ACT 3900 Lecture Notes - Lecture 6: Costs In English Law, Quick Ratio, Static Web Page

The following statements relate to general principles or terms used in the audit of financial statements. Identify at least two errors from each of the following statements (a)-(e) and explain why these are errors and suggest corrections.

(a) Audit objective (4 marks)

The objective of an audit of financial statements is for auditors to make sure the financial statements give a true and correct view in all respects in accordance with an identified financial reporting framework and to ensure that they detect all fraud that may have taken place.

(b) HKSA (4 marks)

The Hong Kong Standards on Auditing specify exactly the necessary audit procedures that auditors should perform. For all private and listed companies, the Financial Reporting Council is responsible for investigating all deviations from the Hong Kong Standards on Auditing.

(c) Terms of engagement (4 marks)

Auditors and their clients should agree on the terms of the engagement, which can be recorded either in the management representation letter or other suitable form of verbal contract. This letter is required to be reissued before the start of every audit, regardless of whether there are any changes to the terms.

(d) Audit opinion (4 marks)

The auditor was unable to attend and observe the inventory count of the company’s subsidiary in Bangkok due to the recent riots over the current government. The inventory in Bangkok accounts for 80% of the group’s total inventory. lnventory is a significant amount within current assets but is not considered significant in respect of total assets. The auditor decided the most appropriate audit opinion is an adverse opinion.

(e) Audit documentation (4 marks)

Since the client paid for the audit, the audit working papers are the property of the audit client and they can be used as substitutes for the company's accounting records in case the company’s accounting records are destroyed in a fire.

1. For each of the following independent situations (a – k),describe the most appropriate course of action that the auditorsshould take.

A. While reviewing audit documentation, Tyson Michaels, apartner at K&O was reviewing working papers as part of thefirm’s system of quality control. Tyson noted that after releasingan audit report related to the financial statements of a publiclytraded client, it does not appear that any tests were conducted toevaluate the need for impairment of the carrying value of theCompany's property, plant, and equipment. These tests are importantwith respect to supporting the audit opinion.

B. Prior to the audit completion date (April 1, 2015), anauditor learned that their audit client Bubbagump Inc., haddeclared a significant dividend payable to its shareholders. Thisdividend was declared on March 14, 2015, to be paid to Bubbagump’sshareholders of record on May 16, 2015.

C. Pat Colt completed the December 31, 2014, audit of Manningand issued an unmodified opinion on Manning's financial statementsdated March 15, 2015. Colt's opinion was released, along withManning's financial statements, on March 21, 2015. During a reviewof Manning's first quarter 10-Q in late April, Colt became aware ofthe company's settlement with a customer over a product warrantylawsuit; this case had been settled on March 17, 2015. AlthoughColt had received the necessary letter from Manning's attorneys,the letter arrived prior to the settlement of the case and did notmention this development. After reviewing the information relatedto the settlement, Colt does not believe that the settlement ismaterial to Manning's financial condition or results of operationsand believes the opinion on Manning's financial statements is stillsupportable.

D. During a PCAOB inspection, it was determined that WKRP, LLPhad not adequately documented their rationale for not observing thephysical inventory count in its audit of King Manufacturing. Thisdiscovery occurred over a full year after the audit report releasedate. Lebron McWhiney, the lead engagement partner conceded thatthe inventory observation had not occurred and alternativeprocedures were not available due to the client’s accounting recordretention policies. In discussions with the PCAOB investigatorsLebron noted that the rationale, although not documented, was thatKing’s year-end inventory is quantitatively immaterial, at just 1%of total assets.

E. Drew Allison is conducting the audit of Anderson Inc. as ofDecember 31, 2014. At the beginning of the evidence gathering,Allison becomes aware that one of Anderson's major customers(Jones) is experiencing significant financial difficulties. Jonesnormally accounts for 5 percent of Anderson's net sales. Afterperforming the necessary procedures, Allison believes that $2.8million of Jones's receivable balance will ultimately becomeuncollectible. Allison further believes this amount is material toAnderson's financial condition and results of operations.

F. Charles Carmelo is completing the December 31, 2014, audit ofNugget Company. As part of the final procedures, Carmelo hasrequested representations from Nugget's management regarding theirassertion as to the fairness of the financial statements and otherimportant matters addressed by professional standards on February5. Because Nugget's management is attending an analyst briefing inthe upcoming week, Carmelo receives these signed representationsdated February 9, 2015. Because Carmelo had already completed allof the important procedures he released his auditor’s report, datedFebruary 5, 2015, with the financial statements on February 6.

G. Gruden LLP, was auditing Raider Company for the year endedDecember 31, 2014. Gruden plans on completing the audit by February17, 2015. On January 17, 2015, Gruden LLP learned that RaiderCompany activated a portion of its line of credit on January 5,2015, by borrowing $2.5 million. This additional obligationincreased Raider Company's long-term liabilities by 10 percent.

H. Cameron Alta completed the December 31, 2014, audit of SaxeCompany on February 10, 2015. Saxe is planning to release itsfinancial statements, along with Alta's opinion on these financialstatements and internal control over financial reporting, onFebruary 17, 2015. On February 12, 2015, a flood in one of Saxe'swarehouses located in the Gulf Coast region destroyed more than $10million of inventory. The extent to which this loss is recoverablethrough Saxe's insurance is unlikely, Alta believes that this losscould have a material impact on Saxe's financial condition andresults of operations.

I. During the audit of Glomco, Angel Myron identified a numberof misstatements. These misstatements are not material in dollaramount, do not appear to represent any discernable pattern, and donot represent fraudulent activity. As a result, Myron has decidedthat Glomco's financial statements do not need to be adjusted toreflect the effect of these misstatements.

J. Crismus and Stori, LLP is auditing Frozen Pole Desserts (FPD)for the year ended December 31, 2014. On February 9, 2015, theaudit partner in-charge Ralphy, learned of the following eventsduring his meeting with FPD's chief operating officer. A classaction lawsuit was brought against FPD by some of its formeremployees for workplace discrimination. An attorney on behalf of aclass of employees filed the lawsuit on January 10, 2015. Theletter from FPD's attorneys suggested that the amounts are notestimable and the likelihood of a negative outcome cannot bedetermined at this time.

K. Following the completion of the 2014 audit (including therelease of the audit report) of Blankenship Corporation, bySeeanSee, Muzik, and Fakdurry, LLC (SMF). Reese Jill, SMF’s auditpartner met with the manager on the audit engagement to conduct apostmortem on the engagement and identify how changes inBlankenship's operations noted during the most recent audit mayaffect future audits. During this review, Jill became aware thatBlankenship's process for evaluating potential impairment ofgoodwill related to an acquisition made by Blankenship during themost recent year had been considered and calculated by the auditteam, but for unknown reasons the adjustment had not been proposedto the client. Thus, the impairment had not been properly disclosedor accounted for in the financial statements. Jill believes thatthe results of the procedure is important in supporting the opinionon Blankenship's financial statements and notes that Blankenship’smanagement would probably be receptive to adjusting thefinancials.

Required: Unless otherwise noted, assume that each scenarioaffect (are material) to the Company’s financial statements, andthere are persons who continue to rely on the financial statements.For each of the preceding items, determine:

I. whether the event described should be classified as:

A. Subsequent Event

B. Subsequently Discovered Event

C. Omitted Procedure

D. None of the above

II. what actions the auditor should take after the firm'squality review identified these issues:

1) Disclosure in financial statements

2) Adjustment to and/or disclosure in the financialstatements

3) No further action is necessary (specific auditprocedures)

4) Determine if alternative procedures are available, if so takeaction 5, if procedures are not available, withdraw the auditor’sreport

5) Perform procedures related to the item and revise theauditor’s report date if necessary

6) Perform procedures related to the items and if facts wouldresult in revision of auditors’ report or financials, then notifyindividuals relying on financials and issue revised financialswhich provide disclosure of facts

7) Not applicable

Q4

Part A

(a) How does the materiality of a condition that might lead to a departure affect the auditor’s choice of audit opinions? Discuss in detail naming the various types of audit opinions that may be issued given the different amounts of misstatements detected. (10 marks)

(b) For each of the following independent situations, indicate the type of audit report you would issue and provide your reasons. You may assume that each item is material. (10 marks)

(i) On 2 January 2017, the Hot Wheels Auto Parts Limited received a notice from its primary supplier that, effective immediately, all wholesale prices would be increased by 10%. On the basis of this notice, Hot Wheels Auto Parts revalued its 31 December 2016 inventory to reflect the higher costs. The inventory constituted a material proportion of total assets; the effect of the revaluation was material to current assets but not to total assets. The increase in valuation is adequately disclosed in the notes to the financial statements.

(ii) Your client holds a significant investment in Iraq. Due to recent political instability sparked off by a series of terrorist acts by the militants, Iraq’s communication with the outside world has been completely cut-off. You are thus unable to obtain sufficient and appropriate evidence regarding your client’s investment in Iraq.

Part B

During an examination of financial statements, an auditor needs to verify management’s assertions that are part of the financial statements. In doing so, the auditor must choose the quality and quantity of evidence, and the timing of the tests to be performed.

(a) Describe five factors that influence the quality or appropriateness of audit evidence. (5 marks)

(b) Why is it necessary to obtain corroborating evidence for inquiry and for observation? (5 marks)

(c) Describe the highest quality form(s) of evidence an auditor would normally obtain to verify each of the following assertions. Be sure to state the type of audit evidence/audit procedure technique being used, e.g. inquiry. (10 marks)

(i) ownership of share certificates held in a safe deposit box

(ii) valuation of gross trade accounts receivable

(iii) completeness of additions of fixed assets

(iv) validity of trade accounts payable

(v) valuation of finished goods inventory

Part C

An auditor is required to obtain sufficient understanding of each element of a company’s internal control system in order to properly plan the audit of the company’s financial statements and to assess control risk for the assertions included in the account balances.

How does the quantity of evidence differ between procedures to obtain an understanding of internal control and tests of internal controls? (4 marks)

(b) Distinguish between a compliance/reliance strategy and a substantive strategy. (6 marks)

(c) For each of the following, give an example of a physical control the client can use to protect the asset or record: (5 marks)

(i) cash received by retail clerks

(ii) accounts receivable records

(iii) raw material inventory

(iv) manufacturing equipment

(v) marketable securities

(d) Explain what is meant by independent checks on performance! (5 marks)

performance review and give two specific examples.