Order instructions

APPLICATION CASE WITH SOLUTION & ANALYSIS

Review of an Audit Plan

DISCUSSION CASE

Toward the end of his first year in public practice, Jack is assigned to the audit team for Foyer Properties Inc. (Foyer). Foyer’s main activity is development and leasing of commercial real estate properties, such as shopping malls and office towers. In the past few years, Foyer has developed a niche residential property business: building university residences and nursing homes and leasing them under a head lease with a public sector organization, such as a university or municipal government. The public sector organization handles collection from the individual residents. Foyer is a private company, with the chair holding 60% of the shares and the president and chief operating officer (COO) holding the remaining 40%.

Foyer has been a long-time audit for Jack’s firm. The previous audit manager, Hank, just left the firm after 10 years to be the CFO at a local mining company, and Hilda has taken over from him for the 20X8 audit. Hank had been on the Foyer audit since joining the firm and had managed the audit for the past six years. Looking over the previous audit files, Hilda noted that Hank had not changed the audit approach for years: a substantive approach focusing primarily on verifying existence and valuation of all the major real estate properties and all large transactions, such as the major purchase or sale of a property. Since accounts receivable from the universities and governments were always received by the time the audit was being done, they were verified by vouching subsequent receipts, not by confirmation. Revenues and expenses from the property leasing operations were audited entirely by analytical procedures.

Hilda is confident that the past audits obtained sufficient appropriate evidence to support the audit opinion, which has always been unmodified, but Hank left too many important planning judgments “in his head” rather than documenting them. Hilda feels that the audit planning documentation should be updated to follow the risk-based approach. This may identify areas where a more effective audit approach could be applied. Since Jack has had experience using risk-based audit plans in several of his other audits this year, Hilda thought it would be a good learning experience for Jack to apply the risk-based approach in Foyer’s audit planning.

Hilda has asked Jack to develop a risk-based overall audit strategy and preliminary audit plan for the current-year audit of Foyer. She would then like him to compare this plan with the plan used in previous years to identify and justify any differences.

The first thing Jack does is get out Foyer’s prior-year audit files (for its year ended December 31, 20X7) and study the final financial statements and the planning memorandum that Hank had prepared. Jack notices that Hank’s planning memo has been copied and carried forward for several years, with any new information tacked on at the end. Extracts from Foyer’s prior-year audited financial statements and planning memorandum are provided below. What steps will Jack go through to create a risk-based audit plan?

Page 401

Foyer Properties Inc.

Planning Memorandum

Prepared by: Hank Grouse, Senior Manager

Knowledge of the Auditee Business

Private corporation, provincial incorporation on April 1, 20X0. Two shareholders: one (holds 40%) is the general manager of the business; the other (holds 60%) is chair of the corporation’s board. Both have access to monthly financial reports and other information they require. Main reason for audit is to support borrowing for construction financing—the shareholders feel audited financial statements show the company is solid. Main operations are developing and leasing commercial shopping malls and office buildings, with focus on high-quality properties and tenants (e.g., banks, pharmacies).

Materiality

Materiality $90,000 (10% normal pretax profit)

Page 402

Risk Analysis

• Audit risk: Can accept the highest level

Reasons for conclusion: Private company, few shareholders have access to all financial reports, other users are creditors with property-securing loans, company is profitable and in strong financial position.

• Inherent risk: LOW

Reasons for conclusion: Operations and accounting not complex, previous audit work good, typically find only small (less than $3,000) misstatements that management always corrects, and low volume of high-value transactions not susceptible to error and easily monitored by management.

• Control risk: HIGH—assumed to be high: we cannot rely on control risk being lower since we don’t plan to test controls; we will test substantively only

Reasons for conclusion: Controls appear strong, management control attitudes good, senior management monitors financial results closely, president is a major shareholder, clear job descriptions and lines of authority, rigorous human resource policies for hiring and evaluation and compensation, and no fraud indicators noted.

• Detection risk: MODERATELY HIGH

Reasons for conclusion: Substantive evidence will verify key assertions for all significant financial statement amounts.

Other Planning Points

• Commercial real estate market values tend to be stable.
• Environmental liabilities—management is on top of this; no problems to date over 25 purchase deals.
• Management policy is to retain adequate cash reserves to have flexibility to pay for unexpected repairs, or to be able to seize good acquisition opportunities that can arise at any time.
• Communications between shareholders are open; any shareholder loans or other related party transactions are agreed on and approved by both.
• All accounting policies used are acceptable in the real estate industry.
• Management’s key performance measure is cash flow from operations (net revenue from properties less debt service, so risk of manipulation of accruals is minimal—only cash is considered)

Systems Notes

• Control environment is strong; will not rely on systems and application controls; substantive approach will be used.
• An industry standard financial reporting package (Yardi) is used—providing reliable monthly operating information (actuals vs. budgets)—summary data automatically update the general ledger accounts.
• Logins used for access; no systems changes required as operation is quite stable.
• The Yardi system is behind a firewall from the office computer network, so the Internet interface has minimal security risk.

Significant Financial Statement Accounts, Audit Approach to Verify to Assertions:

R/R/R Key Assertions—Completeness, Existence, Valuation

• Rent roll (rent revenue journal) is updated regularly, management reviews reports monthly, and rent entries are easily auditable by matching to lease agreements.

P/P/P Key Assertions—Completeness, Existence, Valuation

• Management closely monitors monthly financial reports and follows up discrepancies.

Page 403

• Expenditures are largely regular and predictable, so variances are easily detected.
• Two signatures (CFO and Operations Manager) required on all cheques.
• Audit will be by analytical procedures: detailed comparison to prior years, by property, by month, and comparison to budgets.

Rental Properties—Existence, Ownership, Valuation

• Purchase agreement and lease agreement terms will be verified. Property tax bills will be inspected to verify Foyer retains ownership of each property. Loans and collateral agreements will be confirmed; analysis of interest and property taxes will be based on these inputs. Lease agreements and lease receipts will be analyzed in relation to properties leased. Management representations will be obtained to ensure no property sales are unrecorded and all purchases and new leases are recorded.

Additions to Planning Memorandum

Note new information for 20X5 audit:

Company has entered a specialized residential real estate leasing business. Residential properties, such as student residences and nursing homes, are developed to order for public sector organizations, such as universities and municipal governments—risks seem low. Foyer’s management has capability to handle this type of operation, so no impact on audit for now.

Note for planning 20X6 audit:

Asset sale transactions can be complex. We were asked to review the agreement terms and management’s proposed accounting entry prior to finalizing so that there are no surprises when it comes to reporting sale in year-end financial statements; determined a $300,000 adjustment was required to management’s proposed entry to account for the stepped-up rent payments over the term of the lease, per GAAP.

Notes for planning 20X7 audit:

Hank met with Foyer president to discuss the audit plan. He noted that construction project cost overruns on the public sector residential property have been a problem, as public sector officials get involved and demand various changes to the agreed plans. Foyer has hired a new construction project manager with experience in the public sector so these demands can be handled better. The construction manager reviews and approves all expenditures, and the two cheque-signing officers will not sign unless this approval is received. Construction changes and cost overruns are a potential risk area, since the lease payments are set prior to construction and may not be adequate to recover a higher investment in the property.

Note for planning 20X8 audit:

Hank had lunch with the Foyer president and learned that 10 public sector residential properties are now leased, and 6 more are under construction. The company’s strategy is to grow the public sector residential business, as commercial real estate leasing is mature and harder to grow. Most of Foyer’s commercial properties can be sold now for good gains, so the new strategy is to begin to divest the commercial buildings when market conditions are optimal and buyers are found.

SOLUTION & ANALYSIS

After reviewing all the planning notes, Jack realizes that Hank had obtained a very thorough knowledge of the company and its risks and controls, and he had assessed the risks of material misstatement appropriately. He had also developed a reasonable response to the assessed risks by deciding to use a substantive audit approach.

However, the effectiveness of the audit can be improved by implementing a more strategic analysis of the business risk factors, explicitly linking these to risk of material misstatement at the financial statement level and at the assertion level for the significant classes of transactions, account balances, and disclosures. Jack could reorganize the information from the planning notes and preliminary analysis of Foyer’s financial statements to follow the risk-based planning steps and develop more fully the links between the business risks and specific risks of material misstatement and the audit responses that should be performed. The risk assessment must also consider fraud risk more explicitly.

Page 404

Management’s related controls to reduce those risks could be considered, and the remaining risks that the audit plan needs to respond to identified. This analysis would more likely draw the audit team’s attention to the potential increase in risk from the company’s new strategy in the public sector residential leasing business. The audit team will develop appropriate responses by planning further audit procedures related to this business line. The materiality determination and qualitative factors considered should also be more fully explained and documented.

Jack could document the business risk analysis by type of factor, as follows.

Understanding the Entity and Its Business, Environment, Risks, and Controls

Nature of entity

Private corporation, provincial incorporation on April 1, 20X0. Two shareholders: one (holds 40%) is the general manager of the business; the other (holds 60%) is chair of the corporation’s board. Both have access to monthly financial reports and other information they require. Main reason for audit is to support borrowing for construction financing; the shareholders feel audited financial statements show potential lenders that the company is solid. Main operations are developing and leasing commercial shopping malls and office buildings, focus on high-quality properties and tenants (e.g., banks, pharmacies).

Industry risk factors

No significant risks: local operation, very minimal and non-complex regulatory environment, and simple valuation measurements.

Legal regulatory risk factors

For land/property purchases need to do due diligence re environmental liabilities. Management is on top of this; no problems to date with over 25 purchase deals closed.

Economic risk factors

Real estate values have stopped increasing in current year but are expected to be stable, not crash, in near term. Fair values exceed carrying values so no impairment expected; no financial instruments or complex financing are used, just standard mortgage loans.

Business relations

No key competitors/suppliers. Key customers are city government and universities involved in residential properties.

Strategy and related processes

Develop and lease profitable buildings.

• Select unique locations for targeted tenants—high-quality businesses, public sector residential.
• Plan construction and monitor project costs closely to keep investment at level where required return can be achieved.
• Structure leases to ensure adequate rate of return on investment and recovery of operating cost and any increases (e.g., energy, property taxes, insurance).
• Implement effective collection procedures to ensure cash flows are on time and as planned.

Page 405

• Arrange loans from large financial institutions, using specific assets as collateral, to obtain low-cost financing.
• Retain adequate cash reserves to have flexibility in paying for unexpected repairs or seizing good acquisition opportunities that can arise at any time.

Internal Control Factors

Control environment

• Management is experienced and successful in industry.
• Management works as team.
• Clear job descriptions and lines of authority exist.

Management’s risk assessment process

• Conservative risk takers, focus on rates of return on investment
• Budgeting for new property developments and ongoing operations

Information system, related business processes, financial reporting, and communication

• Company uses industry-standard information system (Yardi).
• Accounting policies follow real estate industry guidelines re depreciation assumptions and so on.
• Cash and straight line revenue recognition for stepped rent leases (per GAAP) is used.

Control activities

• Access controls, regular reporting

Monitoring of controls

• Top management is actively involved and monitors all aspects of the operation.

Key Financial Statement Accounts and Underlying Business Processes

Revenue process

• The rent roll is updated regularly; system controls are strong; management reviews key reports.
• As long as the company-level controls are adequate, the audit approach can be based on substantive testing alone because the rent transactions can be verified by matching them to lease agreements.

Purchasing process

• Management closely monitors monthly financial reports and follows up discrepancies.
• Expenditures are largely regular and predictable, so variances are easily detected.
• Two signatures are required on all cheques.

Key performance measure

Cash flow operations show net revenue from properties less debt service (so risk of manipulation of accruals is minimal—only cash is considered).

Systems

Industry standard financial reporting package (Yardi) used:

• Provides reliable monthly operating information (actuals vs. budgets)
• Summary data from Yardi manually transferred to general ledger
• Logins used for access; no systems changes required as operation is quite stable
• Yardi system is behind firewall from the office computer network; reduces Internet security risk

Page 406

Materiality Determination

Users—Shareholders, lenders

Qualitative considerations—very profitable business, well capitalized, well managed, low transaction volume; we have audited it problem-free for many years, no management or operating changes this year.

Worksheet:

A matrix such as the one below could be used to organize the planning considerations. The key risk revealed by Jack’s review is entered as an example, and the other business risks in Foyer can be analyzed and entered similarly.

Click here to view the enlarged pdf

Page 407

Overall Audit Strategy—Other Preliminary Conclusions

• Financial reporting framework is GAAP (Accounting Standards for Private Enterprises [ASPE]), an acceptable, fair presentation framework.
• Preliminary risk assessment at financial statement level: LOW
  • It appears risks of material misstatement are low initially, and management risk assessment is adequate to reduce these. Some further procedures are needed to verify conclusions based on management control effectiveness via observation and inquiry of management.
  • Risk of material misstatement due to fraud is addressed as follows. The close attention of the two shareholders to operating matters and discussion with management and shareholders indicates no employee fraud has been discovered or suspected in recent years. Risk of fraud in revenues must always be considered, especially as the rent receipts are mainly cash. We use a substantive approach: substantive analytical procedures can be highly effective in this business since the lease terms are fixed. Also, indicators of revenue fraud are specifically noted in the planned tests of details for the rental revenue cash receipts transactions. Past audits have not found any fraud indicators. Finally, overall review of the financial statements will play close attention to the possibility of manipulation of revenue recognition procedures by management.
• Preliminary audit strategy to respond to assessed risk at financial statement level:
  • Consider that business processes involve a small number of large transactions for property sales, planned and monitored construction project costs for development process, lease-driven revenue streams, and predictable cost patterns for rental processes. The substantive approach is most effective to obtain sufficient appropriate evidence.
• Preliminary risk assessment at assertion level:
  • Main identified risks affect the following accounts/assertions:
  • Rental property/Valuation (costs incurred and recoverability of investment)
  • Rental revenue/Existence (public sector leases)

Preliminary Audit Plan to Respond to Assessed Risks:

Staffing

Experienced staff should be assigned to perform the bulk of the audit work as the analysis requires careful judgment and preparation. One junior staff member should be assigned to get experience but needs close supervision. A team meeting should be held prior to beginning audit preparations. Daily meetings should be held during field work to cross-reference findings. A final meeting should be held after the files are completed for the partners’ review and to clear any outstanding issues, if possible, or ensure they are documented clearly for the partner to follow up.

Page 408

Summary

Overall, the auditee presents a low risk of misstatement, and the substantive verification of year-end balances of rental property (vouching costs), loan balances and terms (confirmation), and public sector residential lease revenues (confirmation), combined with detailed analytical procedures, will provide sufficient appropriate evidence that material misstatement does not exist in the financial statements.