You, CPA, are a Senior Auditor at ABC LLP, a small-sized CPA firm that performs audit engagements for public and private companies. You have just been assigned to the financial statement audit of a new client, Innovative Systems Inc. for the year-end December 31, 2021 (January 1, 2021 - December 31, 2021).

Innovative Systems Inc. is a private computer software company that reports its financial statements under International Financial Reporting Standards (IFRS) and requires a financial statement audit to satisfy its preferred shareholders and the bank. The preferred shareholders receive annual dividend payments that are determined based on profitability of the company. There is a bank covenant that requires Innovative Systems Inc. maintain a debt to equity ratio of at least 1, however the bank is mostly concerned with the overall profitability of Innovative Systems Inc. as one of the largest customers of Innovative Systems Inc. has recently filed for bankruptcy.

You have started the planning phase of the financial statement audit and the Audit Partner has asked you to prepare-an assessment of materiality and audit approach for the upcoming audit. In addition, the Audit Partner would like to receive an update if there are any preliminary observations of internal control weaknesses at Innovative Systems Inc.

During your first week of the audit, you have gathered the following information:

Background Information:

Innovative Systems Inc. - Draft 2021 Financial Statements:

Innovative Systems Inc.

Draft Income Statement

For the year-ended December 31, 2021

Revenue 1,000,000

Expenses:

Other Operating Expenses 150,000

Amortization 80,000

Rent 20,000

Insurance 15,000

Office Supplies 25,000

Salaries, Wages and Benefits 250,000

Total Expenses 540,000

Net Income before taxes 460,000

Income taxes 300,000

Net Income after taxes 160,000

In addition to the financial information above, you recently met with the Christina Paul (Controller) of Innovative Systems Inc. and learned the following important information:

• Innovative Systems Inc. is a medium sized owner managed company, owned by brothers Matthew and Jackson McKinnon.
• Matthew primarily manages the day-to-day administrative and accounting related tasks. Matthew is hard working; however, he does not have significant knowledge about the technical and complex aspects of financial reporting and accounting.
• Jackson also operates a number of other companies and therefore is not extensively involved in the day-to-day operations of Innovative Systems Inc. As a result, Matthew is left with the responsibility of overseeing daily operations, however he has not been able to extend as much oversight lately as the demands for his administrative and related tasks have been increasing.
• The Controller (Christina Paul) has just recently joined Innovative Systems Inc. and has been with the company for less than a month. The Controller indicated that she has been quite overwhelmed and busy since joining the company because there have been a lot of issues with employees not following the appropriate policies and procedures when submitting travel expense claims. Travel expense claims are a significant component of the Other Operating Expenses line item.
• Travel expense claims are supposed to undergo review and approval by one of the owners (i.e Matthew or Jackson) prior to reimbursement to the employee, however since Jackson has been preoccupied with his other ventures and since Matthew has been busy, they have struggled to find sufficient time to review the expense claims. As a result, they have started to reimburse employee's travel expense claims without prior review and are relying on the trust and integrity of the employees to submit factual claims.
• Innovative Systems Inc. has recently implemented a new accounting and procurement system and there have been significant issues in the implementation of the new system. The IT Department at Innovative Systems Inc. experienced issues with transferring the accounting ledger details from the legacy system to the new system. These issues also resulted in the approval policies for the procurement and purchase of expensive office furniture not having been followed.
• Innovative Systems Inc. customers primarily pay in cash. There have been 5 instances of fraud that have occurred during the fiscal year, whereby employees have stolen cash that was stored in a cash box. The cash box is stored in the Office Supplies Room that is accessible by all the employees, from clerks to senior management, without the requirement to use a security pass to enter. Matthew and Jackson strongly believe that it is only fair that all employees have the same level of system and physical access in the office. The Controller (Christina Paul) thinks that the employee theft could also have been caused due to the overall low morale in the company as several employees are disgruntled with the way the company is being managed by the owners.
• Innovative Systems Inc. have implemented a new employee performance program whereby employees will receive a bonus at the end of the year depending on their work performance. The Human Resources Director keeps track of employee performance and updates the employee's personnel files each month. The employee master file is stored in a directory on the shared server that is accessible by all staff at Innovative Systems Inc.
• On a bi-weekly basis, the Payroll Clerk will initiate the payroll processing function by summarizing the total Salaries and Wages that are to be paid for the period and sends this information to the Payroll Manager via e-mail. The Payroll Manager is typically required to review and approve the dollar amount and confirm via e-mail to the Payroll Clerk to proceed with payroll disbursement.
• During part of the fiscal year, the Payroll Manager had to fill-in for the Human Resources Manager who was away on maternity leave, and as a result the Payroll Manager was extremely busy getting accustomed to her new role. In addition, Innovative Systems Inc. experienced a substantial increase in new hires which resulted in the Payroll Manager leading the efforts on recruitment, hiring and conducting interviews. As a result of her increased workload, the Payroll Manager entrusted the Payroll Clerk to proceed with payroll disbursement without the customary review and approval of the Salaries and Wages report.
• The Payroll Clerk was provided with Human Resources computer access in case the Human Resources Clerk was away due to vacation or illness. Human Resources Clerk's have the ability to setup new hire employees in the payroll system.

REQUIRED:

a) Prepare-a preliminary assessment and calculation of Overall Materiality. As part of your assessment, clearly explain and justify your rationale for the chosen benchmark and benchmark percentage. (6 Marks)

b) Prepare-a preliminary assessment and calculation of Performance Materiality. As part of your assessment, clearly explain your rationale for the chosen percentage. (3 Marks)

c) Based on the background information available, discuss the appropriate audit approach (i.e Substantive vs. Combined Audit Approach) that ABC LLP should employ for the upcoming audit. As part of your analysis, clearly explain your rationale for the selected method by including discussion of three (3) factors that helped you conclude on audit approach. (8 Marks)

d) The Audit Partner has asked you to prepare-a preliminary summary of three (3) internal control issues you have identified. Provide an assessment of the internal control weaknesses and their implication, as well as a recommendation to explain how the control process can be improved. (12 Marks)