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9-20
9-39 (continued)
inventory, or could be the result of an acquisition, or they simply
haven’t paid it off. In any case, verifying this balance is a relatively
easy audit procedure.
2016. Federal income taxes payable on the balance sheet is
significantly lower at 12-31-16 than would be expected based on
Sales Whenever there is a drastic increase in business
activity, there is an increased risk of problems. It is possible that
controls will lapse or not be carefully observed. It is possible that
transactions will not be carefully accounted for. Therefore, in a
Cost of Goods Sold and Gross Profit Consistent with the
comments under sales, the auditors must determine why the gross
Pension Cost It appears that the Company exceeded the
contractual amount for additional pension contribution. Yet,
pension cost is a lesser percent of sales in 2016 than in 2015.
9-39 (continued)
d.
ACCEPTABLE
AUDIT RISK
INHERENT
RISK
SUBSTANTIVE
ANALYTICAL
PROCEDURES
Detail tie-in
Existence
Completeness
Accuracy
Classification
Cutoff
Realizable value
Rights
Medium
Medium
Medium
Medium
Medium
Medium
Medium
Medium
Medium
Medium
Medium
Medium
Medium
High
High
Medium
See Note 5
See Note 5
See Note 5
See Note 5
See Note 5
High
High
See Note 5
Performance materiality:
Trade accounts receivable $80,000
Allowance for uncollectible
accounts 15,000
Total $95,000
RATIONALE
4. Inherent risk for realizable value is considered high because of the
establishing the allowance for uncollectible accounts.
5. The analytical procedures performed are preliminary only, and
don’t provide substantive evidence. However, they can indicate
9-22
9-39 (continued)
Stanton Enterprises
Worksheet 9-39A
Determination of Materiality and
Allocation to the Accounts
12/31/2016
DETERMINATION OF MATERIALITY:
Income before taxes $8,004,277
Possible adjustments - estimated.
equal same %
of trade accounts
receivable as
prior year.
Increase accounts payable (1,070,000) Reflect same
Adjusted net income before taxes $6,714,277
Note: A key consideration is whether the
Company will be required to make its
additional pension contribution. As more
9-23
9-39 (continued)
Stanton Enterprises
Worksheet 9-39A, cont.
ALLOCATION TO THE ACCOUNTS:
Prelim.
12/31/16
Performance
Materiality
Cash
$243,689
5000
Easy to audit at low cost.
Trade accounts receivable
3,544,009
80000
Large performance materiality (PM) because
account is large and requires extensive sampling
to audit.
Allowance for uncollectible accounts
(120,000)
15000
Fairly large PM because of inherent risk.
Inventories
4,520,902
100000
Large PM because account is large and requires
extensive sampling to audit.
Prepaid expenses
29,500
5000
Easy to audit at low cost.
Total current assets
8,218,100
Property, plant, and equipment, at cost
12,945,255
100000
Small PM as a percent of account balance because
most of balance is unchanged from prior year &
audit of additions is relatively low cost.
Less: accumulated depreciation
(4,382,990)
40000
Fairly low PM due to possible risk of misstatement.
See answers to part c. of HW 9-39 and worksheet
9-39B.
8,562,265
Goodwill
1,200,000
20000
Fairly low PM due to possible risk of misstatement.
See answers to part c. of HW 9-39 and worksheet
9-39B.
Total assets
$17,980,365
Accounts payable
$2,141,552
70000
Large PM because account is large and requires
extensive sampling to audit.
Bank loan payable
150,000
0
Easy to audit at low cost.
Accrued liabilities
723,600
20000
Easy to audit at low cost.
Federal income taxes payable
1,200,000
40000
Fairly low PM due to possible risk of misstatement.
See answers to part c. of HW 9-39 and worksheet
9-39B.
Current portion of long-term
240,000
0
Easy to audit at low cost.
Total current liabilities
4,455,152
Long-term debt
960,000
0
Easy to audit at low cost.
Stockholders’ equity:
Common stock
1,250,000
0
Easy to audit at low cost.
Additional paid-in capital
2,469,921
0
Easy to audit at low cost.
Retained earnings
8,845,292
NA
Total stockholders’ equity
12,565,213
Total liabilities and stockholders’ equity
$17,980,365
$495,000
(1.5 x $330,000)
9-24
9-39 (continued)
Stanton Enterprises
Worksheet 9-37B
Analysis of Financial Statements
and Audit Planning Worksheet
12/31/2016
BALANCE SHEET
Preliminary
12/31/16
%
Audited
12/31/15
%
%
Change
Cash
$243,689
1.4
$133,981
1.1
81.9
Trade accounts receivable
3,544,009
19.7
2,224,921
17.7
59.3
Allowance for uncollectible accounts
(120,000)
-0.7
(215,000)
-1.7
-44.2
Inventories
4,520,902
25.1
3,888,400
31.0
16.3
Prepaid expenses
29,500
0.2
24,700
0.2
19.4
Total current assets
8,218,100
45.7
6,057,002
48.3
35.7
Property, plant, and equipment:
At cost
12,945,255
72.0
9,922,534
79.1
30.5
Less, accumulated depreciation
(4,382,990)
-24.4
(3,775,911)
-30.1
16.1
8,562,265
47.6
6,146,623
49.0
39.3
Goodwill
1,200,000
6.7
345,000
2.7
247.8
$17,980,365
100.0
$12,548,625
100.0
43.3
Accounts payable
$2,141,552
11.9
$2,526,789
20.1
-15.2
Bank loan payable
150,000
0.8
0
0.0
--
Accrued liabilities
723,600
4.0
598,020
4.8
21.0
Federal income taxes payable
1,200,000
6.7
1,759,000
14.0
-31.8
Current portion of long-term debt
240,000
1.3
240,000
1.9
0.0
Total current liabilities
4,455,152
24.8
5,123,809
40.8
-13.0
Long-term debt
960,000
5.3
1,200,000
9.6
-20.0
Stockholder's equity:
Common stock
1,250,000
7.0
1,000,000
8.0
25.0
Additional paid-in capital
2,469,921
13.7
1,333,801
10.6
85.2
Retained earnings
8,845,292
49.2
3,891,015
31.0
127.3
12,565,213
69.9
6,224,816
49.6
101.9
$17,980,365
100.0
$12,548,625
100.0
43.3
9-25
9-39 (continued)
Stanton Enterprises
Worksheet 9-39B, cont.
COMBINED STATEMENT OF INCOME
AND RETAINED EARNINGS
Preliminary
12/31/16
%
Audited
12/31/15
%
%
Change
Sales
$43,994,931
100.0
$32,258,015
100.0
36.4
Cost of goods sold
24,197,212
55.0
19,032,229
59.0
27.1
Gross profit
19,797,719
45.0
13,225,786
41.0
49.7
Selling, general, and
administrative expenses
10,592,221
24.1
8,900,432
27.6
19.0
Pension cost
1,117,845
2.5
865,030
2.7
29.2
Interest cost
83,376
0.2
104,220
0.3
-20.0
11,793,442
26.8
9,869,682
30.6
19.5
Income before taxes
8,004,277
18.2
3,356,104
10.4
138.5
Income tax expense
1,800,000
4.1
1,141,000
3.5
57.8
Net income
6,204,277
14.1
2,215,104
6.9
180.1
Beginning retained earnings
3,891,015
2,675,911
10,095,292
4,891,015
Dividends declared
(1,250,000)
(1,000,000)
Ending retained earnings
$8,845,292
$3,891,015
SIGNIFICANT RATIOS
Current ratio
1.84
1.18
Quick ratio
0.82
0.42
Cash ratio
0.05
0.03
Accounts receivable turnover
12.41
14.50
Days to collect
29.40
25.18
Inventory turnover
5.35
4.89
Days to sell
68.20
74.57
Days to convert to cash
97.60
99.75
Debt to equity ratio
0.43
1.02
Tangible net assets to equity
1.34
1.96
Times interest earned
97.00
33.20
Efficiency ratio
2.62
2.64
Profit margin ratio
0.18
0.11
Profitability ratio
0.48
0.28
Return on total assets
0.45
0.27
Return on equity
0.64
0.54
Note: Some ratios are based on
year-end balances, as 12-31-14
balances are not provided.
9-26
Integrated Case Application
9-40
PINNACLE MANUFACTURING―PART II
External users’ reliance on financial statements:
1. The company is privately held, but there is a large amount
of debt; therefore, the financial statements will be used
fairly extensively. Also, management is considering
debt financing.
Likelihood of financial difficulties:
1. The solar power engine business revolves around
constantly changing technology, thus making it inherently
Solar-Electro.
3. Item 9 in the planning phase indicates there is a debt
covenant requiring a current ratio above 2.0 and a debt-to-
Management integrity:
No major issue exists that would cause the auditor to question
management integrity, but the auditor should have done extensive
fraudulent financial reporting.
b. Acceptable audit risk is likely to be medium to low because of the
factors listed previously, especially the planned increase in
financing and the potential violation of the debt covenant
9-27
9-40 (continued)
c. Inherent risks are addressed by examining each of the 11 items in
the planning phase.
1. Inherent Risk: No effect on inherent risk.
3. Inherent Risk: There is a potential related party
transaction, which could affect the valuation of the
transaction and may require disclosure as a related party
transaction.
Accounts Affected: Manufacturing equipment, footnote
4. Inherent Risk: This situation involves a nonroutine
of sales
5. Inherent Risk: A receivable outstanding for several months
from a customer making up 15% of the company’s
outstanding accounts receivable balance may indicate a
understatement of the allowance for uncollectible
accounts.
Accounts Affected: Accounts receivable, bad debt
expense, allowance for uncollectible accounts
6. Inherent risk: No effect on inherent risk.
transaction.
Accounts Affected: Repairs and maintenance expense
and accounts payable
8. Inherent Risk: Although this does not directly affect
Accounts Affected: All accounts
9-28
9-40 (continued)
all debt covenants have been met.
Accounts Affected: All accounts
10. Inherent Risk: An ongoing dispute with the Internal
Revenue Service may require an adjustment to income tax
payable
11. Inherent Risk: This situation involves a related party
transaction (Solar-Electro borrowed money from the
Welburn division). Because this transaction was not
statements.
Accounts Affected: Notes payable, notes receivable,
interest expense and interest income
