Auditing Principles and Procedures

Assignment Question(s):(Marks 15)

IMPORTANT NOTE: Answer in your own words, DO NOT COPY from slides, fellow students, or internet sources without proper citation.

Q1. Rick is an independent auditor. The audit committee of the board of directors of Eastern Corporation asked Rick to audit Eastern’s financial statements for the year ended 31 December 2014. Rick explained the need to make an inquiry of the predecessor auditor and requested permission from the management to do so. Eastern’s management agreed and authorized the predecessor auditor to respond fully to Rick inquiries.

Required: (4 Marks).

• Explain The information that Rick should obtain during its inquiry of the predecessor auditor before they accept the engagement?
• What other audit procedures should Rick perform in evaluating Eastern as a potential client?

Q2. Read the following situations, and explain how the risk of material misstatement should be assessed and how detection risk could be affected by the assessment. (3 Marks).

(The first one is answered for you to get the idea).

• Kelvin is a trucking company. The company is publicly held, and growing rapidly throughout the southeast. But Richard Kelvin and his sons control 55 % of the stock. Richard is chairman of the board and CEO. He personally makes all major decisions with little consultation with the board of directors. Most of the directors, however, are either members of the Kelvin family or long-standing friends. The board confirms Richard Kelvin’s decisions.
• Wooden Corporation is one of several companies engaged in the manufacture of high-speed, high-capacity data storage devices. The industry is very competitive and subject to quick changes in technology. Wooden’s operating results would place the company in the second quartile in terms of profitability and financial position. The company has never been the leader in the industry, with its products typically slightly behind the industry leaders in terms of performance.
• The BAC Bank has been your client for the past two years. During that period, you have had numerous arguments with the president and the controller over a number of accounting issues. The major issue is related to the bank’s reserve for loan losses and the value of collateral. Your prior audits have indicated that a significant adjustment is required each year to the loan loss reserves.

Answer (a)

Two factors are particularly important in assessing the risk of material misstatement for Kelvin , Inc. First, one individual, who also has majority control of the stock, dominates the decision making in the company. This factor should lead to a higher assessment for the risk of material misstatement because there is no review of important decisions and actions may be taken that are not in the best interest of the company or its stockholders. Second, Kelvin , Inc. is expanding rapidly throughout the southeast. Such expansion may result in material misstatements since decision-making may become decentralized without adequate internal control. The increase in the risk of material misstatement due to these two factors will result in a lower determination of detection risk and an increase in the scope of the auditor’s work.

Q3. Read the following situations relating to the audit of internal control over financial reporting, what would be the audit report you will choose as an auditor and why? (3 Marks).

(The first one is answered for you to get the idea).

• During the audit of Health Recipe Pharmaceuticals, you are surprised to find several control deficiencies in the entity’s internal control. You determine that there is a reasonable possibility that any one of them could result in a significant misstatement. Although the odds are extremely low that the deficiencies, singly or taken together, will result in a material misstatement of the entity’s financial statements, the large number of problems causes you concern. Management’s written assessment concludes that the entity’s ICFR was effective ‘as of’ the report date.
• Pure Waters identified what you agree is a material weakness and made an adverse assessment in its report on ICFR. The entity had not corrected the material weakness ‘as of’ the end of the reporting period.
• During the audit of ICFR for Sara Industries, you discover several control deficiencies. You determine that there is more than a reasonable possibility that any one of them could result in a financial statement misstatement. Although you do not believe that any of the deficiencies taken individually will result in a material misstatement, you believe there is a moderate likelihood that, taken together, the deficiencies could produce a material misstatement. Management’s written assessment concludes that the entity’s internal control was effective ‘as of’ the report date.

Answer (a)

The auditor would most likely issue an unqualified opinion on the effectiveness of internal control. Significant deficiencies do not necessitate an adverse opinion. In this case, the likelihood is extremely low that the deficiencies taken individually or together will result in a material misstatement, meaning that there is no material weakness. If the significant deficiencies remain uncorrected in future years, the auditor may conclude that management’s attitude toward internal control reflects a poor control environment and may issue an adverse opinion.

Q4. Success Company, a diversified manufacturer, has five divisions. Success has historically allowed its divisions to operate autonomously. The corporate intervention occurred only when planned results were not obtained. Corporate management has high integrity, but the board of directors is not very active. Success has a policy of hiring competent people. The company has a code of conduct, but there is little monitoring of compliance by employees. Management is fairly conservative in terms of accounting policies and practices, but employee compensation packages depend highly on performance. Success Company does not have an internal audit department, and it relies on your firm to review the controls in each division.

Bader Fahad is the general manager of the Fiberglass Division. The Fiberglass Division produces a variety of standardized parts for small appliances. Bader has been the general manager for the last seven years, and each year he has been able to improve the profitability of the division. He is compensated based largely on the division’s profitability. Much of the improvement in profitability has come through aggressive cost-cutting, including a substantial reduction in control activities over inventory.

During the last year, a new competitor has entered Fiberglass’s markets and has offered substantial price reductions to grab market share. Bader has responded to the competitor’s actions by matching the price cuts in the hope of maintaining market share. Bader is very concerned because he cannot see any other areas where costs can be reduced so that the division’s growth and profitability can be maintained. If profitability is not maintained, his salary and bonus will be reduced.

Bader has decided that one way to make the division more profitable is to manipulate inventory because it represents a large amount of the division’s balance sheet. He also knows that controls over inventory are weak. He views this inventory manipulation as a short-term solution to the profit decline due to the competitor’s price cutting. Bader is certain that once the competitor stops cutting prices or goes bankrupt, the misstatements in inventory can be corrected with little impact on the bottom line.

Required: (5 Marks).

• Evaluate the strengths and weaknesses of Success Company’s control environment.
• What factors in Success Company’s control environment have led to and facilitated Bader’s manipulation of inventory?