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Chapter 8 Audit Planning and Analytical Procedures

Review Questions

8-1 There are three primary benefits from planning audits: it helps the auditor obtain sufficient appropriate evidence for the circumstances, helps keep audit costs reasonable, and helps avoid misunderstandings with the client. 8-2 Eight major steps in planning audits are: 1. . #. $. &. (. ). +. Accept client and perform initial planning !nderstand the client"s business and industry Assess client business risk %erform preliminary analytical procedures 'et materiality, and assess acceptable audit risk and inherent risk !nderstand internal control and assess control risk *ather information to assess fraud risks ,evelop overall audit plan and audit program

8-3 The new auditor -successor. is re/uired by A! #1& to communicate with the predecessor auditor. This enables the successor to obtain information about the client so that he or she may evaluate whether to accept the engagement. %ermission must be obtained from the client before communication can be made because of the confidentiality re/uirement in the Code of Professional Conduct. The predecessor is re/uired to respond to the successor"s re/uest for information0 however, the response may be limited to stating that no information will be given. The successor auditor should be wary if the predecessor is reluctant to provide information about the client. 8-4 %rior to accepting a client, the auditor should investigate the client. The auditor should evaluate the client"s standing in the business community, financial stability, and relations with its previous 1%A firm. The primary purpose of new client investigation is to ascertain the integrity of the client and the possibility of fraud. The auditor should be especially concerned with the possibility of fraudulent financial reporting since it is difficult to uncover. The auditor does not want to needlessly e2pose himself or herself to the possibility of a lawsuit for failure to detect such fraud. 8-5 Auditing standards re/uire auditors to document their understanding of the terms of the engagement with the client in an engagement letter. The engagement letter should include the engagement"s objectives, the responsibilities of the auditor and management, and the engagement"s limitations. An engagement letter is an agreement between the 1%A firm and the client concerning the conduct of the audit and related services. 3t should state what services will be provided, whether any restrictions will be imposed on the auditor"s work, deadlines

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8-5 continued! for completing the audit, and assistance to be provided by client personnel. The engagement letter may also include the auditor"s fees. 3n addition, the engagement letter informs the client that the auditor cannot guarantee that all acts of fraud will be discovered. 8"# 5ecause the 'arbanes462ley Act of 77 e2plicitly shifts responsibility for hiring and firing of the auditor from management to the audit committee for public companies, the audit committee is viewed as 8the client9 in those engagements. 8"$ All audit and non4audit services must be preapproved in advance by the audit committee for public companies. 8"8 The second standard of fieldwork re/uires the auditor to obtain an understanding of the entity and its environment. Auditors need an understanding of the client"s business and industry because the nature of the business and industry affect business risk and the risk of material misstatements in the financial statements. Auditors use the knowledge of these risks to assess the risk of material misstatement and to determine the appropriate e2tent of further audit procedures. The five major aspects of understanding the client"s business and industry, along with potential sources of information that auditors commonly use for each of the five areas are as follows: 1. Industry and External Environment : ;ead industry trade publications, A31%A 3ndustry Audit *uides, and regulatory re/uirements. . Business Operations and Processes : Tour the plant and offices, identify related parties, and in/uire of management. #. Management and Governance : ;ead the corporate charter and bylaws, read minutes of board of directors and stockholders, and in/uire of management. $. Client Objectives and Strategies : 3n/uire of management regarding their objectives for the reliability of financial reporting, effectiveness and efficiency of operations, and compliance with laws and regulations0 read contracts and other legal documents, such as those for notes and bonds payable, stock options, and pension plans. &. Measurement and Performance : ;ead financial statements, perform ratio analysis, and in/uire of management about key performance indicators that management uses to measure progress toward its objectives. 8-% ,uring the course of the plant tour the 1%A will obtain a perspective of the client"s business, which will contribute to the auditor"s understanding of the entity and its environment. ;emember that an important aspect of the audit will be an

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8-% continued! effective analysis of the inventory cost system. Therefore, the auditor will observe the nature of the company"s products, the manufacturing facilities and processes, and the flow of materials so that the information obtained can later be related to the functions of the cost system. The nature of the company"s products and the manufacturing facilities and processes will reveal the features of the cost system that will re/uire close audit attention. <or e2ample, the audit of a company engaged in the custom4 manufacture of costly products such as yachts would re/uire attention to the correct charging of material and labor to specific jobs, whereas the allocation of material and labor charges in the audit of a beverage4bottling plant would not be verified on the same basis. The 1%A will note the stages at which finished products emerge and where additional materials must be added. =e or she will also be alert for points at which scrap is generated or spoilage occurs. The auditor may find it advisable, after viewing the operations, to refer to auditing literature for problems encountered and solved by other 1%As in similar audits. The auditor"s observation of the manufacturing processes will reveal whether there is idle plant or machinery that may re/uire disclosure in the financial statements. 'hould the machinery appear to be old or poorly maintained, the 1%A might e2pect to find heavy e2penditures in the accounts for repairs and maintenance. 6n the other hand, if the auditor determines that the company has recently installed new e/uipment or constructed a new building, he or she will e2pect to find these new assets on the books. 3n studying the flow of materials, the auditor will be alert for possible problems that may arise in connection with the observation of the physical inventory, and he or she may make preliminary estimates of audit staff re/uirements. 3n this regard, the auditor will notice the various storage areas and how the materials are stored. The auditor may also keep in mind for further investigation any apparently obsolete inventory. The auditor"s study of the flow of materials will disclose the points at which various documents such as material re/uisitions arise. =e or she will also meet some of the key manufacturing personnel who may give the auditor an insight into production problems and other matters such as e2cess or obsolete materials, and scrap and spoilage. The auditor will be alert for the attitude of the manufacturing personnel toward internal controls. The 1%A may make some in/uiries about the methods of production scheduling, timekeeping procedures and whether work standards are employed. As a result of these observations, the internal documents that relate to the flow of materials will be more meaningful as accounting evidence. The 1%A"s tour of the plant will give him or her an understanding of the plant terminology that will enable the 1%A to communicate fluently with the client"s personnel. The measures taken by the client to safeguard assets, such as protection of inventory from fire or theft, will be an indication of the client"s attention to internal control measures. The location of the receiving and shipping departments and the procedures in effect will bear upon the 1%A"s evaluation of internal control. The auditor"s overall impression of the client"s plant will suggest the accuracy and ade/uacy of the accounting records that will be audited.

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8-1& 6ne type of information the auditor obtains in gaining knowledge about the clients" industry is the nature of the client"s products, including the likelihood of their technological obsolescence and future salability. This information is essential in helping the auditor evaluate whether the client"s inventory may be obsolete or have a market value lower than cost. 8-11 A related party is defined in A! ##$ as an affiliated company, principal owner of the client company, or any other party with which the client deals where one of the parties can influence the management or operating policies of the other. >aterial related party transactions must be disclosed in the financial statements by management. Therefore, the auditor must identify related parties and make a reasonable effort to determine that all material related party transactions have been properly disclosed in the financial statements. 5ecause instances of fraudulent financial reporting often involve transactions with related parties, auditors should be alert for the presence of fraud risk. 8-12 5ecause of the lack of independence between the parties involved, the 'arbanes462ley Act prohibits related party transactions that involve personal loans to e2ecutives. 3t is now unlawful for any public company to provide personal credit or loans to any director or e2ecutive officer of the company. 5anks or other financial institutions are permitted to make normal loans to their directors and officers using market rates, such as residential mortgages. 8-13 The recent economic events have led to the collapse of several large financial services entities that has triggered a broader economic decline affecting all industries. The unstable economy has resulted in a significant slowdown in most businesses. These declines are likely to have a significant impact on financial reporting. <irst, severe market declines may impact the accounting for many types of investments and other assets that now may be impaired or may have e2perienced significant declines in their fair values. The determination of those accounts is largely dependent on numerous management judgments and estimates. Auditors should apply appropriate professional skepticism as they evaluate management"s judgments and estimates. 'econd, the significant lack of sales and other revenues may be placing undue pressure on management to meet revenue targets, including the need for entity survival. Thus, there may be a greater presence of fraud risk due to these significant pressures. Third, auditors should closely evaluate the entity"s ability to continue as a going concern. There may be several instances where the auditor"s report should be modified to include an e2planatory paragraph describing the auditor"s substantial doubt about the entity"s ability to continue as a going concern.

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8-14 The information in a mortgage that is likely to be relevant to the auditor includes the following: 1. . #. $. &. (. ). +. @. 17. 11. 1 . 1#. The parties to the agreement The effective date of the agreement The amounts included in the agreement The repayment schedule re/uired by the agreement The definition and terms of default %repayment options and penalties specified in the agreement Assets pledged or encumbered by the agreement ?i/uidity restrictions imposed by the agreement %urchase restrictions imposed by the agreement 6perating restrictions imposed by the agreement ;e/uirements for audit reports or other types of reports on compliance with the agreement The interest rate specified in the agreement Any other re/uirements, limitations, or agreements specified in the document

8-15 3nformation in the client"s minutes that is likely to be relevant to the auditor includes the following: 1. . #. $. &. (. ). +. @. ,eclaration of dividends AuthoriAed compensation of officers Acceptance of contracts and agreements AuthoriAation for the ac/uisition of property Approval of mergers AuthoriAation of long4term loans Approval to pledge securities AuthoriAation of individuals to sign checks ;eports on the progress of operations

3t is important to read the minutes early in the engagement to identify items that need to be followed up on as a part of conducting the audit. <or instance, if a long4term loan is authoriAed in the minutes, the auditor will want to make certain that the loan is recorded as part of long4term liabilities. 8-1# The three categories of client objectives are -1. reliability of financial reporting, - . effectiveness and efficiency of operations, and -#. compliance with laws and regulations. Each of these objectives affects the auditor"s assessment of inherent risk and evidence accumulation as follows: 1. eliability of financial reporting ! 3f management sees the reliability of financial reporting as an important objective, and if the auditor can determine that the financial reporting system is accurate and reliable, then the auditor can often reduce his or her assessment of inherent risk and planned evidence accumulation for material

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8-1# continued! accounts. 3n contrast, if management has little regard for the reliability of management"s financial reporting, the auditor must increase inherent risk assessments and gather more appropriate evidence during the audit. Effectiveness and efficiency of operations : This area is of primary concern to most clients. Auditors need knowledge about the effectiveness and efficiency of a client"s operations in order to assess client business risk and inherent risk in the financial statements. <or e2ample, if a client is e2periencing inventory management problems, this would most likely increase the auditor"s assessment of inherent risk for the planned evidence accumulation for inventory. Compliance "it# la"s and regulations : 3t is important for the auditor to understand the laws and regulations that affect an audit client, including significant contracts signed by the client. <or e2ample, the provisions in a pension plan document would significantly affect the auditor"s assessment of inherent risk and evidence accumulation in the audit of unfunded liability for pensions. 3f the client were in violation of the provisions of the pension plan document, inherent risk and planned evidence for pension4related accounts would increase.

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8-1$ The purpose of a client"s performance measurement system is to measure the client"s progress toward specific objectives. %erformance measurement includes ratio analysis and benchmarking against key competitors. %erformance measurements for a chain of retail clothing stores could include gross profit by product line, sales returns as a percentage of clothing sales, and inventory turnover by product line. An 3nternet portal"s performance measurements might include number of Beb site hits or search engine speed. A hotel chain"s performance measures include vacancy percentages and supply cost per rented room. 8-18 Client business ris$ is the risk that the client will fail to achieve its objectives. 'ources of client business risk include any of the factors affecting the client and its environment, including competitor performance, new technology, industry conditions, and the regulatory environment. The auditor"s primary concern when evaluating client business risk is the risk of material misstatements in the financial statements due to client business risk. <or e2ample, if the client"s industry is e2periencing a significant and une2pected downturn, client business risk increases. This increase would most likely increase the risk of material misstatements in the financial statements. The auditor"s assessment of the risk of material misstatements is then used to classify risks using the audit risk model to determine the appropriate e2tent of audit evidence. 8-1% >anagement establishes the strategies and business processes followed by a client"s business. 6ne top management control is management"s philosophy and operating style, including management"s attitude toward the importance

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8-1% continued! of internal control. 6ther top management controls include a well4defined organiAational structure, an effective board of directors, and an involved and effective audit committee. 3f the board of directors is effective, this increases management"s ability to appropriately respond to risks. An effective audit committee can help management reduce the likelihood of overly aggressive accounting. 8-2& Analytical procedures are performed during the planning phase of an engagement to assist the auditor in determining the nature, e2tent, and timing of work to be performed. %reliminary analytical procedures also help the auditor identify accounts and classes of transactions where misstatements are likely. 1omparisons that are useful when performing preliminary analytical procedures include:

1ompare client and industry data 1ompare client data with similar prior period data 1ompare client data with client4determined e2pected results 1ompare client data with auditor4determined e2pected results 1ompare client data with e2pected results, using nonfinancial data

8-21 Analytical procedures are re/uired during two phases of the audit: -1. during the planning phase to assist the auditor in determining the nature, e2tent, and timing of work to be performed and - . during the completion phase, as a final review for material misstatements or financial problems. Analytical procedures are also often done during the testing phase of the audit as part of the auditor"s further audit procedures, but they are not re/uired in this phase. 8-22 *ordon could improve the /uality of his analytical tests by: 1. >aking internal comparisons to ratios of previous years or to budget forecasts. . 3n cases where the client has more than one branch in different industries, computing the ratios for each branch and comparing these to the industry ratios. 8-23 ;oger >orris performs his ratio and trend analysis at the end of every audit. 5y that time, the audit procedures are completed. 3f the analysis was done at an interim date, the scope of the audit could be adjusted to compensate for the findings, especially when the results suggest a greater likelihood of material misstatements. A! # @ re/uires that analytical procedures be performed in the planning phase of the audit and near the completion of the audit. The use of ratio and trend analysis appears to give ;oger >orris an insight into his clientCs business and affords him an opportunity to provide e2cellent business advice to his client. 3t also helps provide a richer conte2t for ;oger to really understand his client"s business, which should help ;oger in assessing the risk of material misstatements.

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8-24 The four categories of financial ratios and e2amples of ratios in each category are as follows: 1. . #. $. S#ort%term debt%paying ability : 1ash ratio, /uick ratio, and current ratio. &i'uidity activity : Accounts receivable turnover, days to collect receivables, inventory turnover, and days to sell inventory. (bility to meet long%term debt obligations : ,ebt to e/uity and times interest earned. Profitability ! Earnings per share, gross profit percent, profit margin, return on assets, and return on common e/uity

'ultiple Choice Questions (ro) CPA *+a)inations -#. -1. -$. b. b. b. -#. -$. -1. c. c. c. -$. -$. - . d. -$. d. -1.

8-25 a. 8-2# a. 8-2$ a.

,iscussion Questions And Pro-le)s

8-28 Audit Activities 1. 'end an engagement letter to the client. . Tour the client"s plant and offices. #. 1ompare key ratios for the company to industry competitors. $. ;eview management"s controls and procedures. &. 3dentify potential related parties that may re/uire disclosure. (. 3dentify whether any specialists are re/uired for the engagement. ). ;eview the accounting principles uni/ue to the client"s industry. +. ,etermine the likely users of the financial statements. Related Planning Procedure -1. Accept client and perform initial audit planning - . !nderstand the client"s business and industry -$. %erform preliminary analytical procedures -#. Assess client"s business risk - . !nderstand the client"s business and industry -1. Accept client and perform initial audit planning - . !nderstand the client"s business and industry. -1. Accept client and perform initial audit planning.

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8-2% a.

A related party transaction occurs when one party to a transaction has the ability to impose contract terms that would not have occurred if the parties had been unrelated. <A'5 &) concludes that related parties consist of all affiliates of an enterprise, including -1. its management and their immediate families, - . its principal owners and their immediate families, -#. investments accounted for by the e/uity method, -$. beneficial employee trusts that are managed by the management of the enterprise, and -&. any party that may, or does, deal with the enterprise and has ownership, control, or significant influence over the management or operating policies of another party to the e2tent that an arm"s4length transaction may not be achieved. Bhen related party transactions or balances are material, the following disclosures are re/uired: 1. The nature of the relationship or relationships. . A description of the transaction for the period reported on, including amounts if any, and such other information deemed necessary to obtain an understanding of the effect on the financial statements. #. The dollar volume of transactions and the effects of any change in the method of establishing terms from those used in the preceding period. $. Amounts due from or to related parties, and if not otherwise apparent, the terms and manner of settlement.

b.

<inancial statements are used by people to make decisions about the future. The presumption is that the nature of the transactions and balances in the financial statement are likely to be repeated in the future unless there is information to the contrary. ;elated party transactions can be conducted on a basis other than that which would normally happen with independent parties. That may indicate that these transactions may be on more or less favorable terms than can be e2pected to occur in the future. These transactions may affect users" decisions about a company, and therefore are relevant for their decision making. The most important related parties that are likely to be involved in related party transactions involving management include relatives of management or management itself, companies in which such related parties have financial interests or dealings, significant suppliers of materials and services, and customers. ;elated party transactions that could take place in a company include: 1. ?ease of property by the company from a corporate officer who owns the property.

c.

d.

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8-2% continued! . Ac/uisition of materials or merchandise by a company from another company which is owned or managed by an officer of the company or in which an officer of the company has a financial interest. A company conducts a seminar at a facility that is owned or managed by the family or friend of an officer or another employee of the company. A company contracts with a food service to run the company"s cafeteria. An officer of the company has an investment in the food service.

#. $.

e.

Auditors can determine the e2istence of material transactions with related parties by performing the following procedures: 1. 6btain background information about the client in the manner discussed in this chapter to enhance understanding of the client"s industry and business0 i.e., e2amine corporate charter bylaws, minutes of board meetings, material contracts, etc. %erform analytical procedures of the nature discussed in 1hapters ) and + to evaluate the possibility of business failure and assess areas where fraudulent financial reporting is likely. ;eview and understand the client"s legal obligations in the manner discussed in this chapter to become familiar with the legal environment in which the client operates. ;eview the information available in the audit files, such as permanent files, audit programs, and the preceding year"s audit documentation for the e2istence of material non4arm"s4 length transactions. Also discuss with ta2 and management personnel assigned to the client their knowledge of management involvement in material transactions. ,iscuss the possibility of fraudulent financial reporting with company counsel after obtaining permission to do so from management. Bhen more than one 1%A firm is involved in the audit, e2change information with them about the nature of material transactions and the possibility of fraudulent financial reporting. 3nvestigate whether material transactions occur close to year4 end. 3n all material transactions, evaluate whether the parties are economically independent and have negotiated the transaction on an arm"s4length basis, and whether each transaction was transacted for a valid business purpose. Bhenever there are material non4arm"s4length transactions, each one should be evaluated to determine its nature and

#. $.

&. (. ). +.

@.

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8-2% continued! the possibility of its being recorded at the improper amount. The evaluation should consider whether the transaction was transacted for a valid business purpose, was not unduly comple2, and was presented in conformity with its substance. Bhen management is indebted to the company in a material amount, evaluate whether management has the financial ability to settle the obligation. 3f collateral for the obligation e2ists, evaluate its acceptability and value. 3nspect entries in public records concerning the proper recording of real property transactions and personal property liens. >ake in/uiries with related parties to determine the possibility of inconsistencies between the client"s and related parties" understanding and recording of transactions that took place between them. 3nspect the records of the related party to a material transaction that is recorded by the client in a /uestionable manner. Bhen an independent party, such as an attorney or bank, is significantly involved in a material transaction, ascertain from them their understanding of the nature and purpose of the transaction.

17.

11. 1 .

1#. 1$.

f.

<or each of the non4arm"s4length transactions in part d. above, the auditor can evaluate whether they are fraudulent, if he or she knows the transactions e2ist, by: 1. . 1omparing the terms of the lease to the terms in another comparable situation to determine that the terms are fair to the parties involved. 1omparing the price paid or received and other circumstances involved in the transaction to determine whether or not the circumstances are comparable to those available in the market. ;eceiving a rate /uote from a similar facility for similar service and comparing this to the amount paid by the company. ;eceiving a /uote from another company that would be willing to provide a similar service to the company and comparing this to the rate presently being paid by the company.

#. $.

g.

The auditor must first evaluate the significance of inade/uate disclosure. Assuming it is material -highly material., the auditor must issue a /ualified -adverse. opinion for the failure to follow generally accepted accounting principles. ,isclosure of the facts must be made in a separate paragraph.

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8-3& a.

<irst, the minutes of each meeting refer to the minutes of the previous meeting. The auditor should also obtain the ne2t year"s minutes, probably for <ebruary 717, to make sure the previous minutes referred to were those from 'eptember 1(, 77@. Additionally, the auditor will re/uest the client to include a statement in the client representation letter stating that all minutes were provided to the auditor.

b.
./(0R'A1.0/ R*2*3A/1 10 2&&% A4,.1 (e-ruary 155 1. Approval for increased distribution costs of D&77,777. . !nresolved ta2 dispute. #. 1omputer e/uipment donated. $. Annual cash dividend. &. 6fficers" bonuses. A4,.1 AC1.0/ R*Q4.R*, ,uring analytical procedures, an increase of D&77,777 should be e2pected for distribution costs Evaluate resolution of dispute and ade/uacy of disclosure in the financial statements if this is a material uncertainty. ,etermine that old e/uipment was correctly treated in 77+ in the statements and that an appropriate deduction was taken for donated e/uipment. 1alculate total dividends and determine that dividends were correctly recorded. ,etermine whether bonuses were accrued at 1 4#147+ and were paid in 77@. 1onsider the ta2 implications of unpaid bonuses to officers. 3nform staff of possibility of related party transactions. Eote information in audit files for 717 audit. ,etermine if the pensionFprofit sharing plan was approved. 3f so, make sure all assets and liabilities have been correctly recorded. ,etermine that there is appropriate accounting treatment of the disposal of the 14year4old e/uipment. Also trace the cash receipts to the journals and evaluate correctness of the recording. E2amine supporting documentation of loan and make sure all provisions noted in the minutes are appropriately disclosed. 1onfirm loan information with bank. Thank management for selecting your firm for the 77@ audit. 3f your firm has e2perience with pension and profit sharing plans, ask management if there is anything they need help with regarding their new proposed plan.

6epte)-er 1#5 1. 77@ officers elected. . 6fficers" salary information. #. %ensionFprofit sharing plan. $. Ac/uisition of new computer system.

&. ?oan.

(. Auditor selection.

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8-3& continued! c. The auditor should have obtained and read the <ebruary minutes, before completing the 1 4#147+ audit. Three items were especially relevant and re/uire follow4up for the 1 4#147+ audit: unresolved dispute with the 3;', replacement of computer e/uipment, and approval for the 1 4#147+ bonuses.

8-31 6tate)ent 1. Eot re/uired during this stage. . 'hould focus on enhancing the auditor"s understanding of the client"s business and the transactions and events that have occurred since the last audit date. #. 'hould focus on identifying areas that may represent specific risks relevant to the audit. $. ,o not result in detection of misstatements. &. ,esigned to obtain evidential matter about particular assertions related to account balances or classes of transactions. (. *enerally use data aggregated at a lower level than the other stages. ). 'hould include reading the financial statements and notes to consider the ade/uacy of evidence gathered. +. 3nvolve reconciliation of confirmation replies with recorded book amounts. @. !se of preliminary or unadjusted working trial balance as a source of data. 17. E2pected to result in reduced level of detection risk. Related 6tage o7 Audit . 'ubstantive testing 1. %lanning the audit

1. %lanning the audit

$. 'tatement is not correct concerning analytical procedures . 'ubstantive testing

. 'ubstantive testing #. 6verall review

$. 'tatement is not correct concerning analytical procedures 1. %lanning the audit

. 'ubstantive testing

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8-32 =ere are e2pected values for each account e2cept sales and the calculated difference between the e2pected value and actual recorded balance:
,.((*R*/C* ./ *8P*C1*, A/, R*C0R,*, 4@.#$G -D$+@,+(+ 4 D&#&,( (. F D$+@,+(+ 1.$)G -D17,(7@,)+$4D17,$&#,(1+. F D17,(7@,)+$

ACC04/1 E2ecutive salaries

*8P*C1*, 3A24* :48%;8#8 -D$)&,(77 2 17#G.

R*A60/./9 10 64PP0R1 *8P*C1*, 3A24* All e2ecutives received a # percent increase in salaries effective 6ctober 1, 77+. There were no additions to the number of e2ecutives in the current year. The increase in factory hourly payroll is attributed to two primary factors. <irst, payroll e2pense would be e2pected to increase #G over the prior year to account for the #G wage increase for all employees -e2cept e2ecutives.. 'econd, payroll e2pense should increase 1+G to account for the 1+G increase in the number of units produced and sold. All factory supervisors" salaries received a # percent increase effective 6ctober 1, 77+. There were no additions to the number of factory supervisors in the current year. All office personnel received a # percent increase in salaries effective 6ctober 1, 77+. There were no additions to the number of office personnel in the current year. 'ales increased by D1 ,$@$,#+). 1ommissions are only earned on about )&G of the sales. Thus, only )&G of the increase -D@,#)7,)@7. would be considered in the calculation of commission e2pense. The fact that commissions are paid one month after they are earned does not affect commission e2pense for the year since management would have to accrue the e2pense for commissions earned but not paid as of 'eptember #7, 77@.

<actory hourly payroll

:1&;#&%;$84 3ncrease due to #G payrate increase: -D+,) @,$&+ 2 #G HD (1,++$ increase due to payrate increase. 1+G increase due to increased production -D+,) @,$&+ I D (1,++$ H +,@@1,#$ 2 11+ G H D17,(7@,)+$.

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<actory supervisors" salaries 6ffice salaries

:$&3;82# -D(+#,# ( 2 17#G. :1;$82;#13 -D1,)#7,(@ 2 17#G.

4.1&G -D)7#,+ ( 4 D)7$,+&@. F D)7#,+ ( 4. (G -D1,)+ ,(1#4D1,)+), 1@. F D1,)+ ,(1# 11.1$G D ,#1),1&@4D ,7&@,7@). F D ,#1),1&@

'ales commissions

:2;31$;15% 3ncrease in commissions due to increased sales: -(G 2 D@,#)7,)@7 H D&( , $). D1,)&$,@1 I D&( , $) H ,#1),1&@

Eote: 'ales have increased + percent over prior year. Ten percent of that is due to an increase in the average selling price. The remaining 1+ percent is attributed to an increase in the number of units sold.

8-33 a.

*ross margin percentage for drug and nondrug sales is as follows:


,R496 77@ 77+ 77) 77( $7.(G $ . G $ .1G $ .#G /0/,R496 # .7G # .7G #1.@G #1.+G

The e2planation given by Adams is correct in part, but appears to be overstated. The gross margin percentage for nondrugs is appro2imately consistent. <or drugs, the percent dropped significantly in the current year, far more than industry declines. The percent had been e2tremely stable before 77@. 3n dollars, the difference is appro2imately D+ ,777 -$ . G 4 $7.(G 2 D&,1 (,777. which appears to be significant. 6f course, the decline in JonesC prices may be greater than the industry due to e2ceptional competition. b. As the auditor, you cannot accept AdamsC e2planation if D+ ,777 is material. The decline in gross margin could be due to an understatement of drug inventory, a theft of drug inventory, or understated sales. <urther investigation is re/uired to determine if the decline is due to competitive factors or to a misstatement of income. 8-34 a. 1. 1ommission e2pense could be overstated during the current year or could have been understated during each of the past several years. 6r, sales may have been understated during the current year or could have been overstated in each of the past several years. 6bsolete or unsalable inventory may be present and may re/uire markdown to the lower of cost or market. Especially when combined with above, there is a high likelihood that obsolete or unsalable inventory may be present. 3nventory appears to be maintained at a higher level than is necessary for the company. 1ollection of accounts receivable appears to be a problem. Additional provision for uncollectible accounts may be necessary. Especially when combined with $ above, the allowance for uncollectible accounts may be understated. ,epreciation e2penses may be understated for the year.

. #.

$. &. (.

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8-34 continued! b. .1*' 1 4 >ake an estimated calculation of total commission e2pense by multiplying the standard commission rate times commission sales for each of the last two years. 1ompare the resulting amount to the commission e2pense for that year. <or whichever year appears to be out of line, select a sample of individual sales and recompute the commission, comparing it to the commission recorded. .1*'6 2 A/, 3 4 'elect a sample of the larger inventory items -by dollar value. and have the client schedule subse/uent transactions affecting these items. Eote the ability of the company to sell the items and the selling prices obtained by the client. <or any items that the client is selling below cost plus a reasonable markup to cover selling e2penses, or for items that the client has been unable to sell, propose that the client mark down the inventory to market value. .1*'6 4 A/, 5 4 'elect a sample of the larger and older accounts receivable and have the client schedule subse/uent payments and credits for each of these accounts. <or the larger accounts that show no substantial payments, e2amine credit reports and recent financial statements to determine the customersC ability to pay. ,iscuss each account for which substantial payment has not been received with the credit manager and determine the need for additional allowance for uncollectible accounts. .1*' # 4 ,iscuss the reason for the reduced depreciation e2pense with the client personnel responsible for the fi2ed assets accounts. 3f they indicate that the change resulted from a preponderance of fully depreciated assets, test the detail records to determine that the e2planation is reasonable. 3f no satisfactory e2planation is given, e2pand the tests of depreciation until satisfied that the provision is reasonable for the year. 8-35
RA1.0 /4'<*R /**, (0R ./3*61.9A1.0/ R*A60/ (0R ./3*61.9A1.0/ /A14R* 0( ./3*61.9A1.0/

1.

Kes

1urrent ratio has decreased from previous year and is significantly lower than the industry averages. This could indicate a shortage of working capital re/uired for competition in this industry.

6btain e2planation for the decrease in current ratio and investigate the effect on the companyCs ability to operate, obtain needed financing, and meet the re/uirements of its debt agreements.

+41(

8-35 continued!
RA1.0 /4'<*R /**, (0R ./3*61.9A1.0/ R*A60/ (0R ./3*61.9A1.0/ /A14R* 0( ./3*61.9A1.0/

Kes

An 114 F#G increase in the amount of time re/uired to collect receivables provides less cash with which to pay bills. This change could represent a change in the collection policy, which could have a significant effect on the company in the future. 3t may also indicate that a larger allowance for uncollectible accounts may be needed if accounts receivable are less collectible than in 77+.

,etermine the cause of the change in the time to collect and evaluate the long4term effect on the companyCs ability to collect receivables and pay its bills. The difference between the companyCs and the industryCs days to collect could indicate a more strict credit policy for the company. The investigation of this possibility could indicate that the company is forfeiting a large number of sales and lead to a recommendation for a more lenient credit policy. 3nvestigate the reasons for the difference in the days to sell between the company and the industry. ,etermine the effect on the company in terms of customer dissatisfaction and lost customers due to stock4 outs or long waits for delivery. EFA 3nvestigate the market demand for the companyCs product to determine if a significant disposal problem may e2ist. There may be a net realiAable value problem due to these conditions.

#.

Kes

The difference in the companyCs days to sell and the industry is significant. This could indicate that the company is operating with too low an inventory level causing stock4outs and customer dissatisfaction. 3n the long term, this could have a significant adverse effect on the company. EFA The industry average increased almost 17G indicating that the industry is building inventories either intentionally to fill an increased demand or unintentionally due to decreased demand and inability to dispose of inventory -as indicated further by significant decrease in the industry gross profit percent 4 see + below..

$. &.

Eo Kes

+41)

8-35 continued!
RA1.0 /4'<*R /**, (0R ./3*61.9A1.0/ R*A60/ (0R ./3*61.9A1.0/ /A14R* 0( ./3*61.9A1.0/

(. ). +.

Eo Eo Kes

EFA EFA The company appears to have raised prices during the past year to achieve the gross profit G of the industry. =owever, it appears that the industryCs gross profit G has been reduced from either increased cost of goods which could not be passed on to customers in price increases or reduction in selling prices from competition, decreased demand for product, or overproduction. The result of these changes could be significant to the companyCs ability to produce a profit on its operations. EFA

EFA EFA ,etermine the reason for the change in the industryCs gross profit percent and the effect this might have on the company.

@.

Eo

EFA

b.

>ahogany %roducts operations differ significantly from the industry. >ahogany has operated in the past with higher turnover of inventory and receivables by selling at a lower gross margin and lower operating earnings. =owever, the company has changed significantly during the past year. The days to convert inventory to cash have increased )G -11 days., while the current ratio has decreased by 1&G. The company was able to increase its gross margin percent during the year when the industry was e2periencing a significant decline in gross margin. The companyCs financial position is deteriorating significantly. The companyCs ability to pay its bills is marginal -/uick ratio H 7.@). and its ability to generate cash is weak -days to convert inventory to cash H ((.) in 77@ versus 1)#.+ in 77&.. The earnings per share figure is misleading because it appears stable while the ratio of net income to common e/uity has been halved in two years. The accounts receivable may contain a significant amount of uncollectible

8-3# a.

+41+

8-3# continued! accounts -accounts receivable turnover reduced &G in four years., and the inventory may have a significant amount of unsalable goods included therein -inventory turnover reduced $7G in four years.. The companyCs burden for increased inventory and accounts receivable levels has re/uired additional borrowings. The company may e2perience problems in paying its operating liabilities and re/uired debt repayments in the near future. b.
A,,.1.0/A2 ./(0R'A1.0/ 1. ,ebt repayment re/uirements, lease payment re/uirements, and preferred dividend re/uirements . ,ebt to e/uity ratio #. 3ndustry average ratios

R*A60/ (0R A,,.1.0/A2 ./(0R'A1.0/ To project the cash re/uirements for the ne2t several years in order to estimate the companyCs ability to meet its obligations.

To see the companyCs capital investment and ability of the company to e2ist on its present investment. To compare the companyCs ratios to those of the average company in its industry to identify possible problem areas in the company. To see the collection potential and e2perience in accounts receivable. To compare the allowance for uncollectible accounts to the collection e2perience and determine the reasonableness of the allowance. To compare the age of the inventory to the markdown e2perience since the turnover has decreased significantly. To evaluate the net realiAable value of the inventory. To indicate whether the company may have li/uidity problems within the ne2t five years.

$. Aging of accounts receivable, bad debt history, and analysis of allowance for uncollectible accounts &. Aging of inventory and history of markdown taken (. 'hort4 and long4term li/uidity trend ratios

c.

5ased on the ratios shown, the following aspects of the company should receive special emphasis in the audit: 1. . Ability of the company to continue to ac/uire inventory, replace obsolete or worn4out fi2ed assets, and meet its debt obligations based on its current cash position. ;easonableness of the allowance for uncollectible accounts based on the reduction in accounts receivable turnover and increase in days to collect receivables.

+41@

8-3# continued! #. $. ;easonableness of the inventory valuation based on the decreased inventory turnover and increased days to sell inventory. 1omputation of the earnings per share figure. 3t appears inconsistent that earnings per share could remain relatively stable when net earnings divided by common e/uity has decreased by &7G. This could be due to additional stock offerings during the period, or a stock split.

8-3$ a.

e5ay"s decision to offer goods for sale at fi2ed prices in addition to goods offered through its 3nternet auctions may be related to any of these possible business strategies: Matc# Competition. 5ecause other retailers offer products at fi2ed prices through the 3nternet, e5ay"s ability to offer products at fi2ed prices allows e5ay to attract customers interested in purchasing goods offered by other retailers. 1ustomers less interested in participating in online auctions may come to e5ay to purchase items at fi2ed prices instead of visiting other retailer"s Beb sites. Thus, e5ay may have decided that it needed to also offer products at fi2ed prices to match their competition and meet consumer e2pectations in the marketplace. )arget *e" Mar$ets. >any consumers may not be willing to participate in online auctions due to the inconvenience of refreshing their online bids during the auction period. 5y offering products at fi2ed prices to consumers through its Beb site, e5ay may be able to e2pand its market to consumers who do not choose to participate in the online auction. E2amples of business risks associated with the e5ay"s operations may include the following: Insufficient Capacity to +andle ,emand . 3f demand for products through the e5ay Beb site e2ceeds e2pectations, internal systems may not be able to handle the volume of auctions and the processing of completed transactions in a timely fashion. Customer Satisfaction "it# Product. 5ecause e5ay products are offered by independent third parties, e5ay faces risks related to product /uality. 3f products ac/uired through e5ay fail to meet consumer e2pectation for /uality, customer use of e5ay auctions may deteriorate over time.

b.

+4 7

8-3$ continued!

Consumer Privacy. *iven that online consumers will be providing confidential personal information, including credit card data, e5ay"s system must be designed to protect consumer privacy during transmission and processing of orders. 5reaches in consumer privacy may affect future demand for online sales and may increase legal e2posure to the company. Internet (vailability. e5ay"s business model is dependent solely on access to auctions through the 3nternet. ,uring periods when the 3nternet is not available, e5ay is unable to conduct business. 3f 3nternet outages are lengthy or fre/uent, consumers may be less interested in shopping on e5ay.

c.

The decision by e5ay to ac/uire the online payment service, %ay%al, streamlines the payment process between buyers and sellers on the e5ay auctions. e5ay"s business risk may be affected if the payment process fails to work properly. %ay%al enables customers, whether an individual or business, with an email address to securely, easily and /uickly send and receive payments online. %ay%alCs service builds on the e2isting financial infrastructure of bank accounts and has tens of millions of registered accounts. Ac/uiring %ay%al allows e5ay to reduce business risk by ensuring they control this important aspect of the payment process in online commerce. e5ay"s business model is totally dependent on buyer and seller easy access to the 3nternet. The decision to ac/uire the 3nternet communications company, 'kype, strengthens e5ay"s access to the fastest growing 3nternet communications company. That helps ensure the company controls this important aspect of its business model. d. Each of the business risks identified in 8b9 may lead to an increased risk of material misstatements in the financial statements, if not effectively managed. Insufficient Capacity to +andle ,emand . 3f demand for products through the e5ay Beb site e2ceeds the company"s ability to process orders in a timely fashion, consumers may cancel earlier recorded orders or re/uest returns when delivery occurs well beyond the e2pected delivery date. The accounting systems must be designed to accurately reflect cancellations and returns in a timely fashion consistent with *AA%. Additionally, if the processing of orders is significantly delayed, the accounting systems must be ade/uately designed to ensure sales are not recorded prematurely -e.g., not until delivery..

+4 1

8-3$ continued!

Customer Satisfaction "it# Product. Bhile the independent sellers who offer products on e5ay auctions bear primary responsibility for product /uality, some customers may seek financial reimbursement from e5ay when products are not delivered or are in poor /uality. Thus, e5ay"s financial statements may need to include reserves for product returns. Consumer Privacy. 3f consumer privacy is breached, e2isting sales may be cancelled or returns beyond the normal period may be re/uested. 'uch activity would need to be properly reflected in the financial statements. Additionally, legal e2posures may increase, which may re/uire additional financial statement disclosures. Internet (vailability. The lack of 3nternet availability will may lead to penalties or fee payments to online sellers who use e5ay to auction goods and to online advertising wanting to place advertisements on the e5ay site. Bhen the 3nternet is down, there may be fees owed to sellers and advertisers.

Cases

8-38 This case illustrates the common problem of an audit partner having to allocate his scarcest resourceLhis time. 3n this case, Binston 5lack neglects a new client for an e2isting one and causes himself several serious problems. a. A! 1(1 incorporates the A31%A"s statement of /uality control standards governing an audit practice into *AA'. 6ne of the /uality control standards re/uires that firms maintain client acceptance procedures. =enson, ,avis has such a policy0 however, whatever enforcement mechanism for compliance with it must not be sufficient, as >c>ullan ;esources was accepted without the procedures being completed. >ore to the point, A! #1& makes the importance of ade/uate communication by a successor auditor with the predecessor auditor abundantly clear. 3n this case, 'arah 5eale initiated a communication, but then left it incomplete when the predecessor auditor did not return her call. 'he rationaliAed this away by accepting representations from the new client. 6f course, the predecessor auditor may be able to offer information that conflicts with the new client"s best interest. 3t is not appropriate or in accordance with auditing standards to consider management"s representations in lieu of a direct communication with the predecessor auditor. The client should not have been accepted until a sufficient communication occurred. 1an this be remediedM Kes and no. Bhile A! #1& re/uires communication with the predecessor auditor before accepting the engagement, a communication with the predecessor auditor should

+4

8-38 continued! be conducted now, presumably by 5lack. =owever, if alarming information were obtained, =enson, ,avis would find itself in the awkward position of having accepted a client it might not want. 3n that case, if it decides to withdraw from the engagement, it may be breaching a contractual obligation. 3f it continues, it may be taking an unwanted level of business andFor audit risk. A related implication is the wisdom of 5lack"s assumption about 5eale"s competence and how that affects her performance on the engagement. 5lack relied on 5eale e2tensively, yet 5eale"s performance on the new client acceptance was deficient. ,oes this mean that 5eale"s performance in other areas was deficient as wellM 1ertainly, 5lack can do a thorough review of 5eale"s work, but review may or may not reveal all engagement deficiencies. 5lack"s handling of this engagement also implies something about his attitude and objectivity. This was an initial engagement, yet he delegated almost all responsibility up to final review to 5eale. =e got credit for bringing in the new client, which directly benefited him in terms of his compensation. 3t would be against his best interest to not accept -withdraw from. this client. 3f he is unwilling to 8do the right thing9 here, how will he handle other difficult audit problemsM b. 3n the audit of long4term contracts, it is essential to obtain assurance that the contract is enforceable so that income can be recogniAed on the percentage4of4completion basis. 3t is also important to consider other aspects of the contract that relate to various accounting aspects, such as price and other terms, cancellation privileges, penalties, and contingencies. 3n this case, 5eale has concluded that the signed contract, written in <rench, is >c>ullan"s 8standard9 contract, based on client representation. 6f course, auditing standards re/uire that management"s representations, a weak form of evidence, be corroborated with other evidence where possible. 5eale might argue that the confirmation obtained constitutes such evidence. 5eale"s argument may seem logical with regard to enforcement, however, the confirmation form refers to e2isting disputes. 3t says nothing about contractual clauses that may foreshadow enforceability. <or that reason the audit program re/uires the contract to be read. =ow would an auditor know whether the contract form was that of a standard contract without reading itM <urthermore, it may be unrealistic to assume there is such a thing as a 8standard9 contract in the first place. ?ong4term and short4term contracts are the result of negotiation and often contain special clauses and changed language.

+4 #

8-38 continued! 3n this case, not reading the contract was an insufficiency and the <rench4language copy should be translated by an independent translator and read by the auditors. c. 1ompliance with *AA' is a matter that is always subject to professional judgment. 6ne professional auditor may conclude he or she has complied with *AA', and another would conclude that *AA' has been violated, so these matters are very seldom clear cut. =owever, in this case, it appears that 5lack and 5eale may have violated *AA' in the following ways: Standard of -ield .or$ *o/ 0 % )#e auditor must ade'uately plan t#e "or$ and must supervise any assistants/ The re/uirements of A! #1&, discussed above, relate to this standard. >ore generally, the audit partner should participate in planning, at least with a timely review. This would be more important than otherwise in the situation of a first4time engagement, as we have here. 'imilarly, some level of on4going partner supervision would seem prudent and logical. 5lack, apparently, did not really participate at all until final review. Standard of -ield .or$ *o/ 1 ! )#e auditor must obtain sufficient appropriate audit evidence by performing audit procedures to afford a reasonable basis for an opinion regarding t#e financial statements under audit/ As discussed above, the work on the >ontreal contract was deficient and further evidence is re/uired. 3n addition, whenever the field work standards are violated there are implied violations of other standards. 3t might be argued that 5eale was not proficient as an auditor because of her failures with the new client acceptance procedures and the >ontreal contract. 'imilarly, it might be argued that due professional care was not taken both by 5eale and by 5lack for delegating so much to 5eale. 8-3% a. Bhen the computer option is assigned, an E2cel spreadsheet -<ilename %+#@.2ls. is used to compute a set of ratios as would be done manually -as shown below.. <ive specific aspects of using the computer in doing this are discussed below. The first applies to both the manual and the computer approach. 1. 1omputation of ratios. The selection of ratios is arbitrary and should include a set that gives a good overview of all aspects of the companyCs financial statements that the user is interested in. And, in computing specific ratios, certain decisions must be made, such as whether to use net sales or gross sales. The formulas for the ratios selected for this

+4 $

8-3% continued! solution are shown below. Eote: where possible, the solution uses average balances -inventory and accounts receivable, for e2ample. when re/uired by the ratio formulas. 5ecause 77& balances are not available for computing 77( average inventory and receivables, the solution does not calculate average inventory and calculate average inventory and accounts receivable turnover ratios for 77(. Nuick ratio H -cash I accounts receivable 4 allowance for doubtful accounts. F current liabilities *ross marginFsales H gross margin F gross sales Average inventory turnover H -cost of goods sold. F average inventory 1urrent ratio H 1urrent assets F current liabilities Average days to collect receivables H -average accounts receivable 2 #(7. F -net sales. Eet incomeFtotal assets H -self4e2planatory. Eet incomeFsales H net income F gross sales 'alesFe/uity H *ross sales F e/uity ,ebtFe/uity H -total liabilities. F total e/uity Eet incomeFe/uity H -self4e2planatory. Allowance for doubtful accounts F accounts receivable H -self e2planatory. 5ad debtsFsales H bad debts F gross sales 'ales returns and allowancesFsales H sales returns and allowancesFgross sales . 'et4up. E2cel spreadsheets must be planned in advance. This can be referred to as Oset4up.O A useful techni/ue is to use a block diagram to plan the set4up. This helps see the overall shape and content of the spreadsheet and is helpful for guiding its detailed preparation and how outputs will be controlled and formatted. A block diagram for this spreadsheet

+4 &

8-3% continued! follows. 3t shows the spreadsheet divided into three sections: the heading, the input section, where data will be entered, and the results section where the ratios will be calculated. A vertical structure is used to facilitate printouts that will fit in an +41F 2 1$ inch format. The structure could just as easily be side4by4side. A1 * 1olumns for years 7@47( A& ;ows for account Amounts

headings

*$# A$) ;ows for various ratios 1olumns for years 7@47(

<ormulas for ratios

*)1

+4 (

8-3% continued! #. 1heck on accuracy of inputs. A major concern is knowing that input data has been entered accurately. This can usually be achieved by two alternative procedures. The first is computing totals and comparing them to check figures. <or e2ample, the details of assets can be computed and added to 177. The second procedure is verification of details on a figure4by4figure basis back to the source. Treatment of negative values. Eegative values can be entered as negative inputs or positive inputs. 3t is important to respond properly to the treatment used when the values are included in computations. 1heck on accuracy of formulas. 6ne of the biggest problems with using spreadsheets is errors in the development of formulas. 6ne use of each formula should be done manually to check its correctness and the formulas should receive a careful second party review. 3f this second step is impractical, a second party should at least review the results for reasonableness. Templates for the computer solutions prepared using E2cel are included on the 1ompanion Bebsite. 6olo)on <ros" 'anu7acturing Co" Analytical Procedures 1alculated from adjusted year4end balances =*> RA1.06 Nuick *ross marginFsales Average inventory turnover 1urrent Average days to collect receivables Eet incomeFtotal assets Eet incomeFsales 'alesFe/uity ,ebtFe/uity Eet incomeFe/uity Allowance for doubtful accountsFaccounts receivable 5ad debtsFsales 'ales returns and allowancesFgross sales 2&&% .@( 1.7G 1.)@ .1@ 1#1.17 #.@G &.7G #.+@:1 $.7 :1 .1@:1 17.(G #.)G #.1G +4 ) 2&&8 .+# .1G 1.+ 1.@( 1 #.@$ #.@G &. G $.#):1 $.+ :1 . #:1 11.&G $.7G #.7G 2&&$ .+1 #. G 1.@# 1.@1 11(.7( #.@G &.#G $.++:1 &.($:1 . (:1 1 .&G $.1G #.7G 2&&# .)$ &.7G EA 1.)& EA $.#G (.1G &. ):1 (.$ :1 .# :1 1$.+G $.(G .@G

$.

&.

8-3% continued! The 'olomon brothers are considering going public to e2pand the business at a time that land and building costs in 5oston are at e2tremely inflated values. %resently gross profit margins are 1G of sales and net income is &G of sales. 5oth ratios decreased during the past year. To finance e2pansion, additional debt is out of the /uestion because long4term debt is presently e2tremely high -debt to e/uity ratio is $.7 .. ,epreciation on new plant and e/uipment at the inflated prices will cause high depreciation charges, which may significantly reduce the profit margins. b. The account that is of the greatest concern is allowance for uncollectible accounts. The following are three key analytical procedures indicating a possible misstatement of allowance for uncollectible accounts: 1. <rea?down o7 the aging in percent 7 4 #7 days #1 4 (7 days (1 4 1 7 days over 1 7 days . #. 2&&% #@.+G ##.&G 1@.1G ).(G 177.7G 2&&8 $ .1G ##.#G 1).(G ).7G 177.7G 11.&G $.7G 2&&$ $(.7G # .7G 1(.7G (.7G 177.7G 1 .&G $.1G 2&&# $@.@G #7.1G 1&.7G &.7G 177.7G 1$.+G $.(G

AllowanceFaccounts receivable 17.(G 5ad debtsFsales #.)G

3t appears that the allowance is understated: 1. . #. 3f accounts were as collectible as before, allowanceFaccounts receivable should be about constant. 3f accounts become less collectible, allowanceFaccounts receivable should increase. Eumber seems to be the case.

The aging of accounts receivable shows a deterioration in the overall aging -74#7 decreased significantly in the past several years, while those in all other categories increased., while the allowance for uncollectible accounts as a percentage of accounts receivable has decreased from 1$.+G to 17.(G. This indicates that the allowance for uncollectible accounts may be understated, especially considering the trend between 77( and 77+. Accounts Receiva-le" The average days to collect receivables has increased steadily over the four4year period, which indicates that some accounts may not

+4 +

8-3% continued! be collectible. This idea is supported by the deterioration in overall aging noted above. 6ales" <inally, gross margin as a percentage of sales has declined steadily over the four4year period from &G to 1G. Eet 3ncomeF'ales has also declined. The auditor should seek an e2planation from the client for these trends.

.ntegrated Case Application P.//AC2* 'A/4(AC14R./9@PAR1 . a. Amounts -in thousands.


Ratios 1urrent ratio: ,ebt to e/uity 1urrent assets 1urrent liab. ,ebt E/uity Eet income bFt 'ales *ross profit 'ales 16*' Ave. inventory 2&&% $$,$@) &,@ ( 1.) $),1(1 &&,+ ( +$.&G $, )$ 1$@, $& .@G $$,$#) 1$@. $& @.+G 17$,+7+ &,11@ $. 2&&8 #(,1@( 1),(7& .7( #),7## & ,)&@ )7. G #,+)7 1#),&+7 .+G $7,@+$ 1#),&)@ @.+G @(,&@( ,7@1 $.$ 2&&$ #(,77& 1(,#$1 . 7 #&,+71 &7,+)# )7.$G ,((7 1 &,+1$ .1G #),1 @ 1 &,+1$ @.&G ++,(+& 1,@)& $.7

8-4&

Eet income btFsales *ross margin G

3nventory turnover

b.

There is a low risk that %innacle will fail financially in the ne2t twelve months. The company has been profitable the past three years, is generating significant cash flows and most of the ratios indicate no financial difficulties. The current ratio and debt to e/uity have deteriorated somewhat, but not enough to cause significant concerns. 'ee page +4# for %innacle"s common4siAe income statement. <or the overall financial statements, the focus is on all accounts e2cept direct e2penses. <or the direct e2penses, it is better to use the disaggregated information. The suggested solution was prepared using E2cel -<ilename %+$7.2ls..

c.

+4 @

8-4& continued! Account <alance %roperty ta2es 5ad debts ,epreciation e2pense <ederal 3ncome Ta2es *sti)ate o7 : A)ount o7 Potential 'isstate)ent ,ecrease of D1$7,777 when property increased 'ee re/uirement f for an analysis 3ncrease of D1. million, perhaps partly due to new building and e/uipment purchases <3T as a G of E35T was #(G in 77+. #(G of 77$ E35T is D1.&#@ million. Actual <3T for 77@ was D1.71$ million. ,ifference of D& &,777. 'hort4term plus long4term interest bearing debt increased by &G, from D ).# million to D#$. 1 million, but interest e2pense decreased. 3f interest rates have not changed, interest e2pense would be e2pected to increase by a similar amount to D ,((1,777 -D ,1 @,77 2 1. &.. %otential misstatement of D)($,777 -D ,((1,777 4 D1,+@),777..

3nterest e2pense

d.

'ee pages +4## to +4#& for common4siAe income statement for each of %innacle"s three divisions. The suggested solution was prepared using E2cel -<ilename %+$7.2ls.. <or disaggregated information it is best to ignore the allocated e2penses. Account <alance Solar Electro: %ayroll benefits *sti)ate o7 : A)ount o7 Potential 'isstate)ent 3ncreased almost D177,777 without a similar siAed increase in salary and wages. %ayroll benefits in Belburn decreased while salary and wages increased in this division. %otential misallocation between divisions. ?arge increase may be indicative of other issues affecting disclosures and asset or liability valuation. D 77,777 increase needs investigation. D1 7,777 increase in warehouse rent even though there is no evidence of any change in facilities.

?egal 'ervice

>iscellaneous .elburn

+4#7

8-4& continued! -part of re/uirement c.


Pinnacle Manufacturing Company Income Statement - All Divisions For the Year Ended Decem er !" Sales Sales Returns and Allowances Cost of Sales !ross "rof#t *PE+A,I-. E/PE-SES-Allocated Salar#es$%ana&e'ent Salar#es$(ff#ce )#cens#n& and cert#f#cat#on fees Secur#t* +nsurance %ed#cal ,enef#ts Ad-ert#s#n& .us#ness /u,l#cat#ons "ro/ert* ta0es .ad de,ts 1e/rec#at#on e0/ense Account#n& fees 2otal o/erat#n& e0/enses$Allocated *PE+A,I-. E/PE-SES-Direct Salar#es$Sales 3a&es Rental 3a&es$%ec4an#cs 3a&es$3are4ouse !ar,a&e collect#on "a*roll ,enef#ts Rent$ 3are4ouse 2ele/4one 5t#l#t#es "osta&e )#nen ser-#ce Re/a#rs and 'a#ntenance Clean#n& ser-#ce )e&al ser-#ce 6uel 2ra-el and enterta#n'ent "ens#on e0/ense (ff#ce su//l#es %#scellaneous 2otal o/erat#n& e0/enses$1#rect 2otal (/erat#n& 70/enses (/erat#n& +nco'e (t4er 70/ense$+nterest +nco'e .efore 2a0es 6ederal +nco'e 2a0es -et Income 1eta#ls of 'anufactur#n& e0/enses are not #ncluded #n t4#s sc4edule. #$$% Dollar (alue 149,424,646 179,470 104,807,966 44,437,210 2,348,025 324,392 196,229 566,716 95,924 24,415 167,268 7,194 23,246 866,330 5,492,959 281,973 10,394,671 15,408,771 506,186 1,146,126 5,034,197 28,458 2,735,670 826,350 33,350 270,072 92,390 17,788 171,872 92,428 407,605 294,933 106,415 235,244 154,213 308,969 27,871,037 38,265,708 6,171,502 1,897,346 4,274,156 1,013,745 !0#1$02"" #$$% ) of Sales 100.00% 0.12% 70.14% 29.74% 1.57% 0.22% 0.13% 0.38% 0.06% 0.02% 0.11% 0.00% 0.02% 0.58% 3.68% 0.19% 6.96% 10.31% 0.34% 0.77% 3.37% 0.02% 1.83% 0.55% 0.02% 0.18% 0.06% 0.01% 0.12% 0.06% 0.27% 0.20% 0.07% 0.16% 0.10% 0.21% 18.65% 25.61% 4.13% 1.27% 2.86% 0.68% 2.18% #$$& Dollar (alue 137,741,766 162,102 96,595,908 40,983,756 2,190,819 272,185 158,608 584,936 95,268 27,021 163,311 5,096 163,311 948,679 4,258,699 273,190 9,141,123 14,062,181 546,228 1,229,015 4,899,331 27,313 2,695,165 701,235 41,443 244,959 122,494 11,330 154,500 74,852 174,807 313,020 95,268 217,752 136,092 97,185 25,844,170 34,985,293 5,998,463 2,128,905 3,869,558 1,399,001 #02'$033' #$$& ) of Sales 100.00% 0.12% 70.13% 29.75% 1.59% 0.20% 0.12% 0.42% 0.07% 0.02% 0.12% 0.00% 0.12% 0.69% 3.09% 0.20% 6.64% 10.21% 0.40% 0.89% 3.56% 0.02% 1.96% 0.51% 0.03% 0.18% 0.09% 0.01% 0.11% 0.05% 0.13% 0.23% 0.07% 0.16% 0.10% 0.07% 18.78% 25.42% 4.33% 1.55% 2.78% 1.02% 1.76% #$$' Dollar (alue 125,982,294 168,022 88,685,361 37,128,911 1,995,723 266,831 141,112 548,133 94,340 25,052 144,068 673 152,776 862,690 3,797,885 260,684 8,289,967 12,960,341 500,630 1,159,488 4,759,347 33,017 2,516,783 659,430 50,319 238,578 131,546 13,985 154,968 67,903 132,381 243,054 87,373 110,444 148,790 125,228 24,093,605 32,383,572 4,745,339 2,085,177 2,660,162 1,166,553 "02%!01$% #$$' ) of Sales 100.00% 0.13% 70.40% 29.47% 1.58% 0.21% 0.11% 0.44% 0.07% 0.02% 0.11% 0.00% 0.12% 0.68% 3.01% 0.21% 6.56% 10.29% 0.40% 0.92% 3.78% 0.03% 2.00% 0.52% 0.04% 0.19% 0.10% 0.01% 0.12% 0.05% 0.11% 0.19% 0.07% 0.09% 0.12% 0.10% 19.13% 25.69% 3.78% 1.66% 2.12% 0.93% 1.19%

+4#1

8-4& continued! -part of re/uirement d.


Pinnacle Manufacturing Company Income Statement - 4el urn Division For the Year Ended Decem er !" Sales Sales Returns and Allowances Cost of Sales !ross "rof#t *PE+A,I-. E/PE-SES-Allocated Salar#es$%ana&e'ent Salar#es$(ff#ce )#cens#n& and cert#f#cat#on fees Secur#t* +nsurance %ed#cal ,enef#ts Ad-ert#s#n& .us#ness /u,l#cat#ons "ro/ert* ta0es .ad de,ts 1e/rec#at#on e0/ense Account#n& fees 2otal o/erat#n& e0/enses$Allocated *PE+A,I-. E/PE-SES-Direct Salar#es$Sales 3a&es Rental 3a&es$%ec4an#cs 3a&es$3are4ouse !ar,a&e collect#on "a*roll ,enef#ts Rent$ 3are4ouse 2ele/4one 5t#l#t#es "osta&e )#nen ser-#ce Re/a#rs and 'a#ntenance Clean#n& ser-#ce )e&al ser-#ce 6uel 2ra-el and enterta#n'ent "ens#on e0/ense (ff#ce su//l#es %#scellaneous 2otal o/erat#n& e0/enses$1#rect 2otal o/erat#n& e0/enses *PE+A,I-. I-C*ME 1eta#ls of 'anufactur#n& e0/enses are not #ncluded #n t4#s sc4edule. #$$% 5 (alue 121,371,795 126,522 86,671,580 34,573,693 1,905,965 263,320 144,046 460,017 77,861 19,956 135,777 4,336 18,396 708,015 4,329,633 230,075 8,297,397 12,947,327 $ $ 4,124,063 $ 2,099,069 690,375 26,659 200,398 80,204 14,539 127,063 67,780 119,122 224,342 82,614 193,389 125,176 58,819 21,180,939 29,478,336 5,095,357 #$$% ) of Div6 Sales 100.00% 0.10% 71.41% 28.49% 1.57% 0.22% 0.12% 0.38% 0.06% 0.02% 0.11% 0.00% 0.02% 0.58% 3.57% 0.19% 6.84% 10.67% #$$& 5 (alue 111,877,873 113,483 79,914,454 31,849,936 1,774,466 220,457 117,118 473,767 77,159 22,048 132,276 2,735 132,276 762,910 3,449,347 220,363 7,384,922 11,646,277 $ $ 3,968,235 $ 2,182,959 571,916 33,069 198,409 99,207 9,642 107,833 60,628 120,490 253,526 77,159 176,367 110,228 53,130 19,669,075 27,053,997 4,795,939 #$$& ) of Div6 Sales 100.00% 0.10% 71.43% 28.47% 1.59% 0.20% 0.10% 0.42% 0.07% 0.02% 0.12% 0.00% 0.12% 0.68% 3.08% 0.20% 6.60% 10.41% #$$' 5 (alue 102,308,887 117,627 73,370,003 28,821,257 1,616,447 216,121 104,199 443,958 76,407 20,441 116,690 361 123,743 693,759 3,076,109 210,276 6,698,511 10,733,735 $ $ 3,854,855 $ 2,038,477 537,821 40,152 193,240 106,538 11,900 108,159 55,000 91,247 196,858 70,765 89,454 120,513 68,461 18,317,175 25,015,686 3,805,571 #$$' ) of Div6 Sales 100.00% 0.11% 71.71% 28.18% 1.58% 0.21% 0.10% 0.43% 0.07% 0.02% 0.11% 0.00% 0.12% 0.68% 3.01% 0.21% 6.54% 10.49%

3.40% 1.73% 0.57% 0.02% 0.17% 0.07% 0.01% 0.10% 0.06% 0.10% 0.18% 0.07% 0.16% 0.10% 0.05% 17.46% 24.30% 4.19%

3.55% 1.95% 0.51% 0.03% 0.18% 0.09% 0.01% 0.10% 0.05% 0.11% 0.23% 0.07% 0.16% 0.10% 0.05% 17.60% 24.20% 4.27%

3.77% 1.99% 0.53% 0.04% 0.19% 0.10% 0.01% 0.11% 0.05% 0.09% 0.19% 0.07% 0.09% 0.12% 0.07% 17.91% 24.45% 3.73%

+4#

8-4& continued! -part of re/uirement d.


Pinnacle Manufacturing Company Income Statement - Solar-Electro Division For the Year Ended Decem er !" Sales Sales Returns and Allowances Cost of Sales !ross "rof#t *PE+A,I-. E/PE-SES-Allocated Salar#es$%ana&e'ent Salar#es$(ff#ce )#cens#n& and cert#f#cat#on fees Secur#t* +nsurance %ed#cal ,enef#ts Ad-ert#s#n& .us#ness /u,l#cat#ons "ro/ert* ta0es .ad de,ts 1e/rec#at#on e0/ense Account#n& fees 2otal o/erat#n& e0/enses$Allocated *PE+A,I-. E/PE-SES-Direct Salar#es$Sales 3a&es Rental 3a&es$%ec4an#cs 3a&es$3are4ouse !ar,a&e collect#on "a*roll ,enef#ts Rent$ 3are4ouse 2ele/4one 5t#l#t#es "osta&e )#nen ser-#ce Re/a#rs and 'a#ntenance Clean#n& ser-#ce )e&al ser-#ce 6uel 2ra-el and enterta#n'ent "ens#on e0/ense (ff#ce su//l#es %#scellaneous 2otal o/erat#n& e0/enses$1#rect 2otal o/erat#n& e0/enses *PE+A,I-. I-C*ME 1eta#ls of 'anufactur#n& e0/enses are not #ncluded #n t4#s sc4edule. #$$% 5 (alue 22,381,936 43,430 16,311,635 6,026,871 347,907 48,064 19,868 83,967 14,212 3,641 24,783 900 3,360 124,019 915,513 40,824 1,627,058 2,256,643 $ $ 716,283 $ 492,677 107,026 4,868 54,837 7,340 2,653 35,120 21,300 276,825 55,555 18,729 35,301 22,849 241,764 4,349,770 5,976,828 50,043 #$$% ) of Div6 Sales 100.00% 0.19% 72.88% 26.93% 1.55% 0.21% 0.09% 0.38% 0.06% 0.02% 0.11% 0.00% 0.02% 0.55% 4.09% 0.18% 7.26% 10.08% #$$& 5 (alue 20,073,876 35,208 14,687,724 5,350,944 323,147 40,146 14,025 86,281 14,054 4,015 24,087 497 24,087 144,706 628,135 40,999 1,344,179 2,204,049 $ $ 722,659 $ 397,542 100,370 6,025 36,131 18,069 1,367 36,131 11,039 42,156 46,171 14,054 31,182 20,073 39,433 3,726,451 5,070,630 280,314 #$$& ) of Div6 Sales 100.00% 0.18% 73.17% 26.65% 1.61% 0.20% 0.07% 0.43% 0.07% 0.02% 0.12% 0.00% 0.12% 0.72% 3.13% 0.20% 6.69% 10.98% #$$' 5 (alue 18,373,763 36,494 13,484,900 4,852,369 294,370 39,356 12,478 80,853 13,917 3,722 21,249 66 22,533 131,590 560,167 39,122 1,219,423 2,031,351 $ $ 702,011 $ 371,231 94,386 7,315 35,190 19,404 1,688 36,241 10,014 31,925 35,851 12,889 15,815 21,946 50,811 3,478,068 4,697,491 154,878 #$$' ) of Div Sales 100.00% 0.20% 73.39% 26.41% 1.60% 0.21% 0.07% 0.44% 0.08% 0.02% 0.12% 0.00% 0.12% 0.72% 3.05% 0.21% 6.64% 11.06%

3.20% 2.20% 0.48% 0.02% 0.25% 0.03% 0.01% 0.16% 0.10% 1.24% 0.25% 0.08% 0.16% 0.10% 1.08% 19.44% 26.70% 0.23%

3.60% 1.98% 0.50% 0.03% 0.18% 0.09% 0.01% 0.18% 0.05% 0.21% 0.23% 0.07% 0.16% 0.10% 0.20% 18.57% 25.26% 1.39%

3.82% 2.02% 0.51% 0.04% 0.19% 0.11% 0.01% 0.20% 0.05% 0.17% 0.20% 0.07% 0.09% 0.12% 0.28% 18.94% 25.58% 0.83%

+4##

8-4& continued! -part of re/uirement d.


Pinnacle Manufacturing Company Income Statement - Machine-,ech Division For the Year Ended Decem er !" #$$%
5 (alue

#$$%
) of Div6 Sales

#$$&
5 (alue

#$$&
) of Div6 Sales

#$$'
5 (alue

#$$'
) of Div Sales

Sales Sales Returns and Allowances Cost of Sales !ross "rof#t *PE+A,I-. E/PE-SES-Allocated Salar#es$%ana&e'ent Salar#es$(ff#ce )#cens#n& and cert#f#cat#on fees Secur#t* +nsurance %ed#cal ,enef#ts Ad-ert#s#n& .us#ness /u,l#cat#ons "ro/ert* ta0es .ad de,ts 1e/rec#at#on e0/ense Account#n& fees 2otal o/erat#n& e0/enses$Allocated *PE+A,I-. E/PE-SES-Direct Salar#es$Sales 3a&es Rental 3a&es$%ec4an#cs 3a&es$3are4ouse !ar,a&e collect#on "a*roll ,enef#ts Rent$ 3are4ouse 2ele/4one 5t#l#t#es "osta&e )#nen ser-#ce Re/a#rs and 'a#ntenance Clean#n& ser-#ce )e&al ser-#ce 6uel 2ra-el and enterta#n'ent "ens#on e0/ense (ff#ce su//l#es %#scellaneous 2otal o/erat#n& e0/enses$1#rect 2otal o/erat#n& e0/enses *PE+A,I-. I-C*ME 1eta#ls of 'anufactur#n& e0/enses are not #ncluded #n t4#s sc4edule.

5,670,915 9,518 1,824,751 3,836,646 94,153 13,008 32,315 22,732 3,851 818 6,708 1,958 1,490 34,296 247,813 11,074 470,216 204,801 506,186 1,146,126 193,851 28,458 143,924 28,949 1,823 14,837 4,846 596 9,689 3,348 11,658 15,036 5,072 6,554 6,188 8,386 2,340,328 2,810,544 1,026,102

100.00% 0.17% 32.18% 67.65% 1.66% 0.23% 0.57% 0.40% 0.07% 0.01% 0.12% 0.03% 0.03% 0.60% 4.37% 0.20% 8.29% 3.61% 8.93% 20.21% 3.42% 0.50% 2.54% 0.51% 0.03% 0.26% 0.09% 0.01% 0.17% 0.06% 0.21% 0.27% 0.09% 0.12% 0.11% 0.15% 41.29% 49.58% 18.07%

5,790,017 13,411 1,993,730 3,782,876 93,206 11,582 27,465 24,888 4,055 958 6,948 1,864 6,948 41,063 181,217 11,828 412,022 211,855 546,228 1,229,015 208,437 27,313 114,664 28,949 2,349 10,419 5,218 321 10,536 3,185 12,161 13,323 4,055 10,203 5,791 4,622 2,448,644 2,860,666 922,210

100.00% 0.23% 34.43% 65.34% 1.61% 0.20% 0.47% 0.43% 0.07% 0.02% 0.12% 0.03% 0.12% 0.71% 3.13% 0.20% 7.11% 3.66% 9.43% 21.23% 3.60% 0.47% 1.98% 0.50% 0.04% 0.18% 0.09% 0.01% 0.18% 0.06% 0.21% 0.23% 0.07% 0.18% 0.10% 0.08% 42.30% 49.41% 15.93%

5,299,644 13,901 1,830,458 3,455,285 84,906 11,354 24,435 23,322 4,016 889 6,129 246 6,500 37,341 161,609 11,286 372,033 195,255 500,630 1,159,488 202,481 33,017 107,075 27,223 2,852 10,148 5,604 397 10,568 2,889 9,209 10,345 3,719 5,175 6,331 5,956 2,298,362 2,670,395 784,890

100.00% 0.26% 34.54% 65.20% 1.60% 0.21% 0.46% 0.44% 0.08% 0.02% 0.12% 0.00% 0.12% 0.70% 3.05% 0.21% 7.01% 3.68% 9.45% 21.88% 3.82% 0.62% 2.02% 0.51% 0.05% 0.19% 0.11% 0.01% 0.20% 0.05% 0.17% 0.20% 0.07% 0.10% 0.12% 0.11% 43.36% 50.37% 14.83%

+4#$

8-4& continued! e. 5oth the companywide and the divisional income statements are useful, but for different purposes. The companywide information is useful for identifying material fluctuations in the financial statements. =owever, the disaggregated information is more helpful in identifying the source of the fluctuations.

f.
*sti)ate o7 Potential 4nderstate)ent in Allowance 2&&% AAR 1urnover 'ales Average accounts receivable 1urnover ,ays 6ales 0utstanding #(& Turnover ,ays Allowance as a Percentage o7 9ross Receiva-les Allowance *ross ;eceivables Percentage Potential understate)ent in Allowance 'uggested percent *ross accounts receivable 'uggested allowance Actual Allowance Potential understate)ent 1$@, $& @, $) 1(.1 #(& 1(.1 .( 2&&8 1#),&+7 ),+++ 1).$ #(& 1).$ 7.@ 2&&$ 1 &,+1$ ),&+ 1(.( #(& (.( .7

(@@ 17,#77 (.+G

(@@ +,1@$ +.&G

(+ ),&+ @.7G

@.&G Estimate based on decrease in turnover 17,#77 @)@ (@@ 28&

+4#&

8-41 B AC2 Pro-le) a. The following is a printout of the 'tatistics command for 3nventory Palue at 1ost:
Field : Total Average Positive : 694,361.94 4,788.7 !eros : Negative : #13,88". ",776.4 Totals : 68 ,479.94 4,476.84 Abs$Value : 7 8,"43.94 %a&ge : 11 ,967.6 'ig(est : 1 ,8 . $37,1 . $"5,548.6 $"4,738. $ "3,136. $ )o*est : #1 ,167.6 $#",774.4 $#595." $#19 .7"$#154. 8$ Value Number 145 " 5 15"

There are 1$& positive amounts, amounts.

Aero amounts, and & negative

The following is a printout of the 'tatistics command for >arket Palue:


Field : +,tVal Number 148 " " 15" Total 1, 3 ,3"5."1 Average 6,961.66

Positive : !eros : Negative : Totals : Abs$Value : %a&ge : 'ig(est : 143,88 . $47,647. 3",97 . $ )o*est : #839.76$#4"3.84$ .

#1,"63.6 #631.8 1, "9, 61.61 6,77 .14 1, 31,588.81 144,719.76 $44, 98.53$4",163." $ $ . $9 . $

There are 1$+ positive amounts, amounts. b. c.

Aero amounts, and

negative

There are several negative values in inventory, which is not possible. There is also one especially large item that should be verified. There are alternative E2pressions that can be used. 6ne is PalueF>ktPal. Three items have market value less than cost. 'everal have a small difference between market value and cost that may night represent normal markups.

+4#(

.nternet Pro-le) 6olution5 0-tain Client <ac?ground .n7or)ation

8"1 %lanning is one of the most demanding and important aspects of an audit. A carefully planned audit increases auditor efficiency and provides greater assurance that the audit team addresses the critical issues. Auditors fre/uently prepare audit planning documents that provide client and industry background information and discuss important accounting and auditing issues related to the client"s financial statements. Kour assignment is to find and document information for inclusion in the audit planning memorandum. Kou should obtain the necessary information by downloading a public company"s most recent annual report from its Beb site -your instructor will give you the company"s name.. Kou may also use other sources of information such as recent 174Q filings to find additional information. Kou should address the following matters in four brief bulleted responses:

5rief company history. ,escription of the company"s business -for e2ample, related companies and competitors.. Qey accounting issues identified from a review of the company"s most recent annual report. -Eote: ,o not concentrate solely on the company"s basic financial statements. 1areful attention should be given to >anagement"s ,iscussion and Analysis as well as the <ootnotes.. Eecessary e2perience levels -that is, years of e2perience and industry e2perience. re/uired of the auditors to be involved in the audit.

Answer5 This problem allows the instructor to select any company that may be of interest. The following suggested answer has been prepared based upon Target 1orporation. >uch of the information has been taken from the company"s Beb site Rwww.target.comS and its 174Q filing for the year ended <ebruary , 77+.

Brief company #istory 4 !nlike most other mass merchandisers, Target has department store roots. 5ack in 1@(1, ,aytonCs department store identified a demand for a store that sold less e2pensive goods in a /uick, convenient format. Target was born. 3n 1@( , the first Target store opened in ;oseville, >innesota. This was the first retail store to offer well4known national brands at discounted prices. 3n the 1@)7s, Target paved new ground by implementing electronic cash registers storewide to monitor inventory and speed up guest service. The company also began hosting an annual shopping event for seniors and people with disabilities, plus a toy safety campaign. 3n the 1@+7s, Target rolled out electronic scanning nationwide. <inally, in the 1@@7s, the company launched a number of new ventures: its first Target

+4#)

*reatland store, a national bridal registry 4 1lub Bedd, and ?ullaby

+4#+

.nternet Pro-le) 8-1 continued! 1lub. 3ts first 'uperTarget store, which combined groceries and special services with a Target *reatland store, was opened. And, the company introduced its own credit card.

,escription of t#e company2s business 4 The company operates 1,&@1 Target stores in $) states and employees appro2imately #((,777 people. The company"s retail merchandising business is conducted under highly competitive conditions in the discount, middle market and department store retail segments. 3ts stores compete with national -e.g., Qmart, Bal4>art, Balgreens. and local department, specialty, off4price, discount, supermarket, and drug store chains, independent retail stores and 3nternet and catalog businesses that handle similar lines of merchandise. The company also competes with other companies for new store sites. The company believes the principal methods of competing in its industry include brand recognition, customer service, store location, differentiated offerings, value, /uality, fashion, price, advertising, depth of selection and credit availability. Target is a leader in community involvement programs and believes that it is in a strong competitive position with regard to these competitive factors. The company shares are traded on the Eew Kork 'tock E2change. There are appro2imately 1+,1 + shareholders.

3ey accounting issues 4 The following is a list of accounting issues


identified after reviewing Target"s annual report. 'tudent responses may vary. 1. ;evenues : The company e2perienced a slowdown in sales in fiscal 77) -year ended <ebruary , 77+.. *iven the significant downturn in the economy throughout calendar 77+, sales may continue to be slow through its fiscal 77+ year end in <ebruary 77@. . ?3<6 inventory valuation issues 4 3nventory is accounted for by the retail inventory accounting method using ?3<6 and is adjusted to reflect the lower of cost or market. #. Pendor 5enefits : The company receives a variety of benefits from vendors, including vendor rebates, markdown allowances and vendor promotions. These vendor benefits offset either inventory costs or selling, general, and administrative e2penses. $. ,erivatives : The company has derivative financial instruments carried at fair market values. These instruments primarily hedge the fair value of certain long term debt by effectively converting fi2ed rate interest to variable rate interest.

+4#@

.nternet Pro-le) 8-1 continued! &. 1redit card receivables : The company issues Target credit cards. The company sells all credit card receivables to a wholly owned subsidiary, Target ;eceivables 1orporation. All accounts receivable greater than 1+7 days old are written off. Accounts payable 4 The accounts payable balance of D(.) 1 billion represents balances with numerous vendors and suppliers. ?ong4term debt and notes payable 4 The company has substantial long4term debt consisting of both notes payable, notes, and debentures in a total amount of D1&.1 ( billion. 'tock option plan 4 A stock option plan e2ists for key employees and non4employee members of the board of directors. The plan provides for the granting of stock options, performance share awards, restricted stock awards, or a combination of awards. %ension and postretirement health care benefits 4 Target provides a defined benefit pension plan and certain health care benefits to employees who meet certain age, length of service and hours worked per year re/uirements. The company adopted '<A' Eo. 1&+ during fiscal 77(. E'6% 4 The company sponsors a defined contribution employee benefit plan for employees who meet certain eligibility re/uirements. Employees can invest as much as +7 percent of their compensation with the company matching 177 percent of the employee"s contribution up to & percent of the employee"s compensation. ?eases 4 The company leases a number of their retail buildings. The company utiliAes both operating and capital leasing arrangements. As of <ebruary , 77+, the company had capitaliAed lease obligations of D # million and the sum of the future minimum operating lease payments was D#.(@$ billion.

(. ). +.

@.

17.

11.

*ecessary experience levels 4 'tudent responses will vary, however,


students should recogniAe that an audit team is comprised of auditors with varying levels of e2perience and backgrounds. 3t is e/ually important that students recogniAe the need for auditors with industry e2perience.
-/ote: 3nternet problems address current issues using 3nternet sources. 5ecause 3nternet sites are subject to change, 3nternet problems and solutions may change. 1urrent information on 3nternet problems is available at www.pearsonhighered.comFarens..

+4$7

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