Chapter 05 – Evidence and Documentation
5-10
5-38 a. The calculation of the expectation for the reserve for returns account can be made as
follows:
Months
Monthly
Sales
(in 000s)
Historical
Return Rate
Estimated
Returns
July
$ 73,300,000
0.004
$ 293,200
August
82,800,000
0.006
496,800
September
93,500,000
0.01
935,000
October
110,200,000
0.015
1,653,000
November
158,200,000
0.025
3,955,000
December
202,500,000
0.032
6,480,000
$13,813,000
Gross Margin %
x 0.425
Auditor expectation
$ 5,870,525
b. We can establish a tolerable difference by applying a percentage (50%) to the
planning materiality set for EarthWear of $1,800,000. This results in a tolerable
difference of $900,000. Alternatively, the auditor might use a rule of thumb like this
returns account.
d. If the difference between the auditor’s expectation and the book value is greater than
the tolerable misstatement, the auditor should consider performing the following audit
procedures:
• Review the general journal and general ledger for any unusual entries.
Chapter 05 – Evidence and Documentation
5-11
5-39 The issues and potential risks listed below are based on a real-world situation involving a
liquidity crisis and a pending bankruptcy. Because the solution below includes the
benefits of the Home Depot insights it is likely to be more complete than answers
provided by students.
1. Quick Ratio
a. The quick ratio presents a good picture of the client’s liquidity position. A quick
ratio greater than 1.0 generally indicates that the entity’s liquid assets are
sufficient to meet the cash requirements for paying current liabilities. Home
Improvement’s quick ratio has decreased significantly over the past two years and
has fallen well below the 1.0 threshold, whereas the industry’s has been
inherent risks on accounting measures related to debt covenants and new
financing (i.e., incentive to overstate in order to avoid default and/or acquire new
financing).
1: Growth. A cash crunch is not uncommon for companies going through rapid
growth as appears to be the case with The Home Improvements when you
consider the pattern of other ratios and trends (e.g., significant debt to equity,
increase in inventory to total assets). As the client expands, it spends large
amounts of cash on buying more inventory, building new stores, and incurring
other significant start-up costs. The client may also add additional debt during
former seems more likely.
Chapter 05 – Evidence and Documentation
5-12
2. Days of Inventory on Hand
a. This ratio, which is computed as 365 days divided by the inventory turnover,
represents how much inventory the entity has on hand to sell to customers. The
higher the ratio, the slower the inventory turns and the less able the client is to
liquidate inventory and avoid inventory obsolescence. Although the client’s ratio
products or simply that the client has grown too quickly and has increased supply
in excess of market demand.
3. Inventory/Current Assets
a. This ratio sheds light on how the client is increasing inventory purchases
compared to the industry average. Carrying large amounts of inventory on hand
can be expensive when carrying, stocking, and storage costs are considered. As
mentioned previously, when large amounts of inventory are stored on hand, the
risk of inventory obsolescence increases, as does the risk that the client may be
this increase in inventory can also be dangerous if sales do not support the
expansion.
4. Return on Assets (ROA)
a. This ratio indicates the return earned on the resources invested by both the
stockholders and the creditors. As such, when this ratio dips below the industry
average it indicates that the company is not generating as high a return as its
Chapter 05 – Evidence and Documentation
5-13
b. As a growing company, and as shown in other ratios, the client has spent
considerable amounts of money expanding its business, including the build-up in
inventory, which increases the denominator (Total Assets). At the same time, the
high amounts of debt to fund expansion also result in higher interest expense,
further lowering earnings.
5. Debt to Equity Ratio
a. This ratio indicates what portion of an entity’s capital comes from debt. The lower
the ratio, the less debt pressure on the entity. The client’s debt has increased
dramatically over the last three years and although the ratio drops in the final year
in the table, it is still higher than the earliest years as well as the industry ratio
over the same timeframe. The fact that the client’s ratio is significantly above the
dropped to the point that raising capital through a public offering may have been
ineffective and thus debt may have been the client’s only avenue for additional
financing.
NOTE: The data used in this problem are based on Home Depot and its industry
between 1982 and 1986. Founded in 1978, Home Depot quickly became a major
player in its industry. Because of its success, Home Depot sought to rapidly expand
during the early 1980’s. Unfortunately, Home Depot tried to expand too quickly. It
acquired millions of dollars in debt to purchase large amounts of PP&E and inventory
for new stores, but sales did not keep pace with the rapid expansion in assets and
debt. As a result, Home Depot had serious cash shortages to the extent that it was
having trouble financing operations. Home Depot was forced to restructure its debt
and strategy for growth. On the verge of bankruptcy, Home Depot was able to
orchestrate a miraculous turnaround and ultimately returned to profitability.
Solution to Discussion Cases
5-40 Part I
a. Because of the large increase in sales, both in general and abroad, the auditor
primarily would be concerned with occurrence of sales transactions.
Chapter 05 – Evidence and Documentation
5-14
the increase in accounts receivable is greater than the increase in sales (e.g., greater
percentage increase in accounts receivable than for sales, increase in average days
outstanding), the auditor also would be concerned with valuation or allocation (i.e., to
what extent are the receivables collectible).
c. The auditor could vouch sales and receivables. Specifically, to examine the
occurrence and existence assertions, the auditor could choose a sample sales
transactions and examine supporting documents, perhaps paying particular attention
to the existence of a valid sales order as well as evidence that the products were
Part II
a. The auditors could have examined documentation for sales transactions, particularly
searching for valid sales orders and evidence that the products sold were shipped. The
5-15
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5-41
1. See Development of Auditors’ Expectation on the following page.
2. Reported ticket revenue differs from the expectation by approximately 14 percent
(($2,200,000 – $1,922,190) / $1,922,190); this difference is material and should be investigated.
One explanation for the larger than expected reported ticket revenue could be that the football
team performed better than expected. In addition, perhaps the weather also was better than
whether favorable weather conditions are a plausible explanation for the higher attendance.
3. In a problem such as this, analytical procedures will be most effective when accurate
expectations can be developed. From the information provided in this problem, it appears that the
auditors’ knowledge of Western’s ticket sales is sufficient to allow them to develop a reasonable
expectation.
Development of Auditors’ Expectation
Four regular games
24,000
Total attendance
Total
Allocation
Total Fans
Less free
Revenue
0.7
16,800
16,300
$195,600
0.2
4,800
4,800
38,400
0.1
2,400
2,400
12,000
24,000
$246,000
X4
Four normal games
$984,000
Bloomington University
(30% higher attendance, 20%
higher ticket price)
31,200
Total attendance
Total
Allocation
Total Fans
Less free
Revenue
0.7
21,840
21,340
$307,296
0.2
6,240
6,240
59,904
0.1
3,120
3,120
18,720
31,200
$385,920
Norwalk University
(20% more fans, 75% box
seats, 25% upper deck)
Total
Revenue
Extra fans (total):
4,800
Box
3,600
$43,200
Chapter 05 – Evidence and Documentation
Upper
1,200
6,000
49,200
Normal game revenue:
246,000
$295,200
Night Games
(10% higher ticket
prices, 5% lower
attendance)
24,000
Base attendance
Less:
5%
Total
and Free Seats
Revenue
0.7
16,800
15,485
$204,402
0.2
4,800
4,560
40,128
0.1
2,400
2,280
12,540
24,000
22,325
$257,070
Chapter 05 – Evidence and Documentation
5-17
Solution to Internet Assignment
5-43 A general search for each term using an Internet browser resulted in a long list of “hits;”
most of which did not apply to the material covered in the text. The Institute of Internal
Auditors’ home page (www.theiia.org) contained some information related to EDI and
image processing systems. Using the search function at the AICPA’s home page
(www.aicpa.org) identified a significant number of references to the three terms. EDI
refers to the electronic exchange of data, for example, the electronic exchange of data
regarding inventory requirements between a customer and a vendor. Image processing
systems capture and store electronic images, usually reproductions of documents. For
example, many banks and credit unions now make electronic images of cancelled checks
statements.