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However, it is important to recognize that management will want to understate expenses, and
Step 1. Identify the ethical issue. The ethical issue is that the auditor believes that her estimate is
Step 2. Determine who are the affected parties and identify their rights. There are various
affected parties:
• shareholders, who have a right to accurate financial information
Step 3. Determine the most important rights. The most important rights are likely those of
Step 4. Develop alternative courses of action. The auditor could pursue various courses of action:
a. Try again to convince management that the auditor’s estimates are
Step 5. Determine the likely consequences of each proposed course of action.
a. Trying to convince management may or may not work. If it does work, then
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c. Threatening management will obviously strain the relationship with the
Step 6. Assess the possible consequences, including an estimation of the greatest good for the
greatest number. The auditor is required via professional standards to alert the audit committee,
Step 7. Decide on the appropriate course of action. The auditor should first try to convince
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a. The main difficulty that the auditor faces in determining whether the charges are
reasonable is to understand management’s estimation procedures and to decide if they are
reasonable. The auditor will have to understand the following types of decisions:
• Which third party offers were used in the calculations? How did management choose
which offers to use if there were multiple offers?
• What is the appropriate discount rate for the discounted future cash flow calculations?
• Is it appropriate to completely write off the Falkirk, Scotland assets? Or is management
possibly setting up a cookie jar reserve by doing so?
b. The consequences of the auditor’s decisions are associated with providing reasonable
assurance that no fixed assets are inappropriately over-valued on the balance sheet (with
resulting under-expensing of impairment charges on the income statement) or under-valued on
the balance sheet (with resulting over-expensing of impairment charges on the income
statement).
c. The risks are those associated with inaccurate financial reporting, particularly if the
impairment charges are material to the client’s financial statements. The uncertainties involve the
estimates, for example, is a 7% discount rate correct, or should it be 5%?
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• Comparisons of fixed asset values with competitors
Fraud Focus: Contemporary and Historical Cases
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a. IRG’s lease accounts and fixed asset accounts (including related deprecation charges)
were misstated.
b. While the textbook feature does not provide information specifically related to
management motivation and does not suggest that management acted fraudulently, students will
likely note that the company recently went public and may have intentionally misstated the
financial statements so that the public offering would be more successful. The motivation,
coupled with opportunity due to weak internal controls, is often highlighted by students.
c. Typical controls that affect multiple assertions for long-lived assets include:
• Formal budgeting process with appropriate follow-up variance analysis
• Written policies for acquisition and disposals of long-lived assets, including required
approvals
Further, controls should be in place to:
• Identify existing assets, inventory them, and reconcile the physical asset inventory with
the property ledger on a periodic basis (existence).
• Provide reasonable assurance that all purchases are authorized and properly valued
(valuation).
• Appropriately classify new equipment according to its expected use and estimate of
useful life (valuation).
• Periodically reassess the appropriateness of depreciation categories (valuation).
d. The auditors should have gained an understanding of the client’s internal controls over
these long-lived assets. If the controls were not well designed (or determined not to be operating
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effectively), the auditors should have increased the assurance they needed regarding whether the
asset accounts were materially misstated. For the lease audit, the auditors could perform the
following:
• Obtain copies of lease agreements, read the agreements, and develop a schedule of lease
expenditures.
• Review the lease expense account, select entries to the account, and determine if there are
entries that are not covered by the leases obtained from the client. Review to determine if
the expenses are properly accounted for.
• Review the relevant criteria from FASB ASC to determine which leases meet the
requirement of capital leases.
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a. Yes, it would be highly unusual for debits to fixed assets to come from adjusting journal
entries. Most debits to fixed assets should come from purchases of the assets and should be
evidenced by invoices and contracts. The auditor should view significant amounts of debits to
fixed asset as high risk and should investigate all of the entries if the aggregate amount could be
significant or material.
b. No, entries to depreciation expense and accumulated depreciation should normally come
from adjusting journal entries. However, the journal entries should come from an automated
computer program. Thus, the auditor should trace the summary entries back to the detail
computation for specific items.
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• The auditor should determine that the document that is examined was not used to support
other purchases, that is, the auditor should be suspicious of the information because it is
all obtained internally. The auditor should be concerned that one invoice might serve as
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a. The statement of facts for this case reveals that company management had made
promises (earnings expectations) to investors and Wall Street that were not going to materialize,
thereby suggesting the motivation for management. Further, it is likely that the controls in place
were not very effective. While Safety-Kleen had policies prohibiting the types of fraudulent
b. It is important to note that this response has the benefit of hindsight. However, analytical
procedures (either planning or substantive) should have noted the increases in quarter end
adjustments, with rather significant adjustments occurring in the 3rd and 4th quarters of 1999.
Further, the 2000 1st quarter adjustment was quite a bit larger than the previous 1st quarter
adjustment. The case states that these adjustments in 1999 were significantly higher than the
The problem states that one of the adjusting entries was recorded twice. The use of GAS or other
procedures should have identified this duplicate recording.
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Application Activities
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The point of this exercise is to get students to access online financial reports, to see the
relationship to conceptual auditing topics involving impairments, and to read and interpret
financial statement disclosures. Further, discussing each student’s findings in a small group or
even as an entire class may prove beneficial in stimulating conversation about the nature of
impairment charges, their causes, their magnitudes, and implications for the external auditor in
terms of assessing reasonableness of the estimates made by management.
There are many recent examples that students might find including:
• In 2014, Caesars Entertainment Corp. posted a large quarterly loss after taking a hefty
impairment charge. The casino corporation said it took goodwill and asset-impairment
charges because of the continuing slump in Atlantic City and expectations that some
For a less recent example, consider that Starbuck’s recorded a $224 million impairment charge in
2009, and that was following a $325 million impairment charge in 2008. These impairment
charges were associated with a significant slowdown in the Company’s expansion, with fewer
store openings attributed to reduced demand and a steep decline in discretionary consumer
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DRG Audits- Excerpts from PCAOB Order
DRG reported in the notes to its 2008 financial statements that it had incurred advertising
expenses during 2008 and that it had capitalized approximately $840,000 of those expenses as
SOP 93-7 provides that a company may only capitalize advertising expenses as direct response
advertising if (1) the primary purpose of the advertising “is to elicit sales to customers who could
be shown to have responded specifically to the advertising;” and (2) the advertising “results in
probable future benefits.” In addition, SOP 93-7 states that direct response advertising costs
reported as assets are to be “amortized on a cost-pool-by-cost-pool basis over the period during
which the future benefits are expected to be received.”
During the 2008 audit, JSW failed to exercise due professional care and failed to obtain
DDM Audits- Excerpts from PCAOB Order
As of year-end 2008, more than 75% of DDM’s total reported assets were classified as intangible
assets and consisted mostly of website and platform development costs for an unlaunched
product. During the 2008 audit, JSW failed to ensure that the engagement team appropriately
tested DDM’s intangible asset balance for impairment. The work papers reflect that
management’s basis for not recognizing an impairment on its intangible assets in 2008 was a cash
Sanctions
Accordingly, it is hereby ORDERED that: A. Pursuant to Section 105(c)(4)(E) of the Act and
PCAOB Rule 5300(a)(5), Jewett, Schwartz, Wolfe & Associates, P.L. is hereby censured.
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The following excerpts from the speech provide useful points of discussion including the
difficulty of measuring intangible assets, the potential for abuse, and the constraints imposed by
the accounting standards.
One of the biggest measurement dilemmas relates to intangible assets. We know that they are there. While the value of
Facebook’s tangible assets is relatively limited, its business concept is immensely valuable (although 25% less immense
than a month ago).
Likewise, the money-making potential of pharmaceutical patents is often quite substantial. However, both types of intangible
assets go unrecorded (or under-recorded) on the balance sheet. Under strict conditions, IAS 38 Intangible Assets allows for
limited capitalisation of Development expenditures, but we know the standard is rudimentary because it is based on
historical cost, which may not reflect the true value of the intangible asset.
These excerpts highlight the difficulty of auditing intangible assets—if the asset is difficult to
measure, it will be difficult to audit. Estimation and uncertainty make audits of intangibles
extremely challenging and highlight the importance of professional skepticism.
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The appropriate standard is AU-C Section 620, Using the Work of an Auditor’s Specialist. The
AICPA issues the standards that relevant to auditors of non-public companies (non-issuers).
In terms of the qualifications of the specialist, AU-C 620.09 notes:
The auditor should evaluate whether the auditor’s specialist has the necessary
competence, capabilities, and objectivity for the auditor’s purposes. In the case of an
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The student will likely also include information from paragraphs A15-A22, as these paragraphs
provided additional application guidance on the competence, capabilities, and objectivity of the
auditor’s specialist.
As to whether the specialist should be mentioned in the audit report, AU-C 620.14-15 notes:
The auditor should not refer to the work of an auditor’s specialist in an auditor’s report
containing an unmodified opinion.
Further, AU-C 620.A44 notes:
It may be appropriate to refer to the auditor’s external specialist in an auditor’s report
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The appropriate standard is AU-C Section 540 Auditing Accounting Estimates, Including Fair
AU-C 540.21 notes that:
The auditor should review the judgments and decisions made by management in the making
AU-C 540.A133-A134 provides additional guidance:
During the audit, the auditor may become aware of judgments and decisions made by
management that give rise to indicators of possible management bias (see paragraph .A9).
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Examples of indicators of possible management bias with respect to accounting estimates
include the following:
• Changes in an accounting estimate, or the method for making it, when management has
made a subjective assessment that there has been a change in circumstances
Academic Research Cases
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a. From late 2004 to mid-2006 more than 250 U.S. firms uncovered and corrected
accounting errors related to operating leases. The underlying issue was that the accounting
method used was in violation of generally accepted accounting principles (GAAP). Many of
these companies filed restated financial statements with the SEC, while many other companies
elected to use a less visible current-period catch-up adjustment. GAAP allows companies to
avoid formal restatements when the error is deemed immaterial by management and the
independent auditor. This setting is one where materiality considerations are likely to be the
b. The results of the research indicate that the materiality judgment (and hence the judgment
regarding the correction method) is based on more than a purely quantitative approach (for
example, 5 percent of net income). Qualitative factors such as scaled magnitude of the error,
c. In settings where a decision has to made as how to correct an error, there is likely a fair
amount of negotiation between the auditor and the client (preparer). Auditors and their clients
will find it useful to understand the determinants of this decision and whether their own
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At least in the setting examined in the paper, it appears that materiality assessments are pretty
consistent across firms. However, the auditing standard setters might consider providing more
specific materiality guidelines for auditors to follow. This would reduce the amount of judgment
d. The initial sample of companies to use for this research was gathered from the investment
newsletter “Analysts’ Accounting Observer” supplemented by companies found in wire service
press releases and SEC filings. The final sample consisted of 244 firms which included 150 firms
that used restatements to correct lease accounting errors and 91 that used current-period
e. The archival research method used for this paper is subject to certain limitations. For
example, some disclosures regarding correction of the error were not specific as to the dollar
amount of the error and thus were not included in the analysis. Further, there may be variables
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a. This paper addresses the issue of client negotiation in an asset write-down setting. Asset
write-downs can be highly judgmental audit areas, and the amounts reported in financial
statement for such highly judgmental audit areas are a product of auditor-client negotiation. This
paper specifically addresses how an auditor characteristic (negotiation experience) and a client
characteristic (negotiation style) can impact the outcomes of negotiation and thus impact the
b. The authors find that auditor negotiation experience affects auditors’ predictions of the
ultimate outcome of negotiations, but only in situations where the client uses a contentious
negotiating style. Specifically, higher auditor negotiation experience leads auditors to predict a
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c. This paper shows that a client’s negotiation style can affect the amounts reported in the
financial statements. This finding indicates that auditors may benefit from considering clients’
negotiation styles in their decision-making. For example, auditors may benefit from considering
client negotiation style in resource management decisions. The authors note that audit firms
could benefit from assigning auditors with greater negotiation experience to negotiate with
d. The authors perform an experiment using 20 partners (average of 12.1 years of
experience) and 76 managers (average of 7.2 years of experience) from a Big 4 CPA firm in
China during a regular training session. The authors randomly assigned each auditor to one of
two groups: 1) contentious client negotiating style and 2) collaborative negotiating style. The
authors distributed materials indicating the audit team identified an audit adjustment for an
additional asset write-down of $1.8 million, where the materiality level for the overall financial
statements was $1.9 million. Participants in the contentious group were told that the CFO had
previously adopted a tough stand, was typically reluctant to record audit adjustments, and had
expressed reservations in recording the current adjustment. Participants in the collaborative
e. The authors self-identify four limitations of this study:
• The authors use a self-reported measure of negotiation experience to measure auditor
expertise. Self-reported measures are susceptible to bias, and experience does not
necessarily constitute expertise.
• The audit adjustment used in the study was not quantitatively material. The results may
Additional weaknesses to consider may include:
• This experiment was performed in China. Cultural differences could limit the
generalizability of these results.
• The authors do not appear to control for the position of the participants (i.e., manager vs.
partner)
• The authors do not explain why auditor negotiation experience might even matter in
negotiations with a collaborative client. For example, if a client is collaborative, then
Ford and Toyota
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Note to instructor: The solutions based upon the FYE 2012 annual reports for Ford and Toyota