Auditing Assignment
Question 1
As part of the audit of corporate governance, International Insurance Inc. (III) has agreed that they will conduct an audit of the audit committee oversight process. The audit will be conducted by a consulting organization that specializes in internal audit outsourcing and audit consulting. The scope of the audit is to compare III's audit committee practices to published best practices for audit committees. III has requested an analysis of their audit committee practices, as well as suggestions for improvement where warranted.
To facilitate the audit, you, CIA (Certified Internal Auditor), an employee of the consulting organization, have accumulated a list of best practices from two internal control frameworks and from publications provided by the CICA (Canadian Institute of Chartered Accountants) and from the (IIA) Institute of Internal Auditors.
III will provide a copy of the corporate audit committee charter, as well as the agreed upon scope of work of the audit committee, and minutes of the board meetings of both the audit committee and the board for the last two years. III has also agreed that one hour interviews will be held with individual audit committee members, executive management, the director of internal audit and the audit partner responsible for the financial statement audit of III. These interviews have been scheduled over a two week period.
Required:
Describe the five components of the definition of auditing. For each component, identify which aspects of the narrative above fit the definition.
Use a table, as shown below, to organize your response:
Description of definition of auditing components Aspect of the narrative above that fits the definition
Question 2
You work for a large public accounting firm 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 Pop Shop Company, an audit conducted by one of your offices in north west Manitoba.
Your firm has been auditing the Pop Shop Company for the last four years, ever since Pop Shop went public. There may be a problem with the financial statements, as the bank did not recently renew the bank loan, and Pop Shop is scrambling to meet payroll costs. They are also having trouble getting additional financing. There is some concern that the company may have tried to prepare their financial statements in a more favourable light to the bank. It is now late February 2016 and your firm is planning to issue an unqualified opinion on the December 31, 2015 financial statements of the Pop Shop Company.
The following are your notes from the review of the Pop Shop December 31, 2015 year end audit file:
• Files appear to be well organized. Working papers were reviewed by a junior audit partner, although not the partner who signed the auditors' report on the financial statements.
• This is one of three public company audits conducted by this office.
• Only the current year audit file was available. It took several hours before last year's file and the permanent file could be located.
• A recently qualified CA conducted the audit with the help of two assistants. The CA had no previous experience in the pop industry, but was helped by a senior assistant. The senior assistant had good knowledge of the pop industry because the controller of the Pop Shop was his uncle. The CA provided no direction to the assistants as they were considered very bright and had scored high grades on their advanced auditing courses.
• Substantive audit procedures were specifically designed and conducted for this audit engagement. This was done by following the prior year's audit approach. It was also decided that the previous year's assessment of moderate audit risk and materiality level were appropriate for the current year audit. Due to an initial discussion with respect to poor segregation of duties, control procedures were not documented in detail.
• During the testing of inventory several items in the sample were overstated due to errors in pricing and obsolescence, but the combination of all errors in the sample was considered immaterial. Accordingly no extra testing was completed in the area of inventory. They also found more errors than in previous years due to a change in the accounting system to computerize the inventory system.
• It was decided that the prior year's time budget was a reasonable estimate to complete this year's audit. Although more work was anticipated to complete this year's audit, CA was confident that the senior assistant's efficiency would be able to compensate for it. The partner of the audit would be glad of this because the firm promised the Pop Company that they would not increase the audit fee this year.
Required:
Describe which generally accepted auditing standards (GAAS as set out in CAS 200) have been violated. Using case facts, support your conclusion.
Question 3
You have recently joined a Public Accounting firm as an audit trainee. In the first week with the firm you attended a training course. One of the sessions was on the importance of complying with the rules of professional conduct. The instructor presented the three hypothetical scenarios shown below:
Required
For each scenario discuss the acts by the Public Accountant (PA) and the PA friend that were in violation of the Rules of Professional Conduct. Explain why you think the acts were a violation.
Scenario 1
During lunchtime a Public Accountant (PA) informed his friend that he was excited over a new audit client his firm had obtained. The PA told his friend that the new audit client was a men's wear designer clothing company which was in its development stages and that it was going to issue an initial public share offering within the next few weeks, just prior to the latest marketing surveys becoming public.
The PA suggested to his friend to buy some shares as they will probably increase in price once the surveys become public knowledge. One of the surveys indicated that there were a number of retailers who had agreed to buy a significant amount of clothing, which should really get the company up and running.
The PA also told his friend that he thought the designer clothing company's previous auditors should be "kicked out" of the Canadian Institute of Chartered Accountants. The PA said that the previous auditor had allowed the president to run all his personal expenses through the company and bury them in the expense accounts.
Scenario 2
A controller of an electronics company received a phone call from one of his PA friends. The friend indicated that he has just started up his own practice and was wondering whether he could set up a meeting with the controller to make a bid for the audit of the electronic company at a set fee of $2,000 and to arrange to pay the controller, secretly, for the client referral. The friend also mentioned that his firm performs "high quality audits."
Scenario 3
On June 15, 2015 Erica McBride, CA and partner was offered and accepted the ngagement to audit the annual financial statements of Kwoktan Corporation for the year ended December 31, 2015. The audit began on October 1, 2015 and was substantially completed by March 13, 2016. Kwoktan Corporation is a public company listed on the Toronto Stock Exchange and has share capital of $55 million. Ms. McBride served as the corporate controller of Kwoktan from January 8, 2004 until February 5, 2015 at which time she terminated her employment with Kwoktan. Ms. McBride owned a material amount of Kwoktan's common shares from January 8, 2004, until June 12, 2015, at which time she sold the shares.
Question 4
You are the senior auditor in charge December 2016 year-end audit for Cleo Patrick Cosmetics Inc (CPCI). CPCI is a large privately-held Canadian company that was founded in 1995 by one of Canada's most well-known hair stylists, Cleo Patrick. Cleo Patrick, is a well-known celebrity hair stylist who has appeared on a variety of television shows such as Entertainment Tonight, and has been the chief stylist for the Oscars and Emmys. The company includes: (1) a small chain of ten upscale salons situated in major cities in Canada and the US and (2) its well-known signature line of professional hair products that are available at select drug stores and retail chains. The core of its business is its signature hair products line, Cleo Patrick True Professional. The True Professional line represents 85% of the company's total revenue.
During the planning phase of the audit, you performed various planning activities and met with CPCI's management team. Here is what you learned:
1. Your firm has audited CPCI since 2001, when Cleo sold 25% of her company to a group of private investors. The investors receive quarterly dividends that are calculated based upon a combination of sales and net income. The investors, all experienced business people, serve as Cleo's board of directors and give her advice on the strategic direction of the firm.
2. Your firm has not had any major disputes with CPCI management over accounting issues; however, last year it recommended that CPCI improve the quality of its accounting department - which is understaffed and not well organized.
3. High-priced mass-market hair products represent a highly competitive super-saturated market. Large multi-nationals, make up about 70% of the market with niche companies such as CPCI making up the remaining 30%. Management does not consider multinationals to be a threat.
4. From your review of the 2015 annual report and the 3rd quarter 2016 financial statements, you noted the following financial information:
Nine Months Ended
|
Nine Months Ended Sept 30, 2016 (unaudited) (thousands of dollars)
|
Year Ended Dec 31, 2015 (audited) (thousands of dollars)
|
|
Sales
|
$ 350,000
|
$ 450,000
|
|
Net Income
|
1,000
|
1,500
|
|
Cash
|
25,000
|
30,000
|
|
Accounts Receivable
|
25,000
|
25,000
|
|
Inventory
|
45,000
|
40,000
|
|
Property, Plant, and Equipment
|
165,000
|
160,000
|
|
Total Assets
|
285,000
|
280,000
|
|
Current Liabilities
|
$ 45,000
|
$ 40,000
|
5. Cleo plans to expand into Europe and is negotiating contracts with drug stores in the UK and Germany. In order to fund this expansion, CPCI's bank has agreed to increase CPCI's operating credit line of credit. As part of the agreement, CPCI is required to maintain a minimum quick ratio of 1.2 and a positive net income. In addition, CPCI is required to provide the bank with audited financial statements.
6. Your firm has an employee who reads and saves articles about issues that may affect key clients. You read an article that says that two of CPCI's top-selling products recently made "The Dirty Dozen" list. The list, developed by an environmental research foundation, highlights those cosmetic products that have toxic chemicals (some of which are cancer-causing). CPCI claims that all its products are safe and meets the provincial and federal health and safety guidelines. You discuss the issue with CPCI management and find out that it is working on re-formulating both products, which should be ready in 2017. CPCI is offering large rebates to retailers in order to encourage sales of its older products. The two "dirty" products currently make up about 20% of CPCI's current inventory of $45 million.
7. William Kirk was hired recently as the Chief Operating Officer to provide closer oversight of the company. Due to all the new products and expansions, Cleo does not have time to spend monitoring the day-day operations. Kirk is attempting to bring in a greater emphasis on controls around financial reporting and monitoring (as recommended by your firm in the past). Kirk started in June and one of the first things he did was to replace the CFO (the previous CFO was not very organized and tended to delay handling problems). He also implemented a new bonus plan based upon sales growth and profitability targets. He told you he thinks it is working out really well and sales are growing. However, he has not had a chance to implement all his plans - such as hiring additional accounting staff and performing a formal assessment of the quality of internal controls.
8. In early 2016, CPCI launched two new collections, Ultimate Moisture and Moisture Gloss. These two products put an extensive strain on the company's cash flow. CPCI had spent $15 million in product development and $10 million on advertising. However, sales were much lower than predicted. Management had predicted 2016 sales to be between $9 million to $10 million but, as of October 2016, sales were only $1 million. When you inquired about the low sales, the new CFO explained that the buyer had purchased inappropriate raw materials. This was not discovered during the inspection process when the materials were received. As a result, the finished product did not meet quality standards and was destroyed and the new collections arrived in stores much later than planned. The CFO stated that the sales people are working really hard at trying to get product demand back on track by year-end and are negotiating new contracts with their customers.
Required:
(a) Based upon the above description, provide three key business risk factors that could increase the risk of material misstatement in CPCI's financial statements. Explain which account(s) each of these risk factors could affect and the type of misstatement(s) that the risk might cause. Ensure to include in this discussion the most relevant assertions and the potential misstatement for the account. Use the table below and on the next page to complete your answer.
Identify and describe key business risk Account, most relevant assertion(s) Potential Misstatement
(b) What would you set acceptable audit risk (high, medium-high, medium, low-medium, or low) for the CPCI audit engagement? Explain why.
(c) Calculate planning materiality for the CPCI audit. Ensure to include a rationale for the appropriate materiality benchmark (base) and the related appropriate percentage.