You, CA, have been engaged by your provincial insti¬ tute to perform a practice inspection of Dow and Harder, Chartered Accountants (DH). This inspection involves a review of audit files for a DH client to determine whether generally accepted auditing standards (GAAS) were appro¬ priately applied. If, in your opinion, GAAS were not applied, you are to state the procedures that would have been more appropriate in the circumstances. A report detailing the results of your review will be presented to the senior partner of DH and the institute's practice inspection committee.

You select for inspection the completed audit files of Geri¬ atric Supply Limited (GSL), DH's largest client. GSL has been in business for over 30 years and has been an audit client of DH for much of this time. A private company, GSL had sales of \($8\) million for the year ended June 30, 2000. GSL paid DH approximately \($50,000\) in fees for the audit, income tax, and consulting services for the year.

Until December 31, 1999, GSL was a manufacturing and distribution company that manufactured products to order using labour-intensive methods. Under its contract with a provincial government, GSL shipped all its products to hos¬ pitals and government-owned nursing homes in the province as soon as the products were completed. GSL demanded a deposit equal to 30 to 40 percent of the selling price of a product before it would commence manufacturing that product. It required full payment in advance for prod¬ ucts requiring extra design work.

On December 31, 1999, the contract with the provincial government expired. GSL had anticipated the nonrenewal of the contract and during 1999 began to acquire the machinery needed for mass production.

In order to compete in its newly targeted markets, GSL now maintains a finished-goods inventory in different sizes and colours. A one-year warranty had to be provided, and dealers in the newly arranged dealer network had to be allowed to return unsold products. Some dealers were granted extended credit terms of 120 days.

GSL's sales for made-to-order produces were \($4,750,000\) for the six months ended December 31, 1999. This amount was collected by March 31, 2000. These sales resulted in \($45,000\) of minor repair work in fiscal 2000.

Your review of DH's 2000 working papers for GSL reveals the following:

1. Compliance audit procedures were completed in Decem¬ ber 1999. Substantive audit procedures were completed in August 2000.
2. According to the working papers, DH did not circularize receivable confirmations "because the government insti¬ tutions rarely responded in prior years."
3. DH's staff attended the June 30, 2000, inventory count and performed test counts of finished-goods inventory. The working papers state: "There was a significant amount of in-process, machine-produced inventory. The valuation of this inventory was discussed with manage¬ ment."
4. The working papers state: "The overhead application method and rate are consistent with those of prior years. Both fixed and variable manufacturing overhead are applied as a percentage of the direct labour cost."
5. Throughout fiscal 2000, GSL used job-order costing. Products that were being machine-manufactured for inventory were produced in batches of 50 or more and were then placed in finished-goods storage until sold. Actual costs of material and labour were charged to the applicable job number. At year end, DH relied on the compliance work performed in December 1999.
6. The auditors included the following comments in their working papers: "No accruals for warranty costs are required, as these have not been material in prior years. It is not clear what effect the design changes for the new products will have. During July and early August 2000, only \($50,000\) was incurred for repairs on products sold prior to year end."
7. The financial statements at June 30, 2000, show deferred costs of \($162,800\) for developing GSL's dealer network. The audit working papers state: "We were able to sub¬ stantiate 80 percent of these items by checking to invoices. The remaining amount was discretionary and was discussed with management."
8. The new products being inventoried for shipment to dealers were developed over several years, and design costs incurred before January 2000 were expensed. In the six months ended June 30, 2000, design costs of \($122,000\) were incurred and were included with work-in-process inventory. The audit working papers state: "We looked at purchase invoices and payroll records and discussed these items with management. Appears reasonable."
9. Per the working papers: "The client is financing the cur¬ rent assets with a demand bank loan, secured by receiv¬ ables, inventory, and a second mortgage on the building and machinery. The loan cannot exceed the aggregate of 65 percent of receivables and 40 percent of finished goods inventory. We have to report on compliance with these limits annually to the bank."
10.According to the working papers: "Commencing Janu¬ ary 1, 2000, manufacturing overhead variances are being charged to inventory. The calculation was checked, and the treatment was discussed with the bookkeeper."
11. The working papers contain the following note: "The company decided to adopt the following policy regard¬ ing the interest on the bank loan and the financing required for machinery purchase: one-half of the interest is to be expensed, and one-half is to be allocated to man¬ ufacturing overhead. This is appropriate because a 1:1 debt-to-equity ratio seems reasonable in this business."
12. According to the working papers: "All cash receipts for the period from July 1 to August 10, 2000 were traced back to the receivables ledger at June 30, 2000, and to other documents. No discrepancies were found."
13. A review note in the working papers states: "A standard- form audit report is appropriate. A consistency qualifica¬ tion is not required because all accounting changes can be considered changes in practices rather than policies."
14. Another review note states: "I phoned the owners, and they agreed to accrue their standard yearly bonuses of 20 percent of income before income tax and not to withdraw the cash for several months. This will assist liquidity but will not help the bank's covenant with respect to main¬ taining a minimum retained-earnings balance. We should invoice this client monthly."
15. The working papers state: "The income statements for the years ended June 30, 2000, and June 30, 1999, were compared. Management explained that the differences were caused by volume changes."
16. The working papers state: "We traced journal entries to shipping records around the June 30, 2000, cutoff and found no problems."
Required 4s a.List all examples of evidence examined in the DH file of GSL. For each-item of evidence, provide an example of the evidence “appropriateness. Organize your answer in two columns as follows:

b. Identify any other problems associated with the GSL audit, for each of the following phases of the audit:
(1) Knowledge of business (2) Planning (3) Testing (4) Reporting

c. Did DH violate GAAS during the audit of GSL? Support your answer.

Transcribed Image Text:

DH EVIDENCE EVIDENCE APPROPRIATENESS