UNIVERSITY OF WATERLOO
School of Accountancy
Accounting 451 – Audit Strategy
MIDTERM EXAMINATION
Linda A. Robinson
Friday, October 31, 2008 -- 4:30p.m. – 6:30 p.m.
Instructions:
1. Write legibly. Illegible answers will not be graded. Write in pen. No grade
appeals will be considered if you write in pencil.
2. There are 4 questions on 4 pages
3. Ensure that all your statements are supported with an explanation. It is up to you
to provide answers that show you understand what you are saying. The marker
will only mark what is written we will not assume what you mean if you did not
write it. Ask yourself ‘why am I saying this?’ A full answer should support the
why. Full sentences should be used as much as possible.
4. You may have to make assumptions in order to answer certain questions on the
exam: state any assumptions clearly and include them with your answer. Be
careful not to assume away all or part of the question.
Question
Marks
Suggested Time
1
40
48 minutes
2
24
29 minutes
3
20
24 minutes
4
16
19 minutes
100
120 minutes
Total
AFM 451 Fall 2008
page 1 of 4
Question One (42%)
In the audit of Whirlwind Chemical Company, a large publicly traded company, you have
been assigned the responsibility for obtaining background information for the audit.
Your firm is auditing the client for the first time in the current year as a result of a dispute
between WCC and the previous auditors over the valuation of work–in–process inventory
and the inclusion of sales of inventory that had not been delivered but has, for all
practical purposes, been completed and sold.
WCC has been highly successful in its field over the last two decades, primarily because
of a number of successful mergers negotiated by Eric Tam, the President and Chairman
of the Board of Directors. Even though the industry as a whole has suffered dramatic
setbacks in recent years, WCC has continued to prosper, as evidence by its constantly
increasing earnings and growth. Only in the last two years have the company’s profits
turned downwards. Tam has a reputation for having been able to hire an aggressive
group of young executives by the use of relatively low salaries combined with a generous
profit-sharing plan.
The major difficulty you face in the audit is the lack of sophisticated accounting records
for a company the size of WCC. Tam believes that profits come mainly from intelligent
and aggressive action based on forecasts, not by relying on historical data that comes
after the fact. Most of the forecast data are generated by the sales and production
department rather than by the accounting department. The personnel in the accounting
department do seem competent, but somewhat overworked and underpaid relative to
other employees. One of the recent changes that will potentially improve the recordkeeping is a changeover from the old computerized system to a new sophisticated
computer system. All the accounting records are not converted yet, but such major areas
as inventory and sales have been. Much of the new computer time is being reserved for
production and marketing on the grounds that these areas are more essential to operations
and success of WCC than the record-keeping function.
The first six months’ financial statements for the current year include profits of
approximately only 10 percent less than for the six months of the previous year, which is
somewhat surprising considering the reduced sales volume and the disposal of a segment
of the business Atwood Supply Company (ASC). The disposal of this segment was
considered necessary because it had become increasingly unprofitable over the past four
years. ASC was originally acquired from Eric Tam’s brother Ralph Tam. At the time of
the acquisition, ASC was highly profitable and was considered a highly desirable
purchase. The major customer of ASC was Atwood Incorporated (AI) which is still
owned by Ralph Tam. Gradually the market for the products sold by ASC declined as AI
began diversifying and phasing out its primary products in favour of more profitable
business. Even thought AI is no longer buying from ASC, it compensates for it by
buying a large volume of products from WCC.
AFM 451 Fall 2008
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The only major difficulty WCC faces right now, according to financial analysts, is fairly
severe under financing. There is an excessive amount of both current and long-term debt
because of the depressed equity capital market. Management is reluctant to obtain equity
capital at this point because an increase in the number of shares would decrease the
earnings per share even more than 10 percent. At the present time Tam is negotiating
with several cash-rich companies in the hope of being able to merge with them as a
means of overcoming the capital problems.
Required:
Since this is a new audit the partner on the file has asked you for a memo on your
concerns related to the upcoming audit of WCC. Your memo should address for each
concern:
o
Your concerns;
o
Why you have this concerns; and
o
Your recommended approach to investigating each concern.
Question 2 (20%)
Ma & Mann CAs, are the auditors of Lamb’s Toy Store (LTS), a local retail operation.
You are in charge of the audit for the fiscal year ended February 28, 2008. In January
2008 you completed the inventory count and internal control testing. All procedures ran
smoothly and no discrepancies were found. It is now March 22, 2008 and you are about
to begin your year-end audit. The controller, Gina Cooper, is explaining an incident that
occurred before year end.
“We lost control of our microcomputer system temporarily. At noon on February
14, 2008 our computer system shut down. A red heart then appeared on all the
computer screens, with “Happy Valentine’s Day” written under it. This went on
for an hour, after which the computer system started up again.”
“It appears that someone introduced a computer virus into our system that
affected all programs in the network. The virus program was activated by time
and date: noon on Valentine’s Day. Once the program had run its course our
system returned to normal.”
“We have no way of knowing what else this program did. We still don’t know
how this virus got into our system. It could have been entered by one of our
employees playing a joke or by someone breaking into our computer through our
modem access, or the program could have come through one of the purchased
programs we use. We have spent a lot of time and money trying to remove this
program and appear to have succeeded.”
After you explain the virus incident to the audit partner, she asked you to provide her
with a memo discussing the audit implications of this event.
Required:
Prepare the memo to the partner.
AFM 451 Fall 2008
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Question Three (24% 8 marks for each procedure):
Western Canada Meat Processors buys livestock at auction, processes it, and sells it to
supermarkets. Following is a description of their procedures:
1. Each livestock buyer submits a daily report of his purchases to the plant
supervisor. This report shows the dates of purchase and expected delivery, the
vendor, and the number, total mass, and type of livestock purchased. As
shipments are received, any available plant employee counts the number of each
type received and places a check mark beside the quantity on the buyer’s report.
When all shipments listed on the report have been received, the report is returned
to the buyer.
2. Vendors’ invoices are checked for clerical accuracy and are then sent to the buyer
for approval who forwards them to the accounting department. A disbursement
voucher and a cheque for the approved amount are prepared in the accounting
department. Cheques are forwarded to the treasurer for her signature. The
treasure’s office sends the cheque directly to the buyer for delivery to the vendor.
3. Processed carcasses are stored in a refrigerated cooler located in a small building
adjacent to the employee parking lot. The cooler is locked when the plant is not
open, and a company guard is on duty when the employees report for work and
leave at the end of their shift. Supermarket truck drivers wishing to pick up their
orders have been instructed to contact someone in the plant if no one is in the
cooler.
Required:
For each of the parts 1 through 3, identify the weaknesses, if any, in the present internal
control procedures and your suggestions, if any, for improvements. [Be practical with
your suggestions]
Question Four - 16 marks
External critics (judges and peer reviewers) have few grounds for criticizing auditors who
fall victim to sampling risk. Auditors are more open to criticism and fault finding when
erroneous audit decisions result from non-sampling risk. Discuss
AFM 451 Fall 2008
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