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design consultant to create the sales system because the com- pany’s IT personnel lack the necessary experience.
Customers use the link to the inventory parts listing on the website to view product descriptions and prices. The inventory parts listing is updated weekly. To get the system online quickly, management decided not to link the order system to the sales and inventory accounting systems. Cus- tomers submit orders for products through the online system and provide credit card information for payment. Each day, accounting department clerks print submitted orders from the online system. After credit authorization is verified with the credit card agency, the accounting department enters the sale into the sales system. After that, the accounting depart- ment sends a copy of the order to warehouse personnel who process the shipment. The inventory system is updated on the basis of bills of lading information forwarded to account- ing after shipment.
Customers may return parts for a full refund within 30 days of submitting the order online. The company agrees to refund shipping costs incurred by the customer for returned goods.
REQUIRED
a. Describe deficiencies in Parts for Wheels’ online sales system that may lead to material misstatements in the financial statements. Identify which audit assertion is affected.
b. For each deficiency listed in Part (a), identify changes in manual procedures that could be made to minimize risks, without having to reprogram the current online system.
c. Describe potential customer concerns about doing busi- ness online with Parts for Wheels. For each concern, provide one or more controls that could be imple- mented to address the concerns.
12-45 4 6 You are the audit senior for the 2020 year-end audit of Vision Quest (VQ), a publicly traded Canadian com- pany that is one of the largest and fastest online vision care pro- viders in the world. Because of the efficiencies of the internet to bypass middlemen, VQ has a significant competitive advan- tage in its market. You are responsible for auditing the revenue cycle. Performance materiality for the VQ audit is $100 000.
VQ’s year-end is October 31, 2020.
Below is a summary of key information regarding the rev- enue cycle:
Revenue Recognition Policy—Revenue from product sales is recognized when the product has been shipped to the customer. At that point, the amount of sales revenue is deter- minable, no significant vendor obligations remain, and the collection of the revenue is reasonably assured. A provision is made for product returns. Revenue collected in advance of the product being shipped is deferred.
Audit Strategy for Revenue—The audit strategy relies upon tests of controls (including substantive tests of trans- actions) and substantive analytical procedures. No accounts receivable confirmations are sent out. Your audit team has tested controls related to revenue transactions and concluded that controls are effective and support the control risk assess- ment of low for the revenue transaction-related assertions.
Change in Credit Policy—When reviewing the accounts, you noted that a new account, allowance for doubtful
accounts, has been set up. Upon investigation, you find that in February 2020, VQ implemented a program where the majority of customers were granted credit. VQ developed this program to attract new customers who might be wary of order- ing contact lenses from an online retailer and having to pay for them prior to receiving them. The company’s program, named “Invoice Me Later” or “the IML program,” allows cus- tomers to order from VQ and pay after receiving the product.
Management estimates payment should generally be received in less than 15 days.
Estimate for Allowance for Doubtful Accounts—The majority of the balances outstanding are less than $150 and there are a large number of records. Management estimates an allowance based upon the aging of the receivable port- folio. Below is a summary of the aging and management’s estimate for the allowance for doubtful accounts.
Aging of Accounts Receivable 2020 2019
Current $7 714 000 $6 695 000
Aged 60–120 days 88 000 nil
Aged greater than 120 days 66 000 nil
Total receivables 7 868 000 6 695 000
Allowance for doubtful accounts 135 000 nil
Net receivables $7 733 000 $6 695 000
REQUIRED
a. Explain the impact of the IML program on your audit approach for the revenue cycle of VQ. (Use the audit risk model and assertions to support your analysis.) b. Do you agree with the auditors’ decision not to send out
accounts receivable confirmations? Why or why not?
c. If the auditors planned to send out accounts receivable confirmations, what type of confirmations would you recommend? Explain why.
12-46 6 Sylvie Beaubien is the engagement manager for the audit of Terra Enterprises. Sylvie is currently planning tests of details of balances for accounts receivable and is considering the use of electronic confirmation requests to improve response rates. The historical response rate to writ- ten confirmation requests sent to Terra’s customers has been below 50 percent and Sylvie believes they can increase that to over 80 percent using electronic requests. Sylvie is consid- ering two different options. The first option is to use email confirmation requests, with requests emailed directly to cus- tomers and the customers emailing responses directly to the audit firm. The second option is to use direct access to cus- tomers’ electronic records through website links for Terra’s largest customers, and then written requests to the remaining customers.
REQUIRED
a. What factors does Sylvie need to consider in deciding whether to use written confirmation requests, email requests, or direct access to electronic records?
b. How will the audit firm ensure the reliability of the responses? For example, how might they verify the email addresses or the reliability of the electronic records?
Who should provide the email addresses for the email confirmations, or the website links for direct access to electronic records?
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457 12-47 6 You are the audit senior on the audit of Great East-
ern Hotel (GEH). This two-star hotel is located in a major coastal city and as such is prone to seasonal fluctuations. The 200-room hotel is open year round with a standard room rate of $90 per night. GEH charges $95 per room in the summer and $85 per room in the winter, the same as the prior year. The hotel includes a bar and restaurant as well as underground parking.
From the audit work performed to date, you are sat- isfied that GEH has well-established controls. You there- fore decide to place reliance on these controls and for the most part use only substantive analytical procedures to test revenue (summarized below). You are satisfied that this approach will provide you with sufficient assurance on hotel room revenue.
So far, you have obtained a breakdown of room rental revenue by quarter and gathered some statistics on occupancy rates from the local tourist board.
Great Eastern Hotels Statement of Income for the Year Ended December 31
Revenue: 2020 (unaudited) 2019 (audited)
Hotel Room Rental $5 535 617 $5 165 176
Food & Beverage 1 497 612 1 488 619
Parking, Telephone, Other 417 602 396 158
Interest 56 711 58 610
$7 507 542 $7 108 563 Expenses:
Direct Costs:
Hotel Room Rental 3 165 992 3 105 644
Food & Beverage 1 388 691 1 452 107
Other 389 917 365 223
$4 944 600 $4 922 974
Gross Margin $2 462 942 $2 185 589
General & Administration 1 617 532 1 574 805 Advertising & Promotion 364 817 349 576
Other 216 911 166 978
$2 199 260 $2 091 359
Net Income Before Tax $ 163 682 $ 94 230
Income Tax Expense 26 754 40 519
Net Income $ 136 928 $ 52 711
2020 Breakdown of Room Revenue by Quarter ($000s)
Q1 Q2 Q3 Q4
Hotel Room Rental 1 193 1 445 1 471 1 427
2020 Hotel Occupancy Rates
Q1 Q2 Q3 Q4
Summer Fall Winter Spring
First Class 77% 75% 86% 71%
Two Star 76% 70% 84% 71%
Third Rate 69% 74% 78% 60%
REQUIRED
a. Comment on the quality of information you have obtained so far, considering its source, audit assertions, and level of detail in your discussion.
b. What additional analytical procedures would you be required to perform in order to ensure the degree of precision necessary to provide adequate assurance for hotel room revenue?
c. Develop an expectation of GEH’s rental revenue. Based upon this analysis, provide your conclusion on GEH’s 2020 hotel revenue.
d. Based on your analysis and conclusion in Part (b), describe what further inquiries you would make of GEH management and corroborating evidence you would request. Tie your discussion to specific audit assertion(s) you are concerned with.
e. Despite the well-established controls at GEH and your decision to place reliance on them, is it appropriate to use only substantive analytical procedures to gain assur- ance over revenue accounts? Explain why.
12-48 2 6 Biomed Products Incorporated (BPI) is a public company, listed on the Toronto Stock Exchange (TSX), that manufactures and markets various types of medical equipment that monitors patients’ vital signs (i.e., heart rate, breathing, blood pressure). BPI has been audited by Cooper & Zhang, a large public accounting firm, since its inception 10 years ago.
You are the audit senior responsible for the March 2020 year- end audit. Within the next day or two, you will be meeting with the audit manager to go over significant accounting and audit issues regarding the revenue cycle.
Excerpts from the income statement for the first nine months of the current fiscal year and the previous two years are below:
Biomed Products Incorporated Income Statement Excerpts (in thousands of dollars)
9 months ended Decem-
ber 31, 2020 (unaudited)
Year Ended March 31, 2019 (audited)
Year Ended March 31,
2020 (audited)
Equipment sales $31 250 $47 500 $49 000
Cost of sales 12 500 19 500 19 000
Gross profit 18 750 28 000 30 000
Expenses 10 250 17 250 18 000
Interest 4 200 4 200 4 200
General and
administration 3 200 4 500 4 700
Amortization 2 500 3 700 4 200
Warranty provi-
sion 2 500 1 500 1 500
Net loss (3 900) (3 150) (2 600)
Over the past week, you have been updating the preliminary planning related to the revenue cycle, visiting BPI’s premises, and interviewing the client staff. Your notes are summarized below.
1. The preliminary materiality is based upon revenue and overall materiality is set at $250 000. Performance mate- riality is $200 000. Due to each hospital contract being unique, inherent risk for revenue recognition is high;
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458
however, controls have been effective; therefore, risk of material misstatement is set at moderate.
2. Cooper & Zhang have relied upon internal controls in past audits. The internal control environment is strong.
The staff members in the accounting area are compe- tent and there is adequate segregation of duties. Based upon your update and testing of the systems, no changes have occurred in the accounting area. However, your documentation of the processing of revenue reveals that BPI has begun to expand into foreign countries through distributor agreements. This is different from its usual cus- tomer base of Canadian hospitals. Your preliminary dis- cussions with the VP sales reveal that initial contacts with the distributors are made through foreign trade shows.
He notes that before signing a deal, BPI does background and credit checks on the companies. However, the quality of information received varies by country.
3. Your review of foreign revenue reveals that BPI has entered into a distribution agreement with a Russian distributor for a five-year period commencing June 2020. BPI is quite excited about the agreement because the opportunities in Russia are vast—a significant por- tion of hospital medical equipment is worn and needs replacement. BPI believes this agreement has phenom- enal prospects because the distributor is established and knows which hospitals are refurbishing and have money.
As part of the agreement, the distributor has paid BPI an up-front and nonrefundable fee of $250 000. BPI has recorded the fee as part of its current revenue. As part of normal Russian business practice, the distributor pays the individual hospital administrator a commission for agreeing to purchase BPI products. Each month, the distributor will submit a list of individuals who have received the commission and BPI will reimburse the distributor the amount. Although no hospital sales have been finalized, the distributor has the promise of three separate administrators and has paid them each a com- mission of $5 000. The distributor has requested that BPI reimburse it the $15 000.
4. In late August, BPI shipped 500 units (at a sale price of $650 per unit and a cost of $400 per unit) to the distributor so that the distributor may have stock on hand. BPI has recorded this shipment as a sale because part of the agreement is that the distributor pays for all goods received. You note that the Russian distributor balance is still outstanding as of December 31, 2020.
The VP sales is not concerned because it is normal for BPI customers to pay anywhere between 30 and 60 days after receiving the invoice.
REQUIRED
a. Explain how the expansion of BPI to foreign markets impacts inherent risk in the revenue cycle. Do you think it is a significant risk? Explain why.
b. Do you think the current audit approach is appropriate for the new foreign contract? Explain why or why not.
c. Explain the audit implications of the up-front commis- sion payable to the Russian hospital administrators.
12-49 2 6 It is October 21, 2020, and you, an audit manager at E&N LLP, are in charge of reviewing the audit
engagement file of Eye in the Sky Inc., which has a year-end of July 31, 2020. Today you will be reviewing audit work per- formed by your colleague Peter on Eye’s revenue section. Peter has been with E&N LLP for almost two years. He recently passed the CFE and this was his first time working on such a large and complex audit section.
Company Background
Eye is a privately controlled Canadian company that uses specialized drone technology to offer aerial imagery services for surveying and monitoring mining sites. The company also sells high-end specialized drones that customers can buy and use themselves. Most of Eye’s customers are located in Africa and South America, where many new mines are currently under development.
Revenue—Significant Risks
Per the draft financial statements, total revenue for the year was $4 500 000. During planning, occurrence and cutoff of revenue and valuation of accounts receivable were identified as significant risks.
Completed Audit Work
1. On July 1, 2020, Big Dig, a mining company operating in Tajikistan, placed an order for 15 specialized drones equipped with infrared monitoring cameras. Each drone sells for about $75 000. The company was planning to use the drones to monitor its mines at night. Eye shipped the drones to Tajikistan on July 14, and they arrived in Dushanbe (capital city of Tajikistan) on July 25. The plan was to deliver the drones the next day to Big Dig’s location in the Pamir Mountains. However, due to heavy rains, the road through the mountains were flooded and the drones couldn’t be delivered until August 4, 2020. Eye recognized revenue related to this sale when the drones landed in Dushanbe.
As part of verifying cutoff of revenue, Peter wrote an email to Eye’s sales manager asking him to confirm the date the drones were delivered to Big Dig. The manager replied that the drones were delivered on August 4. In his reply, the manager also wrote that he is currently away on a three-week vacation in Europe, but that from what he remembers the delivery term in the contract was FOB shipping point.
2. On July 29, Eye transferred an encrypted video file, containing surveillance images of potential mining sites, to one of its customers in Zimbabwe. For this work, Eye billed the customer $150 000. The customer wasn’t able to open or use the file because Eye used an encryp- tion key not compatible with the customer’s computer system. After the customer reported the problem, Eye reformatted the file and sent it back on August 2, 2020.
As part of verifying the occurrence and cutoff of revenue, Peter obtained the contract related to this transaction and matched contract details such as price and customer information to the invoice. Peter also matched the invoice total of $150 000 to a deposit in Eye’s September bank statement, as the customer had already paid for these services.
3. On June 25, Eye completed a mine surveying con- tract for a client operating in the El Caura region in
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459 Venezuela. Eye invoiced the customer $20 000 for the
work. Due to strict Venezuelan banking rules enforced by President Maduro’s government, payment to foreign companies that conduct work in Venezuela can only be made in local currency, the Venezuelan bolivar. Money transfers in Venezuelan bolivar and conversion of the bolivar into other currencies fall under international anti-money laundering rules governed by the Interna- tional Monetary Fund (IMF). In the course of their investigations, the IMF places a 90-day freeze on all international currency conversions and transfers of the bolivar, only releasing the funds to the recipient after the 90-day freeze elapses.
Due to an unstable political situation and the COVID-19 pandemic, Venezuela’s inflation rate in 2020 is estimated to have reached 1640 percent. This has had a significant effect on the exchange rate between the Venezuelan bolivar and the Canadian dollar.
As part of verifying the existence and valuation of accounts receivable, Peter sent a confirmation letter to the IMF to confirm the amount of funds subject to the 90-day freeze. The IMF responded back saying that it had 1 500 000 bolivars and that it will approve the con- version and transfer of the funds to Eye on
September 23, 2018.
4. In March 2020, a company operating mines in Peru ordered 11 drones from Eye with an upgraded long-last- ing battery. The battery can extend flight times between recharges by up to 50 percent. Eye shipped the drones in April 2020, but unfortunately five of the shipped drones were not equipped with the upgraded battery. In June 2020, the mining company sent the drones on a long-distance flight and the five deficient drones ran out of power and crashed in a remote mountainous region of Peru. The customer immediately informed Eye about the crash. In July 2020, Eye uncovered the shipping mistake through an internal investigation and issued a
$95 000 refund to the customer the next month.
As part of verifying the occurrence and cutoff of revenue, Peter obtained Eye’s August 2020 bank state- ment and searched for the refunded amount. He then vouched the amount to the credit note and the original contract.
5. In February 2020, Eye was hired by the King of Swaziland, Mswati III, to conduct drone surveillance of opposition group members. The King feared these members were trying to destabilize the country and overthrow him. A dispute arose when, having shipped too few drones to Swaziland, Eye was not able to carry out the surveillance to the extent that it promised to the King. The King now refuses to pay $300 000 for the work that Eye performed.
Despite the dispute, the King really liked Eye’s drones and bought five of them for $375 000. Eye deliv- ered the drones to the King in June 2020, and he paid for them in September 2018.
As part of verifying the existence and valuation of accounts receivable, Peter sent a confirmation letter to the King of Swaziland in early October. After waiting over two weeks for a response, Peter contacted the King’s
representative. The representative told him that the confirmation has been received; however, everyone is on a one-month holiday celebrating King Mswati III’s birth- day, and the confirmation won’t be processed until late November. Peter couldn’t wait that long, so he tested the existence and valuation of accounts receivable through an alternative procedure, looking at payments made by the King subsequent to year-end. After finding the
$375 000 payment on the September 2020 bank state- ment, Peter concluded that the entire $675 000 accounts receivable balance was stated correctly at year-end.
REQUIRED
a. Review the audit work performed by Peter. For each of the five audit issues, discuss if the evidence he obtained is reliable and if his work related to the stated assertion.
b. Where applicable, suggest more reliable evidence that Peter should obtain and, if his work did not relate to the stated assertion, propose additional audit procedures.
12-50 2 You are the auditor in charge of the financial state- ment audit of Pirouette Systems Inc. Limited (PSI) for the year ended September 30, 2020. PS1, a private company formed in 1995, manufactures and sells components for computers, including screens and printers. PS1 provides components to a variety of big name computer manufacturers all around the world. It is now November 2020. The following are highlights regarding PSI’s revenue cycle:
1. PS1’s main competition consists of foreign manufactur- ing and a very successful multinational conglomerate that has excellent customer recognition, including a distribution network.
2. PS1’s net income has fallen in recent years because it lost several large sales contracts to provide inkjet print- ers. PS1 is expecting that its new production methods for laser printers, which are increasing in popularity, will lead to recovery. However, to date, PS1 has not secured any new significant sales contracts for laser printers.
Revenue and sales information for PS1’s last five years are as follows:
Year Revenues Net Income (Loss)
Before Income Taxes 2020 (unaudited) $ 13 000 000 $ 300 000
2019 25 000 000 3 200 000
2018 57 000 000 5 900 000
2017 69 000 000 6 400 000
2016 53 000 000 (700 000)
3. During fiscal 2019 the President of PS1 authorized a change in credit policies. Previously, customers were granted credit based upon the credit ratings developed by PS1’s credit manager, which took into account the outstanding balance of the customer’s account and an analysis of its financial condition. Due to the recent financial difficulties in the technology sector, the President decided that PS1 must use a more lenient credit policy to keep sales flowing. Accordingly, as a cost cutting measure, the credit manager was laid off in December 2019, and the President now evaluates each