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External Auditing SCS 2331-020 Assignment #2- Due Session 11 50 marks Question 1(10 marks) You are an audit senior in Brennon & Lewis a public accounting firm. You are current working on the audit of Seely Company, one of the firm's clients, and you are preparing the audit program for the sales and collection cycle. Audit documentation is available from the previous year's audit, including internal control questionnaires and audit programmes for the despatch and sales system. As far as you are aware, Seeley's system of internal control has not changed in the last year. Client background - sales system Seeley Co is a wholesaler of electrical goods such as kettles, televisions, MP3 players, etc. The company maintains one large warehouse in a major city. The customers of Seeley are always owners of small retail shops, where electrical goods are sold to members of the public. Seeley only sells to authorised customers; following appropriate credit checks, each customer is given a Seeley identification card to confirm their status. The card must be used to obtain goods from the warehouse. Despatch and sales system The despatch and sales system operates as follows: 1. Customers visit Seeley's warehouse and load the goods they require into their vans after showing their Seeley identification card to the despatch staff. 2. A pre-numbered goods despatch note (GDN) is produced and signed by the customer and a member of Seeley's despatch staff confirming goods taken. 3. One copy of the GDN is sent to the accounts department, the second copy is retained in the despatch department. 4. Accounts staff enter goods despatch information onto the computerised sales system. The GDN is signed. 5. The computer system produces the sales invoice, with reference to the stock master file for product details and prices, maintains the sales day book and also the debtors ledger. The debtors control account is balanced by the computer. 6. Invoices are printed out and sent to each customer in the post with paper copies maintained in the accounts department. Invoices are compared to GDNs by accounts staff and signed. 7. Paper copies of the receivables ledger control account and list of aged receivables are also available. 1 8. Error reports are produced showing breaks in the GDN sequence. Required: b) Using information from the scenario, list five tests of control that an auditor would normally carry out on the despatch and sales system at Seeley Ltd and explain the reason for each test. (10 marks) Arrange your answer in a table as follows: Test of control Reason for Test 2 Question 2 (12 marks) As part of your firm's training program, newly hired PA recruits must audit a fictitious audit client, Merlon Intercom Inc. (MII). The recruits complete various sections of the audit file for the year ended December 31, 2015. The files are then reviewed by more experienced co-workers. The partner in charge of the training program asks you, an experienced public accountant, to review a file prepared by a recruit and comment on each section. Below is a description of MII, followed by the work on the file completed by the recruit. DESCRIPTION OF MII OPERATIONS MII is a privately held, medium-sized company that is managed by the sole owner who is actively involved. MII buys intercom equipment, telephone equipment, parts and related equipment and resells them at a mark-up to a loyal base of corporate customers (approximately 250 customers). Approximately 60 of MII's 250 customers make up 75% of MII's total sales. Competition is growing, but the market is favourable, and MII offers excellent customer service, giving it a competitive advantage. The owner is very involved in most of the operating decisions. His capable assistant steps in when necessary. The owner wishes to implement a code of ethics at some point and also wishes to improve certain controls. MII operates multiple (six in total) warehouses, each carrying a mix of inventory items approximately 1,500 different products. The first type of inventory, that can be quite costly, consists of specialized telecom equipment hardware, high end intercom equipment and parts. The turnover rate of this inventory is high since new technology is always emerging. Because the company orders months in advance, MII occasionally overestimates demand. After three or four months, products are difficult to sell but they are kept because most cannot be returned to the supplier, and MII is reluctant to hold liquidation sales for fear they would negatively affect the sales of the regular products. The second type of inventory, parts and peripherals, generates a significant portion of MII's sales. This category includes items such as cables, headphones and replacement parts. The third type of inventory includes batteries and chargers for cordless phones. This inventory can be returned to suppliers if unsold after a certain period. 3 The sales mix has not changed significantly from previous years. Ten new accounts were opened during the year, with average monthly sales of $5,000 each. Sales also increased because a new sales representative was hired at the beginning of the fiscal year. Average monthly sales for the 10 experienced representatives are $500,000 each. Rookie representatives normally perform at 50% of an experienced representative's level in their first year. MII also lost a customer, who had averaged $90,000 a year in sales, to the competition. Purchases of products increased in the current year and were distributed across the inventory types in amounts similar to the overall sales mix. Sales representatives enter orders into the sales database, and can modify the information, including quantities and selling prices. Any changes are usually made to orders before shipping. Problems result if representatives make changes after shipping, since they should issue credits instead. The timing differences create reconciliation problems for both customers and MII when settling invoices. Also, sometimes credits have been issued in error. Sales representatives are compensated based on a combination of a basic salary and commissions on sales. The owner noted he just received a memo from a clerk at one of the warehouses. It says the amount of damaged inventory has been gradually increasing over the past eight months. The clerk suggests this is because the forklift is not operating properly and items are being dropped as they are loaded for shipment. He wants the forklift replaced. He asks what he should do with the damaged inventory that has been piling up in a corner of the warehouse. He suggests holding a liquidation sale to get rid of it, since it needs space. The owner's assistant has a vital role in the day to day operations of the business. He is responsible for developing relationships with the various vendors and finding new vendors. He adds new vendors in the system and also places orders when inventory items are low. Lastly the assistant assumes all of the owner's responsibilities when the owner is on vacation or on a business trip. SECTIONS FROM THE RECRUIT'S AUDIT FILE INVENTORY WORK PERFORMED 1. Matched totals on inventory listing to sub-ledger and general ledger. 2. Went to one of the six warehouse locations. Traced quantities from MII's inventory listing to the warehouse floor for a random sample of 10 cordless phones. My inventory count matched quantities on the inventory listing. 3. Traced prices for the 10 cordless phones sampled in the previous test. Prices matched those on the price listing, except for two models. The owner explained that employees sometimes manually change inventory prices to adjust for errors made when 4 recording purchases. He provided a second listing with handwritten corrections. However, no backup documents were available to substantiate the changes. 4. Recalculated quantity and price extensions for the same 10 cordless phones and they were accurate. 5. One customer placed an order of more than $800,000 for specialized telephone equipment. Unfortunately, the customer went bankrupt and, 10 months later, the specialized telephone equipment was still in inventory. MII never posted the sale because the equipment was never shipped. The company is certain it can resell the equipment to another customer, so no provision has been booked. EXCERT FROM SALES WORK PERFORMED Sales variance analysis: 2014 2015 Telephone Devices Parts & peripherals Cordless Phones Variance ($) Variance % $20,000,000 $22,000,000 $2,000,000 10% 35,000,000 37,500,000 2,500,000 7% 5,000,000 5,500,000 500,000 10% Total $60,000,000 $65,000,000 $5,000,000 8% Explanation for variance: Sales increased because a new sales representative was hired. ACCOUNTS RECEIVABLE WORK PERFORMED 1. Customers have 30 days to pay invoices, but most take advantage of the 2% discount offered for payment within 10 days. A sample of five year-end balances was tested, and all payments were received subsequent to year-end, so accounts receivable were reasonable at year-end. 2. On January 2, 2016, goods related to a sale made on December 29, 2015 were destroyed in a transport accident. The goods were sold FOB shipping point and the customer is refusing to pay for the goods. The goods were valued at $200,000. 3. In order to save time, MII applied a blanket provision of 5% for uncollectible accounts. Historically, the amount of uncollectible accounts ranges from 4% to 5%. Credit procedures were tightened two years ago, and since then, the rate has been at the lower end. Therefore, 5% is quite conservative, allowing for potential overstatement of receivables. 5 Required: a) Identify six deficiencies with the sample selection process in the accounts receivable and inventory work performed by the recruit. Your response should describe any deficiencies in the samples selected and provide an appropriate recommendation to correct each deficiency. (12 marks) Sampling - Description of Deficiencies Recommendation Sampling - Description of Deficiencies Recommendation Sampling - Description of Deficiencies Recommendation 6 Sampling - Description of Deficiencies Recommendation Sampling - Description of Deficiencies Recommendation Sampling - Description of Deficiencies Recommendation 7 Question 3 (15 marks) You are the in charge auditor for Johnny Gold Jewellers (JGJ) which has seven stores in the Toronto area. The fiscal year end of the company is December 31. The company deals in precious and semi-precious stones and high quality costume jewellery. Diamond engagement rings make up over 50% of sales and 10, 14, and 18 carat gold chains make up another 20%. During peak demand periods, for example just before Christmas and Valentines Day, Mr. Gold acquires on consignment jewellery from another manufacturer. The president, Johnny Gold, is an accredited geologist. Mr. Gold attends auctions in New York and London several times a year. The rough cut gems are ground and polished in JGJ's lab in the flagship store and distributed among the seven stores. Mr. Gold needs to anticipate well in advance what he believes the latest trends in costume jewellery will be. Mr. Gold's track record is excellent but occasionally he misses the mark and has to sell some of the jewellery at a substantial discount. The company plans to do its inventory count on December 31, 2015. Perpetual inventory records are kept in each store, which should balance to a control account kept in the main branch. Documentation for all purchases is kept in the main branch. Mark-ups average 150% on cost. All inventories are insured with a 50% co-insurance clause, and employees are bonded. All employees receive a bonus based on sales for the last 2 weeks in December. The bonus is based on the numbers of years working at JGJ as well as a percentage of sales. It is now December 10, 2015 and you are preparing for the physical inventory count on December 31, 2015. Required Explain briefly five specific risk factors related to the counting and valuation of JGJ's inventory at December 31, 2015. For each risk identify the management assertion and one audit procedure to address the assertion (12 marks). Arrange your answer using the table on the following page. 8 Explanation of Risk (1 mark) Audit procedure to address management assertion ( 1 mark) and note the assertion (1 mark) 9 Question 4 ( 13 marks) You are the audit senior for the 2015 year-end audit of Clearly Contacts (CC), a publicly traded Canadian company, that is one of the largest and fastest on-line vision care providers in the world. Because of the efficiencies of the Internet to bypass middlemen, CC has a significant competitive advantage in its market. You are responsible for auditing the revenue cycle. Performance materiality for the CC audit is $100,000. CC's year-end is October 31, 2015. Below is a summary of key information regarding the revenue cycle: Revenue Recognition Policy - Revenue from product sales is recognized when the product has been shipped to the customer. At that point, the amount of sales revenue is determinable, no significant vendor obligations remain and the collection of the revenue is reasonably assured. A provision is made for product returns. Revenue collected in advance of the product being shipped is deferred. Audit Strategy for Revenue - The audit strategy relies upon tests of controls, (including substantive tests of transactions), and substantive analytical procedures. There are no accounts receivable confirmations sent out. Your audit team has tested controls related to revenue transactions and concluded that controls are effective and support the control risk assessment of low for the revenue transaction-related assertions. Change in Credit Policy - When reviewing the accounts, you noted that a new account, allowance for doubtful accounts, has been set up. Upon investigation, you find that in February 2014, CC implemented a program where the majority of customers were granted credit. CC developed this program to attract new customers who might be wary of ordering contact lenses from an on-line retailer and having to pay for them prior to receiving them. The company's program, named \"Invoice Me Later, or IML, allows customers to order from CC and pay after receiving the product. Management estimates payment should be generally received in less than 15 days. Estimate for Allowance for Doubtful Accounts - The majority of the balances outstanding are less than $150 and there are a large number of records. Management estimates an allowance based upon the aging of the receivable portfolio. Below is a summary of the aging and management's estimate for the allowance for doubtful accounts. Aging of Accounts Receivable Current Aged between 60 -120 days Aged greater than 120 days 2015 $ 7,714,000 88,000 66,000 2014 $ 6,695,000 nil nil 10 Total Receivables Allowance for Doubtful Accounts Net Receivables $7,868,000 135,000 7,733,000 6,695,000 nil 6,695,000 Required a) Explain the impact of the IML program on your audit strategy for the revenue cycle of CC. (Use the audit risk model and assertions to support your analysis). (5 marks) b) Do you agree with the auditors' decision to not send out accounts receivable confirmations? Why or why not? (4 marks) c) If the auditors planned to send out accounts receivable confirmations, what type of confirmations would you recommend? Explain why. (4 marks) 11