Solution Manual for Assurance Practice Set for Comprehensive Assurance & Systems Tool (CAST), 4th Edition

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Solution Manual for Assurance Practice Set for Comprehensive Assurance & Systems Tool (CAST), 4th Edition - Page 1 preview image

Comprehensive Assurance& Systems Tool: AnIntegrated Practice SetFourth EditionLaura R. IngrahamJ. Gregory JenkinsSolutions ManualforAssurance Module

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Assurance - 1INSTRUCTIONAL NOTESCLIENT ACCEPTANCE:The Winery at Chateau AmericanaINSTRUCTIONAL OBJECTIVESUnderstand types of information used to evaluate a prospective audit clientEvaluate background information about an entity and key members of managementBrainstorm relevant financial and non-financial factors related to client acceptancePerform and evaluate preliminary analytical proceduresMake and justify a client acceptance decisionDescribe matters that should be included in an engagement letterKEY FACTSChateau Americana (CA) is a family-owned winery that is currently considering whether to hire anew public accounting firm.Current year sales - $21,945,000; net income - $1,997,000; total assets - $42,029,000.CA operates a 125-acre vineyard which yields one-fourth of the winery’s production needs. CA is amodest winery with annual production of 385,000 cases of wine.The wine industry is a fragmented industry with more than 8,000 wineries in the United States.Most key management positions are held by members of the Summerfield family. The exception tothis rule is Rob Breeden, the CFO.The winery implemented a new accounting information system some fourteen months ago. There hasbeen some employee turnover as a result of the new system.Discussions with the predecessor auditor, William Lawson, revealed no significant disagreementswith management; however, Mr. Lawson indicated that RobBreeden was “more aggressive” than thewinery’s former CFO.

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Ingraham & JenkinsAssurance - 2SUGGESTED SOLUTIONSThe following solutions relate to steps from the audit program that students were asked to complete.1.Brainstorm about and briefly describe financial and non-financial factors that are relevant to thedecision to accept the potential client.Student responses to this requirement will vary. The following is a partial list of the factors that arelikely to be relevant to the firm’s decision.Financial Factors:a.CA has strong and upwardly trending sales and has been profitable for the last three years andbeyond as evidenced by the retained earnings balance.b.Although CA’s current ratio is below the industry average, its AR and Inventory turnovercompare favorably.c.The company’s debt load is lower than the industry average (debt-to-equity ratio for the companyis 0.52 [calculation shown in solution to question 3 below] compared to the industry average of0.99 in the most recent year). The company’s strong sales and earnings have provided sufficientcash to cover debt and interest payments and produce a Times Interest Earned measure above theindustry average (9.41 [calculation shown in solution to question 3 below]compared to 6.91 inthe most recent year).d.CA’s balance sheet appears to be strong with increasing current assets. Much of the increase inthe last yearis in the company’s Investments and Production Inventories balances. In addition,the company has invested more than $2,000,000 in productive assets in the last year.e.Accounts payable have increased by more than 35% since the prior year and long term debt hasincreased slightly.Non-financial Factors:a.The company is considering an initial public offering in the near future.b.The wine industry is a highly fragmented industry that is dominated by a small number of largecompanies such as Ernest & Julio Gallo and Constellation Brands.c.Wine distribution is primarily achieved through supermarket chains and mass merchandisers.Other distribution outlets offer substantially less growth opportunity.d.The wine industry appears to have a bright future and the industry, as a whole, has significantgrowth opportunities in the US. Wine consumption is highest among adults 35-64 years of age,the generation that tends to have the greatest amount of disposable income.e.Significant consolidation has taken place in the wine industry and the trend is likely to continue.f.CA has entered into exclusive distribution agreements with outlets in several large metropolitanareas and is seeking similar opportunities in other areas.g.The Summerfield family owns the winery and members of the family hold most managementpositions.h.Rob Breeden became the winery’s CFO just two years ago after the company’s CFO of morethan 15 years resigned. There are rumors that the resignation was in response to disagreementsbetween the CFO and the president, Edward Summerfield, regarding the need for a new IS.i.The vice-president of winery operations, Jacques Dupuis, was accused of theft of trade secretsform a former employer, but the charges were ultimately dropped due to insufficient evidence.j.CA implemented a new IS some fourteen months ago. The new system is fully integrated withmodules for purchasing and accounts payable, sales and accounts receivable, production andinventory, payroll, and the general ledger. Each of these modules provides data that are critical to

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CAST: Client Acceptance SolutionAssurance - 3the company’s operations. There has been some employee turnover due to continuing problemswith the AP and AR modules.k.Discussions with the predecessor auditor indicate that there were no significant disagreements,but the former partner-in-charge made the comment that Rob Breeden was “more aggressive thanCA’s former CFO.”2.Perform preliminary analytical procedures using the financial statements provided by the client.Calculate ratios for comparison to the industry averages provided.CompanyRatiosIndustry Ratio20XX20XX20XWCurrent Ratio27,076 ÷ 7,082 = 3.823.824.94.7Accounts Receivable Turnover21,945 ÷ [(5,241 + 4,816) ÷ 2] = 4.364.364.424.30Average Days to Collect Accounts Receivable365 ÷ 4.36 = 83.7283.7282.5884.88Inventory Turnover11,543 ÷ [(15,593* + 14,309) ÷ 2] =.77* Includes production and finished goods0.770.670.80Days in Inventory365 ÷ 0.77 = 474474545456Assets to Equity42,029 ÷ 27,718 = 1.521.521.992.14Debt to Equity Ratio14,311÷ 27,718 = 0.520.520.991.14Times Interest Earned3,386 ÷ 360 = 9.419.416.917.29Return on Assets(1,997 + 360) ÷ [(42,029 + 38,322) ÷ 2] = 5.9%5.9 %5.56 %7.61 %Return on Equity1,997 ÷ [(27,718 + 25,721) ÷ 2] = 7.5 %7.5 %5.92 %10.76 %3.Discuss the overall results of the preliminary analytical procedures. Identify relationships or areasthat may be of concern during the audit.Ratios for CA generally compare favorably to industry averages. Certainly the company’s currentratio is below the industry average, but it’s AR and inventory turnover measures compare favorably.In addition, the asset to equity ratio is below the industry average and debt to equity is lower than theindustry average. The company is generating a higher return on profits and equity than the industry.This also bears investigation. Notwithstanding the results from the analytical procedures, areas thatwould generally be treated as significant and requiring more audit effort include accounts receivable,investments, inventory, accounts payable, and long term debt.4.Based on the information obtained do you recommend that the firm accept or not accept thepotential client? Briefly explain the basis for your recommendation.Although there is no correct answer, most CPA firms would accept CA as a client. Student responsesshould include discussion of the financial and non-financial factors identified in response to question

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Ingraham & JenkinsAssurance - 4#1 above. It may also be useful to have a discussion of whether a CPA firm can accept a client suchas CA if they do not possess experience in that client’s industry. Students often believe that CPAfirms cannot accept engagements when they have no related experience, but such is not the case.5.Identify matters that should be included in an engagement letter for this client.Auditors are required to obtain an understanding with their client which should be documented in anaudit engagement letter or other written agreement. The following are matters that should generallybe included in an engagement letter(Refer to “AU-C 210: Terms of Engagement” for more discussionof obtaining an understanding with a client.):The objective and scope of the audit of the financial statementsThe responsibilities of the auditorThe responsibilities of managementA statement that because of the inherent limitations of an audit, together with the inherentlimitations of internal control, an unavoidable risk exists that some material misstatementsmay not be detected, even though the audit is properly planned and performed in accordancewith GAASIdentification of the applicable financial reporting framework for the preparation of thefinancial statementsReference to the expected form and content of any reports to be issued by the auditor and astatement that circumstances may arise in which a report may differ from its expected formand contentEngagement letters may include other matters such as:Elaborationofthescopeoftheaudit,includingreferencetoapplicablelegislation,regulations, GAAS, and ethical and other pronouncements of professional bodies to whichthe auditor adheresThe form of any other communication of results of the audit engagementArrangementsregardingtheplanningandperformanceoftheaudit,includingthecomposition of the audit teamThe expectation that management will provide written representationsThe agreement of management to make available to the auditordraft financial statements andany accompanying other information in time to allow the auditor to complete the audit inaccordance with the proposed timetableThe agreement of management to inform the auditor of events occurring or facts discoveredsubsequent to the date of the financialstatements, of which management may become aware,that mayaffect the financial statementsThe basis on which fees are computed and any billing arrangementsA request for management to acknowledge receipt of the audit engagement letter and to agreeto the terms of the engagement outlined therein, as may be evidenced by their signature onthe engagement letterArrangements concerning the involvement of other auditors and specialists in some aspects ofthe auditArrangements concerning the involvement of internal auditors and other staff of the entityArrangements to be made with the predecessor auditor, if any, in the case of an initial auditAny restriction of the auditor's liability when not prohibitedAny obligations of the auditor to provide audit documentation to other partiesAdditional services to be provided, such as those relating to regulatory requirementsA reference to any further agreements between the auditor and the entity

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Assurance - 5INSTRUCTIONAL NOTESUNDERSTANDING THE BUSINESS ENVIRONMENT:The Winery at Chateau AmericanaINSTRUCTIONAL OBJECTIVESDescribe and document information related to the evaluation of a client’s business environmentDescribe sources of business risks and understand the relationship between business risk and the riskof material misstatements in the financial statementsDescribe the types of information that should be used in assessing the risk of material misstatementsin the financial statementsArticulate the types of questions that may be used to conduct interviews of client personnelKEY FACTSThe winery is a family business with most management positions held by family members.The wine business is highly competitive with almost 8,000 wineries in the U.S.The winery has a relatively stable workforce of 250 permanent employees and is currently operatingbelow capacity.The company’s products are sold in more than 20 states.The company is planning to expand its sales force and increase sales to a level slightly below capacityover the next three to five years.There is an active board of directors comprised of seven individuals–three employees and four non-employees. There are no sub-committees.There is an incentive plan that is available to all employees. Bonuses are based upon companyperformance (e.g., sales, profits, and various production efficiency measures).The company just completed its first full year after implementing a fully integrated accountinginformation system. The chief financial officer believes the system provides accurate and usefulinformation.

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Ingraham & JenkinsAssurance - 6SUGGESTED SOLUTIONS1.Document your assessment of Chateau Americana on each of the following criteria: business andindustry, operations, management and corporate governance system, objectives and strategies, andperformance measurement system.Many students will tend to want to focus on an evaluation of the company’s accounting system andwill fail to understand the importance ofunderstanding the company’s business environment.Instructors may wish to motivate this particular requirement by asking students to discuss the meansby which a company might respond to various external business forces (e.g., competition, laborshortages, general economic conditions, investor expectations) and the impact that such actions canhave on accounting decisions and choices. These criteria are based upon those discussed included in“AU-C 315: Understanding the Entity and its Environment and Assessing the Risks of MaterialMisstatement.”The following is a partial list of issues that students may discuss for each of the dimensions:Industry, regulatory and other external factorsa.The winery is a typical family business with many management positions held by familymembers.b.Edward Summerfield, the winery’s president, founded the winery in 1980 following a long careerin the wine industry.c.The wine business is highly competitive with some 8,000 wineries in the U.S.d.The company is located in California, home to almost half of all domestic wineries. This locationgives the company reasonable access to a talented labor pool.e.While there is a trend toward consolidation, the Summerfield family does not intend to sell thecompany.Nature of the entitya.The winery has a stable work force of 250 permanent employees. Temporary employees are hiredas needed to assist with the harvest each year.b.The winery’s current production level is below capacity such that unexpected demand can beaccommodated given sufficient lead time.c.The company currently sells its wine in more than 20 states.d.The board of directors (BOD) has seven total members - three employees and four non-employees. Employee members are Taylor Summerfield and Rob Breeden. The non-employeemembers are Edward Summerfield’s wife Charlotte, Bill Jameson, and Susan Martinez, andTerrence Dillard. Bill and Susan are local business owners and Terrence is an attorney.e.The BOD generally meets for two to three hours four times a year. There are no subcommittees(e.g., audit committee, compensation committee, etc.).f.Management appears to be competent and each individual has relevant and substantial outsidebusiness experience.g.Management has no intentions of selling the company. The owners/managers rely on thecompany for their livelihood.Objectives and Strategiesa.The winery plans to increase its sales force and to increase and sustain production at a levelslightly below capacity within the next three to five years. Planned annual sales growth is eight toten percent.

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CAST: Understanding the Business Environment SolutionAssurance - 7b.The company currently has several exclusive agreements with distributors in several largemetropolitan areas. Management plans to pursue similar agreements with distributors in otherareas in the near future.c.The advertising and marketing budget appear to be sufficient. The vice president of marketingexpects to increase the budget by 10 to 20 percent in the near future.d.The company is very conscious of its reliance on single customers. Consequently, no singlecustomer represents more than five percent of annual sales.e.The company’s president noted that the company has excess production capacity of 80,000 casesper year, but the company’s vice-president of winery operations stated that excess capacity wasjust 20,000 to 30,000 cases. This difference should be resolved and its implications understood.Measurementand review of the entity’s financial performancea.The winery recently implemented a new, fully integrated accounting information system. Thechief financial officer believes that the new accounting information system provides higherquality information than the old system.b.The sales force is compensated through a salary and sales-based commission plan. All othercompany employees receive annual bonuses based on the company’s overall performance.c.The company considers operating effectiveness and efficiency measures to determine the bonusamounts.2.Document your assessment of Chateau Americana’s control environment.Students should document their assessment based upon the control environments outlinedin “AU-C315:UnderstandingtheEntityanditsEnvironmentandAssessingtheRisksofMaterialMisstatement.”Thesefactorsareintegrityandethicalvalues,commitmenttocompetence,participation by those charged with governance, management’s philosophyand operating style,organizational structure, assignment of authority and responsibility, and human resource policies andpractices.Chateau Americana measures-up reasonably well on each of these factors. Based on the interviewsthe management group appears to be committed to honesty and hard work and also to rewarding theseattributes. Employees are encouraged to maintain their competence levels and the company has areimbursement policy which allows employees to continue to maintain their education and skilllevels. The company has a board of directors comprised of three employee directors and four non-employee directors (although one of these individuals, Charlotte Summerfield, is the wife of thepresident). The company does not have an audit committee, but does appear to be reasonably active.Based on the available evidence the board appears to be filled with competent directors.The management group is committed to open communications with employees and maintains an“open door” policy. There has been little employee turnover over the years which suggests that thisapproach is successful at maintaining employee morale. The company’s organizational structure istypical of a small, privately-owned business. The president appears to respect the opinions of othermembers of management and there does not appear to be a great deal of domination by a singleperson. While there is no explicit description of the company’s policies regarding assignment ofauthority and responsibility, the interview transcripts suggest that management employees understandtheir functions and are vested with the appropriate authority. The company seems to be committed toits employees and takes actions to reduce turnover and maintain their skills.The final requirement asks students to make an overall assessment of the control environment. Thereis no single answer to the question; rather, students’ memos should support their assessments which

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Ingraham & JenkinsAssurance - 8should be generally favorable. Instructors may wish to slightly modify this requirement by askingstudents to weight the seven underlying factors so that they gain an appreciation for the relativeimportance among the factors.3.Identify and discuss factors affecting Chateau Americana’s business risk. For each of the factors,indicate the client’s business objective that is put at risk.Student responses will likely differ as students may be less confident in their ability to identifybusiness risks and the related at-risk business objectives. The following is a partial list of factors andthe related at-risk business objectives:a.Wine consumption (i.e., sales)may decrease due to a deterioration in generaleconomicconditions–Increasing sales and profitsb.A poor-quality or lower than expected harvest could have negative consequences for the winery’sproduction and reputation–Future sales growthc.Consolidation within the industry could put pressure on the company’s ability to competitivelyprice its wines–Growth in market share and sustained sales and profitsd.General economic conditions could lead to higher than expected bad debts–Cash managementstrategies may be ineffective at maintaining necessary liquiditye.Unforeseen events (fire, flooding, freezing, etc.) may destroy or severely damage the winery’svineyard or their suppliers’ vineyards –Sustained productionf.The company’s new accounting information system may provide erroneous data to management–Numerous business objectives may be put at risk including cash management, accountsreceivable collection activities, inventory management, and vendor paymentsg.A limited number of interested and qualified family members may give rise to managementsuccession problems–Management succession is a significant issue in many companies, butespecially in family owned businesses. If management succession and transition are not properlyaddressed a company can suffer from a host of operational and strategic difficulties.4.Based on your knowledge of Chateau American, what accounts are likely to have a lower risk ofmaterial misstatement and what accounts are likely to have higher risk of material misstatement?NOTE: You may wish to ask students to begin by explaining the relationship between business riskand the risk of material misstatement in the financial statements. Responses may follow along theselines: Business risk represents the risk that a company will fail to achieve its objectives due tointernal and/or external factors. The auditor should be concerned that management will respond toincreasedbusinessrisksbypursuingoperationalplansthatmightbeineffectiveorutilizingaccounting practices that may be inappropriate. If management is unsuccessful in responding tobusiness risks, there may be increased incentives to select accounting treatments that provide adesired outcome. Such pressures are greatest when the company reports results to outside parties suchas stockholders and creditors.Students may have difficulty with this question. Nonetheless, the question is intended to encouragestudents to think carefully about how an auditor goes about making such an assessment. Thesuggested solution is based upon a typical audit environment with reasonably strong controls.Changes in the auditor’s assessment of the components of the audit risk model would influence thefollowing discussion. Accounts that are likely to have a lower risk of material misstatement include:Cash, Investments, Notes payable, and Long-term debt. Cash is generally considered to have highinherent risk; however, because the year-end balance can be confirmed with an outside party, there isa lower risk of material misstatement. The Investments, Notes payable and Long term debt accounts

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CAST: Understanding the Business Environment SolutionAssurance - 9are also easy to confirm with outside parties and so there is a lower risk of material misstatement forthese accounts as well. Accounts that may have a higher risk of material misstatement include:Accounts receivable, Inventories, and Accounts payable and accrued expenses. Accounts receivableand Inventories require management to exercise considerable judgment in estimating bad debts andassessing inventory obsolescence. These types of judgments are subjective and may result inmisstatements to either account. Accounts payable and accrued expenses also have a higher risk ofmaterial misstatement due to their nature and the volume of transactions. Of particular concern withliabilityaccountsistheissueof“completeness.”

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Assurance - 10INSTRUCTIONAL NOTESIDENTIFICATION OF AUDIT TESTSFOR THE EXPENDITURE CYCLE (ACQUISITIONSAND CASH DISBURSEMENTS):The Winery at Chateau AmericanaINSTRUCTIONAL OBJECTIVESRecognize common business documents used with purchases and cash disbursementsRecognize common control activities used to process purchases and cash disbursementsIdentify control activities that reduce the likelihood of material misstatements and link the activities tomanagement assertionsDesign tests of controls for control activities related to purchases and cash disbursementsDesign substantive tests of transactions to detect material misstatements for non-payroll accounts in theexpenditure cycleDesign analytical tests to detect potential material misstatements for non-payroll accounts in theexpenditure cycleDesign substantive tests of balances to detect material misstatements for accounts payableLink tests of controls and substantive tests to management assertions related to purchases, cashpayments, and accounts payableIdentify significant deficiencies and material weaknesses for non-payroll expenditure cycle accountsKEY FACTSThe audit manager, Mikel Frucella, reviewed CA’s control environment, risk assessment policies, andmonitoring system and assessed them as strong.The audit staff, Julia Granger, reviewed CA's policies and procedures related to purchases and cashdisbursements and prepared the flowcharts on audit schedulesE-110, E111,andE-112.Processes not documented in the flowcharts are as follows:Purchase returns and allowances are recorded in the purchases journal,Purchase discounts are recorded in the cash disbursements journal,Other expenditure cycle adjustments are recorded in the general journal and require preparationof a pre-numbered adjustment memo.Documents and records used to record purchase transactions include a purchase requisition, purchaseorder, receiving report, vendor invoice, standardized chart of accounts, purchases journal, vendorledgers file, and general ledger.Documents and records used with respect to cash disbursement transactions include a voucher cover,signed check, bank statement, standardized chart of accounts, cash disbursements journal, vendorledgers file, and general ledger.

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CAST: Identification of Audit Tests SolutionAssurance - 11Receiving reports are only generated for production and PP&E purchases.Purchase orders are not generated for recurring services, such as utilities.SUGGESTED SOLUTIONComplete steps 5 through 8 in the Expenditure Cycle Planning Audit Program (audit schedule E-100) anddocument your work on audit schedules E-100, E-120, E-121, E-130, E-140, E-141, E-150, E-151, E-160,E-161, E-170, and E-171. Julia Granger has already completed steps 1 through 4 and has documentedthe results of her work on audit schedules E-100, E-110, E-111, and E-112. Assume that the clientperforms the control activities identified in the flowcharts.A solution to the assignment is provided using schedules similar to the schedules provided to students onthe pages that follow. Again, due to the subjective nature of some of the judgments alternative solutionscould be considered equally acceptable. Note that the solution lists potential audit tests that could beperformed. It is very unlikely that an auditor would decide to perform all these audit tests. Additionally,the solution does not indicate whether the audit test should be performed on the entire population or asample of the population.

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Ingraham & JenkinsAssurance - 12The Winery at Chateau AmericanaReference:E-100Expenditure Cycle Planning Audit PlanPrepared by:JG (initial)Date:(date)11/12/XXFor the Year Ended December 31, 20XXReviewed by:Audit ProceduresInitialDateA/S Ref.1.Obtain and study a copy of the client's policiesand procedures manuals related to purchases andcash disbursements.JG11/12/XXN/A2.Discuss with and observe client personnelperforming control activities related to purchasesand cash disbursements.JG11/12/XXN/A3.Perform a walk-through of the client's policiesand procedures related to purchases and cashdisbursements.JG11/12/XXN/A4.Obtain or prepare a flowchart for purchases andcash disbursements showing control activities,document flows, and records.JG11/12/XXE-110E-111E-1125.Document client control activities that reduce thelikelihood of material misstatements formanagement assertions related to purchases andcash disbursements.(initial)(date)E-120E-1216.Document potential internal control deficiencies.(initial)(date)E-1307.Use the planning audit test matrices to listpotential tests of controls related to purchases andcash disbursements.(initial)(date)E-140E-1418.Use the planning audit test matrices to identifypotentiala.Substantive tests of transactions,(initial)(date)E-150E-151b.Analytical tests, and(initial)(date)E-160E-161c.Tests of balances related to non-payrollexpenditure cycle accounts.(initial)(date)E-170E-171

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CAST: Identification of Audit Tests SolutionAssurance - 13The Winery at Chateau AmericanaReference:E-120Expenditure Cycle–Purchases Control ActivitiesPrepared by:(initial)MatrixDate:(date)For the Year Ended December 31, 20XXReviewed by:Control ActivitiesExistenceRights andObligationsValuationPresentationand DisclosureCompleteness1)Purchasingsupervisor reviews and signs allpurchase orders.XX2)Receiving department counts and inspects productionand PP&E items and compares to purchase order.XXX3)Receiving department prepares a pre-numberedreceiving report for production and PP&E purchases.X4)Vendor invoices are recomputed and matched toreceiving report and purchase order.XX5)Vendor invoices for non-production and non-PP&E itemsare routed to department purchasing item foracceptance and approval.XX6)Purchases journal, vendor ledgers, inventory file, andG/L are automatically updated when vendor invoice isinput by accounting.X7)Accounting supervisor reviews purchases journal forproper account classification of purchases.XXXIdentify the management assertion(s) affected by each control activity with an "X."

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Ingraham & JenkinsAssurance - 14The Winery at Chateau AmericanaReference:E-121Expenditure Cycle–Cash Disbursements ControlPrepared by:(initial)Activities MatrixDate:(date)For the Year Ended December 31, 20XXReviewed by:Control ActivitiesExistenceRights andObligationsValuationPresentationand DisclosureCompleteness1)Cash disbursements journal, vendor ledgers, and G/Lare automatically updated when accounting printschecks.X2)Accounting supervisor reviews voucher packages forreasonableness and proper account classification andinitials voucher cover.XXXX3)CFO reviews voucher packages for reasonableness, signschecks, and stamps documents included in voucherpackage “Paid.”XXX4)Cash checking account is reconciled monthly by theexecutive secretary and reviewed by CEO.XXXIdentify the management assertion(s) affected by each control activity with an "X."

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