ACCTMIS 5500HSOLUTIONS TO GENERAL ASSIGNMENTS

The file includes answers to all multiple-choice questions in the text, assigned problems from the text, and assigned supplemental problems (SPs).

Answers to All Multiple-Choice Questions from the Textbook (Messier et al. 8th)

1-13 b 1-19 a1-14 b 1-20 d1-15 c 1-21 d1-16 c 1-22 d1-17 c 1-23 b1-18 c

2-15 b 2-20 a2-16 a 2-21 a2-17 a 2-22 c2-18 d 2-23 c2-19 c

3-16 d 3-21 d3-17 d 3-22 d3-18 a 3-23 a3-19 c 3-24 a3-20 b 3-25 d

4-13 d 4-18 c4-14 a 4-19 c4-15 c 4-20 b4-16 b 4-21 a4-17 c 4-22 a

5-17 b 5-24 b5-18 c 5-25 c5-19 b 5-26 c5-20 d 5-27 c5-21 a 5-28 d5-22 b 5-29 a5-23 b

6-12 d 6-19 B6-13 d 6-20 B6-14 d 6-21 D6-15 d 6-22 C6-16 a 6-23 B6-17 c 6-24 D6-18 b

7-19 d 7-27 c7-20 b 7-28 a7-21 c 7-29 c7-22 c 7-30 a7-23 c 7-31 c7-24 b 7-32 a7-25 d 7-33 d7-26 d

8-11 c 8-16 b8-12 a 8-17 b8-13 a 8-18 d8-14 c 8-19 d8-15 a 8-20 c

9-11 d 9-16 b9-12 d 9-17 a9-13 b 9-18 a9-14 a 9-19 c9-15 c 9-20 c

10-12 c 10-18 b10-13 d 10-19 a10-14 c 10-20 c10-15 b 10-21 a10-16 a 10-22 a10-17 d 10-23 b

11-13 c 11-19 c11-14 c 11-20 d11-15 b 11-21 c11-16 d 11-22 c11-17 b 11-23 a11-18 b

12-14 b 12-19 c12-15 c 12-20 b12-16 a 12-21 c12-17 b 12-22 b12-18 c 12-23 c

13-14 d 13-21 b13-15 a 13-22 d13-16 c 13-23 d13-17 b 13-24 b13-18 d 13-25 a13-19 c 13-26 d13-20 d

14-12 c 14-18 d14-13 a 14-19 a14-14 b 14-20 d14-15 b 14-21 b14-16 a 14-22 a14-17 a

15-11 d 15-16 d15-12 b 15-17 d15-13 b 15-18 d15-14 b 15-19 b15-15 b 15-20 c

16-12 b 16-18 d16-13 a 16-19 b16-14 d 16-20 b16-15 a 16-21 b16-16 b 16-22 c16-17 b 16-23 b

17-13 c 17-18 a17-14 d 17-19 a17-15 a 17-20 a17-16 b 17-21 c17-17 a

18-10 b 18-16 c18-11 c 18-17 b18-12 a 18-18 b18-13 a 18-19 b18-14 a 18-20 c18-15 a 18-21 c

19-14 c 19-21 a19-15 d 19-22 c19-16 c 19-23 b19-17 b 19-24 b19-18 b 19-25 a19-19 c 19-26 a19-20 c

20-14 d 20-20 c20-15 c 20-21 c20-16 b 20-22 a20-17 d 20-23 b20-18 b 20-24 d20-19 d 20-25 d

21-15 d 21-23 d21-16 b 21-24 c21-17 d 21-25 a21-18 c 21-26 c21-19 b 21-27 b21-20 a 21-28 c21-21 c 21-29 d21-22 b

Answers to Non-Multiple-Choice Assigned Problems from the Textbook

2-24

Item Number Type of Audit Type of Auditor

a. Operational Government

b. Financial statement External

c. Compliance or operational or possibly internal control

Internal or external

d. Forensic Internal, external, or forensic

e. Operational Government, external, or internal

f. Operational Internal or external

g. Compliance Government

h. Compliance or forensic Government, external, or forensic

3-30

Audit Procedure Assertion

1 Accuracy

2 Existence

3 Cutoff

4 Valuation and allocation

4-24

Client No. Detection Risk

1 25%

2 10%

3 67%

4 25%

5-34 a. The bank confirmation would be considered more reliable than the observation

of segregation of duties because an independent external party provided the information. Observation is not as reliable because the individuals performing the functions may act differently when someone is observing them.

b. The auditor's recalculation of depreciation is more reliable than the examination of the raw material requisitions because the auditor has direct personal knowledge of the outcome.

c. The bank statement would be considered more reliable than shipping documents because the bank statement was prepared by an entity that is external to the client.

d. The examination of the common stock certificates would generally be considered more reliable than a physical examination of inventory components for a personal computer because the stock certificates are prepared by an entity external to the client. Additionally, the auditor may not be able to easily determine the quality or value of the computer components.

5-35

a. Type b. Reliability

1. Internal 1. High if internal control is excellent, moderate to low otherwise.

2. Internal 2. High if internal control is excellent, moderate to low otherwise.

3. External 3. High because it comes from an external party.

4. External 4. High to moderate because the document has been circulated to a party outside the entity.

5. External 5. High because it comes from an external party.

6. Internal 6. High if internal control is excellent, moderate to low otherwise.

7. Internal 7. High if internal control is excellent, moderate to low otherwise.

8. Internal 8. High if internal control is excellent, moderate to low otherwise.

9. Internal 9. High to moderate because the document has been circulated to a party outside the entity.

10. External 10. High because it comes from an external party.

5-39 The issues and potential risks listed below are based on a real-world situation involving a liquidity crisis and a pending bankruptcy. Because the solution below includes the benefits of the Home Depot insights it is likely to be more complete than answers provided by students.

1. Quick Ratioa. The quick ratio presents a good picture of the client’s liquidity position. A quick

ratio greater than 1.0 generally indicates that the entity’s liquid assets are sufficient to meet the cash requirements for paying current liabilities. Home Improvement’s quick ratio has decreased significantly over the past two years and has fallen well below the 1.0 threshold, whereas the industry’s has been consistently increasing and above the 1.0 threshold in the last year. Home Improvement appears to be facing serious liquidity issues that are not reflected in the industry. The lack of liquidity presents many risks, including the potential inability to stay current with payments owed to vendors and creditors. A lack of liquidity also increases the risk that the company may face bankruptcy (i.e., may not be able to continue as a going concern). Liquidity pressures also increases the inherent risks on accounting measures related to debt covenants and new financing (i.e., incentive to overstate in order to avoid default and/or acquire new financing).1: Growth. A cash crunch is not uncommon for companies going through rapid growth as appears to be the case with The Home Improvements when you consider the pattern of other ratios and trends (e.g., significant debt to equity, increase in inventory to total assets). As the client expands, it spends large amounts of cash on buying more inventory, building new stores, and incurring other significant start-up costs. The client may also add additional debt during these growth periods to help finance expansion, and this debt also requires repayment as well as interest charges. Although this cash shortage is not uncommon for growth companies, it is vital that sales increase at such a rate as to allow the client to repay future debt and meet all liabilities and/or the client have the ability to acquire additional capital to survive the cash crunch.2: Repayment of Debt. The cash crunch in the final year could be the result of repayment of debt (perhaps due to a balloon payment). Note that debt to equity dropped significantly in the last year…indicating that either debt significantly reduced or equity significantly increased. Given the pattern in this case, the former seems more likely.

2. Days of Inventory on Handa. This ratio, which is computed as 365 days divided by the inventory turnover,

represents how much inventory the entity has on hand to sell to customers. The higher the ratio, the slower the inventory turns and the less able the client is to liquidate inventory and avoid inventory obsolescence. Although the client’s ratio is not much worse than the industry average, the last several years show a large increase, which may represent increasing difficulty in selling its products. This increasing ratio represents an increasing risk of inventory obsolescence and the potential that inventory is being carried at an amount in excess of its market value.

b. As the client has grown, it may be that it has established a strategy of maintaining a large volume of inventory on hand in order to meet customer demands. As such, its inventory turnover would naturally decrease. However, the lower inventory turnover may also be a result of a decreased demand for home improvement products or simply that the client has grown too quickly and has increased supply in excess of market demand.

3. Inventory/Current Assetsa. This ratio sheds light on how the client is increasing inventory purchases

compared to the industry average. Carrying large amounts of inventory on hand can be expensive when carrying, stocking, and storage costs are considered. As mentioned previously, when large amounts of inventory are stored on hand, the risk of inventory obsolescence increases, as does the risk that the client may be poorly investing cash in such a way that materially decreases necessary operating liquidity. Inventory as a percent of current assets has skyrocketed over the past two years, especially when compared to industry averages and deserves further attention indicating that inventory will be an account that should be considered high risk by the auditor.

b. This ratio highlights the fact that the client is dramatically increasing inventory purchases to stock new stores and expand rapidly. Although necessary for growth, this increase in inventory can also be dangerous if sales do not support the expansion.

4. Return on Assets (ROA)a. This ratio indicates the return earned on the resources invested by both the

stockholders and the creditors. As such, when this ratio dips below the industry average it indicates that the company is not generating as high a return as its competitors and may represent going concern issues. Additionally, if the client feels pressured to keep its ROA higher through higher earnings, the client may engage in earnings management or fraud. ROA over the past three years are quite a bit lower than the earlier years and are quite a bit lower than the industry average and as such deserve further investigation to determine underlying causes and related financial statement risks.

b. As a growing company, and as shown in other ratios, the client has spent considerable amounts of money expanding its business, including the build-up in inventory, which increases the denominator (Total Assets). At the same time, the company may be experiencing lower profit margins (as they attempt to liquidate inventory at lower prices) and lower net earnings due to higher expenses related to expansion. These factors reduce Net Income, which also reduces ROA. The high amounts of debt to fund expansion also result in higher interest expense, further lowering earnings.

5. Debt to Equity Ratio a. This ratio indicates what portion of an entity’s capital comes from debt. The lower

the ratio, the less debt pressure on the entity. The client’s debt has increased dramatically over the last three years and although the ratio drops in the final year in the table, it is still higher than the earliest years as well as the industry ratio over the same timeframe. The fact that the client’s ratio is significantly above the industry average indicates that the client may be too highly leveraged and may not be able to meet its debt obligations on a long-term basis, which increases the risk that the client is a viable going concern. As the amount of debt increases, so does the pressure to meet potentially restrictive debt covenants, putting pressure on the client to be aggressive or even fraudulent in financial statement reports.

b. As a growth company, the client has understandably sought out debt as a way to finance its expansion. However, this debt has increased at an alarming rate. As the client has experienced lower than expected earnings, its stock price may have dropped to the point that raising capital through a public offering may have been ineffective and thus debt may have been the client’s only avenue for additional financing.

NOTE: The data used in this problem are based on Home Depot and its industry between 1982 and 1986. Founded in 1978, Home Depot quickly became a major player in its industry. Because of its success, Home Depot sought to rapidly expand during the early 1980’s. Unfortunately, Home Depot tried to expand too quickly. It acquired millions of dollars in debt to purchase large amounts of PP&E and inventory for new stores, but sales did not keep pace with the rapid expansion in assets and debt. As a result, Home Depot had serious cash shortages to the extent that it was having trouble financing operations. Home Depot was forced to restructure its debt and strategy for growth. On the verge of bankruptcy, Home Depot was able to orchestrate a miraculous turnaround and ultimately returned to profitability.

8-25 The sample size for each control procedure is:

ParametersControl Procedure

1 2 3 4

Risk of incorrect acceptance 5% 5% 10% 10%

Tolerable deviation rate 4% 5% 7% 8%

Expected population deviation rate 1% 2% 3% 4%

Sample size (using tables) 156 181 94 98

Sample size (using ACL) 158 184 96 100

8-26 The computed upper deviation rate and the auditor’s decision for each control procedure are:

Results Using TablesControl Procedure

1 2 3 4

Number of deviations 0 5 4 3

Sample size 156 181 94 98

Sample deviation rate 0.0 2.8 4.3 3.1

Computed upper deviation rate 2.0 6.9 8.7 7.3

Auditor’s decisionSupports Does not

supportDoes not support

Supports

Results Using ACLControl Procedure

1 2 3 4

Number of deviations 0 5 4 3

Sample size 158 184 96 100

Sample deviation rate 0.0 2.7 4.2 3.0

Computed upper deviation rate 1.9 5.7 8.3 6.7

Auditor’s decisionSupports Does not

supportDoes not support

Supports

9-22 a. Using Table 8-5 with a desired confidence level = 95% (risk of incorrect acceptance = 5%); tolerable misstatement = 5% ($212,500 $4,250.000); expected misstatement = 1.5% ($63,750 $4,250,000); the sample size is equal to 124. The sampling interval is $34,274 ($4,250,000 124).

Using ACL with a desired confidence level = 95%; population = $4,250,000; tolerable misstatement = $212,500; and expected misstatement = $63,750; the sample size is equal to 119 items. The sampling interval is $35,527.34.

b. The upper misstatement limit is calculated as follows:

Overstatement Errors

ErrorNumber

Book Value Audit Value Tainting Factor

1 6,000 2,000 .667

2 24,000 20,000 .167

3 140,000 65,000 Not applicable, since the book value exceeds the sampling interval.

Error Number Tainting Factor

Sampling Interval

Projected Misstatement(column 2 x 3)

95% Misstatement

Factor or Increment (from

Table 9-3)

Upper Misstatement

Limit(column 2 x 3

x 5)Basic Precision 1.0 $34,274 NA 3.0 $102,822 1 .667 34,274 22,861 1.7 (4.7-3.0) 38,864 2 .167 34,274 5,724 1.5 (6.2-4.7) 8,586Add misstatements detected in logical units greater than the sampling interval:

Error 3 NA 34,274 75,000 NA 75,000

Upper Misstatement Limit $225,272NA—Not Applicable

Since the UML ($225,272) is more than the TM ($212,500), Zhu can not accept the inventory account as being fairly stated since there is more than a 5 percent risk that the account contains a misstatement greater than $212,500.

Using ACL and the sampling interval calculated by ACL in part a, the Upper Error Limit (UML) is $232,208.45 and the Most Likely Error is $104,606.11. The ACL output follows:

Command: EVALUATE MONETARY CONFIDENCE 95 ERRORLIMIT 6000, 4000,24000, 4000,140000, 75000 INTERVAL 35527.34 TO SCREEN

Confidence: 95, Interval: 35527

Item Error Most Likely Error Upper Error Limit

Basic Precision 106582.006000.00 4000.00 23684.89 41448.5624000.00 4000.00 5921.22 9177.89

140000.00 75000.00 75000.00 75000.00Totals 104606.11 232208.45

Since the UML ($232,208.45) is more than the TM ($212,500), Zhu can not accept the inventory account as being fairly stated since there is more than a 5 percent risk that the account contains a misstatement greater than $212,500.

9-23 a. Using Table 8-5 with a desired confidence level of 95% (risk of incorrect acceptance = 5%); tolerable misstatement = 4% ($360,000 $9,000,000); expected misstatement = 1% ($90,000 $9,000,000); the sample size is equal to 156. The sampling interval is $57,692 ($9,000,000 156).

Using ACL with a desired confidence level = 95%; population = $9,000,000; tolerable misstatement = $360,000; and expected misstatement = $90,000; the sample size is equal to 130 items. The sampling interval is $68,906.25.

b. The upper misstatement limit is calculated as follows:

Overstatement Errors

ErrorNumber

Book Value Audit Value Tainting Factor

1 10,000 7,500 .25

2 9,000 6,000 .33

3 60,000 0 Not applicable, since the book value exceeds the sampling interval.

4 800 640 .20

Error Number Tainting Factor

Sampling Interval

Projected Misstatement(column 2 x 3)

95% Misstatement

Factor or Increment (from

Table 9-3)

Upper Misstatement

Limit(column 2 x 3

x 5)

Basic Precision 1.0 $57,692 NA 3.0 $173,076 2 .33 57,692 19,038 1.7 (4.7-3.0) 32,365 1 .25 57,692 14,423 1.5 (6.2-4.7) 21,635

4 .20 57,692 11,538 1.4 (7.6-6.2) 16,153Add misstatements detected in logical units greater than the sampling interval:

Error 3 NA 57,692 60,000 NA 60,000

Upper Misstatement Limit $303,229NA—Not Applicable

Since the UML ($303,229) is less than the tolerable misstatement ($360,000), Nancy Van Pelt can accept the inventory account as being fairly stated since there is only a 5 percent risk that the account contains a misstatement greater than $360,000.

Using ACL and the sampling interval calculated by ACL in part a, the Upper Error Limit (UML) is $407,351.03 and the Most Likely Error is $122,882.81. The ACL output follows:

Command: EVALUATE MONETARY CONFIDENCE 95 ERRORLIMIT 10000.00,2500.00,9000.00,3000.00,60000.00,60000.00,800.00,160.00 INTERVAL 68906.25 TO SCREEN

Confidence: 95, Interval: 68906

Item Error Most Likely Error Upper Error Limit

Basic Precision 206719.0060000.0

0 60000.00 68906.25 120585.94

9000.00 3000.00 22968.75 35601.5610000.0

0 2500.00 17226.56 25150.78

800.00 160.00 13781.25 19293.75Totals 122882.81 407351.03

Since the UML ($407,351.03) is greater than the tolerable misstatement ($360,000), Nancy Van Pelt cannot accept the inventory account as being fairly stated. The difference in the evaluation between the manual calculation using the tables and ACL is driven by the difference in the size of the sampling interval. The larger sampling interval increases the UML for the Basic Precision and the other errors detected in the sample. Because the $60,000 item is smaller than the sampling interval in the ACL calculation, there is an error projection (most likely error) and an upper error limit or allowance for sampling risk added on. When using the tables, the sample size is larger and the sampling interval is $57,692: all items greater than the interval will be tested and therefore the error associated with the $60,000 item is not projected and requires no additional margin for sampling risk.

c. The calculation of the adjustment for the understatement errors is as follows:

Understatement Errors

Error Number Book Value Audit Value Tainting Factor

5 6,000 6,500 -.083

6 750 800 -.067

Adjustment for Understatement Errors

TaintingFactor

SamplingInterval

ProjectedMisstatement

-.083 57,692 -4,788

-.067 57,692 -3,865

Adjustment to Most Likely Error (and UML)*

-8,653

* As noted in the textbook, some auditors adjust down both the Most Likely Error and the UML. Note that ACL only adjusts down Most Likely Error.

Using ACL and the results from parts a and b, the Adjustment to the Most Likely Error is -10,335.94 (112,546.87-122,882.81. The ACL output follows:

Command: EVALUATE MONETARY CONFIDENCE 95 ERRORLIMIT 10000.00,2500.00,9000.00,3000.00,60000.00,60000.00,800.00,160.00,6000.00,-500.00,750.00,-50.00 INTERVAL 68906.25 TO SCREEN

Confidence: 95, Interval: 68906

Item Error Most Likely Error Upper Error Limit

Basic Precision 206719.0060000.0

0 60000.00 68906.25 120585.94

9000.00 3000.00 22968.75 35601.5610000.0

0 2500.00 17226.56 25150.78

800.00 160.00 13781.25 19293.75750.00 -50.00 -4593.75 0.006000.00 -500.00 -5742.19 0.00

Totals 112546.87 407351.03

Note that the larger ACL sampling interval resulted in error #3 having a most likely error greater than the known error, unlike the solution based on the attributes sampling tables.

9-27 The incorrect assumptions, statements, and inappropriate applications of sampling are as follows: Classical variables sampling is not designed for tests of controls. MUS sampling uses each dollar in the population, not each account, as a separate

sampling unit. MUS sampling is not efficient if many misstatements are expected because the

sample size can become larger than the corresponding sample size for classical variables sampling as the expected amount of misstatement increases.

Each account does not have an equal chance of being selected; the probability of selection of the accounts is proportional to the account's dollar amount.

MUS sampling requires special consideration for negative (credit) balances. Tolerable misstatement was not considered in calculating sample size. Expected misstatement was not considered in calculating sample size. The standard deviation of the dollar amounts is not required for MUS sampling. The three selected accounts with insignificant balances should not have been ignored

or replaced with other accounts. The account with the $1,000 difference (recorded amount of $4,000 and audited

amount of $3,000) was incorrectly projected as a $1,000 misstatement; the projected misstatement for this difference was actually $2,500 ($1,000/$4,000 x $10,000 sampling interval).

The difference in the understated account (recorded amount of $1,900 and audited amount of $2,000) should not have been omitted from the calculation of projected misstatement.

The reasoning (the comparison of projected misstatement with the allowance for sampling risk) concerning the decision that the receivables balance was not overstated was erroneous.

10-25 The following weaknesses were identified by Smith in the existing control system over cash admission fees should be along with the related recommendation for improvement:

Weakness Recommendation

2. There is no segregation of duties between persons responsible for collecting admission fees and persons responsible for authorizing admission.

2. One clerk (the collection clerk) should collect admission fees and issue prenumbered tickets. The other clerk (the admission clerk) should authorize admission upon receipt of the ticket or proof of membership.

3. An independent count of paying patrons is not made.

3. The admission clerk should retain a portion of the prenumbered admission ticket (admission ticket stub).

4. There is no proof of accuracy of amounts collected by the clerks.

4. Admission ticket stubs should be reconciled with cash collected by the treasurer each day.

5. Cash receipts records are not promptly prepared.

5. The cash collections should be recorded by the collection clerk daily on a permanent record that will serve as the first record of accountability.

6. Cash receipts are not promptly deposited. Cash should not be left undeposited for a week.

6. Cash should be deposited at least once each day.

7. There is no proof of accuracy of the amounts deposited.

7. Authenticated deposit slips should be compared with daily cash collection records. Discrepancies should be promptly investigated and resolved. In addition, the treasurer should establish a policy that includes an analytical review of cash collections.

8. There is no record of the internal accountability for cash.

8. The treasurer should issue a signed receipt for all proceeds received from the collection clerk. These receipts should be maintained and periodically checked against cash collection and deposit records.

10-26 a. 1b. 3c. 4d. 6e. 5

11-29 a. 3b. 4c. 5d. 1

13-32 a. 6b. 3c. 1d. 4e. 2

14-27 a. 4b. 7c. 2

16-26 a. 4, 7b. 1, 5, 6, 7, 8c. 2, 5, 6, 7, 8d. 7e. 3

17-25 1. The explosion in Agronowitz's plant that led to the uncollectibility of Scornick Company’s accounts receivable was an event whose conditions did not exist at the balance sheet date. Thus, the event is a Type II event, and should be disclosed in the 2011 financial statements.

2. The tax court ruling in favor of Scornick Company is an event whose conditions existed at the balance sheet date and which involves the revision of an estimate. Thus, the event is a Type I event, and the 2011 financial statements should be adjusted to reflect the favorable ruling.

3. The sale of Scornick's Manufacturing Division is an event whose conditions did not exist at the balance sheet date and is thus a Type II event. This event, at a minimum, requires disclosure in the 2011 financial statements. However, due to the size of the division being sold, pro-forma financial statements may be necessary.

4. This is not an event that is considered a subsequent event for financial statement purposes.

5 This is not an event that is considered a subsequent event for financial statement purposes.

18-22 a. The auditor would issue an unqualified audit report with modified wording for the reliance on the other auditors. In this case, the principal auditor does not intend to take responsibility for the other auditor's work.

b. The auditor should issue a qualified audit report because management has not complied with GAAP. The auditor is not required to prepare the statement of cash flows for disclosure in the audit report.

c. This approach is not in accordance with GAAP because such contingencies must be disclosed in the notes to the financial statements if the amount of the contingency cannot be reasonably estimated. A departure from GAAP such as this one requires either a qualified or an adverse opinion, depending on the materiality of the item in question. In this case the potential settlement is likely to be very large given the proportions of the tragedy in terms of human loss and suffering. In addition, the tragedy may well threaten the company’s ability to be involved in similar projects in the future and perhaps its own survival. Thus, an adverse opinion is very likely the most appropriate response.

d. Because the client wouldn’t allow the confirmations to be sent, the appropriate response would generally be either a qualified opinion or a disclaimer of opinion for a scope limitation imposed by the client’s management, depending on the materiality of accounts receivable. However, even if accounts receivable isn’t highly material, if the auditor suspects fraud by upper management, the scope limitation would merit a disclaimer.

e. Since the auditor is satisfied about the inventory balance using alternative audit procedures, a standard unqualified audit report can be issued. The alternative audit procedures would normally include a physical count subsequent to year end and reconciliation to the balance at the end of the reporting period.

f. Since the client fails to disclose the related-party transaction, the auditor should issue a qualified or adverse audit report depending on the materiality of the matter. The client’s failure to disclose means that the financial statements do not comply with GAAP.

g. Recall that the instructions to the problem indicate the assumption that all matters listed are significant. Since the change in accounting principle is properly accounted for, the auditor should issue an unqualified audit report with an explanatory paragraph for a lack of consistency in the application of GAAP.

18-23 a. The auditor should issue a standard unmodified audit report. It is acceptable for an entity to use different inventory methods in different international regions. Many countries do not allow LIFO, and it can be costly for the entity to maintain inventory records using both valuation methods.

b. The auditor should issue a standard unmodified audit report. As long as this uncertainty is properly disclosed or accounted for in accordance with GAAP, the auditor need not modify the audit report. In this case, a negative outcome for this uncertainty appears to be remote. Therefore, the client is not required to disclose the uncertainty in the financial statements.

c. This is a change in reporting entity that requires the auditor to modify the standard unmodified audit report by adding an emphasis-of-matter paragraph describing the change.

d. This is a correction of an error in principle because the use of replacement cost to value inventory is not in accordance with GAAP. The auditor should modify the standard unmodified report by adding an emphasis-of-matter paragraph describing the change from replacement cost to FIFO for valuing inventory.

e. This is a change in accounting estimate. Such a change does not affect consistency in the application of accounting principles, and the auditor should thus issue a standard unmodified audit report.

f. The auditor should issue a standard unmodified audit report because the client corrected the mistake before issuing the financial statements.

g. The CPA is not independent of the company and should issue a disclaimer for a lack of independence.

h. If the client refuses to make the adjustment to the loan-loss reserve, the auditor should issue a qualified or adverse opinion because the financial statements will not be in accordance with GAAP. The auditor may also have substantial doubt about the entity’s ability to continue as a going concern, which could result in the addition of an emphasis-of-matter paragraph to the audit opinion to disclose the going concern issues. If the auditor concludes that there is a going concern problem and the client refuses to disclose the issue in the notes to the financial statements, the auditor’s opinion will be adverse.

19-28 a. A ruling of the Professional Ethics Executive Committee allows an auditor to provide such advisory services to an audit client and not violate Rule 101. Independence would be not considered impaired because the member's role is advisory in nature and because the client is a privately held entity.

b. A ruling of the Professional Ethics Executive Committee indicates that the auditor's independence under Rule 101 is not impaired under these circumstances provided the client makes all significant management decisions related to the hiring of new personnel and the implementation of the system. The auditor must also limit his or her supervisory activities to initial instruction and training of personnel and should avoid direct supervision of the actual operation of the system or related activities that would constitute undue involvement in or identification with management functions. The auditor would be prohibited from providing these services for a public company audit client.

c. The independence of the auditor, under Rule 101, would be considered impaired whether or not the financial interest is placed in a blind trust.

d. Interpretation 101-1 indicates that an auditor's independence would be considered impaired if a close relative (e.g., a parent) has a material financial interest in an enterprise of which the auditor is participating in the engagement and has knowledge of the financial interest.

e. Independence under Rule 101 is impaired if a member has a direct financial interest in a client during the period of the professional engagement or at the time of expressing an opinion. The period of professional engagement starts when the member begins to perform professional services requiring independence and ends with the client's or member's notification of that relationship's termination.

f. Independence under Rule 101 is impaired because the note is a prohibited loan from the member to the client.

19-31 a. Services that Perez may perform: Counsel on potential expansion plans. Search for and interview new personnel. Train personnel.Services that Perez may not perform: Hire new personnel. Supervise the operation of the system. Monitor client-prepared source documents and make changes in basic IT-generated

data without the concurrence of the client.

b. The significant matters related to an engagement generally include (a) the engagement's objectives, (b) the scope, (c) the approach, (d) the role of all personnel, (e) the manner in which results are to be communicated, (f) the timetable, and (g) the fee.

20-28 a. 1. Union Bank will be successful in its negligence suit against Meng. To be successful in a lawsuit for accountant's negligence, there must be: Duty. Breach. Reliance. Loss.

Meng had a duty because it knew that Union would receive the financial statements and was thereby an intended user. Meng was negligent in performing the audit by failing to confirm accounts receivable, which resulted in failing to discover the overstatement of accounts receivable. Meng's failure to confirm accounts receivable was a violation of Meng's duty to comply with generally accepted auditing standards. Union relied on Meng's opinion in granting the loan and, as a result, suffered a loss.

2. Union Bank will be successful in its common-law fraud suit against Meng. To be successful in a lawsuit for common-law fraud, there must be: An intentional material misstatement or omission. Reliance. Loss.

Meng was grossly negligent for failing to qualify its opinion after being advised of Butler's potential material losses from the product liability lawsuit by legal counsel. Meng will be liable to anyone who relied on Meng's opinion and suffered a loss as a result of this fraudulent omission.

b. Butler's stockholders who purchased stock will also be successful in their suit against Meng under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934. Under the act, stock purchasers must show: Intentional material misstatement or omission (scienter). Reliance. Loss.

Meng's failure to qualify its opinion for Butler's potential legal liability was material and done intentionally (scienter). Meng will be liable for losses sustained by the purchasers who relied on Meng's opinion.

Answers to Supplemental Problems

SP1 1. A2. A3. D4. A5. B

SP2

Part A: Cost of goods sold as a percent of sales for drug and nondrug sales is as follows:

DRUGS NONDRUGS20X6 59.4 68.020X5 57.8 68.020X4 57.9 68.120X3 57.7 68.2

The explanation given by Adams is correct in part, but appears to be overstated. Cost of goods sold as a percent of sales 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 20X6. In dollars, the difference is $82,000 = (59.4 – 57.8) 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 overstated sales. Further investigation is required to determine if the decline is due to competitive factors or to a misstatement of income,

Part B:

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.

Calculate an estimate 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 seems out of line, select a sample of individual sales and recompute the commission, comparing it to the commission recorded.

2. Obsolete or unsalable inventory may be present and may require markdown to the lower of cost or market.3. 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 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 the sell the items and the selling price. 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.

4. Depreciation expense may be understated for the year.Discuss the reason for the reduced depreciation expense with client personnel responsible for the

fixed asset 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.

SP3

Part A:

1. Control procedures: Require that payments be made only on original invoices. Require a receiving report be attached to vendor’s invoice before a payment is made.

Audit objective: existence/validity

2. Control procedures: Fence in the physical facilities and prohibit employees from parking insider the fence. Require the accounting department to maintain perpetual inventory records and periodically take physical counts of actual sides of beef.

Audit objective: existence/validity

3. Control procedures: Make sure the salesman has a current price list. Require independent approval of all transactions, including the price, before shipment is made.

Audit objective: valuation

4. Control procedure: Carefully coordinate the physical count of inventory on the last day of the fiscal year with the recording of sales to make sure counted inventory has not been billed and billed inventory has not been counted.

Audit objective: cutoff

Part B:

1. a. (1) Supplying the receiving department with a the purchase order is regarded as a weakness in that the department may be less careful in checking goods than they would be if they were working without a record of the quantities that should be received. (2) The failure to have the storekeeper receipt for the materials when they are sent to him from the receiving department or to tie in the items placed in stores with the purchase constitutes a weakness in control in that responsibility for shortages cannot be definitely placed on either receiving or stores. The receiving department might, in collusion with a vendor, report receipt of materials which were never received. Also, either the receiving department or the stores department might fraudulently convert some of the materials and because of the lack of responsibility, the company would be unable to determine which one was responsible.

b. (1) This weakness increases the likelihood of obsolete inventory and the possibility of theft of shipments larger than the amount ordered. (2) The failure to isolate responsibility for shortages also increases the likelihood of obsolescence in that employees are likely to be less concerned when they are not held accountable. Since the company cannot isolate responsibility it might also encourage receiving or stores to take goods.

c. (1) Use a “blind” copy of the purchase order or a separate receiving report without a copy of the purchase order. (2) Use perpetual inventory records to hold the storekeeper accountable. The storekeeper should also initial the receiving report or purchase order when he receives the goods.

2. a. (1) The payroll checks are returned to the supervisor. (2) There is a lack of internal verification of the hours, rates, extensions, or employees.

b. (1) Padding of the payroll with fictitious names and extracting the checks made out to the fictitious employees (when the checks are returned after being signed). (2) There may be errors in hours, rates, or extensions, and there may be non-existent employees.

c. (1) Have the checks handed out by an independent person and not returned to Strode. (2) require internal verification of the information by Webber or someone else.

3. a. The bank statement and cancelled checks are sent to the manager, and she prepares the reconciliation.

b. The branch manager may draw checks to herself and omit them from her list of disbursements or inflate other reported disbursement amounts.

c. Have all bank statements and cancelled checks sent directly to the home office and have Cooper report directly to the home office by use of a list of expenditures and all supporting documentation.

SP4

a. Major deficiencies in the audit are as follows:1. The change in the accounting system to computerize the inventory, a change in accounting

personnel, and the existence of a few more errors in the tests of controls should have alerted the auditors to expand the scope of the work. It was questionable to conclude that the internal control structure was effective.

2. Reduction in the scope of the inventory work based on the lack of errors last year was improper because a new internal control structure was in place this year, as well as new personnel. Further, the inventory balance was higher.

3. The new division should have been audited more thoroughly. It came to Merkle through merger and was likely to have different operating characteristics and internal controls.

4. The determination that the errors in the sample were immaterial was improper. The errors should have been projected from the sample to the population, and the projected error should have been compared to tolerable error, after considering sampling risk. The obsolescence problem uncovered in the audit should have been evaluated carefully.

5. Given the new personnel on the engagement, Brewer apparently failed to adequately supervise and review the work of assistants.

6. There was an apparent lack of the use of analytical procedures. A decline in sales should have warned the auditor to a potential decline in profits and the existence of obsolete inventory.

b. Brewer should have been aware that the inventory internal control structure and the personnel in that department were new, that the interim tests revealed more errors than normal, and that the inventory tests revealed more errors than normal despite the reduction in scope. In this situation, the scope of the inventory should have been increased to reveal the magnitude of the problems encountered. In addition, because of the staff turnover on this engagement, Brewer should have devoted more of his time to supervising the work of the staff.

c. The likelihood of the Brewer losing the suit is high. The auditors appear not to have followed general standards 1 and 3 and standards of field work 1, 2, and 3 in the performance of the engagement. Although the misstatements resulted from management fraud, the auditors may be held responsible because apparently the audit was not conducted in accordance with GAAS.

SP5 1. B2. C

SP6 1. B2. D3. D4. B5. C6. B

SP7

1. The oral evidence that the motors are on consignment should be substantiated by a review of the client’s records of consigned inventory, examination of contracts and correspondence with consignors, and confirmation of consigned stocks by direct communication with consignors.

2. The location of the machine in the receiving department, together with the presence of the “REWORK” tag, suggests that the machine had been shipped to a customer but rejected and returned. The auditors should examine the receiving report for the machine, the accounts receivable confirmation from the customer, and records of the client’s quality control department, to ascertain who has title to the machine. If the customer has title, the machine should not be included in inventory, and a liability for rework costs should be established. If the client has title, the customer’s account should be credited for the sales return and the machine should be included in the client’s inventory at estimated realizable value.

3. The “Material Inspection and Receiving Report” signed by the Navy Source Inspector is evidence that title to the machine passed to the U. S. Naval Base on November 30. Accordingly, the auditors should ascertain that the sales value of the machine is included in accounts receivable, and that the cost of the machine is not in the inventory.

4. The location of the storeroom and the dusty condition of the goods suggest that the items may be obsolete, or at least slow moving. The auditors should inspect perpetual inventory records for usage of the materials, and should inquire of production personnel whether the materials are currently useful in production. The materials may have to be valued at scrap value.

SP8

1. Qualified or Adverse. Disclosure of the subsequent is required in a footnote. Failure to do so is a violation of GAAP and likely to result in a qualified opinion—or it could be so important as to require an adverse opinion.

2. Standard Unqualified. Because the auditor was able to obtain alternative evidence, no scope qualification is necessary. If alternative evidence were not available, the opinion would be qualified or disclaimer, depending on materiality.

3. Qualified. Because the auditor was unable to satisfy herself about beginning inventories, it would be necessary to issue either a qualified or disclaimer of opinion on the income statement and statement of cash flows, as well as on the beginning balance sheet. The use of a qualified or disclaimer would depend on the opinion given in the prior year. An unqualified opinion could be issued for the current period balance sheet.

4. Standard unqualified. The change of estimated life is a change of condition and not a change in accounting principle. Therefore, an unqualified opinion is appropriate since there is adequate disclosure.

SP9

1. Indeterminate. If John Brown can influence the audit, he is in violation even though he is not a partner and is not on the audit team. Otherwise, he is not in violation. (Rule 101)

2. Violation. In tax practice, a CPA may resolve doubt in favor of her client as long as there is reasonable support. In this case, there is no reasonable support. (Rule 102)

3. Violation. A CPA who accepts a professional engagement is required to have the necessary competence to complete the engagement. Bacon does not have the expertise to review the work of the consultant hired by Bacon. Bacon should have suggested that the company hire the consultant directly. (Rule 201)

4. Violation. The client should have been notified that the review was to take place, and an attempt made to obtain the client’s permission because the review was not part of an AICPA review program. (Rule 301)

5. No violation. The rule regarding discreditable acts is vague; the state board of accountancy likely would make an interpretation. In most states this would be a civil action and likely not be a violation of the Code of Conduct. (Rule 501)

6. Violation. Appearance of independence has been impaired by Wendal’s agency’s financial dealing with her audit clients and participation in a business which impairs her objectivity. It is also a conflict of duties to recommend her own firm to review the adequacy of the existing insurance coverage of existing clients. (Rules 101 and 102)

7. No violation. If the services do not result in Rankin making decisions for the client, then he is not in violation of the independence requirements. There would be a violation of SEC rules if the client is publicly held. (Rule 101)

SP10

a. The basis of Jackson’s claim will be that she sustained a loss based upon misleading financial statements. Specifically, she will rely upon section 11(a) of the Securities Act of 1933, which provides the following:

In case any part of the registration statement, when such part because effective, contained an untrue statement of a material fact of omitted to state a material fact requirement to be stated therein or necessary to make the statements therein not misleading, any person acquiring such security (unless it is proved that at the time of such acquisition he knew of such untruth or omission) may, either at law or in equity, in any court of competent jurisdiction, sue . . . every accountant . . . who has with his consent been named as having prepared or certified any part of the registration statement . . .

To the extent that the relatively minor irregularities resulted in certification of materially false or misleading financial statements, there is potential liability. Jackson’s case is based on the assertion of such an untrue statement or omission coupled with an allegation of damages. Jackson does not have to prove reliance on the statements nor the company’s or auditor’s negligence in order to recover the damages. The burden is placed on the defendant to provide defenses that will enable it to avoid liability.

b. The first defense that could be asserted is that Jackson knew of the untruth or omission in the audited financial statements included in the registration statement. The act provides that the plaintiff may not recover if it can be proved that at the time of such acquisition she knew of such untruth or omission. Since Jackson was a member of the private placement group and presumably privy to the type of information that would be contained in a registration statement, plus any other information requested by the group, she may have had sufficient knowledge of the facts claimed to be untrue or omitted. If this be the case, then she would not be relying on certified financial statements but upon her own knowledge.

The next defense assertible would be that the untrue statement or omission was not material. The SEC has defined the term as meaning matters about which an average prudent investor ought to be reasonably informed before purchasing the registered security. For section 11 purposes, this has been construed as meaning a fact that, had it been correctly stated or disclosed, would have deterred or tended to deter an average prudent investor from purchasing the security in question.

Allen, Dunn, and Rose would also assert that the loss in question was not due to the false statement or omission; that is, that the false financial statement was not the cause of the price drop. It would appear that the general decline in the stock market would account for at least a part of the loss. Additionally, if the decline in earnings was not factually connected with the false statement or omission, the defendants have another basis for refuting the causal connection between their wrongdoing and the drop in the stock’s price.

Finally, the accountants will claim that their departure from generally accepted auditing standards was too minor to be considered a violation of the standard of due diligence required by the act.