Problem DC 15-3, Page 844 (Subsequent Events) The following events occurred in independent cases, but in each instance the event happened after the close of the fiscal year under the audit but before the financial statements were authorized for issue, which is also the report date. For each case, state what impact, if any, you would expect on the financial statements (and notes). The balance sheet date in each instance is December 31, 20X1. On December 31, the commodities handled by the company had been traded in the open market for $1.40 per kilogram. The price had prevailed for two weeks, following an official market report that predicted vastly enlarged supplies; however, no purchases were made at $1.40. The price throughout the preceding year, and several prior years, had been about $2. On January 18, 20X2, the price returned to $2, following the disclosure of an error in the official calculations of the prior December – correction of which destroyed the expectations of excessive supplies. Inventory at December 31, 20X1, had been valued on a lower-of-cost-and-net-realizable-value basis, using the prevailing price known at that time, $1.40. On February 1, 20X2, the board of directors adopted a resolution accepting an investment banker’s offer to guarantee the marketing of $100 of preferred shares. On January 22, 20X2, one of the auditee’s three major plants burned down, a $50 million loss that was covered to $40 million by insurance. The auditee in this case is an open-end-type investment company. In January, 20X2, new management took control. By February 20X2 it had sold 90% of the investments carried at December 31, 20X1, and had purchased substantially more speculative ones. This company has a wholly owned but not consolidated subsidiary producing oil in a foreign country. A serious rebellion began in that country on January 20X2, and continued beyond the completion of your audit work. There has been extensive coverage of the fighting here.

The auditee, Comtois Corp., sells property management software systems. Shortly before its December 31, 20X1, year-end, Comtois’s president finalized a large sale to a provincial ministry. The contract has ben completed and all the terms agreed to by the assistant deputy minister, but the minister herself is the only one authorized to sign the contract because of the large dollar amount involved. As of the date Comtois’s board authorized the financial statements to be issued March 3, 20X2, Comtois has not yet received the signed contract because the minister has not been available. The president wants to recognize the revenue in Comtois’s 20X1 fiscal year anyway so that the salespeople and managers involved can be paid a bonus this year based on it. The auditee’s stated accounting policy for revenue recognition on these types of sales, established five years earlier, is to recognize revenue when the contract is signed. During its fiscal year ending December 31, 20X1, Noriker Inc. issued common shares to its vice-president of marketing. At the date of issuing these shares, the company also provided the vice-president with a non-interest bearing loan of $50,000 to purchase the shares. While reviewing the minutes of all the Noriker board of directors meetings during the audit fieldwork, Noriker’s auditor notes that in a meeting on February 12, 20X2, the Noriker board agreed to forgive this loan, effective that day. ( © 2000, American Institute of CPAs.)

Solution to DC 15-3 If the $1.40 price had been used to value the inventory at December 31 on a lower-of-cost-or-NRV basis, the inventory figure should be adjusted because the actual quotation of $1.40 was a transitory error and no purchases had been made at that price. Report on the action of the new share issue in a note to the financial statements. Consider presenting a pro-forma shareholders’ equity section of the balance sheet, showing the financial position as it would look with the new shares issued. Report the fire loss in a note to the balance sheet and refer to it in connection with the income statement, since earning power is presumably affected. Consider the need for pro-forma financial statements reflecting the loss of production capacity. Report this change in investment composition in notes to the statements because it changes the character of the assets and operations which are being reported upon and which the reader tends to assume are continuing. Consider presenting a pro-forma balance sheet (and detail schedule of investments). Although information of the rebellion is common knowledge, the users of the financial statements may not be aware of the auditee’s subsidiary located in the foreign country. The statements should disclose through a note both the location of the subsidiary’s operations and the rebellion, particularly if the parent’s investment is a significant portion of its total assets, or the total assets or gross revenues of the unconsolidated subsidiary are significant in relation to the consolidated assets or revenues. The case presents various issues that involve using judgment in assessing how accounting policies should be applied. A possible analysis and conclusion is the following. Strictly speaking the revenue recognition criterion set out in Comtois’s accounting policy note has not been met. However, in substance the conditions for revenue recognition may have been met, as long as the delay in signing the contract is only due to the Minister’s time constraints and not business uncertainties. The auditor may be able to get comfort on this from enquiries of Ministry assistants and that may support recognizing revenue. The exception to the policy would need to be disclosed in this case, and consideration could be given to revising the policy if this kind of contract is expected to occur more often in future. One possible analysis and conclusion as follows. The share issue and loan are related party transactions and should be disclosed. The loan forgiveness should also be disclosed as a subsequent event. These are relevant transactions for the company’s other shareholders to be informed of.  

Problem DC 15-5, Page 846 (Lawyer’s letters) The controller of Kim Engineering LTD. (KEL), sent a legal representation letter to KEL’s law firm at the request of the company’s auditors. The controller told the auditors that there are no ongoing lawsuits. The lawyers replied to the letter, agreeing that there were no outstanding or possible claims of which they have knowledge, or for which their legal advice has been sought. However, the controller was not aware that the board of directors had sought legal advice from a second law firm regarding a harassment lawsuit. Due to the nature of the matter, the board of directors did not want anyone to know about the possible claim. There are no records of it outside of the president’s office, but the auditor noticed it when reviewing the minutes of the board of directors meetings. The auditor, therefore, requested that a letter be sent to the second law firm as well. One of the members of the board of directors is Yung, who started the company 20 years ago, but is now retired from any duties other than being a director. When the company first started, Yung performed almost all of the duties herself, but over the years, her duties have been assigned to other people. For example, only the controller or the president of the company sign cheques on behalf of the company, and the controller’s authority is limited to $15,000. Any cheque request must be supported by an authorized purchase requisition, and any request over $15,000 must be authorized by the president. The accounting manager does all of the bank requisitions himself, but his assistant enters the journal entries according to the accounting manager’s instructions. Required: Indicate what effect will be on the audit if the auditor receives no response from the second law firm. If the second law firm replies and provides information to the auditor, indicate how the auditor should treat this information for financial statement purposes. State whether the control risk is high or low, and support your decision with four points. (Adapted from External Auditing (AU1), September 2010, with permission of Chartered Professional Accountants of Canada, Toronto, Canada.)

Solution to Problem DC 15-5 This would be a scope limitation. The auditor is not being given access to all of the information necessary to audit the client’s financial statements. The auditor has to ensure that proper disclosure is made in the notes to the financial statements, not in the audit report. If information provided to the auditor by the second law firm showed that the claim can be a contingent liability, existence of contingent liability should be disclosed in the notes to the financial statements. Based on the given information, control risk is high. The controller is not trusted enough to be made aware of an issue as important as a lawsuit for harassment, which must have some effect on the work environment. If the controller is not competent or trustworthy, then the risk of misstatements or fraud is increased. The information does not explain how purchases up to $15,000 are authorized, but the president has the power to both authorize a payment above $15,000 and to sign the cheque, which is a clear lack of segregation of incompatible duties. The accounting manager also has incompatible duties, preparing the bank reconciliation and deciding how journal entries are to be recorded. Having monthly bank reconciliations is a strength, but this is not strong enough to overcome the weaknesses noted above. Also there could be a concern that the accounting manager can misappropriate funds by altering smaller cheques and then altering the bank reconciliation to conceal this.