the client’s actions with respect to any duties for safe handling of assets • Inquire of management about plans for continuing mothballing or reassigning assets to other locations

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PROFESSIONAL APPLICATION 10.5 – Inventory LO 1, 4 (a) Controls at the local store level include: • Locked doors to store and to any warehouse area • Receiving documents when goods are received from the supplier • Any discrepancies in deliveries are reported to the central office for backorder • Electronic tills record inventory items and update store stock records • Cyclical inventory counts reconciled to store inventory records • Obsolete, damaged, or impaired inventory is identified promptly Controls at the central office include: • Purchase orders are placed with approved suppliers • Invoices from suppliers are not paid until local store receiving reports are reconciled with purchase order and supplier invoice – quantities and prices for each unit, and overall accuracy of invoice is verified (quantities and prices total correctly) – voucher prepared before payment • Invoice payment is authorized by a senior staff member who does not participate in placing purchase orders • Inventory records are reconciled to the store level inventory records (b) Brompton conducts cyclical inventory counts during the year at each store location. Therefore, the auditor would substantiate a sample of these inventory counts.

The auditor would observe the inventory count to establish that • the client’s personnel are complying with the instructions for taking the counts • items belong to the client, and those the client is responsible for, are accurately counted and recorded • items to be excluded from the inventory count (such as those with no value or belonging to others) are either subject to satisfactory control and excluded • count tags, sheets, or cards are properly controlled.

The auditor would also perform test counts of the client’s counts (from tags to items, and from items to tags), and trace the tags to the inventory records (including treatment of unused, voided, etc tags).

The auditor would inspect documents for receiving and any transfer between stores, to establish the numbers of the last documents used and other information required for cut-off of inventory movements in accounting records.

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The auditor would also perform procedures to verify inventory valuation. This would include identification of obsolete, slow-moving, damaged items.

Inventory records would be inspected for evidence of correct pricing and record of cost of goods sold.

Analytical procedures would compare physical item numbers and pricing, compared with previous periods, comparisons across stores (by month, product line).

Additional procedures listed in table 10.9.

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PROFESSIONAL APPLICATION 10.6 – Payables cut-off testing LO 1, 6 (a) In general, the key assertions for payables are usually completeness and valuation and allocation. This is because the bigger risk is that the client has omitted amounts from the balance, which is then understated.

For Hyde Ltd, the disruption in the accounts department has increased the risk for all assertions because there is an increased risk of mistake and error.

The disruption also means that former systems of segregation of duties (such as preparation of cheques for payment and updating suppliers' ledgers) will not be as effective because some staff are required to perform additional duties. The lack of control increases the risk of individual fraud, creating the risk that accounts payable are not valid (existence assertion) because personal expenses are being treated as business expenses. (b) Payments made after the year-end are evidence of an amount owing by the client to another party. Subsequent payments testing is the process of vouching sample of payments made after year-end to supporting invoices.

The purpose of the test is to ensure that if the date of the invoice relates to the period prior to year-end, the payable is shown in the accounts at year-end.

The auditor would select a sample of payments made after year-end. If the key assertions at risk are valuation and allocation and completeness, the auditor is most concerned about large payables that are not included in the accounts payable balance at year-end. This would suggest that large payments are more likely to be selected. In addition, the closer the date of payment to year-end, the more likely that the amount was owing at year-end, so these are more likely to be selected. The auditor might also select payments to suppliers that were not included in the list of accounts payable at year-end, or suppliers that are new to the client. (c) Cut-off testing is establishing the last valid transaction (using document numbers) in the current financial year and testing transactions with lower document numbers to ensure that they are included in the current financial year, and transactions with higher document numbers to ensure that they are included in the next financial year. The testing is not confined to cash payments; cut-off testing can include any transaction, such as inventory transfers, supplier and customer invoices, cash receipts and payments, etc. In the accounts payable area, the auditor would focus on a sample of purchases, and a sample of purchase returns, either side of the reporting date to ensure they are being processed in the correct accounting period.

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PROFESSIONAL APPLICATION 10.7 – Substantive testing of inventory LO 1, 4 (a) Securimax is a manufacturer so it would hold inventory in the form of raw materials (RM), work-in-process (WIP), and finished goods (FG). Depending on the nature of waste and damage to vehicles in production and the value of these items, there could be another inventory category to represent these items.

RM would be held at the purchase price, or net realisable value if purchase price overstated the net realizable value (NRV. WIP would be held at the cost of production. The manufacturing costing system would be used to calculate costs of RM, labour and machinery time, and overheads applicable to each unit based on its degree of completion. The ‘Terrain Master’ product is likely to be completed on a batch basis; that is, different government clients are likely to order the vehicle with different specifications. Each specification type would have a different manufacturing cost representing the different components, labour and machinery time, and overhead used in production.

FG would be held at the lower of cost of production and NRV. Any damaged or waste items would be held at NRV. (b) The key risk assertions for Securimax’s inventory are valuation and allocation and existence. In addition, complex sales agreements could mean that the rights and obligations assertion is at risk if ownership of the vehicles passes to the buyer at an early stage of production (this issue would be determined by reading the sales contracts).

Existence would be tested by seeing a sample of inventory.

Valuation and allocation is the most difficult to audit because of the complexity of valuation of WIP and FG. The installation of a new product costing system means that the auditor does not have assurance about the controls over inventory costing based on prior year audit evidence. The products are highly specialized and sophisticated and there would be numerous assumptions embedded into the decisions about cost allocation of RM, labour and machinery hours and overheads to individual products.

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Substantive procedures would include: • testing of RM costing through comparison of purchase requisitions, purchase orders, receiving documents, and vendors’ invoices • testing of posting of purchases, production transfers to the inventory records • Testing of recording of inventory movements to the general ledger accounts • Test mathematical accuracy of invoices, purchases register • Test timely recording of purchases to purchase order register, invoices to creditors ledger • Test physical inventory count of RM, WIP, FG, and waste inventories • Perform test counts and trace client count documents (inventory tags, sheets) to inventory records and general ledger.

• Vouch general ledger and inventory records to underlying client count documents and purchase documents, inventory transfer documents • Perform cut-off procedures around inventory purchases, transfers • Test valuation of inventory through analytical procedures (e.g., analyze turnover, units produced and sold with RM, WIP, FG movements and balances) • Review reconciliation of physical inventory counts with general ledger and inventory records • Investigate large and unusual differences • Compare manufacturing budgets with actual, investigate differences • Assess reasonableness of assumptions underlying standard costing used • Compare current period labour and machinery usage with previous year s and investigate any unusual fluctuations • Inspect waste, damage items • Review minutes for discussion of waste, difficulties with customer orders, etc • Compare cost assigned to RM, WIP, FG, waste with NRV Other tests in table 10.9.

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PROFESSIONAL APPLICATION 10.8 – Substantive testing of PPE LO 1, 2 (a) An increase in property, plant, and equipment (PPE) acquisitions suggests that the risk would be related to overstatement of PPE – existence and valuation and allocation assertions. The analytical procedures have detected a fluctuation which could be explained by the large investment in a new manufacturing process. The auditor needs to consider if the increase is consistent with this investment. It is possible, for example, that old equipment is being disposed of and the overall balance of PPE is not excessive. The acquisitions need to be assessed for their appropriate valuation in the accounts. Are the acquisition costs to be treated as capital, or are there costs associated with the acquisitions that should be expensed? Is any part of the cost of purchase to be written off as an impairment charge to recognize the recoverable value?

Another assertion that is at risk when there are increased PPE acquisitions is rights and obligations. Are the new acquisitions being purchased or are they being acquired under lease or other forms of finance? Are there additional disclosures required to recognize these financing arrangements? (b) Substantive tests of details that would be appropriate include: • Recalculation of new depreciation charges, consideration of underlying assumptions of useful life, residual value, etc (V&A) • Inspect authorizations for acquisitions (R&O) • Examine cash payments, invoices for new acquisitions (V&A) • Compare actual costs with authorized costs (E, V&A) • Inspect assets (E) and vouch entries in fixed asset register (E) • Test mathematical accuracy of fixed asset register (V&A) • Review documents relating to financing for fixed asset acquisitions (R&O, V&A), evidence of ownership (R&O) and review financial statement disclosures (C&U) • Consider likelihood of continued production using new assets (V&A) (c) If the PPE additions have been manufactured in-house the auditor should focus on the process of assigning costs to the assets. Therefore, instead of reviewing documents relating to evidence of ownership of the asset or its purchase, the auditor would focus on testing the data and assumptions supporting the manufacturing cost allocations. The auditor would still be concerned with gathering evidence to support the existence and valuation and allocation assertions.

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PROFESSIONAL APPLICATION 10.9 –Accounts Receivable confirmations LO 2, 3, 4 (a) The key assertions at risk are existence and valuation and allocation.

Confirmation addresses the existence assertion. This indicates that it will be most useful to confirm large accounts receivable balances (debtors), as these are more likely to be overstated than small accounts receivable. However, a large number of small accounts receivable balances that do not exist could also result in a large overstatement. Accounts receivable balances that have been outstanding for a longer period of time are more likely than new accounts receivable balances to be invalid, suggesting that older accounts receivable should also be targeted for confirmation.

Stratify the sample. Choose a sample of large accounts receivable balances (select all five large accounts receivable balances and a sample of the group with moderate balances) and a sample of older accounts receivable balances (outstanding for more than 60 days) for confirmation. Take smaller samples from the remaining group of accounts receivable. Also send confirmations to new accounts with significant balances or accounts with significantly different balances or activity from previous periods. (b) Any non-responses should be investigated through other procedures. For example, subsequent receipts testing would provide evidence of payment.

Other procedures for the non-responses: • Trace entries in the accounts receivable balance to the underlying documents, including invoices; agree dates, customer, services, amounts • Test mathematical accuracy of the accounts receivable balances • Examine any allowances to the accounts receivable in the subsequent period. Test for authorization of discounts or credits.

• Examine any invoices issued to these customers in the subsequent period to verify the validity of these accounts • Test cut-off for these accounts by inspecting invoices and other supporting documents before and after cut-off date • Examine the adequacy of the allowance for doubtful accounts for these accounts

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PROFESSIONAL APPLICATION 10.10 – Payables’ confirmations LO 1, 2 (a) The biggest risk for payables is that it is understated. Sending confirmation requests to large accounts payable balances shown in the accounts does not address the risk of understatement. The auditor should focus on the completeness assertion and the valuation and allocation assertion. (b) Substantive procedures include: • Test cut-off for cash payments at year-end • Account for numerical sequence of cheques issued • Compare paid cheques with supporting documents for accounts payable • Trace from purchase register and creditors’ subledger to general ledger • Examine subsequent payments to detect unrecorded accounts payable at year-end • Search for invoices held but not yet recorded in accounts payable ledger • Test mathematical accuracy of creditors ledger • Compare accounts payable balances with previous years and investigate any missing from current period list or those with substantially lower balances or differences in ageing • Compare number of days purchases in accounts payable with prior years • Read directors meeting minutes for authorization of loans between the client and banks or its directors, pledges, or mortgages • Perform bank confirmation and request solicitor representation letter • Test mathematical accuracy of accruals • Review debit memos or purchases allowance after year-end • Compare payroll expense and provisions with previous years

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PROFESSIONAL APPLICATION 10.11 – Substantive procedures LO 3, 6 (a) Existence or occurrence of sales: • Reconcile sales invoices to general ledger account (compare total sales invoices for the period to sales total in the general ledger and determine the source of any discrepancies).

• Trace from sales invoices to shipping documents. (b) Completeness of accounts payable: • List vendor invoices for the 2-week period subsequent to the year end, and determine when the goods were received.

• Review receiving reports for a period (say, 1 week) prior to the year end, and ensure they are included in the accounts payable. (c) Valuations or measurement of accounts receivable: • Reconcile sub-ledgers to the control account in the general ledger.

• Send confirmations to customers.

• Review payment history of selected accounts and/or payments after year end.

• Review customer correspondence for evidence of dispute of amounts.

• Review methods used in estimating the allowance for doubtful accounts.

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PROFESSIONAL APPLICATION 10.12 – Substantive procedures LO 5 (a) You should personally inspect the fixed assets in question and verify serial numbers or other identification. (b) Completeness: • Verify that all fixed assets noted on the plant tour are included on the continuity schedule for fixed assets.

• Agree the opening balance to the prior year’s audited ending balances, vouch disposals to ascertain completeness, and agree the closing balances to the general ledger.

• Review the details of repairs and maintenance for large or unusual items to see if they should be reclassified as fixed assets.

Ownership: • Review the title documents for significant fixed assets purchased during the year.

• Enquire of management about liens on fixed assets, and review the terms of mortgages, bond indentures, and equipment trust certificates.

• Review insurance policies to ensure that recorded fixed assets are properly insured (if clients do not own an asset, they would be unlikely to insure it).

• Review minutes of board meetings for approval of major asset acquisitions and credit arrangements (mortgages, bond indentures, and so on).

PROFESSIONAL APPLICATION 10.13 – Substantive procedures to achieve audit objectives.

LO 4 Suggested Solution: 1. d.

2. d.

3. b.

4. e.

5. c.

PROFESSIONAL APPLICATION 10.14 – Identifying assertions LO 6 Suggested Solution: 1. Existence 2. Existence 3. Classification 4. Valuation and Allocation 5. Completeness Solutions Manual 10-22 Chapter 10 Copyright © 2012 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of this page is strictly prohibited.

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CASES 10.15 – Floral Impressions Ltd. (a) Three factors that have changed over the prior year that impact the audit risk assessment for the current year, and an indication of how these factors influence audit risk include: • A new lender is relying on the financial statements.

• Liz received stock options for the first time, and she has a potential bias to show revenue increases. We will therefore need to do more work to ensure that revenue is fairly stated. This risk is mitigated by the fact that Liz is a major shareholder in the company and is not likely to be so biased that she would risk the viability of the company overall.

• For three months during the year, FIL lacked an adequate replacement for the controller.

• There is little segregation of duties since the number of head office employees is low.

All of the above factors would increase audit risk. Overall audit risk for this audit engagement would be high. (b) The two primary audit assertions B&B should be concerned with over the accounts receivable of FIL are existence and valuation. (c) A substantive audit program of at least five procedures for B&B over the accounts receivable could include: • Reconcile A/R sub-ledger to the control account in the general ledger.

• Send confirmations to customers.

• Vouch subsequent receipts.

• Review customer correspondence for evidence of dispute of amounts.

• Review methods used in estimating the allowance for doubtful accounts. (d) A substantive audit program for B&B of at least five procedures relating to the new line of credit could include the following substantive audit procedures: • Examine any new debt agreements and determine status of existing agreements.

• Trace large cash receipts/ disbursements to source documents and general ledger.

• Confirmation of long term liabilities (notes/bonds payable) — i.e., confirm amount, interest rates, due date, collateral, restrictive debt covenants, etc.

• Analytical relationships with interest expense can be used to recalculate interest expense during the period – compare to client’s interest expense and accrual recorded and assess whether any issues exist.

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Auditing: A Practical Approach, First Canadian Edition

Examine debt agreements to ensure all note disclosure details are provided — i.e., any restrictive covenants, due dates, interest rates, maturity dates, and redemption privileges.

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Case Study — Cloud 9 Based on your overall risk assessment (ORA) and detection risk (DR) estimates, design substantive audit procedures for Cloud 9 that would address the detection risk for the accounts: (1) accounts receivable (do not include the allowance for doubtful accounts), and (2) cash.

Solution – includes solutions for chapters 10 and 11 1.

Complete the table to determine the Combined Risk Assessment and acceptable Detection Risk.

Account Assertion Sales – Occurrence

IR High

CR Medium

ORA Higher

DR Lower

Sales - Completeness

Low

Low

Lowest

Highest

A/R – Existence

Medium

Medium

Medium

Medium

A/R – Completeness

Low

Low

Lowest

Highest

Cash – Existence

High

Low

Medium

Medium

Cash – Completeness

Low

Low

Lowest

Highest

Design substantive audit procedures for the three accounts – cash, accounts receivable (do not include the allowance for doubtful accounts), and sales – that would address the detection risk of each account. When determining testing thresholds for your detail procedures, consider using a percentage of performance materiality (PM).

NOTE: The percentages used to determine testing thresholds are based on the auditor’s professional judgment. Students do not have to have the same percentages, but should demonstrate an understanding of performance materiality.

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Assertions E V C R&O P&D Cash 1 Bank Confirmations:

X X X

X

X

X

X

Obtain bank confirmations for all accounts, including the accounts closed during the year to confirm the relationship with the bank including contingencies, liens, pledges, restrictions on the client´s assets, guaranteed amounts, etc.

2 Analytical Review:

X X X

Compare the listing of cash accounts with those of prior periods and investigate any unexpected changes (e.g., credit balances, unusual large balances, new accounts, closed accounts) or the absence of expected changes.

3 Bank Reconciliations:

X X X

Examine the client's bank reconciliation as of year-end, including cash-in-transit accounts, to verify the proper reconciliation of bank statements and general ledger accounts. (a) Trace the bank balance to the confirmation. (b) Trace the book balance to the general ledger. (c) Test the clerical accuracy of the reconciliation. (d) For those greater than 80% PM, test deposits in transit and selected outstanding checks by tracing from the bank reconciliations to the cut-off bank statement (or subsequent month's bank statement) and vice versa. (e) Review the nature and extent of other reconciling items for reasonableness and investigate any large (> 80% PM) or unusual reconciling items.

4 Cash cut-off:

X

X

Test cut-off of cash receipts and cash disbursements for transfers between different bank accounts at the balance sheet date. (a) Obtain or prepare a schedule of bank transfers made in the 5 days before and after year end. For those greater than 80% PM, trace to the bank statements.

5 Cash Reconciliation:

X X X

Examine the client's year-end reconciliation of physical cash on hand to cash accounts balances in the books.

Investigate large (> 80% PM) or unusual reconciling items and determine the proper revenue recognition.

6 Valuation of coupons and vouchers:

X X

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Test that coupons, gift vouchers, and tokens at year end closing are carried in accordance with the client's accounting policies or applicable financial reporting framework and determine appropriate revenue recognition.

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Assertions E V C R&O P&D Accounts Receivable trade 1 Agreement of sub-ledger with general ledger:

X

X

Agree receivables sub-ledger to the general ledger and investigate large (> 80% PM) and unusual reconciling items.

2 Analytical review:

X X X

X

Compare the aged listing of accounts receivable with those of prior periods and note any significant changes (e.g., changes in major customers, in major customers’ balances in the percentage of overdue accounts, in the proportion of credit balances). Obtain explanations for unexpected changes.

3 Confirmations and subsequent cash receipts:

X X

X

X

Verify the existence of accounts receivable trade through confirmation or subsequent cash receipts or a combination of those procedures. (a) Select customer account balances greater than 50% PM to prepare and send positive confirmations of year end balances. (b) For confirmation requests for which no reply is received, vouch customer account balance through cash receipts received after year end. If amounts still remain untested, then vouch to the supporting invoice and dispatch note.

4 Accounts receivable cut-off:

X

X

X

X

Inspect sales register, billings, shipping documents and other supporting documents 5 days before and 5 days after the year-end date. Select those transactions greater than 80% PM and verify that the sales were recorded in the proper period.

5 Credit balances and unusual items: Inquire about or review list of credit balances and investigate large items.

6 Allowance for returned goods:

X X X

X

X

Evaluate significant assumptions made regarding the frequency/ percentage of goods returned for which refunds are given and verify mathematical correctness of respective allowance.

7 Credit (card) fraud:

X X

Consider the risks arising from fraudulent credit card use and other credit payment options to assess the need to Solutions Manual 10-28 Chapter 10 Copyright © 2012 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of this page is strictly prohibited.

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provide for such losses.

O

Assertions A C P&D

X

X

Revenue / Sales 1

Analytical review:

X

Perform an analytical review and investigate any significant changes or lack of expected changes.

2

Analytical review of gross margin:

X

X

X

Review the monthly/quarterly trading results to gain an understanding of the trends relating to gross margin by major product groups/ geographical areas/ income generating units. Investigate unusual discrepancies, trends and relationships.

3

Revenue recognition procedures:

X

Test recorded sales invoices to the records of products shipped; agree dates, customers, products, quantities, prices and amounts. Select the sample so as to ensure at least 25% of the revenue balance has been tested.

4

Sales cut-off:

X

X

Refer to work performed in Accounts Receivable 5

Credit memos:

X

X

Investigate large or unusual credit memos issued subsequent to year end. Co-ordinate with the work performed in Accounts Receivable.

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RESEARCH QUESTION 10.1 – The trend to use fair value measurement in accounting standards The guidelines for auditing fair values are contained in CAS 540 Auditing Accounting Estimates, including Fair Value Accounting Estimates, and Related Disclosures (ISA 540). CAS 540 (ISA 540) discusses the requirements for auditing accounting estimates, including fair value accounting estimates and related disclosures.

The standard requires the auditor to obtain sufficient appropriate evidence about whether the estimates are reasonable. The auditor should assess how management makes the relevant accounting estimates and should also understand the data on which the estimates are based. The auditor would consider the relevant controls and whether external experts have been used.

The auditor should determine whether the management has appropriately applied the relevant accounting standards, and whether the estimates have been made consistently and appropriately. The procedures used by the auditor include testing the method and data, and the reasonableness of the underlying assumptions. The auditor should also develop an estimate to compare with management’s estimate.

CAS 540 recognizes that greater uncertainty exists for some estimates, and management could be more biased under some conditions. In some cases, the estimation uncertainly is so high that a reasonable accounting estimate cannot be made. This could be dealt with by additional disclosure of the range of the estimate and the uncertainty associated with them.

The student should consider: • the factors that make fair value estimates difficult to audit and compare those with the factors that make other accounting balances and disclosures difficult to audit.

• The benefit to financial statement users of fair value disclosures in a time of uncertainty and the perceived cost to auditors of making mistakes when auditing estimates.

• Relevant press reports of problem cases — e.g., fair value accounting during the global financial crisis when it was claimed that markets for some assets were not functioning, or rapidly changing market conditions.

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Legal Notice Copyright

Copyright © 2012 by John Wiley & Sons Canada, Ltd. or related companies.

All rights reserved.

The data contained in these files are protected by copyright. This manual is furnished under licence and may be used only in accordance with the terms of such licence.

The material provided herein may not be downloaded, reproduced, stored in a retrieval system, modified, made available on a network, used to create derivative works, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise without the prior written permission of John Wiley & Sons Canada, Ltd.

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Solutions Manual to accompany

Auditing: a practical approach by

Robyn Moroney Fiona Campbell Jane Hamilton Valerie Warren

CHAPTER 11 Substantive testing and income statement accounts

John Wiley & Sons Canada, Ltd. 2012

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Chapter 11 – Substantive testing and income statement accounts SOLUTIONS TO REVIEW QUESTIONS REVIEW QUESTION 11.1 LO 1 Balance sheet accounts are ‘permanent’ and their balance is carried forward from one period to the next. Income statement accounts are ‘temporary’ and their balance is closed to the income account at the end of each financial year. Therefore, the audit work done in one year on a balance sheet account carries forward to the next year, but the audit work done in one year on an income statement account does not.

Another difference is that income statement accounts typically comprise many transactions of the same type and are usually exclusively either debit or credit (except for closing or correcting entries). Balance sheet accounts may contain very few entries, but they could be both debits and credits and the transactions could be made up of several different types of transactions. This means that controls over income statement accounts typically are designed to control the regular type of transaction, but controls are not usually so standardized for balance sheet accounts.

The balances of payables and receivables (balance sheet accounts) are typically made up of the purchases, expenses, and revenue transactions from the last 30 or 60 days. Income accounts, such as sales, purchases, and other revenues and expenses, comprise the transactions from the entire year.

Audit testing needs to take all these factors into account. The focus for substantive testing for income statements is on testing the assertions for a year of transactions, which are relatively regular and predictable. Analytical procedures are useful for this type of auditing because of the predictable patterns between the revenue and expense accounts, and between them other measures of activity.

Analytical procedures are more likely to be chosen as the type (nature) of substantive testing for income accounts than for balance sheet accounts. This is supplemented with some tests of details, such as vouching back to underlying documentation.

Timing of substantive procedures for income accounts can be done during interim periods, to confirm relationships, although cut-off testing is done at the year-end.

The extent of substantive testing is usually less for income accounts relative to the number of transactions because of a greater reliance on control testing.

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REVIEW QUESTION 11.2 LO 2 The most important assertions for sales revenue are occurrence, accuracy, and cut-off. Occurrence relates to the fact that the sale actually occurred. It is important to gather evidence that revenue recognition has taken place at an appropriate point in the sales cycle. Accuracy means that the sale has been recorded at the correct amount, and not overstated. Cut-off means that the sale is recorded in the correct accounting period.

Sales revenue could be related to goods or services. If the revenue is derived from selling services the auditor has to gather evidence on whether the service has actually been delivered to the customer. In the case of contracts with progress billings, the auditor has to test the percentage of completion for the contract in order to determine the appropriate amount of revenue. The important assertions for service revenue are also occurrence and accuracy and cut-off.

Other revenue items include interest or dividend income. These can be substantiated using analytical procedures, bank and dividend statements.

Once again, the same assertions are important for these revenue items even though the substantive procedures vary.

REVIEW QUESTION 11.3 LO 2 The cut-off assertion relates to recording revenues and expenses in the correct accounting period. The date that revenue is earned or the expense incurred determines the appropriate accounting period, not the date the item is recorded in the accounts. Deliberate violation of the cut-off assertion could occur in order to meet a sales target. If the client’s revenue is below the target revenue, staff could backdate sales invoices issued in the early part of the next accounting period to the previous accounting period. Alternatively, if revenue is above target, staff could postdate the sales invoices to move them to the next accounting period to help reach that period’s targets.

The auditor could determine the last valid sale of the accounting period and test invoices with dates either side of the last valid sale for the date entered into the accounting records. The auditor would inspect the sales ledger, billings, shipping documents and other supporting documents immediately before and after the cut-off date of revenue with cut-offs in other areas, for example, accounts receivable and inventory.

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REVIEW QUESTION 11.4 LO 2 The processes impacting sales revenue are cash receipts, sales, and sales returns and allowances. The extent of substantive testing of the processes impacting sales revenue is determined by the risk assessment for those processes. If controls over these processes are assessed as likely to be strong, it is preferable to test the controls and supplement the evidence with high level analytical procedures. However, if controls are likely to be ineffective or it is more efficient to test the balances substantively, the auditor would rely more heavily on substantive testing.

The auditor gains sufficient assurance about the processes from the control testing. If there are any remaining detection risks, the auditor uses additional substantive tests of the processes and sales revenue.

REVIEW QUESTION 11.5 LO 2, 3 Client budgets for revenue and expenses are prepared by the client for internal use. They are used to control expenses and motivate staff to achieve targets. They contain the client’s predictions and are used by the client to assess performance and investigate differences. They are useful to the auditor because they provide a benchmark against which to compare actual performance. The auditor can use them to form expectations for the balances of revenues and expenses. In addition, the auditor can investigate the action taken by the client when targets are not achieved. For example, the auditor will test for evidence that the client used the budgets to assess performance against budget and the evidence gathered by the client about any variations from the budget.

A test that would normally be performed is to compare current year’s expenses to the prior year’s actual and the current year’s budgeted amount (both in absolute amounts and as a percentage of sales). The auditor would also review the client’s comparison of budgeted and actual costs and expenses by month or by quarter. The auditor would corroborate the reasons identified by the client for important variations and investigate any unexpected variations or the absence of expected variations not identified by the client.

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REVIEW QUESTION 11.6 LO 1 Analytical procedures can use financial data from the client’s records to make comparisons between items (e.g., gross profit ratio) or between periods (e.g. gross profit ratio this year compared to previous year). Analytical procedures can also use non-financial data. For example, the auditor could compare payroll expense to the number of employees and compare these ratios across years. The auditor could compare revenue for a hotel to its occupancy rate, or parking fee revenue for a car park operator to the number of vehicle movements through the barriers and entry/exit gates. A manufacturer would have data about labour hours and machinery hours which could be compared to costs, and units of production that could be compared to sales revenue.

The auditor should always consider the source of the data (audited or not, internally generated or not) when judging the degree of reliance to place on the analysis.

REVIEW QUESTION 11.7 LO 3 If labour expense for manufacturing personnel is included as a general expense then cost of sales is understated. This violates the completeness assertion for cost of sales and the occurrence assertion for general expenses.

In addition, if the goods are still on hand at the end of the accounting period, the valuation and allocation assertion for inventory is violated.

Auditors need to consider the method of assigning costs to cost of sales (and inventory). If the client uses standard costing there will potentially be variances that should be passed through the income statement. The auditor might consider the variances should be allocated to inventory and cost of sales rather than treated as a period expense.

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REVIEW QUESTION 11.8 LO 1 Subsequent payments are examined to determine if there are any payments of accounts that did not appear in the creditor’s listing at year-end. The auditor is primarily looking for evidence of unrecorded liabilities and expenses. The auditor will examine the documents supporting the cash payment to determine if the invoice relates to the financial period of the audit or the following period.

The subsequent payment could also be evidence of an accrual (such as payroll) that was not properly accounted for at year-end.

The technique is useful because the payment is good evidence of the existence of a liability and an expense that should appear in the audited financial period. However, the auditor will not be able to determine if the liability should have been shown on the balance sheet at year-end without examining the documents for evidence of the date the expense was incurred.

REVIEW QUESTION 11.9 LO 3 The auditor will examine the records of employees who left the client during the year for several reasons. For example, the auditor will be considering if termination payments were appropriately recorded. The auditor will also consider if the payroll expense for that employee terminated on the appropriate date.

The information about departed employees will be on a file held by the human resources (HR) department. The HR department is responsible for employment and termination, and setting appropriate conditions, including wage rates. The payroll department should not have access to the HR files.

They pay employees based on information about pay rates provided by HR, and on time cards (or other records of time worked).

The auditor should trace from the HR files to the payroll function and vouch payroll expenses by examining underlying records of pay rates and hours worked.

REVIEW QUESTION 11.10 LO 1 Roll forward is used when the auditor conducts some testing at an interim date. Where controls are relatively good, the auditor will complete some testing during the financial period. The auditor will then compare the activity in that account for the current year with the same period in the previous year. If there are no unexpected fluctuations, the auditor can conclude that there is sufficient evidence that the final balance is appropriate. If there are any

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unexpected fluctuations (or the lack of expected fluctuations) the auditor will need to consider investigating the reasons for the changes.

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SOLUTIONS TO PROFESSIONAL APPLICATION QUESTIONS PROFESSIONAL APPLICATION 11.1 – Internal audit and substantive testing LO 1, 2 The problems at Lynch Brothers five years ago showed that high risk of misstatement existed for revenue occurrence as well as more generally for income statement accounts. The circumstances appear to have changed considerably since that time, with a much greater emphasis within the company on ethical behaviour and good corporate governance. The audits for the last four years have provided evidence of these changes and the risk of misstatement for revenue would be assessed as much lower now.

The internal audit team reports to the audit committee, which is consistent with good practice. In addition, the audit committee appears to be independent. There appears to be evidence that the internal audit team is highly qualified and effective. This suggests that the external auditor can place reliance on the internal audit team’s findings, if the auditor completes appropriate testing for the current year to supplement past evidence (i.e., are there any changes this year, is the team still effective, etc).

Pedro would be able to adopt an approach which relies heavily on testing controls over processes affecting income statement accounts and perform minimal substantive testing.

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PROFESSIONAL APPLICATION 11.2 – Auditing an Internet business LO 1, 2 Revenue for Search.com is generated when members post a profile or message or make contact with another person, and when advertisements are ‘hit’ or followed by users of their website. Holly suspects that revenue is overstated, i.e., she has concerns about the occurrence and accuracy assertions for revenue (and the cut-off assertion for transactions around yearend). She needs evidence of the ‘transactions’ that provide revenue.

Substantive procedures include: - correlate activity for the recorded ‘sales’ with the activity for the bank account, seeking confirmation that revenue has been received in cash - Test recorded sales to supporting documents (e.g., invoices sent electronically to customers) - Test posting of individual sales documents to sales ledger and to trade receivables (customers and advertisers) sub-ledger - Test recorded sales to the records of ‘product’ (i.e., profile pages added to website, hits on advertisements) - Review receivables sub-ledger and sales, returns, ledger for unusual items - Test cut-off in processing sales and credits or allowances granted to customers and advertisers - Test accounting classification of cash receipts (to ensure receipts from customers and advertisers are classified and posted correctly) - Test mathematical accuracy of cash receipts, sales, receivables, returns, ledger accounts - Test pricing and mathematical accuracy of sales documents - Test accounting classification of sales transactions - Test bank reconciliation process with respect to receipts, cut-off - Review activity using indicators produced by webpages for unusual patterns (e.g., many hits from same computer, at same date, just before year-end, etc) - Correlate computer generated activity metrics with sales and cash receipt transaction data - Compare sales to customers and advertisers with industry averages, previous period - Inquire of management, sales personnel, webpage designers, about special arrangements - Review minutes, contracts (especially with advertisers)

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PROFESSIONAL APPLICATION 11.3 – Substantive testing of sales LO 3 Memo to André The key assertions at risk for sales are occurrence, accuracy, and cut-off. In this case, clothing sales are growing, but sales from camping and climbing equipment are down in most stores. Because your risk assessment shows that controls are reasonably effective, I suggest you use monthly sales budgets and actual results to perform analytical procedures for the 8 months to date, then roll-forward results for the remainder of the year.

You should compare budgeted sales with actual sales for the past eight months and test for management review of the results and follow-up of variances. This means that where management have indicated on the report that specific action should be taken, gather evidence to show that such action was taken. Also, you should consider the reasonableness of the action that was recommended. If management have indicated that certain events have occurred which would explain the results, gather evidence that those events did occur and test the reasonableness of the explanation.

In addition, you should obtain industry data for the same period to ascertain if the patterns shown in Rock’s results are similar to those experienced by other firms in the industry, and whether the same events and conditions that affected sales also affected sales for those businesses.

Your primary concern with the analytical review is to test the reasonableness of the actual sales data. Therefore, you should form expectations for the actual results based on all the available information and review the results for departures from those expectations. In some cases, no change in actual results would be unusual because you believe that there should be some fluctuation. Use the expense data to help form your expectations. For example, if sales are down, cost of sales should also be down. Compare ratios such as gross profit ratio with the previous period, and correlate the financial data (e.g., sales) with the physical data (e.g., units shipped). In times of uncertainty, such as falling demand for camping equipment, pay careful attention to sales returns and allowances. Substantiate a sample of sales returns, particularly after the year-end.

To test cut-off, I suggest you inspect the journals, ledgers and relevant documents for the period immediately before and after the cut-off date (i.e., this will be done at the year-end not during the interim period), and determine that transactions were recorded in the proper period. Compare revenue cut-off with cut-off for inventory and accounts receivable.

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PROFESSIONAL APPLICATION development expenditure LO 1, 3

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11.4

–

Auditing

research

and

(a) Classification of expenditure into accounts is important because users rely on the classification of expenditure to assess the level of spending by the client on research and development, and its likely success. The accounting standards require that research expenditure is expensed and development expenditure is capitalized only when certain conditions are satisfied relating to its likely recoverability from sales of the product (see International Accounting Standard (IAS) 38 Intangible Assets). If research expense is misclassified as development (and capitalized), or if research and development expense is classified as general administrative expense, the financial statements will not be true and fair. In this case, the expenditure does not meet the requirements of IAS 38 for capitalization so all expenditures ($24m) must be expensed. If it is shown as research and development expenditure in the income statement, users will be informed that the amount was spent on these activities and did not meet the criteria for capitalization. If the amount is shown as general expenses, the users will not be informed about the expenditure on R&D. Therefore, the auditor must gather evidence as to whether the expenditure is appropriately classified. (b) To obtain evidence of the accuracy of the amounts claimed by the client, the auditor will vouch the expenditures to the supporting documentation. There are several categories of expenses: salaries, depreciation, supplies consumed, and amortization of patent.

Salaries will be supported by contracts of employment and other details held on file by human resources. It is possible that chemists will be paid an hourly rate (e.g., if they are casual employees), so records of times worked will also be checked in these cases, and the amounts paid recalculated. The auditor should gather evidence of the employees who worked during the period, and search for departed employees to ensure that they were removed from the payroll on a timely basis. Vouch payments for payroll to documents and perform cut-off tests around year-end, compare salaries with previous year and program budgets.

Depreciation and amortization are substantiated by reference to the cost of the assets and assumptions about their useful lives and pattern of usage, and recalculation of expense using appropriate amortization/depreciation rate.

Assets should be substantiated for existence, rights and obligations, valuation and allocation, to ensure that depreciation/amortization is charged only for assets held during the period. Acquisitions and disposals of assets should be substantiated, and where appropriate, valuations of assets obtained to test of impairment.

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Supplies consumed will be evidenced by documents showing transfer of the supplies from storeroom to laboratory. These records should show authorization for the transfer of the supplies, including date, details, and units.

Cost of supplies is substantiated through reference to purchase documents (invoices, receiving reports) and entry into supply and accounts payable accounts in the general ledger.

PROFESSIONAL APPLICATION 11.5 – Purchases testing LO 1, 3 (a) Strengths: - Sales orders received by clerk without store access - Packing slip generated by computer based on sales order - Variety of suppliers used - Perpetual inventory control system - Periodic inventory counts Weaknesses: - Chris Cho takes drugs without formally recording removal, and without any control over which drugs, quantities, etc, taken. Should have process for approval of taking inventory from stores.

- No apparent control over incomplete customer orders, packing slip is not amended. What follow up exists to ensure that items are sent at a later date? Should have system of recording backorders (and follow up when inventory on hand) and generating new packing slip and invoice.

- Who approves supplier list? Who selects suppliers – the storeman?

What control exists to ensure only approved suppliers (e.g., for quality of product) are used? What control exists to ensure that the storeman is not using suppliers who provide personal incentives to him? Should have approval process for purchase orders from approved suppliers.

- Supplies ordered in bulk – is there control (other than the storeman ‘being careful’) over use-by dates? Obsolete inventory? Should have system of recording use-by-dates and limits on order quantities for time-sensitive inventory.

- What control over follow up to receive inventory from a supplier that was not provided in response to the order? Should have process of receiving reports with comparison (not by the storeman) of units ordered vs. received with automatic reordering of supplies. Receiving reports and purchase orders to be reconciled with supplier invoices.

- Inventory counts performed by the storeman. Should have involvement of independent personnel with reconciliation to general ledger.

- Sales made by telephone – credit checks performed? Relates to valuation and allocation of accounts receivable.

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(b) Several questions exist around controls over inventory control, including existence of inventory, valuation, and allocation (with specific reference to obsolete out-of-date products). Main issues with purchases are occurrence (whether goods were received), accuracy (cost of goods purchased) and cutoff (because of numerous back-order issues for both sales and purchases).

Procedures for substantiating purchases include: • Test cut-off by inspecting purchases journal, inventory receiving records, supplier invoices around year-end.

• Search for unmatched invoices, inventory receiving reports, purchase orders.

• Examine payments of payables balances subsequent to year-end to verify recorded purchases.

• Compare entries in payable sub-ledger to the creditor invoices.

• Test account postings within general ledger by comparing nature of goods or services purchased with description of accounts and account name transaction was posted to.

• Test mathematical accuracy of purchases, payables invoices, and payables sub-ledger.

• Trace details or purchases to invoices, receiving reports, purchase orders.

• Compare purchases with previous period, against budget • Review interim financial statements and investigate any unusual fluctuations.

• Compare gross profit with previous years.

• Investigate physical movements (number of parcels despatched, shipments received) with financial data for number of years.

Separate tests for inventory existence, such as inventory counts, will also provide evidence relevant to purchases accuracy.

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PROFESSIONAL APPLICATION 11.6 – Assessing the results of payroll substantive testing LO 3, 4 (a) Accounts: • Payroll expense • Liability accounts — Accrued wages, leave provisions (annual, sick, longservice leave all depend on accurate records) Assertions: • Occurrence, accuracy, cut-off, completeness of payroll expense – expense is most likely to be understated (completeness) but could also be overstated (occurrence) because of delay in removing employees from payroll. In addition, accuracy is likely to be violated due to poor records and miscalculations. Cut-off is at risk because of timing of adding and removing employees from payroll.

• Completeness, valuation and allocation of liability accounts because accrued wages are not included. (b) To search for overpayment - All payments made for a week should be tested against underlying record of hours worked, and back to file in human resources to ensure that the employee was employed, and the rate of pay that should be used, for that week.

The amounts for the weekly wages expense should be recalculated.

Additional supporting evidence should be sought to verify the employee’s right to claim pay.

To search for underpayments – details of employee held on file in human resources should be traced to payroll and payment.

All payments and human resource file changes on both sides of year-end should be tested for cut-off.

To verify liabilities – search for employees that have not been paid, search for vacation pay entitlements that have not been accrued – review files, payments made in previous periods, list of employees added or removed during year, analytical review of payroll expense compared to previous periods, against non-financial data, such as truck movements (i.e., who was driving the truck?, how many drivers have been paid for each truck movement?)

Review payment amounts to ensure that overtime has been paid correctly.

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11.7 – Substantive procedures for cost of sales LO 1, 3 (a) Cost of sales are properly supported as charges against the entity in the period. Costs applicable to future periods are carried forward as inventories.

(Occurrence) All cost of sales relating to the current period’s revenue are included in the income statement. (Completeness) Cost of sales are stated in income statement at the appropriate amounts.

(Accuracy and cut-off) Cost of sales are properly classified, described, and disclosed in the financial statements , including the notes, in conformity with IFRSs. (Classification and understandability) The principal objectives relate to occurrence, accuracy, and cut-off because there is a greater risk of understatement than overstatement of cost of sales (to increase gross profit). The complex costings for Securimax’s products suggest accuracy of costing of manufactured items will be at risk. (b) The nature, timing, and extent of substantive testing of cost of sales are dependent on results of control assessment and testing. The new manufacturing costing system will be tested for its ability to provide accurate costing data for cost of sales and inventory balances.

The manufacturing costing system must support costing of sophisticated product designs (including likely individual specification requests by the foreign governments) and integrate with the general ledger for all inventory movements. All expenses that are included in the manufacturing process will need to be substantiated (including purchases of materials and supplies, transfer of materials and supplies into the production process, labour and allocation to individual products or batch processes, machinery costs) and estimates of percentage of completion of work in process on hand at the end of the period. In addition, movements of completed items from finished goods to cost of sales during the period will be substantiated.

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Substantive procedures include: • Tracing and vouching purchases (supplier invoices, etc, to entries in purchases/general ledger and entries in ledger to supporting documents) • Tracing and vouching labour expense (list of employees and HR records to payroll expense and payroll expense to documents and timecards); compare relationship of direct labour costs to number of employees with prior period, investigate significant fluctuations • Testing mathematical accuracy of product costing • Cut-off procedures for purchases, inventory transfers, payroll • Review production data and compare relationship of overhead costs in cost of dales to direct labour, hours and/or dollars with prior years • Review relationship with respect to flow of goods, such as gross profit analysis, comparison of standard and actual costs, and review reconciliation between cost of sales and shipments.

• Compare actual and budgeted costs by month or quarter. Investigate reasons identified by client for important variations. Investigate unexpected variations (or their absence) not identified by the client.

PROFESSIONAL APPLICATION 11.8 – Substantive testing of income statement and balance sheet accounts LO 1, 3 All manufacturing costs must be allocated between cost of sales and closing inventories of finished goods (FG) or work in process (WIP) (or charged as period expenses). Substantive testing of the FG and WIP inventory balances on the balance sheet will provide some evidence for cost of sales because costs that are not part of inventory are allocated to cost of sales (or separately identified as wastage or damaged inventory). Evidence from testing controls over manufacturing costs or direct substantiation of manufacturing costs relate to both cost of sales and closing FG and WIP inventory.

Evidence of misstatement of a component of manufacturing cost (e.g., labour that has been incorrectly classified as direct labour that should be treated as non-manufacturing, evidence about incorrect amounts for cost of raw materials, etc) potentially impacts on both cost of sales and FG and WIP inventory.

Evidence of cut-off errors (e.g., purchases that should be recorded in current period incorrectly recorded as next period) also impact on both cost of sales and raw materials (RM) inventory. Also, cut-off of inventory transfers potentially impact on cost of sales and RM inventory.

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PROFESSIONAL APPLICATION 11.9 – Tests of details for purchases LO 3 •

• • • • •

Test cut-off by inspecting the purchases journal , purchase orders, receiving reports, supplier invoices, and cheque requisitions, immediately before and after the cut-off date to determine that the transactions were recorded in the proper period. Compare purchases cut-off with cut-off in other areas, (e.g., accounts payable) (cut-off).

Examine payments of suppliers’ accounts subsequent to year-end for selected purchases in records (occurrence).

Search for unrecorded purchases by inspecting subsequent payments, unmatched invoices, receiving reports, purchase orders (completeness).

Test classification of recorded purchases by inspecting underlying documents for evidence of items ordered and received (classification), amounts paid (accuracy).

Test mathematical accuracy of documents supporting an authorized cheque requisition (accuracy).

Test postings from purchases sub-ledger to supporting documents, and payables sub-ledger to the general ledger (completeness, occurrence, and accuracy).

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PROFESSIONAL APPLICATION procedures for revenue LO 1, 2

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11.10

–

Analytical

substantive

Revenue for Shady Oaks is generated from patients for stays in the treatment facility practitioners in private practice for use of the facilities and provision of nurses, chiropractors, physiotherapists’ supplies.

To perform analytical procedures the auditor would require: • Financial data from Shady Oaks’ trial balance (with a breakdown of revenue by each service) for the current period.

• Budgets for each category of revenue compared with actual revenue received.

• Management reports investigating budget variances and explanations of causes of variances, follow-ups.

• Revenue for period prior to and after year-end.

• Gross margins, cost as percentage of sales by category of cost and revenue.

Other non-financial information: • Statistics on numbers of patient stays, duration of stays, services used whilst an in-patient.

• Statistics on facilities’ usage, numbers of staff (nurses, physiotherapists) provided to the medical practitioners for each type of treatment procedure, costs of each staff hour.

• Statistics for times in operating theatres (dates, charge-out rates).

• Supplies used by each practitioner, by type of supply, with costings.

The data should be comparable across periods.

Audited data is more reliable than unaudited data.

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CASES 11.11 – Bazaar Company Audit (a) The risk assessment was not adequate as the recruit failed to consider the following factors in reaching that conclusion: • Bazaar deals with computers and related equipment, and new technology is always emerging, so inventory obsolescence may be a factor.

• The existence of multiple warehouses may increase the risk of inventory obsolescence.

• In addition, the fact that inventory items are computer-related may increase the risk of asset misappropriation since they could be considered highdemand products.

• The nature of the business appears to be non-complex (except for the specialized orders) – there does not appear to be complex or non-routine transactions to contend with.

• However, the volume of transactions appears to be high, which may or may not be a risk factor, depending on the reliability of the systems processing the transactions (see the discussion of control risk that follows).

• There appears to be a problem with the issuance of credit notes. One that had been issued for a price adjustment made by a sales representative was apparently issued in error, but the corresponding cancelled refund cheque could not be located.

The detection risk — the risk of not finding a material misstatement — should be derived from the two previous risk level assessments and should be used to determine the amount of audit work required to reduce the overall risk to an acceptable level. The recruit does not seem to have integrated the components of the risk model. In order to achieve a low detection risk level, a large sample is required, contrary to what the recruit suggested. (b) Documentation that appears to be inadequate or missing includes: • Documentation should include a discussion of the financial statement users.

• Documentation should include a consideration of other possible bases for materiality.

• Documentation should include discussion of qualitative factors.

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(c) Sales • The first step performed to audit sales was done correctly. However, the substantive variance analysis was incomplete. Current year balances were obtained and compared to the prior year in dollar amounts and percentage, but further analysis could have been performed on these numbers.

• The hiring of a new representative explains a large portion of the variation, but the client provided far more information. Here is what the analysis should have looked like:

• Having done this analysis, the recruit should have investigated further, since the variance is larger than materiality ($250,000), by asking the client for further explanations for the increased sales. If the results of that inquiry were inconclusive, additional procedures should have been performed to substantiate the variance, such as tracing sales transactions to customer invoices and shipping documents.

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Credit Notes The backup paper work was missing for the cancelled refund cheque that was issued by a sales representative as a credit for a price adjustment. This is also suspicious (it could be another indication of fraudulent activity) and should be followed up to see if there were other similar occurrences during the year.

Additional procedures should be performed to extend the sample for credit notes to determine whether other credits for price adjustments had been issued, then traced back to the supporting documentation, including the refund cheque. The issuances of credit notes and refunds are somewhat atypical transactions and should always be reviewed closely as part of an audit.

Expenses Out of the 10 expense items randomly sampled, only three were traced to invoices and cheques. The rest were reviewed for reasonableness. Out of those three, two appeared to be items that should have been capitalized and depreciated over the course of their useful lives rather than expensed. The recruit should have enquired further of the client as to the nature of the work invoiced in order to assess whether these items should have been capitalized or expensed.

Taken on an individual basis, the expense amounts are not material, but the total of the two exceeds the materiality level assessed by the partner.

Expense accounts should be thoroughly examined for similar types of discrepancies and corrections should be requested of the client.

I am concerned about the “reasonableness” check the recruit performed since there is no explanation as to what the recruit looked for. Based on the fact that the recruit missed the potential capital items in the expense items that were traced, I wonder what might have been missed in the other seven items that were considered reasonable. In addition, it is unclear why all 10 items were not traced back to supporting documentation. If they were part of the random sample, they should have all been tested the same way.

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Case Study — Cloud 9 See the solution to the Case Study – Cloud 9 in Chapter 10, which is a combined solution for both Chapters 10 and 11.

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RESEARCH QUESTION 11.1 – IASB/FASB revenue recognition project joint discussion paper Students should discuss general issues in revenue recognition rules and the reasons revenue recognition is problematic for clients and auditors. The student should apply this discussion to their chosen industry. What are the key features of construction and telecommunication industries that make revenue recognition problematic? For example: long term contracts, and bundling of products and services with contracts with various cancellation rights and minimum charges.

The student should examine the audit implications of the old and proposed (at the time of writing) rules. The student should address the issues of risk and evidence with specific reference to the problem identified as the main issue confronting the industry. Students should use appropriate references to the IASB documents, particularly submissions by members of the relevant industries and their auditors.

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Legal Notice Copyright

Copyright © 2012 by John Wiley & Sons Canada, Ltd. or related companies.

All rights reserved.

The data contained in these files are protected by copyright. This manual is furnished under licence and may be used only in accordance with the terms of such licence.

The material provided herein may not be downloaded, reproduced, stored in a retrieval system, modified, made available on a network, used to create derivative works, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise without the prior written permission of John Wiley & Sons Canada, Ltd.

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Solutions Manual to accompany

Auditing: a practical approach by

Robyn Moroney Fiona Campbell Jane Hamilton Valerie Warren

CHAPTER 12 Completion and reporting on the audit

John Wiley & Sons Canada, Ltd. 2012

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Chapter 12 – Completion and reporting on the audit SOLUTIONS TO REVIEW QUESTIONS

REVIEW QUESTION 12.1 LO 1 The process of engagement wrap-up involves the auditor finalizing any open items before issuing their audit report. The finalization process could include completing additional audit procedures to ensure that sufficient and appropriate evidence is held on which to base the audit opinion. The process usually includes work in the following areas: 1. Review planned audit procedures for proper and complete execution.

2. Determine that all necessary matters have been appropriately considered.

3. Revisit open review notes, ‘to-do’ items and any audit procedures not yet completed. The auditor determines if any additional work is needed or the matter is no longer relevant.

4. Determine that all unnecessary documentation, drafts and review notes have been removed from engagement files. In some cases, the auditor notes that the item is no longer required and the reason, in other cases the item is removed along with any references to it.

5. For multi-location engagements, determine that all documents requested from other audit teams have been obtained and reviewed.

6. Remove all documents from the working papers that do not provide audit evidence supporting the auditor’s conclusions.

7. Consider the amount used for materiality. In some cases, revise the amount used for materiality when evaluating audit misstatements.

Consider if additional procedures are required to support the changed materiality.

8. Reconsider the assessments of internal control at the entity level and the risk of fraud. Their conclusions about the effectiveness of internal control could be affected by control exceptions found during testing.

Consider whether any material misstatements indicate fraud.

9. Revisit planning documentation to determine that all significant issues identified during the planning phase have been addressed.

10. Perform subsequent events procedures.

The engagement-wrap up process is important because it ensures that the auditor considers all matters that are relevant to finalising the documentation on the audit and ensuring enough evidence is held to support the audit opinion.

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REVIEW QUESTION 12.2 LO 2 Going concern is an assumption that the entity will remain in business for the foreseeable future. The entity has neither the intention nor the need for liquidation, ceasing trading or seeking protection from creditors pursuant to laws or regulation. The going concern assumption supports the recording of assets and liabilities on the basis that the entity will be able to realize its assets and discharge its liabilities in the normal course of business. An auditor must consider the entity’s ability to continue as a going concern as part of an audit (CAS 570 Going Concern).

The auditor must also consider the financial reporting framework when performing an audit. IAS 1 Presentation of Financial Statements requires management of the entity to make an assessment of the entity’s ability to continue as a going concern. If management is aware of material uncertainties related to events or conditions that may cast significant doubt upon the entity’s ability to continue as a going concern those uncertainties shall be disclosed.

Therefore, the auditor has a specific requirement to consider management’s assessment of the going concern basis, and the relevant disclosures, because of IAS 1.

REVIEW QUESTION 12.3 LO 3 Contingent liabilities exist or possible obligations on the balance sheet date when the final outcome is uncertain and contingent upon a future event. Most financial reporting frameworks require an entity to record or disclose such contingent liabilities, depending on whether they are “likely” or “probable” and “measureable.” While it is management’s responsibility to determine the appropriate accounting treatment, given the financial reporting framework under which the financial statements will be prepared, CAS 501 Audit Evidence—Specific Considerations for Selected Items requires the auditor to “search” for any litigation and claims involving the entity that the auditor may not be aware of but which may give rise to a material misstatement.

The auditor is required to perform the following procedures: • Inquire of management and others within the entity, including in-house legal counsel, if there are any unreported contingent liabilities.

• Review minutes of meetings of those charged with governance and correspondence between the entity and its external legal counsel.

• Review correspondence with taxation authorities.

• Review legal expense accounts for unexpected fluctuations.

• Include in the management representation letter the fact that all contingent liabilities have been disclosed to the auditor.

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If the auditor has assessed a risk of material misstatement regarding litigation and claims as required per CAS 501.10, they may request permission from the client to contact the entity’s external counsel. This is usually done via the legal letter, as discussed in chapter 5. If the client does not grant permission for this communication, then the auditor will look to gather evidence by performing alternative procedures. If the alternative procedures do not provide sufficient and appropriate evidence, then the auditor will need to modify the opinion in the auditor’s report.

The procedures for contingent liabilities are usually performed at the end of the audit to ensure that there is sufficient and appropriate evidence in the audit file to support not only contingent liabilities but also the work performed for subsequent events, as described in the next section. While performing the procedures for contingent liabilities, the auditor will also look for evidence that the entity has entered into long-term commitments that have not been appropriately disclosed.

REVIEW QUESTION 12.4 LO 4 IAS 10 Events After the Reporting Period and CAS 560 Subsequent Events both explain that there are two types of subsequent events.

Type 1: Events that provide additional evidence with respect to conditions that existed at year-end. These events can affect the estimates inherent in the financial report or indicate that the going concern assumption is not appropriate. Where appropriate, the financial report should be amended to recognize the event. For example, the entity had made an insurance claim which was still in negotiation at year end. Subsequent to the year-end, the claim was settled. The settlement provides a certain amount that can be recognized in the accounts. In some cases, the subsequent event provides additional evidence about a matter that was disclosed in the notes to the financial report rather than the accounts. In these cases, the note is updated to reflect the new information.

Type 2: Events that provide evidence with respect to conditions that developed subsequent to year-end. These events do not result in changes to amounts in the financial statements because they are new events. However, they may be of such significance as to require disclosure in the financial statements. For example, an uninsured loss of plant or inventories as a result of a fire or flood subsequent to year-end. This event does not affect the value of the asset at year-end, but it would be important to users of the financial statements to know that the asset has been destroyed. The disclosure is made through a note to the financial statements.

The auditor’s responsibility for detecting these events is explained in CAS 560.

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Prior to completing field work the auditor the auditor shall consider their risk assessment relating to identifying subsequent events. The risk assessment shall include obtaining an understanding of any management procedures to identify subsequent events.

Prior to signing the audit report the auditor will perform procedures to gather evidence to cover the period from the date of the financial statements to the date of the auditor’s report. These procedures include enquiring of management as to whether any subsequent events have occurred, and reading relevant minutes of meetings held after the date of the financial statements and latest interim financial results.

After the date of the auditor’s report the auditor has no obligation to perform any audit procedures regarding the financial statements. However, the auditor could become aware of a fact that if it had been known to the auditor at the date of the auditor’s report, may have caused the auditor to amend the auditor’s report. In this case the auditor shall discuss the matter with management, determine whether the financial statements need amendment, and if so, enquire how management intends to address the matter in the financial statements. If the financial statements are amended, the auditor could carry out the necessary audit procedures on the amendment and extend the subsequent event procedures to the date of the new auditor’s report and provide a new auditor’s report.

If management do not amend the financial statements, the auditor would take action to prevent the release of the statements or to prevent reliance on the auditor’s report.

After the financial statements have been issued, the auditor has no obligation to perform any audit procedures. However, if a fact becomes known to the auditor that, had it been known to the auditor at the date of the auditor’s report, may have caused the auditor to amend the auditor report, the auditor follows the procedures outlined above. If management do not amend the report, the auditor would take action to prevent the release of the report or to prevent reliance on the auditor’s report.

In both cases, the auditor should include an emphasis of matter paragraph in the new auditor’s report referring to the subsequent event matter disclosure in the financial statements.

REVIEW QUESTION 12.5 LO 5 An error is an unintentional audit misstatement in the financial report, and includes the omission of an amount or a disclosure. The auditor should try to understand why the error or exception has arisen. One response could be to increase the sample to ensure that there are no other errors. The auditor should continue testing until the error can either be accurately quantified or Solutions Manual 12-5 Chapter 12 Copyright © 2012 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of this page is strictly prohibited.

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the balance has been fully tested to an extent that proves a material error can no longer exist within the balance. The auditor should evaluate whether the error causes the financial statements to be materially misstated or requires additional disclosure.

If the error relates to the current year, the auditor will prepare a working paper for all misstatements uncorrected by the client to consider the aggregate effect, and whether the error is material in isolation or in aggregate. The auditor will consider both qualitative and quantitative considerations.

If the error relates to the prior year(s) the auditor should consider whether the error ‘reverses ’. For example, if there is a cut-off error in one year that causes the balance of an account to be overstated, the error turns around or reverses in the following period and causes the balance to be understated. If the problem is due to judgemental differences between the client and the auditor, it may not reverse or turnaround. For example, the overvaluation of an asset due to a judgement about fair values would persist if the asset was still held and valued in the same way. The auditor is required to use professional judgement in these cases to determine the appropriate response.

REVIEW QUESTION 12.6 LO 6, 7 CAS 700 Forming an Opinion and Reporting on Financial Statements requires the auditor to prepare an auditor’s report including these two paragraphs. The first paragraph outlines to the reader that management is responsible for establishing and maintaining internal controls relevant to the preparation and fair presentation of the financial statements which are free from material audit misstatement, selecting and applying appropriate accounting policies and making reasonable accounting estimates.

The second paragraph explains that the auditor’s responsibility is for expressing an opinion on the financial statements based on the audit, that the audit was conducted in accordance with auditing standards and ethical requirements, describe the audit and state that the auditor believes that the audit evidence obtained is sufficient and appropriate to provide a basis for the auditor’s opinion.

The requirement to include both these paragraphs is designed to inform readers of the differences in responsibility and to reinforce the concept that the auditor is not responsible for preparing the financial statements. The auditor is able to explain the scope of the audit and the limitations of the audit process.

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REVIEW QUESTION 12.7 LO 8 CAS 705 (ISA 705) Modifications to the Opinion in the Independent Auditor's Report and CAS 706 Emphasis of Matter Paragraphs and Other Matter Paragraphs in the Independent Auditor's Report outline the modified wording to be included in an auditor’s report when the opinion is not unqualified and/or there are circumstances which the auditor would like to emphasise to readers of the report.

A qualified, adverse, or disclaimer of opinion is issued when the auditor has a disagreement with those charged with governance regarding the application of accounting policies or the adequacy of financial statement disclosures (qualified or adverse) or when there is a limitation of scope of the engagement (qualified or disclaimer). In both cases the audit opinion is qualified is the matter is material but not pervasive. An adverse opinion or disclaimer of opinion is used when the matter, disagreement or limitation of scope respectively, is material and pervasive. The auditor adds an explanatory paragraph prior to expressing the modified opinion.

An emphasis of matter does not affect the auditor’s opinion and applies where the resolution of a matter is dependent on future actions or events not under the direct control of the entity, but that may affect the financial report, and the matter is disclosed in the financial statement. The paragraph is added to the audit report following the audit opinion to draw readers’ attention to the appropriate disclosure in the financial statements.

REVIEW QUESTION 12.8 LO 9 A limitation of scope of an audit occurs when the auditor is unable to obtain the necessary evidence to resolve a significant uncertainty. The auditor is unable to perform procedures due to the circumstances (such as a natural disaster or the passage of time) or due to an imposition by the entity (such as not making certain records, documents, or personnel available to the auditor).

A disagreement with those charged with governance occurs when the auditor has a different view about matters such as acceptability of accounting policies selected, the method of their application, or the adequacy of disclosures in the financial statements. If the client’s management will not change the financial statements to resolve the disagreement, the auditor will consider qualifying the audit opinion (either qualified or adverse opinion depending on the pervasiveness of the issue).

The difference between these circumstances is that the auditor is unable to obtain sufficient appropriate evidence in the case of a limitation of scope, but has sufficient evidence on which to base a conclusion that the financial

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statements are misleading where there is a disagreement with those charged with governance.

REVIEW QUESTION 12.9 LO 9 Those charged with governance is defined in CAS 260 Communication with Those Charged with Governance as: The person(s) or organization(s) with responsibility for overseeing the strategic direction of the entity and obligations related to the accountability of the entity. This includes overseeing the financial reporting process.

The identity of the people will depend on the jurisdiction and the entity. For example, in some cases it could be a corporate trustee. In other cases it will be the management personnel, the executive members of a governance board or an owner-manager.

The auditor could communicate with a sub-group of those charged with governance, for example an audit committee that is a sub-group of the board of directors. The auditor has to decide with whom to communicate each matter, based on the topic of the matter and the structure of the entity.

The auditor communicates with those charged with governance to assist those charged with governance to understand better the consequences of the auditor’s work, to discuss issues of risk and the concept of materiality with the auditor, and to identify any areas in which they may request the auditor to undertake additional procedures, and to assist the auditor to understand better the entity and its environment (CAS 260 para A11). The communication of findings may include requesting further information from those charged with governance in order to complete the audit evidence obtained (CAS 260, para A16).

In general, the communication is for the purpose of assisting an effective, efficient audit and clear communication of the audit outcome, and to ensure that the entity’s representatives understand the nature of their responsibilities and the auditor’s responsibilities. It is important, therefore, that the communication be with senior members of the entity who can make decisions on behalf of the entity and resolve issues brought to their attention by the auditor. If the communication is with management, and not those charged with governance, there is a risk that the matter is not properly resolved. For example, the auditor could be concerned about management override of controls. Reporting such a matter to management, who are breaching the controls, is less likely to result in change than reporting it to the board of directors who are in a position to direct management to stop overriding controls.

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REVIEW QUESTION 12.10 LO 9 Matters communicated by the auditor at the end of the audit to those charged with governance include: • general approach and overall scope of the audit, including any limitations or additional requirements • selection of, or changes in, significant accounting policies and practices that could have a material effect on the entity’s financial statements • potential effect on the financial statements or any material risks and exposures, such as pending litigation, that are required to be disclosed in the financial statements • misstatements, whether or not recorded by the entity that have, or could have, a material effect on the entity’s financial statements • material uncertainties related to events and conditions that may cast significant doubt on the entity’s ability to continue as a going concern • disagreements with management about matters that, individually or in aggregate, could be significant to the entity’s financial statements or the audit report, including whether the matter has, or has not, been resolved and the significance of the matter • expected modifications to the audit report. The auditor discusses any expected modifications to their audit report on the financial statements with those charged with governance to confirm that: o those charged with governance are aware of the proposed modification and the reasons for it before the report is finalized o there are no disputed facts in respect of the matter(s) giving rise to the proposed modification (or that matters of disagreement are confirmed as such) o those charged with governance have an opportunity, where appropriate, to provide further information and explanations in respect of the matter(s) giving rise to the proposed modification • any practical difficulties encountered in performing the audit • any irregularities or suspected non-compliance with laws and regulations that came to the auditors attention during the audit • comments on the design and operation of the internal controls and suggestions for their improvement, particularly if the auditor has identified material weaknesses in internal control during the audit • any other matters agreed upon in the terms of the audit engagement • uncorrected misstatements aggregated by the auditor during the audit that were determined by management to be immaterial, both individually and in the aggregate, to the financial statements taken as a whole.

These matters are important because the auditor has determined that they are relevant to those charged with governance in their governance duties. For example, they may wish to make changes to the internal controls to improve the entity’s ability to achieve its goals more effectively or efficiently.

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SOLUTIONS TO PROFESSIONAL APPLICATION QUESTIONS PROFESSIONAL APPLICATION 12.1 – Audit wrap-up LO 1 (a) Open matters are those matters that are not yet finalized to the auditor’s satisfaction. The auditor may be waiting for evidence to be received (e.g., waiting for receipt of a solicitor’s representation letter), a procedure to be completed (e.g., an audit assistant has not completed testing the sample of documents), or the auditor has not yet made a decision on whether further evidence is required. The open matters could need attention such as a followup letter to be written to an external party, additional staff assigned to complete a procedure, or a decision to be made to complete additional procedures. In some cases, the auditor decides that no further action is required and closes the matter. (b) Lucy’s reference to a famous case in the US is a reference to the Arthur Andersen audit firm (Andersen) which was prosecuted for destroying files relating to the audit of Enron (although the prosecution was later overturned on appeal). CAS 230 Audit Documentation requires auditors to prepare audit documentation on a timely basis that provides a sufficient appropriate record of the basis for the auditor’s report and evidence that the audit was planned and performed in accordance with the standards and law. It also requires the auditor to adopt procedures to maintaining the confidentiality, safe custody, integrity, accessibility and retrievability of audit documentation.

CAS 230 (para 14) requires the auditor to assemble the audit documentation, and (para 15) to not delete or discard audit documentation of any nature before the end of its retention period. However, the auditor is not required to include superseded drafts of working papers and financial statements, notes that reflect incomplete or preliminary thinking, previous copies of documents corrected for typographical or other errors, and duplicates of documents (para A4). In assembling, the final audit file could involve making administrative changes to the documentation (para A22). For example, discarding or deleting superseded documentation, sorting, collating and cross-referencing working papers, signing off on completion checklists relating to the file assembly process, documenting audit evidence that the auditor has obtained, discussed and agreed with the relevant members of the engagement team before the date of the auditor’s report.

Therefore, it is clear that some papers are not required to be kept.

Unnecessary documents include superseded drafts, notes from early stages of work, corrected documents and duplicates.

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PROFESSIONAL APPLICATION 12.2 – Assessing going concern LO 2, 7 (a) Factors indicating a going concern issue: • Drop in demand for products based on general economic conditions and increased competition.

• High gearing (high debt/equity ratio) means little capacity for further borrowing.

• Recent borrowings due for renewal 3 months after year-end, but no agreement reached with the bank.

• Potential difficulties borrowing from other banks because of economic conditions and fall in demand for entity’s products.

Mitigating factors: • High expertise within the company suggesting ability to make new sales contracts despite economic conditions and competition.

• Borrowings were used to purchase assets which have potential resale value.

• Ongoing negotiations with another bank to refinance debt.

• Possible cost-cutting – e.g., staff layoffs could be explored. (b) Audit reporting options are detailed in CAS 570 Going Concern – see appendix 1 for flowchart. Essentially, the auditor must consider the degree of uncertainty surrounding the going concern and assess the adequacy of management’s disclosures in the financial statements. The greater the degree of uncertainty around the going concern assumption and the less satisfactory the management’s disclosures, the more likely that the auditor will qualify the audit report. An emphasis of matter paragraph could be added to draw the reader’s attention to the doubts and mitigating factors if the auditor believes that the management has made sufficient disclosure.

The flowchart in CAS 570 could be summarized as follows: • If there is not sufficient appropriate audit evidence on which to base an opinion o Express a qualified opinion or disclaimer of opinion due to limitation of scope • If the doubts about entity’s ability to continue as a going concern are not significant, the audit report would be unqualified.

• If the doubts are significant but the additional audit procedures confirm the appropriateness of the going concern assumption, then if the mitigating factors are o adequately disclosed, the audit report is unqualified o not adequately disclosed, the audit report is qualified for inadequate disclosure • If the doubts are significant and the additional audit procedures do not confirm the appropriateness of the going concern assumption,

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o if there is adequate disclosure of all material uncertainties in the financial statements, the audit report is unqualified with an emphasis of matter paragraph o if there is not adequate disclosure of all material uncertainties in the financial statements, the audit report is ▪ qualified for inadequate disclosure if the matter is not pervasive ▪ adverse opinion for inadequate disclosure if the matter is pervasive If there is significant doubt the entity will continue as a going concern o Adverse opinion for inadequate disclosure

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PROFESSIONAL APPLICATION 12.3 – Subsequent events procedures LO 3 (a) IAS 10 Events After the Reporting Period and CAS 560 Subsequent Events both explain that there are two types of subsequent events.

Type 1: Events that provide additional evidence with respect to conditions that existed at year-end. These events can affect the estimates inherent in the financial statements or indicate that the going concern assumption is not appropriate. Where appropriate, the financial statements should be amended to recognize the event.

For example, the entity had made an insurance claim for damage to property because of a fire during the year, which was still in negotiation at year end.

Subsequent to the year-end, the claim was settled. The settlement provides a certain amount that can be recognized in the accounts. The adjustment that would be made in this case is to recognize the amount of the insurance claim as a receivable from the insurance company (debit) and as a credit to offset the loss on the property damage (i.e., credit to income statement).

Type 2: Events that provide evidence with respect to conditions that developed subsequent to year-end. These events do not result in changes to amounts in the financial statements because they are new events. However, they may be of such significance as to require disclosure in the financial statements. For example, an uninsured loss of plant or inventories as a result of a fire or flood subsequent to year-end. This event does not affect the value of the asset at year-end, but it would be important to users of the financial statements to know that the asset has been destroyed. The disclosure is made through a note to the financial statements, not by an accounting entry.

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(b) Audit procedures normally used for the detection of subsequent events include: • gaining an understanding of, and evaluating processes that management has established to, determine that subsequent events are identified and dealt with • reading minutes of meetings of the board of directors and executive committees held after the reporting date and inquiring about matters discussed at meetings for which minutes are not available • reading and analyzing the latest available interim financial statements and, as considered necessary and appropriate, budgets, cash flow forecasts and other related management reports for events such as changes in accounting principles, significant changes in results or working capital, non-compliance with loan terms, and reviewing sales, receipts, journals and other accounting records relating to transactions that have occurred subsequent to the date of the financial statements • extending any analytical procedures performed during the audit to include the period up to the date of the auditor’s report • inquiring, or extending previous oral or written inquiries of the entity’s legal counsel concerning litigation and claims • assessing continued compliance with borrowing limits and loan covenants • inquiring of those charged with governance as to whether any subsequent events have occurred that might affect the financial statements • inquiring of management as to whether any subsequent events have occurred that might affect the financial statements, or (an experienced member of the engagement team) reviewing management reports • obtaining written representations from management as part of the management representation letter confirming oral representations made in respect of subsequent events and that they are not aware of other relevant subsequent events. (c) Prior to the date of the audit report the auditor is required to perform specific procedures to detect subsequent events (as outlined in part b above). After the date of the auditor’s report the auditor is not required to perform these procedures, but the auditor should consider taking action if they become aware of facts that may have caused them to qualify the audit opinion if they had been aware of these facts prior to signing the audit report. The auditor should consider discussing the matter with management or those charged with governance and whether the financial statements need amendment. If management amend the financial statements, the auditor has to continue the audit procedures required to be able to form an audit opinion and write a new audit report. If management refuse to amend the financial statements, the auditor should consider whether they should take action to prevent reliance on the audit report.

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PROFESSIONAL APPLICATION 12.4 – Reporting subsequent events LO 3 The board is planning to issue shares in a private placement on August 15.

This is a type 2 event – evidence of conditions that arose after the date of the financial statements, because the private placement is to occur after June 30.

The appropriate treatment is to make a note disclosure of the details of the private placement.

The share issue is to fund the purchase of a 60 percent stake in another company.

This is a type 2 event – evidence of conditions that arose after the date of the financial statements, because the purchase is to occur after June 30.

The appropriate treatment is to make a note disclosure of the details of the purchase.

A statement of claim was lodged in the Supreme Court in the week after yearend claiming damages for illness allegedly caused by chemicals used at a subsidiary company’s manufacturing plant in the 1990s.

This is a type 1 event – evidence of conditions that existed at the date of the financial statements, because the events that gave rise to the statement of claim occurred prior to June 30 and is a further case of a continuing series of claims being lodged for the same reason.

The appropriate treatment is to make a note disclosure of the statement of claims and the reasons the company is defending the writ and believes it will win the case. Normally, type 1 events give rise to amendments to the accounts, and it could be argued that the company should recognize the cost of the claim as a loss and a liability. However, the company believes that it has sufficient evidence to defeat the case and will not be required to pay the claim. The company is asserting that the obligation is not probable and will not exist unless the court case goes against the company. The correct accounting treatment is to make a note disclosure of the contingent liability (IAS 37 Provisions, Contingent Liabilities and Contingent Assets).

The review of subsequent cash receipts has revealed that several of the trade receivables that were considered doubtful have now been paid. However, the audit procedures have shown that a large customer that was considered safe at June 30 was unexpectedly declared bankrupt on July 20.

This refers to a type 1 event - evidence of conditions that existed at the date of the financial statements. In this case some doubtful accounts have been paid, and another debt is now known to have been doubtful at June 30. If management had better knowledge at June 30 of the financial condition of all customer accounts receivable with balances at that date (i.e., the conditions existing at June 30) they would have made better assessments about their ‘doubtful’ status.

The appropriate treatment is to write off the bad debts and to show the full debt of those that subsequently paid in the customers’ balance.

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PROFESSIONAL APPLICATION 12.5 – Misstatements and the audit report LO 4, 5, 7 (a) Katrina has a duty under rules of professional conduct and independence principles to comply with the fundamental principles: integrity, objectivity, professional competence and due care, confidentiality, and professional behaviour.

The threats to these principles in this case include: • self-interest, where Katrina may not wish to upset the CEO any further in case the audit firm loses the audit.

• intimidation, where the CEO appears to be intimidating Katrina in an effort to get her to agree to his valuations. The CEO’s statement ‘I think we need an auditor who is a bit more realistic’, could be interpreted as a threat to replace Katrina, and her firm, with another auditor who would agree with his valuations.

These threats could result in Katrina losing her objectivity and complying with the CEO’s request.

Katrina must consider the seriousness of the threats and how she can safeguard the principles. Possibilities include: • Ensuring all audit documentation is complete and referring it to her audit firm’s ethical committee with a request for guidance • Asking another partner at the audit firm to review the case and join her in dealing with the CEO • Referring the matter formally to the client’s board and/or audit committee • Requesting another independent valuation of the assets in question • Asking to be heard at the client’s annual general meeting (AGM) to explain the problem to the company’s shareholders • Referring the matter to publicly traded company regulator (TSX) or to the CPAB, or the auditor's governing professional body for advice • Resigning from the audit (b) Katrina’s report options are: • Unqualified if she is able to reach an agreement with the CEO on the appropriate value for the assets • Unqualified with an emphasis of matter if an agreement on the asset valuations is reached and as a result a significant going concern doubt is raised which is adequately disclosed • Qualified (except for) if the valuations do not have a pervasive effect on the financial statements – unlikely given the information about the critical nature of the valuations to the assessment of profitability and solvency

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Adverse if the valuations have a pervasive effect on the financial statements , this is particularly likely given the possible going concern issue

(c) Katrina should attempt to resolve the issue, with the help of the client’s board and other partners at her audit firm, and ensure that correct valuations for these assets are disclosed in the financial statements. The second reporting option in (b) is then most likely. Issuing an adverse report, reporting the matter to CPAB or the auditor's governing professional body for advice and resigning from the audit are last resort options if the relationship between the auditor and the client break down. Katrina should not comply with the CEO’s ‘request’ to overvalue the assets because this would appear to be against professional ethics.

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PROFESSIONAL APPLICATION 12.6 – Misstatements and the audit report LO 4, 5, 7 (a) The auditor would issue a qualified report or an adverse report as the financial statements are materiality misstated. The total impact on the financial statements is that net income is overstated by $70,000. This is greater than overall planning materiality. The auditor must ask the client to book some of the adjustments before issuing a clean audit opinion. (b) The auditor could issue an unqualified report as the total accumulated errors are below financial statement materiality. However, the auditor should still discuss the errors with management and request that the adjustments be recorded in the company's accounting records. (c) Prior year’s entries impact current year results if the entries do not reverse.

For example, the prior year entry to amortization will not reverse in the current year. This entry therefore results in current year balance being incorrect and this must be considered when assessing the type of opinion to issue.

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PROFESSIONAL APPLICATION 12.7 communication at the end of an audit LO 5, 7, 9

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Audit

reports

and

other

(a) The missing files create a limitation on the scope of the audit. There is the possibility that the auditor is not able to gather sufficient appropriate evidence on which to base an opinion. It appears that the circumstances were beyond the control of the client, and mainly affect sales revenue and accounts receivable valuation.

The reporting possibilities in these circumstances are: - unqualified if the problem is not material - qualified if the problem is material but not pervasive - disclaimer of opinion if the problem is pervasive.

Critical issues for the audit opinion decision include: - evidence that the problem was confined to a defined period. The information is that the problem began four months into the year, and appears to be corrected.

- ability to perform alternative procedures, such as using subsequent cash receipts to verify sales for the period.

- Confidence in the value of the accounts receivable at the end of the financial period – if the problem has been corrected the receivables at the end of the period should be unaffected by problems which occurred at the start of the year.

The most likely audit opinion is qualified because the problem is not pervasive to the financial statements, but is material.

The audit report would contain the usual paragraphs identifying the subject of the audit, management and auditor’s responsibilities, then the following: Basis for qualified opinion As disclosed in note xx to the financial statements, the entity’s sales for the eight months to the end of the year are stated at $xxx and for the first four months of the year are stated at $xxx. We were unable to obtain sufficient appropriate audit evidence about the sales for the first four months of the year because we were unable to gain access to the financial records for this period. Consequently, we were unable to determine whether any adjustments to these amounts were necessary.

Qualified opinion In our opinion, except for the possible effects of the matter described in the Basis for Qualified Opinion paragraph, the financial statements present fairly, in all material respects, the financial position of Kingston Catering as at December 31, 20XX, and its financial performance and its cash flows for the year then ended in accordance with International Financial Reporting Standards.

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(b) The letter to those charged with governance would contain a full description of the matter giving rise to the audit qualification, including details of difficulties in performing the usual audit procedures and the evidence obtained. The letter would explain why the auditor had to qualify their audit opinion.

The auditor would also make a recommendation for internal control changes to prevent a similar problem arising again, including details of the deficiencies in the previous systems that allowed this problem to occur.

Other matters would include the usual explanation of significant audit findings, views on appropriateness of accounting policies, independence issues if any, and other matters that are relevant to future successful audits.

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PROFESSIONAL APPLICATION 12.8 – Subsequent events LO 3 The sale of the land and buildings is a subsequent event – it occurred in the month following the end of the financial year. It is a type 2 subsequent event because it provides evidence of conditions that arose after the date of the financial statements. The sale of the land and buildings was not contemplated at December 31 (the offer was unexpected). It could be argued that the unexpected offer of $24.5 million was evidence that the asset had a fair value of greater than the stated $20.8 million at the balance sheet date, and thus the sale provides evidence of conditions that existed at the date of the financial statements (i.e., a type 1 event). However, if the auditor has conducted the usual audit procedures to test the fair value of the land at buildings at December 31, and has evidence to support the valuation of $20.8 million as being reasonable, it would not be appropriate to recognize the higher value in the accounts at December 31. The offer price was higher than fair value because that particular buyer wanted the asset and was prepared to pay a higher price.

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PROFESSIONAL APPLICATION 12.9 – Audit reports and subsequent events LO 7 As a type 2 subsequent event, the sale should be disclosed by note in the financial statements for the year ended December 31, 2011. If this disclosure is made, the audit report would be unqualified.

The auditor would consider whether an emphasis of matter paragraph would be included in the audit report to draw the reader’s attention to the relevant note in the financial statements. An emphasis of matter paragraph would be appropriate if the sale had a material effect on the financial statements. It is unlikely to have such a significant effect on the entity’s financial position.

If the disclosure is not made, the audit report would be qualified for material non-disclosure.

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PROFESSIONAL APPLICATION subsequent events LO 3

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(a) The cafeteria fire took place ‘last week’. As today’s date is July 13, the date of the fire must have been post June 13, making it a subsequent event. The auditor is required by CAS 560 Subsequent Events to perform audit procedures to obtain sufficient appropriate audit evidence that all events occurring between the date of the financial statements (June 30) and the date of the auditor’s report (in three weeks time) that require adjustment of or disclosure if the financial statements have been obtained. Therefore, the auditor has a duty to plan, and execute, procedures designed to detect an event such as a fire on the premises. The auditor must then determine whether the event is appropriately reflected in the financial statements in accordance with the standards. (b) The fire would be disclosed by way of note to the financial statements. The accounts would not be adjusted because the event is a type 2 event – provides evidence of conditions that arose after the date of the financial statements.

If the event is properly disclosed, the auditor would issue an unqualified audit report. The auditor would consider whether an emphasis of matter paragraph would be included in the audit report to draw the reader’s attention to the relevant note in the financial statements. An emphasis of matter paragraph would be appropriate if the fire was considered to be a major catastrophe that has, or would have, a significant effect on the entity’s financial position. The fire damage is not covered by insurance, but it is unlikely to cause such damage that the event has a significant effect on the entity’s financial position on its own. However, in combination with other events, such as those casting doubt on the entity’s ability to continue as a going concern, it could have such an effect.

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PROFESSIONAL APPLICATION 12.11 – Final review issues — going concern and reporting LO 2, 7 (a) The factors indicating a going concern issue are: - post balance date fire in the cafeteria which was uninsured, creating a substantial loss for the company - major debt due for refinancing, but the refinancing is not yet arranged, and poor economic conditions increasing the likelihood that refinancing will not be possible - significant changes in senior personnel making it difficult to conclude the refinancing arrangements - suppliers are requesting cash on delivery rather than the usual credit terms, suggesting that they are experiencing difficulty in being paid in a timely manner by the client - lawyers for HCHG reveal that the facility is unlikely to have adequate professional indemnity insurance to meet the current demands of several legal cases that have been brought against the facility in the last 12 months.

Mitigating factors: - new senior finance personnel have been appointed - ongoing refinancing discussions are being held with the banks (?)

- consider if HCHG has any plans to cut costs - lawyers may suggest that the client has sufficient grounds for defending malpractice claims - suppliers are still making deliveries, even though they are demanding cash on delivery, so the business is able to continue to get sufficient supplies. (b) The mitigating factors appear to be relatively weak compared with the factors indicating doubt about the going concern assumption. The auditors must perform procedures to test the strength of the mitigating factors and discuss with management their plans to deal with the issue.

If management recognizes the issues with the going concern assumption and makes adequate disclosure of all factors (including mitigating factors) the auditor would issue an unqualified audit report with emphasis of matter paragraph to draw reader’s attention to the relevant note disclosures in the financial statements. However, if the auditor decided that despite the disclosures that management was willing to make, the business is not a going concern, the financial statements should be prepared on a liquidation basis.

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If management do not agree to make the relevant disclosures, the auditor would issue an adverse audit opinion for inadequate disclosure, unless they thought the matter was not pervasive, in which case they would issue a qualified opinion for inadequate disclosure.

If the management refuse to cooperate and extend their assessment of the company’s ability to continue as a going concern to cover the period when the debt is due for refinancing, the auditor could issue a disclaimer of opinion due to limitation of scope.

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PROFESSIONAL APPLICATION 12.12 – Types of audit reports and modifications LO 8 The type of modification/audit report that would be most appropriate in each situation is: a. modified with a qualification. b. modified with an adverse opinion. c. modified with a disclaimer of opinion. d. unmodified.

PROFESSIONAL APPLICATION 12.13 – Disclosure of subsequent events LO 4 The recommended disclosure for each item is as follows: 1. Setting out the loan in the balance sheet as a loan from an officer would be sufficient disclosure. The source of the funds would not be disclosed because it is the officer's personal business and has no effect upon the corporation's financial statements.

2. The item would not require separate disclosure in the notes or otherwise, and would be handled by adjusting the Raw Material Inventory, and Accounts Payable by $24,720, the amount of the additional charge. (i.e., the actual total charge would be $41,200 × 80/50 = $65,920 and an estimate of $41,200 has already been recorded).

3. Disclosure should be made in a note to the financial statements of these conditions and the facts available at the date of the audit report.

4. All important details of the contract should be disclosed in a note to the financial statements because of the very substantial effect upon the corporation's future.

PROFESSIONAL APPLICATION 12.14 – Approaches to reporting contingent liabilities LO 3, 4 1. b – Disclose the information in a footnote in the December 31, 2011, financial statements.

2. a – Adjust the December 31, 2011 financial statements.

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CASE 12.15 – Integrative Case Study — Ball Construction Company (a) During the course of the audit, there was an error as a result of a transposition error. This caused trade accounts receivable and sales to be overstated. A progress billing error was made where a completion rate of 86% was used instead of 68%. It appears that this error is isolated and represents a known error of $277,560 ($1,542,000 × 18%). However, we will need to determine whether the same transposition error was made to the Construction in Progress account, and whether that account will need an adjustment as well.

The adjustments need to be discussed again with the CFO. Based on conversations to date, he is reluctant to record any adjustments. However, this should be recorded because net income is overstated. This amount is greater than our calculated materiality and therefore will have an impact on our audit report if the adjustment is not made. This fact, on its own, does not make the financial statements misleading. However, if we consider the users of the financial statements (such as the bank) and their reliance on our audit report, the statements as presented by management are misleading.

If Ball Construction Corporation (BC) wants a clean audit report, it must address the issue highlighted and make the required entry. Once again, we must request that management book the adjustment. If management will still not make the adjustments to the financial statements for the material error, we will have to issue a reservation in our audit report due to IFRS (GAAP) departures.

Because the reservation does not relate to a scope limitation and we are aware of the required adjustment, we would not issue a denial of opinion.

Reporting options would include a qualified opinion or an adverse opinion. A qualified opinion would be justified if we are comfortable that we can express a positive opinion on the financial statements as a whole and we can fully disclose in our report the reasons for the qualification. In this situation, because we are certain of the effects of the adjustments, I believe that we can issue a qualified opinion. (b) Management Letter Points The following operational issues were noted: 1. The company decided to expand operations into the United States without much discussion so that they could get in "before slowdown" occurred.

Expanding into another market at a time when that market is expected to "crash" and do poorly is a really bad operational and financial decision; the fact that this expansion was approved without much discussion is strongly indicative that there is insufficient operational oversight by the board of directors, who should be willing to speak out against decisions that are bad for the company as a whole.

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• Recommendation: Review the composition of the board for financial and industry experience; ensure qualified to be in this position.

• Recommendation: Review the decision-making process to determine who was involved in the decision; review the performance and qualifications of those involved in the decision.

• Recommendation: Implement proper processes for large operational decisions; ensure the approval of the board of directors and senior management is needed before such events can go ahead.

2. Improper segregation of duties in the payables department have been noted; if the same person is able to order goods, record the order in the system, and send a cheque for those goods, the risk of fraud as a result increases (i.e., the employee could record a fictitious purchase order in the system then send a cheque to him or herself).

• Recommendation: Separate the recording of an invoice from the payment of that invoice (oversight of cheque runs, currently in place, insufficient).

3. Controls over financial reporting are very weak. Unauthorized entries in the accounting system have been noted; if individuals are able to make unauthorized entries, we cannot rely on the underlying financial data (as we would have no documentation to which we could vouch the transaction), and a qualified opinion may be necessary.

• Recommendation: Restrict access to accounting system to accounting staff.

Put policies in place that require authorization from higher management for all manual journal entries. Ensure all recorded manual entries have a time/date/account stamp indicating who entered the accounting entry.

Other The CFO has displayed a pattern of lack of interest in financial controls, a proven bias towards misstating the financial statements (unwillingness to adjust the adjustment found). This could be the reason that the original Controller quit (i.e., did not want to perform unethical behaviours).

We should consider whether or not we want to be associated with a company that has a financial officer that seems to display unethical behaviour.

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Case Study — Cloud 9 Based on everything you know about the audit of Cloud 9, finalize the audit by preparing the audit report and the letter to those charged with governance of the company.

Solution Prepare audit report and letter. Use audit report examples in CAS 700 (and 705, 706 if applicable).

Letter to those charged with governance could include paragraphs: • • •

Summarizing general approach and overall scope of the audit, including any expected limitations thereon, or any additional requirements.

Comments on the design and operation of the internal controls and suggestions for their improvement, particularly if the auditor has identified material weaknesses in internal control during the audit.

Any other matters agreed upon in the terms of the audit engagement.

Major issues arising during the course of the audit, including practical difficulties, suspected non-compliance with laws and regulations found during the audit, management’s inappropriate decisions regarding accounting standards or estimates, modifications to the audit report would also be included in the letter, but there is unlikely to be any evidence of these in the case of Cloud 9.

The auditor also informs those charged with governance of those uncorrected misstatements aggregated by the auditor during the audit that were determined by management to be immaterial, both individually and in the aggregate, to the financial statements taken as a whole.

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RESEARCH QUESTION 12.1 – The global financial crisis led to increasing legal action against auditors Students are required to conduct and write up a literature search for all cases against auditors for issues related to the global financial crisis. This would be a search of newspapers and online press.

Students could include reports of investigations made by regulatory authorities, such as CPAB (Canadian Public Accountability Board) or the TSX (Toronto Stock Exchange) in Canada, the PCAOB (Public Company Accounting Oversight Board) in the US, ASIC (Australian Securities and Investments Commission) in Australia, of audit firms during the period. For example, ASIC released a report in 2010 suggesting that valuation issues were not being adequately assessed and documented following the GFC. Students are required to evaluate the evidence they discover in the context of the merit of the case against auditors or evidence of poor quality auditing, as opposed to searching for scapegoats.

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