Question

You are auditing the financial statements of the ATLAS Company, a small manufacturing firm that has been your client for many years. Because you were busy working on another engagement, you sent a second-year accountant to begin the audit, with the suggestion that he start with accounts receivable.

Using the prior year’s working papers as a guide, the auditor prepared a trial balance of the accounts, aged them, prepared and mailed positive confirmation requests, examined underlying support for charges and credits, and performed other work he considered necessary to obtain evidence about the validity and collectability of the receivables. At the conclusion of his work, you reviewed the working papers he prepared and found he had carefully followed the prior year’s working papers.

ATLAS Company acquired the assets of another corporation during the year, so the nature and quality of its accounts receivable have changed. It has many more small accounts, as well as three larger international clients involving foreign exchange sales transactions. Sales have gone up substantially, and the accounts receivable balance has doubled. Two of the international accounts are over six months old and involve complex hedging transactions.

Required

What auditing standards have been violated in this case? Explain why (6marks)

How does the acquisition and the change in the nature of sales and accounts receivable affect control risk and inherent risk of accounts receivable? (6marks)

Describe how you would adjust your audit strategy for the change in sales and accounts receivable. Explain what additional audit procedures would be necessary (include discussion of the purpose of the procedure).

Answer 1

a.         Planning

Work is to be adequately planned: Fulfilling this standard would include preparation of an audit program for the accounts receivable, but this was not done.

Supervision

If assistants are employed they are to be properly supervised. You should have reviewed the audit program with the assistant prior to the beginning of the examination. The completed working papers should have been reviewed to determine whether an adequate examination was performed.

Internal controls and risk assessment

There needs to be an understanding of internal control in the context of a risk assessment. Risk assessments were not updated. There is no evidence that the internal controls were updated via questionnaire or flow chart or narrative.

Relying entirely on prior year working papers in lieu of an evaluation of existing controls is improper because there are changes to the nature of the accounts receivable, including the introduction of complexity.

b.         The acquisition has increased the volume of accounts receivable, which, all things equal, could increase the risk of material misstatement and would likely result in the need for increasing the level of substantive tests (such as confirmations) for the accounts receivable balance. Increased volume could also increase inherent risks of error, if staff is overworked and unable to keep up with the workload. The foreign transactions increase inherent risk (there could be greater risks of non-collectability and accuracy due to foreign exchange differences). Also, as there is increased complexity due to the use of complex hedging transactions, there is an increased in the potential for error (inherent risk) simply due to the presence of these transactions. Finally, controls may have changed, so the auditor will need to assess control risks over these new types of transactions. Control risk could be the same, better, or worse, depending upon the quality of the internal controls put in place.

c.         The auditor may need to confirm or conduct alternative procedures with respect to the foreign accounts. Alternative procedures may involve reviewing contracts and purchase orders with respect to these transactions. Specialist assistance should be obtained from the audit firm with respect to examination of the hedging transactions to ensure that they are recorded and disclosed correctly. Also, the volume of testing should likely be increased.