Jenny's Pharmacy Inc Case Study

Question 1 (100 marks)

Jenny's Pharmacy Inc. (JPI) is a new audit client of Smith and Clang, CGAs. In your first engagement since being promoted to the position of audit senior, you have been assigned to the audit of JPI as part of a team for the year ended December 31, 2010. During several meetings and discussions with the audit manager, you made the following notes:

1. JPI is owned by Jenny Sung and her husband, Tom Sung. In the past, the business was financed from their personal resources and loans from family members. They are planning to expand the business and are looking for approval of a loan from a bank that requires audited financial statements prepared in accordance with private enterprise GAAP to accompany the loan application. In previous years, the financial statements of JPI were reviewed by a CGA practicing as a sole practitioner, who did not want to expand her business to include audit engagements.

2. JPI sells a range of prescription and non-prescription medical products and a variety of beauty products, souvenir items, and so on. The company also imports products that it wholesales to local retailers and invoices them with payment terms of net 30 days.

3. In order to keep prices lower than its competitors, JPI buys in bulk and encourages retail customers to use cash or debit cards as payment by offering a discount. This has worked well and, on average, 60% of its retail sales and services volumes are paid by debit cards or cash.

4. You have conducted a preliminary survey to gain some knowledge about both the client company and the industry in which it competes. JPI appears to be in good financial condition as assessed from a comparison of the firm's ratios with those of other companies in its industry. You recommended a preliminary materiality level of $140,000 which has been approved by the engagement partner. The firm's policy, in the absence of known adverse factors, is to set audit risk at 2%. Your preliminary assessment of inherent risk for the revenue and collections cycle indicates that there is a 40% likelihood of a material misstatement occurring. Your preliminary assessment of control risk indicates a 20% probability that the control systems in place will not prevent or detect such an error. Your firm uses the planning model (audit risk model) to determine detection risk.

5. As part of this assessment of control risk, you reviewed the accounting systems and internal controls over sales transactions. The controller has provided the following description of the company's system of processing sales:

o Orders are received in writing and by telephone from retail stores that sell the company's products. Approved customer orders with proper credit authorization are sent to the sales clerk. Based on this information, a clerk prepares a two-part pre numbered sales order. Part #1 of the order is sent to the warehouse,