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b. Examine client copies of insurance policies or certificates of insurance to determine
compliance with the covenant. The auditor should prepare a summary of all the scheduled
information contained in the policies. In addition, the auditor should confirm the existence of the
policies with the trustee.
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The following deficiencies should be identified:
1. The subject matter of the working paper and client name are not properly
indicated in the title.
2. The workpaper should include information on the accrued interest payable for
3. There is no indication whether the confirmation exception was resolved.
4. There is no indication that the loan with the violation of a provision of the debt
agreement (First Commercial Bank) has been reclassified as short-term.
6. There is no indication of cross-referencing of the stockholder loan to the related
party transactions working papers.
8. There is no indication that the dates under “interest paid to” were audited.
10. There is no indication that the working paper was prepared by client personnel
(should indicate PBC).
Fraud Focus: Contemporary and Historical Cases
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a. As stated in the feature, Quinton’s audit team conducted an analysis identifying that Soyo
was not in compliance with three of its six debt covenants with UCB as of December 31, 2007.
Because of the debt covenant violations, UCB could take action that would force Soyo into
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information that would highlight the organization’s precarious financial situation. The high
levels of debt, and the identified debt covenant violations, should have signaled to the auditors a
need to employ a heightened level of professional skepticism.
b. A key procedure for the auditor is to review debt agreements for the restrictive covenants
and consider their effect on disclosures in the financial statements. The auditor should also
The auditor should obtain an understanding of the procedures the client uses to determine
whether they are in compliance with their debt covenants. The auditor should then independently
determine if the client is in compliance. Consider a covenant that requires the client to maintain a
current ratio that does not fall below a specified level. If the auditor determines that the client’s
current ratio is below that level, the auditor should assess the effects of the violation. (If the
current ratio does not fall below the stated level, the auditor will want to be sure to use
appropriate professional skepticism when auditing the components of the ratio.) If the violation
is not waived by the creditor and the loan is in default, the creditor may declare the outstanding
balance immediately due and payable. In that case, the auditor generally would assume that the
debt would need to be reclassified as short-term debt. In addition, the auditor must consider what
financial statement disclosures will be required and how the events of default will affect the audit
opinion. For example, could the default suggest going concern issues that would need to be
identified in the audit opinion?
c. Students will likely put forth a number of very plausible responses. The students were not
asked to obtain the SEC release, but if they were to do so, they would note that the SEC release
states:
PCAOB Standards required Quinto to exercise due professional care throughout the audit. Due
professional care means the auditor must act with professional skepticism – an attitude that
includes a questioning mind and a critical assessment of audit evidence. The auditor should not
be satisfied with less than persuasive evidence because of a belief that management is honest.
See PCAOB Interim Standard – AU § 230, Due Professional Care in the Performance of Work.
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obligations, he did not appropriately modify Vasquez’s opinion on the financial statements due
to the omission of information required by GAAP.
d.
(1) Identify the ethical issue. The issue is that you know that the financial statements do not
(2) Determine who are the affected parties and identify their rights. Affected parties include
shareholders (right to receive accurate investment information), the audit committee and
(3) Determine the most important rights. Shareholders of Soyo are the most numerous and
(4) Develop alternative courses of action.
• Appeal further to the audit partner, trying to encourage him to “do the right thing”.
(5) Determine the likely consequences of each proposed course of action.
• Appeal further to the audit partner, trying to encourage him to “do the right thing”.
Likely consequences: unknown, depending on audit partner’s personality and your
(6) Assess the possible consequences, including an estimation of the greatest good for the
(7) Decide on the appropriate course of action. The most appropriate course of events would
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a. A needed increase in warranty reserves is likely an action that the client would want to
avoid. This action could have alerted the auditor to that the client would have incentives to
misstate its financial performance (that is, hide the expenses). Further, a direct entry to Retained
Earnings would probably be an unusual transaction and should have heightened the auditor’s
professional skepticism regarding the appropriateness of the treatment of the transaction.
b. In terms of auditing retained earnings, the auditor will typically examine all transactions
recorded in the retained earnings account during the audit period. The common entries include
net income or loss. These amounts would be tested through substantive audit procedures related
Application Activities
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The level of detail provided in the students’ responses will vary with the extent of their research.
Possible resources include:
a. In the SEC release, the following is noted:
Mark K. Schonfeld, Director of the SEC’s Northeast Regional Office said, “What is
especially troubling here is that Deloitte recognized the risk of fraud posed by this client
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An online blog describes the situation as follows (http://retheauditors.com/2007/01/30/meet-the-
auditors-deloitte-touche-tohmatsu/):
“Deloitte’s characterization of the case is simply wrong. Deloitte was not deceived,” said
b. Adelphia excluded $1.6 billion in debt from its balance sheet. Further, it overstated its
stockholders’ equity by $375 million.
c. Deloitte also agreed to significant undertakings designed to address its audit of high-risk
clients in the future, including the involvement of Deloitte’s forensic accounting specialists in
All of these actions are intended to improve audit quality. Whether the result is obtained will
likely depend on whether the firm addresses these requirements in a compliance mentality or
whether the tone at the top of firm stresses and emphasizes the importance of performing quality
audits.
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The relevant standard is INTERNATIONAL STANDARD ON AUDITING 550, “RELATED
PARTIES.”
Definition of a Related Party (Ref: Para. 10(b))
A4. Many financial reporting frameworks discuss the concepts of control and significant
influence. Although they may discuss these concepts using different terms, they generally
explain that:
(a) Control is the power to govern the financial and operating policies of an entity so as to obtain
A5. The existence of the following relationships may indicate the presence of control or
significant influence:
(a) Direct or indirect equity holdings or other financial interests in the entity.
(b) The entity’s holdings of direct or indirect equity or other financial interests in other entities.
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(c) Being part of those charged with governance or key management (that is, those members of
management who have the authority and responsibility for planning, directing and controlling the
Related Parties with Dominant Influence
A6. Related parties, by virtue of their ability to exert control or significant influence, may be in a
position to exert dominant influence over the entity or its management. Consideration of such
A7. In some circumstances, a special-purpose entity18 may be a related party of the entity
because the entity may in substance control it, even if the entity owns little or none of the
Evaluation of the Accounting for and Disclosure of Identified Related Party Relationships
and Transactions
Materiality Considerations in Evaluating Misstatements (Ref: Para. 25)
A46. ISA 450 requires the auditor to consider both the size and the nature of a misstatement, and
the particular circumstances of its occurrence, when evaluating whether the misstatement is
Evaluation of Related Party Disclosures (Ref: Para. 25(a))
A47. Evaluating the related party disclosures in the context of the disclosure requirements of the
applicable financial reporting framework means considering whether the facts and circumstances
of the entity’s related party relationships and transactions have been appropriately summarized
and presented so that the disclosures are understandable. Disclosures of related party transactions
may not be understandable if:
(a) The business rationale and the effects of the transactions on the financial statements are
unclear or misstated; or
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The SEC release states:
PCAOB Standards required Quinto to exercise due professional care throughout the audit. Due
professional care means the auditor must act with professional skepticism – an attitude that
includes a questioning mind and a critical assessment of audit evidence. The auditor should not
be satisfied with less than persuasive evidence because of a belief that management is honest.
In terms of sanctions, the Release notes that:
“A. Quinto is denied the privilege of appearing or practicing before the Commission as an
accountant.
B. After one year from the date of this Order, Respondent may request that the Commission
Analytical Procedures: A Case in the Context of the Pharmaceutical Industry
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Part 1: Planning Analytical Procedures
a. The following are examples of typical planning analytical procedures related to debt
obligations:
• Perform a trend analysis of the balances in notes payable and accrued interest with prior
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b. There are a number of factors affecting data reliability, with one of the more important
being the quality of the system producing the data used in the analytical procedures. The quality
of that system is dependent on the effectiveness of the controls. Thus, it is typical that the data
would be considered reliable if the client’s controls were effective. However, when performing
c. Based on the fact that the client’s amount of long-term debt decreased over the prior year,
an initial expectation is that the interest expense in the current year will be less than the interest
expense in the prior year. Thus, for PharmaCorp, a reasonable expectation for planning purposes
d. Common materiality benchmarks applied to PharmaCorp:
1% of
assets:
$1,858,000
1% of
revenue:
5% of net
income:
Student answers will likely vary widely given the judgmental nature of this task. For clearly
trivial amounts, the level of materiality should be fairly small, in the range of $20,000-$50,000.
The auditor will also want to consider qualitative factors. For example, the auditor should
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e. Given that the client recorded $1,800,000 of interest expense related to long-term debt (a
difference of $238,815 from the auditor’s expectation), the auditor will likely plan to do more
precise analytical procedures as a substantive test.
In terms of Step 7, the auditor will want to ensure that the documentation of planning analytical
procedures is proper. As the auditor proceeds through planning analytical procedures,
Part 2: Substantive Analytical Procedures
f. The auditor could improve the precision of the estimate by performing the calculation
used in planning analytical procedures (average long term debt * interest rate) for each category
of long-term debt. This improved precision accounts for the fact that a weighted average interest
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Academic Research Case
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a. The primary focus of the paper is to examine whether investors react to going concern
audit report (GCAR). Of relevance to the current chapter is the fact that many firms carry debt
with a covenant that requires the firm to present GCAR-free financial statements. Therefore,
b. The authors find that investors do react negatively when an organization receives a
GCAR. The reaction is more adverse if the GCAR triggers a technical violation of a debt
PharmaCorp.
Long-Term Debt
Average
Debt
(millions)
Calculated
Interest
3287.5 203.825
7.20%
1196 43.355
2356.5 153.1725
2,088
5.95%
Apr-40
2,086
6.51%
The following table provides the components of senior unsecured long-term debt:
Maturity Date
2015
(millions)
2014
(millions)
6.20%
March 2022
$
3,327
$
3,248
3.625% (At
December 31,
2015, the note
has been
reclassif ied to
Curren t
portion of lon g –
term deb t .)
Jun-16
—
2,392
6.50%
Jun-41
2,407
2,306
c. The information related to debt covenants violations is important to investors. As noted in
the chapter, if a debt covenant is in violation the related financial statement disclosure is
important. Within the context of this study, the unique aspect is that the auditor’s action (to issue
d. The authors use a large sample of 1,194 firms that receive first-time GCARs in the period
1995 to 2006 to examine if investors react to GCARs, and whether certain conditions, such as a
GCAR-free set of financial statements is required by lenders.
e. The study provides robust evidence that investors pay attention to GCAR. In terms of the