ACCTG456 Lecture Notes - Accounts Payable, Subledger, Audit Evidence
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A424
Homework #3
Due Tuesday, February 28
Worth 100 Points
Note: Students are expected to work independently (i.e., on your own) on all homework assignments. Please type and post to Canvas.
Part I. Risk Assessments
1. For each illustration, select the component of audit risk that is most directly illustrated. The components of audit risk may be used once, more than once, or not at all. (10 points, 1 point each). |
Components: Inherent Risk (IR), Control risk (CR), or Detection Risk (DR) |
a. A client fails to discover employee fraud on a timely basis because bank accounts are not reconciled monthly.
b. Cash is more susceptible to theft than an inventory of coal.
c. Confirmation of receivables by an auditor fails to detect a material misstatement.
d. Disbursements have occurred without proper approval.
e. There is inadequate segregation of duties.
f. A necessary substantive audit procedure is omitted.
g. Notes receivable are susceptible to material misstatement, assuming there are no related internal controls.
h. Technological developments make a major product obsolete.
i. The client is very close to violating debt covenants.
j. XYZ Company, a client, lacks sufficient working capital to continue operations.
2. Read Case 1.6, Nextcard, Inc. from our Casebook. Pretend you are the auditor for Nexcard, Inc. in the planning phase of the audit for FY 2000 and perform the following risk assessment procedures. That is, just focus on the information in the case prior to the discovery of the fraud (pages 83-86). (50 points total)
a. Perform a risk assessment as part of your audit plan for fiscal year 2000. Set or assess each component/factor of the audit risk model. Describe in detail how you set or assessed each factor (i.e., include specific risk factors from the case and explain how they influenced your assessment). (25 points)
b. Perform a fraud risk assessment for the risk of material misstatement due to fraudulent financial reporting. That is, identify and briefly describe specific fraud risk factors (i.e., more than 1) for each of the three components of the fraud risk triangle, specific to fraudulent financial reporting. (15 points)
c. Identify and describe one significant pervasive risk present during the Nextcard audit. In doing so, explain how the pervasive risk affects the risk of material misstatement. Then, describe how the auditor could respond to that pervasive risk (how could they change the audit plan to address that risk). (5 points)
d. Identify and describe one significant specific risk present during the Nextcard audit. In doing so, explain how the specific risk affects the risk of material misstatement. Then, describe how the auditor could respond to that specific risk (how could they change the audit plan to address that risk). (5 points)
Part II. Evidence and Management Assertions
1. For each of the following specific audit procedures, indicate the type of audit procedure it represents: (1) inspection of records or documents, (2) inspection of tangible assets, (3) observation, (4) inquiry, (5) confirmation, (6) recalculation, (7) reperformance, (8) analytical procedures, and (9) scanning. (10 points, 1 point each)
a. sending a written request to the entityâs customers requesting that they report the amount owed to the entity
b. examining large sales invoices for a period of two days before and after year-end to determine if sales are recorded in the proper period.
c. agreeing the total of the accounts receivable subsidiary ledger to the accounts receivable general ledger account.
d. discussing the adequacy of the allowance for doubtful accounts with the credit manager.
e. comparing the current-year gross profit percentage with the gross profit percentage for the last four years.
f. examining a new plastic extrusion machine to ensure that this major acquisition was received.
g. watching the entityâs warehouse personnel count the raw materials inventory.
h. performing test counts of the warehouse personnelâs count of the raw material.
i. obtaining a letter from the entityâs attorney indicating that there were no lawsuits in progress against the entity.
j. tracing the prices used by the entityâs billing program for pricing sales invoices to the entityâs approved price list.
2. For each of the audit procedures listed above in Part II. 1. (a-j), identify the category (assertions about classes of transactions and events, or assertions about account balances) and identify the primary management assertion being tested. (30 points, 3 points each)
Background
You are a manager in the audit division at Miller Yates Howarth (MYH), an accounting firm with offices throughout the major regional centres of NSW and Queensland. Although a medium sized firm by national standards, MYH is the second largest regional accounting firm in Australia. Most of MYHâs audit clients are in the agriculture, mining, manufacturing and property industries. All of those industries are currently under pressure, either from a downturn in commodity prices or fierce competition from overseas competitors.
You are gathering information in order to prepare the audit plan of GPSA Limited for the year ended 30 June 2017. Along with Morgan Fertilisers, GPSA is one of MYHâs most significant and longstanding clients. The following information has been gathered to date.
Principal activities of GPSA
⢠research and development of technologies relating to medical equipment;
⢠manufacture and distribution of medical equipment;
⢠investment of surplus funds; and
⢠investment in the property market.
GPSA was incorporated in 1992 and has operated successfully and profitably since that date. In the last few years it has branched out into the property market, acquiring a number of commercial properties which are let mainly to medical practitioners.
The directors of GPSA are:
⢠Mr. John Stanton, Chairman
⢠Ms Jane Quade, Chief Executive Officer
⢠Mr. Joe Quade
⢠Dr Barry Jones
⢠Dr Beryl Yeo
Doctors Jones and Yeo are independent non-executive directors and have been directors since 2003. The other three executive directors have been employed by the company since its incorporation and have considerable experience in the industry. Mr Stanton controls a number of private companies.
In prior years MYH placed reliance on internal controls based on satisfactory results of extensive tests of control. Recent discussions with the client have revealed no changes in the system of internal control since last year. The company does not have an internal audit function.
In February 2016, research activities relating to a new laser surgery device commenced. Significant costs were incurred in relation to this research. In April 2017 a competitor announced that it had successfully developed and patented a similar device. In order to finance the research activities noted above the company borrowed from its bankers an additional $5 million during the year. The loan agreement contains a covenant to the effect that should the company's debt to equity ratio (measured as total liabilities: shareholders' equity) increase above 1.2:1.0 at any time, the bankers have the right to demand immediate repayment.
Throughout the 2017 financial year, the property market has been in decline. The end of financial year audit is scheduled to start on 1 August 2017 and should take about two weeks to complete. The client completed a stock count on 30 June 2017. The directors require the signed audited final financial report by 28 August 2017.
Your audit partner, John Richards, has approached you and advised that there are several areas he is concerned about and he wants to you to report back to him about these areas before you complete your audit program. These areas and accounts are:
⢠Accounts receivable
⢠Current investments
⢠Property assets
⢠Intangible assets
⢠Research and development capitalisation
Ratios extracted from an unaudited set of financial reports at 30 June 2017 together with audited comparatives for the year ended 30 June 2016 and 2015 are set out below for your review.
Ratio | 2017 (Unaudited) | 2016 (Audited) | 2015 (Audited) |
Return on equity % | 7.19 | 18.61 | 22.17 |
Return on total assets % | 4.86 | 13.7 | 15.52 |
Gross margin % | 31.76 | 30.00 | 24.94 |
Net profit margin % | 10.38 | 20.27 | 17.85 |
Times interest earned | 1.90 | 3.51 | 4.10 |
Days in inventory | 166.53 | 127.89 | 115.85 |
Days in accounts receivable | 83.07 | 60.65 | 53.24 |
Current ratio : 1 | 1.80 | 1.54 | 1.66 |
Quick asset ratio : 1 | 0.89 | 0.78 | 0.82 |
Debt to equity ratio : 1 | 1.11 | 1.02 | 1.04 |
Internal controls
The financial controller at GPSA has been refining the system of internal controls and informs you, at the planning stage of the current year's audit, that he has put together an internal control manual for the company. He has stated that this manual will create greater awareness of controls in the company, particularly with management which, in the past, has not been overly conscious of the need to implement and enforce effective internal controls.
Management staff receive bonuses based on certain agreed-upon target ratios which include measures such as targeted monthly sales volumes, variance of actual to budget departmental overheads and profit before interest and tax. The major shareholder takes an active interest in the performance of the company and is quick to request explanations on variances from the agreed-upon monthly budgets.
Two years ago, the company devoted significant time and resources to the development and implementation of a new IT system. All teething problems associated with the implementation phase have now been resolved, and the financial controller is satisfied that the automated controls in place are assisting in producing accurate and complete accounting records. The sales director also looks after the IT function as the position is not regarded by management as being a full-time job. Once application programs have been tested, strict password control exists over access to the programs. Passwords are not required for access to databases.
To assist in the planning for the current year's audit engagement, you extracted the following information from a review of the systems notes in the permanent file and perusal of the new internal control manual:
manual delivery notes for dispatch of tiles to customers are raised by the dispatch department from the sales order form. Where a delivery is only partially filled, the delivery note is marked 'hold for invoice' and placed on the incomplete deliveries file. At month end, the supervisor of the dispatch department is responsible for follow-up of the reasons why incomplete deliveries have been outstanding for greater than 30 days.
returns of medical equipment by customers due to inferior quality, incorrect specifications or oversupply are received by the dispatch department where staff are required to check quantity and condition of the returned tiles. Details noted by the dispatch personnel, including the reason for the return, are recorded on a âgoods returnedâ note. Once completed, this document is passed on to the trade receivables clerk who raises a credit note and sends it to the customer.
once a delivery has occurred, the office copy manual delivery note is forwarded to the trade receivables clerk who is responsible for generating an invoice on the computer system. An invoice is raised by inputting the total quantity delivered (Note: this could be a number of partial deliveries) and the stock code which is also recorded on the delivery note. The computer then automatically retrieves the stock code price from the selling price master file. Posting to the debtors account occurs automatically once the trade receivables clerk has performed a screen check on the accuracy of the input of delivery details.
for valued customers, discounts are applied in accordance with the company's volume rating system. The trade receivables clerk is responsible for updating the individual customer volume ratings every six months after preparing the 'sales volume analysis by customer' report. This report is authorised by the sales director prior to updating the customer discounts.
a sales journal summarising all sales invoices is prepared monthly by the computer system. This journal is then used by the trade receivables clerk for posting to the general ledger.
receipts from debtors are passed on to the trade receivables clerk after having been opened by the mail room. The trade receivables clerk lists all receipts from the debtors and then prepares a bank deposit slip. The list prepared by the trade receivables clerk is used to enter the debtorsâ payments on the computer system. The batch total of postings to the individual debtorsâ accounts is balanced to the bank deposit slip before processing occurs on the system. At each month end, the trade receivables clerk prepares a reconciliation of the trade receivables ledger to the debtors control account in the general ledger.
the computer generates an aged analysis at month end based upon all invoices that have been processed onto the system for the period up until the last day of the month.
the financial controller obtains the latest trade receivables aged analysis at the end of each month and reviews all amounts outÂstanding for longer than 90 days. The trade receivables clerk is required to detail reasons for delays in payment by long outstanding debtors and the financial controller discusses items of concern with the clerk.
usually an action plan is agreed for follow-up; this may include involvement of debt collectors or the issuing of writs. Where necessary the financial controller records details of amounts that should be provided for as doubtful debtors. Whilst performing this re view, the financial controller notes the level of individual debtorsâ balances and, in instances where he is uncomfortable with the level of this balance, he instructs the dispatch area to withhold any shipments until a minimum prescribed payment is received.
John Richards your partner on the audit has mentioned to you that, in the past, a substantive approach had been adopted for the audit of GPSA. He now feels that, with the improvements that the client claims to have made to the systems of internal control, an opportunity exists to place reliance on the internal controls and therefore reduce the extent of substantive work.
Required
Write a report, including a brief executive summary, to your managing partner that addresses the questions below. Where indicated, use the required format to answer that question.
Question 1A 8%
Analyse the ratios and additional information associated with the five accounts listed by your audit partner, John Richards. Identify the potential audit risks and any particular audit steps that need to be undertaken to reduce audit risk.
Answer this question using the following headings:
(a) Account (b) Analysis (c) Audit risk (d) Audit steps to reduce risk
Question 1B 2%
Analyse the ratios and additional information to outline business risks that GPSA faces.
Question 2A 7%
Identify the internal controls in the system that are potentially effective, the risk that the control could alleviate and one test of control for each of the identified potentially effective controls.
Answer this question using the following headings:
(a) Effective control (b) Risk alleviated (c) Test of control
Question 2B 2%
List and justify the weaknesses in internal control for sales and trade receivables.
Management assertions for the financial statements referenced inPCAOB Auditing Standards are:
Existence, occurrence
Completeness
Rights, obligations
Valuation, allocation
Presentation and disclosure
The purpose of tests of controls is to permit the auditor toassess whether properly designed controls operate effectivelyenough to prevent or detect material misstatements that would makethese managements assertions wrong.
Required:
For each of the following audit procedures identify whether theprocedure is:
(a) directed at a control or at an amount ordisclosure, or both, and
(b) what assertion (or assertions) is (are)targeted.
Accounts, Classes of Transactions | Audit Procedure | Directed at: | Assertion: |
---|---|---|---|
All | Inquire who controls passwords for IT access. | ||
Sales, Receivables, Inventory | Examine document packages for items that have been shipped forinclusion of a customer order, credit approval, and shippingdocument. Make sure the documents are properly matched andcomplete, with all required signatures and trace amounts to thesales journal, accounts receivable subsidiary ledger, and inventoryfiles. | ||
Payroll | For the Hourly Payroll Expense account, multiply the averagenumber of workers times the average number of hours worked per yeartimes the average hourly rate. Compare to the total posted annualamount. | ||
Cash | Inspect the client-prepared bank reconciliation for each monthof the year, recalculate the amounts, examine the supporting bankstatements, and trace the cash amount to the general ledger. | ||
Fixed assets | Obtain a list of fixed assets and physically look at theassets. | ||
Long-term debt | Read the contract related to each of the companyâs long-termborrowings and agree the terms of the contracts to the financialstatements notes. | ||
Cash, Long-term debt | For each item of long-term debt that existed both at thebeginning and end of the year, inspect the debt contracts and thecompanyâs analysis of the discounted debt amount and its analysisof violation of debt covenants and look for whether the detailsagree. Recalculate the amounts, and examine recorded entries andbank statements for cash disbursements for debt repayments. Usingthat information, determine whether the company has been inviolation of any debt covenants during the year. | ||
Prepaid rent | Using the beginning financial statement amount, cash receiptsand cash disbursements evidence, and the lease agreement, calculateyear-end prepaid rent and agree that amount to what is shown in thegeneral ledger. | ||
Inventory | At the end of the last day in the fiscal year, go to theclientâs shipping area and record the last shipment; trace theshipment into the clientâs |