1

Johnson Medical (Core 1 Practice Case):

Case Facts:

- Medical Startup Company.

- Follows IFRS.
- Owner’s wife prepares F/S – no accounting background, lots of errors.
- Owner wants to sell the business at a huge profit to a large pharmaceutical
company, research (There is an ACCO 310 R& D issue here) is worthless since trials
were not promising but owner wants to argue otherwise.
- Company running out of cash fast.
- Other case facts will be tied in wherever relevant.
N.B: There were several financial reporting issues in the case, but for practical purposes,
we will ONLY focus on the Audit part.

@Pierre Hilal, CPA, CMA, May 2021

 2

Assessment opportunity 3:
Candidate prepares a complete planning memo in preparation for the upcoming audit.
Audit risk
In planning the upcoming audit, our auditors will consider a number of factors in establishing the
level of risk. These factors include:
• This is Johnson Medical’s first audit. Given that our auditors would have never had any
experience working with us, their knowledge of our business, our operations, and our
financial controls would be very limited. This would increase audit risk.
• There is no financial controller. While your wife has taken a bookkeeping course in her spare
time, she is not really formally trained to handle complex accounting tasks, and therefore
there is no CPA that is acting in a Financial Controller capacity at the company. This would
increase audit risk as well.
• There are already errors in the financial statements. From an auditor’s standpoint, this may
suggest that there are other errors that have not yet been identified, which increases audit risk
further.
• You are preparing the company for an ultimate sale. As a result, the auditors are likely to be
of the opinion that you may have a bias to inflate the financial performance of the business in
order to maximize the sale price you would obtain. This increases audit risk.
• The company is experiencing significant cash flow issues. While this is common for startups
like ours, having such a significant cash flow problem (i.e., may run out of cash before the
end of the year) may make the auditors question our ability to continue as a going concern,
which also increases audit risk.
• The user base of the audit report is limited. Since the report would only be used by a
potential acquirer and possibly the bank, this would represent a narrow user base, which may
somewhat decrease audit risk.
Overall, it is clear that the risk involved with this audit would be high. This would make the
auditors increase the extent of the procedures they will be performing in order to obtain sufficient
and appropriate audit evidence.

@Pierre Hilal, CPA, CMA, May 2021

 3

Approach
Since there is no financial controller in place, and the bookkeeping duties have been managed
primarily by your wife in her spare time, it would be reasonable to assume that there are few
financial controls in place, if any. This means that the auditors would undertake a substantive
audit approach.
Since the company started in 2016, this would mean that there are four full years of operations
without any corresponding audited financial statements. This implies that the auditors would
need to gain comfort over the opening balances of the 2019 statements, which may be difficult
depending on what types of records you have been keeping. If they are not able to obtain
sufficient and appropriate audit evidence over the opening balance, they may be forced to issue a
qualified audit opinion due to this scope limitation.
Furthermore, as I noted earlier, we are experiencing significant cash flow issues, which may
make the auditors question our ability to continue as a going concern. They may also decide to
include this fact in an Emphasis of Matter paragraph in their audit report, which would be
something that a potential acquirer would immediately notice.

Materiality
Since we are a for-profit entity, materiality is usually determined based on net income, EBITDA,
net sales or total assets. Seeing as we have no sales for the year, and the company is currently
running at a loss as a result, I would recommend using total assets as the basis for determining
preliminary materiality.
Standard guidance suggests that when total assets is used as the basis, an amount of 0.5% to 2%
of total assets be used. While there are low number of users of the financial statements (i.e.
management, the bank, potential acquirers), their reliance on the statements will be high.
Therefore, I would recommend we set preliminary materiality at 1% of unadjusted total assets
(or $25,000 – i.e., 1% of $2,500,000).
However, I note that we have already found a number of errors in the statements. Therefore, we
should calculate a revised materiality based on the revised total assets. I would recommend a
benchmark of 1% due to the level of reliance the users are placing on our statements.
Finally, given the moderate user reliance on the statements, I would set performance materiality
at 60% of materiality.
As I have not been provided with any financial statements, I am unable to calculate the dollar-
value of what my recommended materiality and performance materiality levels would be.

@Pierre Hilal, CPA, CMA, May 2021

 4

Assessment opportunity 4:
Candidate proposes examples of procedures the auditors are likely to perform
in the context of their audit

Given the high risk associated with this audit, the auditors are likely going to have to increase the
extent of their testing. I have identified the following areas on which the auditors are most likely
to focus their efforts:
Leases
• Risk: No liability has been recorded on the financial statements related to the long-term
lease of medical equipment, since all payments have been expensed.
• Assertion: Completeness and valuation of lease obligations
• Procedure: Inspect a copy of the lease agreement to tie and agree the lease conditions
(specifically: start date, end date, payment amount, payment frequency, guaranteed
residual value) and recalculate the present value of the lease payments to determine the
value of the lease obligation that must be recorded as a liability. Trace this amount back
to the lease obligations subledger.
Depreciation and finance expenses
• Risk: Since lease payments were all expensed, it is likely that no depreciation or finance
expense has been recorded.
• Assertion: Completeness and accuracy of expenses
• Procedure: Using the copy of the lease contract obtained via the previous procedure,
build an amortization table to recalculate the amount of monthly depreciation and
financing expense that should be recorded, and trace these amounts back to the expense
subledger.
Intangible assets
• Risk: Costs may have been capitalized as intangible assets, even though they may not
have met the recognition criteria (as evidenced by the fact that the $500,000 of
development expenses needed to be reversed).
• Assertion: Existence of intangible assets / completeness of development expenses
• Procedure: Obtain a copy of the intangible assets additions subledger, and select a
sample of transactions to vouch to source documents. Inspect the source documents to
understand the nature of the expenses to see if they meet the six criteria for recognition
as defined by IAS 38.

• Risk: Incorrect amounts were put into the system by Dr. Johnson’s wife (as evidenced by
a couple of typos already identified)
• Assertion: Accuracy of intangible assets / development expenses

@Pierre Hilal, CPA, CMA, May 2021

 5

• Procedure: Using the subledger obtained following the previous procedure, select a
sample of items and vouch to the underlying invoices or calculation documents and tie
and agree the amounts from the source documents to the subledger.
Accounts payable
• Risk: Not all accruals have been recorded in accounts payable (as evidenced by Dr.
Johnson identifying existing errors in accruals).
• Assertion: Completeness and valuation of accounts payable
• Procedure: Obtain a copy of the bank statement and purchases listing for the month
following the year-end, select a sample of these items and vouch to source documents
(like a third-party invoice). Inspect the invoice to see what date the expenses related to.
If the services relate to the 2019 fiscal year, trace the amount to the accruals listing to see
if the correct accrual was recorded. If it is missing, this would represent an error.
Loan payable
• Risk: The bank may end up wanting to call the loan, which would mean that the current
$2m long-term liability should be treated as a short-term liability.
• Assertion: Classification of long-term liabilities
• Procedure: After we inform the bank of our results for the year and wait for their
decision of whether or not to call the loan, the auditors will likely prepare and send a
debt confirmation to our bank, asking them to confirm the main terms of the loan
(specifically: outstanding balance, interest rate, due date, anything held as collateral).

**End of Document. **

@Pierre Hilal, CPA, CMA, May 2021