Computer Bazaar Inc

CPA MOCK Evaluation Assurance Elective Page 1

CHARTERED PROFESSIONAL ACCOUNTANTS OF CANADA, CPA CANADA, CPA. © 2014, Chartered Professional Accountants of Canada. All Rights Reserved.

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ELECTIVE (ASSURANCE)- Elective examinations will be 3 hours in length. Candidates will be given 4 hours to complete the examination, providing an extra hour to formulate their responses. The intention is to reduce the time constraint. The examinations will be made up of a mix of objective-format and medium to large -sized, moderately complex cases. The split and length may vary across the Electives to adapt to learning outcomes required.

Elective examinations may use a mix of single-competency and multi-competency area questions, but greater than 50% of assessment opportunities will be related to the Elective area being examined. Elective examinations use larger and more complex cases than those used for Core 1 and Core 2 (requiring between 60 and 120 minutes). The assessment of professional skill will continue in a multi-competency environment, always building on prior learnings. Cases will require candidates to simulate the “roles” they will play in real life, and therefore access will be provided to the reference tools they would use, where practical to do so. Assurance cases may use preloaded information and forms like checklists, the summary of adjusted errors form, etc..

COMPUTER BAZAAR INC. Suggested Time: 85 minutes (represents the time judged necessary to complete the question) (HITS COMPETENCIES IN ASSURANCE- risk assessment, audit strategy; IT conversion controls, review of staff’s work, AND FIN REP- stock options, etc.)

As part of your firm’s training program, newly hired CPA recruits must audit a fictitious client, Computer Bazaar Inc. (Bazaar). Exhibit I describes Bazaar’s operations. The recruits perform an overall risk assessment and complete various sections of the audit file, including the inventory, sales, and accounts receivable, for the year ended December 31, 2015. The files are then reviewed by more experienced co-workers. Their comments are reviewed by a partner. The recruits are specifically asked to consider the client’s accounting policies, information technology (IT) infrastructure, and internal control environment. They are told to document and support their findings and conclusions, and are allowed to seek advice from more experienced co-workers. The partner in charge of the training program, Raymond Morissette, asks you, an experienced CPA, to review a file prepared by a recruit and comment on each section. Exhibit II is an excerpt from the audit file. The partner asks you to indicate the strengths and weaknesses in the recruit’s approach and identify anything critical missing from the file sections, which he will discuss with the recruit. He reminds you he will also evaluate your work.



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EXHIBIT I DESCRIPTION OF BAZAAR’S OPERATIONS Bazaar buys computers, parts, and related equipment and resells them at a markup to a loyal base of corporate customers. Competition is growing, but the market is favourable, and Bazaar offers excellent customer service, giving it a competitive advantage. The owner is very involved in most of the important operating decisions. His capable assistant steps in when necessary. The owner plans to implement a code of ethics at some point and also wishes to improve certain controls. Bazaar is a medium-sized private company that operates multiple warehouses, each carrying a mix of inventory items. The first type of inventory, which can be quite costly, consists of specialized computer hardware, desktop computers, and laptop computers. The turnover rate for this inventory is high since new technology is always emerging. Because the company orders months in advance, Bazaar occasionally overestimates demand. After three or four months, products are difficult to sell, but they are kept because most cannot be returned to the supplier, and Bazaar is reluctant to hold liquidation sales for fear they would negatively affect the sales at regular prices. The second type of inventory, parts and peripherals, generates a significant portion of Bazaar’s sales. This category includes items such as monitors, printers, and toner cartridges. The third type of inventory includes software packages ranging from sophisticated operating systems to games. This inventory can be returned to suppliers if unsold after a certain period. This year, Bazaar implemented an integrated computer system to manage the general ledger as well as inventory, purchases, and sales. The system was developed by external consultants and is maintained by Bazaar’s IT department. Sales representatives enter orders into the sales database, and can modify the information, including quantities and selling prices. Any changes are usually made to orders before shipping. Problems result if representatives make changes after shipping, since they should issue credits instead. The timing differences create reconciliation problems for both customers and Bazaar when settling invoices. Also, sometimes credits have been issued in error. Electronic purchase orders require authorization from either the owner or his assistant through the use of a personal identification number (PIN). Each user has a specific PIN. Orders greater than $5,000 require the owner’s authorization. Before making a payment, the accounting department matches the invoice to the authorized purchase order and the receiving slip.



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EXHIBIT I (continued) DESCRIPTION OF BAZAAR’S OPERATIONS Other Information The owner noted that Bazaar’s costs seem higher than expected, particularly since this year he decided to pay suppliers faster in order to benefit from discounts. According to his calculation, the cost of goods sold should have decreased by around 2% over last year, since most suppliers offer discounts and did not increase prices. Instead, he noted a 3% increase in costs. He wants to take a closer look next week. The sales mix has not changed significantly from previous years. Ten new accounts were opened during the year, with average monthly sales of $5,000 each. Sales also increased because a new representative was hired at the beginning of the fiscal year. Average monthly sales for the 10 experienced representatives are $500,000 each. Rookie representatives normally perform at 50% of an experienced representative’s level in their first year. Bazaar also lost a customer, who had averaged $90,000 a year in sales, to the competition. Purchases increased and were distributed across the inventory types in amounts similar to the overall sales mix. To help retain the sales team, stock options were given this year for the first time as an added form of compensation. The options will vest after two years, provided sales representatives remain employees and Bazaar’s net income before tax is at least $5 million per year. The owner likes the fact that options do not affect Bazaar’s financial statements, unlike salary increases. The owner noted he just received a memo from a clerk at one of the warehouses. It says the amount of damaged inventory has been gradually increasing over the past eight months. The clerk suggests this is because the forklift is not operating properly and items are being dropped as they are loaded for shipment. He wants the forklift replaced. He asks what he should do with the damaged inventory that has been piling up in a corner of the warehouse. He suggests holding a liquidation sale to get rid of it, since he needs the space.



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EXHIBIT II SECTIONS FROM THE RECRUIT’S AUDIT FILE Engagement Risk Assessment

Inherent risk (The entity and its environment) Items reducing risk: Bazaar has been operating for many years and has a good reputation. Bazaar has a loyal customer base. Owner has many years of experience in the industry. Market is favourable. Activities are simple (buying and reselling at a markup). Items increasing risk: Competition is strong, increasing the possibility of a decline in sales. Multiple warehouse locations increase the complexity of the engagement. I conclude that inherent risk is high. Control risk (internal control components) Items reducing risk: Structured procedures are in place for purchases and sales. Items increasing risk: Owner says controls could be improved. Conversion took place during the year; new system is now in place. IT personnel can modify the program’s code right in the production environment (see

below). No code of ethics in place, which shows a lack of clear policies and poor tone at the top. I conclude that control risk is medium to high. Detection risk I conclude that detection risk is low, so large samples are not required. Audit risk Item reducing risk: Bazaar is privately owned, so there is little risk of a lawsuit. Bazaar applies accounting

generally accepted accounting principles for private enterprises. Overall, I conclude that audit risk is low.



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EXHIBIT II (continued) SECTIONS FROM THE RECRUIT’S AUDIT FILE Audit Strategy A mixed audit strategy would be appropriate because some controls seem to be in place and could be relied upon. The controls need to be tested before confirming the strategy. Bazaar uses an accounting system that includes modules for inventory, purchases, and sales. Two programmers work on the system. Since they participated in its development, they are comfortable performing changes directly in the production environment. This practice frustrates the system’s operators, who are often not aware of these changes until they inadvertently affect other components of the software and systems.

Conversion procedures completed by Bazaar The balances from the previous accounting system, as well as those in other master records such as the customer and supplier databases, were transferred to a new system at the beginning of the year. The old system has been kept functional to allow historical records to be viewed, since they were not transferred. This is the supplier’s standard procedure, because it would take too much time to enter the previous years’ information into the new system, which provides more details. It also allows audit procedures to be performed on the old system in case they are required. Bazaar performed the following procedures as part of the conversion: a) Ensured total general ledger debits equalled total general ledger credits b) Ensured total accounts payable, accounts receivable, and inventory sub-ledger balances

equalled general ledger balances c) Ensured the total number of records in each of the customer and supplier master databases

didn’t change Bazaar noted that problems with balances occurred during the conversion because a text file was used to transfer data between systems. Some customers and suppliers have complained about incomplete addresses, which has caused delivery delays. Slight imbalances were noticed during conversion, and manual adjustments were made to correct the balances in the new system.



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EXHIBIT II (continued) SECTIONS FROM THE RECRUIT’S AUDIT FILE Conversion procedures performed Audited the matching of balances and found no discrepancies. Bazaar’s conversion procedures were adequate since errors were corrected immediately. IT recommendation noted for management letter: Making programming changes in the production environment is not ideal because they can affect the business, and the changes are made without authorization. Programmers should use a separate development environment for modifications so they do not disrupt business processes. Audit Sections Materiality The partner established a materiality of $250,000 for the engagement, based on 5% of net income after tax. Inventory procedures performed 1. Matched totals on inventory listing to sub-ledger and general ledger. 2. Traced quantities for a random sample of 10 computers. My inventory count matched

quantities on the inventory listing. 3. Traced prices for the 10 computers sampled in the previous test. Prices matched those on

the price listing, except for two models. The owner explained that employees sometimes manually change inventory prices to adjust for errors made when recording purchases. He provided a second listing with handwritten corrections. However, no backup documents were available to substantiate the changes.

4. Recalculated quantity and price extensions for the same 10 computers and they were

accurate.

5. One customer placed an order of more than $800,000 for specialized servers. Unfortunately, the customer went bankrupt and, 10 months later, the servers are still in inventory. Bazaar never posted the sale because the servers were never shipped. The company is certain it can resell them to another customer, so no provision has been booked.



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EXHIBIT II (continued) SECTIONS FROM THE RECRUIT’S AUDIT FILE Sales procedures performed 1. Matched totals on sales listing to sub-ledger and general ledger. 2. Sales variance analysis:

2014

2015

Variance ($)

Variance (%)

Computers $ 20,000,000 $ 22,000,000 $ 2,000,000 10%

Parts & peripherals 35,000,000 37,500,000 2,500,000 7%

Software 5,000,000 5,500,000 500,000 10%

Total $ 60,000,000 $ 65,000,000 $ 5,000,000 8%

Explanation for variance: Sales increased because a new representative was hired. Accounts Receivable procedures performed 1. Customers have 30 days to pay invoices, but most take advantage of the 2% discount

offered for payment within 10 days. A sample of five year-end balances was tested, and all payments were received subsequent to year-end, so accounts receivable were reasonable at year-end. The system indicates that three of the samples were paid in fewer than 10 days and the customers received their discounts. However, when the receipts were traced to the bank deposits, I noted that the customers had made full payments. The discounts appeared to be reimbursed later by system-generated cheques, but the cheques could not be traced to any backup documentation. I found very few details in the system so I wasn’t able to do any additional work. However, since the customers had earned the discount, it was correct to reimburse them.

2. In order to save time, Bazaar applied a blanket provision of 5% for uncollectible accounts.

Historically, the amount of uncollectible accounts ranged from 3% to 4%. Credit procedures were tightened two years ago, and since then, the rate has been at the lower end. Therefore, 5% is quite conservative, allowing for potential overstatement of receivables.



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EXHIBIT II (continued) SECTIONS FROM THE RECRUIT’S AUDIT FILE 3. Sampled credit notes. A credit was issued for a price adjustment made by a sales

representative. The supporting paperwork stated that the credit had been issued in error (which seems to happen often) and the refund cheque was cancelled. However, the details of the refund cheque could not be located. The clerk says he left the cheque copies on his desk and the next morning they were gone. He gave up looking for them.

Purchases procedures performed Randomly selected 10 purchases. A purchase order for $24,000 was authorized by the owner’s assistant, who explained that the transaction occurred while the owner was away. He stated that authorizations on behalf of the owner were rare. As this was an exception, no further work was performed. Expense analysis Randomly sampled 10 general ledger expense accounts. Three of the expense account items sampled were traced to invoices and issued cheques. The remaining items were reviewed for reasonableness. Expense Description Supplier (purchase details) Amount

Small tools Tools & Tools (hammer, screwdrivers,

etc.) $ 1,159.98

Repairs and maintenance

Colder & Sons (air conditioner unit replacement)

106,545.87

Miscellaneous expenses

Design Lavoie (office redecoration and design)

156,985.52



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MARKING GUIDE TRAINING PROGRAM

Assessment Opportunity #1 (NOTE: The Board of Examiners will be the one to define what each assessment opportunity will be. This is simply an example for illustration purposes. ) The candidate assesses the audit work performed by the recruit in the recruit’s working paper file. The candidate demonstrates competence in Assurance.

CPA Mapping: 4.3.5 Assesses the risks of the project, or for audit engagements, assesses the risks of material misstatement at the financial statement level and at the assertion level for classes of transactions, account balances, and disclosures, (Elective- Level B).

Introduction The new recruit documented the audit approach taken and related findings for the Computer Bazaar Inc. (Bazaar) engagement. The documentation includes an assessment of engagement risk, an audit strategy description, comments on Bazaar’s controls and systems, a description of the work performed on certain sections (Accounts Receivable, Purchases and Payables, and Inventory), and conclusions on the findings. Risk Assessment CAS 200 defines the components of risk. The risk of material misstatement, the risk that the financial statements are materially misstated prior to audit, consists of two components, inherent risk and control risk. The risks of material misstatement may exist at two levels, the overall financial statement level, and the assertion level for classes of transactions, account balances, and disclosures. At the assertion level inherent risk is “the susceptibility of an assertion about a class of transaction, account balance or disclosure to a misstatement that could be material, either individually or when aggregated with other misstatements, before consideration of any related controls.” Control risk is “the risk that a misstatement that could occur in an assertion about a class of transaction, account balance or disclosure and that could be material, either individually or when aggregated with other misstatements, will not be prevented, or detected and corrected, on a timely basis by the entity's internal control. The recruit started with the risk assessment, but failed to distinguish between the two levels of risk assessment required by CAS 315 (financial statement and assertion) and instead provided a general discussion of “inherent”, “control” and “detection” risks. The CAS does not refer to inherent risk and control risk separately, but rather refers to a combined assessment of the risks of material misstatement. Inherent risk and control risk are both components of the risk of material misstatement. However, auditors may make separate or combined assessments of inherent and control risk depending on preferred audit techniques or methodologies and practical considerations. (CAS 200.A40)



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Risk of Material Misstatement (RMM) a) Inherent risk The recruit correctly identified some of the risk factors and was able to assess whether they increased or decreased the risk of material mistatement. The conclusion reached — that inherent risk is high — appears appropriate. However, the recruit failed to consider the following factors in reaching that conclusion: 1. Bazaar deals with computers and related equipment, and new technology is always

emerging, so inventory obsolescence may be a factor. The existence of multiple warehouses may increase the risk of inventory obsolescence. In addition, the fact that inventory items are computer-related may increase the risk of asset misappropriation since they could be considered high-demand products. These risk factors impact the existence and valuation of inventory.

2. The nature of the business appears to be non-complex (except for the specialized orders): there do not appear to be complex or non-routine transactions to contend with. However, the volume of transactions appears to be high, which may or may not be a risk factor, depending on the reliability of the systems processing the transactions (see the discussion of control risk that follows). This risk factor may increase or decrease the inherent risk associated with multiple accounts and assertions.

3. The distribution of stock options for the first time is an added risk factor because employees

may be inclined to manipulate net income in order to obtain their options. Therefore, the stock options may increase the risk of fraud.

b) Control risk The recruit partially described the control risk and recognized valid strengths and weaknesses in the controls, but neglected to mention important items: 1. The owner was puzzled by an increase in costs that seemed inconsistent with his decision to

pay suppliers faster in order to benefit from discounts. This risk impacts the existence of accounts payable and the occurrence of expenses.

2. The purchase authorization mechanism, which the recruit describes as being a structured procedure, seems weak since the assistant was able to authorize a purchase over his limit without much trouble. This risk impacts the existence of inventory, the existence of accounts payable and the occurrence of cost of sales.

3. There appears to be a problem with the issuance of credit notes. One that had been issued

for a price adjustment made by a sales representative was apparently issued in error, but the corresponding cancelled refund cheque could not be located. This risk impacts the existence and valuation of accounts receivable, as well as the occurrence and accuracy of sales.



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4. There were also some bizarre transactions in accounts receivable, including discount reimbursements and missing refund cheques for credited price adjustments. These incidents might indicate that fraud has occurred, and should be investigated further. This risk impacts the existence and valuation of accounts receivable, as well as the occurrence and accuracy of sales.

The recruit’s work was insufficient. The findings do not support relying on internal controls because they seem to be easily circumvented. The odd transactions and suspicious activities should have caused the recruit to question the reliability of the IT system and to question whether controls are being circumvented. This suspicion should have translated into an increased level of control risk for the engagement, as well as the recognition of possible fraud risk. The recruit assessed the control risk as medium to high. However, considering the number of control breakdowns noted, an assessment of high appears more appropriate. This assessment increases the risk of material misstatement at both the financial statement and assertion levels. Detection risk The detection risk — the risk of not finding a material misstatement — should be derived from the assessed risk of material misstatement (the inherent and control risk level assessment) and should be used to determine the amount of audit work required to reduce the audit risk to an acceptable level. In order to achieve a low detection risk level, a large sample is required, contrary to what the recruit suggested. Revising the assessment of control risk to high results in an even larger sample (see the sampling discussion later in this report). Audit risk In the audit risk conclusion, the recruit identified that the company was privately owned and that therefore there is little risk of lawsuits. The recruit automatically assumed that this would lower the overall level of audit risk. The recruit should also have noted the additional factor that there is only one owner. The risk of a lawsuit may not be related to being a privately owned company, however. It may have more to do with other factors, such as the nature of the product sold. Therefore, the audit risk level is higher than what the recruit assessed, which was low. It is likely medium to high risk. This increases the amount of audit work to be performed, which also influences the audit approach and sample sizes. As a result, more audit work would be required to reduce the overall audit risk to an acceptable level.



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Audit Approach The recruit suggested using a combined approach with reliance on controls. If the recruit plans to rely on the controls or if substantive procedures alone cannot provide sufficient and appropriate, then test of controls must be performed. The recruit mentions that the controls need to be tested before relying on them, and therefore appears to understand this concept. The recruit believes we can rely on some of the controls. However, based on the risk of material misstatement at both the inherent and control levels, this may not be the case. Although some controls exist, they appear to be easily circumvented or to not be functioning properly, so more substantive risk is required. The recruit has failed to sufficiently consider the breakdowns in controls in planning the nature and extent of audit work required to reduce the audit risk to an acceptable level. In addition, the fact that there is a new computer system in place may affect the ability to rely on controls. The new system needs to be properly documented and tested before it can be relied on. The fact that some documents are in electronic form only may require some of the testing to be computer-based, using computer-assisted audit techniques (CAATs). The recruit concluded that we take a combined approach for this audit as a whole. It should be noted that we need to consider the risks of material misstatement at the financial statement level and at the assertion level to determine the appropriate approach to be taken. We may take a substantive approach for one assertion of an account and take a combined approach for another assertion of that same account. It is important to assess the audit approach at the assertion level so the risks of material misstatement are addressed, rather than determine an approach to the audit as a whole. Materiality The recruit does not appear to have addressed the CAS 320 requirement to determine performance materiality for purposes of assessing the risks of material misstatement and determining the nature, timing and extent of further audit procedures. Performance materiality would be necessary to complete the risk assessment and the audit work. The recruit should have identified this issue. Sampling The recruit does not appear to have addressed how the sample sizes used in the testing of the sections were determined. The recruit mentions only that large samples are not required, which is incorrect. Based on a conclusion of low detection risk, the sample sizes should actually be large, otherwise the sampling approach will not achieve the audit objective. Furthermore, CAS 530.7 requires that a sufficient sample size be determined such that sampling risk is reduced to an acceptably low level. It appears that the samples the recruit used were manually chosen and the same size across the various sections. Statistical sampling, although not required, could have been used in this audit to obtain a representative sample across the population of documents tested.



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Assessment Opportunity # 2 The candidate assesses the audit work performed by the recruit in the recruit’s working paper file. The candidate demonstrates competence in Assurance.

CPA Mapping: 4.3.6 Develops appropriate procedures based on the identified risk of material misstatement (Elective- Level A) 4.3.7 Performs the work plan (Elective-Level A)

Audit Procedures Performed Inventories The audit work performed on the inventory started off well. However, the second and third steps involved using a sample size of 10 computers. The sample was selected randomly, but a statistical method or a justified manual sample would have been more appropriate. As a result, the sample size may not be adequate and may not represent the population well enough to draw conclusions and extrapolate on errors found. Considering that Bazaar runs multiple warehouses with distinct inventory, it is likely that very few items were tested at each location. The recruit did not mention whether the samples were selected from the same warehouse or from all warehouses. Any significant inventory balances should have been tested at the different warehouses. It would be possible to test inventories on a rotational basis for small warehouses, but any material location must be included in the annual audit work. In addition, the report mentions that there is damaged inventory in one of the warehouses. The recruit should address the possibility of the other warehouses having damaged inventory too, and should ask management and warehouse staff whether damaged product is accumulating in other locations. In general, inventory obsolescence is a concern. Given the rapid emergence of new computer technology, the fact that Bazaar occasionally overestimates demand indicates that excess product remains. The company’s unwillingness to liquidate its excess stock raises concerns regarding inventory valuation and obsolescence. An assessment of valuation and obsolescence must be made. This will require information relating to cost, such as purchase invoices, and to net realizable value, such as selling information from later sales invoices and market pricing information for similar models of older computers (less related shipping and warehousing costs). The items selected in the recruit’s sample were all computers. Although they likely represent a significant portion of the inventory, other inventory types, such as equipment, parts, and software, may also represent an important portion of what Bazaar carries in stock. It would be essential to test all types of inventory. Perhaps there are specific problems related to toner cartridges that do not apply to computers, and focusing only on computers would not bring these problems to light.



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The sample items were also tested for pricing. Two discrepancies were found and revealed that employees made manual changes to the price list. A second price list was obtained with the handwritten changes. This reduces the reliability of the price list. The recruit should have increased the sample size to determine whether these changes were isolated incidents. Price extensions were recalculated for the sample of 10 items. This is a good idea, but it would have been a better idea to obtain the master file and revalidate all price extensions using CAATS or a reapplication of the formulas to determine if they are consistent with the price extensions of the entire file. Sales The first step performed to audit sales was done correctly. However, the substantive variance analysis was incomplete. Current year balances were obtained and compared to the prior year in dollar amounts and percentage, but further analysis could have been performed on these numbers. The hiring of a new representative explains a large portion of the variation, but the client provided far more information. Here is what the analysis should have looked like: Computers Parts Software Total

Starting point: Last year’s sales $ 20,000,000 $ 35,000,000 $ 5,000,000 $ 60,000,000

Variance factors: Loss of a client (90,000) — — (90,000) 10 new accounts at $5,000/month 200,000 350,000 50,000 600,000 Rookie representative 1,000,000 1,750,000 250,000 3,000,000

Extrapolated sales 21,110,000 37,100,000 5,300,000 63,510,000 Actual sales 22,000,000 37,500,000 5,500,000 65,000,000

Variance 890,000 400,000 200,000 1,490,000 Having done this analysis, the recruit should have investigated further, since the variance is larger than materiality ($250,000), by asking the client for further explanations for the increased sales. If the results of that inquiry were inconclusive, additional procedures should have been performed to substantiate the variance, such as tracing sales transactions to customer invoices and shipping documents.



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Accounts receivable Here again the recruit selected a very small sample size, in this case a sample of five. It is very possible that the sample will not allow for extrapolation of errors and is most certainly not representative of the entire population of accounts receivable. However, the method used by the recruit to validate the selected items is good, since subsequent payment proves an account existed at year-end. The three samples that were traced to the bank deposits showed an interesting anomaly. The system showed that the payments were received in time to benefit from the discount, but the client still paid the full amount. The discount was later given to the customers through system-generated cheques, but there were few details in the system. These cheques could not be traced to any backup documentation, which is suspicious and might indicate that fraud has occurred. Further investigation of this situation should be done, including an examination of the cheques to ensure that the payees were the customers and not other companies or individuals. Additional procedures that should be considered include vouching a sample of other discounts paid out in this manner and agreeing amounts to receipt information or sales invoicing reports to determine that the customers were entitled to refunds of the discounts not taken. The backup paper work was missing for the cancelled refund cheque that was issued by a sales representative as a credit for a price adjustment. This is also suspicious (it could be another indication of fraudulent activity) and should be followed up to see if there were other similar occurrences during the year. Additional procedures should be performed to extend the sample for credit notes to determine whether other credits for price adjustments had been issued, then traced back to the supporting documentation, including the refund cheque. The issuances of credit notes and refunds are somewhat atypical transactions and should always be reviewed closely as part of an audit. Additional audit work will have to be performed to substantiate the historical amount of uncollectible accounts (3% to 4%), which has declined in recent years as a result of tightened credit procedures. A review of prior years’ uncollectible accounts in relation to total accounts receivable should be performed in order to support the historical range. The documentation of management’s assessment of the impairment of accounts receivable should have been obtained and assessed for reasonableness Purchases A situation occurred regarding the authorization of a purchase by an assistant when the purchase was over his limit. The recruit questioned the assistant directly on this matter, and it appears that the assistant had overridden the authorization PIN. The recruit should have extended the sample size to determine if this override happened on other occasions. In addition, the recruit should have asked to see supporting documentation (such as the supplier invoice) for this purchase to ensure that it was for business purposes.



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The recruit did not address the owner’s comment that cost of goods sold should have decreased by around 2% over last year but instead increased by 3%. Analytical procedures, including a gross margin analysis or an analysis of cost of sales components, should have been performed to investigate the increase, particularly since most suppliers offered discounts and did not increase their prices. Depending upon the results of the analytical procedures, substantive procedures such as the tracing of purchases to supplier invoices and ultimate payment may be required to ensure that proper discounts were taken and received (as available) and to support the validity of the increase. Expense analysis Out of the 10 expense items randomly sampled, only three were traced to invoices and cheques. The rest were reviewed for reasonableness. Out of those three, two appeared to be items that should have been capitalized and depreciated over the course of their useful lives rather than expensed. The recruit should have enquired further of the client as to the nature of the work invoiced in order to assess whether these items should have been capitalized or expensed (see GAAP Deviations discussion later in this report). Taken on an individual basis, the expense amounts are not material, but the total of the two exceeds the materiality level assessed by the partner. Expense accounts should be thoroughly examined for similar types of discrepancies and corrections should be requested of the client. I am concerned about the “reasonableness” check the recruit performed since there is no explanation as to what the recruit looked for. Based on the fact that the recruit missed the potential capital items in the expense items that were traced, I wonder what might have been missed in the other seven items that were considered reasonable. In addition, it is unclear why all 10 items were not traced back to supporting documentation. If they were part of the random sample, they should have all been tested the same way. Stock options The recruit did not perform audit work on the new stock option plan. The recruit should have reviewed the documents describing the plan to determine if the accounting treatment was appropriate (I discuss this further in the next section, GAAP Deviations), and should have verified the number of options awarded, etc.

Assessment Opportunity #3 The candidate explains the GAAP deviations that the recruit failed to identify. The candidate demonstrates competence in Financial Reporting

CPA Mapping: 1.2.2 Evaluates treatment for routine transactions (Elective Level A) 1.2.3 Evaluates treatment for non-routine transactions (Elective Level A)



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GAAP Deviations Overall, the recruit does not appear to be aware of certain Handbook — Accounting Part II (ASPE) rules since the recruit failed to discuss the stock options. The recruit also missed the error in the way Bazaar provides for its uncollectible accounts, the fact that capital items were expensed in error, and the fact that Bazaar had failed to address its inventory obsolescence issue. Stock options The issuance of stock options to employees did not raise any concerns with the recruit, even though the owner mentioned there was no financial statement impact. Since the granting of options in this case represents a form of compensation, the recruit should have assessed whether they should be recognized in the financial statements and, if so, what amount should be recognized. Based on the information provided by the owner about the stock option plan, it sounds like it represents a performance award as defined in Section 3870.07 of the CICA Handbook — Accounting, Part II: A performance award is an award of stock-based employee compensation for which vesting depends on both: (i) an employee’s rendering service to the enterprise for a specified period of time; and (ii) the achievement of a specified performance target,(for example, attaining a specified

growth rate in return on assets or a specified percentage increase in market share for a specified product).

In the case of Bazaar’s stock option plan, the employees’ plans vest if they stay employed for a minimum of two years and if Bazaar meets a minimum level of net income (after tax). 3870.43 — The total amount of compensation cost recognized for an award of stock-based employee compensation should be based on the number of instruments that eventually vest. No compensation cost should be recognized for awards that employees forfeit either because they fail to satisfy a service requirement for vesting, such as for a fixed award, or because the enterprise does not achieve a performance condition, unless the condition is a target stock price or specified amount of intrinsic value on which vesting or exercisability is conditioned. Therefore, Bazaar needs to estimate how many of the options are likely to vest. First, Bazaar must assess whether it can meet the minimum net income requirement of $5 million per year. 3870.45 — The measurement of compensation cost for an award with a performance condition that will determine the number of options or shares to which all employees receiving the award will be entitled should be based on the best estimate of the outcome of the performance condition, although forfeitures by individual employees may either be estimated at the grant date or recognized only as they occur.



Sep12/14

Based on the information provided by the owner, it appears that the December 2015 year-end income before tax is approximately $5 million. Therefore, it appears that the income performance condition would be met for the current year. However, there is no guarantee that the condition will be met in the second year, particularly when considering how close the actual income appears to be in 2015. Therefore, Bazaar must assess the probability of reaching the target in 2016. If it does not seem probable that the net income target will be met, compensation cost would not be recorded for the options. Second, Bazaar needs to assess how many employees are likely to meet the other vesting condition of staying a minimum of two years. Bazaar can probably estimate this number based on historical turnover rates. If it is probable that the options will vest based on the expected achievement of the net income target, the total compensation cost recognized over the vesting period will be the grant date fair value of all options that actually vest. A policy choice can be made as to whether to estimate the options that will not vest due to failure to meet the two-year continued employment vesting requirement and to reduce compensation cost for those expected forfeitures. Regardless, compensation cost will ultimately be adjusted to recognize the cost of only those options that actually vest once actual results are known, determined based on the stock price at the grant date. Since Bazaar is a private company, valuing the options is not an easy task. The CICA Handbook — Accounting, Part II provides some guidance. 3870.32 — The fair value of a stock option (or its equivalent) is estimated using an option pricing model (for example, the Black-Scholes or a binomial model) that takes into account as of the grant date: (a) the exercise price; (b) the expected life of the option; (c) the current price of the underlying stock; (d) its expected volatility; (e) expected dividends on the stock (except as provided in paragraphs 3870.50 and 3870.51);

and (f) the risk-free interest rate for the expected term of the option. For options that an enterprise

grants on its own stock, the risk-free interest rate used is the rate currently available on zero coupon Canada government bonds with a remaining term equal to the expected life of the options.

To reflect the effect of a holders' inability to sell their vested options, the value of a holder's stock option is based on its expected life rather than its maximum term. The Appendix in 3870 provides guidance on selecting assumptions for use in an option pricing model.



Sep12/14

Inventory The specialized servers ordered by the client who went bankrupt are still included in inventory and no provision has been taken. This implies that Bazaar can resell the servers. Even though the owner says he is confident Bazaar can resell them, this likely is unrealistic. For one thing, the servers are specialized goods. This means that the market they are destined for is narrow and that there are fewer buyers for this product. In addition, the servers have been in stock for more than 10 months. The technology may have improved during that time frame, making the goods non-saleable. The turnover time for this type of inventory averages three to four months, so Bazaar might never be able to resell these servers or it might have to significantly reduce the selling price to make a sale. Additionally, in most cases specialized items cannot be returned to the supplier. Bazaar has kept the servers for 10 months, which infers that it is not able to return them. Based on the above arguments, Bazaar should take a provision for obsolescence and write off a large portion of the cost of the servers, if not all, to reflect their actual net realizable value (NRV). Damaged goods are sitting in the warehouse and seem to be accumulating. There is likely little or no value to these goods. The question is whether Bazaar has written down the value of this inventory to reflect its NRV. If the goods are recorded in inventory at their full cost, they are likely overvalued because Bazaar would not be able to sell them for the same price as new, undamaged items, and an adjustment would be required to write them down (or off). Bazaar’s management should determine if there is any value to the goods by determining (as an initial step) their intentions with respect to liquidation sales or questioning whether there are other ways of recovering some value (for instance, discounted sales to employees or discounted sales to a refurbisher). If it can be substantiated that there is some value that could be regained through a liquidation sale, then a reduction to NRV would suffice. Bazaar should also determine if other locations have damaged goods by asking the warehouse managers or by visiting multiple warehouses to see if damaged goods are piling up there. In addition to the above items, the recruit should have considered that there may be obsolete inventory in other areas. Information relating to cost (such as purchase invoices) and net realizable value (such as selling information from later sales invoices and market pricing information for similar models of older computers) must be obtained so that an assessment of valuation and obsolescence can be made. A difference between cost and NRV should be recorded as obsolescence against inventory. Accounts receivable A provision was taken for uncollectible accounts receivable based on an arbitrary percentage of overall sales (5%). A method based on a percentage unsupported by historical data is not appropriate for GAAP. During the past few years, the total amount of uncollectible accounts receivable has ranged from 3% to 4%, and new credit policies and procedures were implemented in order to diminish losses. Based on this information, a provision of 5% appears too high and should be adjusted down to the 3%–4% range.



Sep12/14

While a general provision is an acceptable method, individual accounts with large balances (and definitely those in excess of materiality) should be analyzed by the client to determine whether the general provision is still adequate in those cases. Accounts with small balances could be provisioned using an average based on percentages of loss experienced after the implementation of the new credit procedures. An adjustment to the allowance, if necessary, should be made. The CICA Handbook-Accounting, Part II, Section 3856 requires that any financial asset measured at cost or amortized cost be assessed for impairment at the end of each reporting period. Accounts receivable is a financial asset which is generally measured at amortized cost and therefore must comply with this requirement. Impairment can be assessed on each individual receivable balance, or on a group of receivable balances. Accounts with large balances (and definitely those in excess of materiality) should be analyzed for impairment individually. Accounts with small balances could be assessed for impairment as a group using an average based on percentages of loss experienced after the implementation of the new credit procedures. If it is determined that impairment exists, the carrying amount of accounts receivable should be adjusted directly through the allowance account, with a related impairment loss recorded in the income statement. The carrying amount should be adjusted to the highest of: The present value of the cash flows expected to be generated by holding the receivable, or

group of receivables. This would be the amount expected to be generated by collecting the receivable in the normal course of business, discounted to present value if collection is expected to take longer than 1 year.

The amount that could be realized by selling the receivable, or group of receivables, at the balance sheet date

The amount that the client expects to realize by exercising its right to any collateral held to secure repayment of the receivable, or group of receivables, net of all costs necessary to exercise those rights. It is doubtful that the client has any collateral rights on its receivable balances, so this value is likely nil.

Capitalization versus expense An accounting issue appears to have arisen based on the expense accounts vouched. Of the three items vouched, two appear to be capital in nature and should have been capitalized rather than expensed. The purchase details provided for these two expenditures suggest they were not for regular repairs (not expected to occur frequently or annually), but rather were for improvements to the existing building, in which case they would be considered betterments. We need to determine through discussion with management if these expenditures enhanced the useful life of the building. If they did, capitalization is appropriate, and these assets should have been depreciated over their useful lives. Bazaar should establish a policy with respect to items that should be capitalized and ensure that it has a system in place to capture all items that should be capitalized. We should ask the client to review the year’s expenses to ensure there are not more items that should be capitalized.



Sep12/14

Materiality of errors It appears that some of the GAAP errors exceed the materiality amount provided by the partner ($250,000) and therefore they would also clearly exceed performance materiality. This would be an important issue for the recruit to document in the audit file because the client would have to be asked to make the necessary adjustments. In fact, per CAS 450, we are required to request management to correct all errors that are not clearly trivial, whether material or not. If management does not adjust all of the errors we request, we must ask those charged with governance to adjust them. In addition, there could be an impact on the audit report if the adjustments are not made.

Assessment Opportunity #4 The candidate understands that conversion controls are inadequate and discusses the IT management letter recommendations the recruit made and failed to make. The candidate demonstrates competence in Assurance (IT).

CPA Mapping: 4.3.6 Develops appropriate procedures based on the identified risk of material misstatement (Elective, Level A)

System Conversion A system conversion took place during the year, and it appears that minimal controls were put in place to ensure the integrity of the data transferred from the old system to the new one. Control totals were used but balances were adjusted, which suggests that data was either lost or corrupted during the transfer. An example of this would be the incomplete addresses mentioned by Bazaar’s clients and the manual adjustments made to balance the sub-ledger and general ledger. Even if the imbalances were described as “slight,” the recruit should check into them because they could be the result of a large number of debits and credits that essentially net themselves out. Individual balances should have been compared electronically between the old system and the new one for each general ledger account as well as for each sub-ledger balance. The controls applied to validate the conversion of the master databases for clients and suppliers were also insufficient. Controlling the total number of records transferred is good, but sampling should have been performed on different types of clients and fields to make sure the data was appropriately transferred from the old system to the new one. This may be the cause of the incomplete or erroneous addresses, which could render the mailings undeliverable or harder to deliver due to postal code errors or incomplete street names, resulting in postal delays. The recruit did not identify these weaknesses, which are critical to the business and, to some extent, the financial statements. They could lead to many underlying problems and cause significant errors, such as overstated or understated account balances. Since the old system is still available, it would be easy to perform spot checks. The text file used for the conversion can also be tested. It would be an excellent occasion to perform CAATs by comparing the contents of both systems and identifying areas of divergence.



Sep12/14

Programming Controls The recruit describes the system and identifies the weakness related to the programmers’ ability to make modifications directly in the production environment. The recruit recommends that this be stopped. This recommendation, although good, is insufficient. The recruit should also recommend that a change request authorization process be instated so that proposed changes would need to be approved before programmers spend time developing and implementing the changes. This would prevent unwanted changes from being developed or initiated. The fact that the changes often frustrate the system’s operators, since they interfere with other components of the system, suggests that no tests are performed on changes prior to implementation. This could lead to serious business disruption and even data loss. The recruit should have mentioned that tests are not an option but rather essential to any change, whether major or minor. The recruit should also have recommended that appropriate approvals be obtained to move changes from the test environment to the production environment to prevent the transfer of changes that are not functional from affecting the production environment. As auditors, we should consider whether the programmers’ ability to make unauthorized changes may be a reason for some of the unusual activity, such as credit notes not being processed correctly. System Controls Inventory As noted by the recruit, manual changes to the inventory price list occurred, which reduced the reliability of the price list. Such changes may have an impact on the business in terms of product pricing because inventory items valued at less (or greater) than their original amounts could affect the gross margin realized on sales. These inventory pricing changes may also be a factor in the rise of cost of sales, which has increased 3% over the previous year. Management letter point: The recruit should have recommended that the computer system only allow inventory pricing changes to be made by authorized employees (for instance, by implementing authorization levels within the computer system), with proper backup. Purchases — PINs As noted by the recruit, a situation occurred in which the assistant authorized a purchase that was over his limit. To do so, he would have had to use the owner’s PIN. This indicates that system controls in place (the use of PINs for approvals over a specified amount) are not functioning as intended. Controls around authorization may have been compromised and improper purchases may have been made, resulting in losses to the company. This may be related to the unexplained increase in the cost of sales that seemed to bother the owner. Management letter point: It should be noted that the PINs used to authorize purchase orders should not be shared among staff. They should be locked away and changed on a regular basis to ensure their security.



Sep12/14

Sales The database used for sales is shared by all representatives. They can modify the sales orders after a deal is concluded with a client, and they can make changes to these orders both before and after shipping occurs. The fact that no authorization is required to modify sales orders, and that no controls seem to be in place to restrict access or changes, causes problems. One of these problems is difficulty reconciling sales orders with clients upon invoicing. Additional controls should be put in place to lock the data once it has been entered into the system. Sales order change request screens should be used to restrict access and track changes. This would allow for proper authorization and verification to be performed before the changes are completed and recorded in the database. We should suggest to the client that they run exception reports for credit note authorizations since there seems to be a lack of control with regards to the authorization of changes to sales orders and the generation of credit notes. Other Control Issues Purchases — PIN override The assistant used the owner’s PIN to authorize a purchase that was over his limit. If no subsequent approval of the PIN override is in place, improper purchases could be made since this would allow the assistant to purchase excess or lower quality goods. To ensure that purchases by the assistant have been approved and are related to legitimate business activities, the recruit should recommend that the owner review and authorize the items purchased upon his return. Cost of goods sold (COGS) The owner was expecting a decrease of 2% in the cost of goods sold, but instead noted an increase of 3%. A portion of this increase may be related to inventory prices that have been manually changed. Since prices can easily be changed, this can lead to improper valuation of inventory and cost of goods sold. The recruit should have recommended that changes to the price list be documented and supported by proper backup. In addition, manual changes to the price list should be approved by authorized employees. No changes to prices within the computer system should occur by unauthorized employees. Discount refunds When customers pay within the discount period, they often make full payments. A system-generated cheque is then issued to refund the discount, often without backup documentation. As a result, it is difficult to determine whether the discount was legitimately refunded to the proper customer or whether something suspicious happened.



Sep12/14

The recruit should have advised management that, in order to ensure that discount refund cheques are appropriately prepared and are legitimate, adequate supporting documentation approving the issuance of the refund cheque should be in place prior to cheque preparation, and the refund should be approved prior to issuance. Credit notes A refund cheque issued for a price adjustment credit made by a sales representative was cancelled, but the details of the refund cheque could not be located. The clerk says he left the cheque copies on his desk and the next morning they were gone, and he is no longer looking for them. The recruit should have emphasized to the client that cheque copies, accompanied by appropriate documentation supporting the issuance of cheques (including authorizations or approvals by a sales manager), should be maintained in a secure location and only available to people authorized to have access to this information. Authorizations and approvals for credit issuances should be noted to ensure that price adjustments are in accordance with agreements or contracts and are prepared for legitimate purposes. The recruit should have included a management letter point stating that copies of cheques, along with their supporting documentation, should be kept locked away at all times to ensure that documentation is kept secure and that items can be subsequently reviewed.

Assessment Opportunity #5 The candidate comes to a conclusion on the work performed by the recruit and recognizes the potential for fraud. The candidate demonstrates competence in Assurance.

CPA Mapping: 4.3.8 Evaluates the evidence and results of analysis (Elective- Level A) 4.3.10 Draws conclusions and communicates results (Elective- Level A)

Conclusion on Work Performed The recruit has done a reasonable job on the individual sections of the audit file in terms of the procedures performed. However, there were some significant flaws in the audit file that should be discussed with the recruit. Inexperience is probably the main contributor to the situation. I recommend that the recruit consult with senior co-workers more often and ask more questions until more experience is gained.



Sep12/14

Planning The recruit failed to take into account important information in deciding the audit approach, neglecting to make connections between the audit approach and the information provided by the client (for example, not taking into account system weaknesses). In addition, the recruit does not seem to have a clear understanding of the different elements of a risk assessment, which is a critical element of auditing. As a result, the recommended audit approach was inappropriate and insufficient audit work was performed. A substantive approach should have been taken, rather than a combined approach. Testing and interpreting results The recruit’s knowledge of sampling methods needs to be improved. In each case where sampling was required, too small of a sample was used and it was random, judgmentally chosen rather than statistically chosen, which means that the samples may not have been representative. In addition, the recruit did not expand the sampling when anomalies were found. The recruit’s variance analysis capabilities appear to also need development. They were weak, and the analysis performed was incomplete. The recruit needs to have a clearer understanding of materiality and what do to when materiality is exceeded based on the audit findings (i.e., tracking adjusted and unadjusted errors). Fraud There is one audit finding that I believe the recruit should have put much more emphasis on in the findings and audit report, and that is the possibility of theft or fraud. Again, a lack of experience may be the reason the issue was not identified as being significant. As explained in CAS 240, although a financial statement audit is not designed to specifically detect fraud, the auditor should still demonstrate professional skepticism when examining information. Suspicious activities took place, yet the recruit did not recognize them as being suspicious and, as a result, did no additional work. In terms of accounts receivable, throughout the results of the audit work the recruit noted two instances that seemed suspicious: the discount refunds and the missing refund cheque. These items (and the fact that the supporting documentation seemed to be nonexistent or had gone astray) may indicate that fraud has occurred. As noted in the review of the audit file, additional work is required to investigate further and to determine whether these issues might have occurred at other points during the year. With respect to the discount refunds and the missing refund cheque, sales representatives may have taken advantage of the ability to change information in the system and made changes to sales contracts in order to obtain payment of the discounts for themselves. It is too early to draw conclusions, but the recruit should have been skeptical of this strange situation.



Sep12/14

Since there were indications in the audit evidence of possible fraud, it is the auditor’s responsibility to do more work. In the case of Bazaar, the owner has also mentioned that he wants to investigate an unexpected increase in costs, specifically related to cost of goods sold and the discounts that he thought were being taken on payments to suppliers, although he seems to be putting off investigating the matter (he says he wants to take a closer look next week). Therefore, more audit work should be performed with regards to the possibility of fraud. The owner has also indicated he wishes to improve certain controls, although he has not identified in which areas. As noted in earlier discussions, there seem to be control weaknesses that have not been addressed. I believe the recruit should have informed the team leader of the situation. Senior staff could then properly assess the risk of fraud and determine the impact on the audit strategy. Had the recruit considered the increased possibility of fraud from the outset — while doing the risk assessment — the fraud risk factors could have been taken into account in the audit testing.

Documents

Computer Bazaar Inc