Advanced Auditing
Autor: Tina Zhang • October 24, 2016 • Course Note • 2,866 Words (12 Pages) • 674 Views
Materiality
Key Points:
- Key users of the financial statements are the bank, Gerald and the Government
- The common range for private companies is 5% to 10% of net income.
- The bank would be interested in net income as they would be concerned with TAL being able to pay off their interest on the bank loan. Gerald Scollon (key user)would be also focused on earnings/net income to determine the amount he would have to pay for an additional 20% interest in TAL. The Government would be interested in the audited f/s
- As the company has 2 years of net income and considering the bank/Gearld we conclude that net income is an appropriate base for determining materiality
- Normalizing net income for the past 2 years would result in net income of $10,050,000 (14,400,000 + 7,700,000 /2).
- Given that the client and the users ( bank) would be sensitive to small changes in the net income and with a high engagement risk suggest 5% ( lower end ) of net income would be a more appropriate figure
- 5% of 10,050,000=$502,500
- I would suggest using 75% of overall materiality as overall performance materiality, or $375,000 ($502,500 × 75%).
- Need to recalculate materiality after all material errors see below) have been adjusted.
Risk Assessment and Audit Strategy
Engagement Risk Assessed at High Based upon the following:
There are two key “high-level risk” factors as discussed below:
1. Management Integrity
2. Management Bias
1. Management Integrity
Management integrity is questionable based on the following:
- At John Pollen’s request a questionable payment ( mailed to his home address) to an employee of BBI for signing the contract with TAL.
- Pollen has instructed the controller on how to record the cost of the rebate program
- Ivan informed Michelle to pay his sons from petty cash and not worry about income deductions.
- Ivan was alleged to recommend an employee be fired for contacting WSIB about unsafe working conditions at TAL.
- Ivan provides his advice on accounting matters to the controller ( eg. how to record placement fees)
2. Management bias
- The pending share sale provides an opportunity of bias for Ivan, the CEO. He will be inclined to make the income statement appear more favourable, to increase the price of the 20% shares that Gerald is interested in receiving He is also the only active shareholder that is involved in the business, and has the opportunity to act on such a bias.
- There is evidence that Ivanl has acted on this bias as discussed below re: BBI Contract, Accounts Receivable, Placement Fees and Government Grant.( all these issues reduce earnings)
- John Pollen has an incentive to have sales in 2014 increase over 2013 because he has a bonus tied into this.( receives $500,000 if sales revenue in 2014 increases by at least 25% over 2013) There is evidence that he has acted on this as he has told the controller to record the cost of the volume rebate program as selling expense when the cheque is issued.
Engagement Risk is high due to following factors:
- Gerald is an inactive shareholder and relies upon audit
- Gerald will be relying upon statements to determine share price
- Ivan appears to be taking advantage of controlling position and limited controls in place to monitor (through related party transactions and management override).
- A number of high risk factors ( see below)
- Control environment is weak as noted below.
Financial Reporting Risk
Financial Reporting Risk Analysis | ||
Issue | Financial Statement Risk | Pervasive, Account, & Assertion |
Entity and Its Environment | ||
Industry and Other External Factors | ||
Extremely Competitive – Need to ensure prices are competitive | If products are not properly priced they could lose their share of the market and this could impact the bottom line- could lead to going concern issues | Overstatement of inventory due to obsolescence (Valuation) Pervasive – affects all accounts & all assertions
|
Downturn in the economy, (recession) | Difficult to finance operations-possible going concern issue. May be difficult to sell their inventory, collect the receivables or pay off its long term debt. Unusual that a company is doing much better than the industry. ( sales and net income for 2014 is much better than 2013) | Overstatement of Accounts Receivable ( under provision of the allowance For doubtful accounts) Overstatement of inventory due to obsolescence (Valuation ) Pervasive- all accounts & all assertions |
TAL was named in a civil lawsuit brought against them by a past part time employee regarding unsafe working conditions | TAL may have to pay out between $5,000 and $10,000. There maybe other claims against the company for the same thing. | Accounts Payable ( valuation- recording of contingency- likely ) Contingencies-Presentation and disclosure |
Financing Issues | ||
TAL has offered their customers a more lenient credit policy ( more time to pay off their a/r) | Customers may not be able to pay off their receivables-affects TAL’s cash flow | Sales may be overstated , (Valuation), and Accounts Receivable may be overstated due to under provision of the allowance for doubtful accounts ( Valuation) |
. BSL has long term debt and a bank operating loan that is secured against the accounts receivable and the bank will be relying on our audit opinion | Bank is more likely to use the f/s to assess financial stability of TAL. The bank agreement and long-term debt may have some covenants that are required to be met . The debt needs to be disclosed in the f/s along with the pledging of any the accounts receivable | All accounts that could impacted. Disclosure of the mortgage payable along with any assets pledged ( Presentation and Disclosure- Completeness) |
The possible sale of 20% of his interest in TAL to Gerald will motivate Ivan to overstate earnings. As well John Pollen has incentives to overstate sales as he receives a large bonus if 2014 sales are 25% over 2013 sales | Creates a bias for management to overstate income and understate expenses | Sales (Occurrence, Valuation), C of GS (Valuation) and various income statement accounts Accounts Receivable (Existence, Valuation) Inventory (Existence, Valuation) |
Strategy and Business Processes | ||
TAL purchases their parts from API who is owned by Ivan’s sister and this is a related party transactions | Related party transactions need to be properly recorded and disclosed. | Inventory and Cost of goods sold ( Valuation) and presentation and disclosure |
Internal Control | ||
Control Environment – Commitment to competence | ||
Ivan provides advice to Michelle on accounting matters | Management is bias and evidence of management override of the controls | Placement fees may be overstated- ( maybe should be expensed Classification/Valuation) Pervasive – affects all accounts & all assertions. |
Michelle, last prepared a f/s when IFRS did not exist therefore she may not be competent. | Recording errors resulting in material misstatements in the f/s | Pervasive – affects all accounts & all assertions |
Mgt. does not believe in wasting time and effort to put controls in place. | Poor control environment. Lack of poor internal controls may lead to errors in all accounts and possible fraud. | Pervasive – affects all accounts & all assertions |
Control Environment - Corporate Governance | ||
Gerald relies on Ivan to take care of day to day business. They meet infrequently ( once a year) to review the f/s | Lack of internal controls over the Financial Reporting process could lead to incorrect and/or fraudulent financial statements. | Pervasive, all accounts all assertions. |
Ivan does not follow-up significant differences between budget and actual | There could be material misstatements in the f/s accounts and it would not be detected | Pervasive, all accounts all assertions |
Monitoring of Controls | ||
There were a number of control deficiencies noted during last year’s audit ( mgt. letter) and they have not been implemented | Lack of internal controls over the Financial Reporting process could lead to incorrect and/or fraudulent financial statements. | Pervasive, all accounts all assertions. |
...