Audit Planning and Analytical Procedures: Review Questions 8-1

Chapter 8
Audit Planning and Analytical Procedures
Review Questions
8-1
There are three primary benefits from planning audits: it helps the auditor
obtain sufficient competent evidence for the circumstances, helps keep audit
costs reasonable, and helps avoid misunderstandings with the client.
8-2
Eight major steps in planning audits are:

1.
2.
3.
4.
5.
6.
7.
8.
Accept client and perform initial planning

Understand the clients business and industry
Assess client business risk
Perform preliminary analytical procedures
Set materiality, and assess acceptable audit risk and inherent risk
Understand internal control and assess control risk
Gather information to assess fraud risks
Develop overall audit plan and audit program
8-3
The new auditor (successor) is required by SAS 84 (AU 315) to
communicate with the predecessor auditor. This enables the successor to obtain
information about the client so that he or she may evaluate whether to accept the
engagement. Permission must be obtained from the client before communication
can be made because of the confidentiality requirement in the Code of
Professional Conduct. The predecessor is required to respond to the successors
request for information; however, the response may be limited to stating that no
information will be given. The successor auditor should be wary if the
predecessor is reluctant to provide information about the client.
8-4
Prior to accepting a client, the auditor should investigate the client. The
auditor should evaluate the clients standing in the business community, financial
stability, and relations with its previous CPA firm. The primary purpose of new
client investigation is to ascertain the integrity of the client and the possibility of
fraud. The auditor should be especially concerned with the possibility of
fraudulent financial reporting since it is difficult to uncover. The auditor does not
want to needlessly expose himself or herself to the possibility of a lawsuit for
failure to detect such fraud.
8-5
An engagement letter is an agreement between the CPA firm and the
client concerning the conduct of the audit and related services. It should state
what services will be provided, whether any restrictions will be imposed on the
auditors work, deadlines for completing the audit, and assistance to be provided
by client personnel. The engagement letter may also include the auditors fees. In
addition, the engagement letter informs the client that the auditor cannot
guarantee that all acts of fraud will be discovered.
8-1
8.6
Because the Sarbanes-Oxley Act of 2002 explicitly shifts responsibility for
hiring and firing of the auditor from management to the audit committee for public
companies, the audit committee is viewed as the client in those engagements.
8.7
All audit and non-audit services must be preapproved in advance by the
audit committee for public companies.
8.8
Auditors need an understanding of the clients business and industry
because the nature of the business and industry affect business risk and the risk
of material misstatements in the financial statements. Auditors use the
knowledge of these risks to determine the appropriate extent of audit evidence to
accumulate.
The five major aspects of understanding the clients business and industry,
along with potential sources of information that auditors commonly use for each
of the five areas are as follows:
1. Industry and External Environment Read industry trade publications,
AICPA Industry Audit Guides, and regulatory requirements.
2. Business Operations and Processes Tour the plant and offices,
identify related parties, and inquire of management.
3. Management and Governance Read the corporate charter and
bylaws, read minutes of board of directors and stockholders, and
inquire of management.
4. Client Objectives and Strategies Inquire of management regarding
their objectives for the reliability of financial reporting, effectiveness
and efficiency of operations, and compliance with laws and
regulations; read contracts and other legal documents, such as
those for notes and bonds payable, stock options, and pension
plans.
5. Measurement and Performance Read financial statements, perform
ratio analysis, and inquire of management about key performance
indicators that management uses to measure progress toward its
objectives.
8-9
During the course of the plant tour the CPA will remember that an
important aspect of the audit will be an effective analysis of the cost system.
Therefore, the auditor will observe the nature of the companys products, the
manufacturing facilities and processes, and the flow of materials so that the
information obtained can later be related to the functions of the cost system.
The nature of the companys products and the manufacturing facilities and
processes will reveal the features of the cost system that will require close audit
attention. For example, the audit of a company engaged in the custommanufacture of costly products such as yachts would require attention to the
correct charging of material and labor to specific jobs, whereas the allocation of
material and labor charges in the audit of a beverage-bottling plant would not be
verified on the same basis. The CPA will note the stages at which finished
products emerge and where additional materials must be added. He or she will
also be alert for points at which scrap is generated or spoilage occurs. The
auditor may find it advisable, after viewing the operations, to refer to auditing
literature for problems encountered and solved by other CPAs in similar audits.
8-9
(continued)
8-2
The auditors observation of the manufacturing processes will reveal

whether there is idle plant or machinery that may require disclosure in the
financial statements. Should the machinery appear to be old or poorly
maintained, the CPA might expect to find heavy expenditures in the accounts for
repairs and maintenance. On the other hand, if the auditor determines that the
company has recently installed new equipment or constructed a new building, he
or she will expect to find these new assets on the books.
In studying the flow of materials, the auditor will be alert for possible
problems that may arise in connection with the observation of the physical
inventory, and he or she may make preliminary estimates of audit staff
requirements. In this regard, the auditor will notice the various storage areas and
how the materials are stored. The auditor may also keep in mind for further
investigation any apparently obsolete inventory.
The auditors study of the flow of materials will disclose the points at which
various documents such as material requisitions arise. He or she will also meet
some of the key manufacturing personnel who may give the auditor an insight
into production problems and other matters such as excess or obsolete
materials, and scrap and spoilage. The auditor will be alert for the attitude of the
manufacturing personnel toward accounting controls. The CPA may make some
inquiries about the methods of production scheduling, timekeeping procedures
and whether work standards are employed. As a result of these observations, the
internal documents that relate to the flow of materials will be more meaningful as
accounting evidence.
The CPAs tour of the plant will give him or her an understanding of the
plant terminology that will enable the CPA to communicate fluently with the
clients personnel. The measures taken by the client to safeguard assets, such as
protection of inventory from fire or theft, will be an indication of the clients
attention to internal control measures. The location of the receiving and shipping
departments and the procedures in effect will bear upon the CPAs evaluation of
internal control. The auditors overall impression of the clients plant will suggest
the accuracy and adequacy of the accounting records that will be audited.
8-10 One type of information the auditor obtains in gaining knowledge about the
clients industry is the nature of the clients products, including the likelihood of
their technological obsolescence and future salability. This information is
essential in helping the auditor evaluate whether the clients inventory may be
obsolete or have a market value lower than cost.
8-11 A related party is defined in SAS 45 (AU 334) as an affiliated company,
principal owner of the client company, or any other party with which the client
deals where one of the parties can influence the management or operating
policies of the other.
Material related party transactions must be disclosed in the financial
statements by management. Therefore, the auditor must identify related parties
and make a reasonable effort to determine that all material related party
transactions have been properly disclosed in the financial statements.
8-3
8-12 Because of the lack of independence between the parties involved, the
Sarbanes-Oxley Act prohibits related party transactions that involve personal
loans to executives. It is now unlawful for any public company to provide
personal credit or loans to any director or executive officer of the company.
Banks or other financial institutions are permitted to make normal loans to their
directors and officers using market rates, such as residential mortgages.
8-13 In the audit of a client previously audited by a different CPA firm, it would
be necessary to obtain a copy of the corporate charter and bylaws for the
permanent files and to read these documents and prepare a summary abstract of
items to test for compliance. In an ongoing engagement, this work has been
performed in the past and is unnecessary each year. The auditors responsibility
is to determine what changes have been made during the current year and to
update and review the summary abstract prepared in previous years for
compliance.
8-14 The information in a mortgage that is likely to be relevant to the auditor
includes the following:
1. The parties to the agreement
2. The effective date of the agreement
3. The amounts included in the agreement
4. The repayment schedule required by the agreement
5. The definition and terms of default
6. Prepayment options and penalties specified in the agreement
7. Assets pledged or encumbered by the agreement
8. Liquidity restrictions imposed by the agreement
9. Purchase restrictions imposed by the agreement
10. Operating restrictions imposed by the agreement
11. Requirements for audit reports or other types of reports on compliance
with the agreement
12. The interest rate specified in the agreement
13. Any other requirements, limitations, or agreements specified in the
document
8-15 Information in the clients minutes that is likely to be relevant to the auditor
includes the following:
1. Declaration of dividends
2. Authorized compensation of officers
3. Acceptance of contracts and agreements
4. Authorization for the acquisition of property
5. Approval of mergers
6. Authorization of long-term loans
7. Approval to pledge securities
8. Authorization of individuals to sign checks
9. Reports on the progress of operations
It is important to read the minutes early in the engagement to identify items that
need to be followed up on as a part of conducting the audit. For instance, if a
long-term loan is authorized in the minutes, the auditor will want to make certain
that the loan is recorded as part of long-term liabilities.
8-4
8-16 The three categories of client objectives are (1) reliability of financial
reporting, (2) effectiveness and efficiency of operations, and (3) compliance with
laws and regulations. Each of these objectives affects the auditors assessment
of inherent risk and evidence accumulation as follows:
1.
2.
3.
Reliability of financial reporting If management sees the reliability

of financial reporting as an important objective, and if the auditor
can determine that the financial reporting system is accurate and
reliable, then the auditor can often reduce inherent risk and planned
evidence accumulation for material accounts. In contrast, if
management has little regard for the reliability of financial reporting,
the auditor must increase inherent risk assessments and gather
more evidence during the audit.
Effectiveness and efficiency of operations This area is of primary
concern to most clients. Auditors need knowledge about the
effectiveness and efficiency of a clients operations in order to
assess client business risk and inherent risk in the financial
statements. For example, if a client is experiencing inventory
management problems, this would most likely increase both the
auditors assessment of inherent risk for the planned evidence
accumulation for inventory.
Compliance with laws and regulations It is important for the
auditor to understand the laws and regulations that affect an audit
client, including significant contracts signed by the client. For
example, the provisions in a pension plan document would
significantly affect the auditors assessment of inherent risk and
evidence accumulation in the audit of unfunded liability for
pensions. If the client were in violation of the provisions of the
pension plan document, inherent risk and planned evidence for
pension-related accounts would increase.
8-17 The purpose of a clients performance measurement system is to measure

the clients progress toward specific objectives. Performance measurement
includes ratio analysis and benchmarking against key competitors.
Performance measurements for a chain of retail clothing stores could
include gross profit by product line, sales returns as a percentage of clothing
sales, and inventory turnover by product line. An Internet portals performance
measurements might include number of Web site hits or search engine speed. A
hotel chains performance measures include vacancy percentages and supply
cost per rented room.
8-18 Client business risk is the risk that the client will fail to achieve its
objectives. Sources of client business risk include any of the factors affecting the
client and its environment, including competitor performance, new technology,
industry conditions, and the regulatory environment. The auditors primary
concern when evaluating client business risk is the risk of material misstatements
in the financial statements due to client business risk. For example, if the clients
industry is experiencing a significant and unexpected downturn, client business
risk increases. This increase would most likely increase the risk of material
misstatements in the financial statements. The auditors assessment of the risk of
8-5
8-18 (continued)
material misstatements is then used to classify risks using the audit risk model to
determine the appropriate extent of audit evidence.
8-19 Management establishes the strategies and business processes followed
by a clients business. One top management control is managements
philosophy and operating style, including managements attitude toward the
importance of internal control. Other top management controls include a welldefined organizational structure, an effective board of directors, and an involved
and effective audit committee. If the board of directors is effective, this increases
managements ability to appropriately respond to risks. An effective audit
committee can help management reduce the likelihood of overly aggressive
accounting.
8-20 Analytical procedures are performed during the planning phase of an
engagement to assist the auditor in determining the nature, extent, and timing of
work to be performed. Preliminary analytical procedures also help the auditor
identify accounts and classes of transactions where misstatements are likely.
Comparisons that are useful when performing preliminary analytical procedures
include:
Compare client and industry data

Compare client data with similar prior period data
Compare client data with client-determined expected results
Compare client data with auditor-determined expected results
Compare client data with expected results, using nonfinancial data
8-21 Analytical procedures are required during two phases of the audit: (1)
during the planning phase to assist the auditor in determining the nature, extent,
and timing of work to be performed and (2) during the completion phase, as a
final review for material misstatements or financial problems. Analytical
procedures are also often done during the testing phase of the audit, but they are
not required in this phase.
8-22 Gordon could improve the quality of his analytical tests by:
1. Making internal comparisons to ratios of previous years.
2. In cases where the client has more than one branch in different
industries, computing the ratios for each branch and comparing
these to the industry ratios.
8-23 Roger Morris performs his ratio and trend analysis at the end of every
audit. By that time, the audit procedures are completed. If the analysis was done
at an interim date, the scope of the audit could be adjusted to compensate for the
findings. SAS 56 (AU 329) requires that analytical procedures be performed in
the planning phase of the audit and near the completion of the audit.
The use of ratio and trend analysis appears to give Roger Morris an
insight into his client's business and affords him an opportunity to provide
excellent business advice to his client.
8-6
8-24 The four categories of financial ratios and examples of ratios in each
category are as follows:
1.
2.
3.
4.
Short-term debt-paying ability Cash ratio, quick ratio, and current

ratio.
Liquidity activity Accounts receivable turnover, days to collect
receivables, inventory turnover, and days to sell inventory.
Ability to meet long-term debt obligations Debt to equity and times
interest earned.
Profitability Earnings per share, gross profit percent, profit margin,
return on assets, and return on common equity
Multiple Choice Questions From CPA Examinations
8-25 a.
(3)
b.
(2)
c.
(4)
8-26 a.
(1)
b.
(4)
c.
(2)
8-27 a.
(4)
b.
(1)
c.
(2)
d.
(4)
Discussion Questions And Problems
8.28
Generally, the first step in preparing to supervise and plan the field work
for an audit is to review and/or study current and background information
on the client and industry. The most important sources in this preparatory
stage are as follows:
1.
2.
3.
4.
5.
6.
7.
8.
Engagement letter
Audit permanent file
Last years audit files
Client correspondence files
Last years reports, including management letter and/or internal
control memorandum
Last years in-charge auditor
Industry and governmental publications
AICPA industry audit guides or firm audit guides
The purpose of this preparatory review and study is to become familiar with such
things as:
1.
2.
3.
4.
5.
The clients organizational structure, including key personnel.

Business activities and special problems of the client or industry in
general.
Recent financial data or other important activities such as new
security offerings or bond financing.
The clients records and procedures especially as they relate to
internal control.
Reports that are anticipated for this engagement.
8-7
8-28 (continued)
After the above review, you should make preliminary plans for the field
work. You need to determine what audit tests can be done on an interim basis
and what must be done on or after the balance-sheet date, including tests that
should be done on a surprise basis. You must plan for what work can be done by
the clients accounting and/or internal audit staff. You should also schedule
critical dates for such things as cash counts, inventory observations, and
confirmations. You should develop a detailed time budget and assign specific
areas of the audit to each staff member on the engagement. Additionally, you
should consider whether you need special expertise, e.g., a computer specialist.
You should prepare a preliminary draft of audit programs based on the
prior years assessment of internal control and any related current
correspondence, as well as suggestions in last years audit files. It is often
possible to use last years audit programs as a start with revisions for changed
conditions or desired audit emphasis then made.
If possible, visit the client to meet the appropriate officers and employees
and discuss arrangements for the engagement and to learn about any significant
changes in the nature of the business and related business risks.
After completing the preliminary preparation as outlined above, you should
schedule a conference with all staff members assigned to the audit. The agenda
would include a review of the engagement letter, brainstorming about possible
fraud risk areas including how management might engage in and conceal fraud,
discussion about the importance of professional skepticism, an estimate of the
scope of work, review of reports to be issued, review of the primary business
operations of the client, assignment of audit areas to the staff, and review of
specific problems or difficulties that are anticipated for this engagement. After this
meeting, it is important to assure that each staff member has adequate time to
review and prepare for his or her assigned audit area.
A final step is to make sure that the necessary supplies, permanent files,
and prior years audit files are carefully packed, downloaded, and prepared for
transport to the clients office. If there is still time before starting the work at the
clients office, you can assign staff to set up audit schedule analyses and lead
schedules.
8-29
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. FASB 57
concludes that related parties consist of all affiliates of an
enterprise, including (1) its management and their immediate
families, (2) its principal owners and their immediate families, (3)
investments accounted for by the equity method, (4) beneficial
employee trusts that are managed by the management of the
enterprise, and (5) any party that may, or does, deal with the
enterprise and has ownership, control, or significant influence over
the management or operating policies of another party to the extent
that an arms-length transaction may not be achieved.
When related party transactions or balances are material,
the following disclosures are required:
8-8
8-29 (continued)
1. The nature of the relationship or relationships.
2. A description of the transaction for the period reported on,
including amounts if any, and such other information deemed
necessary to obtain an understanding of the effect on the
financial statements.
3. The dollar volume of transactions and the effects of any change
in the method of establishing terms from those used in the
preceding period.
4. Amounts due from or to related parties, and if not otherwise
apparent, the terms and manner of settlement.
c.
d.
b.
Financial statements are used by people to make decisions
about the future. The presumption is that the nature of the
transactions and balances in the financial statement are likely to be
repeated in the future unless there is information to the contrary.
Related party transactions can be conducted on a basis other than
that which would normally happen with independent parties. That
may indicate that these transactions may be on more or less
favorable terms than can be expected to occur in the future. These
transactions may affect users decisions about a company, and
therefore are relevant for their decision making.
The most important related parties that are likely to be involved in
related party transactions involving management include relatives
of management or management itself, companies in which such
related parties have financial interests or dealings, significant
suppliers of materials and services, and customers.
Related party transactions that could take place in a company
include:
1.
e.
Lease of property by the company from a corporate officer

who owns the property.
2.
Acquisition of materials or merchandise by a company from
another company which is owned or managed by an officer
of the company or in which an officer of the company has a
financial interest.
3.
A company conducts a seminar at a facility that is owned or
managed by the family or friend of an officer or another
employee of the company.
4.
A company contracts with a food service to run the
companys cafeteria. An officer of the company has an
investment in the food service.
Auditors can determine the existence of material transactions with
related parties by performing the following procedures:
1.
Obtain background information about the client in the

manner discussed in this chapter to enhance understanding
of the clients industry and business; i.e., examine corporate
charter bylaws, minutes of board meetings, material
contracts, etc.
8-9
8-29 (continued)
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
Perform analytical procedures of the nature discussed in

Chapters 7 and 8 to evaluate the possibility of business
failure and assess areas where fraudulent financial reporting
is likely.
Review and understand the clients legal obligations in the
manner discussed in this chapter to become familiar with the
legal environment in which the client operates.
Review the information available in the audit files, such as
permanent files, audit programs, and the preceding years
audit documentation for the existence of material non-armslength transactions. Also discuss with tax and management
personnel assigned to the client their knowledge of
management involvement in material transactions.
Discuss the possibility of fraudulent financial reporting with
company counsel after obtaining permission to do so from
management.
When more than one CPA firm is involved in the audit,
exchange information with them about the nature of material
transactions and the possibility of fraudulent financial
reporting.
Investigate whether material transactions occur close to
year-end.
In all material transactions, evaluate whether the parties are
economically independent and have negotiated the
transaction on arms-length basis, and whether each
transaction was transacted for a valid business purpose.
Whenever there are material non-arms-length transactions,
each one should be evaluated to determine its nature and
the possibility of its being recorded at the improper amount.
The evaluation should consider whether the transaction was
transacted for a valid business purpose, was not unduly
complex, and was presented in conformity with its
substance.
When management is indebted to the company in a material
amount, evaluate whether management has the financial
ability to settle the obligation. If collateral for the obligation
exists, evaluate its acceptability and value.
Inspect entries in public records concerning the proper
recording of real property transactions and personal property
liens.
Make inquiries with related parties to determine the
possibility of inconsistencies between the clients and related
parties understanding and recording of transactions that
took place between them.
Inspect the records of the related party to a material
transaction that is recorded by the client in a questionable
manner.
8-10
8-29 (continued)
14.
f.
When an independent party, such as an attorney or bank, is

significantly involved in a material transaction, ascertain from
them their understanding of the nature and purpose of the
transaction.
For each of the non-arms-length transactions in part d. above, the

auditor can evaluate whether they are fraudulent, if he or she
knows the transactions exist, by:
1.
g.
8-30 a.
Comparing the terms of the lease to the terms in another

comparable situation to determine that the terms are fair to
the parties involved.
2.
Comparing the price paid or received and other
circumstances involved in the transaction to determine
whether or not the circumstances are comparable to those
available in the market.
3.
Receiving a rate quote from a similar facility for similar
service and comparing this to the amount paid by the
company.
4.
Receiving a quote from another company that would be
willing to provide a similar service to the company and
comparing this to the rate presently being paid by the
company.
The auditor must first evaluate the significance of inadequate
disclosure. Assuming it is material (highly material), the auditor
must issue a qualified (adverse) opinion for the failure to follow
generally accepted accounting principles. Disclosure of the facts
must be made in a separate paragraph.
First, the minutes of each meeting refer to the minutes of the
previous meeting. The auditor should also obtain the next years
minutes, probably for February 2006, to make sure the previous
minutes referred to were those from September 16, 2005.
Additionally, the auditor will request the client to include a
statement in the client representation letter stating that all minutes
were provided to the auditor.
8-11
8-30 (continued)
b.
INFORMATION RELEVANT
TO 2005 AUDIT
February 15:
1. Approval for increased
distribution costs of
$500,000
AUDIT ACTION REQUIRED

During analytical procedures, an increase of
$500,000 should be expected for distribution costs.
2.
Unresolved tax dispute.
Evaluate resolution of dispute and adequacy of

disclosure in the financial statements if this is a
material uncertainty.
3.
Computer equipment
donated.
Determine that old equipment was correctly treated in

2004 in the statements and that an appropriate
deduction was taken for donated equipment.
4.
Annual cash dividend.
5.
Officers bonuses.
Calculate total dividends and determine that

dividends were correctly recorded.
Determine whether bonuses were accrued at 12-3104 and were paid in 2005. Consider the tax
implications of unpaid bonuses to officers.
September 16:
1. 2005 officers elected.
Inform staff of possibility of related party transactions.
2.
Officers salary
information.
Note information in audit files for 2006 audit.
3.
Pension/profit sharing
plan.
Determine if the pension/profit sharing plan was

approved. If so, make sure all assets and liabilities
have been correctly recorded.
4.
Acquisition of new
computer system.
Determine that there is appropriate accounting

treatment of the disposal of the 1-year-old equipment.
Also trace the cash receipts to the journals and
evaluate correctness of the recording.
5.
Loan.
Examine supporting documentation of loan and make

sure all provisions noted in the minutes are
appropriately disclosed. Confirm loan information with
bank.
6.
Auditor selection.
Thank management for selecting your firm for the

2005 audit. If your firm has experience with pension
and profit sharing plans, ask management if there is
anything they need help with regarding their new
proposed plan.
8-12
8-30 (continued)
c.
8-31
The auditor should have obtained and read the February minutes,
before completing the 12-31-04 audit. Three items were especially
relevant and require follow-up for the 12-31-04 audit: unresolved
dispute with the IRS, replacement of computer equipment, and
approval for the 12-31-04 bonuses.
a.
The presidents salary is a significant item this year and
therefore should be included in the financial statements as
information that should be disclosed to the shareholders.
b.
Management is primarily responsible for financial statement

presentation. You have the responsibility of determining whether
the presidents salary, which is apparently material in amount, is
adequately disclosed in the financial statements. The presidents
salary would be adequately disclosed if it were shown as a
separate item in the income statement and if the increase in salary
were also readily apparent because of the use of comparative
statements. The presidents salary could be adequately disclosed
also by a footnote. Should the client object to the disclosure of the
presidents salary as a separate item in the income statement or as
a footnote, you would be compelled to decide whether to qualify
your opinion because the financial statements failed to disclose
information of material importance or to render an adverse opinion
because the financial statements are not fairly presented.
c.
1.
2.
You would be concerned with the fairness of the presentation of

the financial statements because of the need for disclosure, as
discussed in the preceding paragraph, and the possibility that a
portion of the salary of the president, who is a substantial
stockholder, may be deemed excessive by the IRS and treated
as a dividend instead of as a business expense. Tax authorities
may attach great significance to the fact that much of the
potential increase in profits was distributed in the form of salary.
You should have a discussion with the client to consider the
possibility of salary expense disallowance by the IRS. If you
believe that a disallowance may occur, you should recommend
an appropriate increase in the provision for income taxes or
footnote disclosure of the potential liability. If the client prefers
not to adopt either recommendation, you should decide whether
to qualify your opinion by taking exception to the failure to
disclose the potential income tax liability or to render an adverse
opinion because the financial statements are not a fair
presentation.
The consistency of the application of accounting principles has
not been disturbed by the use of a different basis for
determining the presidents salary. The change in the method of
computing the presidents salary is not grounds for a
consistency explanatory paragraph in your report because it is
not a change in accounting methods.
8-13
8-32
b.
a.
The use of analytical procedures in an audit has two general
advantages to a CPA: 1) a broad view is obtained of the data under
audit, and 2) attention is focused on exceptions or variations in the
data.
A broad view of the data under audit is needed by the CPA to
draw conclusions about the data as a wholesuch conclusions
cannot be drawn by merely looking at individual transactions. The
application of analytical procedures to obtain this broad view
requires a discerning analysis of the data, which results in overall
conclusions upon which the CPA's audit satisfaction rests. The CPA
is thus able to satisfy himself or herself as to the reasonableness,
validity, and consistency of the data in view of the surrounding
circumstances.
The focusing of the CPA's attention on exceptions or
variations in the data results in a more efficient and economical
audit because there is a reduction in the amount of detailed testing
which would be required, in the absence of overall checks, to
uncover these exceptions or variations. Furthermore, manipulations
of accounts may be revealed because the double-entry
bookkeeping system extends the effects of manipulations to
additional accounts, which will then bear a changed relationship to
other accounts.
In addition, managerial problems and trouble spots will be
highlighted for the CPA and may lead to the opportunity for the
auditor to be of additional service to his client.
The ratios that an auditor may compute during an audit as overall
checks on balance sheet accounts and related income accounts
may include the following:
1.
2.
3.
4.
5.
Accruals of individual expenses to related total expenses

(accrued interest/interest expense, accrued payroll/salaries
and wages)
Accounts payable to purchases (days of purchases
outstanding)
Long-term debt and interest expense thereon
Return on equity (relationship of net income to owners'
equity)
Return on investments (relationship of investment income to
investments).
c.
1.
The possible reasons for a decrease in the rate of inventory

turnover include the following:
(a)
Decline in sales
(b)
Increase in inventory quantities, intentional or
unintentional
(c)
Incorrect computation of inventory because of errors
in pricing, extensions, or taking of physical inventory
(d)
Inclusion in inventory of slow-moving or obsolete
items
(e)
Erroneous cutoff of purchases
8-14
8-32 (continued)
(f)
2.
8-33
Erroneous cutoff of sales in a perpetual inventory

system
(g)
Unrecorded purchases
(h)
Change in inventory valuation method.
The possible reasons for an increase in the number of days'
sales in receivables including the following:
(a)
Change in credit terms
(b)
Decreasing sales
(c)
Change in the sales mix of products with different
sales terms
(d)
Change in mix of customers
(e)
Improper sales cutoff
(f)
Unrecorded sales
(g)
Lapping
(h)
Slower collections caused by tighter economic
conditions or lowering of the quality of the
receivables.
a.
Gross margin percentage for drug and nondrug sales is as
follows:
2005
2004
2003
2002
b.
DRUGS
NONDRUGS
40.6%
42.2%
42.1%
42.3%
32.0%
32.0%
31.9%
31.8%
The explanation given by Adams is correct in part, but appears to

be overstated. The gross margin percentage for nondrugs is
approximately consistent. For drugs, the percent dropped
significantly in the current year, far more than industry declines. The
percent had been extremely stable before 2005. In dollars, the
difference is approximately $82,000 (42.2% - 40.6% x $5,126,000)
which appears to be significant. Of course, the decline in Jones'
prices may be greater than the industry due to exceptional
competition.
As the auditor, you cannot accept Adams' explanation if $82,000 is
material. The decline in gross margin could be due to an
understatement of drug inventory, a theft of drug inventory, or
understated sales. Further investigation is required to determine if
the decline is due to competitive factors or to a misstatement of
income.
8-34 a.
1.
Commission expense could be overstated during the current

year or could have been understated during each of the past
several years. Or, sales may have been understated during
the current year or could have been overstated in each of
the past several years.
8-15
8.34(continued)
2.
3.
4.
5.
6.
Obsolete or unsalable inventory may be present and may

require markdown to the lower of cost or market.
Especially when combined with 2 above, there is a high
likelihood that obsolete or unsalable inventory may be
present. Inventory appears to be maintained at a higher level
than is necessary for the company.
Collection of accounts receivable appears to be a problem.
Additional provision for uncollectible accounts may be
necessary.
Especially when combined with 4 above, the allowance for
uncollectible accounts may be understated.
Depreciation expenses may be understated for the year.
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 to the commission expense for that year. For
whichever year appears to be out of line, select a sample of
individual sales and recompute the commission, comparing it to the
commission recorded.
ITEMS 2 AND 3 - Select a sample of the larger inventory items (by
dollar value) and have the client schedule subsequent transactions
affecting these items. Note the ability of the company to sell the
items and the selling prices obtained by the client. For any items
that the client is selling below cost plus a reasonable markup to
cover selling expenses, or for items that the client has been unable
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
receivable and have the client schedule subsequent payments and
credits for each of these accounts. For the larger accounts that
show no substantial payments, examine credit reports and recent
financial statements to determine the customers' ability to pay.
Discuss each account for which substantial payment has not been
received with the credit manager and determine the need for
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.
If they indicate that the change resulted from a preponderance of
fully depreciated assets, test the detail records to determine that
the explanation is reasonable. If no satisfactory explanation is
given, expand the tests of depreciation until satisfied that the
provision is reasonable for the year.
8-16
8-35
RATIO
NUMBER
NEED FOR
INVESTIGATION
REASON FOR
INVESTIGATION
NATURE OF
INVESTIGATION
1.
Yes
Current ratio has

decreased from previous
year and is significantly
lower than the industry
averages. This could
indicate a shortage of
working capital required
for competition in this
industry.
Obtain explanation for

the decrease in
current ratio and
investigate the effect
on the company's
ability to operate,
obtain needed
financing, and meet
the requirements of its
debt agreements.
2.
Yes
An 11-2/3% increase in
the amount of time
required to collect
receivables provides less
cash with which to pay
bills. This change could
represent a change in
the collection policy,
which could have a
significant effect on the
company in the future. It
may also indicate that a
larger allowance for
uncollectible accounts
may be needed if
accounts receivable are
less collectible than in
2004.
Determine the cause

of the change in the
time to collect and
evaluate the long-term
effect on the
company's ability to
collect receivables
and pay its bills. The
difference between
the company's and
the industry's days to
collect could indicate
a more strict credit
policy for the
company. The
investigation of this
possibility could
indicate that the
company is forfeiting a
large number of sales
and lead to a
recommendation for a
more lenient credit
policy.
3.
Yes
The difference in the

company's days to sell
and the industry is
significant. This could
indicate that the
company is operating
with too low an inventory
level causing stock-outs
and customer
dissatisfaction. In the
long term, this could
have a significant
adverse effect on the
company.
Investigate the
reasons for the
difference in the days
to sell between the
company and the
industry. Determine
the effect on the
company in terms of
customer
dissatisfaction and
lost customers due to
stock-outs or long
waits for delivery.
8-17
8-35 (continued)
RATIO
NUMBER
NEED FOR
INVESTIGATION
REASON FOR
INVESTIGATION
4.
No
N/A
N/A
5.
Yes
The industry average

increased almost 10%
indicating that the
industry is building
inventories either
intentionally to fill an
increased demand or
unintentionally due to
decreased demand and
inability to dispose of
inventory (as indicated
further by significant
decrease in the industry
gross profit percent - see
8 below).
Investigate the market

demand for the
company's product to
determine if a
significant disposal
problem may exist.
There may be a net
realizable value
problem due to these
conditions.
6.
No
N/A
N/A
7.
No
N/A
N/A
8.
Yes
The company appears to

have raised prices during
the past year to achieve
the gross profit % of the
industry. However, it
appears that the
industry's gross profit %
has been reduced from
either increased cost of
goods which could not
be passed on to
customers in price
increases or reduction in
selling prices from
competition, decreased
demand for product, or
overproduction. The
result of these changes
could be significant to
the company's ability to
produce a profit on its
operations.
Determine the reason

for the change in the
industry's gross profit
percent and the effect
this might have on the
company.
9.
No
N/A
N/A
c.
NATURE OF
INVESTIGATION
Mahogany Products operations differ significantly from the industry.

Mahogany has operated in the past with higher turnover of
inventory and receivables by selling at a lower gross margin and
lower operating earnings. However, the company has changed
significantly during the past year. The days to convert inventory to
8-35 (continued)
8-18
cash have increased 7% (11 days), while the current ratio has
decreased by 15%. The company was able to increase its gross
margin percent during the year when the industry was experiencing
a significant decline in gross margin.
8-36
a.
The company's financial position is deteriorating significantly.
The company's ability to pay its bills is marginal (quick ratio = 0.97)
and its ability to generate cash is weak (days to convert inventory to
cash = 266.7 in 2005 versus 173.8 in 2001). The earnings per
share figure is misleading because it appears stable while the ratio
of net income to common equity has been halved in two years. The
accounts receivable may contain a significant amount of
uncollectible accounts (accounts receivable turnover reduced 25%
in four years), and the inventory may have a significant amount of
unsalable goods included therein (inventory turnover reduced 40%
in four years). The company's burden for increased inventory and
accounts receivable levels has required additional borrowings. The
company may experience problems in paying its operating liabilities
and required debt repayments in the near future.
b.
ADDITIONAL
INFORMATION
REASON FOR ADDITIONAL INFORMATION
1.
Debt repayment
requirements, lease
payment
requirements, and
preferred dividend
requirements
To project the cash requirements for the next several years

in order to estimate the company's ability to meet its
obligations.
2.
Debt to equity ratio
To see the company's capital investment and

ability of the company to exist on its present investment.
3.
Industry average ratios
To compare the company's ratios to those of the average

company in its industry to identify possible problem areas
in the company.
4.
Aging of accounts
receivable, bad debt
history, and analysis of
allowance for
uncollectible accounts
To see the collection potential and experience in accounts

receivable. To compare the allowance for uncollectible
accounts to the collection experience and determine the
reasonableness of the allowance.
8-19
8-36 (continued)
ADDITIONAL
INFORMATION
REASON FOR ADDITIONAL INFORMATION
5.
Aging of inventory and

history of markdown
taken
To compare the age of the inventory to the markdown

experience since the turnover has decreased significantly.
To evaluate the net realizable value of the inventory.
6.
Short- and long-term

liquidity trend ratios
To indicate whether the company may have liquidity

problems within the next five years.
c.
Based on the ratios shown, the following aspects of the
company should receive special emphasis in the audit:
1.
2.
3.
4.
Ability of the company to continue to acquire inventory,

replace obsolete or worn-out fixed assets, and meet its debt
obligations based on its current cash position.
Reasonableness of the allowance for uncollectible accounts
based on the reduction in accounts receivable turnover and
increase in days to collect receivables.
Reasonableness of the inventory valuation based on the
decreased inventory turnover and increased days to sell
inventory.
Computation of the earnings per share figure. It appears
inconsistent that earnings per share could remain relatively
stable when net earnings divided by common equity has
decreased by 50%. This could be due to additional stock
offerings during the period, or a stock split.
8-37
a. The Toys R Us decision to sell toys and other products through its
Web site may be related to any of these possible business
strategies:
Match Competition. Because other toy retailers may be

offering products through the Internet, Toys R Us may have
decided that it needed to also offer products online to match
their competition and meet consumer expectations in the
marketplace.
Target New Markets. By offering products to consumers

through its Web site, Toys R Us may be able to expand its
market to consumers in geographic areas not having a Toys
R Us retail store. Consumers throughout regions of the
country and world can now order products without visiting a
Toys R Us store.
8-20
8-37 (continued)
Enhance New Economy Image. Management may be

using the offering of products through its Web site to signal
that Toys R Us embraces the new e-commerce economy
and is a technology leader in the toy retail industry. The
online sales offering may provide a signal that the company
intends to be a competitive player in both traditional and ecommerce markets.
b. Examples of business risks associated with the Toys R Us decision to

offer online product sales may include the following:
Insufficient Capacity to Handle Demand. If demand for

products through the Toys R Us Web site exceeds
expectations, internal systems and personnel may not be
able to handle the volume of orders in a timely fashion. The
time it takes for inventory warehousing and distribution
processes for online sales may be greater than expected
given that single orders must be individually handled. In
contrast, shipments made to retail outlets are often
processed in bulk.
Inadequate Accounting System Interface. The offering of

sales online requires the design and implementation of new
Internet-based accounting systems that must capture,
process, and record online transactions. Those transactions
must be integrated with traditional sales transactions into the
Toys R Us accounting records and financial statements.
Those systems may not be adequately designed for timely
and accurate interface.
Consumer Privacy. Given that online consumers will be

providing confidential personal information, including credit
card data, the Toys R Us system must be designed to
protect consumer privacy during transmission and
processing of orders. Breaches in consumer privacy may
affect future demand for online sales and may increase legal
exposure to the company.
Security. Toys R Us may be exposing its internal

accounting and other IT systems to security breaches.
Consumers will be accessing the company Web site and
related databases that interface with existing internal
systems. Adequate protection, such as firewalls, is needed
to protect company systems from infiltration.
c. The decision by Toys R Us to partner with Amazon.com to handle
online sales may provide these advantages:
Link
With
Established
E-commerce
Participant.
Amazon.coms core business strategy involves the offering
of products through the Internet directly to consumers. As a
result, Amazon.com represents one of the more experienced
8-21
8-37 (continued)
market participants in the online sales marketplace.

Partnering with Amazon.com allows Toys R Us to take
advantage of that experience and already established
systems, which shortens the learning curve for Toys R Us
management.
Capture
Amazon.com
Customers.
Partnering
with
Amazon.com may lead to increased sales opportunities. As
Amazon.com customers visit the Amazon.com Web site,
they may also make decisions to purchase toys and other
products from Toys R Us.
Increase Consumer Confidence in Web Site Portal. Given
Amazon.coms reputation in the e-commerce marketplace,
consumers may be more confident transacting business with
Toys R Us, given its partnering with Amazon.com.
Concerns about consumer privacy may be diminished when
customers realize that Toys R Us is offering online sales
processing through a known, reputable e-commerce vendor.
d. Each of the business risks identified in b may lead to an increased

risk of material misstatements in the financial statements, if not
effectively managed.
Insufficient Capacity to Handle Demand. If demand for

products through the Toys R Us Web site exceeds the
companys ability to process orders in a timely fashion,
consumers may cancel earlier recorded orders or request
returns when delivery occurs well beyond the expected
delivery date. The accounting systems must be designed to
accurately reflect cancellations and returns in a timely
fashion consistent with GAAP. Additionally, if the processing
of orders is significantly delayed, the accounting systems
must be adequately designed to ensure sales are not
recorded prematurely (e.g., not until delivery).
Inadequate Accounting System Interface. If the online sales

system interface with the main accounting system is
inadequate, online sales may (1) not be processed, (2) be
processed more than once, or (3) be processed inaccurately.
Any of these risks could lead to material misstatements in
the financial statements.
Consumer Privacy. If consumer privacy is breached, existing

sales may be cancelled or returns beyond the normal period
may be requested. Such activity would need to be properly
reflected in the financial statements. Additionally, legal
exposures may increase, which may require additional
financial statement disclosures.
Security. Unauthorized access to other Toys R Us systems

and databases may introduce unintentional and intentional
misstatements into the accounting records. If unauthorized
access is not restricted, material misstatements in financial
statements may result.
8-22
Cases
8-38 This case illustrates the common problem of an audit partner having to
allocate his scarcest resourcehis time. In this case, Winston Black neglects a
new client for an existing one and causes himself several serious problems.
a.
AU 161 incorporates the AICPAs statement of quality control
standards governing an audit practice into GAAS. One of the
quality control standards requires that firms maintain client
acceptance procedures. Henson, Davis has such a policy; however,
whatever enforcement mechanism for compliance with it must not
be sufficient, as McMullan Resources was accepted without the
procedures being completed. More to the point, AU 315 makes the
importance of adequate communication by a successor auditor with
the predecessor auditor abundantly clear. In this case, Sarah Beale
initiated a communication, but then left it incomplete when the
predecessor auditor did not return her call. She rationalized this
away by accepting representations from the new client. Of course,
the predecessor auditor may be able to offer information that
conflicts with the new clients best interest. It is not appropriate or in
accordance with auditing standards to consider managements
representations in lieu of a direct communication with the
predecessor auditor. The client should not have been accepted until
a sufficient communication occurred.
Can this be remedied? Yes and no. While SAS 84 (AU 315)
requires communication with the predecessor auditor before
accepting the engagement, a communication with the predecessor
auditor should be conducted now, presumably by Black. However, if
alarming information were obtained, Henson, Davis would find itself
in the awkward position of having accepted a client it might not
want. In that case, if it decides to withdraw from the engagement, it
may be breaching a contractual obligation. If it continues, it may be
taking an unwanted level of business and/or audit risk.
A related implication is the wisdom of Blacks assumption
about Beales competence and how that affects her performance on
the engagement. Black relied on Beale extensively, yet Beales
performance on the new client acceptance was deficient. Does this
mean that Beales performance in other areas was deficient as
well? Certainly, Black can do a thorough review of Beales work, but
review may or may not reveal all engagement deficiencies.
Blacks handling of this engagement also implies something
about his attitude and objectivity. This was an initial engagement,
yet he delegated almost all responsibility up to final review to Beale.
He got credit for bringing in the new client, which directly benefited
him in terms of his compensation. It would be against his best
interest to not accept (withdraw from) this client. If he is unwilling to
do the right thing here, how will he handle other difficult audit
problems?
8-23
8.38(continued)
b.
In the audit of long-term contracts, it is essential to obtain assurance

that the contract is enforceable so that income can be recognized
on the percentage-of-completion basis. It is also important to
consider other aspects of the contract that relate to various
accounting aspects, such as price and other terms, cancellation
privileges, penalties, and contingencies. In this case, Beale has
concluded that the signed contract, written in French, is McMullans
standard contract, based on client representation. Of course,
auditing standards require that managements representations, a
weak form of evidence, be corroborated with other evidence where
possible. Beale might argue that the confirmation obtained
constitutes such evidence.
Beales argument may seem logical with regard to
enforcement, however, the confirmation form refers to existing
disputes. It says nothing about contractual clauses that may
foreshadow enforceability. For that reason the audit program
requires the contract to be read. How would an auditor know
whether the contract form was that of a standard contract without
reading it? Furthermore, it may be unrealistic to assume there is
such a thing as a standard contract in the first place. Long-term
and short-term contracts are the result of negotiation and often
contain special clauses and changed language.
In this case, not reading the contract was an insufficiency
and the French-language copy should be translated by an
independent translator and read by the auditors.
c.
Compliance with GAAS is a matter that is always subject to
professional judgment. One professional auditor may conclude he
or she has complied with GAAS, and another would conclude that
GAAS has been violated, so these matters are very seldom clear
cut. However, in this case, it appears that Black and Beale may
have violated GAAS in the following ways:
Standard of Field Work No. 1 - The work is to be adequately
planned and assistants, if any, are to be properly supervised. The
requirements of AU 315, discussed above, relate to this standard.
More generally, the audit partner should participate in planning, at
least with a timely review. This would be more important than
otherwise in the situation of a first-time engagement, as we have
here. Similarly, some level of on-going partner supervision would
seem prudent and logical. Black, apparently, did not really
participate at all until final review.
Standard of Field Work No. 3 - Sufficient competent evidential
matter is to be obtained through inspection, observation, inquiries,
and confirmations to afford a reasonable basis for an opinion
regarding the financial statements under audit. As discussed above,
the work on the Montreal contract was deficient and further
evidence is required.
8-24
8-38 (continued)
In addition, whenever the field work standards are violated
there are implied violations of other standards. It might be argued
that Beale was not proficient as an auditor because of her failures
with the new client acceptance procedures and the Montreal
contract. Similarly, it might be argued that due professional care
was not taken both by Beale and by Black for delegating so much
to Beale.
8-39
When the computer option is assigned, an Excel spreadsheet (Filename
P839.xls) is used to compute a set of ratios as would be done manually (as
shown below.) Five specific aspects of using the computer in doing this are
discussed below. The first applies to both the manual and the computer
approach.
1. Computation of ratios. The selection of ratios is arbitrary and should
include a set that gives a good overview of all aspects of the
company's financial statements that the user is interested in. And,
in computing specific ratios, certain decisions must be made, such
as whether to use net sales or gross sales. The formulas for the
ratios selected for this solution are shown below. Note: where
possible, the solution uses average balances (inventory and
accounts receivable, for example) when required by the ratio
formulas. Since 2001 balances are not available for computing
2002 average inventory and receivables, the solution does not
calculate average inventory and calculate average inventory and
accounts receivable turnover ratios for 2002.
Quick ratio = (cash + accounts receivable - allowance for doubtful
accounts) / current liabilities
Gross margin/sales = gross margin / gross sales
Average inventory turnover = (cost of goods sold) / average
inventory
Current ratio = Current assets / current liabilities
Average days to collect receivables = (average accounts receivable
x 360) / (net sales)
Net income/total assets = (self-explanatory)
Net income/sales = net income / gross sales
Sales/equity = Gross sales / equity
Debt/equity = (total liabilities) / total equity
8-25
8-39 (continued)
Net income/equity = (self-explanatory)
Allowance for doubtful accounts / accounts receivable = (self
explanatory)
Bad debts/sales = bad debts / gross sales
Sales returns and allowances/sales = sales returns and
allowances/gross sales
2.
Set-up. Excel spreadsheets must be planned in advance.
This can be referred to as "set-up." A useful technique is to use a
block diagram to plan the set-up. This helps see the overall shape
and content of the spreadsheet and is helpful for guiding its detailed
preparation and how outputs will be controlled and formatted. A
block diagram for this spreadsheet follows. It shows the
spreadsheet divided into three sections: the heading, the input
section, where data will be entered, and the results section where
the ratios will be calculated. A vertical structure is used to facilitate
printouts that will fit in an 8-1/2 x 14 inch format. The structure could
just as easily be side-by-side.
8-26
8-39 (continued)
A1
G2
A5
Rows
for
account
Columns for years 05-02
Amounts
headings
G43
A47
Columns for years 05-02

Rows
for
various
ratios
Formulas for
ratios
G71
3.
Check on accuracy of inputs. A major concern is knowing

that input data has been entered accurately. This can usually
be achieved by two alternative procedures. The first is
computing totals and comparing them to check figures. For
example, the details of assets can be computed and added
to 100. The second procedure is verification of details on a
figure-by-figure basis back to the source.
8.39(continued)
8-27
4.
Treatment of negative values. Negative values can be entered as

negative inputs or positive inputs. It is important to respond properly
to the treatment used when the values are included in
computations.
Check on accuracy of formulas. One of the biggest problems with
using spreadsheets is errors in the development of formulas. One
use of each formula should be done manually to check its
correctness and the formulas should receive a careful second party
review. If this second step is impractical, a second party should at
least review the results for reasonableness.
Templates for the computer solutions prepared using Excel
are included on the Companion Website and on the Instructors
Resource CD-ROM, which is available upon request.
5.
Solomon Bros. Manufacturing Co.

Analytical Procedures
Calculated from
adjusted year-end balances
KEY RATIOS
Quick
2005
2004
2003
2002
.96
.83
.81
.74
21.0%
22.1%
23.2%
25.0%
Average inventory turnover
1.79
1.82
1.93
NA
Current
2.19
1.96
1.91
1.75
Average days to collect

receivables
131.10
123.94
116.06
NA
Net income/total assets
3.9%
3.9%
3.9%
4.3%
Net income/sales
5.0%
5.2%
5.3%
6.1%
Sales/equity
3.89:1
4.37:1
4.88:1
5.27:1
Debt/equity
4.02:1
4.82:1
5.64:1
6.42:1
.19:1
.23:1
.26:1
.32:1
10.6%
11.5%
12.5%
14.8%
Bad debts/sales
3.7%
4.0%
4.1%
4.6%
Sales returns and

allowances/gross sales
3.1%
3.0%
3.0%
2.9%
Gross margin/sales
Net income/equity
Allowance for doubtful
accounts/accounts receivable
8-39 (continued)
8-28
The Solomon brothers are considering going public to expand the

business at a time that land and building costs in Boston are at extremely
inflated values. Presently gross profit margins are 21% of sales and net
income is 5% of sales. Both ratios decreased during the past year. To
finance expansion, additional debt is out of the question because longterm debt is presently extremely high (debt to equity ratio is 4.02).
Depreciation on new plant and equipment at the inflated prices will cause
high depreciation charges, which may significantly reduce the profit
margins.
b.
The account that is of the greatest concern is allowance for

uncollectible accounts. The following are three key analytical
procedures indicating a possible misstatement of allowance for
uncollectible accounts:
1.
Breakdown of the
aging in percent
0 - 30 days
31 - 60 days
61 - 120 days
over 120 days
2.
3.
Allowance/accounts
receivable
Bad debts/sales
2005
2004
2003
2002
39.8%
33.5%
19.1%
7.6%
100.0%
42.1%
33.3%
17.6%
7.0%
100.0%
46.0%
32.0%
16.0%
6.0%
100.0%
49.9%
30.1%
15.0%
5.0%
100.0%
10.6%
3.7%
11.5%
4.0%
12.5%
4.1%
14.8%
4.6%
It appears that the allowance is understated:

1.
2.
3.
If accounts were as collectible as before, allowance/accounts

receivable should be about constant.
If accounts become less collectible, allowance/accounts receivable
should increase.
Number 2 seems to be the case.
The aging of accounts receivable shows a deterioration in the overall

aging (0-30 decreased significantly in the past several years, while those
in all other categories increased), while the allowance for uncollectible
accounts as a percentage of accounts receivable has decreased from
14.8% to 10.6%. This indicates that the allowance for uncollectible
accounts may be understated, especially considering the trend between
2002 and 2004.
Accounts Receivable.
The average days to collect receivables has increased steadily over the
four-year period, which indicates that some accounts may not be
collectible. This idea is supported by the deterioration in overall aging
noted above.
8-39 (continued)
8-29
Sales.
Finally, gross margin as a percentage of sales has declined steadily over
the four-year period from 25% to 21%. Net Income/Sales has also
declined. The auditor should seek an explanation from the client for these
trends.
Integrated Case Application
8-40
PINNACLE MANUFACTURINGPART I
a.
Amounts (in thousands)
2004
2003
44,497
36,196
25,926
17,605
1.72
2.06
2002
36,005
16,341
2.20
47,161
55,826
84.5%
37,033
52,759
70.2%
35,801
50,873
70.4%
4,274
149,245
2.9%
3,870
137,580
2.8%
2,660
125,814
2.1%
Gross margin percent Gross profit

Sales
44,437
149,245
29.8%
40,984
137,579
29.8%
37,129
125,814
29.5%
Inventory turnover
104,808
25,119
4.2
96,596
22,091
4.4
88,685
21,975
4.0
Ratios
Current ratio
Current assets
Current liabilities
Debt to equity
Debt
Equity
Net income bt/sales
Net Income BT
Sales
Cost of goods sold

Average inventory
b. There is a low risk that Pinnacle will fail financially in the next twelve
months. The company has been profitable the past three years, is
generating significant cash flows and most of the ratios indicate no
financial difficulties. The current ratio and debt to equity have deteriorated
somewhat, but not enough to cause significant concerns.
c. See page 8-33 for Pinnacles common-size income statement. For the
overall financial statements, the focus is on all accounts except direct
expenses. For the direct expenses, it is better to use the disaggregated
information. The suggested solution was prepared using Excel (Filename
P840.xls).
8-30
8-40 (continued)
Account Balance
Property taxes
Estimate of $ Amount of Potential Misstatement

Decrease of $140,000 when property increased
Bad debts
See requirement f for an analysis
Depreciation expense Increase of $1.2 million, perhaps partly due to new

building and equipment purchases
Federal Income Taxes FIT as a % of NIBT was 36% in 2003.
36% of 2004 NIBT is $1.539 million. Actual FIT for
2004 was $1.014 million. Difference of $525,000.
Interest expense
Short-term plus long-term interest bearing debt

increased by 25%, from $27.3 million to $34. 1 million,
but interest expense decreased. If interest rates have
not changed, interest expense would be expected to
increase by a similar amount to $2,661,000
($2,129,00 x 1.25). Potential misstatement of
$764,000 ($2,661,000 - $1,897,000).
d. See pages 8-34 to 8-36 for common-size income statement for each of
Pinnacles three divisions. The suggested solution was prepared using Excel
(Filename P840.xls). For disaggregated information it is best to ignore the
allocated expenses.
Account Balance
Solar Electro:
Payroll benefits
Estimate of $ Amount of Potential Misstatement

Increased almost $100,000 without a similar sized
increase in salary and wages. Payroll benefits in
Welburn decreased while salary and wages increased
in this division. Potential misallocation between
divisions.
Legal Service
Large increase may be indicative of other issues

affecting disclosures and asset or liability valuation.
Miscellaneous
$200,000 increase needs investigation.
Welburn
$120,000 increase in warehouse rent

even though there is no evidence of any change in
facilities.
e. Both the companywide and the divisional income statements are useful, but
for different purposes. The companywide information is useful for identifying
material fluctuations in the financial statements. However, the disaggregated
information is more helpful in identifying the source of the fluctuations.
8-31
8-40 (continued)
f.
Estimate of Potential Understatement in Allowance
2004
2003
2002
149,245
137,580
125,814
9,247
7,888
7,582
16.1
17.4
16.6
365
365
365
Turnover
16.1
17.4
16.6
Days
22.6
20.9
22.0
699
699
682
10,300
8,194
7,582
6.8%
8.5%
9.0%
A/R Turnover
Sales
Average accounts receivable
Turnover
Days Sales Outstanding
365
Allowance as a Percentage of Gross Receivables

Allowance
Gross Receivables
Percentage
Potential understatement in allowance
9.5% Estimate based on decrease in turnover
10,300
Suggested percent
Gross accounts receivable
Suggested allowance
979
Actual Allowance
699
Potential understatement
280
8-32
8-40 (continued)
(part of requirement c)
Pinnacle Manufacturing Company
Income Statement - All Divisions
For the Year Ended December 31
Sales
Sales Returns and Allowances
Cost of Sales*
Gross Profit
OPERATING EXPENSES-Allocated
Salaries-Management
Salaries-Office
Licensing and certification fees
Security
Insurance
Medical benefits
Advertising
Business publications
Property taxes
Bad debts
Depreciation expense
Accounting fees
Total operating expenses-Allocated
OPERATING EXPENSES-Direct
Salaries-Sales
Wages Rental
Wages-Mechanics
Wages-Warehouse
Garbage collection
Payroll benefits
Rent- Warehouse
Telephone
Utilities
Postage
Linen service
Repairs and maintenance
Cleaning service
Legal service
Fuel
Travel and entertainment
Pension expense
Office supplies
Miscellaneous
Total operating expenses-Direct
Total Operating Expenses
Operating Income
Other Expense-Interest
Income Before Taxes
Federal Income Taxes
Net Income
2004
Dollar Value
149,424,646
179,470
104,807,966
44,437,210
2004
% of Sales
100.00%
0.12%
70.14%
29.74%
2003
Dollar Value
137,741,766
162,102
96,595,908
40,983,756
2003
% of Sales
100.00%
0.12%
70.13%
29.75%
2002
Dollar Value
125,982,294
168,022
88,685,361
37,128,911
2002
% of Sales
100.00%
0.13%
70.40%
29.47%
2,348,025
324,392
196,229
566,716
95,924
24,415
167,268
7,194
23,246
866,330
5,492,959
281,973
10,394,671
1.57%
0.22%
0.13%
0.38%
0.06%
0.02%
0.11%
0.00%
0.02%
0.58%
3.68%
0.19%
6.96%
2,190,819
272,185
158,608
584,936
95,268
27,021
163,311
5,096
163,311
948,679
4,258,699
273,190
9,141,123
1.59%
0.20%
0.12%
0.42%
0.07%
0.02%
0.12%
0.00%
0.12%
0.69%
3.09%
0.20%
6.64%
1,995,723
266,831
141,112
548,133
94,340
25,052
144,068
673
152,776
862,690
3,797,885
260,684
8,289,967
1.58%
0.21%
0.11%
0.44%
0.07%
0.02%
0.11%
0.00%
0.12%
0.68%
3.01%
0.21%
6.56%
15,408,771
506,186
1,146,126
5,034,197
28,458
2,735,670
826,350
33,350
270,072
92,390
17,788
171,872
92,428
407,605
294,933
106,415
235,244
154,213
308,969
27,871,037
38,265,708
6,171,502
1,897,346
4,274,156
1,013,745
3,260,411
10.31%
0.34%
0.77%
3.37%
0.02%
1.83%
0.55%
0.02%
0.18%
0.06%
0.01%
0.12%
0.06%
0.27%
0.20%
0.07%
0.16%
0.10%
0.21%
18.65%
25.61%
4.13%
1.27%
2.86%
0.68%
2.18%
14,062,181
546,228
1,229,015
4,899,331
27,313
2,695,165
701,235
41,443
244,959
122,494
11,330
154,500
74,852
174,807
313,020
95,268
217,752
136,092
97,185
25,844,170
34,985,293
5,998,463
2,128,905
3,869,558
1,399,001
2,470,557
10.21%
0.40%
0.89%
3.56%
0.02%
1.96%
0.51%
0.03%
0.18%
0.09%
0.01%
0.11%
0.05%
0.13%
0.23%
0.07%
0.16%
0.10%
0.07%
18.78%
25.42%
4.33%
1.55%
2.78%
1.02%
1.76%
12,960,341
500,630
1,159,488
4,759,347
33,017
2,516,783
659,430
50,319
238,578
131,546
13,985
154,968
67,903
132,381
243,054
87,373
110,444
148,790
125,228
24,093,605
32,383,572
4,745,339
2,085,177
2,660,162
1,166,553
1,493,609
10.29%
0.40%
0.92%
3.78%
0.03%
2.00%
0.52%
0.04%
0.19%
0.10%
0.01%
0.12%
0.05%
0.11%
0.19%
0.07%
0.09%
0.12%
0.10%
19.13%
25.69%
3.78%
1.66%
2.12%
0.93%
1.19%
* Details of manufacturing expenses are not included in this schedule.
8-33
8-40 (continued)
(part of requirement d)
Income Statement - Welburn Division
Sales
Cost of Sales*
Gross Profit
Salaries-Management
Salaries-Office
Security
Insurance
Medical benefits
Advertising
Property taxes
Bad debts
Accounting fees
Salaries-Sales
Wages Rental
Wages-Mechanics
Wages-Warehouse
Garbage collection
Payroll benefits
Rent- Warehouse
Telephone
Utilities
Postage
Linen service
Cleaning service
Legal service
Fuel
Pension expense
Office supplies
Miscellaneous
Total operating expenses
OPERATING INCOME
2004
2004
2003
2003
2002
2002
Dollar Value % of Div. Sales Dollar Value % of Div. Sales Dollar Value % of Div. Sales
121,371,795
100.00%
111,877,873
100.00%
102,308,887
100.00%
126,522
0.10%
113,483
0.10%
117,627
0.11%
86,671,580
71.41%
79,914,454
71.43%
73,370,003
71.71%
34,573,693
28.49%
31,849,936
28.47%
28,821,257
28.18%
1,905,965
263,320
144,046
460,017
77,861
19,956
135,777
4,336
18,396
708,015
4,329,633
230,075
8,297,397
1.57%
0.22%
0.12%
0.38%
0.06%
0.02%
0.11%
0.00%
0.02%
0.58%
3.57%
0.19%
6.84%
1,774,466
220,457
117,118
473,767
77,159
22,048
132,276
2,735
132,276
762,910
3,449,347
220,363
7,384,922
1.59%
0.20%
0.10%
0.42%
0.07%
0.02%
0.12%
0.00%
0.12%
0.68%
3.08%
0.20%
6.60%
1,616,447
216,121
104,199
443,958
76,407
20,441
116,690
361
123,743
693,759
3,076,109
210,276
6,698,511
1.58%
0.21%
0.10%
0.43%
0.07%
0.02%
0.11%
0.00%
0.12%
0.68%
3.01%
0.21%
6.54%
12,947,327
4,124,063
2,099,069
690,375
26,659
200,398
80,204
14,539
127,063
67,780
119,122
224,342
82,614
193,389
125,176
58,819
21,180,939
29,478,336
5,095,357
10.67%
11,646,277
3,968,235
2,182,959
571,916
33,069
198,409
99,207
9,642
107,833
60,628
120,490
253,526
77,159
176,367
110,228
53,130
19,669,075
27,053,997
4,795,939
10.41%
10,733,735
3,854,855
2,038,477
537,821
40,152
193,240
106,538
11,900
108,159
55,000
91,247
196,858
70,765
89,454
120,513
68,461
18,317,175
25,015,686
3,805,571
10.49%
3.40%
1.73%
0.57%
0.02%
0.17%
0.07%
0.01%
0.10%
0.06%
0.10%
0.18%
0.07%
0.16%
0.10%
0.05%
17.46%
24.30%
4.19%
8-34
3.55%
1.95%
0.51%
0.03%
0.18%
0.09%
0.01%
0.10%
0.05%
0.11%
0.23%
0.07%
0.16%
0.10%
0.05%
17.60%
24.20%
4.27%
3.77%
1.99%
0.53%
0.04%
0.19%
0.10%
0.01%
0.11%
0.05%
0.09%
0.19%
0.07%
0.09%
0.12%
0.07%
17.91%
24.45%
3.73%
8-40 (continued)
Income Statement - Solar-Electro Division
Sales
Cost of Sales*
Gross Profit
Salaries-Management
Salaries-Office
Security
Insurance
Medical benefits
Advertising
Property taxes
Bad debts
Accounting fees
Salaries-Sales
Wages Rental
Wages-Mechanics
Wages-Warehouse
Garbage collection
Payroll benefits
Rent- Warehouse
Telephone
Utilities
Postage
Linen service
Cleaning service
Legal service
Fuel
Pension expense
Office supplies
Miscellaneous
OPERATING INCOME
2004
2004
2003
2003
2002
2002
22,381,936
100.00%
20,073,876
100.00%
18,373,763
100.00%
43,430
0.19%
35,208
0.18%
36,494
0.20%
16,311,635
72.88%
14,687,724
73.17%
13,484,900
73.39%
6,026,871
26.93%
5,350,944
26.65%
4,852,369
26.41%
347,907
48,064
19,868
83,967
14,212
3,641
24,783
900
3,360
124,019
915,513
40,824
1,627,058
1.55%
0.21%
0.09%
0.38%
0.06%
0.02%
0.11%
0.00%
0.02%
0.55%
4.09%
0.18%
7.26%
323,147
40,146
14,025
86,281
14,054
4,015
24,087
497
24,087
144,706
628,135
40,999
1,344,179
1.61%
0.20%
0.07%
0.43%
0.07%
0.02%
0.12%
0.00%
0.12%
0.72%
3.13%
0.20%
6.69%
294,370
39,356
12,478
80,853
13,917
3,722
21,249
66
22,533
131,590
560,167
39,122
1,219,423
1.60%
0.21%
0.07%
0.44%
0.08%
0.02%
0.12%
0.00%
0.12%
0.72%
3.05%
0.21%
6.64%
2,256,643
716,283
492,677
107,026
4,868
54,837
7,340
2,653
35,120
21,300
276,825
55,555
18,729
35,301
22,849
241,764
4,349,770
5,976,828
50,043
10.08%
2,204,049
722,659
397,542
100,370
6,025
36,131
18,069
1,367
36,131
11,039
42,156
46,171
14,054
31,182
20,073
39,433
3,726,451
5,070,630
280,314
10.98%
2,031,351
702,011
371,231
94,386
7,315
35,190
19,404
1,688
36,241
10,014
31,925
35,851
12,889
15,815
21,946
50,811
3,478,068
4,697,491
154,878
11.06%
3.20%
2.20%
0.48%
0.02%
0.25%
0.03%
0.01%
0.16%
0.10%
1.24%
0.25%
0.08%
0.16%
0.10%
1.08%
19.44%
26.70%
0.23%
8-35
3.60%
1.98%
0.50%
0.03%
0.18%
0.09%
0.01%
0.18%
0.05%
0.21%
0.23%
0.07%
0.16%
0.10%
0.20%
18.57%
25.26%
1.39%
3.82%
2.02%
0.51%
0.04%
0.19%
0.11%
0.01%
0.20%
0.05%
0.17%
0.20%
0.07%
0.09%
0.12%
0.28%
18.94%
25.58%
0.83%
8-40 (continued)
Income Statement - Machine-Tech Division
2004
2004
2003
2003
2002
2002
Sales
5,670,915
100.00%
5,790,017
100.00%
5,299,644
100.00%
9,518
0.17%
13,411
0.23%
13,901
0.26%
Cost of Sales*
1,824,751
32.18%
1,993,730
34.43%
1,830,458
34.54%
Gross Profit
3,836,646
67.65%
3,782,876
65.34%
3,455,285
65.20%
Salaries-Management
94,153
1.66%
93,206
1.61%
84,906
1.60%
Salaries-Office
13,008
0.23%
11,582
0.20%
11,354
0.21%
32,315
0.57%
27,465
0.47%
24,435
0.46%
Security
22,732
0.40%
24,888
0.43%
23,322
0.44%
Insurance
3,851
0.07%
4,055
0.07%
4,016
0.08%
Medical benefits
818
0.01%
958
0.02%
889
0.02%
Advertising
6,708
0.12%
6,948
0.12%
6,129
0.12%
1,958
0.03%
1,864
0.03%
246
0.00%
Property taxes
1,490
0.03%
6,948
0.12%
6,500
0.12%
Bad debts
34,296
0.60%
41,063
0.71%
37,341
0.70%
247,813
4.37%
181,217
3.13%
161,609
3.05%
Accounting fees
11,074
0.20%
11,828
0.20%
11,286
0.21%
470,216
8.29%
412,022
7.11%
372,033
7.01%
Salaries-Sales
204,801
3.61%
211,855
3.66%
195,255
3.68%
Wages Rental
506,186
8.93%
546,228
9.43%
500,630
9.45%
Wages-Mechanics
1,146,126
20.21%
1,229,015
21.23%
1,159,488
21.88%
Wages-Warehouse
193,851
3.42%
208,437
3.60%
202,481
3.82%
Garbage collection
28,458
0.50%
27,313
0.47%
33,017
0.62%
Payroll benefits
143,924
2.54%
114,664
1.98%
107,075
2.02%
Rent- Warehouse
28,949
0.51%
28,949
0.50%
27,223
0.51%
Telephone
1,823
0.03%
2,349
0.04%
2,852
0.05%
Utilities
14,837
0.26%
10,419
0.18%
10,148
0.19%
Postage
4,846
0.09%
5,218
0.09%
5,604
0.11%
Linen service
596
0.01%
321
0.01%
397
0.01%
9,689
0.17%
10,536
0.18%
10,568
0.20%
Cleaning service
3,348
0.06%
3,185
0.06%
2,889
0.05%
Legal service
11,658
0.21%
12,161
0.21%
9,209
0.17%
Fuel
15,036
0.27%
13,323
0.23%
10,345
0.20%
5,072
0.09%
4,055
0.07%
3,719
0.07%
Pension expense
6,554
0.12%
10,203
0.18%
5,175
0.10%
Office supplies
6,188
0.11%
5,791
0.10%
6,331
0.12%
Miscellaneous
8,386
0.15%
4,622
0.08%
5,956
0.11%
2,340,328
41.29%
2,448,644
42.30%
2,298,362
43.36%
2,810,544
49.58%
2,860,666
49.41%
2,670,395
50.37%
OPERATING INCOME
1,026,102
18.07%
922,210
15.93%
784,890
14.83%
8-36
Internet Problem Solution: Industry Research and Client Acceptance
8-1 The vignette at the beginning of Chapter 6 in the text contains a brief
description of the ZZZZ Best fraud. One area where the auditors were particularly
criticized in that audit had to do with the auditors' lack of industry knowledge.
With hindsight it appeared that the fraud should have been easily detected
because ZZZZ Bests large restoration contracts were in excess of $7 million
while the largest restoration jobs on record in the insurance restoration industry
were less than $3 million.
You have been approached by On the Sunny Side, a team sports uniform
designer and manufacturer for women, about performing the companys financial
statement audit. The company began operations eight years ago and has
experienced strong growth in the last several years. Teri Kloth, the chief
executive officer, has told you that her company expects production in 2004 to be
450,000 units. She also provided summary historical financial and operating data
regarding unit sales. In 2002 and 2003, the company reported sales of 365,000
and 402,000 units, respectively.
Are On the Sunny Sides 2002 and 2003 unit sales reasonable? Why or
why not? (Hint: Visit the U.S. Census Bureau's Web site [www.census.gov]. Once
you are at the site, go to the Business section and then to the Manufacturing
sector-specific data section. Once you are there, locate the Current Industrial
Reports. Next search the CIRs by Subject Title for Apparel. Data about womens
team sports uniforms can be found by search for Apparel. Use the most current
annual report for your analysis.
Answer: The 2002 and 2003 sales do not appear reasonable. The U.S. Census
Bureau reports that annual shipments of womens team sports uniforms were as
follows:
2001 - not disclosed

2002 - 676,000 units shipped
Quarterly shipments, in units, for 2002 were as follows:

1st
2nd
3rd
4th
231,000
123,000
121,000
201,000
These data suggest that it is unlikely that On the Sunny Side shipped more than
50% of all uniforms during 2002.
More information can be found in the U.S. Census Bureaus report on Apparel:
2002 [www.census.gov/industry/1/mq315a025.pdf].
8-37
Internet Problem Solution: Obtain Client Background Information
8-2 Planning is one of the most demanding and important aspects of an audit.
A carefully planned audit increases auditor efficiency and provides greater
assurance that the audit team addresses the critical issues. Auditors frequently
prepare audit planning documents that provide client and industry background
information and discuss important accounting and auditing issues related to the
clients financial statements.
Your assignment is to find and document information for inclusion in the
audit planning memorandum. You should obtain the necessary information by
downloading a public companys most recent annual report from its Web site
(your instructor will give you the companys name). You may also use other
sources of information such as recent 10-K filings to find additional information.
You should address the following matters in four brief bulleted responses:
Brief company history.

Description of the companys business (for example, related
companies and competitors).
Key accounting issues identified from a review of the companys most
recent annual report. (Note: Do not concentrate solely on the
companys basic financial statements. Careful attention should be
given to Managements Discussion and Analysis as well as the
Footnotes.)
Necessary experience levels (that is, years of experience and industry
experience) required of the auditors to be involved in the audit.
Answer: This problem allows the instructor to select any company that may be of
interest. The following suggested answer has been prepared based upon Target
Corporation. Much of the information has been taken from the companys Web
site [www.target.com] and its 10-K filing for the year ended February 1, 2003.
Brief company history - Unlike most other mass merchandisers, Target

has department store roots. Back in 1961, Dayton's department store
identified a demand for a store that sold less expensive goods in a
quick, convenient format. Target was born. In 1962, the first Target
store opened in Roseville, Minnesota. This was the first retail store to
offer well-known national brands at discounted prices. In the 1970s,
Target paved new ground by implementing electronic cash registers
storewide to monitor inventory and speed up guest service. The
company also began hosting an annual shopping event for seniors and
people with disabilities, plus a toy safety campaign. In the 1980s,
Target rolled out electronic scanning nationwide. Finally, in the 1990s,
the company launched a number of new ventures: its first Target
Greatland store, a national bridal registry - Club Wedd, and Lullaby
Club. Its first SuperTarget store, which combined groceries and special
services with a Target Greatland store, was opened. And, the company
introduced its own credit card.
8-38
8-2 (continued)
Description of the companys business - The company operates 1,147

Target stores in 47 states, 264 Mervyns and 64 Marshall Fields stores.
Target Corporation employees approximately 304,000 people.
The companys retail merchandising business is conducted under
highly competitive conditions in the discount, middle market and
department store retail segments. Its stores compete with national
(e.g., Kmart, Wal-Mart, Walgreens) and local department, specialty, offprice, discount and drug store chains, independent retail stores and
Internet and catalog businesses that handle similar lines of
merchandise. The company also competes with other companies for
new store sites. The company believes the principal methods of
competing in its industry include brand recognition, customer service,
store location, differentiated offerings, value, quality, fashion, price,
advertising, depth of selection and credit availability. Target is a leader
in community involvement programs and believes that it is in a strong
competitive position with regard to these competitive factors.
Key accounting issues - The following is a list of accounting issues

identified after reviewing Targets annual report. Student responses
may vary.
Related parties - The company is comprised of three operating
segments: Target, Mervyns and Marshall Fields. Target
contributed 84% of 2002 total revenues, while Mervyns and
Marshall Fields contributed 8.7% and 7.3%, respectively.
LIFO inventory valuation issues - Inventory is accounted for by
the retail inventory accounting method using LIFO. The
companys LIFO provision decreased by $12 million from 2001
to 2002.
Accounts payable - The accounts payable balance of $4.684
billion represents balances with numerous vendors and
suppliers.
Long-term debt and notes payable - The company has
substantial long-term debt consisting of both notes payable,
notes, and debentures in a total amount of $10.186 billion.
Stock option plan - A stock option plan exists for key employees
and non-employee members of the board of directors. The plan
provides for the granting of stock options, performance share
awards, restricted stock awards, or a combination of awards.
Pension and postretirement health care benefits - Target
provides a defined benefit pension plan and certain health care
benefits to employees who meet certain age, length of service
and hours worked per year requirements.
ESOP - The company sponsors a defined contribution employee
benefit plan for employees who meet certain eligibility
requirements. Employees can invest as much as 80 percent of
their compensation with the company matching 100 percent of
he employees contribution up to 5 percent of the employees
compensation.
8-39
8-2 (continued)
Leases - The company leases a number of their retail buildings.

The company utilizes both operating and capital leasing
arrangements. The present value of operating and capital
leases for the next 5 years total $924 and $144 million,
respectively.
Necessary experience levels - Student responses will vary, however,

students should recognize that an audit team is comprised of auditors
with varying levels of experience and backgrounds. It is equally
important that students recognize the need for auditors with industry
experience.
(Note: Internet problems address current issues using Internet sources. Because
Internet sites are subject to change, Internet problems and solutions may change.
Current information on Internet problems is available at www.prenhall.com/arens.)
8-40

Audit Planning and Analytical Procedures: Review Questions 8-1

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Chapter 8

Audit Planning and Analytical Procedures

Eight major steps in planning audits are:

Accept client and perform initial planning

The auditors observation of the manufacturing processes will reveal

Reliability of financial reporting If management sees the reliability

8-17 The purpose of a clients performance measurement system is to measure

Compare client and industry data

Short-term debt-paying ability Cash ratio, quick ratio, and current

Multiple Choice Questions From CPA Examinations

Discussion Questions And Problems

The clients organizational structure, including key personnel.

Lease of property by the company from a corporate officer

Obtain background information about the client in the

Perform analytical procedures of the nature discussed in

When an independent party, such as an attorney or bank, is

For each of the non-arms-length transactions in part d. above, the

Comparing the terms of the lease to the terms in another

AUDIT ACTION REQUIRED

Unresolved tax dispute.

Evaluate resolution of dispute and adequacy of

Determine that old equipment was correctly treated in

Annual cash dividend.

Calculate total dividends and determine that

Inform staff of possibility of related party transactions.

Note information in audit files for 2006 audit.

Determine if the pension/profit sharing plan was

Determine that there is appropriate accounting

Examine supporting documentation of loan and make

Thank management for selecting your firm for the

Management is primarily responsible for financial statement

You would be concerned with the fairness of the presentation of

Accruals of individual expenses to related total expenses

The possible reasons for a decrease in the rate of inventory

Erroneous cutoff of sales in a perpetual inventory

The explanation given by Adams is correct in part, but appears to

Commission expense could be overstated during the current

Obsolete or unsalable inventory may be present and may

Current ratio has

Obtain explanation for

Determine the cause

The difference in the

The industry average

Investigate the market

The company appears to

Determine the reason

Mahogany Products operations differ significantly from the industry.

REASON FOR ADDITIONAL INFORMATION

To project the cash requirements for the next several years

Debt to equity ratio

To see the company's capital investment and

Industry average ratios

To compare the company's ratios to those of the average

To see the collection potential and experience in accounts

REASON FOR ADDITIONAL INFORMATION

Aging of inventory and

To compare the age of the inventory to the markdown

Short- and long-term

To indicate whether the company may have liquidity

Ability of the company to continue to acquire inventory,

Match Competition. Because other toy retailers may be

Target New Markets. By offering products to consumers