You have just joined Docile and Co., an audit firm as Audit Manager.

Docile and Co is in reality a three-person practice, The Audit Partner is a Mr. Donald Docile, who has been auditing businesses in the local town for 50 years. He is considered by locals to be a very nice man with a strong reputation for honesty.

On your first day of work, you attend the office to find it in a state of turmoil. You ask what is wrong, and are told one of the previous audits overseen by the person you replaced as audit manager had resulted in the issue of an inappropriate opinion. The audit manager had made a mistake. It appears that while auditing Beta Tools, the previous audit manager, rather than visiting a warehouse located 600km away, had accepted a certification by one of the company directors that a material amount of stock as stated on the stock report was held at that warehouse. In fact the warehouse was empty. Beta Tools had gone into receivership a few weeks ago. The solicitors for the receivers had just sent a letter to Docile and Co. demanding that they reimburse the company the value of the missing stock.

Mr Docile asks you to urgently draft a short report to him setting out the possible liability and reasons.

Required:

Now that Docile and Co have accepted DMC as a client, you are instructed by Mr Docile to draft an engagement letter. Briefly set out the key headings you will put in your engagement letter.

(4 Marks)

You commence the preliminary analytical review, and note the following figures:

DMC Industry Average

Current Ratio 1.0 2.5

Quick Ratio 0.8 1.3

Equity as a % of assets 25% 50%

Gross Margin 20% 35%

Inventory Turnover (days) 30 25

Question 4

Required:

Explain where you would wish to concentrate your audit activities given these ratios. Why?

(4 Marks)

Mr Docile asks you to come into his office so that he can plan the audit of DMC with you. He says all you need to do is see if you can prove the assets listed by Mr Diffident. If you cannot, then you should ask the office manager for guidance. You ask about controls and Mr Docile replies; I know it is in the manual but no auditor has been sued successfully for not studying the controls.

You decide to tell Mr Docile about how control based audits can reduce audit costs and lessen the risk of being sued. You decide to draft a memo about modern audit attitudes to controls and the audit risk model. You also plan to mention case law to prove that his statement about being sued is not correct.

Question 5

Required:

Draft a memo to Mr Docile setting out the requirements of the auditing standards regarding controls and how the Audit Risk Model works. In your answer, point to the case law that shows an auditor can be sued over controls. (5 Marks)

Mr Docile reads your memo and decides that he can save much time by relying on the controls of DMC. He sends you out to test the controls. You arrive and ask Mr Diffident about the companys internal controls. He calls in the office manager, Mr Cozener, who pulls a thin dusty manual from the book shelf labelled DMC Trading Ltd Internal Control Manual 1985. You take this to Mr Docile who takes the manual, and states that he can now rely on controls.