Question 1 (100 marks)

Mona s Pharmacy Inc. (MPI) is a new audit client of Sharp and Ming, CGAs. In your first engagement since being promoted to the position of audit senior, you have been assigned to the audit of MPI as part of a team for the year ended December 31, 2012. During several meetings and discussions with the audit manager, you made the following notes:

1. MPI is owned by Mona Mane and her husband, Michael Mane. The business consists of a small retail pharmacy shop and an import and wholesale operation for various pharmaceutical-related products. Recently the store unit next door has become available for lease. Mona and Michael have decided to expand the business by leasing this unit and combining it with the current location. They plan on using the extra square footage for a small grocery section within the store, which would include basic grocery items (bread, milk, and packaged goods). In the past, the business was financed from their personal resources and loans from family members. In order to finance the expansion they are currently seeking approval of a loan from a bank.

2. The bank has outlined the following preliminary conditions for the loan:

o MPI must provide audited financial statements prepared in accordance with Accounting Standards for Private Enterprises to accompany the loan application. Subsequent to the loan being approved, audited financial statements will be required within 90 days of each year end. In previous years, the financial statements of MPI were reviewed by a CGA practising as a sole practitioner, who did not want to expand her business to include audit engagements.

o The net income before taxes and management bonus must remain above $450,000.

o MPI s inventory will be held as collateral for the loan.

3. MPI sells a range of prescription and non-prescription medical products and a variety of beauty products, souvenir items, and so on. The company also imports other pharmaceutical-related products such as first aid and hygiene products. These products are sold wholesale to other local owner-managed pharmacies and convenience stores. MPI provides all of its wholesale customers payment terms of net 30 days.

4. In order to keep prices lower than its competitors, MPI buys in bulk to benefit from supplier discounts, and encourages retail customers to use cash or debit cards as payment by offering a discount. In the past, this worked well with, on average, 60% of its retail sales and services volumes paid by debit cards or cash. In the current year, this has dropped by 10%, with 50% of its retail sales now being paid by debit cards or cash.

5. You have conducted a preliminary survey to gain some knowledge about both the client company and the industry in which it competes. Recently Salmart and Boblaws have both opened large super center retail outlets in the neighbourhood, both containing pharmaceutical departments. As a result, both MPI and many of MPI s wholesale customers have been experiencing increased competitive price pressure.

6. In the current year, MPI has experienced a 15% reduction in sales. Inventory levels have increased by 20%, and there is concern that various high dollar value pharmaceutical items are approaching their expiry dates. The preliminary financial statements indicated a net income before taxes of $357,000 and a net income after taxes of $285,600. Mona and Michael were each awarded a $100,000 bonus.

7. The firm s policy, in the absence of known adverse factors, is to set audit risk at 3%. Your preliminary assessment of inherent risk for the revenue and collections cycle indicates that there is a 55% likelihood of a material misstatement occurring. Your preliminary assessment of control risk indicates a 10% probability that the control systems in place will not prevent or detect such an error. Your firm uses the planning model (audit risk model) to determine detection risk.

8. As part of this assessment of control risk, you reviewed the accounting systems and internal controls over sales transactions. The controller has provided the following description of the company s system of processing sales:

o Orders are received in writing and by telephone from retail stores that sell the company s products. Based on this information, a clerk prepares a two-part pre-numbered sales order. Part #1 of the order is sent to the warehouse, while part #2 is sent to the billing clerk.

o The warehouse fills the orders and ships the goods to the customers. Any items that are not in stock at the time an order is filled are marked back ordered on part #1 of the order form. The shipping clerk prepares a three-part bill of lading. Copy #1 accompanies the goods, while copy #2 is attached to part #1 of the order form and the two documents are sent to the billing clerk. The third copy of the bill of lading is retained at the warehouse in numerical sequence.

o At the beginning of each month, the billing clerk matches the order/bill of lading copies received from the warehouse with part #2 of the order form, and then prepares a three-part pre-numbered sales invoice. The description of items and quantities shipped are taken from part #2 of the order, while the prices are taken from the company s approved standard price list. The terms of all sales are net 30 days.

o The original invoice is sent to the customer. Invoice copy #2, together with the sales order copies and the copy of the bill of lading, are filed by customer in the billing department. The third copy of the invoice is sent to the bookkeeper to serve as the basis for posting to the individual customer accounts and for preparing the monthly sales journal. Statements are prepared by the bookkeeper and sent to customers only when requested.

9. In your discussions with the controller, he mentioned that the following issues have been occurring and he would like to know if you can provide any recommendations:

Many customers have indicated that they have been overcharged.

Customers have called, indicating they have not yet received goods that they ordered weeks ago.

The time to collect accounts receivable balances has increased from 30 days to 45 days, and several customers continue to order goods even though they have not yet paid for previous orders.


Based on the work completed to date, the following items need to be resolved and tasks (among others) need to be completed.

Task 1: Distinguish between an audit, a review, and a compilation engagement (10 marks)

A friend of Mona and Michael told them that there are several different types of assurance that an auditor can provide. They would like you to explain the differences between an audit, a review, and a compilation engagement. They also would like to know the likely reason(s) that the bank has requested an audit. (10 marks)

Task 2: Materiality and audit risk model (25 marks)

a. Identify three factors specific to MPI that could affect the preliminary assessment of inherent risk. For each factor, indicate whether it is at the account level or the financial statement level. For all factors affecting a specific account, indicate the account and assertion affected. (6 marks)

b. Based on MPI s preliminary financial information for December 31, 2012, calculate a preliminary materiality. Describe the users of the financial statements and explain your reasoning for the quantitative measure selected. (5 marks)

c. Based on the preliminary determination of audit risk and your assessment of the risk of material misstatement, calculate the planned detection risk for the audit of the revenue and collections cycle. Show your work. (2 marks)

d. Prepare a short analysis of each of the following independent what-if situations for the audit manager. Consider each situation independently, varying only the factors stated in each situation and holding all other factors constant. When determining the effect of various changes on the detection risk, calculate the new detection risk and explain whether the detection risk varies directly, inversely, or independently of the factor that has changed.

i. After further study of the client s operations, you decide that the inherent risk of a material error is 45%. What effect would this have on the calculated detection risk? (2 marks)

ii. You decide to test key internal controls and find that the control risk is 25%. What effect would this have on the calculated detection risk? (2 marks)

e. What effect does a decrease in the detection risk you are prepared to take have on the nature of the audit work performed? What effect does it have on the extent of audit work performed? What effect does it have on the timing of audit work performed? (3 marks)

f. Assume you decide to decrease the amount of misstatement considered material by $20,000. What effect will this decrease in the amount considered material have on the detection risk? A change in the amount considered material is not an explicit component of the audit risk model. How then (if at all) does a change in the amount considered material result in a change in the detection risk if there is no change in the audit risk and no change in the client s operations or controls? (5 marks)

Task 3: Audit programs and working papers (12 marks)

a. During the course of the audit, you will be performing tests of control audit procedures as well as substantive procedures. Briefly explain the difference between these two types of procedures and describe the two major categories of substantive procedures. (6 marks)

b. The audit work performed must be documented using appropriate working papers. List six purposes of audit working papers. (6 marks)

Task 4: Internal control assessment sales transactions (17 marks)

a. Identify three control weaknesses based on the controller s description of the company s system of processing sales and the current issues that MPI is experiencing. For each weakness identified, describe the implications of the weakness and provide a control recommendation. Use three columns headed Control weakness, Implication, and Recommendation. (9 marks)

b. Identify two control procedures based on the controller s description of the company s system of processing sales. For each procedure, list the key objective it fulfills for internal control over sales transactions. Use two columns headed Control procedure and Control objective. (4 marks)

c. List two examples of control tests that the auditor could perform to ensure the operating effectiveness of the controls identified in Task 4(b). Explain under what circumstances the auditor would perform the tests of controls. (4 marks)