Reference no: EM132952459

You are the audit senior at the CPA firm of King & King, in charge of the 2020 audit of Red Corporation for the year ended December 31, 2020. Red Corporation earns revenue arising from both the sale of ice skates and the provision of repair service. Red earns 50% of its revenues during the winter months of December to March.

• It is now February 2021 and the year audit has commenced. This is King & King's third year as auditor for Red. In the previous year, due to the strong control environment, as well as strong process controls in place, your audit plan indicated a combined approach for all major cycles. Based upon your control tests performed at interim, controls are still effective and there have been no significant changes to Red Corporation's policies and procedures during the year.

In the past two years, few misstatements were identified and an unqualified audit opinion was issued. Planning materiality was set based on 5% of Net Income and performance materiality at 70% of planning materiality.

Selected balances from Red Corporations financial statements are as follows:

Accounts receivable $7,000
Current assets 322,000
Total assets 630,000
Shareholders' equity 570,000
Revenue 720,000
Net income 190,000

• Red Corporation had been doing well over the past few years and additional investments were needed to buy new skate production equipment, which required the company to obtain a loan on June 7, 2020 from Trust Bank. As a condition of the loan, Trust bank required that Red Corporation provide it with annual audited financial statements and that the company maintain current ratio (current assets/current liabilities) of at least 1:1, otherwise the full loan amount was due within 30 days.

• Red Corporation had a temporary cash squeeze in the last week of November 2020. It needed cash badly to cover a seasonal dip in sales caused by unusually warm weather that affected the entire skating industry and was widely reported in the press as impacting all winter sports. However, if any additional money were borrowed (from any other willing bank), the company would violate the loan covenant requiring that a defined current ratio be maintained.

• To get around this requirement, the top two officers at the Red Corporation set up another corporation called Pink, Inc. Red sold made a large sale of inventory to Pink at cost in December 2020. Pink then used the inventory as collateral for a $100,000 three-month loan from another local bank, WeBank, on Jan 21, 2021. On the same day, the money from the loan was used to immediately pay Red for the inventory transaction. At the end of the three-month period, Red intended to repurchase the inventory from Pink at a price that would allow Pink repay the loan plus interest.

Required:

Problem 1: Your audit manager has just found out about the new loan WeBank loan and the arrangement between Red and Pink. She has advised you that you need to modify the audit plan to take into account these transactions. Explain why this necessary even though the bank loan happened after year end.

Problem 2: Propose two modifications to the overall audit strategy and approach in your new audit plan. Ensure you provide your rationale for each modification.

Problem 3: Assuming the auditor was not explicitly aware of the situation, describe one substantive procedure that could detect the arrangement between Red and Pink