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Solutions to Problems
5-29 a. The procedures Hall should perform before accepting the engagement include the
following:
1. Hall should explain to Adams the need to make an inquiry of Dodd and should
request permission to do so.
2. Hall should ask Adams to authorize Dodd to respond fully to Hall's inquiries.
3. If Adams refuses to permit Dodd to respond or limits Dodd's response, Hall should
inquire as to the reasons and consider the implications in deciding whether to
accept the engagement.
4. Hall should make specific and reasonable inquiries of Dodd regarding matters Hall
believes will assist in determining whether to accept the engagement, including
specific questions regarding:
 Facts that might bear on the integrity of management.
 Disagreements with management as to accounting principles, auditing
procedures, or other similarly significant matters.
 Dodd's understanding as to the reasons for the change of auditors.
5. If Hall receives a limited response, Hall should consider its implications in
deciding whether to accept the engagement.
b. The additional procedures Hall should consider performing during the planning phase
of this audit that would not be performed during the audit of a continuing client may
include the following:
1. Hall may apply appropriate auditing procedures to the account balances at the
beginning of the audit period and, possibly, to transactions in prior periods.
2. Hall may make specific inquiries of Dodd regarding matters Hall believes may
affect the conduct of the audit, such as
 Audit areas that have required an inordinate amount of time.
 Audit problems that arose from the condition of the accounting system and
records.
3. Hall may request Adams to authorize Dodd to allow a review of Dodd's working
papers.
4. Hall should document compliance with firm policy regarding acceptance of a new
client.
5. Hall should start obtaining the documentation needed to create a permanent
working paper file.
5-32 a. The typical engagement letter generally includes the following:

1. The name and address of the person or persons who retained the auditor to
perform the auditing services.
2. An opening paragraph that confirms the understandings of the auditor and the
client.
3. A summary of significant events that led to the retention of the services of the
auditor.
4. A general description of the CPA firm that will conduct the examination.
5. A statement that the examination will be performed in accordance with PCAOB
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auditing standards.
6. A description of the scope of the services to be rendered, which should establish
the nature of the engagement.
7. Any scope restrictions or special limitations and their effect on the auditor's
report.
8. A statement regarding the auditor's responsibility for the detection of fraud.
9. An indication of the possible use of client personnel in connection with the audit
work to be performed.
10. A statement that the auditor will provide a management letter if required in the
circumstances.
11. The method and timing of billings as well as billing rates and fee arrangements.
12. Space for the client representative's signature, which indicates acceptance of the
letter and the understandings therein.
b. The benefits of preparing an engagement letter include the avoidance of possible

problems between the CPA and the client concerning (1) the scope of the work, (2) the
service to be rendered, and (3) the audit fee. In addition, the "in-charge" auditor
conducting the examination can avoid misunderstanding the nature and scope of the
engagement if the engagement letter is included in the permanent section of the audit
working papers. The letter should eliminate misunderstandings and confusion about
the type of financial statements to be examined, the estimated report date, and the type
of opinion expected. In this respect, the letter lessens any problems associated with
the first standard of field work, which requires the work to be adequately planned and
assistants to be properly supervised. In addition to avoiding possible
misunderstandings, any legal problems relating to the auditor's failure to perform
certain procedures can be reviewed with reference to the contractual commitment
assumed. For example, if scope limitations prevent the auditor from performing
normal audit procedures, the auditor cannot be legally responsible if a fraud is not
detected when clearly it would have been detected if such procedures were performed.
The engagement letter is also useful as a reference document when preparing for
future engagements.
5-33 a. An audit committee is an important part of a company's organizational structure. It is

a special committee formed by the board of directors. It should be a group of outside
(independent) directors who have no active day-to-day operational role and who are a
liaison between the independent auditor and the board of directors. The audit
committee assists and advises the full board of directors and in doing so aids the board
in fulfilling its responsibility for public financial reporting.
b. Audit committees are formed to satisfy the shareholders' need for assurance that
directors are exercising due care in the performance of their duties. For public
companies they are required by regulation. They may also be formed so that a
company can be more responsive to the needs of those interested in financial
reporting. Their formation itself is recognition of the responsibilities of both the
corporation and its auditor to the public investor. Also, they may be formed to
reinforce auditor's independence, particularly the appearance of independence, from
the management of a company whose financial statements are being examined by the
auditor.
c. The functions of an audit committee may include the following:

 Selection of the independent auditor, discussion of audit fee with the auditor, and
review of the auditor's engagement letter.
 Review of the independent auditor's overall audit plan (scope, purpose, and general
audit procedures).
 Review of the annual financial statements before submission to the full board of
directors for approval.
 Review of the results of the auditor's examination including experiences,
restrictions, cooperation received, findings, and recommendations. Matters that
the auditor believes should be brought to the attention of the directors or
shareholders should be considered.
 Review of the independent auditor's evaluation of the company's internal control
systems.
 Review of the company's accounting, financial, and operating controls.
 Review of the reports of internal audit staff.
 Review of interim financial reports to shareholders before the board of directors
approves them.
 Review of company policies concerning political contributions, conflicts of interest,
and compliance with federal, state, and local laws and regulations, and
investigation of compliance with those policies.
 Review of financial statements that are part of prospectuses or offering circulars;
review of reports before they are submitted to regulatory agencies.
 Review of the independent auditor's observations of financial and accounting
personnel.
 Participation in the selection and establishment of accounting policies; review the
accounting for specific items or transactions as well as alternative accounting
treatments and their effects.
 Review of the impact of new or proposed pronouncements by the accounting
profession or regulatory bodies.
 Review of the company's insurance program.
 Review and discussion of the independent auditor's management letter.
5-35
Audit Procedure Assertion
1 Accuracy
2 Existence
3 Cutoff
4 Valuation and allocation
5-36 a. Analytical procedures are used for three broad purposes:

 To assist the auditor in planning the nature, timing, and extent of other auditing
procedures.
 As a substantive test to obtain evidential matter about particular assertions related to
account balances or classes of transactions.
 As an overall review of the financial information in the final review stage of the
audit.
b. An auditor's expectations (types of analytical procedures) are developed from the

following sources of information:
 Financial and operating data.
 Budgets and forecasts.
 Industry publications.
 Competitor information.
c. The factors that influence an auditor's consideration of the reliability of data for
purposes of achieving audit objectives are whether the
 Knowledgeable independent source of the evidence.
 The effectiveness of internal controls.
 The auditor’s direct personal knowledge.
 Documentary evidence.
 Original documents.
5-37 a. The calculation of the expectation for the reserve for returns account can be made as
follows:
Monthly
Sales Historical Estimated
Months (in 000s) Return Rate Returns
July $ 73,300,000 0.004 293,200
August 82,800,000 0.006 496,800
September 93,500,000 0.01 935,000
October 110,200,000 0.015 1653,000
November 158,200,000 0.025 3,955,000
December 202,500,000 0.032 6,480,000
13,813,000
Gross Margin % x 0.425
Auditor expectation $5,870,525
b. We can establish a tolerable difference by applying a percentage (50%) to the

planning materiality set for EarthWear of $1,800,000. This results in a tolerable
difference of $900,000.
c. The expectation of $5,870,525 is approximately $20,000 less the book value of

$5,890,000. Since this amount is less than the tolerable difference of $900,000, the
analytical procedure supports the fair presentation of the reserve for returns account.
d. If the difference between the auditor’s expectation and the book value is greater than
the tolerable misstatement, the auditor should consider performing the following audit
procedures:
 Review the general journal and general ledger for any unusual entries.
 Reevaluate the historical return rates.
 Reevaluate the gross profit margin.
 Ask the client to adjust the books.
5-40 1. Reported ticket revenue differs from the expectation by approximately 14 percent
((2,200,000 - 1,922,190)/ 1,922,190); this difference is material and should be
investigated. One explanation for the larger than expected reported ticket revenue
could be that the football team performed better than expected. In addition, perhaps the
weather also was better than expected. Auditors can verify ticket sales, perhaps by
comparing deposits of ticket revenue with reported attendance. The auditors also could
check weather conditions on game days to ascertain whether favorable weather
conditions are a plausible explanation for the higher attendance.
Development of Auditor’s Expectation
Four regular games
24,000 Total attendance
Price per Total
Allocation Total Fans Less free Ticket Revenue
0.7 16,800 16,300 12 195,600
0.2 4,800 4,800 8 38,400
0.1 2,400 2,400 5 12,000
24,000 246,000
x4
Four normal games 984,000
Bloomington (30% higher attendance, 20%

University higher ticket price)
31,200 Total attendance

Price per Total
Allocation Total Fans Less free Ticket Revenue
0.7 21,840 21,340 14.40 307,296
0.2 6,240 6,240 9.60 59,904
0.1 3,120 3,120 6.00 18,720
31,200 385,920
Norwalk University (20% more fans, 75% box

seats, 25% upper deck)
Normal game revenue: 246,000
Price per Total

Extra fans (total): 4,800 Ticket Revenue
Box 3,600 12 43,200
Upper 1,200 5 6,000
295,200
Night game (10% higher ticket

prices, 5% lower
attendance)
24,000 Base attendance tickets

Less:
Free seats Price per Total
and 5% Ticket Revenue
0.7 16,800 15,485 13.20 204,402
0.2 4,800 4,560 8.80 40,128
0.1 2,400 2,280 5.50 12,540
24,000 22,325 257,070
Total estimated revenue $1,922,190

for the year
Reported ticket revenue differs from the expectation by approximately 14 percent
((2,200,000 – 1,921,860)/1,921,860); this difference is material and should be
investigated. One explanation for the larger than expected reported ticket revenue could
be that the football team performed better than expected. In addition, perhaps the weather
also was better than expected. Auditors can verify ticket sales, perhaps by comparing
deposits of ticket revenue with reported attendance. The auditors also could check
weather conditions on game days to ascertain whether favorable weather conditions are a
plausible explanation for the higher attendance.
In a problem such as this, analytical procedures will be most effective when accurate
expectations can be developed. From this information provided in this problem, it appears
that the auditor’s knowledge of Western’s ticket sales is sufficient to allow them to
develop a reasonable expectation.
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Solutions to Problems

5-32 a. The typical engagement letter generally includes the following:

b. The benefits of preparing an engagement letter include the avoidance of possible

5-33 a. An audit committee is an important part of a company's organizational structure. It is

c. The functions of an audit committee may include the following:

5-36 a. Analytical procedures are used for three broad purposes:

b. An auditor's expectations (types of analytical procedures) are developed from the

b. We can establish a tolerable difference by applying a percentage (50%) to the

c. The expectation of $5,870,525 is approximately $20,000 less the book value of

Bloomington (30% higher attendance, 20%

31,200 Total attendance

Norwalk University (20% more fans, 75% box

Normal game revenue: 246,000

Price per Total

Night game (10% higher ticket

24,000 Base attendance tickets

24,000 22,325 257,070

Total estimated revenue $1,922,190

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