Solution Auditing

Moroney, Campbell, Hamilton, Warren Auditing: A Practical Approach, Canadian Edition

Solutions Manualto accompany

Auditing: a practical approach

by

Robyn MoroneyFiona CampbellJane HamiltonValerie Warren

CHAPTER 3

Audit Planning I

John Wiley & Sons Canada, Ltd.2012

Solutions Manual 3-1 Chapter 3Copyright © 2012 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of this page is strictly prohibited.


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.


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



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.


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).


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?



Fraud risk — factors indicating high risk of fraud, identify incentives, pressures, and opportunities for fraud, management attitudes.Going concern — risk and mitigating factorsCorporate governance — board structure, listing status, audit committeeInformation technology — risks to processes, security, changes, controlsClosing procedures — types of procedures, monitoring, pressure on results


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.


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,



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.




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.


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.



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)


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.


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 cut-off).



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.



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 governanceLO 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



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.



PROFESSIONAL APPLICATION 3.3 – Understanding the client and its risks — audit planningLO 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.



PROFESSIONAL APPLICATION 3.4 – Financial reporting fraud riskLO 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 (non-recognition of accruals, etc)



(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.



PROFESSIONAL APPLICATION 3.5 – Going concernLO 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.



PROFESSIONAL APPLICATION 3.6 – Assessing the risks associated with information technologyLO 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 non-routine 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.



PROFESSIONAL APPLICATION 3.7 – Audit planning in an EDP environmentLO 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 reasonswhy the company implements computer systems. Rather than having separateaccounts 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 computersystem. 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).



• 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 andcomputersmay 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.



PROFESSIONAL APPLICATION 3.8 – Impact of closing procedures on performanceLO 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.



PROFESSIONAL APPLICATION 3.9 – Gaining an understanding of a new clientLO 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?



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.



PROFESSIONAL APPLICATION 3.11 – Fraud riskLO 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 fraudLO 4

Items that would be considered as:

1) a motive for fraud: a, b, f, g, h, i, l



2) an opportunity for fraud: c, d, e, f, j, k, l, m

PROFESSIONAL APPLICATION 3.13 – The fraud triangleLO 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



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



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.



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

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

Economic characteristics/Supplier information/RegulatoryThe 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.



Competitive environment/Product information/Customer informationCompetition 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 SystemsTechnological 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:



Growth of revenues given industry outlook and management incentiveRisk DescriptionConsumer 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 systemRisk DescriptionRetail 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 competitionRisk DescriptionMost 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 trendsRisk DescriptionRapidly changing fashion trends and slow sales outlooks can result in obsolete inventory/stock.

Misappropriation of inventory and cashRisk DescriptionRetail 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 retailersRisk DescriptionFor 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.



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?).



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)?



• 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



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.



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.


Date post:	03-Dec-2015
Category:	Documents
Upload:	farhad-hussain
View:	47 times
Download:	7 times