Exercise 1 Professional Standards and Ethics [15 points]

Given: Cheetah is a German company which distributes and sells various sports articles. The assortment
consists of shoes, clothing, accessories and equipment. Cheetah’s mission is to create groundbreaking sport
innovations and to become the leader in the market of sports articles.
In growing their business, Cheetah firmly believes that this growth should be accompanied with cutting down
on environmental impact. Therefore sustainability innovations are important pillars in their mission.

The Cheetah head office is located in Florida, United States of America (USA) and the company is listed at the
US Stock Exchange since early 2018. Before that time all shares were held by the founder of the company Mr.
Cheetah. As of 2018 the board of Cheetah consists of two members; Mrs. Sunshine as the CEO, Mr. Wave as
the CFO. Finance, controlling, procurement, marketing, IT and HR departments are organized centrally and are
located at the head office. An internal audit department is not in place, the budget for these costs is not yet
approved.

In order to comply with the SOX regulations, the board has initiated the implementation of an internal control
framework to document required internal controls and to assess their effectiveness. This way of working is still
quite new to the company.

Previously the financial statements were audited by Wells audit firm. Since Cheetah is listed at the stock
exchange, the company switched auditors. As of 2018 you are an audit manager of Cheetah and you have been
assigned the audit of the Cheetah financial statements 2018. The audit acceptance procedures have been
followed by you and the engagement letter has been signed by Cheetah management.

Required:
1.1 Name two different types of information and the related source you collect it from, before you can
accept the audit engagement of Cheetah. [2 points]

The CPAs should assess the backgrounds and reputations of the prospect and its major shareholders,
directors, and officers. Thus, inquiries are made of underwriters, bankers, and attorneys that conduct
business with the prospective client.

Also, the CPAs are required to make inquiries of the prospect's predecessor.

Required:
1.2 Describe which specific responsibility the previous auditor Mr. Wells has in communicating with the
potential new auditor of Cheetah. [1 points]

The former auditor should first ask his former audit client for approval to share confidential information with
the potential new auditor. This approval is necessary, otherwise there will be a breach of the confidentiality
agreement.

In order to execute the audit services properly, you have assembled an audit team consisting of twelve
members. In order to assess the required and available capabilities, you have included some notes on potential
team members:

Audit file notes:

- Team member Jesse has worked as a controller for Cheetah until 2017, before he joined your audit
firm. Jesse knows a lot about the company since he has worked there for over 10 years.
- The CFO Mr. Wave has requested to temporarily assign one of your team members, Colin, to the
internal audit department. Apparently Mr. Wave sees great potential in Colin and would like him to
support his internal audit staff for 6 months.
- One of your colleagues Brett has audited several other companies similar to Cheetah. He knows the
sports industry very well and has a lot of knowledge about the specific risks in the industry, the
competitors and economic developments in sports industry.
- Sally, an experienced manager, knows the Cheetah company quite well as her husband is working
there as a sales manager. She and her husband also hold 2% of the total outstanding shares of
Cheetah.

1.3 Describe and explain three potential threats to independence in case all these team members would
be assigned to your audit team and include the appropriate category per threat. [6 points]
Threat to independence Category:
(self-interest/self-review/fa
miliarity/management
participation)

Jesse: risk of self-review (considering he may have implemented several

internal controls at the time of his employment) or familiarity (he might be
close to a lot of employees at Cheetah and therefore not
objective/independent enough in his assessment.

Colin: these kinds of internal audit outsourcing services are not allowed under
SOX (self-review)

Sally: financial self-interest because she might be financially dependent

considering she and her husband are holding shares. Familiarity risk as her
husband is working for Cheetah (depends on his position and power in the
company.

1.4 Describe two safeguards which you need to take in order to minimize the threats to the
independence. [2 points]

 Exclude team members from the engagement (Sally)

 Additional supervision for team member Jesse
 Overall peer review of the audit file by a colleague
 Explain to the CEO that providing internal audit services are not allowed under SOX, recommend
another company to provide these services
After your assessment of independence you have taken all the necessary safeguards and you and your team
are ready to start with the audit. An audit of financial statements is also referred to as an attest service. In the
past you have also been involved in various consulting services (nonattest service).

1.5 Explain what defines an attest service and what the difference is with a nonattest service. [2 points]

Attest service: the auditor provides an opinion on a statement provided by management. In this case the
financial statement is the statement that management is making, the auditor verifies whether or not the
statements present a true and fair view (with reasonable assurance).

A consulting service is not related to the investigation of a statement made by another party, it is more
related to advisory and consulting.

The CEO Mrs. Sunshine has been thinking about expanding the business to Canada as this could be an
amazing opportunity to boost the business. Plans have been developed to open up 5 new sales offices and
distribution centres. An additional loan will be required for the expansion and Mr. Wave proposes that 2
major USA banks are approached.
Mr. Wave as CFO has asked his team to create the financial prognoses which will be presented to the
banks. The CEO and CFO discuss the draft prognoses and the margins look very positive. However they are
a bit disappointed in some of the ratio’s; especially the solvency ratio is lower than expected and Mr. Wave
proposes to lower the provisions on the balance sheet. Mrs. Sunshine agrees but proposes to discuss the
matter with you as the auditor in charge.

1.6 Explain how this discussion can cause an ethical dilemma for you as the audit manager in charge [2
points]

An ethical dilemma means that there is a mental conflict for the auditor. In this case he wants to service
the audit client by agreeing with the adjustments in the provision, in order for the audit client to get the
loans from the bank. Considering the rest of the figures look good, this might seem like a small thing.
However, the client is still adjusting the numbers in the prognoses. On the other hand, they are adjusting
the prognoses and not the financial statement yet….. However, in the end the auditor needs to serve the
public and should make sure he is not associated with any erroneous information.

Exercise 2 Audit planning [14 points]

Given: Case Cheetah continues:
The Cheetah brand has become known worldwide over the last couple of years, therefore the distribution
network has gone international. Various distribution centers and sales offices have been set up throughout the
USA, Europe and Northern Africa. Every season (in total 4 times a year) a new line of shoes and clothing is
presented in the stores in order to keep up with the trends and the competitors in the market.

Each distribution center is managed by a dedicated supply chain manager. All the supply chain managers report
to the global supply chain director. Every sales office is supervised by a sales manager, in turn they report to
the global sales director. Communication between managers and directors takes place on an ad-hoc basis,
mainly the directors rely on the management reports they receive.
Each supply chain manager and sales manager have received specific targets for the year 2018. In case they
reach these targets, they will be awarded with an annual bonus. Supply chain targets mainly relate to the KPI’s
of delivery in full on time and inventory accuracy (including minimal inventory differences). Sales targets also
relate to delivery in full on time and a gross margin target of 40%.
In order to have sufficient stock at every distribution center, a lot of intercompany deliveries take place
between the different locations: On average 30,000 stock movements take place on a daily basis.

Risk assessment procedures are part of ‘Understanding the Client’ and an important phase in audit planning.
These aspects might indicate that an inherent risk is present.

Required:
2.1 Based on the case descriptions so far, fill in the table below for the Cheetah organization. [5 points]
Aspect Relevant aspects for the audit
A Competitive
position and Strong competition, possible pressure on organization to perform. Every season a new
industry line is coming out.

B Organizational
structure Central office in the USA, however also direct reports spread out throughout the
world.

C Critical
business Sales organization, so mainly the sales and distribution processes are critical. Also
processes managing the different flows of stock is important, considering the multitude of
intercompany deliveries.

D Methods of
measuring Targets are set for DIFOT (Delivered In Full, On Time), inventory accuracy and sales
performance margins. Could raise pressure on employees, important to verify how targets are set
and monitored.

E Internal
Control Internal Control framework in the making, is the company already in compliance with
SOX requirements.

Managing inventory flows considering the magnitude of transactions every day.

Lack of internal audit department.

An inherent risk can be further related to ‘what can go wrong’ on an assertion level.
2.2 Describe for each relevant aspect from the previous table, which inherent risk might have an impact
on the risk of material misstatement either on financial statement level or on assertion level. [5 points]
Inherent risk
A
Risk of fraud: manipulation of figures in order to satisfy management or the Board in times of strong
competition.
Risk that inventory decreases in value, inherent risk that valuation is not in accordance with US GAAP.

B
Inherent risk of errors in managerial reports, long distance communication. Overall inherent risk of
errors in financial reporting.

C
Inherent risk that existence of inventory is compromised, cut-off of deliveries, revenue recognition cut-
off

D
General Inherent risk of fraud because of target pressure, trying to meet impossible targets etc. Or
inherent risk of errors or fraud in sales (occurrence of sales transactions) and inventory (completeness
of inventory difference, valuation of inventory) figures.

E
Risk of non compliance with rules and regulations, the company has been listed as of this year.

As part of your audit planning procedures, you decide to explore the role of Human Resources and Payroll
within Cheetah. You schedule a conversation with the HR director Mr. Penny. The HR director is involved in the
verification of the annual bonuses for management. The HR director shares the following circumstances with
you which may create an increased risk of material misstatement due to fraud:
- Sales management bonuses are based on revenue. Revenue targets are ambitious and Cheetah
engages in complex sales agreements; and
- Periodic stock counts are conducted at the warehouses by warehouse staff. The warehouses in
Rotterdam (The Netherlands) and Abuja (Ivory Coast) have often difficulty delivering products;
according to the system the products should be on the shelf, however cannot always be found.

The above information makes you alert of the possibility of fraud risks.

2.3 For each of the two circumstances, define the fraud risk that you as auditor should consider . [2
points]

Fraudulent financial reporting: modifying the numbers in order to achieve the targets on paper and
collect the bonus

Misappropriation of assets: warehouse manager is counting the stocks as well, not independent as the
custodian. Stocks could go missing which would stay undetected.
2.4 For each of the two circumstances, indicate a possible response by you as the auditor. [2
points]

Modification in the approach: for example, focus more on the process around how KPI reports and
whether they are reviewed independently before bonuses are determined and paid out.

An alteration in the nature/timing/extent of procedures: spend more time on test of controls regarding
the stock count procedures, or review of segregation of duties etc.

Exercise 3 Internal Control [13 points]

Given: Case Cheetah continues: During the planning phase, you planned to rely mainly on evidence gathered
from test of controls and apply a limited number of substantive procedures in the inventory and warehousing
cycle.

Required:
3.1 Describe for each category below an example of a test of control you can execute to assess internal
controls in the sales cycle. [4 points]

Method of testing Example of test of control for sales cycle

internal control
Inquiry Interview sales staff to understand sales agreements, sales invoicing, discounts
etc.

Inspecting documents Verifying approval of sales invoices, sales orders etc.

Observation Observing how sales orders are processed, how application controls in the
system work

Re-performance Recalculating the monthly reconciliation regarding sales bonuses

After the interim audit and multiple test of control procedures, you and your team concluded that the internal
controls surrounding the sales ordering, price setting and invoicing (part of the sales cycle) are not sufficient to
rely on.

3.2 Explain how this conclusion (that internal controls are not sufficient), impacts and relates to the Audit
Risk (AR = IR x CR x DR). [3 points]

Audit risk needs to be at an acceptable level in order to provide the reasonable assurance. In case the RMM
is higher than initially assessed, then the DR needs to be lowered by means of additional substantive
testing.

In order to address the deficiencies in internal control, you distributed a management letter including your
recommendations regarding internal control improvements. Mrs. Sunshine and Mr. Wave agree with the
findings in the management letter, however they have a different view on how to implement the
improvements for the warehouse and sales.

3.3 Provide an evaluation of the internal controls as proposed by Cheetah. Use the table below to
document your findings and remember the concepts of segregation of duties. [4 points]
Internal control measure Effective? If not, describe the risk of material misstatement
The warehouse manager will No Lack of segregation of duties, the warehouse manager is
conduct periodic stock counts in held responsible for inventory differences, so he might not
the warehouse and will report report the differences at all
and analyze the stock count
differences
The sales managers will create a No Sales managers will be tempted to overstate revenue,
monthly sales target overview to there is lack of a reporting duty which will create KPI
substantiate their actual sales reports independently from the sales/authorization duty
versus budget and target

Mr. Wave is convinced that the internal control framework at Cheetah should be aligned with a worldwide
acknowledged framework for internal control.

3.4 Explain how the COSO element Risk Assessment can support internal control at Cheetah. [2 points]

Risk Assessment is used to score identified risks on a scale to determine likelihood and impact. Based on the
risk appetite of the company the company can determine which control activities are applied to mitigate the
risks.
1. Control Environment: How has management put into place policies and procedures that guide the
organization? What kind of tone has management set in the organization so that everyone knows
that they are supposed to make sure that your controls are operating effectively and are achieving
the results that they expect?
2. Risk Assessment: How does your organization assess risk in order to identify the things that
threaten the achievement of their objectives?
3. Information and Communication: How does management communicate to their internal and
external users what is expected of them? How do you make sure that you receive
acknowledgement from those people that they understand what you’re asking them to do?
4. Monitoring Activities: How does management oversee the functioning of the entire organization?
How do you identify when things aren’t working correctly and correct those deficiencies as quickly
as you possibly can?
5. Existing Control Activities: What are the controls that you currently have in place? Were they in
place and operating effectively over a period of time?

Exercise 4 Audit evidence [13 points]

Given: Case Cheetah continues:
The interim audit has finished and you are about to start with the final year-end audit. You acquired the
following information regarding the fixed assets in the balance sheet.
Fixed assets:
Cheetah periodically revalues land and buildings. Once every 3 years an independent company is requested to
revalue the land and buildings Cheetah owns. The company provides Cheetah with a specialized report
explaining and supporting the value. Buildings are depreciated according to a standard method which is
mentioned in the financial statements. During 2018 in total 5 new warehouses were acquired.

Required:
4.1 Complete the following table to indicate which substantive procedure and audit evidence is required
to verify the different assertions related to Land and Buildings.[6 points]
Assertion Substantive procedure Audit evidence
Existence Inspection of assets: Perform an observation Contracts, legal documents, photographs
(sample based) to verify the existence of the
buildings. Verify official documents such as
 extracts from the local government or verify the
contracts signed by both Cheetah and external
parties

Valuation Inspection of records or external confirmation (in Valuation documents, official report
case a second opinion is requested to determine
the value) Asset/depreciation overview

Recalculation of asset overviews

Rights and Inspection of records and confirmation from third Extract from the local government
obligations party stating ownership

Analytical procedures are a specific substantive audit procedure used to gather audit evidence.

4.2 Explain how you would use an analytical procedure to audit the bad debt provision included in the
financial statement at year-end. [2 points]
 Develop expectation of the account (based on previous years, or ratio analysis)
 Determine amount of difference that is acceptable
 Compare the actual provision with the expectation and determine the difference
 Investigate the difference and evaluate the possible causes

Audit evidence should be both relevant and reliable.

4.3 Indicate in the table below which audit evidence you find more reliable or relevant and explain your
answer. [3 points]
Audit evidence Most Explanation
reliable/
relevant:
A or B
A: letter received from customers B Documentation received from external parties without
via your audit client to interference of the auditee increases reliability
substantiate the outstanding
receivable amount
B: letter received directly from
customers to substantiate the
outstanding receivable amount
A: Export from the Accounting A Reliable: Assuming application controls are well set-up and
information system of sub ledger manipulation of figures is difficult
accounts payable at year-end
B: Overview in Excel of the
accounts payable at year-end
with additional columns of
payment terms

The year-end (final) audit is about to come to an end and you are preparing the auditor’s report including your
audit opinion. You are reviewing the total of audit differences you identified and are comparing these to the
materiality you have defined.

4.4 Explain the difference between an unqualified opinion and a qualified opinion (such as an adverse
opinion) and which role the materiality plays in determining the final opinion. [2 points]

qualified means that the auditor concludes with reasonable assurance that the financial statements present
fairly, in all material aspects the financial position and the results in accordance with GAAP.
In case material deficiencies exists in the financial statements, the opinion cannot be unqualified. Material
means that the differences are sufficiently important to influence economic decisions made by reasonable
users of the financial statements.