AP3.

2
a. Since WaterFun granted permission for DDD to communicate with the predecessor auditor, DDD will
contact the predecessor auditor and inquire about the following matters (slide 9):
• Information that might bear on the integrity of management
• Disagreements with management about accounting policies, auditing procedures, or other
significant matters
• Communications to those charged with governance regarding fraud and noncompliance with laws
or regulations by the entity
• Communications to management and those charged with governance regarding significant
deficiencies and material weaknesses in internal control
• The predecessor auditor’s understanding about the reasons for the change of auditors

b. (On course shell) According to auditing standards, key items that should be included in an engagement
letter are:
• The objective and scope of the audit of the financial statements, including reference to applicable
legislation, regulations, GAAS, and ethical and other pronouncements of professional bodies to
which the auditor adheres
• The responsibilities of the auditor, such as arrangements regarding the planning and performance
of the audit including the composition of the audit team
• The responsibilities of management, including making available to the auditor draft financial
statements and any other accompanying information in time to allow the auditor to complete the
audit in accordance with the proposed time table
• The expectation that management will provide written representations
• The agreement of management to make available to inform the auditor of events occurring or
facts discovered subsequent to the date of the financial statements, of which management may
become aware, that may affect the financial statements
• A statement that because of the inherent limitations of an audit, together with the inherent
limitations of internal control, an unavoidable risk exists that some material misstatements may
 not be detected, even though the audit is properly planned and performed in accordance with
GAAS
• Identification of the applicable financial reporting framework for the preparation of the financial
statements
• Reference to the expected form and content of any reports to be issued by the auditor and a
statement that circumstances may arise in which a report may differ from its expected form and
content
• 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 agree to
the terms of the engagement outlined therein, as may be evidenced by their signature on the
engagement letter

c. If DDD is not granted permission to communicate with the predecessor auditor, then DDD should
inquire about the reasons and consider the implications of that refusal in deciding whether to accept the
engagement with WaterFun.

AP3.3
The client continuation decision is critical. Rebecca should evaluate and document the firm’s ability to
service the major client, Carolina Company Inc., and any other major clients for the coming year. The key
factors to be evaluated are client integrity and any threats to the auditor’s compliance with the
fundamental principles of professional ethics (integrity, objectivity, independence, professional
competence and due care). Although Carolina Company has been a client of the firm for several years, its
integrity must still be reevaluated. Rapid growth and the stress of being publicly traded can create
pressures within the client that could compromise its integrity. This is particularly so in the case of
Carolina Company because there is already evidence of difficulties in its financial systems.

A major issue confronting the audit firm is its ability to comply with the fundamental principles of
independence. Rebecca should be particularly concerned with the firm’s ability to be objective given its
dependence on the large client’s fees. Although Carolina Company is only one of the major clients
experiencing rapid growth, fee dependence arises when a client’s fees form a significant proportion of the
audit firm’s overall revenue.

Rebecca should also be concerned about the firm’s ability to use professional competence and due care in
audits for rapidly growing clients at a time when the audit firm is growing rapidly and the client is
undergoing major changes to its reporting requirements when transitioning to a publicly traded company.
Issues that Rebecca should consider are: If the firm is not already registered with the PCAOB, does it
want to take that step in order to keep Carolina Company as a client? Does the audit firm have the
expertise to audit publicly traded clients? Does the audit firm have enough staff to audit a publicly traded
company, including enough partners to comply with the SOX’s mandatory partner rotation? What sort of
auditing difficulties are likely to be created by the stretched financial systems at Carolina?

The client continuation decision must be properly documented and the engagement letter drafted to reflect
the responsibilities of both parties.
 AP3.5
(a) Inherent risks for inventory for Carl’s Computers include:
1. Likelihood of rapid obsolescence of computer hardware and accessories – risk of incorrect valuation of
obsolete product
2. Foreign exchange transactions – are contracts written in U.S. dollars? Are the transactions hedged
against adverse movements in exchange rates, leading to difficulty ascertaining cost of purchase and
incorrect creditor liability?
3. Competition from aggressive discounters - risk that inventory will not be held on hand to meet
fluctuating sales, risk that inventory will be unsold because of competition which increases risk of
obsolescence and valuation problems
4. Rapidly changing product lines – risk that suppliers will change and products not be to required
standards which increases valuation problems
5. Correct inventory will not be received from suppliers due to inability to meet orders or confusion
between U.S. importers and foreign suppliers – risk that purchase orders are unfilled or incorrectly
filled, and payment for inventory not received
6. Dealing with multiple transportation companies (ships from overseas and trucks from ports) – could
increase risk of goods not being received, or not received in a timely manner, and missing inventory
7. Many different products, wide range of value per item – risk of incorrect calculations of inventory on
hand
8. Theft (either during transport or from the stores) would vary across products – risk that inventory
account would be overstated if thefts were not identified
[ Also remember the practice we got as well from the Aquamarine Audit Risk identification question.
Please review the Aquamarine Class Question ]
(b) Strengths of inventory control system:
• Branch manager in each store and permanent staff who can receive consistent training in inventory
control
• Permanent staff used to supervise part-time staff at stores
• Inventory held at central warehouse under control of specialist inventory supervisors
• Requisition required for transfer from central warehouse to branch store

Weaknesses in inventory control system:

• Part-time staff may not be sufficiently trained or supervised despite procedures requiring this
• Inventory requisition authorized by branch manager rather than central manager
• Passing through central warehouse could delay receipt of product at branch, leading to overriding
system to increase speed of delivery

(c) Inventory would be a material balance because the company is an importer and retailer of computer
hardware and accessories. Inventory is likely to be the largest asset after property, plant and equipment.
It is likely that the majority of sales are made for cash, so accounts receivable is unlikely to be a large
balance (except for balances owing from credit card companies for card transactions). The inventory is
also qualitatively material because the business model requires expert inventory management to deal
with obsolescence and competition issues. Users of financial statements would be very interested in
data such as inventory turnover. Therefore, we will expect a Low materiality level set because the
balance will be highly material for testing and capturing potential misstatement. Remember, Lower
Overall/Planning/Performance Materiality levels result in more testing and hence higher risk
engagements.
Summary:
[Link] material?: Yes
2. Quantitatively material?: Yes
3. Expecting higher or lower materiality level?: Lower end/Low
AP3.9
a. Factors affecting preliminary assessment of inherent risk include:
• Cheese is perishable, suggesting high risk of spoilage, affecting inventory valuation
• Boutique cheese operation – highly skilled processes requiring skilled staff, and reliance on a few
customers
• Export sales, foreign exchange transactions – complicated transactions with risk of incorrect pricing,
risk assessment
• Tourism-based sales at shop and café – could be fluctuating demand
• Competing incentives for export sales and café consulting businesses
• Heavy reliance on export sales increases vulnerability of business to this source of revenue, and making
product available to meet this demand

Factors affecting preliminary assessment of control risk include:

• Effectiveness over quality control over cheese operations, affecting saleability of product (although
quality control is apparently high)
• Risk of product spoilage, affecting value of inventory
• Controls over sales made by Jim, documentation, pricing, sales allowances
• Lack of communication between Jim and brother Bob and other staff – affecting efficiency and
effectiveness of management

b. Reliance on controls approach is appropriate when control risk is assessed as low while a predominantly
substantive approach is appropriate when control risk is assessed as high, and it is more efficient not to rely
on controls.

For Sales
The poor communication between Jim and other management and staff, plus his competing incentives and
the lack of control over his actions means that control risk in these areas would be considered high. The
validity of sales transactions, including the amounts and terms of the sale, is at risk. There is also a risk that
sales made to customers are not entered correctly in the accounts. Control risk (and by extension, inherent
and overall RoMM) for sales and accounts receivable is high, meaning that a predominantly substantive
approach would be adopted in these areas.

For Inventory
The inherent risk of inventory spoilage is great; however, control over production appears to be good, and
inventory quality seems to be high. This suggests that a lower assessed level of inherent and control risk
could be adopted for inventory as the controls mitigate the initially high inherent risk due to spoilage (low
RoMM), leading to a reliance on controls approach. Testing the controls over inventory, and obtaining
satisfactory results, would mean that less substantive testing would be required.

For Customer Receivables

Same as Sales. A predominantly substantive approach for sales is more appropriate because the adjustments
to customer accounts do not appear to be adequately controlled. Rather than developing and implementing
a policy and procedures on credit notes, Jim frequently issues credit notes to clients who complain about
their statement without investigating it. Also the lack of resources to follow company’s protocol (i.e. Jim is
to too busy to respond to customer complaints) increases the control risk.