CGA-CANADA AUDITING 1 EXAMINATION March 2006 Marks 30

Time: 3 Hours Question 1 Select the best answer for each of the following unrelated items. Answer each of these items in your examination booklet by giving the number of your choice. For example, if the best answer for item (a) is (1), write (a)(1) in your examination booklet. If more than one answer is given for an item, that item will not be marked. Incorrect answers will be marked as zero. Marks will not be awarded for explanations. Note: 2 marks each

a.

Which of the following would be an assurance engagement? 1) 2) 3) 4)

Advising on the tax effects of a proposed transaction Designing an internal control system for an audit client Preparing the financial records and financial statements for a client Conducting an external audit

b. A CGA firm is auditing the 2005 financial statements of XYZ Services Inc. The partner of the audit firm finished her review of the audit results on March 3, 2006, and the financial statements were issued one week later. The evidence included only one subsequent event, which was the audited details of the issuance of common shares, on February 15, 2006. When should the audit report be dated? 1) 2) 3) 4) c.

December 31, 2005 February 15, 2006 March 3, 2006 March 10, 2006

Which of the following procedures is tracing? 1) Selecting a journal entry for a purchase, and then checking to see if there is a corresponding purchase invoice 2) Looking through the cash receipts journal for unusual amounts 3) Selecting a journal entry for a purchase, then verifying that there is a receiving document 4) Selecting a cancelled cheque and verifying that it was recorded in the cash disbursements journal

d. Which of the following procedures would obtain evidence of existence? 1) 2) 3) 4) e.

Scanning Tracing Vouching Computation

Which of the following procedures would obtain evidence of completeness? 1) 2) 3) 4)

Scanning Tracing Vouching Computation

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f.

Which of the following would be the most reliable documents in terms of evidence? 1) 2) 3) 4)

Shipping documents Receiving reports Cancelled cheques Sales summaries

g. Which of the following statements would be inappropriate in an audit engagement letter? 1) “Our audit work is subject to the unavoidable risk that errors may not be detected.” 2) “We expect to obtain reasonable assurance that material errors do not exist in the financial statements.” 3) “We will provide your staff with a package of blank schedules needed by our staff during the audit. We understand that your staff will prepare all of the schedules in the package.” 4) “We will advise you of our fee at the conclusion of the audit.” h. Materiality for an audit was set at $60,000, identified misstatements at $45,000, and likely misstatement estimated at $75,000. In this case, what audit opinion should you recommend? 1) 2) 3) 4) i.

Which of the following would be described as “the risk of a material misstatement occurring in the first place”? 1) 2) 3) 4)

j.

Unqualified Qualified or adverse Adverse or denial Denial only

Audit risk Business risk for the audit firm Business risk for the client Inherent risk

Which of the following risks can the auditor control? 1) 2) 3) 4)

Control risk and audit risk Inherent risk and control risk Audit risk and detection risk Control risk and detection risk

k. Which of the following statements is true? 1) 2) 3) 4) l.

Increasing control risk will increase detection risk. Detection risk is inversely related to the amount of evidence required. Increasing inherent risk will increase detection risk. Inherent risk and control risk are inversely related to audit risk.

Which of the following assertions would be the least important for the audit of inventory? 1) 2) 3) 4)

Existence Valuation Compliance Ownership

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m. PPP Inc. sells all of its products through its website. The company sells specialty tea, mostly imported from China. Most of its customers are in North America, and the rest are in Europe. The company’s website is attractive and receives hundreds of hits every day, including some from Russia, Africa, and South America. PPP has instituted a firewall to protect its website. Which of the following is false concerning firewalls in a situation similar to PPP’s? 1) 2) 3) 4)

They can monitor the data traffic both into and out of the organization’s network. They can block certain kinds of data. They can block all traffic from particular locations. They are an effective alternative for other security measures such as digital certificates.

n. Which of the following would be a weakness of the test data approach? 1) 2) 3) 4)

A computer program tends to process each transaction of the same type, in the same manner. Some incompatible functions of a computerized system may not be adequately segregated. A computer system may contain offsetting errors in its programming. Special technical knowledge of the computer system is required in order to design the test data.

o. JJJ Inc. changed to a new computerized accounting system during the past year because JJJ was acquired by another company, and the parent company required all subsidiaries to have the same accounting system. What are the likely implications for an auditor designing a test of controls for the year in this situation? 1) The auditor should treat both systems as one system (ignore the conversion) because controls need to be tested for the entire year. 2) The auditor can safely ignore the first system and the conversion because the year-end balances depend on the final system in use at year end. 3) The auditor should set control risk to maximum. 4) The auditor should test both systems and the conversion (three tests). 6

Question 2 DDD Motor Sales Inc. is privately owned. It wants to expand its business and has approached its bank for a loan. DDD wants the funds to purchase additional inventory and will be able to provide excellent security to the bank. The bank has agreed that since DDD can provide good security for the loan, an external audit will not be required. The bank manager had insisted that DDD hire a firm of professional accountants to examine DDD’s financial records and provide some level of assurance. Required 2

a.

What type of engagement is required? Explain your answer.

1

b. Assume that DDD contracts with Smith & Jones, CGAs, to perform the required services. What is the title of the report or communication that Smith & Jones would prepare?

11/2

c.

11/2

d. Will Smith & Jones be required to obtain an understanding of DDD’s internal control? Briefly explain.

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Identify the type of procedures Smith & Jones will be required to conduct.

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Question 3 Tim is an auditor with a CGA firm. He was formerly an internal auditor and has extensive experience in that field. The CGA firm is auditing MMM Inc., a plastics manufacturer where Tim formerly worked as an internal auditor. Tim’s experience in this industry is considered invaluable by the CGA firm. During his last year of employment at MMM, he conducted reviews and designed controls for the acquisition and expenditure cycle. He was hired by the CGA firm right after MMM’s year end. As this is Tim’s first experience in external audit, he has been assigned an assistant, Hassan, who is a co-op accounting student. Tim assigned Hassan to develop a test of controls for the work-in-process inventory. Hassan designed the program, which Tim reviewed and suggested some changes to. Tim also reviewed the evidence that Hassan obtained to ensure that it was sufficient and appropriate. Required 4

a.

6

b. List three points indicating that the situation above violates the general standard of GAAS. Do not comment on the examination or the reporting standards.

4

c.

2

d. Identify two analytical procedures that Tim could use in the audit of inventory at MMM.

15

Briefly define the general standard of GAAS.

Hassan designed a test of controls with a sample size of 75 and an ARACR of 5%. He found 2 deviations, which meant a UEL of 8.2 according to the statistical tables he used. The sample was selected from the population of time cards with overtime and then matched to overtime authorizations submitted by the shift supervisors for those shifts. What is the minimum TDR that Hassan could have been using if he designed a combined approach for the related account, based on the above results? Explain your answer.

Question 4 Lilan’s working papers for evaluating a client’s internal controls include the following notes: • •

• •

There were over 1,000 purchase transactions under $4,500 from 4 vendors — these are routine purchases. All purchases over $4,500 are non-routine transactions and must be pre-approved by the purchasing manager, but one purchase for $15,000 was authorized by the plant manager without the purchasing manager’s initials. All cheque stubs for purchases should have purchase order numbers recorded, but 5% of the sample did not have the purchase order number recorded — traced the 5% to August payments. Conclusion — internal controls are weak; substantive approach is recommended.

Required 4

a.

8

b. Explain four reasons why Lilan’s conclusion may be incorrect.

3

c.

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For each of the deviations found by Lilan, state what the deviation is and why it indicates a problem from an internal control standpoint.

If Lilan uses dollar unit sampling (DUS) in her substantive testing of the purchases, should she stratify the population? Explain your answer.

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Question 5 An auditor had been accumulating potential adjustments throughout the audit, and in her review of the entire audit, she has determined that a sales cut-off error should be corrected by an adjusting entry. Sales had mistakenly been recorded for goods sold after the balance sheet date. The client has an integrated computerized accounting system; therefore, all related accounts were affected by the error. The auditor has determined that sales were overstated by $185,000, and that cost of goods sold have to be reduced by $110,000. Required 2

a.

4

b. Prepare the auditor’s adjusting entry.

9

In addition to the two accounts noted above, what other accounts would be affected by the client’s error?

Question 6 Kim is a senior auditor with a CGA firm, conducting an external audit. This is the second year that the firm has conducted the audit of this client. Kim has already done some work on liabilities by reviewing the client’s notices of assessment from Canada Revenue Agency for the year being audited. Kim is now reviewing his plans for the receivables, which includes sending confirmations, and will also audit fixed assets. The client decided this past year to sell its receivables to a finance institution at a discount. Required 4

a.

2

b. What management assertion is involved when an auditor studies the client’s Canada Revenue Agency notices of assessment for the year being audited? What evidence is the auditor looking for?

3

c.

6

Using only the data generated by the client’s own accounting system, design one audit procedure using analysis of the accounts receivables. State the assertion being tested and explain how the evidence obtained from your procedure will relate to that management assertion.

When customers confirm the amount owed as of a certain date, this does not provide evidence of ownership. Explain how Kim would be aware of the sale of the receivables, and suggest an audit procedure Kim could undertake to verify this.

Question 7 Ajay is a senior auditor and is assisting in the planning for the audit of capital assets of RRR Ltd., a company that provides services to the heavy construction industry. Ajay has become very knowledgeable about this industry and about RRR in particular over the past few years. Part of his planning included comparing capital asset balances to prior years, comparing total additions to capital budgets, in order to identify any changes in capital assets during the year, and to see if the level of changes is consistent with his expectations based on his knowledge of the business. Ajay also performed the following analysis procedures: 1. Compared the amortization expense/capital assets ratio to prior years. 2. Compared the balance of repairs and maintenance expense to prior years. Required 4

a.

2

b. Ajay is aware of a company in the U.S. that is a subsidiary of the same parent company that owns RRR Ltd. As such, he has concerns about the possibility of related-party transactions. Identify two audit procedures that Ajay could undertake to obtain evidence of RRR’s related-party transactions.

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In each of the two analysis procedures, Ajay recorded whether the accounts increased or decreased. Explain what other audit evidence Ajay will obtain from each of the procedures.

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Question 8 The following parts are independent. For each statement, state whether you agree or disagree, and explain your reasoning. Required 3

a.

When an audit firm issues the correct opinion on the financial statements under audit, it still has business risk.

3

b. The auditor’s business risk increases if the client’s business risk decreases.

3

c.

3

d. Two weeks after the year end, XYZ company advises your client that it will be unable to pay its account, which was outstanding at your client’s year end. This is sufficient appropriate evidence for you, as an auditor, to adjust the client’s financial statements.

Further possible misstatement (FPM) can be calculated as (1–risk).

END OF EXAMINATION 100

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AUDITING 1 [AU1] EXAMINATION Before starting to write the examination, make sure that it is complete and that there are no printing defects. This examination consists of 6 pages. There are 8 questions for a total of 100 marks.

READ THE QUESTIONS CAREFULLY AND ANSWER WHAT IS ASKED.

To assist you in answering the examination questions, CGA-Canada includes the following glossary of terms.

Glossary From David Palmer, Study Guide: Developing Effective Study Methods (Vancouver: CGA-Canada, 1996). Copyright David Palmer. Compare

Contrast

Criticize

Define

Describe Diagram

Discuss

Evaluate

Explain

Examine qualities or characteristics that resemble each other. Emphasize similarities, although differences may be mentioned. Compare by observing differences. Stress the dissimilarities of qualities or characteristics. (Also Distinguish between) Express your own judgment concerning the topic or viewpoint in question. Discuss both pros and cons. Clearly state the meaning of the word or term. Relate the meaning specifically to the way it is used in the subject area under discussion. Perhaps also show how the item defined differs from items in other classes. Tell the whole story in narrative form. Give a drawing, chart, plan or graphic answer. Usually you should label a diagram. In some cases, add a brief explanation or description. This calls for the most complete and detailed answer. Examine and analyze carefully and present both pros and cons. To discuss briefly requires you to state in a few sentences the critical factors. This requires making an informed judgment. Your judgment must be shown to be based on knowledge and information about the subject. (Just stating your own ideas is not sufficient.) Cite authorities. Cite advantages and limitations. In explanatory answers you must clarify the cause(s), or reasons(s). State the "how" and "why" of the subject. Give reasons for differences of opinions or of results.

Illustrate Indicate Interpret

Justify List

Outline

Prove Relate

Review

State

Summarize

Trace

Make clear by giving an example, e.g., a figure, diagram or concrete example. Provide a short explanation. Translate, give examples of, solve, or comment on a subject, usually making a judgment on it. Prove or give reasons for decisions or conclusions. Present an itemized series or tabulation. Be concise. Point form is often acceptable. (Also Enumerate or Identify) This is an organized description. Give a general overview, stating main and supporting ideas. Use headings and sub-headings, usually in point form. Omit minor details. Establish that something is true by citing evidence or giving clear logical reasons. Show how things are connected with each other or how one causes another, correlates with another, or is like another. Examine a subject critically, analyzing and commenting on the important statements to be made about it. Present the main points in brief, clear sequence, usually omitting details, illustrations, or examples. Give the main points or facts in condensed form, like the summary of a chapter, omitting details and illustrations. In narrative form, describe progress, development, or historical events from some point of origin.

CGA-CANADA AUDITING 1 EXAMINATION March 2006 SUGGESTED SOLUTIONS Marks 30

Time: 3 Hours Question 1 Note: 2 marks each

Sources: a.

4) Topic 1.5 (Level 1)

b. 2) Topic 1.7 (Level 1) c.

4) Topic 3.5 (Level 1)

d. 3) Topic 3.5 (Level 1) e.

2) Topic 3.5 (Level 1)

f.

3) Topic 3.4 (Level 1)

g. 4) Topic 3.8 (Level 2) h. 2) Topic 4.5 (Level 1) i.

4) Topic 4.6 (Level 1)

j.

3) Topic 4.7 (Level 1)

k. 2) Topic 4.7 (Level 1) l.

3) Topic 9.2 (Level 1)

m. 4) Topic 7.6 (Level 2) n. 3) Topic 7.11 (Level 1) o. 4) Topic 7.5 (Level 2) 6

Question 2 Source: Topic 1.6 (Level 1) 2

a.

1

b. Review engagement report

11/2 1

1 /2

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c.

A review engagement is required because the bank requires a certain level of assurance, but it has already been agreed that an external audit will not be required.

Inquiry, analysis, and discussion

d. No. This is a review engagement.

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Question 3 a. Source: Topic 2.1 (Level 1) The general standard states that the examination should be performed and the report prepared by a person or persons having: • • • •

adequate technical training proficiency in auditing due care an objective state of mind

Note: 1 mark for each bullet

6

b. Source: Topic 2.1 (Level 1) Violations of the general standard of GAAS are: • •

•

Proficiency in auditing is not met, as Tim lacks external audit experience since he was formerly an internal auditor. Objective state of mind is not achieved as Tim would be involved in auditing of MMM Inc. Tim was a former employee of MMM, who designed the controls for the acquisition and expenditure cycle. Hassan lacks technical training and proficiency in auditing since he is a co-op accounting student.

Note: 2 marks for each bullet

4

c.

Source: Topic 5.4 (Level 1) and Topic 6.6 (Level 2) • •

The combined approach means that the auditor is accepting the control as being effective. The minimum TDR would have to be no greater than the calculated UEL of 8.2%.

Note: 2 marks per bullet

2

d. Source: Topic 9.4 (Level 2) • • •

Comparisons of gross profit margins to previous periods, industry, or budgets Comparisons of inventory turnover to previous periods, industry, or budgets Analysis of the periodic cost accounting reports prepared for management control purposes

Note: 1 mark per bullet to a maximum of 2 marks

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Question 4 a. Source: Topic 5.1 (Level 1) •

•

“One purchase for $15,000 was authorized by the plant manager without the purchasing manager’s initials”: This is a problem because it indicates management over-ride. This means management is willing to ignore the internal controls of the company. “5% of the sample did not have the purchase order number recorded — traced the 5% to August payments.” This is a problem because this means that cheques were issued without a purchase order and, therefore, that specific internal control was not working or was ignored.

Note: 2 marks per bullet

8

b. Source: Topic 5.1 (Level 1) • • • • •

There may be other controls in place that were effective. The controls over the routine transactions may be effective (Lilan did not note any deviations in these transactions). Lilan could test 100% of the non-routine transactions. The 5% of transactions with deviations were all traced to one time period, so Lilan could have tested these transactions 100% but relied on the controls for the balance of the period. There is no indication that Lilan compared the deviation rate to the tolerable deviation rate in making the decision. There may be sampling error and/or non-sampling error.

Note: 2 marks per bullet

3

c.

Source: Topics 6.8 and 6.11 (Level 2) If the auditor wants to sample based on dollars, then no stratification is required since DUS automatically stratifies based on dollar amounts. If the auditor wants to ensure that smaller purchases are included, then the population could be stratified into routine and non-routine purchases.

6

Question 5 Source: Topic 10.10 (Level 1) 2

a.

4

b. Sales ..................................................................................................................... 185,000 Inventory .............................................................................................................. 110,000 Accounts receivable....................................................................................... Cost of goods sold .........................................................................................

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Inventory and accounts receivable

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185,000 110,000

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Question 6 a. Source: Topic 8.5 (Level 1) Valuation • •

Compare the percentage change and volume change (from prior years) for sales relative to that for accounts receivable. If accounts receivable have increased by more than the increase in sales, there may be a collectibility problem. (Customers may have started to default on their payments, or the company may have relaxed its credit granting policies in order to increase or maintain sales volumes.)

Existence • •

Compare the gross profit margin to the prior year. For example, an unexpected increase in gross profit may indicate a possible overstatement of sales, which in turn would point to an overstatement of accounts receivable.

Valuation • • • •

Compare the current year’s aged listing of accounts receivable total to the control account in the general ledger and the amount reported in the financial statements. If the totals agree, this would support the valuations assertion. Compare the current year’s aged listing of accounts receivable to that of the prior year to determine if there have been significant changes in major customers accounts. No significant changes would support the valuations assertion.

or • •

Determine whether the ratio of overdue accounts to total accounts receivable has increased. No significant changes would support the valuations assertion.

or • •

Determine whether there are outstanding balances from the previous year end that are still outstanding at the current year end. Any amount still outstanding must be investigated, and likely indicates a valuation problem.

Valuation • •

Evaluate the change in the ratio of allowance for doubtful accounts to accounts receivable from the prior year. A lower or higher ratio may indicate a significant change in policy, such as the method used to estimate uncollectible accounts (accounting policy) or the rules for granting credit (operating policy).

Note: 1 mark for assertion; 11/2 marks for analysis procedure; 11/2 marks for explanation of evidence

2

b. Source: Topic 8.11 (Level 1) • •

The completeness assertion The CRA notices of assessment would provide evidence of unrecorded liabilities.

Note: 1 mark per bullet

3

c.

Source: Topic 8.6 (Level 1) • •

The auditor should be aware of the company’s various credit arrangements through adequate knowledge of the client, for example, by enquiry of management. A review of the minutes of board of directors’ meetings, and a review of all loan documents, bond indentures, and other debt covenants should determine whether accounts receivable have been factored or pledged as collateral.

Note: 11/2 marks per bullet

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Question 7 a. Source: Topic 9.5 (Level 2) Procedure 1 would provide evidence: • •

concerning whether amortization expense has been calculated consistently from year to year, and whether capital assets may be overstated or understated.

Procedure 2 would provide evidence: • •

some transactions that have been expensed should have been capitalized, and to indicate the likelihood that some capital asset balances may have been understated.

Note: 1 mark per bullet to a maximum of 2 marks for each procedure

2

b. Source: Topic 10.8 (Level 1) • •

Enquiries of management Review of the minutes of board of directors’ meeting

Note: 1 mark per bullet

12 3

Question 8 a. Source: Topic 4.6 (Level 1) Agree • •

3

Business risk is the risk that the audit firm will have to defend itself, for example, in a lawsuit. It exists regardless of whether the firm issues the correct opinion.

b. Source: Topic 4.6 (Level 1) Disagree • •

3

c.

If the client’s business risk increases, the auditor’s business risk would also increase. If the client’s business fails, it is more likely that a creditor or investor would try to hold the auditor responsible.

Source: Topic 4.5 (Level 1) Disagree • • •

3

FPM is made up of sampling risk and non-sampling risk. Non-sampling risk cannot be calculated. Sampling risk can be calculated if the sample is drawn using statistical methods.

d. Source: Topic 10.9 (Level 1) Disagree • •

Adjustment is required if XYZ’s inability to pay existed at the balance sheet date. Otherwise, only a disclosure note is required in your client’s financial statements.

Note: 1 mark for agree/disagree and 1 mark for each bullet to a maximum of 3 marks for each part

END OF SOLUTIONS

100

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CGA-CANADA AUDITING 1 EXAMINATION March 2006 EXAMINER’S COMMENTS

General Comments The overall performance of the students on this examination was better than on previous examinations, as reflected in the higher pass rate. Students demonstrated a very good awareness of internal controls, audit procedures, related-party issues, GAAS, and management assertions. One specific improvement noted on this examination was that students performed better on questions dealing with audit procedures. As often occurs on examinations, some students did not focus their answers specifically on the question. Students are reminded to read the questions carefully to be sure they are answering the question asked.

Specific Comments Question 1 Multiple choice (Levels 1 and 2) This question was answered satisfactorily. The multiple choice questions covered Topics 1.5, 1.7, 3.4, 3.5, 3.8, 4.5, 4.6, 4.7, 7.5, 7.6, 7.11, and 9.2. Question 2 Review engagements (Level 1) Most students did well on parts (a) and (b) of this question. Students who had difficulty were generally unaware of the level of assurance provided by different types of engagements. Parts (c) and (d) were not answered as well overall; some students were unfamiliar with the difference in procedures between a statutory audit and a review engagement. Question 3 The general standard of GAAS; internal control evaluation; analytical procedures (Levels 1 and 2) Many students answered this question very well. Students who had difficulty tended to confuse the general standard with the examination standard. The standards are extremely important for students to understand. Question 4 Internal control; dollar unit sampling and stratification (Levels 1 and 2) Part (a) of this question was answered very well. Some students did not seem to understand what a deviation is in the internal control context, as their answers identified as a deviation the fact that there were over 1,000 routine purchases from 4 vendors. In this case, marks were not deducted for this incorrect answer but students should take more care in reading the examination question. In part (b), students who did not obtain full marks tended to give answers that were too brief, or made unwarranted assumptions such as assuming that the auditor had only sampled from the August purchases (which is contrary to the text of the question). Most students obtained satisfactory marks for part (c) but some students were not aware of the issues of stratification and dollar unit sampling. Question 5 Tasks involved in evaluating the results of the audit at the completion stage (Level 1) This question was a different style from previous examinations but almost all students were able to identify accounts that would be affected by the client’s accounting error, and to prepare an appropriate adjusting entry. Question 6 Audit procedures and analysis of accounts receivable; management assertions and evidence for liabilities (Level 1) Most students obtained satisfactory marks for parts (a) and (c), and full marks for part (b). A few students did not incorporate any analysis of accounts receivable in their answer to part (a). Alternative answers for part (b) were accepted provided the assertion noted was consistent with the evidence noted. Some answers for part (c) were too brief. Continued... ©CGA-Canada, 2006

Question 7 Auditing capital assets and related-party transactions (Levels 1 and 2) Analytical procedures are a common audit procedure, and most students can list various examples. In part (a) of this question, the task was to identify the type of evidence beyond simply looking for a change in the ratio from year to year. Despite the wording of the question, some students’ answers focused on the simple increase or decrease. Other answers were too brief or the student simply compared amortization expense between years. Students should consider that a 4-mark question requires more than a one-line or one-point answer. However, it should be noted that many students provided thoughtful answers to part (a) and most students received full marks for part (b). Question 8 Business risk and the audit opinion; business risk and the client’s business risk; further possible misstatement; subsequent events; sufficient appropriate evidence (Level 1) a. Most students answered this part well. Students who had difficulty tended to overlook the fact that an auditor could be sued (and thus have to expend significant resources) even if the auditor had issued the correct opinion.

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b.

Many students obtained satisfactory marks on this question. Some students thought that a client’s business risk would have no effect on the auditor’s business risk, or confused business risk with audit risk.

c.

Most students obtained some marks on this part, but common difficulties included confusing further possible misstatement with maximum possible misstatement, and providing answers that were too brief.

d.

Some students made unwarranted assumptions. The fact that a customer advises that it will be unable to pay an account is not sufficient appropriate evidence to write off the account. It would have to be determined if the inability to pay existed at the client’s year end or resulted from an event subsequent to the year end.

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