Key Auditing Concepts and Final Exam Review Guide
School
University of Manitoba**We aren't endorsed by this school
Course
ACC 4010
Subject
Accounting
Date
Dec 10, 2024
Pages
14
Uploaded by CountPanther4633
Final Review and Recap Class1.Final Exam Review:•Important auditing concepts that you should be familiar with:•Identification of breaches of fundamental ethical principles.•Identification of threats to independence and actions to eliminate or reduce threats to acceptably low level.•Gaining an understanding of the client and procedures used (such as analytical procedures).•Assessment of audit risk for the audit as a whole and impact on audit overall.•Identification and assessment of risks of material misstatement at the overall FS level and assertion level for each FS line item (including assessment of related party, fraud and going concern risks).•Assessment of inherent, control and detection risks by assertion for each FS line item and impact on audit approach/strategy (i.e. combined versus substantive approach).•Understanding of concept of materiality and how to calculate preliminary materiality leveland evaluate unadjusted misstatements as part of forming an opinion at the end of the audit.•Understanding of FS assertions and how they relate to the FS line items in terms of the risks of material misstatement and appropriate audit response to address risks – refer to In-class Problems #s 5 & 6 for examples.•Understanding of FS transaction cycles (i.e. Revenues/Receivables/Receipts (R/R/R); Purchases/Payables/Payments (P/P/P) / Payroll / Inventories) and related internal controls - must also be able to identify key internal controls and related FS assertions and explain nature of the risk being addressed by the control. •Understanding of tests of controls and substantive procedures - must also be able to relate tests of controls and substantive procedures to related FS assertions and risks being addressed.•Understanding of procedures to perform inventory count and how to test inventory count procedures.•Understanding of procedures to complete and report on audit engagement. •Understanding of different types of audit report modifications and ability to assess and identify appropriate audit report depending on circumstances (i.e. based on assessment of materiality and pervasiveness of misstatements or scope limitations identified)1
Final Review and Recap Class•Please review the Lecture Notes and In-Class Problems (posted on UM Learn) – there is a lot of good information.•Any questions? 2
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Final Review and Recap ClassAllentown Credit UnionAllentown Credit Union (ACU) is located in a rural community in Canada. Membership is open topeople in the community and the surrounding area. The local economy, which is predominantly agricultural, has been harmed by droughts in recent years and by declines in commodity prices, leading to a decline in ACU’s profitability.ACU has always had an external audit and has always prepared its financial statements in accordance with IFRS. Ellino & Co. has audited ACU for the last several years. You, CPA, a senior with Ellino & Co., have been appointed to the audit of ACU for the year ended December 31, 2016. It is now early January 2017, and you are at the client’s premises reviewing the information gathered to date.ACU was founded in 1942, and it has always maintained a philosophy of serving the community. This has resulted in liberal lending practices and investment in the local community whenever possible. This stance has distinguished it from other financial institutions, which are primarily branches of national banks, and has given ACU a 75% share of the market.ACU has been headed by the general manager, Ted Richards, for the past ten years. Ted reports directly to the Board of Directors, which is comprised of local people, some of whom have no formal financial training. Ted has always been accessible to members of the credit union and, on occasion, he has intervened in favour of the customer over the staff. He maintainsthat this flexibility is crucial to generating revenue, which is an important objective of the Board.The loan manager, Sheila Meigs, joined ACU in the past year. She is responsible for the entire lending function, which includes authorization of loans, appraisal of collateral, and assessment of the collectability of outstanding loans. The loan portfolio is the largest asset on the balance sheet, representing 75% of total assets.The accountant, Vivian Larson, and the head teller, Joanne Blake, both have 15 years of experience at ACU. Both are married to farmers and work to supplement their income. Both families are members of ACU, and all their personal and business transactions are conducted through the credit union.As you read through your notes, Ted Richards interrupts you to tell you about some of the events that have occurred at ACU during the year.•ACU foreclosed on a large loan and sold the land held as collateral. One effect of this sale was to depress the land prices in the surrounding area. ACU still maintains a high inventory of land received from past foreclosures but has decided to hold onto this land for fear of depressing land prices further.•As a result of the depressed state of the local economy, provisions have recently been made to allow some customers to repay their loans with grains (i.e., oats and barley) instead of cash. Although such payments are not a common practice, Ted has approved these transactions on an exception basis. 4
Final Review and Recap Class•Even though the economy is depressed, Ted believes this will turn around and loans will be collected over the long term. Therefore, he has instructed to Sheila Meigs, Loan Manager, not to write off any significant loan balances. Required:a)Perform an inherent risk assessment.b)Perform a control risk assessment.c)Conclude on the overall risk of material misstatement. How will your audit risk conclusion impact the audit strategy?Solution:a) The overall inherent risk has increased for several reasons.•First, there has been a downturn in the local economy and ACU’s performance is very sensitive to economic conditions. •The tough economic conditions increase the likelihood of uncollectible loans. There is a management bias to maximize asset values and income as demonstrated by Ted who advised the loans officer not to write off significant balances due to the belief that the economy will pick up over the long term. •The Loans are a significant account on the balance sheet and the valuation of the loansand the loss provision requires professional judgment. As a result, there is considerablescope for error in evaluating the judgment exercised by management. •Also, the presence of unusual transactions such as allowing some customers to repay their loans with grains instead of cash increases the inherent risk.b) Control risk is also a potential problem. •A new person is handling the lending function, which means there is a greater chance that internal controls will not be observed because of unfamiliarity. •Also, the experience of the new loan manager is not known, and her job requires the exercise of judgment. Until we have gained confidence in her ability as a loan manager, the control risk has increased. •In addition, Ted Richards seems to override internal controls. For example, he has accepted grain in lieu of payment on loans, which is an unusual way of running the business.•The board of directors appears to be very unsophisticated which increases control risk.c)The overall risk of material misstatement associated with the ACU engagement is high. As a result, we will have to do more audit work than in previous years to attain the necessary audit assurance.5
Final Review and Recap ClassBazaarBazaar buys computers, parts, and related equipment and resells them at a mark-up to a loyal base of corporate customers. Competition is growing, but the market is favourable, and Bazaar offers excellent customer service, giving it a competitive advantage. The owner is very involved in most of the important operating decisions. His capable assistant steps in when necessary. The owner plans to implement a code of ethics at some point and also wishes to improve certain controls.Bazaar is a medium-sized private company that operates multiple warehouses, each carrying a mix of inventory items. The first type of inventory, which can be quite costly, consists of specialized computer hardware, desktop computers, and laptop computers. The turnover rate for this inventory is high since new technology is always emerging. Because the company orders months in advance, Bazaar occasionally overestimates demand. After three or four months, products are difficult to sell, but they are kept because most cannot be returned to the supplier, and Bazaar is reluctant to hold liquidation sales for fear they would negatively affect the sales at regular prices. The second type of inventory, parts and peripherals, generates a significant portion of Bazaar’s sales. This category includes items such as monitors, printers, and toner cartridges. The third type of inventory includes software packages ranging from sophisticated operating systems to games. This inventory can be returned to suppliers if unsold after a certain period.This year, Bazaar implemented an integrated computer system to manage the general ledger aswell as inventory, purchases, and sales. Sales representatives enter orders into the sales database, and can modify the information, including quantities and selling prices. Any changes are usually made to orders before shipping. Problems result if representatives make changes after shipping, since they should issue credit notes instead. The timing differences create reconciliation problems for both customers and Bazaar when settling invoices. Also, sometimes credit notes have been issued in error. For example, the owner described one example where a credit note was issued for a price adjustment made by a sales representative. The supporting paperwork stated that the credit note had been issued in error (which seems to happen often) and the refund cheque was cancelled. However, the details of the refund cheque could not be located. When asked, the clerk said he left the cheque copies on his desk and the next morning they were gone. He gave up looking for them.Electronic purchase orders require authorization from either the owner or his assistant through the use of a personal identification number (PIN). Each user has a specific PIN. Orders greater than $5,000 require the owner’s authorization. Occasionally, the owner is not available. He has given one of the accounting clerks he trusts his PIN to be used for emergency situations. Beforemaking a payment, the accounting department matches the invoice to the authorized purchase order and the receiving slip.Other Information:The owner noted that Bazaar’s costs seem higher than expected, particularly since this year he decided to pay suppliers faster in order to benefit from discounts. According to his calculation, the cost of goods sold should have decreased by around 2% over last year, since most suppliers offer discounts and did not increase prices. Instead, he noted a 3% increase in costs. 6
Final Review and Recap ClassThe sales mix has not changed significantly from previous years. Purchases increased and were distributed across the inventory types in amounts similar to the overall sales mix. To help retain the sales team, stock options were given this year for the first time as an added form of compensation. The options are available if Bazaar’s net income after tax is at least $5 million per year. Customers have 30 days to pay invoices, but most take advantage of a 2% discount offered for payment within 10 days. Customers make payments in full payments and discounts are reimbursed later by system-generated cheques. Cheques may be issued with or without supporting documentation. The owner noted he just received a memo from a clerk at one of the warehouses. It says the amount of damaged inventory has been gradually increasing over the past eight months. The clerk suggests this is because the forklift is not operating properly and items are being dropped as they are loaded for shipment. He wants the forklift replaced. He asks what he should do with the damaged inventory that has been piling up in a corner of the warehouse. He suggests holding a liquidation sale to get rid of it,Required:a) Assess and conclude on inherent risk. Be sure to discuss items that both increase and decrease risk for a balanced discussion.b) Assess and conclude on the control risk. c) Based on your inherent and control risk assessment, conclude on detection risk. d) Based on the risk assessment, what type of audit strategy should be implemented? Solution:a) Items reducing inherent risk:• Bazaar has been operating for many years and has a good reputation.• Bazaar has a loyal customer base.• Owner has many years of experience in the industry.•Market is favourable. • Activities are simple (buying and reselling at a markup).• The nature of the business appears to be non-complex (except for the specialized orders): there do not appear to be complex or non-routine transactions to contend with. Items increasing inherent risk:• Competition is strong, increasing the possibility of a decline in sales. • Multiple warehouse locations increase the complexity of the engagement. • Bazaar deals with computers and related equipment, and new technology is always emerging, so the risk of inventory obsolescence 7
Final Review and Recap Class• Inventory items are computer-related, which may increase the risk of asset misappropriation since they could be considered high-demand products. • The volume of transactions appears to be high• The distribution of stock options for the first time is an added risk factor because employees may be inclined to manipulate net income in order to obtain their options. Therefore, the stock options may increase the risk of fraud. Conclusion: Inherent risk is assessed as high.b)Control riskItems increasing control risk:• Owner says controls could be improved.• The purchase authorization mechanism seems weak since the assistant was able to authorize a purchase over his limit without much trouble.• Conversion took place during the year; new system is now in place.• No code of ethics in place, which shows a lack of clear policies and poor tone at the top.• There appears to be a problem with the issuance of credit notes. One that had been issued by a sales representative was apparently issued in error. Conclusion: Control risk is assessed as high.c) Detection riskThe detection should be derived from the assessed inherent risk (IR) and control risk (CR) and should be used to determine the amount of audit work required to reduce the overall risk to an acceptable level. As IR and CR are high, meaning there is a high risk of material misstatement, detection risk should be set at “low”, therefore, more work is required to reduce the audit risk to an acceptable level.d) Audit Strategy (Approach)The overall audit risk is high. This increases the amount of audit work to be performed, A substantive audit strategy should be planned. Although some controls exist, they appear to be easily circumvented or to not be functioning properly, therefore it does not seem likely we can rely on the controls in place. This means the auditor will plan to do more substantive testing. 8
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Final Review and Recap ClassMoore PackagingMoore Packaging is a manufacturer of corrugated products servicing all of Ontario. Its annual audit was in progress and the senior on the audit was reviewing procedures over accounts receivable, inventory, property plant and equipment and accounts payable.The accounts receivable accounts were deemed to be key when it came to possible material misstatements. The preliminary work on test of controls had indicated higher than usual exceptions of shipments of goods to customers without the appropriate credit checks being performed.The inventory taking was missed this year at two of the three locations as local flooding had prevented the auditors from attending the annual inventory. The company keeps perpetual records for 90% of its inventory values. The property plant and equipment account had not changed significantly over the last 5 years, and it was anticipated that there would be little extra effort required to audit this account. Last year’s balance - net of amortization was $7,600,000. The preliminary amount – net of amortization for this year was $7,700,000.Total accounts payable was $2,200.000. The accounts payable amounts seemed to be all zero balances or relatively low balances. The exceptions consisted of two major suppliers to whom the company owed $1,800,000.Required:What work should the auditors perform to audit:a)Accounts receivable b)Inventory c)Accounts payables d)Property, plant and equipment (PPE). Solution:a)When accounts receivable is a significant account in an entity’s balance sheet there are two assertions that are considered most important to ensure the auditor has gained sufficient and appropriate audit evidence on which to conclude that there is no material misstatement in the balance at year-end. They are the existence and valuation assertions (i.e. relates to risk of overstatement).There can be confusion as to whether a confirmation provides assurance over the existenceand valuation assertions. A positive confirmation only provides audit evidence as to the existence of the debt owed by the customer. It does not provide any assurance as to whether the client will recover all of the balance. The best way of ensuring the balance is 10
Final Review and Recap Classvalued correctly is by the full receipt of the cash by the client after year-end.b)Similar to accounts receivable, the two key assertions for inventory are existence and valuation (i.e. relates to risk of overstatement).Because the auditors were not able to perform an inventory taking at two of the three sites, they will use alternative means to determine the existence of the inventory at the balance sheet date. They will determine how accurate the perpetual inventory records are, check whether there is a program of cyclical inventory counts to ensure the existence and accuracy of inventory quantities, and review any adjustments that have been made to the perpetual inventory records. If the controls over the perpetual inventory records and cyclical counts are strong (i.e. operating effectively), the auditors will be able to place reliance on theexistence assertion. Typical procedures that the auditors can carry out for valuation of inventory would be to focus on the initial cost recorded (by vouching to supporting invoices), the value recovered for any sales after year-end (by vouching to sales invoices), and any provision for impairment calculations for excess, slow-moving or obsolete inventory on hand at year-end. Note. Completeness of inventory is ordinarily not a major issue for most entities as the auditor is typically most concerned with the overstatement of assets and completeness teststend to focus on the potential understatement of inventory on hand. c)The two key assertions for payables are completeness and valuation (i.e. relates to risk of understatement). Completeness is critical because, as with any liability account balance, therisk is that the balance is understated. While auditing the balance is relatively straightforward, the bigger risk is that the client has omitted amounts from the balance, and it is therefore understated because it is not complete. The typical procedures performed are often referred to as subsequent payments testing and cut-off testing to search for any unrecorded liabilities.Subsequent payments testing involves vouching a sample of payments made after year-endto supporting invoices to ensure that if the amount relates to invoices dated before year-end,they have been correctly included in the payables at the balance sheet date. If the amount paid relates to invoices after year-end, the testing is to ensure they have been correctly excluded from payables at year-end.Cut-off testing involves selecting a sample of purchases on either side of year-end and verifying that each has been correctly included or excluded from payables at year-end based on the date of the invoice. The auditor should also test a sample of invoices on hand but not yet processed by the 11
Final Review and Recap Classclient to ensure the client is not holding back any invoices that should be recorded in payables at year-end.Payables can also include the account referred to as accruals. Accruals are those amounts that the client may not have received the invoice for but for which they know they have incurred an obligation to pay as at year-end. Accruals are tested the same way as payables by vouching to subsequent payments. Note. Existence is not usually significant for payables since it is highly unlikely that the client would record payables that do not exist or that they do not have an obligation to pay.d)The two key assertions for PPE are existence and valuation and allocation (i.e. relates to risk of overstatement). Existence is important because the assets the entity has recorded in it capital assets sub-ledger need to actually exist. Auditors usually test for existence by physically inspecting the assets listed in the capital assets sub-ledger in the first year the client is audited. In subsequent years, the auditors focus on additions to and disposals from the capital assets sub-ledger. It is also important to physically inspect the capital assets on aperiodic basis as this provides insights into not only whether the asset exists but also whether there appear to be any assets that may be damaged, impaired, obsolete or in excess to the client’s needs providing important evidence for the valuation assertion.Valuation is the other important assertion tested by auditors in relation to PPE since it is important that PPE are recorded at the appropriate carrying value, or fair value, as defined by IFRS. Valuation also becomes very important when an entity changes its operations, for example by closing down a factory site. It is likely that the value of the capital assets at the factory site will be impaired and may need to be written down to their fair value (or nil). Typical procedures for valuation include vouching to supporting documentation for any disposals and reviewing and assessing the reasonableness of any impairment calculations for any assets which may need to be written down. 12
Final Review and Recap ClassTHThanks for being such a good class and best of luck on the final exam and in your future endeavors! 13
Final Review and Recap ClassCan you please also take a few minutes to complete the Student Rating of Instruction (SRI) form on UM Learn (if you haven’t already done so ).14