ADMS 4551 Fall 2018 Final Exam

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YORK UNIVERSITY FACULTY OF LIBERAL ARTS AND PROFESSIONAL STUDIES School of Administrative Studies AP/ADMS 4551 Auditing and Other Assurance Services Final Examination Fall 2018 – All sections Student Name Student ID Section You are required to both sign in and sign out with your Photo ID and student card (or YorkCard) for this examination. A YorkCard or acceptable photo identification is required as your identification for this examination. If you do not have identification documents, you will be required to personally bring these to your instructor prior to your grades for this examination being released, or prior to your examination being returned to you. Instructions : NO AIDS. This is a closed book examination. You may use a silent mathematics calculator with no text functions. Please place all other materials (cell phones, PDAs, bags or cases) on the floor, out of reach. Please write all of your case answers IN INK in the lined spaces in the ANSWER booklet paper. Should you require additional paper, please request during the examination. This examination is worth 40% of your grade. The Question Booklet has 10 pages Please complete all answers in the Answer Booklet provided. You are required to hand in both at the end of the exam. Below is the Breakdown of the exam. 1 Marks Minutes Q1 46 120 Q2 12 35 Q3 12 25 Total 70 180

4551 Examination room evacuation procedures SAFETY FIRST, EXAMINATION SECOND! In the event of a need to evacuate the examination room; 1. Stay silent, cell phones and non-examination papers out of reach. Quietly put on your outerwear and gather your possessions. 2. PLACE YOUR EXAMINATION MATERIALS IN THE BOX AT THE FRONT OF THE ROOM OR AS DIRECTED BY YOUR INSTRUCTOR or TEACHING ASSISTANT. YOU WILL NOT HAVE ACCESS TO THESE MATERIALS AGAIN. 3. Take all garbage, coffee cups, and newspapers in your immediate area and place them in the appropriate containers on the way out. 4. Follow an invigilator outside and remain calm, stay with your instructors and invigilators. 2

Question 1 (46 marks, 120 minutes) Creative Activewear Inc. (CAI) is a Montreal based company that designs, manufactures and distributes undecorated active wear (t-shirts, track pants and hoodies) in large quantities. CAI’s customers are primarily wholesale distributors who in turn decorate the products with designs and logos and sell the imprinted active wear. CAI’s active wear products are often used for work or school uniforms, athletic team wear or company promotional materials. CAI produces approximately 150 different product styles and each style is offered in a variety of colours and sizes (approx. 3600 different combinations of style and colour). Every year CAI introduces approximately 50 new styles and colours and discontinues the same number of styles. The industry for undecorated active wear is highly competitive. Maintaining a product line that is consistent with current fashion trends is one of CAIs main competitive advantages. However, the classic T-shirt and the various colours and sizes has been a standard item in the product line since inception. The classic T-Shirt normally constitutes 30% of the inventory balance at any point in time. CAI was founded in 2005 and is equally owned by Catherine Binder and Francis Draper. Both owners are actively involved in the day to day operations of the business. Catherine oversees the sales, administrative and finance areas while Francis oversees inventory management. CAI is a profitable company and since 2005 it has experienced tremendous growth. In 2012, CAI purchased a manufacturing facility in Bradford Ontario. The purchase was financed by a $7 million bank loan. The terms of the loan require CAI to maintain a current ratio of above 1.3 and the manufacturing facility is pledged as collateral for the loan. The bank loan also requires that CAI provide audited financial statements in compliance with ASPE within 60 days of year end. CAI’s year- end is December 31st. Cotton is the main raw material used in the manufacturing. CAI mitigates fluctuations in cotton prices by purchasing cotton futures (sold in U.S. dollars). In late 2015 the costs of cotton futures declined and Catherine and Francis decided to reduce selling prices in order to pass on the cost reductions to its distributers. Due to a miscommunication between Francis and Catherine, Catherine reduced the selling prices before the reduction in cotton prices were realized. The impact was a severe reduction in gross margins for the 2016 fiscal year. This error has caused a significant disagreement between Catherine and Francis and, as a result, Francis doesn’t feel that she can continue to work collaboratively with Catherine anymore. She is considering triggering a buy-out clause in the shareholder’s agreement. The clause allows her to purchase Catherine’s shares for 5 times net income. Once Francis places this offer, Catherine must either accept the offer or counter the offer with a 30% premium. CAI’s credit risk for trade accounts receivable is highly concentrated as the majority of its sales are to a relatively small group of wholesale distributors. CAI’s ten largest customers constitute 61% of total trade receivable and its largest customer, Print 3

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and Go Inc. accounts for 20% of total accounts receivable. Many of CAI’s customers are highly leveraged and rely on CAI providing favourable credit terms. Most customers receive 45 day terms and long standing customers receive 60 day terms. Terms greater than 30 days are standard in the industry because of the time lapse between when the wholesale distributer will ultimately receive collection from the end consumer. Extending credit to customers involves considerable judgment. CAI has a dedicated credit manager, Nancy Tight, who evaluates each customer’s financial condition and payment history. It is her responsibility to prepare recommendations for customer credit limits and payment terms. Nancy reviews external credit ratings (if available), the customer’s financial statements and obtains bank and other references. In the case of existing customers she also reviews the customers past payment history. Based on this analysis she prepares a recommendation and forwards it to Francis for approval. Francis is very conservative when it comes to granting credit to new customers or increasing credit limits of existing customers. She diligently reviews the research conducted by Nancy. She often requires Nancy to reduce her recommended limits and has often denied extending credit to potential customers despite Nancy’s recommendation. Historically, due to this stringent process, CAI has had insignificant bad debts. Once new customers are approved Nancy enters the new customer details and agreed upon terms into the company’s ERP system. Nancy and Francis are the only employees who have access rights to add new customers and make changes to credit terms. The system requires that Francis approve all changes. At the end of each week the system generates a report noting all changes to the customer Masterfile. This report is reviewed by both Francis and Catherine. When customer orders are received they are entered into the system by a customer order clerk. The system automatically validates the order and performs a check to ensure the order value plus the current customer balance is below the authorized credit limit. When goods are shipped, the system automatically generates the sales invoice and the sales is recorded. Standard sales terms are FOB shipping point. The accounts receivable aging for the period ended December 31st 2016 is as follows: 4

Range of Balances Number of Customers # of new customers in this category Total Balance Current 30-60 days 60-90 days over 90 days Less than $0 7 (750,000) (750,000) $0-$50,000 157 16 4,335,524 2,341,183 1,885,953 65,033 43,355 $50,001 to $ $100,000 200 20 4,231,475 2,284,997 1,840,692 63,472 42,315 $100,001 to $150,000 303 61 5,990,652 3,294,859 1,198,130 599,065 898,598 greater than $150,001 10 21,814,114 8,071,222 13,742,892 - - 677 35,621,765 15,242,260 18,667,667 727,570 984,268 When Catherine reduced the selling prices many customers complained that they had recently purchased the large quantities of product at the historical price. Many customers threatened to find a new supplier and since CAI offers a right to return up to 30 days they threatened to return the merchandise. Catherine provided relief to these customers by offering all suppliers a price concession for orders they placed and delivered up to 3 months prior to the price change coming into effect. All customers were issued credit notes for the difference between the new selling price and the price they had paid for the merchandise. Catherine made this decision unilaterally without consulting Francis. It was this decision that caused the current ratio of the company to decline to 1.29. This is one of the main reasons why Francis feels she can no longer work with Catherine. Catherine has a tendency to make unilateral decisions without consulting Francis. Inventory consists mainly of raw materials and finished goods. Average cost is the costing method used to value inventory. Inventory counts take place on December 31st of each year. The warehouse is closed on December 31st and all items are tagged in numerical sequence. Counters work in pairs and recount the others work. Francis prepares detailed count instructions and supervises the count. At the end of the count Francis ensures all tags are accounted for. The results are entered into the system and a report is generated noting all products which had discrepancies between the count quantity and the quantity recorded in the perpetual records. All discrepancies of greater $20,000 are recounted. One area of the warehouse is maintained to hold slow moving items. When trends change and styles are discontinued Francis ensures that the items are protected from getting damaged and stores them in the slow moving section. She saves the items in anticipation of the trend for that particular item or colour will comeback in fashion. Required: PART 1 You are the audit senior on the CAI audit engagement and this is the first year your firm is completing the audit. Previously, the audit was conducted by a local sole practitioner. 5

The audit manager has asked that you complete the following components of the audit file. Overall Risk of Material Misstatement (RMM) Part A . Identify 3 case facts that increase or decrease the risk of material misstatement (inherent risks and/or control risks) at the overall financial statement level (OFSL). For each factor identified, indicate if the factor increases or decreases risk and provide your rational for why the factor increases risk. (6 marks) Sales & A/R cycle Part B. Identify 3 factors which impact the RMM for sales and accounts receivable cycle. For each factor indicate the relevant account(s) and related assertion(s), the impact on RMM (increase or decrease), the type of risk (inherent or control) and the rational for the impact . (7.5 marks) CAI’s credit risk for trade accounts receivable is highly concentrated as the majority of its sales are to a relatively small group of wholesale distributors. CAI’s ten largest customers constitute 61% of total trade receivable and its largest customer, Print and Go Inc. accounts for 20% of total accounts receivable. Since m any of CAI’s customers are highly leveraged and rely on CAI providing favourable credit terms , there is a risk of A/R valuation as if any of these customers (who are highly leveraged) runs into financial problems, CAI, may not be able to collect the outstanding A/R balance. This is especially problematic for Print and Go Inc. accounts for 20% of total accounts receivable. Material amount. Copy and paste case facts + provide the rational The inventory count was supposed to be done by two people, where the second person was supposed to recount what the first person counted, however the second person, Tom, called in sick and the count was only conducted by one person. Therefore , the accuracy of the count is impacted, undercount (comple teness ) overcount existence . Because, the first person could have made errors counting and without the second person re-counting these errors would not be caught. Part C. Provide a conclusion about the audit approach that you will use for the sales and accounts receivable cycle. Explain your rationale. (2 marks) 6

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I recommend combined audit approach, because there is a good control environment, for example, Francis is very conservative she diligently reviews the research conducted by Nancy when approving credit increases . She often requires Nancy to reduce her recommended limits . Therefore the substantive approach is recommended. Part D. Assume that you have decided to rely on controls in the sales cycle. Select 3 different controls in the sales cycle. For each control provide a procedure that would test the effectiveness of control. (6 marks) Use the following chart format to complete your answer. Control in Sales Cycle Francis is very conservative she diligently reviews the research conducted by Nancy when approving credit increases. She often requires Nancy to reduce her recommended limits. Procedure that would test the effectiveness of the control PART E. Prepare the audit plan for the accounts receivable confirmations. The plan should include: i. The type of confirmations to be used: positive or negative confirmations. Include a rationale based on case facts. (2 marks) ii. Using judgmental sampling, stratify the population into different groups with common characteristics that you would like to include in your testing. Include your rationale for selecting these items to test. Note: Assume performance materiality is $200,000. (3 marks) Use the following chart format to complete this answer: Strata (group selected) Rational Inventory Cycle Part F . Identify 3 factors which impact the RMM for inventory cycle. For each factor indicate the relevant account(s) and related assertion(s), the impact on RMM (increase or decrease), the type of risk (inherent or control) and the rational for the impact. (7.5 marks) 7

PART G. You obtained an inventory report listing all inventory items by product number for the period ended December 31, 2016. For each product on hand at year-end the following information is provided in an Excel table: Product # Product Descriptio n Quantity on hand (Q) Average cost per unit (C) Total Cost (QxC) Selling Price Date of last production run Total # of units sold in 2016 Product1 1000000 April 2014 10 Provide 2 different substantive audit procedures you would perform to identify products that have a high RMM for the valuation assertion. (2 marks) To identify products that have a high RMM for valuation assertion we could: Compare the average cost per unit to the selling price. Inventory must be stated at the lower of cost and NRV, so if the cost is higher than the selling price or clost to the selling price there is a risk that the product could be selling below cost and therefore impacting the assertion of valuation. We could also look at the quantity on hand to identify products with a high quantity on hand, for these products we could review the date of last production run, if this date is old and the total units sold in 2016 is low (as compared to the quantity on hand) these products could be considred to be sl ow moving, potentially becoming obsolete and therefore impacting the assertion of valuation. 8

PART 2 The previous auditor has agreed to allow your firm to review the prior year working paper file. The audit manager asked you to review various components of the file. The following are excerpts you reviewed from the previous auditor’s audit file: PART A The following is an excerpt from the accounts payable controls testing. Purchasing and Payable Cycle – Controls testing Statistical sampling used to test controls in the purchasing and payable cycle. The following parameters for the testing have been established: Tolerable exception rate (TER) 9% Acceptable risk of Overreliance (ARO) 5% Estimated population exception rate (EPER) 2% # of sample items selected 70 (based on sampling tables.) The firm’s audit sampling guidelines, a sample of 70, with 5% sampling risk, will have a computed upper exception rate for each of the following number deviations is as follows: 0 (4.2%), 1 (6.6%), 2 (8.7%), 3 (10.7%), 4 (12.6%), 5 (14.4%), 6 (16.2%), 7 (18%), 8 (19.7%), The following control tests were performed: Control tested Result of control test Audit conclusion 1 All expenditures require an invoice which is approved by Catherine and Francis. Three invoices were missing due to misfiling. Control is operating effectively. Exception rate is less than TER. 2 All expenditures were made to vendors included on the pre- approved vendor list. All expenditures were made to vendors on the pre-approved vendor list Control operating effectively. 3 The payables department ensures all invoices have a purchase order and related receiving document prior to entering into the system. Three expenditures were missing the invoice (see Control 1) and the associated receiving document and P.O were also missing. One expenditure had an invoice but did not have a receiving Control is not operating effectively, sample exception rate of 5.7% (4/70) is above TER. 9

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document or a P.O. i) For each of the three control tests performed indicate whether you agree or disagree with the auditor’s conclusion on the controls operating effectiveness and provide your rational. (3 marks) ii) For the 3 rd control test listed, where the auditor concluded the control was ineffective, indicate the potential misstatement, the account and assertion at risk and a substantive audit procedure that the auditor could have performed to identify any potential misstatements. (3 marks) PART B The following is an excerpt from the previous auditor’s Contingent liability testing: Contingent Liabilities testing Catherine Draper prepared and sent an inquiry letter to CAIs lawyers. The lawyer responded directly to Catherine by letter dated January 26 th , 2016. The lawyer’s response indicated that there were no claims outstanding against AIC. A copy of the letter provided by Catherine has been attached to the audit file in WP # CL 100. No contingent liability or disclosure is necessary. No further audit work necessary. i) Identify a deficiency in the audit worked performed above and explain how the auditor should have properly executed this substantive audit procedure. (1 mark) ii) Which is assertion is most at risk for contingent liabilities? Provide one other substantive audit procedure which provides evidence to support the assertion most at risk. (2 marks) PART C The following is an excerpt from the previous auditor’s materiality assessment: Due to prior period audit results and the company’s control environment performance materiality has been set at 50% of overall materiality. What inference about prior period audit results and the auditor’s assessment of the control environment can you draw from this statement. (1 mark) 10

Question 2 (12 marks, 35 minutes) Lily Window Glass Co (Lily) is a glass manufacturer, which operates from a large production facility, where it undertakes continuous production 24 hours a day, seven days a week. Also, on this site are two warehouses, where the company’s raw materials and finished goods are stored. Lily’s year end is December 31, 2017. Lily is finalizing the arrangements for the year-end inventory count, which is to be undertaken on December 31, 2017. The finished windows are stored within 20 aisles of the first warehouse. The second warehouse is for large piles of raw materials, such as sand, used in the manufacture of glass. The following arrangements have been made for the inventory count. The warehouse manager will supervise the count as he is most familiar with the inventory. There will be ten teams of counters and each team will contain two members of staff, one from the finance and one from the manufacturing department. None of the warehouse staff, other than the manager, will be involved in the count. Each team will count an aisle of finished goods by counting up and then down each aisle. As this process is systematic, it is not felt that the team will need to flag areas once counted. Once the team has finished counting an aisle, they will hand in their sheets and be given a set for another aisle of the warehouse. In addition to the above, to assist with the inventory counting, there will be two teams of counters from the internal audit department and they will perform inventory counts. The count sheets are sequentially numbered, and the product codes and descriptions are printed on them but no quantities. If the counters identify any inventory which is not on their sheets, then they are to enter the item on a separate sheet, which is not numbered. Once all counting is complete, the sequence of the sheets is checked and any additional sheets are also handed in at this stage. All sheets are completed in ink. Any damaged goods identified by the counters will be too heavy to move to a central location, hence they are to be left where they are but the counter is to make a note on the inventory sheets detailing the level of damage. As Lily undertakes continuous production, there will continue to be movements of raw materials and finished goods in and out of the warehouse during the count. These will be kept to a minimum where possible. The level of work-in-progress in the manufacturing plant is to be assessed by the warehouse manager. It is likely that this will be an immaterial balance. In addition, the raw materials quantities are to be approximated by measuring the height and width of the raw material piles. In the past this task has been undertaken by a specialist; however, the warehouse manager feels confident that he can perform this task. The external auditor is planning on attending the inventory count on December 31, 2017 in connection with their annual audit. Required: (a) For the inventory count arrangements of Lily Window Glass Co explain three deficiencies and provide a recommendation to address each deficiency (6 marks) 1.None of the warhouse staff involved in the count Recommendation: warehouse staff should involve in the count because they are also famililar with inventory. 11

2.the continue movements of raw materials and finished good in and out of the warehouse during the count. Also, there is no flag in the area that was already counted. The count would be went wrong if there is no systematically recording of the movements. Recommendation: every counted areas should be flagged and clearly label it .and the movements of the raw material to produce should be recorded into the system to match the which flagged area was took. 3.the raw materials quantities are measured by the warehouse manager that was been undertaken by a specialist in the past. Recommendation: the warehouse manager should be trained before he is going to do the measurement to make sure he has competence in the measurement. (b) Identify 3 procedures to be undertaken by the external auditor during the inventory count of Lily Window Glass and indicate the purpose of each procedure. (6 marks) Question 3 (12 marks, 25 minutes) You are the audit manager of Maxwell and King LLP and you reviewing the following items that have come to your attention during the audit of your client Minnie Co. Assume overall or planning materiality for the audit is $500,000. Item 1 Depreciation has been calculated on the total of land and buildings. In previous years it has only been charged on buildings. Total depreciation is $2.5m and the element charged to land only is $700,000. Item 2 Minnie Co’s computerized wages program is backed up daily, however for a period of two months the wages records and the back-ups have been corrupted, and therefore cannot be accessed. Wages and salaries for these two months are $1.1million Item 3 Minnie Co’s main competitor has filed a lawsuit for $5m against them alleging a breach of copyright this case is ongoing and will not be resolved prior to the audit report being signed. The matter is correctly disclosed as a contingent liability. Required: Discuss each of these issues and describe the impact on the audit report if the above issues remain unresolved. e campaign, cash donations that are received during the many special events held and donations from the annual lottery. There is a significant risk that some of the cash donations could be stolen or missing. The auditor is unable to verify the completeness of all cash donations. Required (4 marks for each scenario) For each scenario: 3.1 Indicate the type of auditor’s report to be issued 12

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3.2 Justify your conclusion in 3.1 by describing the conditions and nature of the issue that is affecting the type of audit report to be issued 3.3 Indicate if an additional audit procedure that would address any issues identified prior to the issuance of the audit report is necessary. If a procedure is necessary, explain the procedure. END OF EXAM 13

ADMS 4551 Fall 2018 Final Exam

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