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MIDTERM EXAM: ADMS 4551, Winter 2010, All Sections, February 21, 2010 Student Number: ________________________ Name: ______________________________________ Question 1 (10 marks- 22 minutes) You CA, work for a large public accounting firm, Jones Siegal LLP (JS), with many offices across the country. As part of your new job as a senior manager in the national office, you have been assigned to do a quality control review of the Highland Organic Foods (HOF) audit recently conducted by your Halifax office. HOF is a wholesaler of organic food products. Your firm has been auditing HOF for the past six years ago. Your firm issued an unqualified audit opinion on the December 31, 2009 financial statements. The following are your notes from the review of HOF's December 31, 2009 year end audit file: The audit team was led by Leonard Fink, who obtained his CA designation in 2007 while working at a small firm. Leonard left the accounting firm in January 2008 and joined HOF as the controller. After about a year Leonard realized that he really missed public accounting and accordingly in May 2009 quit HOF and joined JS. The HOF audit partner, Jim Hook, personally selected Leonard to lead the HOF audit. Jim thought that Leonard's extensive understanding of the organic food business and his extensive knowledge of HOF's internal controls would be a great value in the conduct of the audit. Leonard had the help of two assistants, Joe Spine and Marshia Devine . Leonard thought that on-the-job training was one of the best forms of professional development. He decided to let Joe and Marshia perform all of the audit field work and resolve all audit issues. He would not provide any direction to them until the audit was completed, at which time he planned on reviewing the file and providing his feedback. He was confident that they were ready to take this step in their professional development as they were considered very bright and had both done well in their auditing courses at university. The current year's audit working paper files were well organized. However, in November 2009, JS's main server crashed and the previous years' soft copy working papers and the soft copy permanent file were lost. JS's IT department were still working on the recovery of the files at the time of the audit. The files were never recovered. After much searching, Marshia found the hard copy HOF 2008 audit file. The hard copy file that she retrieved only included specific documents that were required to be kept in hard copy form (ie. signed engagement letter, signed accounts receivable confirmations). Since the prior years audit files could not be located, Marshia asked Susan Bam, HOF's assistant controller, for information on the prior year's audits. Susan indicated that the HOF audit has never had any significant problems. Susan 1 MIDTERM EXAM: ADMS 4551, Winter 2010, All Sections, February 21, 2010 Student Number: ________________________ Name: ______________________________________ explained that as a result of internal control weaknesses, JS did not rely on controls. She also, indicated that in last year the audit assistant told her materiality was $50,000. Marshia concluded that since there had not been any changes to HOFs operations in the current year it was appropriate to use the same materiality level and audit approach from previous years. Marshia decided not to perform any procedures on internal controls since they were weak and she had no intention of relying on them. During late 2009, HOF suffered a significant drop in sales due to a recall of organic spinach and strawberries that were tainted by the e-coli. Given HOF's drop in sales, the audit partner gave HOF a 20% reduction in its audit fees for 2009. Required: Evaluate the quality of the HOF audit engagement by identifying any deficiencies in the application of generally accepted auditing standards for the conduct of the December 31, 2009 financial statement audit, for example, the standards set out in CAS 200. Generally Accepted Auditing Standard Assessment of the audit engagement 2 MIDTERM EXAM: ADMS 4551, Winter 2010, All Sections, February 21, 2010 Student Number: ________________________ Generally Accepted Auditing Standard Name: ______________________________________ Assessment of the audit engagement 3 MIDTERM EXAM: ADMS 4551, Winter 2010, All Sections, February 21, 2010 Student Number: ________________________ Name: ______________________________________ Question 2 (14 marks, 30 minutes) The Sockit Corporation is a leader in women's legwear and intimate apparel. Their brands include fashion-forward Hua one of the most recognized and respected brands among women. While their heritage is in hosiery products, their brands have experienced tremendous sales successes with innovative designs and solutions in many other categories, including sleepwear, loungewear, panties, slippers, bras, shoe solutions, fashion legwear, and socks. Sockit is a public company, headquartered in Toronto, who's shares trade on the Toronto Stock Excahnge and has a December year-end. Sockit operates four divisions in both Canada and the Unitied States. The company also has a design studio/showroom in the heart of the fashion district in New York City. Sockit has historically allowed its divisions to operate autonomously. Corporate intervention occurred only when planned results were not obtained. Corporate management has high integrity, but the board of directors and audit committee are not very active. Sockit has a policy of hiring competent people. The company has a code of conduct, but there is little monitoring of compliance by employees. Management is fairly conservative in terms of accounting principles and practices, but employee compensation packages depend highly on performance. Sockit Company does not have an internal audit department and it relies on your firm to review the controls in each division. Stan Silver is the general manager of the Hosiery Division. Silver has been the general manager for the last seven years, and each year he has been able to improve the profitability of the division. His compensation is based largely on the division's profitability. Much of the improvement in profitability has come through aggressive cost cutting, including a substantial reduction in control procedures over inventory. During the last year a new competitor has entered Hosiery's markets and has offered substantial price reductions in order to grab market share. Silver has responded to the competitor's actions by matching the price cuts in the hope of maintaining market share. Silver is very concerned because he cannot see any other areas where costs can be reduced so that the division's growth and profitability can be maintained. If profitability is not maintained, his salary and bonus will be reduced. Silver has decided that one way to make the division more profitable is to manipulate inventory because it represents a large amount of the division's balance sheet. He also knows that controls over inventory are weak. He views this inventory manipulation as a short-run solution to the profit decline due to the competitor's price cutting. Silver is certain that once the competitor stops cutting prices or goes bankrupt, the misstatements in inventory can be corrected with little impact on the bottom line. 4 MIDTERM EXAM: ADMS 4551, Winter 2010, All Sections, February 21, 2010 Student Number: ________________________ Name: ______________________________________ Required: A) Identify the strengths and weaknesses of Sockit Company's control environment. (5 marks) and discuss the effect they would have on the conduct of the audit (1 mark). (Total 6 marks) 5 MIDTERM EXAM: ADMS 4551, Winter 2010, All Sections, February 21, 2010 Student Number: ________________________ Name: ______________________________________ B) Explain the three conditions for fraud (the fraud triangle) and describe whether or not each of these conditions were present at Sockit Company. (6 marks) Fraud Conditions Condition Present at Sockit 6 MIDTERM EXAM: ADMS 4551, Winter 2010, All Sections, February 21, 2010 Student Number: ________________________ Name: ______________________________________ C) Describe two necessary actions that the auditor should take in a situation with high inventory fraud risk. (2 marks) 7 MIDTERM EXAM: ADMS 4551, Winter 2010, All Sections, February 21, 2010 Student Number: ________________________ Name: ______________________________________ Question 3 (8 marks - 19 minutes) Archana is auditing a computer equipment manufacturer. As part of her inventory audit work, she attended the client's inventory count and she has physically examined a sample of the steel plates used to make the computer cases and the electronic parts used to assemble the computers internal processing mechanisms. She then traced the information about the quantities of each item to the client's listing of the inventory on hand at the count. Required: a) Explain what type of audit evidence Archana has obtained and what audit objective(s) and assertion(s) this evidence is most relevant to. (5 marks) b) Which of the two items of evidence that Archana obtained is more reliable? Why? (3 marks) Question 4 (9 marks, 20 minutes) Rub and Scrub Car Wash (RC) operates a car wash in Port Montana, a medium sized town. The current owners of RC are Mike and Susan Smith who have been operating the car wash for over 10 years. They have recently received an offer from a local entrepreneur who operates 5 other car washes that he wants to purchase all the shares of their company. Mike and Susan are interested in selling RC because they would like to focus on another business they have recently started up in town, a fitness club. The prospective purchaser has offered to pay four times the income before taxes, based on audited 2009 financial statements. You are a staff member at a public accounting firm in Port Montana. In the past RC has engaged your firm to prepare its tax returns, but its financial statements have never been audited or reviewed. Because the prospective purchaser wants audited financial statements, Mike and Susan has recently engaged your firm to audit RC's financial statements for its December 31, 2009 year end and you have been assigned to plan the audit. It is now January 15th and you have just met with Mike to discuss the planning for the upcoming audit. The following are the summary notes from your initial meeting: Summary of January 15th meeting with Mike Smith The bookkeeper of the company left during the year to work for a competitor's car wash. Since Mike and Susan are planning to sell the business, they did not bother to hire another bookkeeper. The accounts payable clerk has been able to manage all accounting functions independently. . Mike mentioned that RC's net income and revenue have fallen in recent years for the following reasons: 8 MIDTERM EXAM: ADMS 4551, Winter 2010, All Sections, February 21, 2010 Student Number: ________________________ Name: ______________________________________ 1. New gas stations in the area with superior quality car washes. Most recently, the Ecco gas station operating adjacent to RC built a new, state of the art \"touchless\" car cleaning facility. In response to the increased competition, RC has decreased the price of its car washes. However, even with the decrease in wash price, the opening of the \"touchless\" car wash has caused a significant decline in number of RC customers. 2. An increase in quantity of cleaning supplies utilized on a per wash basis. He indicated that he hasn't had time to investigate the cause of the increase since he has been so busy starting up the new fitness club. 3. Old brushes in the automated car wash system caused small scratches on customer cars. RC reimburses customers for the cost of repairs. This happens from time to time when Mike forgets to change the brushes. 4. Revenue, Net Income and Net Assets for RC's last five years are: Year Revenues Net Income (Loss) Before Income Taxes Net Income (Loss) After Income Taxes Net Assets 2009 $ 120,000 $ 20,000 $ 15,500 $250,000 2008 240,000 62,000 47,000 420,000 2007 360,000 79,000 60,000 490,000 2006 380,000 84,000 75,000 520,000 2005 320,000 (8,000) (8,000) 300,000 Required: A) Identify two factors affecting RC's business risk and discuss the impact on the risk of material misstatement (RMM) (4 marks) Factors affecting business risk Impact 9 MIDTERM EXAM: ADMS 4551, Winter 2010, All Sections, February 21, 2010 Student Number: ________________________ Name: ______________________________________ = B) For each of the identified risks of material misstatements provide an audit procedure that could be performed in response to the assessed risks.(2 marks) 10 MIDTERM EXAM: ADMS 4551, Winter 2010, All Sections, February 21, 2010 Student Number: ________________________ Name: ______________________________________ 11 MIDTERM EXAM: ADMS 4551, Winter 2010, All Sections, February 21, 2010 Student Number: ________________________ Name: ______________________________________ C) Calculate the preliminary materiality. Justify your answer qualitatively. (3 marks) 12 MIDTERM EXAM: ADMS 4551, Winter 2010, All Sections, February 21, 2010 Student Number: ________________________ Name: ______________________________________ PLEASE NOTE: THERE ARE NO LONGER ANY MULTIPLE CHOICE QUESTIONS ON 4551 MIDTERM EXAMS - YOU MAY DO THESE TO TEST YOUR KNOWLEDGE Question 5 MULTIPLE CHOICE QUESTIONS ( 10 marks- 22 minutes) WRITE YOUR ANSWER IN THE TABLE PROVIDED AT THE END. USE CAPITAL LETTERS FOR YOUR ANSWERS 1. The independent audit is important to readers of financial statements because it a) determines the future stewardship of the management of the company whose financial statements are audited. b) measures and communicates financial and business data included in financial statements. c) involves the objective examination of and reporting on managementprepared statements. d) reports on the accuracy of all information in the financial statements. 2. An auditor who accepts an audit engagement and does not possess the industry expertise of the business entity, should a) engage experts familiar with the nature of the business entity. b) withdraw from the engagement. c) refer a substantial portion of the audit to another public accountant who will act as secondary auditor. d) obtain a knowledge of matters that relate to the nature of the entity's business. 3. An audit engagement letter should normally include the following matter of agreement between the auditor and the client: a) b) c) d) schedules and analyses to be prepared by the client's employees. methods of statistical sampling the audit will use. specification of litigation in progress against the client. client representations about availability of all minutes of meetings of the board of directors. 4. The cycle approach to segmenting an audit requires that a) the client's natural business cycle or year be the primary consideration in planning the audit. 13 MIDTERM EXAM: ADMS 4551, Winter 2010, All Sections, February 21, 2010 Student Number: ________________________ Name: ______________________________________ b) closely related transactions and account balances be kept in the same segment. c) every account balance on the financial statements must be treated as a separate segment. d) two different audit teams will cycle between assignments to ensure that the firm has an unbiased view of the client's records. 5. Analytical procedures are a) statistical tests of financial information designed to identify areas requiring intensive investigation. b) analytical procedures of financial information made by a computer. c) substantive tests of financial information made by a study and comparison of relationships among data. d) diagnostic tests of financial information that may not be classified as evidential matter. 6. Which of the following is an example of objective evidence? a) a letter written by the client's lawyer discussing the likely outcome of outstanding lawsuits. b) the physical count of securities and cash. c) inquiries of the credit manager about the collectability of noncurrent accounts receivable. d) observation of cobwebs on some inventory bins. 7. Evidence is usually more persuasive for balance sheet accounts when it is obtained a) b) c) d) as close to the balance sheet date as possible. only from transactions occurring on the balance sheet date. from various times throughout the client's year. from the time period when transactions in that account were most numerous during the fiscal period. 8. The decision as to how much evidence to accumulate for a given set of circumstances is: a) b) c) d) provided by following Canadian generally accepted accounting principles. one requiring professional judgment. determined by statistical analysis. provided in the CICA's technical publications. 14 MIDTERM EXAM: ADMS 4551, Winter 2010, All Sections, February 21, 2010 Student Number: ________________________ Name: ______________________________________ 9. In testing the existence assertion for an asset, an auditor ordinarily works from the a) financial statement to the potentially unrecorded items. b) potentially unrecorded items to the financial statements. c) accounting records to the supporting evidence. d) supporting evidence to the accounting records. 10. The objective in an auditor's review of credit ratings of a client's customers is to obtain evidence related to management's assertion about: a) b) c) d) compliance. existence or occurrence. rights and obligations. valuation or allocation. Multiple Choice Answers: 1 2 3 4 5 6 7 8 9 10 15