Carter & McLean, a Halifax accounting firm, has just taken on the audit of EastJet, a small airline providing private charter service that began operations in 2007. The airline is owned by Dave Wilson and Ron Joyce. The previous auditor has resigned because of poor health. You are an audit senior with Carter & McLean and have been asked to work on the audit.
EastJet uses rented facilities at Halifax International airport. It has purchased three of its airplanes and is leasing six other planes. It employs six pilots full time and has a database of pilots that can be called if additional flights are required at any given time.
EastJet has done well since it began operations, but Carter and McLean are concerned about the profit for the first six months of this year. In addition, two of EastJet’s planes have been grounded because of faulty electrical connections. The warranty has expired on these planes.
You held an audit planning meeting with Dave Wilson, Ron Joyce and Bill Carter, the partner. You were provided with the interim financial statements for the first six months of the current year along with the prior year audited statements (Appendix 1). Your notes for the meeting are in Appendix 2.
A junior accountant from your office has done work on the accounts receivables and property plant and equipment. The work done is documented in Appendix 3.
- Perform the planning analytical review for the financial statements of EastJet, analyzing the key movements. Include supporting calculations. (10 marks)
- Using the audit notes that you took, identify the audit risks and explain how each audit risk could result in a material misstatement in the financial statements. Design the audit approach for each significant audit risk identified. Present your answer in a table with column one identifying the risk and column two explaining the risk. (20 marks)
- Calculate planning materiality for the 2016 fiscal year-end audit. Provide both quantitative and qualitative analysis supporting your figure for preliminary materiality. (5 marks)
- Evaluate the audit work done by the audit junior on the accounts receivable and property plant and equipment and outline additional procedures that should be performed by the audit team on future work in this area.(20 marks)
- Prepare the property, plant and equipment (PPE) audit program that will be used by Carter & McLean accounting for the December 31, 2016, fiscal year-end audit of EastJet. (20 Marks)
- Discuss the importance of documentation in the audit file and identify which parts of the audit file require documentation.(10 marks)
- Assume the 2016 fiscal year-end audit of EastJet is completed and that Carter and McLean Accounting has determined that the financial statements of EastJet are presented fairly, in all material respects, except for the area of capital leases. Capital leases are material. Your audit work indicated the two capital leases should be accounted for as capital leases; however, EastJet did not want to do this. The amount is material but not pervasive to the financial statements. Draft the expected audit report that will be issued by Carter and Mclean Accounting for this engagement. Assume that the financial statements of EastJet are prepared under one of the two general purpose accounting frameworks used in Canada.(15 marks)
Appendix 1: Extracts from management financial statements
Income statement Extracts
|Notes||Six months ended June 30, 2016||Year ended December 31, 2015|
|Other income and expense||3||(3,085)||(6,654)|
|Income before tax||41,860||63,944|
- Revenue is evenly spread throughout the year.
- Operating expenses include repairs and maintenance expense of property, plant and equipment of 151,686 for the six months ended June 30, 2016 and 179,438 for the year ended December 31, 2015.
- The amount for the six months ended June 30, 2016 includes a loss on disposition of equipment. Proceeds on sale of equipment was $22,500.
Balance Sheet Extracts
|Notes||As at June 30, 2016||As at December 31, 2015|
|Cash and cash equivalents||117,806||264,037|
|Property, plant and equipment||1||464,451||368,550|
|Liabilities and shareholders’ equity|
|Advance ticket sales||3||103,316||86,427|
|Total liabilities and shareholders’ equity||776,899||702,490|
Notes to Financial Statements
- Property, plant and equipment
|Six months ended June 30, 2016||Year ended December 31, 2015|
|Net Book Value||466,450||368,550|
- Intangible asset – goodwill
Goodwill is stated at a cost of $9,526, and no impairment has been made to date.
- Advance ticket sales relate to flights that have been booked for future dates.
- Maintenance provision represents amounts accrued for leased planes that have been returned at the end of the lease. The planes must be in a specific condition or the company is charged the costs to bring the plane to the required condition.
- Dividends paid during the six months to June 30, 2016 amounted to $27,790.
Appendix 2: Notes from meeting
Dave Wilson and Ron Joyce explained that EastJet operates in a very competitive environment. The economic downturn has resulted in fewer charter flights and airlines have been offering reduced rates to remain competitive. EastJet has been paying strict attention to cost controls and have introduced a bonus for management that is based on the company’s profitability.
Recently two of EastJet’s major customers have gone into bankruptcy. There is $41,250 in advanced ticket sales related to these customers.
EastJet held a manager’s retreat last month to think of ways to boost the business. The company intends on offering an exclusive business class service for business customers such that they can fly to and from a major city in the same day. This service will begin in the new year. EastJet is optimistic that there will be an 80% uptake of seats on these flights that will be offered from Monday through Friday.
One of EastJet’s planes was damaged because of a fire in the cockpit. Although the plane was insured the insurance company is disputing the claim because the company did not meet safety standards that were required in the industry. The cost of the damage is estimated at $105,000.
Because EastJet is anticipating additional flights in the new year, it will need to lease or purchase additional planes. EastJet has begun discussions with a leasing company regarding leasing the planes. They expect the leasing agreements to be in place by year end.
Appendix 3: Notes regarding the accounts receivable and property, plant and equipment work performed by the junior auditor.
Accounts Receivables / Unearned Revenue
When clients book charter flights, the flight is prepaid, and the amounts are recorded in unearned revenue. Once the service has been provided (the client takes the flight) the unearned revenue related to the flight is transferred to revenue.
Large well-established clients do not have to prepay and are invoiced for the amounts of the flights. These represent the accounts receivable amounts on the balance sheet. The prior year audit file indicates there were issues with accounts receivables in prior years – Eastjet had accounted for unearned revenue as accounts receivable.
The junior accountant performed analytical review on the accounts receivable noting that percentage of accounts receivable as a percentage of total assets was consistent with the prior year. There were several credit balances in accounts receivable which the junior ignored. No confirmations of accounts receivable were performed. The junior auditor concluded the accounts receivable were fairly stated for the interim period.
Property Plant and Equipment
Property plant and equipment represents the largest item on the balance sheet and represents the planes that Eastjet owns as well as leased planes. They are separated in the general ledger accounts. The junior auditor traced each item on the subsidiary ledger to the original invoice, added the subsidiary ledger and agreed the total to the general ledger. Then the junior auditor signed the working paper concluding that property plant and equipment was fairly stated for the interim period.