Auditing Midterm Notes
Auditing Midterm Notes
Auditing Midterm Notes
What is an Audit?
Auditors compare work to criteria, makes sure FS are fairly represented, give opinions
Assurance Services
1. FS Audits - express opinion if FSs are prepared in all material respects in accordance with financial
reporting framework
o CSA requires listed entities on stock exchange to publish audited FS annually
o No guarantee that FS are free from error/fraud = use judgement
2. Compliance Audits - gathering evidence if rules/policies/procedures/laws have been followed
o Ex. Tax audits
3. Performance Audits - refers to economy, efficiency, effectiveness of organization's activities
o Done by internal or outsourced auditors
4. Comprehensive Audits - combines FS, compliance, and operational audits
o Public sector
5. Internal Audits - provides assurance about organization's activities
o Elements of operational and compliance audits, internal control assessment/reviews
6. Corporate Social Responsibility Assurance - voluntary reporting about environment/employee -
**not a focus is this course**
Audit Opinions
Unmodified - nothing changed in audit material
Modified - changes to audit material
FS misstated:
o Material but not pervasive = qualified opinion
o Material and pervasive = adverse opinion
Inability to get sufficient evidence
o Material but not pervasive = qualified opinion
o Material and pervasive = disclaimer of opinion
A report can be an unqualified modified report when an emphasis of matter is added (used to
grab reader attention without changing auditor opinion)
Independence
Ability to act with integrity, objectivity, professional scepticism
In Fact - make decisions free of bias
In Appearance - belief that independence of mind is present
5 Threats:
o Self-Interest - has financial interest in client (shares, loan, biz relationship)
o Self-Review - assurance team has to form opinion on own/their firm's work (used to be an
employee)
o Advocacy - auditor acts on behalf of assurance client, questions auditor's objectivity
o Familiarity - close relationships btw firm and client (encourage others to buy client shares,
represent client in negotiations/legally, accepting gifts/hospitality)
o Intimidation - auditor feels threatened by client, cannot act objectively (threatening to use
different auditor next year, pressure to reduce audit hours to lower costs)
Legal Liability
External auditor must exercise due care, apply standards, document work
Auditor can be liable for damages under tort law
Auditor should hire competent staff, comply with regulations, implement policies
CLIENT liability = under contract or tort law
Negligence – failed to perform audit by being careless/breaching duty of care
Contributory Negligence - where the plaintiff (the party suing) and the defendant (the
auditor) can both be proven to have been negligent, each party must be held
accountable in proportion to their guilt
Contract – failed to act as auditor when responsible for it
THIRD PARTIES = no contract btw auditor and third party
Understanding the client from Entity, Industry and Economic level importance:
1. Entity – gain knowledge of client, through interviews. Gain knowledge of major
customers/suppliers, client’s capacity, nature of warranties, discount terms, client
reputation/operations, nature of contacts, financing sources, structure ownership
2. Industry – client position in industry and size. Understand level of competition, client reputation
in industry, industry government regulations, demand for product
3. Economy – upturns/downturns, interest rates/fluctuations. Can the client withstand economic
pressure?
Related Parties - it is the responsibility of the auditor to ensure that related parties are identified and
appropriately disclosed in accordance with relevant accounting standards.
1. Discuss with the engagement team the susceptibility of the financial statements to material
misstatement due to fraud or error that could result from the entity's related party relationships
2. Ask management to identity all related parties and to provide an explanation of the nature,
type, and purpose of transactions with these entities
3. Obtain an understanding of the processes and procedures management has in place to ensure
all related party transactions are identified, authorized, accounted for, and disclosed in
accordance with the chosen financial reporting framework
4. Remain alert when inspecting documents such as bank confirmations, unusual sales and
purchase invoices, minutes of board of director and shareholder meetings, and contracts for
indicators that related party transactions may not have been identified or disclosed to the
auditor
5. Identify and assess the risk that transactions may not be in the normal course of operation
Fraud Risk - risk of misstatement
Must be professionally sceptic (independent questioning mind, search for evidence), ASK firm
about fraud, plan meetings, preliminary analytics
Red flags = finance employees refusing to leave, dominant mgmt, poor compensation, poor
training, ineffective internal audit, high auditor turnover, unusual transactions, weak internal
controls
TYPES:
o Financial reporting fraud - improper asset values/unrecorded liabilities, delayed
expenses/forward revenues, fictitious revenues/understating expenses
o Misappropriation of assets fraud - company credit card for personal items, failure to
remove ex-employees from payroll, unauthorized discounts/returns, theft of stock
CLIENTS must prevent/detect fraud, AUDITORS must assess risk of fraud/poor controls
Fraud Triangle = rationalize dishonest actions -> pressure to commit fraud -> opportunity to
misappropriate cash/assets
Going Concern Risk - will firm stay in business for foreseeable future? Can we value assets on basis that
they will be used/liabilities paid? Shareholders want to know
CAS 570 list of going concern risk factors:
o D/E ratio
o Long term loans due
o Prolonged loss
o Losing customers/supplier issues
o High staff turnover
o Poor growth planning
o Competitive pressures
Mitigating factors - letter of guarantee, non-core assets sale for cash, raising funds through share
issuance
Audit Risk-auditor makes inappropriate audit opinion when FSs are materially misstated. Risk is never 0!
1. Identify accounts and assertions most at risk for misstatement (inherent risk)
2. Assessment of client internal controls (control risk)
3. Auditor plans to test each account that's necessary
Materiality - guides audit plan, info is material if it impacts decision making of FS users (qualitative and
quantitative)
Qualitative = NATURE of item (fraud, law non-compliance, related party transactions, accounting
method change, operation change)
Quantitative = MAGNITUDE of item (% of base figure)
o 5-10% of normal pre-tax profit
o .5-2% total assets
o .5-5% of equity
o .5-.2% revenues
Performance materiality - amount less than planning materiality, to reduce misstatement in
account balance/transaction class/disclosure does not exceed overall materiality
o 60-85% materiality
Audit Strategy - sets scope/timing/direction, basis for detailed audit plan, based on preliminary
assessment of IR and CR
DR is low = substantive approach, no testing of controls, just tests of balances/transactions
CR is low and DR is high = combined audit strategy, test of controls
Analytical Procedures - evaluate financial info by studying link btw financial and non-financial data
Planning risk identification
Execute estimating account balances
Reporting overall review
Procedures - simple comparisons, trend analysis, common-size analysis, ratio analysis &
interpretation
Chapter 7 – Internal Controls
Entity-Level Controls - difficult to implement formal controls in small entities (low duty segregation,
reliance on owner, increased sub. tests)
1. Control Environment - culture, structure, discipline
2. Risk Assessment Process - how they respond to risk
3. Info Systems and Communication - manual/auto systems
4. Control Activities - policies/procedures to ensure mgmt's directions are done, performance
reviews, info processing, control authorization, account reconciliations, physical controls, duty
segregation, IT reliance, safeguards
5. Monitoring Controls - does mgmt monitor/update controls
Management Letter – deliverable prepared by the audit team and provided to management and those
charged with governance
Discusses internal control weaknesses and other matters discovered during the course of the
audit
Purpose of the management letter is to inform the client of the auditor's recommendations for
improving its internal controls
Chapter 6 – Audit Sampling
Audit Sampling - needed when auditor does not test entire group of transactions/itens in a balance -
often too much to test
Sample of items should represent population
Definition Sample does not represent Error made but not as a result of
population sampling (related to proficiency)
Sampling Categories:
1. Statistical - costly, time-consuming
2. Non-Statistical - lower risk accounts/balances, evidence readily available
Sampling Techniques:
1. Random Selection - person selecting sample cannot influence choice of items, each item equally
can be chosen, can stratify sample before selecting to increase efficiency
2. Systemic Selection - # items in population divided by sample size = sample interval, select starting
point and take every nth item, risk of every nth item being the same
3. Haphazard Selection - does not use methodical technique, not random sampling as bias can affect
choice
4. Block Selection - select items grouped together, make sure not sequence of items, non-statistical
5. Judgmental Selection - choose items based on judgement, non-statistical
Sample Size
INCREASED when = expected rate of deviation of population being tested increases, auditor's
desired assurance of tolerable deviation rate increases, increase in assessment of risk of
misstatement
DECREASES when = increase in tolerable rate of deviation, more use of substantive procedures,
population is stratified
NEGLIGIBLE when = increase in # sampling units in population
Three Categories of Substantive Procedures – nature of audit testing, timing of audit testing, extent of
audit testing
6: Data Analytics for Auditing
Data Analytics - evaluating data with the purpose of drawing conclusions to address business questions
Three vs. of big data: volume, velocity, variety
Enhances quality, transparency, and accuracy of audit
Gathering Techniques
Inspection Examining records/assets
Observation Watching a process occur (walkthrough)
Inquiry Written/verbal questions (interviews)
Recalculations Verifying math accuracy
Re-Performance Redoing process (edit checks)
Analytical Procedures Relationships btw financial/non-financial data
Substantive Procedures – audit procedures designed to detect material misstatements at assertion level
Used to get direct evidence for completeness, accuracy, data validity
Reduces detection risk
If IR/CR is low = auditor accepts high DR, little substantive procedures needed
Need determined by: risk of material misstatement, timing, level of needed assurance, type of
evidence required, complexity of data
Lower level of substantive testing at year-end, higher at half year period
Substantive Test Definition Examples
Test of Detail TRACING (tests completeness Tracing = account/journal
assertion), VOUCHING (tests Vouching = source document
existence/occurrence assertion)
Analytical Procedures Tests of balance, in combo with Absolute data comparisons,
(less useful when operations are other tests, provide min. level ratio analysis, trend analysis,
diverse, severe inflation, of support to conclusion breakeven analysis, patterns
budget’s not well controlled)
Computer Assisted Testing Software used to examine client Re-adding logic tests, select key
files OR used to plan/evaluate items, representative samples,
audit procedures (even if cx is handle large volumes of data,
not automated) more comprehensive
Levels of Evidence
Persuasive Evidence Primary test of balance, no
further procedures required
Corroborative Confirms audit findings from
other procedures, supports
mgmt. representations, if
results unexpected = expand
procedures
1.4/5: Securimax Limited has been an audit client of KFP Partners for the past 15 years, based in Waterloo,
where it manufactures high-tech armour-plated personnel carriers. Securimax often has to go through a
competitive market tender process to win large government contracts. Its main product, the small but
powerful Terrain Master, is highly specialized, and Securimax does business only with nations that have a
recognized, democratically elected government. Securimax maintains a highly secure environment, given
the sensitive and confidential nature of its vehicle designs and its clients. Clarke Field has been the
engagement partner on the Securimax audit for the last five years. The board of Securimax is considering
changing from an audit engagement to a review engagement and has approached Clarke to discuss the
implications of this change. Clarke suggests that KFP could perform the review engagement.
1. What is a review engagement? Why would a review be appropriate for a set of financial
statements for Securimax?
2. Discuss the expectation gap that could exist for the audit of Securimax. Consider the existence
of any special interests of the users of Securimax's financial statements.
1.8: What type of audit report would be appropriate in each of the following scenarios? Explain.
a) There is uncertainty relating to a pending exceptional litigation matter that is adequately
disclosed in the notes.
b) The client's records are inadequate and the auditor is unable to obtain sufficient appropriate
evidence.
c) There is a GAAP departure concerning a highly material item.
d) The client will not allow the auditor to contact the client's legal counsel.
e) The client's accounting records have been destroyed.
f) There is a material misstatement in the client's inventory account. The misstatement is deemed
to be material but not pervasive to the financial statements.
g) Inventories are misstated. The misstatement is deemed to be material and pervasive to the
financial statements.
2.3. Identify and discuss any professional conduct issues in the following independent scenarios.
a) Adnan Hussein is a CPA working for a national firm. He is at his desk when he overhears his
colleague Joan having a phone conversation. She is telling the person on the other end of the
call that Gupta Co., the firm's largest audit client, is about to release its audited annual financial
statements and the results are spectacular. Joan says she just bought some shares as she
expects that the share price will go up.
b) John Drake, a partner at Drake and Buetz, is meeting with a potential new client. The client
recently saw the firm's TV advertisement claiming that the firm was “the premier accounting
firm in western Canada.” The client requires a review engagement report with its financial
statements to obtain a bank loan. John advises that his fee will be 10 percent of any bank loan
granted.
c) Sue Chen, CPA, is working on the audit engagement for Jones Construction, a reporting issuer.
José, the accountant at Jones Construction, is unsure how to calculate the tax provision. Sue has
advised José not to worry. She will prepare the tax provision and ensure that the disclosures are
in accordance with generally accepted accounting principles (GAAP) so that she can issue an
unqualified audit opinion.
d) Sue Chen is working on the audit engagement for Clara's Cleaning Services, a private entity.
During the course of the engagement, she prepares a number of routine journal entries. She
makes the required adjustments and reviews them with Clara, who signs off on them, before
she releases the financial statements.
e) Sue Chen is working on the compilation engagement for Franks Foods, a private entity. During
the course of the engagement, she prepares a number of routine journal entries. She makes the
required adjustments before she releases the financial statements.
f) Jack Bond is a partner in a national firm. He is responsible for the audit for Canada Bank. He
recently purchased a car for his daughter and took out a car loan with Canada Bank.
g) Philip Monroe is a partner in a national firm. The firm is the auditor for Canada Bank. Philip's
father-in-law is the chief operating officer for Canada Bank.
h) James Lei, CPA, is reviewing his firm's accounts receivable. He notices that one of his largest
audit clients has not paid its fees for the last two years.
i) Alison Kotecha, CPA, is meeting with a potential new audit client, Klein Advertising. She paid
Johan Smit, a former colleague, $1,000 for the referral. Although she hasn't performed any audit
engagements for the last four years, she did recently take a GAAP course. During the meeting,
she reads over the prior year's financial statements and tells the client she will accept the
engagement. After reading the financial statements, she is certain that the fee will be less than
the fee charged by the previous auditor.
j) Matt Green is married to Jennifer Green, who owns Muffins to Go, a small private entity.
Jennifer is a baker and not an accountant. However, she needs a set of financial statements
prepared to attach to her tax return. Her husband Matt tells her that he will prepare them.
2.4. Identify and discuss any professional conduct issues in the following independent scenarios.
a) Jason Crane became a CPA in 2020. He is now glad to be finished his education as he does not
plan to take any further accounting courses.
b) Samantha Karadzic received a letter from Malik and Rudolph, another accounting firm, asking if
there is any reason they should not accept the audit engagement of her biggest client, Franks
Plumbing Inc. Samantha was so upset about losing the client, she threw the letter away and decided
not to reply. She ignored all requests for the client's records.
Issue with professional behaviour and objectivity - lets feelings affect her behaviour/decisions
c) Sean Kramer received a letter from Malik and Rudolph, another accounting firm, asking if there is
any reason they should not accept one of her clients, Vanderkrujk Farm Ltd. Because she had
disputes with management of Vanderkrujk, she was glad to see them go. She called Malik and
Rudolph right away and told them about all of the issues she had
d) William Aruna decided to start his own CPA firm as a sole practitioner. In order to attract new
clients, he wants potential clients to believe he has a large established firm with many partners.
Therefore, he has called his firm Aruna and Partners. His advertising materials indicate the firm has
the largest number of audit partners in the region.
Issue with integrity and due care - tried to create assumption of # of partners
e). Alan Reed discovered his long-time client, the Daily Diner, was in financial distress. He decided to
lend the Diner $20,000 and he had the owner sign a note payable. He informed Canada Bank, the
primary user of the financial statements, of this loan after the audit report was issued.
Issue with objectivity - he now has financial interest in company, conflict of interest
2.13. You are the audit manager of Currant & Co and you are planning the audit of Orange Financials Co
(Orange), who specialize in providing loans and financial advice to individuals and companies. Currant &
Co has audited Orange for many years. The directors of Orange are planning to list it on a stock
exchange within the next few months and have asked if the engagement partner at Currant & Co can
attend the meetings with potential investors. In addition, as the finance director of Orange is likely to be
quite busy with the listing, he has asked if Currant & Co can prepare the financial statements for the
current year to later be audited. During the year, the assistant finance director of Orange left and joined
Currant & Co as a partner. It has been suggested that, due to his familiarity with Orange, he should be
appointed as the partner on the audit engagement. Once Orange obtains its stock exchange listing, it
will require several assignments to be undertaken, such as obtaining advice about corporate governance
best practice. Currant & Co is very keen to be appointed to these engagements; however, Orange has
implied that, in order to gain this work, Currant & Co needs to complete the external audit quickly and
with minimal questions/issues. The finance director has informed you that, once the stock exchange
listing has been completed, he would like the engagement team to attend a weekend away at a luxury
hotel with his team, as a thank you for all their hard work. In addition, he has offered a senior member
of the engagement team a short-term loan at a significantly reduced interest rate.
a) Explain six ethical threats that may affect the independence of Currant & Co's audit of
Orange. For each threat, explain how it might be reduced to an acceptable level.
b) Orange is aware that subsequent to the stock exchange listing it will need to establish an
audit committee and has asked for some advice in relation to this. Explain the benefits to
Orange of establishing an audit committee.
2.16. Ahmad & Partners is a public accounting firm in eastern Canada. Last year, it audited Chan
Corporation, a publicly traded company that manufactures automobile component parts. Although the
company has been profitable for many years, Ahmad & Partners was hired by Canada Bank, which was
considering extending a large loan to Chan. The bank wanted the audit because Chan's expansion plans
would change the company's financial structure significantly from the previous year. Ahmad & Partners
conducted the audit and gave an unmodified opinion. Xing Investments Inc. purchased $750,000 of the
common stock of Chan, intending to hold the stock as a long-term investment. Unfortunately, Chan
went bankrupt shortly after the share purchase and Xing Investments lost all of its $750,000 investment.
Canada Bank was unable to recover any of its loan to the company. Xing Investments and Canada Bank
subsequently sued Ahmad & Partners to recover their losses.
1. Explain how you would use this information to understand your new client.
2. Identify and explain any significant fraud risk factors for Featherbed.
3. For each fraud risk factor you identify, explain how the risk will affect your approach to the
audit of Featherbed.
3.6. Sisters Inc. beauty salon is a 100% subsidiary of Benefit Beauty Supply Inc., a beauty supply
company. As a result of this relationship, there were several transactions between the two entities
during the last year. Sisters rented retail space for its salon from Benefit Beauty during the past year.
Sisters also purchased beauty supplies from Benefit Beauty. Lastly, Sisters has a non-interest-bearing
loan owing to Benefit Beauty, and there are no repayment terms for this loan. Sisters is looking to
expand next year and is seeking a new bank loan. As a result, it has asked Sol Newton, CPA, to audit its
financial statements.
1. Discuss the impact these transactions will have on Sol during the risk assessment phase.
3.7. From the list below, identify what you would consider as a motive for fraud and/or an
opportunity for fraud:
a) college or university tuition
b) gambling debts
c) the fact that nobody counts the inventory, so losses are not known
d) the fact that the petty cash box is often left unattended
e) illegal drugs
f) the finance vice-president having investment authority without any review
g) alimony and child support
h) expensive lifestyle (homes, cars, boats)
i) business or stock speculation losses
j) the fact that upper management considered publishing a written statement of ethics but
decided not to
k) taxation on good financial results
l) supervisors setting a bad example by taking supplies home
m) the fact that an employee was caught and fired, but not prosecuted
3.16. Shane Whitebone is getting to know his new client, Clarrie Potters, a large discount electrical
retailer. Ben Brothers has been the engagement partner on the Clarrie Potters audit for the past five
years, but the audit partner rotation rules have meant that the engagement partner had to change this
year. Shane discovers that, toward the end of last year, Clarrie Potters installed a new IT system for
inventory control. The system was not operating prior to the end of the last financial year, so its testing
was not included in the previous audit. The new system was built for Clarrie Potters by a Montreal-
based software company, which modified another system it had designed for a furniture manufacturer
and retailer.
1. What audit risks are associated with the installation of the new inventory IT system at Clarrie
Potters?
4.1. Ajax Finance Ltd. provides small- and medium-sized personal, car, and business loans to clients. It
has been operating for more than 10 years and run throughout its life by Bill Schultz. Bill has been the
public face of the finance company, appearing in most of its television and radio advertisements. He has
developed a reputation as a friend of the “little person” who has been mistreated by the large finance
companies and banks. Ajax's major revenue stream is generated by obtaining large amounts on the
wholesale money market and lending in small amounts to retail customers. Margins are tight, and the
business is run as a “no frills” service. Offices are modestly furnished and the mobile lenders drive small,
basic cars when visiting clients. Ajax prides itself on full disclosure to its clients, and all fees and services
are explained in writing to clients before loans are finalized. However, although full disclosure is made,
clients who do not read the documents closely can be surprised by the high exit charges when they wish
to make early repayments or transfer their business elsewhere. Ajax's mobile lenders are paid on a
commission basis; they earn more when they write more loans. For example, they are encouraged to
sell credit cards to any person seeking a personal loan. Ajax receives a commission payment from the
credit card companies when it sells a new card and Ajax also receives a small percentage of the interest
charges paid by clients on the credit card.
1. What are the inherent and control risks for Ajax's revenue? Explain which assertions are most
at risk.
4.2. Cheap-as-Chips stocks thousands of items in inventory that range in value from $1 to $100. The
inventory on hand represents a material portion of current assets. The merchandise items change
according to the season and the promotional theme adopted by the stores' management for the year.
Merchandise is ordered up to four months in advance from Chinese and Korean suppliers. These special
orders require Cheap-as-Chips to give the suppliers substantial deposits upon placement of the orders.
What are the inherent risks for Cheap-as-Chips' inventory? Discuss the assertions being made by
management about the inventory.
4.8. Ana Dinh used 0.5 to 5 percent of gross profit in determining materiality of $70,000 in her audit of
XYZ Inc., a company that builds replacement engines for tractors and combines. She used the $70,000
amount as her planning materiality, identifying account balances and transactions to be tested. She also
used materiality as a guide when deciding on the appropriate audit opinion in her report.
2. Provide three other examples of a base (other than 0.5 to 5 percent of gross profit) that an
auditor could use in determining materiality in a financial statement audit.
3. Suppose Ana initially reviewed parts inventory account #102641–1 and found that none of the
account transactions exceeded $45,000. Does this mean that none of these transactions should
be selected for examination, based on her materiality decision of $70,000? Explain your answer.
4.9. Atlantic Academy is a private school that offers education to children from Kindergarten to Grade 7.
The school operates as a not-for-profit entity and oversight of the school is performed by the board of
directors. The board reviews the operational and financial results monthly to ensure the school is
meeting its budget responsibilities. Revenues for the school generally come from three sources: student
tuition, government funding, and various fundraising programs seeking additional funds for specific
purposes. Government funding is provided based on the number of students enrolled, and the funds are
to be spent only on the provision of education services. A requirement of the government funding is
that the school must submit annual audited financial statements. Jones and Black, CPAs, are the auditors
of Atlantic Academy. Their firm policy is to use the following percentages when determining materiality:
5% of normalized pre-tax profit
1% of total assets
2% of equity
2% of revenues or expenditures
Performance materiality is to be 65% of planning materiality.
2020 2019
Revenues $1,186,000 $1,229,000
Expenses 1,607,000 1,160,000
Income from continuing (421,000) 69,000
operations
Total assets 3,419,000 2,928,000
5.4. A client has a material balance in property, plant, and equipment. The discussions with
management indicate that there is a risk the client will capitalize all repair costs to minimize the impact
on expenses. Repairs are likely to be material because of the extreme weather conditions affecting
operations and machinery operating conditions. Extensive repairs were due to commence in the month
prior to year-end, with completion around two months later.
5.8. Identify the type of audit evidence being used in each situation described below:
a) The auditor tests cash remittance advices to ensure that allowances and discounts are
appropriate and that receipts are posted to the correct customer accounts in the right amounts.
In addition, the auditor reviews the documents supporting unusual discounts and allowances.
b) The auditor examines vehicle insurance policies and checks insurance expense for the year. In
addition, the auditor reviews the expense with respect to changes and ending balances in
capital asset accounts.
c) The auditor observes the auditee taking a physical inventory count. In addition, a letter is
received from a public storage facility stating the amounts of the auditee's inventory stored in it.
The company uses a weighted average cost flow assumption, which is tested by the auditor's
computer software program.
d) Using audit software, an auditor selects vendors' accounts payable with debit balances from the
client's computer and compares these amounts and their calculation with cash disbursements
and vendor credit memos.
5.16. SolarTubeGen is a start-up company in the renewable energy sector. The founder, Fritz Herzberg,
has developed cutting-edge technology to convert the energy in the sun's rays to electricity via a novel
system of mirrors designed to focus the sun's rays onto tubes containing a patented type of gas, which
then heats and expands to drive turbines. KenKen Partners has won the contract for the first statutory
audit of SolarTubeGen on the basis of its expertise in the energy sector. However, the lead partner, Ken
Kennedy, recognizes that the success of the audit is dependent on the correct assessment of the
technology being used at SolarTubeGen. Ken specified in the successful tender documents that the audit
will use an external expert to help with valuation of the company's assets. Fritz Herzberg is very
protective of his company's intellectual property and is resistant to Ken's first suggested expert,
Manfred Hamburg. Fritz believes that Manfred Hamburg is hostile toward him because they clashed
when they both worked for a German company making photovoltaic cells in the 1990s. Fritz has
suggested another expert, Lily Beilherz, with whom he has had good working relations over the last 20
years.
1. Advise Ken Kennedy about the choice of an expert for the audit of SolarTubeGen. What must
he consider when making his choice?
6.1. Bob Downe is auditing Red Gum Home Furniture (RGHF), a manufacturer and retailer of boutique
home furniture. RGHF was founded 25 years ago by a husband and wife team and has grown rapidly in
the last five years as solid, environmentally friendly, wooden furniture has grown in popularity.
However, although RGHF's owners have attempted to expand the administration department to keep
pace with the growth in sales, some systems are not operating as effectively as they should. This is
partly due to difficulty in attracting and retaining accounting staff with appropriate experience and skills.
RGHF's owners have recently realized that they need to increase pay and improve conditions for the
accounting staff to avoid having periods with unqualified staff, particularly for sales invoice processing.
The staff shortages have resulted in sluggish performance in processing invoices, sending out customer
statements, and collecting cash from account customers. In addition, there have been numerous
mistakes in processing sales invoices, some of which have been discovered after customer complaints.
Bob is selecting a sample of sales invoices for substantive testing. All documents relating to sales
invoices for the last five years are stored in boxes in the shed behind the office. The shed is very small
and the boxes are stacked on top of each other because the shelves are full. Due to the damp
conditions, some labels have peeled from the boxes, so it is not clear which boxes relate to the current
year.
6.2. Match the numbered situations below with one of the following types of audit sampling or sampling
risk:
Statistical sampling
Non-statistical sampling
Sampling risk
Non-sampling risk
1. Rather than looking only for authorized signatures, an auditor checked to see if there were
any signatures in the credit approval box on a sample of sales orders.
2. An auditor concluded that, based on a statistical sample, the client's control system was
working acceptably when, in fact, the population deviation rate was unacceptable.
3. Using the laws of probability, an auditor selected a sample and evaluated the results of her
sample.
6.4. Rahim, a first-year auditor, is asked to select a sample of invoices to audit the utility expense
account. Below is the account detail. The audit program asks to select a sample of four items.
January $15,245 | February 12,973 | March 11,359 | April 9,326 | May 6,380 |
June 4,558 | July 2,901 | August 2,837 | September 3,690 | October 5,890
November 9,823 | December 14,906
1. Using systematic selection, determine which four months will be selected.
2. Using haphazard selection, determine which four months will be selected.
3. Using block selection, determine which four months will be selected.
6.7. Fred Saros is auditing cash payments for OGA, a large supermarket. OGA deals with several very
large corporate suppliers who expect payment by electronic funds transfer within three business days of
delivery. Other large suppliers will accept cheques or electronic funds transfers on terms of 14 days, and
small suppliers receive cheques with payment terms of 30 days. Other regular, large cash payments
include wages (paid weekly by electronic funds transfer from a wages imprest account), utilities
(electricity accounts are paid monthly by cheque), cleaning (paid monthly by cheque), and rent (paid
monthly by electronic funds transfer). In addition, there are irregular payments for items such as
maintenance, fixtures purchase and lease, and vehicle running costs. All cash payments are processed in
the central office after the required set of documents has been assembled and checked by two junior
accounts staff. Payments are authorized by a senior accountant, and electronic funds transfer
authorities and cheques are countersigned by the chief accountant (except if he is on holidays, when
another member of the accounting staff performs this task). Journals and ledgers are maintained by
staff not involved in cash payment processing. Fred needs to test controls over cash payments and has
planned to make extensive use of sampling.
7.1. Powersys is an electricity distribution company based in a large capital city. Its business is to
manage the electricity assets, including poles, wires, and other equipment, that are used to deliver
electricity to more than 500,000 retail and business customers in the city. Pole, wire, and substation
maintenance and improvements are a large part of the company's operations, and teams of highly
trained technicians are used for both planned work and emergency response activities. Emergency
response is required when storms or fires bring down power lines, the power must be turned off at the
direction of police, or the electricity supply fails for any reason. Each team has several vehicles (vans and
trucks) and uses additional heavy equipment, such as cherry pickers, cranes, and diggers, as required.
Each vehicle carries a core set of specialized parts and tools, and additional items are obtained as
required from storage, which is located in a large warehouse in the northern suburbs. The warehouse is
staffed on a 24-hour basis to assist night maintenance (designed to minimize disruption to business
customers) and emergency response.
1. Make a list of the potential problems that could occur in Powersys's maintenance and
improvements program.
2. Suggest ways that good internal control over parts, equipment, and labour could help
Powersys avoid these problems.
7.3. The following errors due to sloppy paperwork and poor controls were found during an audit.
1. A customer's order was shipped without credit approval.
2. Some sales made in January were recorded as December. Company has a December 31 end.
3. Duplicate sales were recorded.
4. Sales to a subsidiary were recorded as sales to outsiders instead of as intercompany sales.
5. Some shipments of goods to customers were not recorded.
Identify which internal control objective was violated in each case.
7.4. International Bank is experiencing bad publicity surrounding huge fraud losses in its foreign
currency department. Accusations are being made in the press that the rogue trader blamed for the
losses was operating outside the official guidelines with the tacit approval of senior management in the
department because of the large profits made by this trader in previous years. The press claims that it
was common knowledge in the foreign currency department that strict policies and procedures
surrounding the size of trades and the processes for balancing out trades at the end of each day were
not to be followed if the trader had verbally informed his supervisor of the trade. The press is also
suggesting that the problems are not confined to the foreign currency department, and that poor
attitudes are prevalent throughout all commercial departments at International Bank.
1. Discuss the control environment at International Bank, assuming the press reports are correct.
Which parts appear to be most deficient?
7.5. There are several categories of control activities listed in this chapter. They include performance
reviews, authorization controls, account reconciliations, physical controls, and segregation of duties.
For each of the following, identify the type of control:
a) Petty cash is kept in a safe.
b) All invoices are stamped “paid” after processing.
c) Cheques received are pre-listed by the receptionist and recorded in the books by the accounts
receivable clerk.
d) Accounts receivable sub-ledger is agreed to the general ledger at each month end.
e) Passwords are required before journal entries may be posted.
f) Monthly results are compared with budget, and unexpected results are investigated.
g) Overtime must be approved by a supervisor.
h) Pre-numbered purchase orders are required before an invoice will be paid.
i) Employee payroll records are kept in a locked filing cabinet.
j) The person responsible for shipping and receiving goods does not perform the related billing.
k) Monthly results are sent to divisional managers for review.
8.2. James Wu has been assigned the audit planning for the property, plant, and equipment section for a
large manufacturing audit client. The client built a new factory during the first six months of the year;
therefore, significant additions were made to its property, plant, and equipment accounts.
a) When should James plan for the audit work for to be performed, given that the client's year
end is December 31 and the audit falls during the firm's busy season? Why?
b) If James plans for the substantive testing on the asset additions to be done before year end,
should James plan to perform additional audit work on asset additions at year end?
8.4. Boris Shonkoff suggests the following audit procedure should be included in the audit program to
gather evidence on the cut-off assertion for the revenue account: Select a sample of sales from the sales
journal and agree the dates on the invoices to the dates on the delivery documents signed by the
customer.
1. Explain how the procedure addresses the assertion. What does it mean if (a) the dates agree,
or (b) the dates do not agree?
8.5. Boris Shonkoff has another suggestion for the audit program for the revenue account. This time he
suggests: Select a sample of sales from the sales journal and agree the details in the journal to the sales
invoices, delivery slips, and customer orders.
1. Explain which assertion for the revenue account would be addressed by this test.
8.6. Seb Lee and Boris Shonkoff are discussing the audit program for the revenue account. Seb and Boris
disagree about whether they should use procedure A or B below to test the occurrence assertion for the
revenue account:
A. Select a sample of sales from the sales journal and agree the details in the journal to the sales
invoices, delivery slips, and customer orders.
B. Select a sample of sales invoices, delivery slips, and customer orders and agree the details to
the details recorded in the sales journal.
1. Which test provides evidence about the occurrence assertion? Why? Which assertion does the
other test provide evidence about?
8.9. North West Paper Ltd. provides cardboard, paper, and plastic packaging materials to a large number
of manufacturers and distributors in all provinces. The cardboard and paper division is a well-established
business, but North West has been providing plastic products only since it took over Plastic Products Ltd.
18 months ago. The takeover doubled North West's revenue and caused changes in its management
structure, adding another two divisional managers. These new divisional managers are in charge of
plastic product sales to different areas of the country—Plastic (Eastern) and Plastic (Western)—and they
join the Paper (Eastern) and Paper (Western) division managers in reporting directly to the CEO. All
internal operating reports are now structured along the four divisional reporting lines, although external
financial statements continue to be produced for the whole business. All purchasing and billing systems
are fully integrated, although it is possible to extract data along divisional lines and by province (as
before). North West purchases bulk supplies of raw plastic and paper and makes boxes, rolls, and sheets
of these materials to fill customer orders. Production processes in the paper divisions have not changed,
and North West has made minimal changes to the production processes used by Plastic Products Ltd.
1. List and discuss the factors that would increase or decrease the reliability of data used in
analytical procedures at North West.