Part 1:
You are a senior auditor at CPA LLP. This year, your audit client is Burnaby Wholesalers Ltd, a Canadian public listed firm that distributes building materials, hardware, gardening, and related products to retail stores that service the “do-it-yourself” home improvement market. The audit engagement team includes you, one engagement partner, three junior auditors, and two senior auditors. The fiscal year-end under audit is December 31, 2021. Prior to the current fiscal year, Burnaby Wholesalers was audited by another public accounting firm, but the client changed auditors in early June 2021 because management was dissatisfied with the predecessor audit firm’s high audit fee and lack of timely service. During the audit of Burnaby Wholesalers, you encounter the following scenarios. Please respond to each scenario and include your discussions in one PDF document.
1. During a meeting with the engagement partner, the engagement partner told you how Burnaby Wholesalers Ltd became the client of CPA LLP. In June 2021, during a golf tournament at a local country club, the engagement partner approached the CEO of Burnaby Wholesalers and asked if the CEO was satisfied with his incumbent audit firm. The CEO expressed some frustration with the firm, saying that their audit fee was quite high and the auditors often did not deal with issues in a timely manner. The engagement partner agreed that the audit fee was high and offered to visit the client’s premises the next day. The partner then spent some time at the client’s premises to get a basic understanding of the business and an estimate of how much time the audit would require. The partner offered to perform this year’s audit at a much lower fee. The CEO agreed to the fee, and immediately telephoned the incumbent audit firm and informed the auditors that their services would no longer be needed. The engagement partner drafted a formal engagement letter containing the usual information and sent it to the CEO for signature. The CEO signed it and returned it to CPA LLP. After receiving the engagement letter, the partner contacted the predecessor audit firm by telephone and asked if he could arrange to review the firm’s audit working papers for the year ended December 31, 2020. This request was politely refused. The partner wrote a detailed memorandum for the permanent files describing the situation and his agreement with the CEO of Burnaby Wholesalers. Please discuss the client acceptance process regarding Burnaby Wholesalers and its implications on this year’s audit engagement.
2. In one of the meetings at the beginning of the audit, the engagement partner and the client’s audit committee discussed the materiality and the overall audit plan. The audit committee proposed setting the planning materiality at $2,500,000. In addition, the audit team reviewed Burnaby Wholesalers’ opening balance for various accounts. One exception was noted that the client had failed to record accounts payable for $300,000 of inventory items on December 31, 2020, which resulted in a $300,000 (before tax) overstatement of 2020 income. After discussions, the audit team decided not to correct the error as it was deemed to be immaterial and self-correcting, since the liability was paid in 2021. The unaudited financial statements show total assets at year-end of 2 $250,000,000, revenues of $300,000,000, and income before taxes of $25,000,000. Please comment on the appropriateness of decisions or judgements made by the client’s audit committee and the audit engagement team.
3. To audit the accounts receivable that is associated with customers in Ontario, as of the year ended December 31, 2021, 20 positive confirmation requests were sent to a random sample of the client’s customers in Ontario by junior auditors. As of the year-end, the recorded accounts receivable includes 140 individual customer accounts. Of the 20 confirmations received from the customers, 15 had no exceptions noted. 5 confirmations suggest some inconsistencies as below. The junior auditors would like you to provide guidance on how to interpret the results from the accounts receivable confirmation and what is the dollar amount of identified misstatement.
Account #
Amount
Customer’s Comment
Clients’ comment
D303
$8,000
We already paid the company $8,000 on October 10, 2020 and we don’t owe anything.
No record of receiving the payment
E836
$4,000
$1,000 of goods were returned for credit on December 28, 2020. So we owe only $3,000
We received returned goods on January 10, 2021 and reduced the customer’s balance that day
K628
$3,500
The confirmation was returned and indicated as “Address Not Found.”
We don’t know what happened to the customer and to that accounts receivable. The balance is not material anyway
F986
$9,000
We paid this amount on December 29, 2020
We received payments on January 8, 2021, and the account was credited that day
A532
$10,000
The company has filed for bankruptcy and requests for payment should be directed to the company’s trustee
Looks like this should be written off. We are surprised by this news. The junior auditors further followed up with the company’s trustee, who acknowledged the existence of $10,000 debt but was not able to estimate the amount that the customer company could pay
4. In performing the audit, the audit team members relied on the client’s internal controls in several areas, including revenue transactions, accounts receivable, purchase transactions, and inventories and accounts payable. Audit team members spent considerable time obtaining a good knowledge of the client’s business through inquiry, observation, and the performance of detailed analytical procedures. In situations where the risk of material misstatement was assessed as high, audit team members performed very limited tests of controls and relied primarily on substantive tests of transactions and account balance details. Where the risk of material misstatement was assessed as moderate or low, audit team members performed extensive tests of controls but reduced their substantive testing to a minimum level. Certain account balances - such as petty cash, prepaid assets, and accrued payroll - were deemed to be immaterial and were not tested. Overall, the audit was performed so as to reduce audit risk to a level of about 5%. Please comment on the appropriateness of the audit approach.
5. Burnaby Wholesalers uses a computerized perpetual inventory system and the audit team members developed a set of test data to verify that the system operated as designed. The test data consisted of 10 purchase transactions randomly selected from the September purchases and 10 sales transactions also randomly selected from transactions recorded by the client during September 2020. The audit staff performed various substantive tests to verify the details of these transactions and then ran the 20 transactions through an offline version of the client’s inventory system, noting how each transaction was processed. No exceptions were found and the conclusion was reached that the system operated as designed. Therefore, control risk over inventory transactions was assessed as low and concluded that year-end testing of the client’s inventory could be restricted. Please comment on the appropriateness of such conclusion.
6. After conducting the audit procedures, you and other team members summarize all the misstatements discovered and possible adjustments to the financial statements as follows
Identified
Likely
Overstatement of finished goods inventories (valuation errors)
$100,000
$800,000
Overstatement of accounts receivable (confirmation exceptions)
$20,000
$200,000
Estimated understatement of allowance for doubtful accounts
$500,000
$500,000
Total
$620,000
$1,500,000
In addition, you identified a $20,000 understatement of finished goods on December 31, 2020 and estimated that finished goods were likely understated by a total of $200,000 at that date. The 4 materiality is determined to be $1,600,000. Please analyze the findings and assess the impact on audit opinion
7. As part of the audit completion procedures, you read a draft of management’s discussion and analysis (MD&A) of the company’s operations for the year that will be included in the company’s annual report to shareholders. In the MD&A, management acknowledges that past operations have been less than successful than expected but forecasts a major turnaround next year because of an expected improvement in sales volumes due to an anticipated increase in demand. In general, you find that the MD&A shows a very optimistic view of the company. You have assessed the ability of the company to continue in business as a going concern and concluded that it is very likely to be able to operate for several more years without new financing, but that its long-term economic prospects may be poor and that management needs to re-evaluate the company’s entire business model. Please suggest what actions would you take under this scenario
8. On January 15, 2022, Burnaby Wholesalers’ founder received a loan of $2,000,000 from the company. This loan was authorized by the company’s board of directors, is due and payable in one year, and bears interest at the prevailing prime rate. One of the audit staff learned about the loan when examining the minutes of the board of directors’ meetings. He said that this is not a concern at this time but the collectability of the loan should be examined next year. Please discuss whether you agree/disagree with him.
9. Burnaby Wholesalers is considering expanding to the U.S. market and the potential of becoming a firm cross-listed in the stock exchange in United States. The CFO at Burnaby Wholesalers noticed that U.S. GAAP requires managers to assess and disclose going concern uncertainty on a quarterly basis. The CFO is confused about the management’s role and the auditor’s role in providing going concern related disclosures. Please explain to the CFO about the different roles of management and auditors regarding going concern disclosure. In addition, please explain the relevant factors in assessing a firm’s ability to continue as a going concern and comment on the possible investor’s perception regarding the effectiveness of different mitigation plans that could potentially alleviate the substantial doubt in going concern.
10. One junior auditor is confused about the degree to which auditors should rely on the internal controls. One of his questions is “which assertion(s) help explain why auditors need to rely on internal controls at some minimal level?” Please explain to him. The junior auditor is also unclear about how the assertion related to fraud detection in CAS 240 is different from other assertions in auditing. Please explain to him