3-24 (Objectives 3-1 , 3-2, 3-4, 3-6, 3-7) Patel, CPA, has completed the audit of the financial statements of Bellamy Corporation as of and for the year ended December 31, 2016. Patel also audited and reported on the Bellamy financial statements for the prior year. Patel drafted the following report for 2016.
© 2017 DeVry/Becker Educational Development Corp. All rights reserved.
We have audited the balance sheet and statements of income and retained earnings of Bellamy Corporation as of December 31, 2016. We conducted our audit in accordance with generally accepted accounting standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of misstatement.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly the financial position of Bellamy Corporation as of December 31, 2016, and the results of its operations for the year then ended in conformity with generally accepted auditing standards, applied on a basis consistent with those of the preceding year.
· Bellamy is a private corporation and is presenting comparative financial statements.
· During 2016, Bellamy acquired Stockard Inc. and the effects of that transaction are reflected in the current year financial statements. Information about this transaction is disclosed in footnote 12.
· Patel was unable to perform normal accounts receivable confirmation procedures for accounts that are material, but not pervasive, to the financial statements. Unfortunately, Patel was not able to perform alternative procedures to support the existence of the receivables.
· Bellamy Corporation is the defendant in litigation where there is a reasonable possibility that Bellamy may be required to pay a substantial amount of cash, which might require the sale of certain fixed assets. Because management does not want to provide any information that the plaintiff might use against Bellamy, the case is not discussed in the financial statements.
· Bellamy issued debentures on January 31, 2015, in the amount of $10 million. The funds obtained from the issuance were used to finance the expansion of plant facilities. The debenture agreement restricts the payment of future cash dividends to earnings after December 31, 2020. Bellamy has disclosed this in the footnotes to the financial statements.
a. Identify and explain any items included in “Other Information” that need not be part of the auditor’s report.
b. Explain the deficiencies in Patel’s report as drafted. *
* Based on AICPA question paper, American Institute of Certified Public Accountants.
3-26( Objectives 3-4 , 3-5, 3-6, 3-7, 3-8) For the following independent situations, assume that you are the audit partner on the engagement:
1. A number of frozen yogurt stores have opened in the last few years and your client, YogurtLand, has experienced a noticeable decline in customer traffic over the past several months that has caused you to have substantial doubt about YogurtLand’s ability to continue as a going concern.
2. Intelligis Electronics is a manufacturer of advanced electrical components. During the year, changes in the market resulted in a significant decrease in the demand for their products, which are now being sold significantly below cost. Management refuses to write-off the products or to increase the reserve for obsolescence.
3. In the last 3 months of the current year, Oil Refining Company decided to change direction and go significantly into the oil drilling business. Management recognizes that this business is exceptionally risky and could jeopardize the success of its existing refining business, but there are significant potential rewards. During the short period of operation in drilling, the company has had three dry wells and no successes. The facts are adequately disclosed in footnotes.
4. Your client, Harrison Automotive, has changed from straight-line to sum-of-the-years’ digits depreciation. The effect on this year’s income is immaterial, but the effect in future years may be highly material. The change is not disclosed in the footnotes.
5. Marseilles Fragrance, Inc., is based in New York but has operations throughout Europe. Because users of the audited financial statement are international, your audit firm was engaged to conduct the audit in accordance with U.S. auditing standards and International Standards on Auditing (ISAs).
6. Circumstances prevent you from being able to observe the counting of inventory at Brentwood Industries. The inventory amount is material in relation to Brentwood Industries’ financial statements. But, you were able to perform alternative procedures to support the existence and valuation of the inventory at year-end.
7. Approximately 20% of the audit of Lumberton Farms, Inc., was performed by a different CPA firm, selected by you. You have reviewed their audit files and believe they did an excellent job on their portion of the audit. Nevertheless, you are unwilling to take complete responsibility for their work.
For each situation, do the following:
a. Identify which of the conditions requiring a deviation from a standard unmodified opinion audit report is applicable, if any.
b. State the level of materiality as immaterial, material, or highly material. If you cannot decide the level of materiality, state the additional information needed to make a decision.
c. Given your answers in parts a. and b., state the appropriate audit report from the following alternatives (if you have not decided on one level of materiality in part b., state the appropriate report for each alternative materiality level):
1. Unmodified opinion—standard wording
2. Unmodified opinion—explanatory paragraph
3. Unmodified opinion—nonstandard report wording
4. Qualified opinion only—GAAP departure
5. Qualified opinion—scope limitation
7. Adverse *
3-29 (Objectives 3-1 , 3-3, 3-7, 3-9) The International Auditing and Assurance Standards Board (IAASB) recently revised its standards related to audit reporting. ISA 700 (Revised), Forming an Opinion and Reporting on Financial Statements, requires the auditor’s report to include the following paragraphs under the headings “Basis for Opinion” and “Auditor’s Responsibilities for the Audit of the Financial Statements”:
Basis for Opinion
We conducted our audit in accordance with International Standards on Auditing (ISAs). Our responsibilities under those standards are further described in the Auditor’s Responsibilities for the Audit of the Financial Statements section of our report. We are independent of the Company in accordance with the International Ethics Standards Board for Accountants’ Code of Ethics for Professional Accountants (IESBA Code) together with the ethical requirements that are relevant to our audit of the financial statements in [the home country] and we have fulfilled our other ethical responsibilities in accordance with these requirements and the IESBA Code. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our opinion.
Auditor’s Responsibilities for the Audit of the Financial Statements
Our objectives are to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, and to issue an auditor’s report that includes our opinion. Reasonable assurance is a high level of assurance, but is not a guarantee that an audit conducted in accordance with ISAs will always detect a material misstatement when it exists. Misstatements can arise from fraud or error and are considered material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users taken on the basis of these financial statements.
Read the preceding paragraphs to answer the following:
a. How does the information in the preceding paragraphs compare to the information in the paragraphs under the “Auditor’s Responsibility” heading in the standard unmodified opinion audit report example for a nonpublic company shown in Figure 3-1 ?
b. How does the information in the preceding paragraphs compare to the information in the scope paragraph in the standard unmodified opinion audit report example for a public company shown in Figure 3-3 ?
c. Discuss whether you believe these paragraphs in the ISA audit report improve auditor communications to users of the financial statements.
4-21 (Objectives 4-5 , 4-6) The following situations involve the provision of nonaudit services. Indicate whether providing the service is a violation of AICPA rules or SEC rules including Sarbanes–Oxley requirements on independence. Explain your answer as necessary.
a. Providing bookkeeping services to a public company. The services were preapproved by the audit committee of the company.
b. Providing internal audit services to a public company audit client with the preapproval of the audit committee.
c. Providing advice to a private company client on accounting for a merger with another private company.
d. Providing bookkeeping services to a private company. The source documents were prepared and authorized by the client.
e. Providing internal audit services to a public company that is not an audit client.
f. Implementing a financial information system designed by management for a private company.
g. Recommending a tax shelter to a client that is publicly held. The services were preapproved by the audit committee.
4-22 (Objectives 4-5 , 4-7) Each of the following situations involves a possible violation of the AICPA Code of Professional Conduct. For each situation, state the applicable rule of conduct and whether it is a violation.
a. Emrich, CPA, provides tax services, management advisory services, and bookkeeping services and also conducts audits for the same nonpublic client. Because the firm is small, the same person often provides all the services.
b. Steve Custer, CPA, set up a casualty and fire insurance agency to complement his auditing and tax services. He does not use his own name on anything pertaining to the insurance agency and has a highly competent manager, Jack Long, who runs it. Custer often requests Long to review the adequacy of a client’s insurance with management if it seems underinsured. He believes that he provides a valuable service to clients by informing them when they are underinsured.
c. Seven small Seattle CPA firms have become involved in an information project by taking part in an interfirm working paper review program. Under the program, each firm designates two partners to review the audit files, including the tax returns and the financial statements, of another CPA firm taking part in the program. At the end of each review, the auditors who prepared the working papers and the reviewers have a conference to discuss the strengths and weaknesses of the audit. They do not obtain authorization from the audit client before the review takes place.
d. Franz Marteens is a CPA, but not a partner, with three years of professional experience with Roberts and Batchelor, CPAs. He owns 25 shares of stock in an audit client of the firm, but he does not take part in the audit of the client, and the amount of stock is not material in relation to his total wealth.
e. A nonaudit client requests assistance of M. Wilkenson, CPA, in the installation of a local area network. Wilkenson has no experience in this type of work and no knowledge of the client’s computer system, so he obtains assistance from a computer consultant. The consultant is not in the practice of public accounting, but Wilkenson is confident of his professional skills. Because of the highly technical nature of the work, Wilkenson is not able to review the consultant’s work.
f. In preparing the personal tax returns for a client, Sarah Milsaps, CPA, observed that the deductions for contributions and interest were unusually large. When she asked the client for backup information to support the deductions, she was told, “Ask me no questions, and I will tell you no lies.” Milsaps completed the return on the basis of the information acquired from the client.
g. Roberta Hernandez, CPA, serves as controller of a U.S.-based company that has a significant portion of its operations in several South American countries. Certain government provisions in selected countries require the company to file financial statements based on international standards. Roberta oversees the issuance of the company’s financial statements and asserts that the statements are based on international financial accounting standards; however, the standards she uses are not those issued by the International Accounting Standards Board.
h. Archer Ressner, CPA, stayed longer than he should have at the annual holiday party of Ressner and Associates, CPAs. On his way home he drove through a red light and was stopped by a police officer, who observed that he was intoxicated. In a jury trial, Ressner was found guilty of driving under the influence of alcohol. Because this was not his first offense, he was sentenced to 30 days in jail and his driver’s license was revoked for one year.
4-24 (Objective 4-5 ) Marie Janes encounters the following situations in doing the audit of a large auto dealership. Janes is not a partner.
1. The sales manager tells her that there is a sale (at a substantial discount) on new cars that is limited to long-established customers of the dealership. Because her firm has been doing the audit for several years, the sales manager has decided that Janes should also be eligible for the discount.
2. The auto dealership has an executive lunchroom that is available free to employees above a certain level. The controller informs Janes that she can also eat there any time.
3. Janes is invited to and attends the company’s annual holiday party. When presents are handed out, she is surprised to find her name included. The present has a value of approximately $200.
Use the three-step process in the AICPA conceptual framework to assess whether Janes’ independence has been impaired.
a. Describe how each of the situations might threaten Janes’ independence from the auto dealership.
b. Identify a safeguard that Janes’ firm could impose that would eliminate or mitigate the threat of each situation to Janes’ independence.
c. Assuming no safeguards are in place and Janes accepts the offer or gift in each situation, discuss whether she has violated the rules of conduct.
d. Discuss what Janes should do in each situation.
5-17 (Objectives 5-2 , 5-3) The following are five independent situations.
1. Joanie Brogan is a partner in an audit firm that operates as a limited liability partnership (LLP). The firm has been sued for an alleged audit failure related to an audit engagement handled by a different partner in the firm. While Brogan had no involvement in the engagement, she is concerned that the plaintiff may successfully sue her seeking restitution from her personal assets.
2. A lawsuit has been filed against Carter Hockaday, CPA, charging him with constructive fraud in the audit of Broughton Company’s financial statements. Hockaday has examined all the audit documentation in his files and reviewed all relevant auditing standards. He is convinced that his audit fully complies with standards of the profession but is uncertain what he should use as his primary defense tactic.
3. West Camera Co. filed for bankruptcy in January 2015. A recent blog suggested that West’s external auditors should be sued for failing to include a going concern explanatory paragraph in the firm’s opinion on the financial statements issued before the bankruptcy, even though the fair presentation of the financial statements is not being disputed.
4. The audit firm Weaver and Jones, LLP, received a subpoena for its documentation related to the audit of Westbrook Corporation’s financial statements. The firm has refused to respond, alleging that the documentation is considered privileged communication between the firm and its client.
5. Spencer Cullen, CPA, is a defendant in a lawsuit alleging that Cullen should be held legally liable for gross negligence for a fraud involving the valuation of securities included in the financial statements of one of his clients. Cullen was uncertain how to establish a correct valuation for the securities and decided to rely on the price estimation supplied by management.
Analyze each situation and provide your assessment of the potential resolution of each scenario, including potential liability for the auditor or audit firm involved.
1. 5-19 (Objectives 5-3 , 5-7) The following independent scenarios describe auditor behavior on an audit engagement.
1. Chad Lewis is the lead audit partner on the audit engagement of a publicly traded company. Chad followed auditing standards on the audit engagement and issued an unmodified opinion. It was subsequently discovered that the financial statements contained a material misstatement that had been undetected by the management of the company and by the audit team.
2. Maria Marquez, CPA, is a sole proprietor. She recently accepted a new audit client who was applying for a bank loan and needed to present audited financial statements to the bank. Maria was not able to complete the audit engagement by herself, so she hired several college students to assist her. The students completed the audit procedures without much guidance, and Maria issued an unmodified opinion on the client’s financial statements.
3. On a recent audit engagement, the client firm neglected to inform the audit firm that a significant percentage of inventory was stored at an outside warehouse. As a result, the auditors did not observe the physical inventory count for that inventory, which represented 20% of the client’s inventory balance. The auditors were able to satisfy themselves that the inventory existed through alternative procedures, and issued an unmodified opinion on the financial statements as a whole.
4. The audit engagement partner, Marc Johnson, recently received a subpoena for workpapers related to an audit engagement on which his audit firm has been named as a defendant. Marc asked the staff auditor to remove and discard two memos from the workpaper files documenting communication between the engagement partner and the CFO regarding the goodwill impairment analysis.
5. Melissa Louis is the lead engagement partner on a publicly traded company. The company’s CEO recently approached Melissa and informed her that they had identified a material misstatement in the prior year’s financial statements, which had been audited by Melissa’s firm and submitted to the SEC. The CEO suggested they correct the misstatement by recording a journal entry in the current year for half of the amount of the misstatement, and in the following year for the remaining half. Melissa agreed to this plan to avoid a public announcement of a restatement and a potential lawsuit, since the amount of the journal entries recorded in the current and subsequent years would be considered immaterial to the financial statements.
For each of the scenarios listed above, discuss whether the auditor’s behavior would be considered nonnegligence, ordinary negligence, gross negligence, constructive fraud, fraud, or criminal behavior.
5-23 (Objectives 5-5 , 5-6) In order to expand its operations, Barton Corp. raised $5 million in a public offering of common stock, and also negotiated a $2 million loan from First National Bank. In connection with this financing, Barton engaged Hanover & Co., CPAs, to audit Barton’s financial statements. Hanover knew that the sole purpose of the audit was so that Barton would have audited financial statements to provide to First National Bank and the purchasers of the common stock. Although Hanover conducted the audit in conformity with its audit program, Hanover failed to detect material acts of embezzlement committed by Barton Corp.’s president. Hanover did not detect the embezzlement because of its inadvertent failure to exercise due care in designing the audit program for this engagement.
After completing the engagement, Hanover issued an unmodified opinion on Barton’s financial statements. The financial statements were relied upon by the purchasers of the common stock in deciding to purchase the shares. In addition, First National Bank approved the loan to Barton based on the audited financial statements. Within sixty days after the sale of the common stock and the issuance of the loan, Barton was involuntarily petitioned into bankruptcy. Because of the president’s embezzlement, Barton became insolvent and defaulted on the loan from the bank. Its common stock became virtually worthless. Actions have been brought against Hanover by:
· The purchasers of the common stock, who have asserted that Hanover is liable for damages under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934.
· First National Bank, based upon Hanover’s negligence.
· Trade creditors who extended credit to Barton based upon Hanover’s negligence.
a. Discuss whether you believe Hanover will be found liable to the purchasers of common stock.
b. Indicate whether you believe First National Bank will be successful in its claim against Hanover.
c. Indicate whether you believe the trade creditors will be successful in their claim against Hanover. *
1. 6-26 (Objectives 6-1, 6-3) Auditors provide “reasonable assurance” that the financial statements are “fairly stated, in all material respects.” Questions are often raised as to the responsibility of the auditor to detect material misstatements, including misappropriation of assets and fraudulent financial reporting.
a. Discuss the concept of “reasonable assurance” and the degree of confidence that financial statement users should have in the financial statements.
b. What are the responsibilities of the independent auditor in the audit of financial statements? Discuss fully, but in this part do not include fraud in the discussion.
c. What are the responsibilities of the independent auditor for the detection of fraud involving misappropriation of assets and fraudulent financial reporting? Discuss fully, including your assessment of whether the auditor’s responsibility for the detection of fraud is appropriate.
1. 6-27 (Objective 6-4) The following information was obtained from several accounting and auditing enforcement releases issued by the Securities and Exchange Commission (SEC) after its investigation of fraudulent financial reporting involving Just for Feet, Inc.:
Just for Feet, Inc., was a national retailer of athletic and outdoor footwear and apparel based in Birmingham, AL. The company incurred large amounts of advertising expenses and most vendors offered financial assistance through unwritten agreements with Just for Feet to help pay for these advertising expenses. If Just for Feet promoted a particular vendor’s products in one of its advertisements, that vendor typically would consider agreeing to provide an “advertising co-op credit” to the Company to share the costs of the advertisement. Just for Feet offset this co-op revenue against advertising expense on its income statement, thereby increasing its net earnings. Although every vendor agreement was somewhat different, Just for Feet’s receipt of advertising co-op revenue was contingent upon subsequent approval by the vendor. If the vendor approved the advertisement, it would usually issue the co-op payment to Just for Feet in the form of a credit memo offsetting expenses on Just for Feet’s merchandise purchases from that vendor. The company’s CFO, controller, and VP of Operations directed the company’s accounting department to book co-op receivables and related revenues that they knew were not owed by certain vendors, including Asics, New Balance, Nike, and Reebok. These fraudulent practices resulted in over $19 million in fictitious pretax earnings being reported, out of total pretax income of approximately $43 million. The SEC ultimately brought charges against a number of senior executives at Just for Feet and some vendor representatives.
a. What does it mean to approach an audit with an attitude of professional skepticism?
b. What circumstances related to the accounting treatment of the vendor allowances should increase an auditor’s professional skepticism?
c. What factors might have caused the auditor to inappropriately accept the assertions by management that the vendor allowances should be reflected in the financial statements?
d. Develop three probing questions related to the vendor allowances that the auditor should have asked in the audit of Just for Feet’s financial statements.
6-30 (Objective 6-8) The following are various management assertions (a. through m.) related to sales and accounts receivable.
a. Receivables are appropriately classified as to trade and other receivables in the financial statements and are clearly described.
b. Sales transactions have been recorded in the proper period.
c. Accounts receivable are recorded at the correct amounts.
d. Sales transactions have been recorded in the appropriate accounts.
e. All required disclosures about sales and receivables have been made.
f. All accounts receivable have been recorded.
g. Disclosures related to receivables are at the correct amounts.
h. Sales transactions have been recorded at the correct amounts.
i. Recorded accounts receivable exist.
j. Disclosures related to sales and receivables relate to the entity.
k. Recorded sales transactions have occurred.
l. There are no liens or other restrictions on accounts receivable.
m. All sales transactions have been recorded.
a. Explain the differences among management assertions about classes of transactions and events, management assertions about account balances, and management assertions about presentation and disclosure.
b. For each assertion, indicate whether it is an assertion about classes of transactions and events, an assertion about account balances, or an assertion about presentation and disclosure.
c. Indicate the name of the assertion made by management.