Question 3 (8 marks)

You are the reviewing partner in the firm Hartley & King (HK) LLP and you are responsible for the independent review of all audits.It is March 1st, 2018 you are reviewing the audit working papers and draft audited financial statements of Hercules Tires (HT) for the year-end December 31, 2019 and the recommended auditor's report (an unqualified opinion) dated February 28, 2020.

Your firm has audited HT for several years.HT is privately held and is owned and operated by members of one family - some who are not actively involved in running the company. The company has a board of directors that consists of active and inactive family members.The inactive family members, as well as the bank, request to receive audited financial statements each year.

HT is one of the largest independent distributors of tires and wheels in Canada. The company helps tire and wheel retail dealers by offering the most complete selection of tires, wheels and related services and provides 24-hour inventory access and order capability to dealers.

The wholesale tire industry is highly competitive, and distributors have significant pressure on pricing and their margins. The industry has grown steadily over the past few years and in 2019 industry sales grew by 4%.

According to the draft audited financial statements, the 2019 net income is $500,000, sales are $50,000,000, total assets are $60,000,000, and total liabilities are $40,000,000.

Based on your independent review of the working papers you have noted the following:

1. Before the fieldwork began, the staff scheduled to work on the engagement met with the audit manager. The manager said that the audit would focus on the possibility of errors in the financial statements, not fraud. He said that there had never been any suggestions of fraud in the past. The staff did discuss those areas in which misstatement due to error was most likely (inventory and receivables) and took those risks into account in determining the extent of testing to be performed.
2. In her audit planning memo, the engagement partner wrote: "The company carries a significant amount of bank debt and the family members receive substantial salaries (about $500,000 in total). As a result, the company has an ongoing liquidity problem and can be quite late when paying its bills. However, I think it is a solid company, our business risk is moderate, and the owners often ask us to perform special services during the year, so the client is quite profitable to our firm."
3. The audit manager set the planning materiality as $8,000. She noted her rationale for materiality as follows: "We always use a low materiality level for HT so we do not miss any important transactions, especially unrecorded liabilities which are always understated."
4. The audit was conducted in the two-month period from mid-December 2019 to mid-February 2020. Two staff members, a senior auditor who had been involved with the audit of HT for several years and a newly hired junior auditor, conducted the audit. No interim audit work was performed as HK decided to not place any reliance on the company's internal control system for any of the cycles.Control risk was set at maximum for as it was deemed to be more efficient to conduct a 100% substantive audit for all cycles.
5. Planning analytical review consisted of the senior auditor comparing the current year's financial statements to 2018 financial statements. Her conclusion was that since no significant changes were noted the account balances appeared reasonable; therefore, the planned audit strategy was appropriate.
6. For the control testing of the sales cycle the junior auditor selected a sample of sales invoices from the sales journal for the months of September 2019 and October 2020.Per the audit program, the junior auditor examined copies of the sales invoices and agreed the details of the invoices to the supporting bills of lading (shipping documents) and to the authorized customer invoices.The junior auditor documented the sample tested and noted that all invoices agreed to the supporting documents and no deviations were noted.The junior concluded that the controls for occurrence, completeness, and accuracy of sales were effective.
7. While the audit was in progress, the audit manager participated in several strategic planning meetings with the CEO and the owners to discuss HP's declining margins. The audit manager recommended that the company change the compensation for sales personnel by drastically reducing their salaries and increasing their commission rates. She also suggested that periodic "clearance sales" could also increase demand. The owners liked these suggestions and asked the engagement partner to undertake a special study of their compensation and pricing policies and make recommendations to their board.
8. Accounts receivable confirmations were sent to 30 customers, which represented 75% of the accounts receivable balance.The following discrepancies were noted in the audit file:

• T1T2 Inc. indicated that they are disputing the $40,000 owing to HT as the tires they received were defective.The audit senior agreed the amounts owing to the invoices, shipping documents, and customer orders and found no discrepancies.The audit senior concluded that no adjustment was required.
• Automotive Parts Inc. indicated that they are in a state of financial difficulty and they would like to re-negotiate the terms for the payment of their $35,000 balance.Based upon this reply, the audit senior concluded that this amount was likely uncollectable and should be provided for in the allowance for doubtful accounts.The proposed adjustment of $35,000 was included in the summary of possible misstatements.

Required:

Provide four major deficiencies in the audit and explain. (1 mark for each).For each deficiency provide a recommendation that you (the reviewing partner) should make to the engagement partner to address the deficiency (1 mark each).