Assurance — Integrated Problem 2

Solution
The following solution is a “best” response, demonstrating a level much higher than
competent. However, there may be additional, acceptable, and reasonable points that
are not reflected in this response.

In addition, candidates are not expected to prepare a response of this level given the
time constraints involved and, if applicable, page limits provided.

Memo

To: Partner
From: CPA
Subject: Real Renovation Inc. (RRI) engagement

Assessment Opportunity #1

The candidate discusses the requirements of Canadian Auditing Standards in deciding

whether to accept an engagement.

The candidate demonstrates competence in Assurance.

CPA Map Competencies:

4.3.1 Assesses issues related to the undertaking of the engagement or project (Elective
– Level A)

Client acceptance

Issue

Horace and Lee CPAs (H&L) are considering accepting a new client but, before doing
so, it must consider whether the requirements for client acceptance have been met in
accordance with Canadian Auditing Standards (CAS).

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Les désignations « Comptables professionnels agréés du Canada », « CPA Canada » et « CPA »

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2021-11-13
Assurance — Integrated Problem 2 Solution

Handbook and analysis

CAS 220 Quality Control for an Audit of Financial Statements describes the auditor’s
responsibilities with respect to whether to accept a new client. The RRI engagement
should be considered by applying the guidance from paragraph 12:

The engagement partner shall be satisfied that appropriate procedures regarding

the acceptance and continuance of client relationships and audit engagements
have been followed, and shall determine that conclusions reached in this regard
are appropriate. (Ref: Para. A8-A10)

Paragraph A8 requires that before accepting an engagement with a new client, the
following information should be considered to determine whether the acceptance of the
client relationship and audit engagement are appropriate.

• The integrity of the principal owners, key management and those charged
with governance of the entity;

At this point in time, there is limited information that would help us to assess
the integrity of this prospective client. If we accept the client, we can
continuously assess the integrity of the owners, management, and those
charged with governance. For now, we will have to use our best judgment
based on our initial meetings with the client. We should be alert for warning
signs such as aggressiveness in attitude toward financial reporting or
indications that management is not concerned with compliance with laws and
regulations that govern RRI’s industry. Discussion with the predecessor
auditor will be required to assist in our assessment.

• Whether the engagement team is competent to perform the audit

engagement and has the necessary capabilities, including time and
resources;

We have the necessary skills, given that our CPA firm performs audits on
privately held companies on a regular basis. This client is in the construction
industry, so we must assess whether we have experience in this industry and,
if not, whether we have the ability to gain the necessary background. We
must also determine whether we currently have the time and resources
available to accept another client engagement.

• Whether the firm and the engagement team can comply with relevant ethical
requirements; and

There are no indications of any ethical concerns. Our firm will conduct the
engagement applying the same ethical standards we would apply to all
engagements. Independence is assessed below.

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Assurance — Integrated Problem 2 Solution

• Significant matters that have arisen during the current or previous audit
engagement, and their implications for continuing the relationship.

This is a first-time engagement, and no significant matters have arisen. We

will need to contact the predecessor auditor to ensure there are no concerns.

Recommendation

Based on the information we currently have, there are no indications that we should not
accept RRI as a new client. However, as described above, we will want to gather more
information on RRI by contacting the predecessor auditor and by assessing our
independence. In addition, we will need to determine whether we have the appropriate
knowledge of RRI’s industry and the time and resources available to perform the
engagement.

Independence threats

Issue

H&L also needs to consider potential threats to independence in accepting the RRI
engagement. We will need to determine if we can safeguard against these threats or if
any of the threats preclude us from accepting the engagement.

Handbook and analysis

In accordance with CAS 220.C11, H&L must ensure that all threats to independence are
identified and addressed appropriately. Based on preliminary information, the following
threats should be safeguarded against to ensure that there is no real or perceived
independence issue with H&L providing an audit opinion for RRI:

Familiarity threat

RRI’s president and majority shareholder is the nephew of an H&L assurance partner.

• Since Sam Real’s aunt is one of our assurance partners, there is a familiarity threat
to independence. Although the partner could probably maintain independence in
fact, as a result of the family relationship she does not appear independent. This
means that others may question her ability to be objective when dealing with her
nephew.
• To safeguard against this risk, Sam’s aunt should not be on the RRI engagement,
and a different assurance partner should be assigned instead. This safeguard would
adequately address the risk.

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Self-review threat

RRI wants H&L to prepare its corporate tax return. The tax return will impact many
reported amounts and disclosures on the financial statements, such as income tax
payable/receivable, income tax expense, and any future tax assets or liabilities.

• A self-review threat exists when H&L prepares the tax return and then audits the
resulting financial statement balances and disclosures.
• Since H&L has a tax group, it should be used, and different individuals from those
who are performing the audit work should prepare the tax return. This will mitigate
the risk of self-review. This separation of tasks should be ensured when assigning
engagement team members to their roles.

Recommendation

Based on the analysis above, there are no threats to independence that prevent H&L
from accepting the RRI engagement.

Assessment Opportunity #2

The candidate discusses the requirements for a CPA being associated with translated
financial statements.

The candidate demonstrates competence in Assurance.

CPA Map Competencies:

4.3.1 Assesses issues related to the undertaking of the engagement or project (Elective
– Level A)

Translated financial statements and auditor’s report

Issue

RRI requires its financial statements and related note disclosures be translated into
German for one of its shareholders. RRI wishes to attach the auditor’s report to the
translated financial statements.

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Assurance — Integrated Problem 2 Solution

Handbook and analysis

CSOA 5000 Use of the Practitioner’s Communication or Name, paragraph 10 states:

If the practitioner intends to consent to the use of the practitioner’s

communication in another language or the use of the practitioner’s
communication or name in connection with information on which the practitioner
reported in the original language that is translated into another language, the
practitioner shall be satisfied that, if applicable:
(a) The information on which the practitioner reported in the original language
that is subsequently issued in the other language includes the same
information, and in all material respects carries the same meaning, as the
information on which the practitioner reported in the original language; and
(b) The practitioner’s communication thereon includes the same information, and
in all material respects carries the same meaning, as the practitioner’s
communication issued in the original language.

We must ensure that the translated version of the financial statements contains all of
the same information, and that, in all material respects, the information has the same
meaning in the translated version as it did in the original version. This may be
challenging if H&L does not have a staff member who is fluent in German. However,
H&L could engage a professional translator to assist us in this task.

If, for some reason, it is simply not possible for H&L to ensure that the German version
meets the requirements of CSOA 5000.10, H&L would not be able to obtain an
appropriate basis to consent to using our name in connection with the translated
financial statements. RRI would have to be informed that it cannot use H&L’s audit
report/name with the translated financial statements.

Recommendation

I recommend that H&L have the financial statements translated to German by a

professional translator. H&L should also arrange to have a comparison done between
the translated financial statements and audit report and the original English documents.
H&L should consider the time required and the cost of this endeavour, and
communicate with the client about the requirements and any additional billings related
to this task.

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Assurance — Integrated Problem 2 Solution

Assessment Opportunity #3

The candidate determines materiality for the engagement.

The candidate demonstrates competence in Assurance.

CPA Map Competencies:

4.3.4 Assesses materiality for the assurance engagement or project (Elective – Level A)

Users

The primary users of the financial statements are:

• The preferred shareholders: They receive dividends based on a formula that uses
net income per the financial statements. If net income is misstated, their dividend
entitlement will be calculated incorrectly.
• The bank: It will be concerned with RRI’s ability to repay the line of credit. However,
this risk is likely low given that the line of credit is not maxed out and RRI has a
strong credit history.

Our primary concern in the audit will be for the preferred shareholders because they are
the most sensitive to error. Both types of users, however, would find earnings an
appropriate basis for materiality — the shareholders for calculation of the dividends and
the bank for purposes of estimating RRI’s ability to repay its debt.

Materiality

A range of 3% to 7% of normalized net income before tax is typically used for an

earnings benchmark. Given that any fluctuation in net income above $100,000 will
impact the dividend that is ultimately paid to the preferred shareholders, we can expect
that they will be highly sensitive to fluctuations in this benchmark. However, seeing as
there aren’t many other users and the preferred shareholders will also want an efficient
audit, I recommend applying a percentage at the mid-point of the range, or 5%.

Net income before tax $135,000

Normalizations:
Non-recurring government grant (25,000)
Discretionary bonus 40,000
Normalized earnings before tax $150,000
× 5%
Materiality $ 7,500

The non-recurring government grant and discretionary bonus were added back, as
these are not a regular part of its operations. The environmental penalty was not

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Assurance — Integrated Problem 2 Solution

removed because, although RRI attempts to avoid this, it is a regular part of its
operations.

Performance materiality

As per CAS 320 Materiality in Planning and Performing an Audit, paragraph 11,
performance materiality must also be set to help guide the audit work: “The auditor shall
determine performance materiality for purposes of assessing the risks of material
misstatement and determining the nature, timing and extent of further audit procedures.”

Given that there are no known previous significant errors, we will use 70% of overall
materiality as our performance materiality to reduce the risk that aggregate undetected
and unadjusted misstatements reach overall materiality.

$7,500 × 70% = $5,250

Recommendation

Based on the draft financial statements for RRI, materiality is set at $7,500 and
performance materiality at $5,250.

Assessment Opportunity #4

The candidate discusses the audit approach.

The candidate demonstrates competence in Assurance.

CPA Map Competencies:

4.3.5 Assesses the risks of the project, or, for audit engagements, assesses the risk of
material misstatement at the financial statement level and at the assertion level for
classes of transactions, account balances, and disclosures. (Elective – Level A)

In determining our approach to the audit of RRI, we will need to consider the control
environment currently in place and whether controls at RRI can be relied on.
Regardless of whether or not we choose to rely on controls in place at RRI, per CAS
315.21 we are required to get an understanding of the control environment.

Management ethics and oversight

RRI is a small, owner-managed company with both Sam and Lucky being highly
involved in the business. Lucky manages the administrative and accounting-related
tasks and takes her work seriously. She strives to report RRI’s financial results
accurately. Additional conversations with Sam and Lucky will be required to gain an
understanding of their motivations in reporting financial results. The preferred
shareholders receive annual dividend payments based on profitability. In order to
minimize the dividend to be paid, Sam may be inclined to understate revenues and

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Assurance — Integrated Problem 2 Solution

overstate expenses so as to reduce apparent profitability. This could be done by doing

work for cash without an invoice and not reporting it.

Control environment

Based on some of the facts provided, I have some initial concerns about the control
environment at RRI. For example:
• Sam has been described as not being concerned with details. He needs to be
reminded to keep track of receipts and submit documentation to Lucky on a timely
basis. This makes it more difficult for Lucky to ensure appropriate cut-off of
expenses and completeness of liabilities.
• Lucky, although hard-working and diligent, does not have a strong accounting
background. She may not be aware of generally accepted accounting principles’
reporting requirements for revenue recognition for long-term contracts, for example.
This creates risk that the financial statements could be materially misstated.
• There are weak controls over purchasing — contractors do not require advance
approval for purchases, and they can be reimbursed regardless of how late they
submit an expense, even if there is no appropriate supporting documentation for it.
This creates risk of material misstatement for cut-off of expenses and completeness
of liabilities, since contractors may submit expenses relating to the prior period after
year end. In addition, there is an increased risk related to the occurrence of
expenses, since contractors could falsify their costs, and they would not be required
to provide supporting documentation. It also impacts our risk assessment for the
accuracy assertion, as expenses could be recorded at improper amounts due to
estimation errors.
• Sam uses Microsoft Excel to track costs and billings for each project. Excel has a
low degree of sophistication for maintaining accounting records, with few automated
controls in place, and therefore the data contained in Excel documents can easily be
subject to manipulation or loss. This increases the risk that costs and billings will not
be accounted for correctly.
• Given RRI’s small size, there is little segregation of duties, with Lucky and Sam
performing most of the controls in the accounting function. This increases the risk of
fraud or error because there is limited oversight and review of the work performed.
This increases the risk that an error will occur and not be detected.

Fazit

Further discussion with Sam and Lucky is required to complete our understanding of the
control environment and the controls in place for the various assertion-level risks. At this
point, it seems apparent that several control weaknesses exist at RRI. As a result, a
substantive approach will be required for most assertion-level risks. As RRI is a fairly
small organization, with only one large job happening at a time, it should be fairly
efficient to perform our audit substantively.

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Assurance — Integrated Problem 2 Solution

Assessment Opportunity #5

The candidate discusses the exchange of renovation work for legal services.

The candidate demonstrates competence in Financial Reporting.

CPA Map Competencies:

1.2.2 Evaluates treatment for routine transactions (Core – Level A)

Non-monetary transaction

Issue

A transaction occurred that may not have been reflected appropriately in RRI’s financial
statements. Since there was an exchange of services that did not involve cash
payment, this exchange should be considered using ASPE Section 3831 Non-monetary
Transactions.

Handbook and analysis

Paragraph 6 discusses how to measure non-monetary transactions:

An entity shall measure an asset exchanged or transferred in a non-monetary

transaction at the more reliably measurable of the fair value of the asset given up
and the fair value of the asset received, unless:

(a) the transaction lacks commercial substance;

This exception does not apply because this transaction does have commercial
substance. The services received by RRI would have cost $5,000 had this
exchange not been undertaken (20 hours × $250/hour billing rate). However, RRI
instead provided services with a fair market value of $4,000. The cash flows
changed as a result of this transaction, so the transaction has commercial
substance.

(b) the transaction is an exchange of a product or property held for sale in the
ordinary course of business for a product or property to be sold in the same
line of business to facilitate sales to customers other than the parties to the
exchange;

This exception does not apply because RRI and Finley Fibbs are in different lines
of business: renovations and legal services.

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Assurance — Integrated Problem 2 Solution

(c) neither the fair value of the asset received nor the fair value of the asset given
up is reliably measurable;

This exception does not apply because each of the services exchanged in the
transaction has a reliably measurable fair value. Legal services are billed at $250
per hour, and the renovation would have been billed at $4,000.

(d) the transaction is a non-monetary non-reciprocal transfer to owners to which

paragraph 3831.14 applies.

This exception does not apply because there is reciprocation in this transaction
— legal services were exchanged for a renovation. As well, Finley is not an
owner of RRI.

Recommendation

The transaction should be measured at fair value in RRI’s financial statements. Since
both fair values seem equally reliable, paragraph 10 applies:

When an entity is able to reliably determine the fair value of both the asset
received and the asset given up, the fair value of the asset given up is used to
measure the asset received unless the fair value of the asset received is more
reliably measurable.

Therefore, the services given up will be used to measure this exchange:

DR Legal expense 4,000

CR Revenue 4,000

Lucky has already accounted for the costs of $2,750 properly.

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