UNIVERSITY OF WATERLOO

School of Accountancy

Accounting 451 – Audit Strategy

MIDTERM EXAMINATION

Linda A. Robinson
Friday, October 30, 2009 -- 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 5 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 35 42 minutes
2 35 42 minutes
3 30 36 minutes
Total 100 120 minutes

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Question 1 (35%)

Jack Black, CA, has been the partner in charge of the audit of Ace Manufacturing
Company for 13 years. Ace has had excellent growth and profits in the past decade,
primarily as a result of the Ace’s leadership headed up by Peter Ace and other company
executives. Black has always enjoyed a close relationship with the company and prides
himself on having made several constructive comments over the years that have aided in
the success of the company. Several times in the past few years, Black’s CA firm has
considered rotating a different audit team on the engagement, but this has been strongly
resisted by both Black and Ace.

For the first few years of the audit, internal controls were inadequate and the accounting
personnel had inadequate qualifications for their responsibilities. Extensive audit
evidence was required during the audit, and numerous adjusting entries were necessary.
However, because of Black’s constant prodding, internal controls improved gradually and
competent personnel were hired. In recent years, there were normally no adjusting
entries required, and the extent of evidence accumulation was gradually reduced. During
the past three years, Black was able to devote less time to the audit because of the relative
ease of conducting the audit and the cooperation obtained throughout the engagement.

In the current year’s audit, Black decided that the total time budget for the engagement
should be kept approximately the same as in recent years. The senior in charge of the
audit, Eric Leung was new on the job and highly competent, and he had a reputation of
being able to cut time off the budget. The fact that Ace Manufacturing had recently
acquired a new division through merger would probably add to the time, but Leung’s
efficiency would probably compensate for that.

The interim test of controls was somewhat longer than expected because of the use of
several new assistances, a change in the accounting system to computerize the inventory
and other accounting records, a change in accounting personnel, and the existence of a
few more errors in the tests of the system. Neither Black nor Leung was concerned about
the budget deficit, however, because they could easily make up the difference at year-end.

At year-end, Leung assigned the responsibility for inventory to an assistant who also had
not been on the audit before but was competent and extremely fast at his work. Even
though the total value of the inventory increased, he reduced the size of the sample from
that of other years because there had been few errors in the preceding year. He found
several items in the sample that were overstated as a result in errors in pricing and
obsolescence, but the combination of all errors in the sample was immaterial. He
completed the tests in 25% less time than the preceding year. The entire audit was
completed on schedule and in slightly less time than the preceding year. There were only
a few adjusting entries for the year, and only two of them were material. Black was
extremely pleased with the results and wrote a special letter to Leung and the inventory
assistant complimenting them on the audit.

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Six months later, Black received a telephone call from Ace and was informed that the
company was in serious financial trouble. Subsequent investigation revealed that the
inventory had been significantly overstated. The major cause of the misstatement was the
inclusion of obsolete items in inventory (especially in the new division), errors in pricing
as a result of the new computer system, and the inclusion of nonexistent inventory on the
final inventory listing. The new controller had intentionally overstated the inventory to
compensate for the reduction in sales volume from the preceding year.

Required: The partner in-charge of the firm where Black is a partner has asked you to
write a memo to him about this situation. In your memo you should:

a) Discuss the major deficiencies in the audit and state why they took place
(20%)
b) Discuss what things should have been apparent to Black in the conduct of the
audit. (10%)
c) Comment on the likely outcome if Black’s firm is sued by shareholders or
creditors. (5%)

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Question 2 (35 marks)

In 1890, the Brooklyn Trolley Dodgers professional baseball team joined the National
League. Over the following years, the Dodgers would have considerable difficulty
competing with the other baseball teams in the New York City area. Those teams,
principal among them the New York Yankees, were much better financed and generally
stocked with players of higher calibre.

After nearly seven decades of mostly frustration on and off the baseball field, the
Dodgers shocked the sports world by moving to Los Angeles in 1958. Walter O’Malley,
the flamboyant owner of the Dodgers, saw an opportunity to introduce professional
baseball to the rapidly growing population of the West Coast. More important, O’Malley
saw an opportunity to make his team more profitable. As an inducement to the Dodgers,
Los Angeles County purchased a goat farm located in Chavez Ravine, an area two miles
northwest of downtown Lost Angeles, and gave the property to O’Malley for the site of
his new baseball stadium.

Since moving to Los Angeles, the Dodgers have been the envy of the baseball world: “In
everything from profit to stadium maintenance … the Dodgers are the prototype of how a
franchise should be run.” During the 1980s and 1990s, the Dodgers reigned as the most
profitable franchise in baseball with a pre-tax profit margin approaching 25 percent in
many years. In late 1997, Peter O’Malley, Walter O’Malley’s son and the Dodgers’
principal owner, sold the franchise for $350 million to media mogul Rupert Murdoch. A
spokesman for Murdoch complimented the O’Malley family for the longstanding success
of the Dodgers organization: “The O’Malley’s have set a gold standard for franchise
ownership.”

During an interview before he sold the Dodgers, Peter O’Malley attributed the success of
his organization to the experts he had retained in all functional areas: “I don’t have to be
an expert on taxes, split-fingered fastballs, or labour relations with our ushers. That talent
is all available.”

Edward Campos, a long time accountant for the Dodgers was seemingly perfect example
of one of those experts in the Dodgers organization. Campos accepted an entry-level
position with the Dodgers as a young man. By 1986, after almost two decades with the
club he had worked his way up the employment hierarchy to the operations payroll chief.

After taking charge of the Dodgers’ payroll department, Campos designed and
implemented a new payroll system, a system that only he fully understood. In fact,
Campos controlled the system so completely that he personally filled out the weekly
payroll cards for each of the 400 employees of the Dodgers. Campos was known not
only for his work ethic but also for his loyalty to the club and its owners: “The Dodgers
trusted him, and when he was on vacation, he even came back and did the payroll.”

Unfortunately, the Dodgers’ trust in Campos was misplaced. Over a period of several
years, Campos embezzled several hundred thousand dollars from his employer.

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According to court records, Campos padded the Dodgers’ payroll by adding fictitious
employees to various departments in the organization. In addition, Campos routinely
inflated the number of hours worked by several employees and then split the resulting
overpayments 50-50 with those individuals.

The fraudulent scheme came unravelled when an appendicitis struck down Campos,
forcing the Dodgers’ controller to temporarily assume his responsibilities. While
completing the payroll one week, the controller noticed that several employees including
ushers, security guards and ticket sales people, were being paid unusually large amounts.
In some cases, employees earning $7 an hour received weekly pay cheques approaching
$2,000. Following a criminal investigation and the filing of charges against Campos and
his cohorts, all the individuals involved in the payroll fraud confessed.

A state court sentenced Campos to eight years in prison and required him to make
restitution of approximately $132,000 to the Dodgers. Another of the conspirators also
received a prison sentence. The remaining individuals involved in the payroll scheme
made restitution and were placed on probation.

Required:
1. What is your assessment of the control risk associated with the payroll cycle at the
Dodgers and why? [5 marks]
2. Given the control risk determined above what should the auditor’s have done in
response [5 marks]
3. Identify the key audit accounts and the audit objectives associated with a client’s
payroll function. Given the nature of the fraud what should have been the focus
of the auditor’s objectives and why? How do auditors normally test payroll
provide some detail for each account involved? Why might this not work given
the fraud that occurred at the Dodgers? [10 marks]
4. What internal control weaknesses were evident in the Dodgers’ payroll system?
[10 marks]
5. Identify audit procedures that might have led to the discovery of the fraudulent
scheme masterminded by Campos. [5 marks]

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Question 3 (30%):

Sunrise Solar Inc. (SS) is a medium-sized company that is developing solar energy
systems for private residences and small business. It is privately owned, with the
majority of the shares held by the company’s president, Shu Mingfei. Started up two
years ago, to date it is mostly involved in research and development, but this year it
completed its first customer sales and installation. Ms. Shu has engaged your firm to do
the current year’s audit because she plans to obtain $20 million in debt financing from
outside investors to allow further commercialization of the SS systems.

You are now reviewing SS’s preliminary general ledger trial balance in order to begin
preparing the audit planning. The following is a summary of the accounts that appear in
this trial balance as at year end:
Account Balance dr/(cr)
Cash $ 101,209
Accounts receivable 85,019
Allowance for bad debts (15,000)
Inventory, finished goods 900,550
Inventory, work-in-progress 44,666
Inventory, raw material 67,890
Deferred development costs 34,445
Property, plant, and equipment 3,700,990
Accumulated amortization, PPE (901,108)
Patents, at cost 1,010,000
Accounts Payable (198,009)
Warranty provision (30,000)
Shareholder loan, non interest bearing (11,000,000)
Share capital, common shares (1,000)
Retained earnings 1,261,558
Revenue (812,202)
Cost of goods sold 666,502
General and administration expenses 1,002,500
Research and development expenses 3,990,000
Other expenses 89,990

Required:
1) Identify factors that your firm should consider before agreeing to conduct the
audit. [5 marks]
2) What are the economic and industry risks affecting this business? How would
these risks affect the company’s financial statements and your overall audit
strategy? [15 marks]
3) State the dollar amount you would consider an appropriate materiality level for
planning this audit, giving your supporting reasons. [5 marks]
4) List two analytical procedures you could perform using the trial balance data
above (you are not required to calculate any ratios). Explain what each procedure
can tell you about the risks in SS’s financial statements. [5 marks]

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