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MGT 321 Assignment

Ishan Sharma (999877085)
Sinan Abdulsattar (1000015690)
University of Toronto
Prof: Manfred Schneider

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PART I
To: Taylor Swift
From: Bea Calm
Date: November 15, 2014
Re: Audit Acceptance and Audit Plan
1. Preliminary engagement memo
1.1 Background Information
Nuvo Research Inc. is a Canadian public company (TSX:NRI) in the business of manufacturing and
providing pharmaceutical products and technologies. Predominant products sold by Nuvo include but are
not limited to: Pennsaid, Pliaglis, Oxoferin and WF10. Nuvo manufactures products that are sold
worldwide. The Company was incorporated on August 22, 1983 under the laws of the Province of Ontario
as Clark Pharmaceutical Laboratories Ltd. The Financial Statements are prepared in accordance to the
applicable reporting standards as outlined in the Canadian Institute of Chartered Accountants Handbook.
Since Nuvo Research Inc. is a publicly listed entity, financial statements must be reported using the
International Financial Reporting Standards (IFRS). Ernst & Young has recently indicated that they will
be resigning from the audit for 2014. The decision was made by NRI, based on expensive audit fees, as
the board is hoping to reduce overhead costs going into the future.
1.2 Objectives
The objective of the audit-planning memo is to provide an effective and efficient framework for the audit
process, which will then serve as an adequate tool that will be used to perform the audit. Also, the memo
will determine audit risk and discuss how to eliminate it as much as possible. Once this is completed,
clear communication will be made to ensure that both parties, auditor and client, are on equal terms and
understand the expectations and needs of the auditor. The audit-planning memorandum is prepared in
order to assess potential risks involved with audit work, along with key issues, which are discovered by
the auditors or brought to their attention. During the preliminary planning process stage, an understanding
of how each department functions as well as the internal control systems is obtained.
The role and responsibility of the auditor is outlined in the Canadian Auditing Standards. CAS 200 states
that the objectives of an independent auditor is to obtain reasonable assurance that the financial
statements as a whole are free from material misstatement (CPA Canada, 2014), enabling the auditor to
express an opinion and report on the financial statements and understand what is required of the CAS.
1.3 Accepting the Engagement:

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1.3.1 Understanding the client
The first step to the engagement is to understand the business, the business environment and the industry
itself. This will be the first time that MGT LLP audits Nuvo Research Inc. because the client has stated
that the previous auditing firm is too expensive and that the client is trying to reduce overheads.
Nuvo Research Inc. seems to be unable to afford the audit fees of the other firm, whereas, they were able
to afford it in the past. The auditors of the engagement need to exercise professional skepticism and have
a questioning mind when conducting the audit, should they choose to accept it. They should not assume
that the information that is presented is free from material misstatements and should be wary of potential
fraudulent activities. The first action should be that MGT LLP asks for permission to contact the
predecessor firm, Ernst and Young, due to confidentiality issues and enquire with them. MGT LLP should
obtain EYs working papers. As stated in the Rules of Professional Conduct - RPC 302.1, A firm shall
not accept an engagement without first communicating with the (predecessor) firm and enquiring
whether there are any circumstances which might influence the decision whether or not to accept the
engagement(CPA Ontario, 2014) and 302.3, A (predecessor) firm shall inform the possible successor if
suspected fraud or illegal activity by the client may have been a factor in the clients decision to appoint a
successor(CPA Ontario, 2014). Finally, we must also follow CAS 210, which highlights the conditions
before acceptance of an engagement. It mainly specifies that the client must have financial statements
which have been prepared by the appropriate financial reporting framework, which is IFRS in this case.
1.3.2 Other Considerations
MGT LLP should pay special attention to related party transactions, proper consolidation for subsidiaries
and legal considerations for operations outside Canada. The objective of the auditors at MGT LLP is to
also state key users of the financial statements. These users are the many new shareholders of NRI, the
CRA for tax purposes, and creditors.
1.4 Competence
The next step of the process is to assess MGT LLPs competence. We must ensure that we have the
competence and the resources needed to complete the audit. As stated in RPC 203.1, A member shall
sustain professional competence by keeping informed of, and complying with, developments in
professional standards(CPA Ontario, 2014). MGT LLP must have enough knowledge of the client,
environment and industry to complete the audit sufficiently. MGT LLP must ensure that we evaluate our
competence going into the engagement, and the competence of any potential component auditors should
we require one. With a professional staff of 37, we must ensure that the ones selected for this assignment
possess the required competence. MGT LLP is a small sized accounting firm whose clients range from
private corporations to entrepreneurs; we need to ensure that we have the required competence, skills, and
knowledge to audit a large public company, such as Nuvo Research Inc.

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1.5 Independence
In the next component, MGT LLP must ensure its independence. As required in the Canadian Standards
of Quality Control, The firm shall establish policies and procedures designed to provide it with
reasonable assurance that the firm, its personnel and, where applicable, others subject to independence
requirements (including network firm personnel) maintain independence where required by relevant
ethical requirements (CPA Ontario, 2014).
MGT LLP must ensure that we follow what is outlined in the Canadian Standards of Quality Control
(CSCQ) and RPC. In the RPC, it is stated that the firm shall be and remain independent such that the
member, firm and members of the firm shall be and remain free of any influence, interest or relationship
which, in respect of the engagement, impairs the professional judgment or objectivity of the member, firm
or a member of the firm or which, in the view of a reasonable observer, would impair the professional
judgment or objectivity of the member, firm or a member of the firm (CPA Ontario, 2014). After
identifying possible threats to independence, MGT LLP should then determine what safeguards can assist
us in reducing a possible threat to independence. Furthermore, it is strange that Nuvo Research Inc.
decided to switch their auditors very late into the year (November 15, 2014) with a December 31 yearend. Possible reason could be that Nuvo Research Inc. believes that MGT LLP will charge a lower audit
fee, but ultimately MGT LLP will provide no fee quote until sufficient and appropriate information is
provided. This is consistent with RPC 214 and 215. RPC 214 states, A member or firm shall not quote a
fee for any professional engagement unless adequate information has been obtained about the
engagement (CPA Ontario, 2014). Further, RPC 215 states that (A) firm engaged in the practice of
public accounting or in a related business or practice shall not offer or engage to perform a professional
service for a fee payable only where there is a specified determination or result of the service, or for a fee
the amount of which is to be fixed, whether as a percentage or otherwise, by reference to the
determination or result of the service (CPA Ontario, 2014). Once this is completed and the status of the
engagement is accepted, MGT LLP must provide a written engagement letter. The engagement letter
outlines the objectives and scope of the audit. It also includes the responsibilities of the auditor and the
management, as well as the appropriate financial reporting framework that will be used. The letter should
include the nature, the timing of the work and extent of the work that will be completed. The next step of
this process is to outline the responsibilities of the auditors and management. The responsibilities of the
auditor are as outlined in CAS 200 and previously stated in this report.The responsibilities of
management include preparing the financial statements in accordance to the appropriate GAAP, as well as
maintaining appropriate internal controls to reduce risk as much as possible. The final step is to test for
potential fraud. MGT LLP can do this by contacting previous auditors and using the working papers to
obtain evidence. To ensure that we have obtained sufficient and appropriate audit evidence, MGT LLP

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can review previous cases or legal letters regarding fraud in order to confirm potential claims or can
contact external specialists that can assist in valuations or related party transactions.
1.6 Other considerations:
CAS 600 - Special Considerations
MGT must take the component auditors into account as this would be a group audit. NRI is a Canadian
company but it has offices and subsidiaries around the world, one of which is in Europe. MGT should
have the competence and the resources to complete the audit in its local area of Toronto, but may not have
the capabilities to audit its other subsidiaries that are located outside Canada, therefore a component
auditor may be required. The group engagement partner will be responsible for the direction, supervision,
and performance of the engagement team and the adherence with professional standards. The group
engagement partner is responsible for setting materiality, scope, timing of the audit, as well as evaluating
component auditors competence and reviewing their working papers.
1.7 Materiality
A crucial part of the audit is the assessment of materiality. According to CAS 320, misstatements and
omissions are considered to be material if they individually or jointly can reasonably influence the
decisions of a user. This is important because it determines the extent of the audit testing. There exists an
inverse relationship between materiality and audit risk. Therefore, the higher the materiality, the more
testing is necessary to collect sufficient and appropriate audit evidence, in order to minimize audit risk.
The first step is to determine who exactly constitute the users of the financial statements. Nuvo Research
Inc. is a public company, and this means that the shareholders are the users and are most affected by the
financial statements. Other users can be the clients and customers who depend on the antidotes and
medicine which Nuvo produces. They would definitely want to know the financial position of Nuvo and
want the assurance that Nuvo is a going concern and will not go bankrupt. Materiality is based upon
professional judgment of the auditor and this usually involves quantitative as well as qualitative analysis
of data. Quantitative analysis means that a specific standard is set based on financial statement values of
income tax expense, long-term financial liabilities or gross profit. The standard, which is set, is mainly
based upon specific criteria of qualitative analysis.
The first one deals with unusual or large changes in assets, liabilities or shareholders equity. The main
accounting definition is that Assets = Liabilities + Shareholders Equity. MGT LLP must ensure that the
increases or decreases are consistent and accurately reflected in the financial statements. This is important
because it greatly affects the materiality. To illustrate, assume that there is a significant increase in
liabilities, such as a long-term note payable, while there is a small increase in assets. This will cause the
accounts to imbalance and create a potential risk of a material misstatement.

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The second criteria deals with specific accounts which are key to the shareholders of the business. One of
the most important measures of a business is Net Income. The shareholders are very interested in the Net
Income because it affects their dividends as well as the earnings per share. Another important factor is the
liquidity and solvency of Nuvo Research Inc., as potential investors are anxious to see if Nuvo Research
Inc. is able to pay their liabilities. As a medicine research company, there is a great deal of money that is
invested in research to find cures. In the market, these cures can sometimes be successful or sometimes
fail. MGT LLP must be very cautious and must maintain professional skepticism in order to be able to
provide a professional opinion on the financial statements. As seen in Exhibit 1, there was a 353.87%
decrease in the debt to equity ratio compared to last year. This indicates that Nuvo is more financially
stable because they are consistent in paying off their debts, which has a positive impact on the image of
the business to the users.
The third criteria deals with related party transactions. Nuvo Research Inc. owns 3 subsidiaries, all of
which are in the health-related industry. As stated in the provided financial statements, there are no related
party transactions except for key management compensation. Therefore, the risk of fraudulent related
party transactions is low, and this lowers the amount of testing necessary and makes it easier to determine
materiality.
Fraudulent activities are the fourth criteria. As stated above, MGT LLP can contact specialists to assist in
locating fraudulent activities. It is not good that Nuvo reported a Net Loss this year. Utilizing professional
skepticism, it can be seen that management at Nuvo might be tempted to change earning figures, overstate
assets or even understate liabilities. Considerable amount of testing should be done to ensure professional
competence of work.
2.0 Risk
The objective of an auditor is to obtain a high degree of assurance in the financial statements, as well as to
gather sufficient and appropriate evidence to reduce audit risk as much as possible. A note to mention is
that it is not possible to produce 0% risk and 100% assurance because absolute assurance is costly and
time consuming, as well as infinitely improbable to achieve. Therefore, auditors are obliged to perform
reasonable assurance. Risk is divided into three main categories: inherent risk, control risk and detection
risk.
Nuvo will be regarded as a high-risk audit due to its involvement in the production of diverse products
and technologies. Also, they have several amortization expenses, research expenses, and impairment
issues. Finally, they recognize revenue from different locations and have different streams such as
royalties, which are related to their sales of Pennsaid sales with Horizon, which complicates this audit.

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Therefore, we have high control risk and high inherent risk, which makes this a high-risk audit. Below are
the different risks that are associated with NRI
2.1 Inherent Risk
This kind of risk is defined as the risk of material misstatements occurring from reasons other than the
failure of controls. Nuvo Research Inc. is a public company and its financial statements prepared by
management have users that include shareholders, potential investors as well as analysts. From a neutral
standpoint, this might potentially create a bias from management towards stating higher earnings and
reporting more successful results in order to impress the users of the financial statement. This creates
inherent risk because the risk of a misstatement happening in the first place is higher. Furthermore, this is
the first time auditing Nuvo for MGT LLP and this further increases inherent risk because they do not
have a previous experience in auditing this client. Also, considering the complexity of the business
industry, it can be seen that complex transactions involving pharmaceutical drugs may be inherently risky.
An addition to this, Nuvo Research Inc. also has 3 different subsidiaries, which are located in different
countries. This has an effect on inherent risk because it will require MGT LLP to reach out to other
auditors of the different subsidiaries to gain sufficient and appropriate evidence for this audit. In this
industry, usually, there are many litigation issues, which arise from patents, research, etc. This usually
leads to contingent liabilities, which are hard to measure and can have faulty assumptions. As a
pharmaceutical company, Nuvo has to follow strict government laws, which many of the times can lead to
litigation if they are not followed. This can sometimes be tricky because licensing fees and collaboration
agreements complicate revenue transactions and expenses. Nuvo Research enters agreements for product
development, licensing, supply and distributions of its commercial products. These kinds of agreements
can lead to complications due to different ways of revenue recognition; Nuvo Research reported revenue
from 4 different categories Product sales, Royalties, Research and other contract revenue, Licensing fees.
In this case revenues can be contingent because the agreements made have certain conditions, so when all
conditions are met revenue is recognized.
Inherent risk is high due to Nuvos business diversification. They are approved to sell Pennsaid in many
countries, Pliaglis in most western countries and HLT patch in the European market. Furthermore, Nuvo
Research Inc. has two main business units, which are Technology and Topical Product Solutions and
Immunology Group. This also increases inherent risk due to the rapid development in technology that
might sometimes leave companies with obsolete technology, research and development as well as
impairments due to trademarks and patents.

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The management of Nuvo Research is worried about their high reliance on external funding. This is due
the the fact that they are not able to fund themselves with the revenue they currently generate. This
increases risk due to the need to report healthy figures to generate more funding and loans in order to
continue operations.
This company operates internationally, and this forces it to deal with credit risk due to its global client
base and foreign transactions. These dealings increase issues for accounts receivables of the business.
There is low risk from this industry because Nuvo Research sells its products to corporations, not to
regular customers. An issue of credit risk can arise here is if the corporations buy from Nuvo using credit
and not cash or cash equivalents. There can be higher inherent risk due to estimates for the account
receivable such as aging of receivables. This can cause discrepancies between accounts receivable and
bad debt or uncollectible bad debt expense.
2.2 Control Risk
This risk arises when a companys internal controls are not strong enough to prevent material
misstatements by employees. Nuvo Research is a publicly traded company; therefore it must comply with
the applicable financial reporting framework, which in this case would be IFRS. Since this is a first time
audit for MGT LLP to Nuvo Research, the auditors must obtain a thorough understanding of the key
controls used by their client. This is done by administering tests, which assess the reliability and
efficiency of current internal controls. The assessment of the efficiency of the companys operations and
reliability of the financial statements can be done through an interim audit. Once that is completed,
auditors must check the reliability of the internal controls using a test of controls. As a public company,
Nuvo is obligated to have their internal controls assessed every three years, and the last interim internal
control test was performed in October. Testing the effectiveness of design, implementation and
maintenance of internal controls by management to address identified risks is a key procedure. In addition
to this, MGT LLP will test the safeguards of customer information and transactions in order to ensure that
sufficient controls are in place to protect assets and internal data. Nuvo Research has established internal
controls since it was founded in 1983. This implies that they should have better performing internal
controls due to more experience and time, and this should further lower control risk. However, due to the
advancement in technology, especially in the field of medicine, Nuvo Research might have an outdated
system, which needs to be renewed, thus increasing control risk. Furthermore, Nuvo Research also has
subsidiaries around the world, and many locations worldwide. Having many locations and offices affects
control risk due to the broadness of operations and the associated greater risk of errors. There may be an
issue with accounts receivable due to Nuvo Researchs worldwide involvement. They need to assess the
collectability of accounts from all around the world. Furthermore, Nuvo Research might consider hedge

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accounting and derivatives in order to combat foreign currency risk. By choosing not to hedge, this
increases currency volatility risk and reduces future benefits from hedging.
2.3 Detection risk
This kind of risk happens when there is failure in recognizing a material misstatement. Inherent and
Control risk cannot be altered by the auditor, but detection risk can. As stated earlier, it is not feasible or
possible to attain 0% risk because of the fact that the audit will be costlier and more time consuming to
the client. Due to this fact, auditors need to select sample sizes to reduce the amount of testing to a
manageable level, while still maintaining a high degree of assurance. This is done by reducing sampling
and non-sampling risk to a low level by utilizing professional judgment and selecting adequate samples.
Factors such as inaccurate assumptions and evidence increase detection risk, which is defined as the risk
of not being able to detect a material misstatement in the financial statements.
Detection risk can be lowered through a substantive auditing approach, where the auditor attempts to find
material misstatements. The substantive testing usually stems from 6 main assertions; completeness,
existence, valuation, allocation, existence and presentation. The objective is to lower detection risk to a
level as low as possible, due to the high inherent and control risk. Furthermore, MGT LLP should attempt
to decrease the sampling risk by picking a comparable and effective sample.
2.4 Business risks
2.4.1 Liquidity risk
Nuvo research faces a minor liquidity risk due to the industry they are in. As a medical research company,
some parts of Nuvos sales are paid by credit. Therefore, there is a minor issue of the possibility of not
retrieving the full amount they are owed. Also, as a medical research and pharmaceutical company, Nuvo
has high research expenses, which are usually paid by creditors. The issue here is that Nuvo has to pay
back what they owe. They have made a timeline regarding when to pay the amounts and for 2015, they
must pay $377,000. $51,000 of this amount are interest payments that are set at 15.5%. As such, Nuvo is
under a tight constraint to pay these amounts given the fact that must pay the interest payments even if
they pay early due to the prepayment penalty charge.
2.4.2 Fraud risk
Nuvo research is under a tight constraint due to their research division. They must show that they are
successful finding new cures using their research fund, which is backed by creditors. Nuvo has an
incentive to show that the research funds are used efficiently and are generating results. Therefore they
have an incentive to show themselves in the best possible light.
2.5 Audit Approach
In order to address the risks of material misstatements, the auditors at MGT LLP must follow the

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framework set out by their audit approach. They must first address the high-level control risk and inherent
risk which currently exists by using a substantive approach to lower detection risk to an acceptable level.
Nuvo Research has high inherent risk and high control risk, which will require the usage of an extensive
substantive approach to lower detection risk. In addition to the substantive testing, MGT LLP should run
a test of controls in order to decrease detection risk in the case where the substantive testing fails to
reduce the risk to an acceptable level. If both tests are done, this will become a combined approach,
however, a combined approach should only be done when the auditors at MGT LLP cannot rely on the
internal controls. These two tests are critical to the success of this audit because the current internal
controls need to be regularly assessed to maintain accuracy and efficiency.
Due to the weak control environment, MGT LLP will have to conduct more substantive testing in order to
obtain sufficient and appropriate evidence for this audit. Extra attention should be placed on the following
accounts:
2.5.1 Accounts receivable
Accounts receivable is subject to risk due to Nuvo Researchs international business. The accounts
receivable is affected by the different risks of operating in each specific country. This creates risk because
Nuvo Research is exposed to credit losses, which arises from sales to customers in foreign countries. Due
to the international business environment, income will usually be recorded from accounts receivable and
not straight cash. It may be difficult for international collectability and increases inherent risk. For control
risk, MGT LLP should ensure there are proper controls to ensure accurate recording of accounts
receivable. If there arent sufficient internal controls for this segment, a combined approach, of
substantive testing and test of controls should be placed.
2.5.2 Inventory
Inventory more than doubled this year from 990 to 1929. But at the same time, there was a write down,
which suggests they are not able to sell all of their products. Inherent risk will be high if there is inventory
impairment. Substantive testing should be administered in order to negate this issue. Furthermore,
inventory can be externally valued from a third party in order evaluate inventory better. Auditors are not
experts for counting chemicals and it is very costly and timely to have an auditor perform these services,
therefore having a team of external experts evaluate inventory can help the auditors obtain more sufficient
and appropriate evidence. It is also important to mention that approach Nuvo Research Inc. recognizes the
inventory lower of cost and net realizable value. MGT should also test the safeguards set in motion for
inventory.
2.5.3 Revenue
Nuvo Research has two main business units and has revenue coming from 4 different streams. There is

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high inherent risk due to the different business agreements, which must be complied with in order to be
recognized as revenue. Contingent revenues are not straightforward due to the requirements that must be
met to be recognized, and this creates extra work in order to determine how to divide revenue streams.
This increases the chance of misstatements due to the complexity of transactions, and thus more
substantive testing should be administered. In addition to this, the global market adds risk mainly from
the foreign currency exchanges. The main currencies, which Nuvo Research works with, is the Canadian
Dollar, U.S dollar and the Euro, along with some other currencies. It does not appear that Nuvo hedges
against the risk, so they are not protecting themselves from currency fluctuations and this creates risk.
Nuvo Research is susceptible to currency risk and this further escalates inherent risk. From another
perspective, control risk can also be affected if there is no segregation of duties. Therefore there must be
efficient controls set in place, such that employees cannot recognize contingent revenues if they are truly
not recognized yet. A test of controls should be done in order to ensure this.
2.5.4 Cash and cash equivalents
This account must be properly checked for its existence and ownership. The procedures needed to check
for their existence would be inspection as well as external confirmation. Positive external confirmation
can be done through communication with the bank, in order to make sure that Nuvo has $48,275,000 in
cash and cash equivalents. Additionally, there should be an inspection of past transactions in order to
ensure the ownership, and completeness of the cash equivalents.
2.5.5 Account payable and accrued liabilities
Nuvo Research Inc is under tight pressure to pay back what it owes. They have contractual obligations,
purchase commitments and other obligations to pay the total to $12.0 million. They are under pressure
because the obligations must be paid in less than a year while $0.4 million of contractual obligations are
due from 2016 to 2018. Furthermore, the notes explain that Nuvo Research does not generate enough
money in order to fund their own operations, and therefore they depend largely on external funding. This
creates issues because it might not be able to pay obligations that are due this year, resulting in late
payment charges and penalties. There is high inherent risk due to the risk of an intentional misstatement
in order to show the company in the best possible light. This might be done in order to impress creditors
and shareholders and this leads to fraudulent activity. Control risk is high here as well, as there are weak
internal controls to stop this from happening. A possible solution is to have the CFO and treasurer recheck
each others work, rather than have the authority given to only one of these individuals. A combined
approach where there will be substantive testing as well as a test of controls is recommended.
2.5.6 Research and development Expense
There is high inherent risk for this type of expense due to the complexity of capitalizing or expensing
research and development. Furthermore, research and development is critical for the existence of this

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company because it depends on the success of creating breakthroughs. If certain criteria are met, these
expenses can be capitalized as assets, so care needs to be taken, as this implies a high inherent risk.
Substantive tests should be administered to ensure that the capitalization or expensing of research and
development is correctly done.
2.5.7 Intangible assets - The values that Nuvo Research calculates for intangible assets require
significant estimates and assumptions, both of which increase inherent risk. Management states that these
estimates can impact Nuvos future results, meaning they are critical for the company. Therefore, it is the
auditors duty to ensure the accuracy of the estimates and assumptions. Auditors of MGT LLP should use
a substantive testing approach in order to ensure the accuracy of the account. Furthermore, a test of
controls should be done as well, due to the importance of this account. The strength of the internal
controls related to this account must be sufficient and adequate.
Exhibit 1
Ratio analysis
Ratio

Current Year

Past Year

Percent Change

Reasoning

Current Ratio

6.887

3.0086

128.91% increase

This is due to the

huge increase in
cash. Current
liabilities
comparatively
stayed similar.
They also have a
new short term
investment.

Debt Ratio

0.1455

0.4358

199.52% decrease

Liabilities
comparatively
stayed the same,
the decrease in
percentage is due
to the huge
increase in assets.
They also paid
most of their

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current
obligations.
Debt to Equity

0.1702

0.7725

353.87% decrease

Ratio

They paid off

most of their
current obligations
from liabilties and
are also paying off
the huge deficit
which they have.

Cash to Total

0.7545

0.5837

29.26% increase

assets ratio

Cash increased
from $12,261 to
$48,275 (in
thousands of
dollars)

3. CONCLUSION
Exhibit 2
3.1 Fee Quotation:
Job Description

Time required

Fee Rate

Total

Audit Planning

2 weeks

$4500/week

$9000

Fieldwork (including expert opinion)

2 weeks

$14000/week

$28000

Compiling data and audit report

2 week

$5000/week

$10,000
$47,000

In order to support NRIs overhead reduction objective, we have made special conservative arrangements
for our audit fees. We believe that the above fee quotation $47,000 is a conservative amount for this audit.
Should NRI stay a client with us for the forthcoming years, the audit fee will decrease as we can
eventually rely on our work. A note to mention is that additional costs may arise throughout the process
due to a need for an external expert as well as the resources required for the component auditors.

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3.2 Client Acceptance
The final decision to accept this client is chosen by our audit partner. However, in our professional
judgement, we believe that the audit engagement should be accepted. NRI is a high- risk clients and
requires additional work, but, this gives our firm an opportunity to expand our portfolio to companies that
are not private or run by entrepreneurs. A client such as this, in my opinion, is critical to the long term
success and expansion of MGT LLP.
PART II
PART A
To: Audit Partner
From: Bea Calm
Re: MinArrels
There are many implications of mothballing on the Property, Plant and Equipment account. In the case
of MinArrels Corp., all use of the PP&E on a particular job site is suspended when the job site is
mothballed. This creates an uncertainty of the estimated usage of the plant and machinery from period
to period. This uncertainty is not captured by the method of depreciation used by MinArrels Corp.
Further, maintenance services continue to be performed on the mothballed PP&E, which raises
additional maintenance expense related to the asset, even while the asset is not generating any cash flows.
These implications create an issue related to the matching concept, which, as defined under ASPE
1000, is a concept which involves the simultaneous or combined recognition of revenues and expenses
from the same transactions or other events (CPA Canada, 2014). The matching concept implies that
the expenses incurred for depreciation of an asset should be matched with the cash flows that are
generated through the use of the asset in the same period. The practice of this concept is skewed with the
mothballing of operations at mining job sites. Also, there are implications associated with the existence of
the assets which are mothballed. The PP&E are mothballed, but they are still listed on the financial
statements, which means they must still exist, be complete and the company must have ownership of
them. This creates more responsibilities for us, as the audit team, to thoroughly assess, both physically
and with the use substantive testing; the existence, completeness, ownership, valuation and presentation
of the items in the PP&E account. Furthermore, there are implications of mothballing on the value of the
mining PP&E owned by MinArrels. As noted, economic conditions determine the decisions of the firm to
mothball certain mining operations. When economic conditions are adverse, this may pose potential
impairment issues on the value of PP&E. Adverse economic conditions may impair the value of these
assets, creating the risk of potential misstatements in the account, if these impairments are not accounted
for adequately.

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The fact that the financial statement audit of MinArrels is a new one for the firm also poses greater
responsibilities us as the audit team. To confirm the opening balances of the accounts, we must contact
the predecessor audit firm. We must communicate with the predecessor that we will require their working
papers of the audit on MinArrels, along with their full compliance with our audit team. We must also
assess whether the predecessor firm can be relied upon by our audit team, and only proceed if the
predecessor appears to be reliable. If there is no predecessor audit firm, we must exercise greater caution
and more thorough testing of the assertions by MinArrels in the PP&E account.
Depreciation, as defined in ASPE 3061, begins when [the asset] is available for use; i.e. when it is in the
location and condition necessary for it to be capable of operating in the manner intended by management
(HTK, 2014). Also, depreciation does not stop when the asset becomes idle or is retired from active use
(HTK, 2014) Thus, when the assets are mothballed, the depreciation does not stop even though the use of
the assets has stopped. Also, as stated by ASPE 3061, the amortization method for PP&E employed by the
firm should recognize amortization in a rational and systematic manner appropriate to its use by the
enterprise (CPA Canada, 2014). In the case of MinArrels, the firm uses the method of straight-line
depreciation. Ingrained in the calculation of straight-line depreciation is the assumption that the asset will
be used equally over the course of its useful lifetime. However, in the case of MinArrels, mothballed
PP&E is shut down, with only essential safety and maintenance operations left running. During the period
of mothballing, the assets at the job site are not used and do not generate any cash flows or income.
Through this observation, it can be seen that the straight-line method of depreciation used for assets such
as plant and machinery may not necessarily be the most accurate estimate of depreciation, as the usage of
the assets is subject to the volatility of economic conditions. ASPE 3061 states that the method of
depreciation of an asset should be reviewed on a regular basis, with a list of significant events which may
trigger the need to review the depreciation method of certain assets. Relevant to the case of MinArrels
would be events which result in a change in the manner in which the asset is used (CPA Canada, 2014)
and removal of the asset from service for an extended period of time (CPA Canada, 2014). Using an
inaccurate and unreasonable estimate of depreciation may result in material misstatements in both the
income statement (related to expenses) and the balance sheet (related to the PP&E account). In years in
which an asset is not being used, a potentially unreasonable estimate of the depreciation of the asset may
cause net income to be lower, allowing MinArrels to effectively pay less income taxes. A more accurate
measurement of depreciation on mothballed assets may be the use of a variable charge method, which
reflects the service of an asset on the basis of its usage (through the amount of machine hours, etc.). We,
as the audit team, must perform specific audit procedures to assess that the estimates of depreciation used
by MinArrels are accurate and represent most reasonably the use of the assets in the periods in which
depreciation expense is incurred.

16
There are many risks related to the PP&E account in general. To assess the accuracy of the account of
PP&E, we will need to first determine whether the included assets conform to the criteria in GAAP. As
defined in ASPE 3061, assets included in PP&E must meet the following criteria:
(i)

are held for use in the production or supply of goods and services, for rental to others, for

administrative purposes or for the development, construction, maintenance or repair of other

property, plant and equipment;
(ii)

have been acquired, constructed or developed with the intention of being used on a

continuing basis; and

(iii)

are not intended for sale in the ordinary course of business. (CPA Canada, 2014).

In determining the accuracy of the PP&E account, we must assess the existence, completeness,
ownership, valuation and presentation of the assets in the account.
The first risk is the risk that the assets simply do not exist. To overcome this risk, we will have to inspect
the assets on the balance sheet. This will require a trip to the various mining operations and a physical
observation of all the property, plant and equipment on the balance sheet. As this may require significant
financial costs, we may utilize other firms in the jurisdictions of the various mining operations to act as
our agents, and check the assets on our behalf. Also, to determine existence, we will have to probe
documents to determine whether these assets were recorded in the correct periods relevant to their
acquisition and disposal.
The second risk is the risk that all the PP&E transactions are not recorded on the balance sheet. To
overcome this risk, we will have to perform audit procedures to determine completeness. We will analyze
the ledgers and reconcile the general ledger to the subsidiary ledgers. We must also analyze any general
maintenance or repairs on the assets, and evaluate whether these were correctly recorded in the ledger of
the period. Also, we will determine whether repairs, maintenance or betterments are correctly expensed or
capitalized in the reporting period.
The third risk is the risk that MinArrels does not own, i.e. possess all the rights and obligations, of the
assets in the PP&E account. We will perform specific audit procedures to determine ownership of the
assets. We will examine the titles to determine which assets are owned by MinArrels, and compare these
against the non-leased assets in the balance sheet. Also, we will analyze lease agreements to determine
which assets are leased, further comparing our findings to the presentation on the balance sheet. For
leased assets, we will evaluate whether the leases are presented accurately as either operating or capital

17
leases. We will compare records of payment, insurance and property taxes to the PP&E records to
determine whether the assets are in fact owned by MinArrels.
The fourth risk is the risk that PP&E assets are not properly valued (in accordance with GAAP) in the
records of the company. As explained previously, we will test to see whether accurate and reasonable
estimates of depreciation have been applied, and whether these estimates are in accordance with GAAP.
We will also analyze records to determine whether all depreciation has been properly recorded in the
ledger. Also, we will analyze all disposals and acquisitions of assets and determine if these have been
accurately reflected in the account of PP&E. In the mining industry, in which there is a large amount of
natural resources, potential impairment issues may arise under adverse economic conditions. As stated in
ASPE 3063, a long-lived asset shall be tested for recoverability whenever events or changes in
circumstances indicate that its carrying amount may not be recoverable (CPA Canada, 2014). An event
which causes a significant decrease in its market price (CPA Canada, 2014) or a significant adverse
change in the business climate that could affect its value (CPA Canada, 2014) would elicit a test of
impairment for the long-lived asset in question. In the case of MinArrels, adverse economic conditions
may be an event which would cause impairment of assets which have been mothballed. This is due to the
fact that the decision of mothballing communicates that the operations are not viable, possibly due to the
reduced demand of the mineral in question. Thus, we will need to perform audit procedure to ensure that
management has properly recorded this potential impairment in the financial statements. To assess the
value of the natural resources, we may need to utilize the expertise of a specialist, as assessing the value
of natural resources is a special matter and can only be accurately measured by a specialist.
The final risk is the risk that the account of PP&E has not been properly presented, and required
disclosures are not given. To overcome this risk, we will read financial reports and accompanying notes,
and assess whether everything has been presented in accordance with GAAP. Following these audit
procedures, we can facilitate the detection of any material misstatements in the PP&E account, and the
detection risk can be minimized.
PART B
To: Audit Partner
From: Bea Calm
Re: TPR Corp.
There are many internal control issues related with the operations of TPR Corp. Firstly, I would like to
point out the issue related to the employment of temporary staff. It is described that the managers of TPR,
who are also the controllers, hire temporary staff for two short periods during the year. In these periods,
they provide on-the-job training. The provision of on-the-job training can create many complications in

18
operations. New employees may commit mistakes early on in the temporary employment, which may go
unnoticed by management. Assuming new temporary staff is hired during each of the two periods of the
year, this can potentially cause a high rate of mistakes by new staff, as there is new temporary staff each
time the staff is hired. Thus, an issue of internal control may be the lack of qualifications and training of
the temporary employees to perform the jobs and services required by TPR Corp. Also, the existence of
temporary staff may imply that the temporary staff will not be concerned with the long term well-being of
the business, and may partake in theft, provided the consequences of apprehension are exceeded by the
utility of escaping apprehension.
The first weakness in internal control can be pointed out when the customer service clerk (CSC) receives
the order, confirms the order and faxes the sales invoice to the customer. The duty of receiving the order
should be segregated from the duty of preparing the sales invoice to achieve better internal control. The
reason for this can be demonstrated by an example. Assume that the CSC receives an order for 100 units
of the product. In the process of checking inventory and price through the online database, the CSC notes
that the inventory is in stock and the price is $100 per unit. However, the CSC has a personal motivation
to commit fraud and make money on the side. The CSC calls the customer, and explains that the
inventory is in stock, and that the price per unit is $110. Through this non-segregation of duties, the CSC
can fraudulently charge more money per unit of the product, hide this additional charge from
management and put the money in his own pocket. On the other hand, the CSC could charge less money
per unit of product (to do someone a favour) and cover his tracks easily, as adequate controls are lacking
concerning the safeguarding of assets. To overcome this weakness in internal control, the duties of (a)
receiving and confirming the order with the customer, and (b) preparing and faxing the sales invoice,
should be segregated. As a result of this segregation of duties, the two separate employees will not have
opportunities to defraud the customer, unless they colluded in the crime, which would be a rare
occurrence. To overcome the risk of colluded fraud with the two employees, the preparer of the sales
invoice could further be required to get authorization from a manager before the issuance of each sales
invoice.
The second weakness in internal control is the lack of safeguarding controls of the inventory. From the
information provided in the text, it can be assumed that there is no logging system to determine who
enters or exits the warehouse. Also, it seems that individual security devices are absent from the products.
Thus, the CSC would have easy access to the inventory, and could potentially engage in theft or fraud.
The direct theft of inventory by the CSC is fairly easy to envision. However, the CSC could also engage
in the theft of inventory indirectly, which would have the advantage of being more discreet. This
opportunity can be best illustrated using an example. Assume that the CSC gets an order from a friend,

19
and they have previously planned out a way to steal inventory from TPR Corp. The customer orders 100
units of the product, and the CSC proceeds to create the sales invoice and fax it to the customer. Next, the
CSC walks over to the warehouse and selects 150 units of the product. The CSC then takes the 150 units
over to the shipping department. The shipping department then takes the whole batch of 150 units and
loads it onto the transportation vehicle. These 150 units arrive at the customers address, and the CSC, on
his own time, travels to the customers address and takes the extra 50 units for himself. Through this
example, we can see how the CSC has the opportunity to steal goods discreetly from the warehouse. A
resolution to this internal control weakness is to introduce or improve security measures (physical
controls) in the warehouse, where each unit of inventory is accounted for in real-time as it is checked out
from the warehouse. Another resolution would be to hire a separate employee for the warehouse, to whom
the CSC would provide the sales order. This employee would then take the sales order and select the
correct number of units to provide to the shipping department. However, this resolution would only be
effective if the resolution related to the first weakness in internal control is implemented.
The third weakness in internal control is related to the shipping department. The shipping department
relies on the sales invoice, initialed by the CSC, to proceed with the shipment of the order. Through this
reliance, the CSC may have an opportunity to engage in theft of inventory. For example, the CSC may
produce a fake sales invoice, which he could then initial and provide to the shipping department. The
shipping department would ship the corresponding inventory, which would then arrive at a fake address
and be collected by the CSC. This weakness in internal control can be resolved by, as mentioned earlier,
segregating the duties of the order receiver and the employee who deals with the sales invoice. Further,
the sales invoice should be signed by a manager to prevent any opportunities for fraud or theft. Also, the
manager should observe a physical count of the inventory alongside the sales invoice, to see that they
match.
The fourth weakness in internal control is inside the shipping department. From the information provided,
it can be assumed that there is no inventory count done in the shipping department. Instead, the
employees in the shipping department simply collect the batch of inventory with the sales invoice and
load the whole batch onto the transportation vehicle. The lack of a counting system in the shipping
department may create opportunities for employees to thieve inventory between the warehouse and the
shipping department, and before shipping the batch. After the theft, it would be easy for a shipping
employee to escape apprehension, as he could simply blame the missing inventory as lost during
transportation. A resolution to this weakness in internal control would be to have two counts of the
inventory in the shipping department. One count would be done by the clerk who receives the batch with
the related sales invoice and prepares the batch for shipping. This count would ensure that the amount of

20
the inventory being sent out with a sales invoice corresponds with the quantity listed on the sales invoice.
The second count would be done after the inventory has been loaded on to the truck, to ensure that the
correct amount of inventory is being shipped out and no inventory was lost during the process of
preparing the shipment. However, it should be noted that these inventory counts could be quite time
consuming, as consequently, cost the firm a substantial amount of money.
The fifth weakness in internal control is the fact that the CSC is personally responsible to contact the
customer in the case of an incorrect address. This responsibility, given to the CSC, in the lack of any of
the other resolutions mentioned above, provides the CSC with open opportunities to escape apprehension
of any theft. This opportunity for theft can be illustrated using an example. Assume that the CSC
purposely ships the goods to the wrong address, and later collects this inventory and keeps it. When it is
discovered that the goods were sent to the wrong address, the company then ships another order to the
updated correct address. Through this method, the CSC can thieve inventory from the company. The
method which can be implemented to resolve this weakness is that the employee who is in charge of
sending the sales invoice to the customer, provided he is separate from the CSC, should contact the
customer after faxing the sales invoice and confirm if the address on the invoice is correct.
The sixth and final weakness in internal control concerns the responsibility of the CSC to contact
customers with overdue accounts personally. Through this responsibility, the CSC has the opportunity to
collect the accounts receivable, and instead of recording it in the books, put it in his own pocket and
write off the account as bad debts expense at the end of the year. A resolution to overcome this weakness
would be to follow up with all accounts receivables which are to be written off as bad debts expense. This
would prompt the accounts receivables who have already paid to reply to the follow-up, stating that they
have already paid, providing a copy of the payment receipt.
These weaknesses in internal control will significantly impact the audit plan and approach of TRP Corp.
The audit team shall communicate these weaknesses in internal control to management, so that
management may improve their internal controls. The lack of adequate internal control raises the control
risk of the entity, and thus, puts the responsibility on the audit team to perform more substantive
procedures to ensure confidence. Since the internal controls of the organization appear not to be reliable,
it is more effective to go the route of substantive testing and omit reliance on controls altogether. These
substantive procedures include tests of individual transactions and the accompanying records and other
substantive analytical procedures. The more it is determined that the entitys controls are not effective, the
higher amount of substantive testing that is necessary to minimize audit risk.
PART C
To: Audit Partner

21
From: Bea Calm
Re: Bedrock Quarries Inc.
The audit of the inventory account of Bedrock Quarries will require performing audit procedures which
encapsulate several criteria. The criteria which will need to be assessed when auditing inventory are
existence, completeness, ownership, valuation, and presentation.
The first risk associated with auditing the inventory is the risk that the inventory does not exist. To
overcome this risk, we will perform certain audit procedures. We will oversee the inventory count and
personally perform inventory checks as well, to ensure that the inventory, which in the case of Bedrock, is
rock, does in fact exist. We will visit the quarry to determine whether the bedrock is present at the
quarries. We may need to seek the help of a specialist to assess the existence of the inventory at the
quarry. The considerations and requirements of seeking the help of an external expert will be discussed
later on in the memorandum.
The second risk is that the inventory account does not contain all the available inventory at the end of the
year. To overcome this risk, we will perform certain procedures to compare the asserted amount of
inventory to industry averages, trends, etc. Further, we will assess the inventory turnover ratio, as well as
other accounts to ensure the completeness of the inventory account at the reporting date. Also, we will
perform substantive tests to compare the purchase and sales of inventory before and after the cut-off date,
to ensure that any transactions have not been improperly recorded in the incorrect reporting period.
The third risk is the risk that Bedrock Quarries does not own, i.e. have all the rights and obligations, of
the inventory listed on their balance sheet. In the case of Bedrock Quarries, the inventory is simply the
bedrock which is removed from the ground. Thus, it is reasonable to assume that Bedrock Quarries does
in fact have all the rights and obligations, and therefore ownership, of the inventory in the quarry. We will
perform substantive tests to assess Bedrock Quarries ownership of the natural resource property
The fourth risk is the risk that the inventory is valued improperly, and not in accordance with GAAP. In
the case of Bedrock Quarries, this risk seems to be the highest. Looking at the inherently risky nature of
the business, it can be seen that a specialists assistance would be needed in valuing the inventory. To
overcome this risk, we will look at the inventory turnover ratio to determine whether inventory is flowing
properly through the business. We will also compare the asserted inventory to the assertions of previous
years. We will determine whether any inventory is impaired, and thus, should be written down to lower of
cost or net realizable value. However, to determine the value of the inventory, an external specialist will
most probably be needed. The issues, recommendations and considerations associated with an external
specialist will be expanded on later in the memorandum.

22
The fifth risk is the risk that inventory and related accounts are not properly presented on the financial
statements, and adequate disclosures are not provided in the notes. To overcome this risk, we will
carefully examine the financial statements, inquire of management about any transactions related to
inventory, and evaluate the accompanying notes to determine if adequate disclosures are provided.
To establish the existence and valuation of the inventory at Bedrock Quarries, we will need to use the
work of an external specialist. In section 620 of the Canadian Auditing Standards (CAS) section, guidance
is given when using the work of an auditors expert. As CAS 620 states, If expertise in a field other than
accounting or auditing is necessary to obtain sufficient appropriate audit evidence (CPA Canada, 2014),
we need to determine if the use of an auditors expert is necessary. In seeking the use of an auditors
expert, we will need to determine whether the expert is competent, capable and objective to assist the
auditor in the gathering of audit evidence. If the expert is currently successfully working in the field for
which the audit evidence is required, this would deem the expert competent to do work for the audit
report. If the expert is unrelated to the client and lacks any financial interest in the client, this would prove
the experts objectivity. Next, we will have to gain an understanding of the experts field of understanding
as it relates to the audit. We will determine the nature, scope and objectives of the work of the expert for
[our] purposes (CPA Canada, 2014). For our purpose, the specialist is to determine whether the inventory
exists in totality and is valued correctly as asserted in the financial statements. After obtaining an
understanding of the experts work, we will contractually bind into an agreement with the expert. This
agreement will encompass a wide range of matters as they relate to the audit. These matters are the
nature, scope and objectives (CPA Canada, 2014) of the work of the specialist, the roles and
responsibilities (CPA Canada, 2014) of the audit partner and the specialist, the nature, timing and extent
of communication (CPA Canada, 2014) between the auditor and the specialist, the form of the report to
be provided by the specialist, and the requirement that the specialist is to keep confidentiality of
information. Following the agreement and the work of the specialist, we will evaluate the work in
determining whether the work is adequate for the purposes of the audit. We will need to assess whether
the work is relevant, reasonable and consistent with other evidence found during the audit. If the expert
decides to use any data to base his measurements on, we will assess the relevance, completeness and
accuracy (CPA Canada, 2014) of the source data. We must also assess the risk of material misstatements
in the financial statements, considering the significance of the account with which we are dealing with.
The balance of inventory and the corresponding cost of goods sold account plays a significant role in the
value of the assets, as well as the earnings capacity and capability of a business. This fact is relevant to
Bedrock Quarries as the intended user of the audit report is the bank.

23
The bank requires the audited financial statements to assess whether Bedrock Quarries is eligible for a
large loan and mortgage. In knowledge of this fact, management may have a bias towards misstating their
inventory account to obtain the loan. We assume that management is honest and reliable, however, we
must maintain professional skepticism at all times. To illustrate a possible bias, assume that the bank will
provide the loan on the terms that there has to be an asset to debt ratio of 2. To meet this objective,
management may have a bias to overstate the value of inventory. Through this approach, management
may aggressively position themselves to obtain the loan.
The nature of the business is inherently risky. This inherent risk makes it inevitable that the auditor will
not be able to measure the value of the inventory. To accurately measure the value of inventory and
compare it against the asserted amount, we will require the work of a specialist. An expert in the industry
can perform specific procedures to value the inventory at its true amount. The auditor may then use that
valuation and compare it against the financial statements account of inventory. Before relying on the
valuation of the specialist, we will also need to determine whether the specialist used an abundance of
actuarial assumptions or whether the valuation is based more heavily on concrete information. If the
valuation of the specialist is below the value of the asserted inventory, the inventory account will be
subject to impairment, and will be brought down to the lower of cost and net realizable value. The
specialist will also be useful in determining the existence of the inventory account. The nature of the
inventory is such that it is not easily measurable, either by weight or any other measure. Thus, the
inherent risk is quite high, and the specialist may be useful in determining the total existence of the
bedrock. This existence may be assessed by the specialist in a number of ways, ranging from the actual
weighing of all inventory, a very detailed physical count, etc. When deciding to rely on the work of the
specialist, we will need to be aware of any risks which may arise from too many actuarial assumptions.
An abundance of actuarial assumptions may cause the valuation of the specialist to be unreliable, which
would impact the appropriateness of the audit evidence.
In addition to the risks envisioned above, there is also risk related to the opening balance of inventory. As
this is an initial audit for Bedrock Quarries, it is possible that inventory has been misstated in past
reporting periods, which may have influenced a materially misstated opening balance in the current
reporting period. To overcome this risk, we will need to analyze and compare past reporting periods to the
current reporting period, specifically comparing the assertions of the inventory account to the valuations
provided by the specialist.
References

24
CPA Canada, (2014). ASPE 3061 - Property, Plant and Equipment. CPA Canada Standards and
Guidance Collection. Retrieved April 2, 2015, from
http://edu.knotia.ca.myaccess.library.utoronto.ca/knowledge/Home.aspx?productid=1
CPA Canada, (2014). ASPE 3063 Impairment of Long-lived Assets. CPA Canada Standards
and Guidance Collection. Retrieved April 2, 2015, from
http://edu.knotia.ca.myaccess.library.utoronto.ca/knowledge/Home.aspx?productid=1
CPA Canada, (2014). ASPE 1000 Financial Statement Concepts. CPA Canada Standards and
Guidance Collection. Retrieved April 2, 2015, from
http://edu.knotia.ca.myaccess.library.utoronto.ca/knowledge/Home.aspx?productid=1
CPA Canada, (2014). CAS 620 Using the Work of an Auditors Expert. CPA Canada Standards
and Guidance Collection. Retrieved April 2, 2015, from
http://edu.knotia.ca.myaccess.library.utoronto.ca/knowledge/Home.aspx?productid=1
CPA Canada, (2014). CAS 200 Overall Objectives of the Independent Auditor. CPA Canada
Standards and Guidance Collection. Retrieved April 2, 2015, from
http://edu.knotia.ca.myaccess.library.utoronto.ca/knowledge/Home.aspx?productid=1
CPA Ontario. (2014). RULES OF PROFESSIONAL CONDUCT. CHARTERED
PROFESSIONAL ACCOUNTANTS OF ONTARIO. Retrieved April 2, 2015, from
http://www.cpaontario.ca/Resources/Membershandbook/1011page2635.pdf
HTK Consulting. (2014). PROPERTY, PLANT AND EQUIPMENT: ASPE 3061. Retrieved April
2, 2015, from http://htkconsulting.com/HTKNotes/PMR/PPE%20-%20ASPE.pdf