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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.

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Lelia Lubowitz
Lelia LubowitzLv2
28 Sep 2019

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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

The following audit report was drafted by a trainee on the audit of Golf (Pty) Ltd (“Golf”), a company which manufactures golf clubs. The trainee was asked to draft the report at the conclusion of the audit for the financial year end 31 March 2017 as part of on-the-job training and you have to evaluate his report. The shareholders of Golf included a clause in the company’s Memorandum of Incorporation which requires that the company’s annual financial statements are extremely audited.

Independent Report To the board of directors. We have evaluated the accompanying financial statements of Golf for fairness based on our annual audit carried out in terms of the Memorandum of Incorporation of the company.

Management is responsible for the preparation of the financial statements and for the prevention of fraud.

The auditor’s responsibility is to perform the audit and in doing do, to detect any fraud which may have material effect on the financial statements not having been prevented by the directors.

We report on the following aspects of the audit: 1. With regard to the detection of fraud, we detected a small wage fraud relating to unauthorized overtime. We reported this to management who subsequently dismissed the guilty persons.

2. An expert was engaged by our firm to assist in the valuation of the work-in-progress. Due to the complexity of the some of the company’s golf clubs, the risk of misstatements in the work-in-progress warranted this.

3. The company is currently being sued by a former employee who suffered personal injury at work whilst testing certain golf clubs during quality control procedures.


Page 12 of 17

In our opinion, except for the matters raised in 1 to 3 above, there are no outstanding issues arising from the audit which was conducted in terms of the International Standards on Auditing and the International Financial Reporting Standards.
Emphasis of matter There are no matters which require emphasis.

ABD Audit Kings 31 March 2017 Windhoek Namibia

YOU ARE REQUIRED TO:

Detail the errors / deficiencies in the audit report presented to you for evaluation (give explanations where necessary). You are NOT required to redraft the report. (30 marks)


QUESTION 4 (16 marks) According to ISA 240R- The auditors responsibility to consider fraud in an audit of financial statements, the auditor is required to recognize situations which may result in misstatements arising out of the misappropriation of assets. Consider the following. 1. A client company which holds large quantities of inventory does not keep the perpetual inventory records. 2. A company makes all its payments (e.g. wages, salaries, creditors) by electronic funds transfer. 10 employees are provided with the facilities on their computers to effect electronic transfers for their various sections. 3. The company reconciles its creditors ledger with creditors statements only at year – end. 4. The company pays salaries well below the industry norm and adopts the attitude that “if staff don’t like it if they can leave”. 5. Employees caught stealing from the company or making unauthorized use of company assets are dismissed immediately and prosecuted. 6. The company makes a significant number of cash sales. 7. Management and other employees constantly complain about the company (many of the complaints being unfounded). Company morale is low.


Page 13 of 17

8. There is inadequate authorization of expenditure incurred by management and employees on behalf of the company e.g. salesmen’s expense claims, management travel claims.

ISA 240R classifies the factors which could lead to the risk of misstatement arising from misappropriation as follows:

Classification a – incentive/pressures to misappropriate assets Classification b – opportunities to misappropriate assets Classification c – attitudes/rationalization which suggest the misappropriation may take place.

YOU ARE REQUIRED TO indicate into which classification each of the above risk factors (1 to 8) falls, and give a brief explanation as to why each of the factors increases the risk of misappropriation

Uncorrected Misstatements and Performance Materiality. AaronRivers, CPA, is auditing the financial statements of ChargerCompany, a client for the past five years. During past audits ofCharger, Rivers identified some immaterial misstatements (most ofwhich relate to isolated matters and do not have commoncharacteristics). A summary of these misstatements follows. (Toillustrate, in 2012, the misstatements would have reduced netincome by $13,200 if corrected) Year Effect on Net Income Effect onAssets Effect on Liabilities Effect on Equity 2012 ($13,200)($20,000) ($6,800) ($13,200) 2013 5,000 12,000 7,000 5,000 2014(9,250) (11,000) (1,750) (9,250) 2015 (2,000) (5,500) (3,500)(2,000) 2016 1,000 1,000 0 1,000 During the most recent audit,Rivers concluded that sales totaling $11,000 were recognized as ofDecember 31, 2017, that did not meet the criteria for recognitionuntil 2018. When Rivers discussed these sales with Chris Turner,Charger Company's chief financial officer, Turner asked Riversabout the performance materiality level used in the audit, whichwas $25,000. Upon learning of this, Turner remarked, "Then there'sno need to worry . . . it's not a material amount. Why should webother with this item?" Required: a. How does the misstatementidentified in 2017 affect net income, assets, liabilities, andequity in 2017? (Assume a 35 percent tax rate for Charger.) b.Comment upon Turner's remark to Rivers. Is Turner's reasoningcorrect? c. Upon doing some research, Rivers learned of therollover method and iron curtain method for evaluating theperformance materiality of misstatements. Briefly define each ofthese methods. d. How would Rivers evaluate the performancemateriality of the $11,000 sales cutoff error in 2017 under therollover method and iron curtain method? e. Based on your responseto part (d), what adjustments (if any) would Rivers propose toCharger Company's financial statements under the rollover methodand iron curtain method? ? Subsequent Events, SubsequentlyDiscovered Facts, and Omitted Procedures. Jay Ralph completed theDecember 31, 2017, audit of Raider Company on February 3, 2018;Raider's financial statements and Ralph's reports on Raider'sfinancial statements and internal control over financial reportingwere released on February 12, 2018. During April 2018, Ralph's firmconducted a quality review over selected audits that had beencompleted during the most recent year, and the audit of RaiderCompany was randomly selected for review. The reviewer identifiedthe following matters that Ralph had not addressed during the auditof Raider: 1. On February 9, 2018, Ralph learned of the followingevents during his post-audit meeting with Raider's chief operatingofficer. a. A class-action lawsuit was brought against RaiderCompany by some of its former employees for workplacediscrimination. An attorney on behalf of a class of employees filedthe lawsuit on January 10, 2018. The letter from Raider's attorneysdid not identify this lawsuit. b. One of Raider's major customersis experiencing significant financial difficulties; this customer'saccount receivable balance on December 31, 2017, was $1.2 million,which represented 2 percent of Raider's total accounts receivableon that date. 2. Because of an important deadline for submittingthe financial statements to lenders for evaluation, Raider did notmodify its financial statements for the preceding events despitethe fact that they were material. Raider's justification was thatbecause the events occurred after the date of the financialstatements, they were not required to be disclosed in the financialstatements. Ralph acquiesced to Raider's wishes and did not modifythe report on Raider's financial statements. 3. On March 16, 2018,Ralph initially learned of the following events affecting RaiderCompany, neither of which was disclosed in Raider's financialstatements: a. Raider Company declared a significant dividendpayable to its shareholders. This dividend was declared on March14, 2018, to be paid to Raider's shareholders of record on May 16,2018. b. Raider Company activated a portion of its line of crediton February l, 2018, by borrowing $2.5 million. This additionalobligation increased Raider Company's long¬-term liabilities by 10percent. 4. Reviewing Ralph's audit documentation, it does notappear that any tests were con­ ducted to evaluate the need forimpairment of the carrying value of Raider Company's property,plant, and equipment. Required: For each of the preceding items,describe what actions Ralph should take after the firm's qualityreview identified these issues.

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