8-11
Discussion Questions And Problems
8–29
AUDIT ACTIVITIES
RELATED PLANNING PROCEDURE
1. Review accounting principles unique to
the client’s industry.
(2) Understand the client’s business
and industry
2. Determine the likely users of the
financial statements.
(1) Accept client and perform initial
audit planning
3. Evaluate the appropriate financial
statement measures for determining
amounts likely to be considered material
by users of the financial statements.
(4) Set preliminary judgment of
materiality and performance
materiality
4. Identify whether any specialists are
required for the engagement.
(1) Accept client and perform initial
audit planning
5. Send an engagement letter to the client.
(1) Accept client and perform initial
audit planning
6. Tour the client’s plant and offices.
(2) Understand the client’s business
and industry
7. Specify materiality levels to be used in
testing of accounts receivable.
(4) Set preliminary judgment of
materiality and performance
materiality
8. Compare key ratios for the company to
industry competitors.
(3) Perform preliminary analytical
procedures
9. Review management’s risk
management controls and procedures.
(2) Understand the client’s business
and industry
10. Identify potential related parties that
may require disclosure.
(2) Understand the client’s business
and industry
8–30 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. Accounting standards
conclude that related parties consist of all affiliates of an enterprise,
including (1) its management and their immediate families, (2) its
8-12
8–30 (continued)
b. (1) Related party transaction. Canyon Outdoor has entered into
an operating lease with a company owned by one of the
(2) Not a related party transaction. The fact that Canyon Outdoor
has purchased inventory items for many years from Hessel
Boating Company is a normal business transaction between
(3) Related party transaction. The financing provided by Cameron
Bank and Trust through the assistance of Suzanne may not
(4) Not a related party transaction. Just because the two owners
are neighbors does not mean that either has significant
(5) Not a related party transaction. The declaration and approval
c. When related party transactions or balances are material, the
following disclosures are required:
1. The nature of the relationship or relationships.
2. A description of the transaction for the period reported on,
3. The dollar volume of transactions and the effects of any
in the preceding period.
4. Amounts due from or to related parties, and if not otherwise
8-13
8–30 (continued)
1. Obtain background information about the client in the manner
2. Perform analytical procedures of the nature discussed in
3. Review and understand the client’s legal obligations in the
4. Review the information available in the audit files, such as
5. Discuss the possibility of fraudulent financial reporting with
management.
6. When more than one CPA firm is involved in the audit,
7. Investigate whether material transactions occur close to
8. In all material transactions, evaluate whether the parties are
9. Whenever there are material non–arm’s–length transactions,
each one should be evaluated to determine its nature and
10. When management is indebted to the company in a material
amount, evaluate whether management has the financial ability
evaluate its acceptability and value.
11. Inspect entries in public records concerning the proper
liens.
8–30 (continued)
12. Make inquiries with related parties to determine the possibility
between them.
14. When an independent party, such as an attorney or bank, is
significantly involved in a material transaction, ascertain from
referred to were those from October 21, 2016.
Additionally, the auditor will request the client to include a
b.
INFORMATION RELEVANT
TO 2016 AUDIT
AUDIT ACTION REQUIRED
March 5:
1. Increase in annual
dividend payment.
Calculate the total dividends and determine that
dividends paid to shareholders are properly reflected in
the financial statements.
2. Approval of additional
administration expenses
to open offices in
Portland.
3. Approval to engage in
negotiations for a
potential acquisition.
Determine the status of any potential acquisition or
merger negotiations. Be alert for any commitments that
may have been made as part of the negotiations
process that may warrant financial statement
disclosure.
4. Potential negative
findings from EPA
investigation.
Evaluate the status of any resolution of negotiations with
the EPA regarding findings in their report. Determine if
any final determinations have been made about
potential fines. Evaluate the need for recording any
provisions for a loss contingency or disclosure of the
status of the negotiations.
8–31 (continued)
INFORMATION RELEVANT
TO 2016 AUDIT
AUDIT ACTION REQUIRED
5. Officers’ bonuses.
Determine whether bonuses were accrued at 12-31-15
and were paid in 2016. Consider the tax implications of
unpaid bonuses to officers.
6. Discussion at the
Audit Committee
and Compensation
Committee.
Determine what, if any, decisions made at either
meeting have any impact on the audit of the financial
statements.
INFORMATION RELEVANT
TO 2016 AUDIT
AUDIT ACTION REQUIRED
October 21:
1. Reduction in sales and
the related cutback in
labor and shipping costs.
During analytical procedures, both the decrease in
revenues and the decreases in labor and shipping
costs should be included in the auditor’s expectation
of the related account balances. The auditor should
be alert to the fact that the drop in operating
performance might create undue incentives and
pressures that could highlight the risk of fraud.
2. Approval of the
acquisition and related
financing.
Examine acquisition documentation and financing
documentation to understand the impact to the
financial statements for recording the acquisition and
the debt transaction. Consider what commitments and
contingencies exist and evaluate the appropriateness
of the recording of the acquisition transaction and
related disclosures.
3. Consideration of a new
incentive stock option
plan.
Determine if the new incentive stock option plan has
been approved. If so, consider accounting treatments
required to reflect any commitments on the part of the
company and evaluate the tax implication of the plan
and need for related disclosure.
4. Identification of
deficiencies in internal
control.
Discuss the deficiencies in internal control with
management and evaluate the impact of any
remediation activities to address the deficiencies.
Evaluate the impact of remediation on the auditor’s
tests of controls and need for substantive procedures.
5. Resolution of the EPA
report findings.
Examine the EPA resolution agreement and determine
if provision has been recorded for the expected costs
to modify the air handling equipment. Consider the
need for any additional disclosures of this resolution.
6. Discussion at the Audit
and Compensation
Committee.
Determine what, if any, decisions made at either
meeting have any impact on the audit of the financial
statements.
8–31 (continued)
c. The auditor should have obtained and read the March minutes,
before completing the 12–31–15 audit. Two items were especially
8–32 a. Gross margin percentage for drug and nondrug sales is as follows:
DRUGS
NONDRUGS
2016
2015
2014
2013
40.6%
42.2%
42.1%
42.3%
32.0%
32.0%
31.9%
31.8%
approximately $82,000 (42.2% – 40.6% x $5,126,000), which appears
b. As the auditor, you cannot accept Adams’ explanation if $82,000
income.
8-33
OBSERVED CHANGE
POSSIBLE EXPLANATION(S)
1. The allowance for obsolete
inventory increased from the
prior year, but the allowance as
a percentage of inventory
decreased from the prior year.
a. Shipments of inventory sold prior to year
end were included in the client’s inventory
counts as of the balance sheet date.
f. The client purchased a large block of
inventory on account close to year end.
2. Long-term debt increased from
the prior year, but total interest
expense decreased as a
percentage of long-term debt.
d. Portions of existing long-term debt were
refinanced at lower interest rates. (Note:
This explanation would not be sufficient by
itself given it does not help explain the
increase in long-term debt).
i. Short-term borrowings were refinanced on a
long-term basis at lower interest rates.
8-33 (continued)
OBSERVED CHANGE
POSSIBLE EXPLANATION(S)
3. The dollar amount of operating
income is consistent with the
prior year although the entity
was more profitable on a net
income basis.
d. Portions of existing long-term debt were
refinanced at lower interest rates.
e. The effective tax rate decreased, as
compared to the prior year.
i. Short-term borrowings were refinanced on a
long-term basis at lower interest rates.
4. The quick ratio decreased from
the prior year, although the
amount of cash and net
accounts receivable is almost
the same as the prior year.
f. The client purchased a large block of
inventory on account close to year end.
8–34 a. 1. Commission expense could be overstated during the current
year or could have been understated during each of the past
2. Obsolete or unsalable inventory may be present and may
3. Especially when combined with 2 above, there is a high
4. Collection of accounts receivable appears to be a problem.
5. Especially when combined with 4 above, the allowance for
b. ITEM 1 – Make an estimated calculation of total commission expense
by multiplying the standard commission rate times commission
sales for each of the last two years. Compare the resulting amount
8-18
8–34 (continued)
to sell, propose that the client mark down the inventory to market
value.
ITEMS 4 AND 5 – Select a sample of the larger and older accounts
additional allowance for uncollectible accounts.
ITEM 6 – Discuss the reason for the reduced depreciation expense
with the client personnel responsible for the fixed assets accounts.
is reasonable for the year.
8–35 a. Target and Kohl’s are similar, but their business descriptions
indicate somewhat different market positioning. Target indicates it
offers customers everyday essentials and fashionable,
b. December is the peak selling month for retailers due to the holiday
shopping season, which is then followed by a brief period with
d. Based on Target’s description as selling at discount prices, it
8-19
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8–36 a. The direct projection of error = (misstatements/amount sampled) x
population value.
b. No, the overall financial statements are not acceptable. Including
misstatements.
8–37 a. Ling should consider the overall audit assurance desired,
c. Ling set performance materiality for inventory at a lower amount
because there are concerns about obsolescence and because
d. Performance materiality is the highest for accounts receivable
because the account is large and requires sampling to test the
8-20
of the auditor’s professional judgment.
The illustrative materiality guidelines in Fig 8–6 (p. 238)
STATEMENT
COMPONENT
PERCENT
GUIDELINES
DOLLAR RANGE
(IN MILLIONS)
Earnings from continuing
operations before taxes
Current assets
Current liabilities
Total assets
3 – 6%
3 – 6%
3 – 6%
1 – 3%
$12.5 – $ 25.1
$67.6 – $135.2
$36.5 – $72.9
$38.6 – $115.8
the same amount to each of the balance sheet accounts on the
consolidated statement of financial position. Using a materiality
limit of $12,500,000 before taxes (because it is the most restrictive)
and the same dollar allocation to each account excluding retained
c. Auditors generally use before tax net earnings instead of after tax