Audit Palnning and Analitycal Procedures

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 competent 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
$. %erform preliminary analytical procedures
&. 'et materiality, and assess acceptable audit risk and inherent risk
(. !nderstand internal control and assess control risk
). *ather information to assess fraud risks
+. ,evelop overall audit plan and audit program
8-3 The new auditor -successor. is re/uired by 'A' +$ -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 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 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.
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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.
88 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 determine the appropriate e2tent of audit evidence to
accumulate.
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 remember that an
important aspect of the audit will be an effective analysis of the 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.
8-# $continued%
+4
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 accounting 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.
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' $& -A! ##$. 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.
+4#
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 3n the audit of a client previously audited by a different 1%A firm, it would
be necessary to obtain a copy of the corporate charter and bylaws for the
permanent files and to read these documents and prepare a summary abstract of
items to test for compliance. 3n an ongoing engagement, this work has been
performed in the past and is unnecessary each year. The auditor"s responsibility
is to determine what changes have been made during the current year and to
update and review the summary abstract prepared in previous years for
compliance.
8-14 The information in a mortgage that is likely to be relevant to the auditor
includes the following:
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
17. 6perating restrictions imposed by the agreement
11. ;e/uirements for audit reports or other types of reports on compliance
with the agreement
1. The interest rate specified in the agreement
1#. 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
$. AuthoriAation for the ac/uisition of property
&. Approval of mergers
(. AuthoriAation of long4term loans
). Approval to pledge securities
+. AuthoriAation of individuals to sign checks
@. ;eports on the progress of operations
3t is important to read the minutes early in the engagement to identify items that
need to be followed up on as a part of conducting the audit. <or instance, if a
long4term loan is authoriAed in the minutes, the auditor will want to make certain
that the loan is recorded as part of long4term liabilities.
+4$
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 inherent risk and planned
evidence accumulation for material accounts. 3n contrast, if
management has little regard for the reliability of financial reporting,
the auditor must increase inherent risk assessments and gather
more 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 both 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.
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
+4&
8-18 $continued%
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 of internal control. 6ther top management controls include a well4
defined 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, 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.
. 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. 'A' &( -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.
+4(
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.
$. Profitability ! Earnings per share, gross profit percent, profit margin,
return on assets, and return on common e/uity
'ultiple Choice Questions (ro) CPA *+a)inations
8-25 a. -#. b. -. c. -$.
8-2! a. -1. b. -$. c. -.
8-2" a. -$. b. -1. c. -. d. -$.
,iscussion Questions And Pro-le)s
828 *enerally, the first step in preparing to supervise and plan the field work
for an audit is to review andDor study current and background information
on the client and industry. The most important sources in this preparatory
stage are as follows:
1. Engagement letter
. Audit permanent file
#. ?ast year"s audit files
$. 1lient correspondence files
&. ?ast year"s reports, including management letter andDor internal
control memorandum
(. ?ast year"s in4charge auditor
). 3ndustry and governmental publications
+. A31%A industry audit guides or firm audit guides
The purpose of this preparatory review and study is to become familiar with such
things as:
1. The client"s organiAational structure, including key personnel.
. 5usiness activities and special problems of the client or industry in
general.
#. ;ecent financial data or other important activities such as new
security offerings or bond financing.
$. The client"s records and procedures especially as they relate to
internal control.
&. ;eports that are anticipated for this engagement.
+4)
8-28 $continued%
After the above review, you should make preliminary plans for the field
work. Eou need to determine what audit tests can be done on an interim basis
and what must be done on or after the balance4sheet date, including tests that
should be done on a surprise basis. Eou must plan for what work can be done by
the client"s accounting andDor internal audit staff. Eou should also schedule
critical dates for such things as cash counts, inventory observations, and
confirmations. Eou should develop a detailed time budget and assign specific
areas of the audit to each staff member on the engagement. Additionally, you
should consider whether you need special e2pertise, e.g., a computer specialist.
Eou should prepare a preliminary draft of audit programs based on the
prior year"s assessment of internal control and any related current
correspondence, as well as suggestions in last year"s audit files. 3t is often
possible to use last year"s audit programs as a start with revisions for changed
conditions or desired audit emphasis then made.
3f possible, visit the client to meet the appropriate officers and employees
and discuss arrangements for the engagement and to learn about any significant
changes in the nature of the business and related business risks.
After completing the preliminary preparation as outlined above, you should
schedule a conference with all staff members assigned to the audit. The agenda
would include a review of the engagement letter, brainstorming about possible
fraud risk areas including how management might engage in and conceal fraud,
discussion about the importance of professional skepticism, an estimate of the
scope of work, review of reports to be issued, review of the primary business
operations of the client, assignment of audit areas to the staff, and review of
specific problems or difficulties that are anticipated for this engagement. After this
meeting, it is important to assure that each staff member has ade/uate time to
review and prepare for his or her assigned audit area.
A final step is to make sure that the necessary supplies, permanent files,
and prior year"s audit files are carefully packed, downloaded, and prepared for
transport to the client"s office. 3f there is still time before starting the work at the
client"s office, you can assign staff to set up audit schedule analyses and lead
schedules.
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:
+4+
8-2# $continued%
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.
c. 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.
d. ;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.
. 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.
+4@
8-2# $continued%
. %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
year4end.
+. 3n all material transactions, evaluate whether the parties are
economically independent and have negotiated the
transaction on 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
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.
17. 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.
11. 3nspect entries in public records concerning the proper
recording of real property transactions and personal property
liens.
1. >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.
1#. 3nspect the records of the related party to a material
transaction that is recorded by the client in a /uestionable
manner.
+417
8-2# $continued%
1$. 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.
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.
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 77(, 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.
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8-3& $continued%
b.
./(0R'A1.0/ R*2*3A/1
10 2&&5 A4,.1 A4,.1 AC1.0/ R*Q4.R*,
(e-ruary 155
1. Approval for increased
distribution costs of
F&77,777
,uring analytical procedures, an increase of
F&77,777 should be e2pected for distribution costs.
. !nresolved ta2 dispute. Evaluate resolution of dispute and ade/uacy of
disclosure in the financial statements if this is a
material uncertainty.
#. 1omputer e/uipment
donated.
,etermine that old e/uipment was correctly treated in
77$ in the statements and that an appropriate
deduction was taken for donated e/uipment.
$. Annual cash dividend.
1alculate total dividends and determine that
dividends were correctly recorded.
&. 6fficers" bonuses.
,etermine whether bonuses were accrued at 14#14
7$ and were paid in 77&. 1onsider the ta2
implications of unpaid bonuses to officers.
6epte)-er 1!5
1. 77& officers elected. 3nform staff of possibility of related party transactions.
. 6fficers" salary
information.
Gote information in audit files for 77( audit.
#. %ensionDprofit sharing
plan.
,etermine if the pensionDprofit sharing plan was
approved. 3f so, make sure all assets and liabilities
have been correctly recorded.
$. Ac/uisition of new
computer system.
,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.
&. ?oan. E2amine supporting documentation of loan and make
sure all provisions noted in the minutes are
appropriately disclosed. 1onfirm loan information with
bank.
(. Auditor selection. 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.
+41
8-3& $continued%
c. The auditor should have obtained and read the <ebruary minutes,
before completing the 14#147$ audit. Three items were especially
relevant and re/uire follow4up for the 14#147$ audit: unresolved
dispute with the 3;', replacement of computer e/uipment, and
approval for the 14#147$ bonuses.
8-31 a. The president"s salary is a significant item this year and
therefore should be included in the financial statements as
information that should be disclosed to the shareholders.
b. >anagement is primarily responsible for financial statement
presentation. Eou have the responsibility of determining whether
the president"s salary, which is apparently material in amount, is
ade/uately disclosed in the financial statements. The president"s
salary would be ade/uately disclosed if it were shown as a
separate item in the income statement and if the increase in salary
were also readily apparent because of the use of comparative
statements. The president"s salary could be ade/uately disclosed
also by a footnote. 'hould the client object to the disclosure of the
president"s salary as a separate item in the income statement or as
a footnote, you would be compelled to decide whether to /ualify
your opinion because the financial statements failed to disclose
information of material importance or to render an adverse opinion
because the financial statements are not fairly presented.
c.
1. Eou would be concerned with the fairness of the presentation of
the financial statements because of the need for disclosure, as
discussed in the preceding paragraph, and the possibility that a
portion of the salary of the president, who is a substantial
stockholder, may be deemed e2cessive by the 3;' and treated
as a dividend instead of as a business e2pense. Ta2 authorities
may attach great significance to the fact that much of the
potential increase in profits was distributed in the form of salary.
Eou should have a discussion with the client to consider the
possibility of salary e2pense disallowance by the 3;'. 3f you
believe that a disallowance may occur, you should recommend
an appropriate increase in the provision for income ta2es or
footnote disclosure of the potential liability. 3f the client prefers
not to adopt either recommendation, you should decide whether
to /ualify your opinion by taking e2ception to the failure to
disclose the potential income ta2 liability or to render an adverse
opinion because the financial statements are not a fair
presentation.
. The consistency of the application of accounting principles has
not been disturbed by the use of a different basis for
determining the president"s salary. The change in the method of
computing the president"s salary is not grounds for a
consistency e2planatory paragraph in your report because it is
not a change in accounting methods.
+41#
8-32 a. The use of analytical procedures in an audit has two general
advantages to a 1%A: 1. a broad view is obtained of the data under
audit, and . attention is focused on e2ceptions or variations in the
data.
A broad view of the data under audit is needed by the 1%A to
draw conclusions about the data as a whole:such conclusions
cannot be drawn by merely looking at individual transactions. The
application of analytical procedures to obtain this broad view
re/uires a discerning analysis of the data, which results in overall
conclusions upon which the 1%ACs audit satisfaction rests. The 1%A
is thus able to satisfy himself or herself as to the reasonableness,
validity, and consistency of the data in view of the surrounding
circumstances.
The focusing of the 1%ACs attention on e2ceptions or
variations in the data results in a more efficient and economical
audit because there is a reduction in the amount of detailed testing
which would be re/uired, in the absence of overall checks, to
uncover these e2ceptions or variations. <urthermore, manipulations
of accounts may be revealed because the double4entry
bookkeeping system e2tends the effects of manipulations to
additional accounts, which will then bear a changed relationship to
other accounts.
3n addition, managerial problems and trouble spots will be
highlighted for the 1%A and may lead to the opportunity for the
auditor to be of additional service to his client.
b. The ratios that an auditor may compute during an audit as overall
checks on balance sheet accounts and related income accounts
may include the following:
1. Accruals of individual e2penses to related total e2penses
-accrued interestDinterest e2pense, accrued payrollDsalaries
and wages.
. Accounts payable to purchases -days of purchases
outstanding.
#. ?ong4term debt and interest e2pense thereon
$. ;eturn on e/uity -relationship of net income to ownersC
e/uity.
&. ;eturn on investments -relationship of investment income to
investments..
c.
1. The possible reasons for a decrease in the rate of inventory
turnover include the following:
-a. ,ecline in sales
-b. 3ncrease in inventory /uantities, intentional or
unintentional
-c. 3ncorrect computation of inventory because of errors
in pricing, e2tensions, or taking of physical inventory
-d. 3nclusion in inventory of slow4moving or obsolete
items
-e. Erroneous cutoff of purchases
+41$
8-32 $continued%
-f. Erroneous cutoff of sales in a perpetual inventory
system
-g. !nrecorded purchases
-h. 1hange in inventory valuation method.
. The possible reasons for an increase in the number of daysC
sales in receivables including the following:
-a. 1hange in credit terms
-b. ,ecreasing sales
-c. 1hange in the sales mi2 of products with different
sales terms
-d. 1hange in mi2 of customers
-e. 3mproper sales cutoff
-f. !nrecorded sales
-g. ?apping
-h. 'lower collections caused by tighter economic
conditions or lowering of the /uality of the
receivables.
8-33 a. *ross margin percentage for drug and nondrug sales is as
follows:
,R476 /0/,R476
77&
77$
77#
77
$7.(H
$.H
$.1H
$.#H
#.7H
#.7H
#1.@H
#1.+H
The e2planation given by Adams is correct in part, but appears to
be overstated. The gross margin percentage for nondrugs is
appro2imately consistent. <or drugs, the percent dropped
significantly in the current year, far more than industry declines. The
percent had been e2tremely stable before 77&. 3n dollars, the
difference is appro2imately F+,777 -$.H 4 $7.(H 2 F&,1(,777.
which appears to be significant. 6f course, the decline in IonesC
prices may be greater than the industry due to e2ceptional
competition.
b. As the auditor, you cannot accept AdamsC e2planation if F+,777 is
material. The decline in gross margin could be due to an
understatement of drug inventory, a theft of drug inventory, or
understated sales. <urther investigation is re/uired to determine if
the decline is due to competitive factors or to a misstatement of
income.
8-34 a.
1. 1ommission e2pense could be overstated during the current
year or could have been understated during each of the past
several years. 6r, sales may have been understated during
the current year or could have been overstated in each of
the past several years.
+41&
834$continued%
. 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.
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. Gote 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.
+41(
8-35
RA1.0
/4'8*R
/**, (0R
./3*61.7A1.0/
R*A60/ (0R
./3*61.7A1.0/
/A14R* 0(
./3*61.7A1.0/
1. Ees 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.
. Ees An 114D#H 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.
#. Ees 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.
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
stock4outs or long
waits for delivery.
+41)
8-35 $continued%
RA1.0
/4'8*R
/**, (0R
./3*61.7A1.0/
R*A60/ (0R
./3*61.7A1.0/
/A14R* 0(
./3*61.7A1.0/
$. Go GDA GDA
&. Ees The industry average
increased almost 17H
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..
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.
(. Go GDA GDA
). Go GDA GDA
+. Ees The company appears to
have raised prices during
the past year to achieve
the gross profit H of the
industry. =owever, it
appears that the
industryCs gross profit H
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.
,etermine the reason
for the change in the
industryCs gross profit
percent and the effect
this might have on the
company.
@. Go GDA GDA
c. >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
8-35 $continued%
+41+
cash have increased )H -11 days., while the current ratio has
decreased by 1&H. The company was able to increase its gross
margin percent during the year when the industry was e2periencing
a significant decline in gross margin.
8-3! a. The companyCs financial position is deteriorating significantly.
The companyCs ability to pay its bills is marginal -/uick ratio J 7.@).
and its ability to generate cash is weak -days to convert inventory to
cash J ((.) in 77& versus 1)#.+ in 771.. 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 accounts -accounts receivable turnover reduced &H
in four years., and the inventory may have a significant amount of
unsalable goods included therein -inventory turnover reduced $7H
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/ R*A60/ (0R 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
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.
#. 3ndustry average ratios To compare the companyCs ratios to those of the average
company in its industry to identify possible problem areas
in the company.
$. Aging of accounts
receivable, bad debt
history, and analysis of
allowance for
uncollectible accounts
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.
+41@
8-3! $continued%
A,,.1.0/A2
./(0R'A1.0/ R*A60/ (0R A,,.1.0/A2 ./(0R'A1.0/
&. Aging of inventory and
history of markdown
taken
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.
(. 'hort4 and long4term
li/uidity trend ratios
To indicate whether the company may have li/uidity
problems within the ne2t five years.
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.
#. ;easonableness of the inventory valuation based on the
decreased inventory turnover and increased days to sell
inventory.
$. 1omputation of the earnings per share figure. 3t appears
inconsistent that earnings per share could remain relatively
stable when net earnings divided by common e/uity has
decreased by &7H. This could be due to additional stock
offerings during the period, or a stock split.
8-3"
a. The Toys 8;9 !s decision to sell toys and other products through its
Beb site may be related to any of these possible business
strategies:
Matc# Competition. 5ecause other toy retailers may be
offering products through the 3nternet, Toys 8;9 !s may have
decided that it needed to also offer products online to match
their competition and meet consumer e2pectations in the
marketplace.
)arget *e" Mar$ets. 5y offering products to consumers
through its Beb site, Toys 8;9 !s may be able to e2pand its
market to consumers in geographic areas not having a Toys
8;9 !s retail store. 1onsumers throughout regions of the
country and world can now order products without visiting a
Toys 8;9 !s store.
+47
8-3" $continued%
En#ance +*e" Economy, Image. >anagement may be
using the offering of products through its Beb site to signal
that Toys 8;9 !s embraces the new e4commerce economy
and is a technology leader in the toy retail industry. The
online sales offering may provide a signal that the company
intends to be a competitive player in both traditional and e4
commerce markets.

b. E2amples of business risks associated with the Toys 8;9 !s decision to
offer online product sales may include the following:
Insufficient Capacity to -andle .emand. 3f demand for
products through the Toys 8;9 !s Beb site e2ceeds
e2pectations, internal systems and personnel may not be
able to handle the volume of orders in a timely fashion. The
time it takes for inventory warehousing and distribution
processes for online sales may be greater than e2pected
given that single orders must be individually handled. 3n
contrast, shipments made to retail outlets are often
processed in bulk.
Inade'uate (ccounting System Interface. The offering of
sales online re/uires the design and implementation of new
3nternet4based accounting systems that must capture,
process, and record online transactions. Those transactions
must be integrated with traditional sales transactions into the
Toys 8;9 !s accounting records and financial statements.
Those systems may not be ade/uately designed for timely
and accurate interface.
Consumer Privacy. *iven that online consumers will be
providing confidential personal information, including credit
card data, the Toys 8;9 !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.
Security. Toys 8;9 !s may be e2posing its internal
accounting and other 3T systems to security breaches.
1onsumers will be accessing the company Beb site and
related databases that interface with e2isting internal
systems. Ade/uate protection, such as firewalls, is needed
to protect company systems from infiltration.
c. The decision by Toys 8;9 !s to partner with AmaAon.com to handle
online sales may provide these advantages:
&in$ /it# Establis#ed E%commerce Participant0
AmaAon.com"s core business strategy involves the offering
of products through the 3nternet directly to consumers. As a
result, AmaAon.com represents one of the more e2perienced
+41
8-3" $continued%
market participants in the online sales marketplace.
%artnering with AmaAon.com allows Toys 8;9 !s to take
advantage of that e2perience and already established
systems, which shortens the learning curve for Toys 8;9 !s
management.
Capture (ma1on.com Customers. %artnering with
AmaAon.com may lead to increased sales opportunities. As
AmaAon.com customers visit the AmaAon.com Beb site,
they may also make decisions to purchase toys and other
products from Toys 8;9 !s.
Increase Consumer Confidence in /eb Site Portal. *iven
AmaAon.com"s reputation in the e4commerce marketplace,
consumers may be more confident transacting business with
Toys 8;9 !s, given its partnering with AmaAon.com.
1oncerns about consumer privacy may be diminished when
customers realiAe that Toys 8;9 !s is offering online sales
processing through a known, reputable e4commerce vendor.
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 Toys 8;9 !s 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..
Inade'uate (ccounting System Interface. 3f the online sales
system interface with the main accounting system is
inade/uate, online sales may -1. not be processed, -. be
processed more than once, or -#. be processed inaccurately.
Any of these risks could lead to material misstatements in
the financial statements.
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.
Security. !nauthoriAed access to other Toys 8;9 !s systems
and databases may introduce unintentional and intentional
misstatements into the accounting records. 3f unauthoriAed
access is not restricted, material misstatements in financial
statements may result.
+4
Cases
8-38 This case illustrates the common problem of an audit partner having to
allocate his scarcest resourceKhis 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 remediedL Ees and no. Bhile 'A' +$ -A! #1&.
re/uires communication with the predecessor auditor before
accepting the engagement, a communication with the predecessor
auditor should 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 andDor 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
wellL 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
problemsL
+4#
838$continued%
b. 3n the audit of long4term contracts, it is essential to obtain assurance
that the contract is enforceable so that income can be recogniAed
on the percentage4of4completion basis. 3t is also important to
consider other aspects of the contract that relate to various
accounting aspects, such as price and other terms, cancellation
privileges, penalties, and contingencies. 3n this case, 5eale has
concluded that the signed contract, written in <rench, is >c>ullan"s
8standard9 contract, based on client representation. 6f course,
auditing standards re/uire that management"s representations, a
weak form of evidence, be corroborated with other evidence where
possible. 5eale might argue that the confirmation obtained
constitutes such evidence.
5eale"s argument may seem logical with regard to
enforcement, however, the confirmation form refers to e2isting
disputes. 3t says nothing about contractual clauses that may
foreshadow enforceability. <or that reason the audit program
re/uires the contract to be read. =ow would an auditor know
whether the contract form was that of a standard contract without
reading itL <urthermore, it may be unrealistic to assume there is
such a thing as a 8standard9 contract in the first place. ?ong4term
and short4term contracts are the result of negotiation and often
contain special clauses and changed language.
3n this case, not reading the contract was an insufficiency
and the <rench4language copy should be translated by an
independent translator and read by the auditors.
c. 1ompliance with *AA' is a matter that is always subject to
professional judgment. 6ne professional auditor may conclude he
or she has complied with *AA', and another would conclude that
*AA' has been violated, so these matters are very seldom clear
cut. =owever, in this case, it appears that 5lack and 5eale may
have violated *AA' in the following ways:
Standard of 2ield /or$ *o0 3 % )#e "or$ is to be ade'uately
planned and assistants4 if any4 are to be properly supervised0 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 2ield /or$ *o0 5 % Sufficient competent evidential
matter is to be obtained t#roug# inspection4 observation4 in'uiries4
and confirmations to afford a reasonable basis for an opinion
regarding t#e financial statements under audit0 As discussed above,
the work on the >ontreal contract was deficient and further
evidence is re/uired.
+4$
8-38 $continued%
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#
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 solution are shown below. Gote: where
possible, the solution uses average balances -inventory and
accounts receivable, for e2ample. when re/uired by the ratio
formulas. 'ince 771 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.
Muick ratio J -cash N accounts receivable 4 allowance for doubtful
accounts. D current liabilities
*ross marginDsales J gross margin D gross sales
Average inventory turnover J -cost of goods sold. D average
inventory
1urrent ratio J 1urrent assets D current liabilities
Average days to collect receivables J -average accounts receivable
2 #(7. D -net sales.
Get incomeDtotal assets J -self4e2planatory.
Get incomeDsales J net income D gross sales
'alesDe/uity J *ross sales D e/uity
,ebtDe/uity J -total liabilities. D total e/uity
+4&
8-3# $continued%
Get incomeDe/uity J -self4e2planatory.
Allowance for doubtful accounts D accounts receivable J -self
e2planatory.
5ad debtsDsales J bad debts D gross sales
'ales returns and allowancesDsales J sales returns and
allowancesDgross sales
. 'et4up. E2cel spreadsheets must be planned in advance.
This can be referred to as Oset4up.O A useful techni/ue is to use a
block diagram to plan the set4up. This helps see the overall shape
and content of the spreadsheet and is helpful for guiding its detailed
preparation and how outputs will be controlled and formatted. A
block diagram for this spreadsheet follows. 3t shows the
spreadsheet divided into three sections: the heading, the input
section, where data will be entered, and the results section where
the ratios will be calculated. A vertical structure is used to facilitate
printouts that will fit in an +41D 2 1$ inch format. The structure could
just as easily be side4by4side.
+4(
8-3# $continued%
A1
*
A&
*$#
A$)
*)1
#. 1heck on accuracy of inputs. A major concern is knowing
that input data has been entered accurately. This can usually
be achieved by two alternative procedures. The first is
computing totals and comparing them to check figures. <or
e2ample, the details of assets can be computed and added
to 177. The second procedure is verification of details on a
figure4by4figure basis back to the source.
83#$continued%
+4)
1olumns for years 7&47
;ows
for
account
headings
Amounts
;ows
for
various
ratios
1olumns for years 7&47
<ormulas for
ratios
$. Treatment of negative values. Gegative 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 and on the 3nstructor"s
;esource 1,4;6>, which is available upon re/uest.
6olo)on 8ros 'anu9acturing Co
Analytical Procedures
1alculated from
adjusted year4end balances
:*; RA1.06 2&&5 2&&4 2&&3 2&&2
Muick
*ross marginDsales
Average inventory turnover
1urrent
Average days to collect
receivables
Get incomeDtotal assets
Get incomeDsales
'alesDe/uity
,ebtDe/uity
Get incomeDe/uity
Allowance for doubtful
accountsDaccounts receivable
5ad debtsDsales
'ales returns and
allowancesDgross sales
.@(
1.7H
1.)@
.1@
1#1.17
#.@H
&.7H
#.+@:1
$.7:1
.1@:1
17.(H
#.)H
#.1H
.+#
.1H
1.+
1.@(
1#.@$
#.@H
&.H
$.#):1
$.+:1
.#:1
11.&H
$.7H
#.7H
.+1
#.H
1.@#
1.@1
11(.7(
#.@H
&.#H
$.++:1
&.($:1
.(:1
1.&H
$.1H
#.7H
.)$
&.7H
GA
1.)&
GA
$.#H
(.1H
&.):1
(.$:1
.#:1
1$.+H
$.(H
.@H
8-3# $continued%
+4+
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 1H of sales and net
income is &H of sales. 5oth ratios decreased during the past year. To
finance e2pansion, additional debt is out of the /uestion because long4
term 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. 8rea<down o9 the 2&&5 2&&4 2&&3 2&&2
aging in percent
7 4 #7 days #@.+H $.1H $(.7H $@.@H
#1 4 (7 days ##.&H ##.#H #.7H #7.1H
(1 4 17 days 1@.1H 1).(H 1(.7H 1&.7H
over 17 days ).(H ).7H (.7H &.7H
177.7H 177.7H 177.7H 177.7H
. AllowanceDaccounts
receivable 17.(H 11.&H 1.&H 1$.+H
#. 5ad debtsDsales #.)H $.7H $.1H $.(H
3t appears that the allowance is understated:
1. 3f accounts were as collectible as before, allowanceDaccounts
receivable should be about constant.
. 3f accounts become less collectible, allowanceDaccounts receivable
should increase.
#. Gumber seems to be the case.
The aging of accounts receivable shows a deterioration in the overall
aging -74#7 decreased significantly in the past several years, while those
in all other categories increased., while the allowance for uncollectible
accounts as a percentage of accounts receivable has decreased from
1$.+H to 17.(H. 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 be
collectible. This idea is supported by the deterioration in overall aging
noted above.
8-3# $continued%
+4@
6ales
<inally, gross margin as a percentage of sales has declined steadily over
the four4year period from &H to 1H. Get 3ncomeD'ales has also
declined. The auditor should seek an e2planation from the client for these
trends.
.ntegrated Case Application
8-4&
P.//AC2* 'A/4(AC14R./7=PAR1 .
a.
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.
c. '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..
+4#7
Amounts -in thousands.
Ratios 2&&4 2&&3 2&&2
1urrent assets $$,$@) #(,1@( #(,77&
1urrent ratio 1urrent liabilities &,@( 1),(7& 1(,#$1
1.) .7( .7
,ebt to e/uity ,ebt $),1(1 #),7## #&,+71
E/uity &&,+( &,)&@ &7,+)#
+$.&H )7.H )7.$H
Get income btDsales Get 3ncome 5T $,)$ #,+)7 ,((7
'ales 1$@,$& 1#),&+7 1&,+1$
.@H .+H .1H
*ross margin percent *ross profit $$,$#) $7,@+$ #),1@
'ales 1$@,$& 1#),&)@ 1&,+1$
@.+H @.+H @.&H
3nventory turnover 1ost of goods sold 17$,+7+ @(,&@( ++,(+&
Average inventory &,11@ ,7@1 1,@)&
$. $.$ $.7
8-4& $continued%
Account 8alance *sti)ate o9 > A)ount o9 Potential 'isstate)ent
%roperty ta2es ,ecrease of F1$7,777 when property increased
5ad debts 'ee re/uirement f for an analysis
,epreciation e2pense 3ncrease of F1. million, perhaps partly due to new
building and e/uipment purchases
<ederal 3ncome Ta2es <3T as a H of G35T was #(H in 77#.
#(H of 77$ G35T is F1.&#@ million. Actual <3T for
77$ was F1.71$ million. ,ifference of F&&,777.
3nterest e2pense 'hort4term plus long4term interest bearing debt
increased by &H, from F).# million to F#$. 1 million,
but interest e2pense decreased. 3f interest rates have
not changed, interest e2pense would be e2pected to
increase by a similar amount to F,((1,777
-F,1@,77 2 1.&.. %otential misstatement of
F)($,777 -F,((1,777 4 F1,+@),777..
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 8alance *sti)ate o9 > A)ount o9 Potential 'isstate)ent
Solar Electro:
%ayroll benefits 3ncreased almost F177,777 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.
?egal 'ervice ?arge increase may be indicative of other issues
affecting disclosures and asset or liability valuation.
>iscellaneous F77,777 increase needs investigation.
/elburn F17,777 increase in warehouse rent
even though there is no evidence of any change in
facilities.
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.
+4#1
8-4& $continued%
f.
*sti)ate o9 Potential 4nderstate)ent in Allowance
A?R 1urnover
2&&4 2&&3 2&&2
'ales 1$@,$& 1#),&+7 1&,+1$
Average accounts receivable @,$) ),+++ ),&+
Turnover 1(.1 1).$ 1(.(
,ays 6ales 0utstanding
#(& #(& #(& #(&
Turnover 1(.1 1).$ 1(.(
,ays .( 7.@ .7
Allowance as a Percentage o9 7ross Receiva-les
Allowance (@@ (@@ (+
*ross ;eceivables 17,#77 +,1@$ ),&+
Percentage (.+H +.&H @.7H
Potential understate)ent in allowance
'uggested percent @.&H
Estimate based on decrease in turnover
*ross accounts receivable 17,#77
'uggested allowance @)@
Actual Allowance (@@
Potential understate)ent 28&
+4#
8-4& $continued%
-part of re/uirement c.
+4##
Pinnacle Manufacturing Company
Income Statement - All Divisions
For the Year Ended Decemer !"
#$$% #$$% #$$! #$$! #$$# #$$#
Dollar &alue ' of Sales Dollar &alue ' of Sales Dollar &alue ' of Sales
Sales 149,424,646 100.00% 137,741,766 100.00% 125,982,294 100.00%
Sales Returns and Allowances 179,470 0.12% 162,102 0.12% 168,022 0.13%
Cost of Sales 104,807,966 70.14% 96,595,908 70.13% 88,685,361 70.40%
!ross "rof#t 44,437,210 29.74% 40,983,756 29.75% 37,128,911 29.47%
(PE)A*I+, E-PE+SES-Allocated
Salar#es$%ana&e'ent 2,348,025 1.57% 2,190,819 1.59% 1,995,723 1.58%
Salar#es$(ff#ce 324,392 0.22% 272,185 0.20% 266,831 0.21%
)#cens#n& and cert#f#cat#on fees 196,229 0.13% 158,608 0.12% 141,112 0.11%
Secur#t* 566,716 0.38% 584,936 0.42% 548,133 0.44%
+nsurance 95,924 0.06% 95,268 0.07% 94,340 0.07%
%ed#cal ,enef#ts 24,415 0.02% 27,021 0.02% 25,052 0.02%
Ad-ert#s#n& 167,268 0.11% 163,311 0.12% 144,068 0.11%
.us#ness /u,l#cat#ons 7,194 0.00% 5,096 0.00% 673 0.00%
"ro/ert* ta0es 23,246 0.02% 163,311 0.12% 152,776 0.12%
.ad de,ts 866,330 0.58% 948,679 0.69% 862,690 0.68%
1e/rec#at#on e0/ense 5,492,959 3.68% 4,258,699 3.09% 3,797,885 3.01%
Account#n& fees 281,973 0.19% 273,190 0.20% 260,684 0.21%
2otal o/erat#n& e0/enses$Allocated 10,394,671 6.96% 9,141,123 6.64% 8,289,967 6.56%
(PE)A*I+, E-PE+SES-Direct
Salar#es$Sales 15,408,771 10.31% 14,062,181 10.21% 12,960,341 10.29%
3a&es Rental 506,186 0.34% 546,228 0.40% 500,630 0.40%
3a&es$%ec4an#cs 1,146,126 0.77% 1,229,015 0.89% 1,159,488 0.92%
3a&es$3are4ouse 5,034,197 3.37% 4,899,331 3.56% 4,759,347 3.78%
!ar,a&e collect#on 28,458 0.02% 27,313 0.02% 33,017 0.03%
"a*roll ,enef#ts 2,735,670 1.83% 2,695,165 1.96% 2,516,783 2.00%
Rent$ 3are4ouse 826,350 0.55% 701,235 0.51% 659,430 0.52%
2ele/4one 33,350 0.02% 41,443 0.03% 50,319 0.04%
5t#l#t#es 270,072 0.18% 244,959 0.18% 238,578 0.19%
"osta&e 92,390 0.06% 122,494 0.09% 131,546 0.10%
)#nen ser-#ce 17,788 0.01% 11,330 0.01% 13,985 0.01%
Re/a#rs and 'a#ntenance 171,872 0.12% 154,500 0.11% 154,968 0.12%
Clean#n& ser-#ce 92,428 0.06% 74,852 0.05% 67,903 0.05%
)e&al ser-#ce 407,605 0.27% 174,807 0.13% 132,381 0.11%
6uel 294,933 0.20% 313,020 0.23% 243,054 0.19%
2ra-el and enterta#n'ent 106,415 0.07% 95,268 0.07% 87,373 0.07%
"ens#on e0/ense 235,244 0.16% 217,752 0.16% 110,444 0.09%
(ff#ce su//l#es 154,213 0.10% 136,092 0.10% 148,790 0.12%
%#scellaneous 308,969 0.21% 97,185 0.07% 125,228 0.10%
2otal o/erat#n& e0/enses$1#rect 27,871,037 18.65% 25,844,170 18.78% 24,093,605 19.13%
2otal (/erat#n& 70/enses 38,265,708 25.61% 34,985,293 25.42% 32,383,572 25.69%
(/erat#n& +nco'e 6,171,502 4.13% 5,998,463 4.33% 4,745,339 3.78%
(t4er 70/ense$+nterest 1,897,346 1.27% 2,128,905 1.55% 2,085,177 1.66%
+nco'e .efore 2a0es 4,274,156 2.86% 3,869,558 2.78% 2,660,162 2.12%
6ederal +nco'e 2a0es 1,013,745 0.68% 1,399,001 1.02% 1,166,553 0.93%
+et Income !.#/$.%"" 2.18% #.%0$.110 1.76% ".%2!./$2 1.19%
1eta#ls of 'anufactur#n& e0/enses are not #ncluded #n t4#s sc4edule.
8-4& $continued%
-part of re/uirement d.
+4#$
Income Statement - 3elurn Division
#$$% #$$% #$$! #$$! #$$# #$$#
Dollar &alue ' of Div4 Sales Dollar &alue ' of Div4 Sales Dollar &alue ' of Div4 Sales
Sales 121,371,795 100.00% 111,877,873 100.00% 102,308,887 100.00%
Cost of Sales 86,671,580 71.41% 79,914,454 71.43% 73,370,003 71.71%
!ross "rof#t 34,573,693 28.49% 31,849,936 28.47% 28,821,257 28.18%
Salar#es$%ana&e'ent 1,905,965 1.57% 1,774,466 1.59% 1,616,447 1.58%
Salar#es$(ff#ce 263,320 0.22% 220,457 0.20% 216,121 0.21%
Secur#t* 460,017 0.38% 473,767 0.42% 443,958 0.43%
+nsurance 77,861 0.06% 77,159 0.07% 76,407 0.07%
%ed#cal ,enef#ts 19,956 0.02% 22,048 0.02% 20,441 0.02%
Ad-ert#s#n& 135,777 0.11% 132,276 0.12% 116,690 0.11%
.us#ness /u,l#cat#ons 4,336 0.00% 2,735 0.00% 361 0.00%
"ro/ert* ta0es 18,396 0.02% 132,276 0.12% 123,743 0.12%
.ad de,ts 708,015 0.58% 762,910 0.68% 693,759 0.68%
1e/rec#at#on e0/ense 4,329,633 3.57% 3,449,347 3.08% 3,076,109 3.01%
Account#n& fees 230,075 0.19% 220,363 0.20% 210,276 0.21%
Salar#es$Sales 12,947,327 10.67% 11,646,277 10.41% 10,733,735 10.49%
3a&es Rental $ $ $
3a&es$%ec4an#cs $ $ $
3a&es$3are4ouse 4,124,063 3.40% 3,968,235 3.55% 3,854,855 3.77%
!ar,a&e collect#on $ $ $
"a*roll ,enef#ts 2,099,069 1.73% 2,182,959 1.95% 2,038,477 1.99%
Rent$ 3are4ouse 690,375 0.57% 571,916 0.51% 537,821 0.53%
2ele/4one 26,659 0.02% 33,069 0.03% 40,152 0.04%
5t#l#t#es 200,398 0.17% 198,409 0.18% 193,240 0.19%
"osta&e 80,204 0.07% 99,207 0.09% 106,538 0.10%
)#nen ser-#ce 14,539 0.01% 9,642 0.01% 11,900 0.01%
Clean#n& ser-#ce 67,780 0.06% 60,628 0.05% 55,000 0.05%
)e&al ser-#ce 119,122 0.10% 120,490 0.11% 91,247 0.09%
6uel 224,342 0.18% 253,526 0.23% 196,858 0.19%
"ens#on e0/ense 193,389 0.16% 176,367 0.16% 89,454 0.09%
(ff#ce su//l#es 125,176 0.10% 110,228 0.10% 120,513 0.12%
%#scellaneous 58,819 0.05% 53,130 0.05% 68,461 0.07%
2otal o/erat#n& e0/enses 29,478,336 24.30% 27,053,997 24.20% 25,015,686 24.45%
(PE)A*I+, I+C(ME 5,095,357 4.19% 4,795,939 4.27% 3,805,571 3.73%
8-4& $continued%
+4#&
Income Statement - Solar-Electro Division
#$$% #$$% #$$! #$$! #$$# #$$#
Sales 22,381,936 100.00% 20,073,876 100.00% 18,373,763 100.00%
Cost of Sales 16,311,635 72.88% 14,687,724 73.17% 13,484,900 73.39%
!ross "rof#t 6,026,871 26.93% 5,350,944 26.65% 4,852,369 26.41%
Salar#es$%ana&e'ent 347,907 1.55% 323,147 1.61% 294,370 1.60%
Salar#es$(ff#ce 48,064 0.21% 40,146 0.20% 39,356 0.21%
Secur#t* 83,967 0.38% 86,281 0.43% 80,853 0.44%
+nsurance 14,212 0.06% 14,054 0.07% 13,917 0.08%
%ed#cal ,enef#ts 3,641 0.02% 4,015 0.02% 3,722 0.02%
Ad-ert#s#n& 24,783 0.11% 24,087 0.12% 21,249 0.12%
.us#ness /u,l#cat#ons 900 0.00% 497 0.00% 66 0.00%
"ro/ert* ta0es 3,360 0.02% 24,087 0.12% 22,533 0.12%
.ad de,ts 124,019 0.55% 144,706 0.72% 131,590 0.72%
1e/rec#at#on e0/ense 915,513 4.09% 628,135 3.13% 560,167 3.05%
Account#n& fees 40,824 0.18% 40,999 0.20% 39,122 0.21%
Salar#es$Sales 2,256,643 10.08% 2,204,049 10.98% 2,031,351 11.06%
3a&es Rental $ $ $
3a&es$%ec4an#cs $ $ $
3a&es$3are4ouse 716,283 3.20% 722,659 3.60% 702,011 3.82%
!ar,a&e collect#on $ $ $
"a*roll ,enef#ts 492,677 2.20% 397,542 1.98% 371,231 2.02%
Rent$ 3are4ouse 107,026 0.48% 100,370 0.50% 94,386 0.51%
2ele/4one 4,868 0.02% 6,025 0.03% 7,315 0.04%
5t#l#t#es 54,837 0.25% 36,131 0.18% 35,190 0.19%
"osta&e 7,340 0.03% 18,069 0.09% 19,404 0.11%
)#nen ser-#ce 2,653 0.01% 1,367 0.01% 1,688 0.01%
Clean#n& ser-#ce 21,300 0.10% 11,039 0.05% 10,014 0.05%
)e&al ser-#ce 276,825 1.24% 42,156 0.21% 31,925 0.17%
6uel 55,555 0.25% 46,171 0.23% 35,851 0.20%
"ens#on e0/ense 35,301 0.16% 31,182 0.16% 15,815 0.09%
(ff#ce su//l#es 22,849 0.10% 20,073 0.10% 21,946 0.12%
%#scellaneous 241,764 1.08% 39,433 0.20% 50,811 0.28%
(PE)A*I+, I+C(ME 50,043 0.23% 280,314 1.39% 154,878 0.83%
8-4& $continued%
+4#(
Income Statement - Machine-*ech Division
#$$% #$$% #$$! #$$! #$$# #$$#
Sales 5,670,915 100.00% 5,790,017 100.00% 5,299,644 100.00%
Cost of Sales 1,824,751 32.18% 1,993,730 34.43% 1,830,458 34.54%
!ross "rof#t 3,836,646 67.65% 3,782,876 65.34% 3,455,285 65.20%
Salar#es$%ana&e'ent 94,153 1.66% 93,206 1.61% 84,906 1.60%
Salar#es$(ff#ce 13,008 0.23% 11,582 0.20% 11,354 0.21%
Secur#t* 22,732 0.40% 24,888 0.43% 23,322 0.44%
+nsurance 3,851 0.07% 4,055 0.07% 4,016 0.08%
%ed#cal ,enef#ts 818 0.01% 958 0.02% 889 0.02%
Ad-ert#s#n& 6,708 0.12% 6,948 0.12% 6,129 0.12%
.us#ness /u,l#cat#ons 1,958 0.03% 1,864 0.03% 246 0.00%
"ro/ert* ta0es 1,490 0.03% 6,948 0.12% 6,500 0.12%
.ad de,ts 34,296 0.60% 41,063 0.71% 37,341 0.70%
1e/rec#at#on e0/ense 247,813 4.37% 181,217 3.13% 161,609 3.05%
Account#n& fees 11,074 0.20% 11,828 0.20% 11,286 0.21%
2otal o/erat#n& e0/enses$Allocated 470,216 8.29% 412,022 7.11% 372,033 7.01%
Salar#es$Sales 204,801 3.61% 211,855 3.66% 195,255 3.68%
3a&es Rental 506,186 8.93% 546,228 9.43% 500,630 9.45%
3a&es$%ec4an#cs 1,146,126 20.21% 1,229,015 21.23% 1,159,488 21.88%
3a&es$3are4ouse 193,851 3.42% 208,437 3.60% 202,481 3.82%
!ar,a&e collect#on 28,458 0.50% 27,313 0.47% 33,017 0.62%
"a*roll ,enef#ts 143,924 2.54% 114,664 1.98% 107,075 2.02%
Rent$ 3are4ouse 28,949 0.51% 28,949 0.50% 27,223 0.51%
2ele/4one 1,823 0.03% 2,349 0.04% 2,852 0.05%
5t#l#t#es 14,837 0.26% 10,419 0.18% 10,148 0.19%
"osta&e 4,846 0.09% 5,218 0.09% 5,604 0.11%
)#nen ser-#ce 596 0.01% 321 0.01% 397 0.01%
Clean#n& ser-#ce 3,348 0.06% 3,185 0.06% 2,889 0.05%
)e&al ser-#ce 11,658 0.21% 12,161 0.21% 9,209 0.17%
6uel 15,036 0.27% 13,323 0.23% 10,345 0.20%
"ens#on e0/ense 6,554 0.12% 10,203 0.18% 5,175 0.10%
(ff#ce su//l#es 6,188 0.11% 5,791 0.10% 6,331 0.12%
%#scellaneous 8,386 0.15% 4,622 0.08% 5,956 0.11%
(PE)A*I+, I+C(ME 1,026,102 18.07% 922,210 15.93% 784,890 14.83%
.nternet Pro-le) 6olution5 .ndustry Research and Client Acceptance
8-1 The vignette at the beginning of 1hapter ( in the te2t contains a brief
description of the PPPP 5est fraud. 6ne area where the auditors were particularly
criticiAed in that audit had to do with the auditorsC lack of industry knowledge.
Bith hindsight it appeared that the fraud should have been easily detected
because PPPP 5ests" large restoration contracts were in e2cess of F) million
while the largest restoration jobs on record in the insurance restoration industry
were less than F# million.
Eou have been approached by 6n the 'unny 'ide, a team sports uniform
designer and manufacturer for women, about performing the company"s financial
statement audit. The company began operations eight years ago and has
e2perienced strong growth in the last several years. Teri Qloth, the chief
e2ecutive officer, has told you that her company e2pects production in 77$ to be
$&7,777 units. 'he also provided summary historical financial and operating data
regarding unit sales. 3n 77 and 77#, the company reported sales of #(&,777
and $7,777 units, respectively.
Are 6n the 'unny 'ide"s 77 and 77# unit sales reasonableL Bhy or
why notL -=int: Risit the !.'. 1ensus 5ureauCs Beb site Swww.census.govT. 6nce
you are at the site, go to the 85usiness9 section and then to the 8>anufacturing9
sector4specific data section. 6nce you are there, locate the 1urrent 3ndustrial
;eports. Ge2t search the 13;s by 'ubject Title for Apparel. ,ata about women"s
team sports uniforms can be found by search for 8Apparel.9 !se the most current
annual report for your analysis.
Answer5 The 77 and 77# sales do not appear reasonable. The !.'. 1ensus
5ureau reports that annual shipments of women"s team sports uniforms were as
follows:
771 4 not disclosed
77 4 ()(,777 units shipped
Muarterly shipments, in units, for 77 were as follows:
1
st
#1,777
nd
1#,777
#
rd
11,777
$
th
71,777
These data suggest that it is unlikely that 6n the 'unny 'ide shipped more than
&7H of all uniforms during 77.
>ore information can be found in the !.'. 1ensus 5ureau"s report on (pparel6
7887 Swww.census.govDindustryD1Dm/#1&a7&.pdfT.
+4#)
.nternet Pro-le) 6olution5 0-tain Client 8ac<ground .n9or)ation
8-2 %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.
Eour assignment is to find and document information for inclusion in the
audit planning memorandum. Eou 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.. Eou may also use other
sources of information such as recent 174Q filings to find additional information.
Eou 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. -Gote: ,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..
Gecessary 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 Swww.target.comT and its 174Q filing for the year ended <ebruary 1, 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
*reatland store, a national bridal registry 4 1lub Bedd, and ?ullaby
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.
+4#+
8-2 $continued%
.escription of t#e company9s business 4 The company operates 1,1$)
Target stores in $) states, ($ >ervyn"s and ($ >arshall <ield"s stores.
Target 1orporation employees appro2imately #7$,777 people.
The company"s retail merchandising business is conducted under
highly competitive conditions in the discount, middle market and
department store retail segments. 3ts stores compete with national
-e.g., Qmart, Bal4>art, Balgreens. and local department, specialty, off4
price, discount and drug store chains, independent retail stores and
3nternet and catalog businesses that handle similar lines of
merchandise. The company also competes with other companies for
new store sites. The company believes the principal methods of
competing in its industry include brand recognition, customer service,
store location, differentiated offerings, value, /uality, fashion, price,
advertising, depth of selection and credit availability. Target is a leader
in community involvement programs and believes that it is in a strong
competitive position with regard to these competitive factors.
:ey accounting issues 4 The following is a list of accounting issues
identified after reviewing Target"s annual report. 'tudent responses
may vary.
;elated parties 4 The company is comprised of three operating
segments: Target, >ervyn"s and >arshall <ield"s. Target
contributed +$H of 77 total revenues, while >ervyn"s and
>arshall <ield"s contributed +.)H and ).#H, respectively.
?3<6 inventory valuation issues 4 3nventory is accounted for by
the retail inventory accounting method using ?3<6. The
company"s ?3<6 provision decreased by F1 million from 771
to 77.
Accounts payable 4 The accounts payable balance of F$.(+$
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 F17.1+( 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.
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
he employee"s contribution up to & percent of the employee"s
compensation.
+4#@
8-2 $continued%
?eases 4 The company leases a number of their retail buildings.
The company utiliAes both operating and capital leasing
arrangements. The present value of operating and capital
leases for the ne2t & years total F@$ and F1$$ million,
respectively.
*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.prenhall.comDarens..
+4$7

Audit Palnning and Analitycal Procedures

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Chapter 8

Audit Planning and Analytical Procedures

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