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Assignment 1 Session 3 | Complete Solution
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Assignment 1 — Session 3 (Spring)

(This assignment is based on Modules 1 and 2)

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Question 1 (15 marks)

(Multiple choice) (1½ marks each)

Note: For multiple-choice questions, select the best answer. Answer each item by giving the number of your choice. Incorrect answers will be marked as zero. Multiple-choice questions must be completed in your Assignment Submission section. This portion of the assignment will be automatically graded. Do not include your answers in your Word document as they will not be graded.

  1. Which of the following has historically represented the key driver in the demand for audits?
    1. Regulators’ requirements
    2. Lenders’ preferences
    3. Clients’ demand
    4. Investors’ information risk

 

  1. An auditor found $5,000 in errors from a representative sample of $50,000 in accounts receivable balances. The population of the total accounts receivable is $200,000. The client corrected $3,000 of the errors. What would be the projected misstatement ?
    1. $2,000
    2. $5,000
    3. $17,000
    4. $20,000

 

  1. Which of the following elements of the audit risk model is most likely to incorporate the lowest numerical value?
    1. Audit risk
    2. Inherent risk
    3. Control risk
    4. Detection risk

 

  1. Which of the following is not a likely consequence of audit team members under-recording hours worked on audit engagements?
    1. The audit firm will likely quote a lower fee for the following year’s audit.
    2. The audit team for the following year’s audit will have trouble meeting the time budget.
    3. Audit members will increase their respect for the integrity of their employer.
    4. Audit team members will benefit in their performance evaluation for that audit engagement.

 

  1. In general, there are two dimensions to audit evidence: sufficiency (quantity) and competency (quality and reliability). When considering the best approach to gather evidence, which of the following factors would most likely not directly affect financial data reliability?
    1. Client economic risk
    2. Management integrity
    3. Persuasiveness of alternative forms of evidence
    4. Client’s control structure

 

  1. Katy, a CGA, is in the process of reassessing control risk. Which of the following is most likely to cause Katy to lower the level of control risk?
    1. Inherent risk is higher than expected.
    2. Tests of control show high sample error rates.
    3. A substantive approach is used.
    4. Tests of control show low sample error rates.

 

  1. Meetings are an important component of the audit process. Meetings may be held prior to the commencement of field work, during the audit, and at the conclusion of the audit with management or the audit committee. Which of the following items would most likely be on the agenda of a meeting that is held during the audit?
    1. Schedules to be prepared by the client
    2. Arrangements for using computer-assisted audit techniques (CAATs) on the audit
    3. Other services that might be provided by your firm (such as tax services)
    4. Arrangements for plant tours

 

  1. Which of the following best describes financial statement risk?
    1. The risk that the auditor will form the wrong opinion on the financial statements
    2. The risk that the auditor will not detect a material misstatement
    3. The business risk faced by the auditor
    4. The risk of material misstatement

 

  1. Bruno, a CGA, is auditing the financial statements of a small business client. Which type of risk is Bruno most likely to encounter when applying the audit risk model?
    1. High engagement risk
    2. High control risk
    3. High detection risk
    4. High risk of material misstatement

 

  1. To assist the auditor in evaluating the effect of misstatements accumulated during the audit, auditing standards require the auditor to distinguish between factual misstatements, judgmental misstatements, and projected misstatements. Which of the following statements would most likely be associated with projected misstatements?
    1. The auditor requests management to record an adjustment for such misstatements.
    2. Such misstatements represent the auditor’s best estimate of misstatements in an audit sample.
    3. Such misstatements are differences arising from the selection or application of accounting policies by management that the auditor considers inappropriate.
    4. Such misstatements represent the auditor’s best estimate of misstatement in a population.

Question 2 (22 marks)

Auditor independence has been a key issue for many years. Requiring the highest levels of independence is seen as a way of ensuring that auditors are not motivated to let clients get away with questionable financial reporting. It is argued that auditor independence supports higher quality audits and deters clients from aggressive earnings management and fraudulent financial reporting. Some research indicates, however, that the stringent independence standards currently in place for auditors actually result in less effective audits as measured by higher audit risk, since auditors do not know their clients as well as they did when they were also acting as consultants.

Required

Evaluate both points of view, commenting on and critiquing each side from the perspectives of the auditor, the client, and the public. Decide which viewpoint has the most merit, and defend your position. In addition to the readings related to independence in your module notes, read The Cost of Auditor Independence, from the CFO.com website.

Allocation of marks:

  • 2 marks are awarded for each valid and well-developed point, to a maximum of 4 marks per point of view/perspective combination and a maximum of 16 marks overall.
  • 2 marks are awarded for a valid conclusion in support of either position.
  • 4 marks are awarded for providing a convincing rationale that is consistent with the analysis.

Question 3 (14 marks)

In Topic 1.3, you read “Transparency of Firms that Audit Public Companies,” a consultation paper from the Technical Committee of The International Organization of Securities Commissions. At the end of the document, the committee raises questions for discussion. Prepare answers to the following questions excerpted from the consultation paper:

The Task Force seeks public input on the following additional matters to facilitate its consideration of the issues surrounding transparency of firms that audit public companies:

17

Would transparency of audit firms improve audit quality and the availability and delivery of audit services? What negative effects, including costs, of increased transparency should regulators consider?

18 & 19

Would investors have increased confidence in financial reporting as a result of increased audit firm transparency? Are there significant benefits to investors of increased audit firm transparency, since they invest in companies and not audit firms?

Allocation of marks: 2 marks are awarded for each valid and well-developed point, to a maximum of 8 marks for question 17 and 6 marks for questions 18 and 19.

Question 4 (16 marks)

You are a senior auditor at Smythe, Chaudhry & Radman, CGAs. In preparation for upcoming audits, you are reviewing the files of a number of potential new clients and continuing clients, and evaluating potential threats to independence. You recall that the framework used in the CGA Independence Standard requires you to identify threats to independence, evaluate whether these threats are clearly insignificant, and in cases where the threats are significant, identify and apply safeguards to eliminate or reduce the threats to an acceptable level.

Required

For each of the following situations (a to e), complete the following steps in your review:

  1. Identify the type(s) of threats to independence.
  2. Evaluate each threat by classifying it as “clearly insignificant” or “ clearly significant.”
  3. For each threat that is clearly significant, identify one or more safeguards that would help eliminate or reduce the threat to an acceptable level.
  1. Six months ago, one of the firm’s partners served as an expert witness at a hearing where Kaledon Inc. (a public company) was being sued for non-performance of contract. The partner testified at the request of Kaledon with respect to the fair value of an asset provided by Kaledon to the plaintiff. The asset was valued at $5 million. Several similar assets are still on hand and recorded in Kaledon’s books. The company was impressed with the partner’s work, and has approached him for a quote on audit services for this year.
  2. The firm recently hired Ninan as a new audit manager. Ninan’s wife owns 5% of the common shares of Tempo Corporation, an existing audit client.
  3. The minutes from your audit team debriefing meeting for last year’s audit of Saltzbury Shutters indicated that several audit staff members had difficulty talking to the company’s controller. One audit team member noted, “I had difficulty following a complicated walk-through, and when I asked the controller for clarification, she made me feel stupid and threatened to tell my supervisor.”
  4. Raj, an audit manager, recently bought a new condo downtown and joined the strata council. At the first council meeting Raj attended, he discovered that the treasurer of the strata council, who is a neighbour in Raj’s new building, is also the CFO of Baltar Corp. Baltar is an audit client of Raj’s firm, and Raj manages the audit engagement.
  5. The firm provides bookkeeping services to non-assurance clients. At the beginning of the current year, EdgeMax Inc., a private company for whom the firm performs review engagements, lost its accounting clerk suddenly. The firm sent Suzanne, a junior staff member on the review engagement team, to do the bookkeeping and payroll for three weeks while EdgeMax found a new staff member.

Note: the solution can be presented in a chart format.

Allocation of marks: 1 or 2 marks are awarded for each of steps i. to iii. for situations (a to e).

Question 5 (33 marks)

You, a CGA, are a senior partner in the CGA firm of Perry, Usher, and Drake (PUD) in Vancouver, B.C. Your firm performs audits, reviews, compilations, accounting, and tax services for small to medium-sized business clients. Your firm has built a good reputation among the local retail and restaurant businesses in the vicinity.

Recently, you were dining at a restaurant called Gastronomical Delights when you were approached by Jamie, the executive chef and owner. Jamie started the conversation by telling you that a neighbouring store had recommended your firm as you provide high-quality work at a reasonable fee.

Jamie’s newly adopted philosophy emphasizes weaving excellence into everything the restaurant does, from sourcing the best seasonal produce from local food and wine artisans to creating unique meals. The restaurant generates retail sales from baked goods and charcuterie through the day, which accounts for approximately 50% of total revenues. Jamie has been featured in a well-known food magazine, Bon Appétit, and she is optimistic that this publicity and her business philosophy will help her draw in more customers and turn a profit in the near future.

Jamie is thinking of switching audit firms for the audit of the current fiscal year (year-end December 31, 20X1). She tells you that she has been dissatisfied with her current accounting firm:

We’ve had a bit of a falling-out as we had a disagreement and the firm ended up issuing a qualified opinion on the financial statements last year. In prior years we were fine, and they have always issued an unmodified opinion. Apparently, last year they could not issue a clean audit opinion — something to do with deficient internal controls in sales revenues and cash balances and not being able to verify these balances. I don’t understand what can be done at my end. I cannot afford to hire more accounting staff to address the going-concern issues or put in a new accounting system, let alone controls. I really don’t want any further contact with my former accountant, and your firm should probably should steer clear as well. I don’t want you to approach this audit with any preconceived notions.

The restaurant has been losing money for several years now, partly because the industry is suffering in the face of the current economic situation and partly because of profit margins that have narrowed in the face of Jamie's newly adopted philosophy of weaving excellence into everything Gastronomical Delights does. To keep the business going, Jamie has been drawing down the restaurant’s $600,000 line of credit and now owes the bank $500,000. She tells you, “Unless I can get an unmodified opinion from you this year, I’m concerned that the bank may call my loan.”

You learn that the restaurant’s business is evenly divided between customers who use credit cards to pay for their meals and those who pay cash. Jamie prefers cash payment since the credit cards companies charge merchants a fee for each transaction. To reduce the paper and time consumed by issuing paper receipts, staff members do not ring in cash retail sales of baked goods and charcuterie during peak periods. Jamie says, “I write down the amount of cash sales at the end of the day when I’m depositing the day’s receipts in the restaurant’s bank account. My staff are all honest, the cash belongs to me anyway, and I end up saving some trees.”

Jamie explains that she is willing to pay your firm the same fixed audit fee she paid to the prior audit firm: $12,000. She tells you that she is willing to give you and each of your partners a 20% preferred customer discount card that she sometimes gives to some of her best customers. This will give you a discount on all food and beverages consumed and purchased at her restaurant.

At the close of this conversation, you tell Jamie that you will consider her proposal, discuss it with your partners, and respond to her within the next few days.

You and your partners have been trying to build up the firm’s auditing practice, but you are aware that there could be serious risks in taking on this engagement. Your firm’s client base has been shrinking because of the economic downturn and credit crunch, which has caused some local businesses to go out of business. You proceed to have a discussion with the firm’s partners.

Required

  1. Assume it is now June, 1, 20X1. Write a letter to Jamie outlining your firm’s response (maximum 1,000 words). (27 marks) (Do not prepare an engagement letter. It is not necessary to state whether to accept or reject this engagement)
  2. Assume you accept Jamie as your client. You start to plan the overall audit strategy. Because of the client’s financial situation, you want a 97-98% level of assurance for the audit as a whole. Based on your initial study of the client’s accounting system and controls and analytical tests, you have assessed the chance that the client’s internal controls will prevent or detect and correct material misstatements at only 50%. In addition, you believe that there is a 30% chance that the client will go bankrupt and your firm will be sued by creditors and investors within the next two years. Explain whether it is appropriate and in accordance with Canadian Auditing Standards for you to consider the risk that your firm will be sued if the client goes bankrupt when designing an audit plan for Gastronomical Delights. (4 marks)
  3. Risk features heavily in an audit. Traditionally, the goal of the auditor has been to reduce risk to an acceptable level during the course of the audit so that a correct opinion can be provided. However, that goal has been complicated by the changing focus of audits, most notably after the fall of Enron and WorldCom. Explain how the audit focus has changed. (2 marks)

100

 

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Assignment 1 Session 3 | Complete Solution
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c. Which of the following elements of the audit risk model is most likely to incorporate the lowest numerical value? 1. Audit risk 2. Inherent risk 3. Control risk 4. Detection risk d. Which of the following is not a likely consequence of audit team members under-recording hours worked on audit engagements? 1. The audit firm will likely quote a lo...
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