Chapter 12 Homework However The Auditors Cannot Satisfied With That

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CASE 12

SUGGESTED ANSWERS TO DISCUSSION QUESTIONS

(1)

The examination of a bank cutoff statement is a common audit procedure that

serves to generate several types of corroborative evidence. In reviewing this

document, the auditor is seeking to verify the client’s reported balance for cash

and related accounts. In addition, the auditor must always be aware of the

possibility of theft in connection with cash held by the client. Thus, the auditor is

especially attentive to any information from the cutoff statement (such as a check

that did not clear the bank in a reasonable time) suggesting the existence of a

defalcation problem.

Audit procedures that could be performed using the information obtained in a

bank cutoff statement would include:

* Review of the checks clearing the bank during the first few days of the new

year. Clearance of these checks serves as evidence of the validity of the

* Review of the specific date on which each returned check cleared the bank.

This procedure serves as a means of ascertaining the appropriateness of

the year-end cutoff made of cash disbursements.

* Verification of any unusually large check or any check of an odd nature

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(2)

Many thefts and other illegal acts are perpetrated through the use of bank

accounts that supposedly have been closed. For example, a dishonest

(3)

a. Warehouse – The construction-in-progress on the warehouse addition must

be reported apart from the other land, buildings, and equipment on the

b. Fire Damage – Although the fire occurred subsequent to the fiscal year,

Statement on Auditing Standards 1 specifies that some events happening

after the end of the period “may be of such a nature that disclosure of them

is required to keep the financial statements from being misleading.” SAS 1

goes on to list a number of examples, including inventory destroyed by fire.

Thus, Lakeside’s 2010 fire loss will probably require disclosure in the 2009

financial statements.

Students may raise a question as to the materiality of the estimated loss

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c. Declaration of Cash Dividend – Unless the auditor views the declaration of

(4)

For many companies, a number of transactions occur within two or three days of

the end of the fiscal year. In seeking evidence of the fair presentation of the

financial information, the auditor needs to ensure that the impact of these

(5)

Determining the fair presentation of the liability accounts is a concern to the

auditor because of the possibility that obligations may have gone unrecorded by

the client company. At least two reasons exist for this potential problem:

* Failure to record liabilities improves a company’s debt/equity ratio and,

(6)

Contingent losses such as those arising from law suits or the possible closing of

a store are frequently quite material in size. Thus, the auditor is usually faced

with a potential outcome that can have an enormous impact on reported financial

(7)

As with any confirmation, the letter of inquiry to the legal counsel must be

prepared and signed by the client but mailed by the audit firm. The confirmation

should direct the recipient to send all responses to the auditor who is attempting

to gain assurance about the existence, evaluation, and reporting of both asserted

(8)

The discovery and assessment of pending and threatened litigation has long

been an area of contention between the auditing and legal professions.

Traditionally, the independent auditor has looked to the client’s attorney for

information to help evaluate these contingent losses. The legal profession has

(9)

Related party transactions will always concern independent auditors because of

the difficulty in distinguishing the economic substance of the transaction from its

legal form. To obtain evidence that all related party transactions have been

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(10) and (11)

In order to arrive at an estimation of the product warranty expense for 2009, the

auditors must certainly look at the past history of the company as mentioned in

this case. A schedule can be determined from the information given of the

expense incurred during the previous months. However, the auditors cannot be

satisfied with that evidence alone. Abernethy and Chapman should look for

The auditors should also look for other changes that are occurring that might

have an impact on this estimation. Some products, as an example, might be

more likely to break. If so, the auditors should determine if sales of those items

Changes at Cypress Products can also impact the product warranty. If Cypress

has recently begun to stress quality in its production, repairs may be reduced;

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SUGGESTED ANSWERS TO EXERCISES

(1)

A good introduction to this question is to ask the students to give their

estimations of the accrued repair expenses as of December 31, 2012. A number

of different responses will probably be volunteered. The instructor can then ask

a few individuals to explain the logic used to derive their figures. This exercise

An additional factor in this case concerns the structuring of the data. Quite often,

the client will have accumulated information in a manner that is not relevant to

the needs of the auditor. Lakeside has classified its repair expense by the month

in which the item is returned while the auditors want to match the expense with

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LAKESIDE COMPANY W.P. No. M-4

Estimated Accrued Product Warranty Expense 2

12/31/12 Accountant: AH

Date: 2/2/13

A: Sales not under warranty

Historical Data 1/11 2/11 3/11 4/11 5/11 6/11 7/11 8/11 9/11 10/11 11/11 12/11

Sales for month 1064000

632000

718000

958000

972000

828000

742000

920000

884000

1066000

1172000

1600000

Repairs:

Month of Sales 386

274

354

444

294

122

512

568

420

584

938

1,010

1 month after 1,066

776

658

738

1,028

552

626

994

1,118

1,166

1,126

1,896

B: Sales still under warranty

Historical Data Cont. 1/12 2/12 3/12 4/12 5/12 6/12 7/12 8/12 9/12 10/12 11/12 12/12

Sales for month 1221000

762000

692000

1114000

1180000

818000

844000

1100000

1022000

1205000

1284000

1748000

Repairs:

Month of Sales 646

672

468

670

842

736

1,198

502

554

440

846

1,008

1 month after 1,938

732

702

1,340

1,472

884

674

1,504

1,476

1,538

1,570

Repair expense as a

Audit Objectives:

To estimate the accrued product warranty expense as of Dec. 31, 2012.

Scope:

All sales and returns for warranty claims for 2011 and 2012.

Audit Procedures:

Comments:

A Historical data for the months from January 2011 to June 2012 (18 months) are being used

to develop an estimate of monthly repairs expense. This estimate will be applied to the last six

months sales of 2012 to determine the year-end accrual.

During the 18-month test period, repair expenses showed a gradual increase from 0.72% to

Proposed Adjustment

220-1 Accrued Expenses Payable 49,350

(2)

This question has been included to emphasize the audit report as the end

product of the auditor’s work. As this text has been an exploration of the attest

function rather than a full-scale audit, determination of an appropriate opinion for

2012 is not feasible. Presented below are two possible conclusions for this case.

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UNQUALIFIED OPINION

INDEPENDENT AUDITOR’S REPORT

We have audited the accompanying balance sheet of the Lakeside

Company as of December 31, 2012, and the related statements of income,

retained earnings, and cash flows for the year then ended. These financial

potential impairment of value for one of Lakeside’s stores.

We conducted our audit in accordance with auditing standards

generally accepted in the United States of America. Those standards require

that we plan and perform the audit to obtain reasonable assurance about

whether the financial statements are free of material misstatement. An audit

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QUALIFIED OPINION