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Solution Manual For Auditing A Risk Based Approach To Conducting A Quality Audit Johnstone Gramling Rittenberg 9th Edition
Solution Manual For Auditing A Risk Based Approach To Conducting A Quality Audit Johnstone Gramling Rittenberg 9th Edition
9-1 F
9-2 F
9-3 T
9-4 F
9-5 T
9-6 T
9-7 F
9-8 F
9-9 T
9-10 F
9-11 F
9-12 F
9-13 T
9-14 F
9-15 F
9-16 T
9-17 B
9-18 D
9-19 D
9-20 C
9-21 C
9-22 A
9-23 D
9-24 C
9-25 D
9-26 D
9-27 A
9-28 B
9-29 D
9-30 B
9-31 C
9-32 A
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9-1
9-33
• Sales
• Sales-Related Expenses and Liabilities:
o Sales Returns & Allowances
o Warranty Expense and Liability
o Salesperson Commissions
• Accounts Receivable
• Allowance for Doubtful Accounts
• Doubtful Accounts Expense
• Cash
Understanding the relationships between the accounts allows the auditor to develop a more
efficient audit approach. As shown in the Exhibit, the credit to sales and the debits to either
accounts receivable or cash are directly related. The sales-related expenses (or liabilities) are
directly tied to the sales figure. For example, most companies will make an estimate of the
warranty expense liability based on a percentage of sales and will then adjust the expense and
liability as experience dictates. Similarly, salesperson commissions may be directly computed as
a percentage of net sales. The provision for doubtful accounts directly affects doubtful accounts
expense. Write-offs of uncollectible accounts directly affect accounts receivable and the
allowance for doubtful accounts.
9-34
For the accounts receivable account, the more relevant assertions are typically existence and
valuation. While the auditor will likely gather evidence related to each of the assertions for
accounts receivable, the more relevant assertions are the ones where there is higher risk of
misstatement and for which the auditor will likely need more evidence. This assessment can vary
across clients. Identifying which assertions are more relevant helps the auditor plan a more
efficient audit by having the auditor focus more attention on the assertions where there are more
risks.
9-35
1. Receive a Customer Purchase Order Processing begins with the receipt of a purchase order
from a customer or the preparation of a sales order by a salesperson. The order might be taken by
(1) a clerk at a checkout counter, (2) a salesperson making a call on a client, (3) a customer
service agent of a catalog sales company answering a toll-free call, (4) a computer receiving
purchase order information electronically from the customer’s computer, or (5) the sales
department directly receiving the purchase order. For example, consider a customer service agent
for a catalog merchandiser taking an order over the phone. The information is keyed into a
computer file, and each transaction is uniquely identified. The computer file (often referred to as
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9-2
a log of transactions) contains all the information for sales orders taken over a period of time and
can be used for control and reconciliation purposes.
2. Check Inventory Stock Status Many organizations have computer systems capable of
informing a customer of current inventory status and likely delivery date. The customer is
informed of potential back-ordered items, as well as an expected delivery date.
3. Generate Back Order If an item is to be back-ordered for later shipment to the customer, a
confirmation of the back order is prepared and sent to the customer. If the back order is not filled
within a specified time, the customer is often given the option of canceling the order. An
accurate list of back-ordered items must be maintained to meet current customer demand and
future inventory needs. Appending a separate field to the individual inventory records to show
back-ordered items usually accomplishes this.
4. Obtain Credit Approval Formal credit approval policies are implemented by organizations to
minimize credit losses. Some organizations eliminate credit risk by requiring payment through a
credit card. Others require that a check accompany the order, and generally they delay the
shipment until the check clears through the banking system to assure that the payment is
collectible.
5. Prepare Shipping and Packing Documents Many organizations have computerized the
distribution process for shipping items from a warehouse. Picking tickets (documents that tell the
warehouse personnel the most efficient sequence in which to pick items for shipment and the
location of all items to be shipped) are generated from the sales order or from the customer’s
purchase order. Separate packing slips are prepared to insert with the shipment and to verify that
all items have been shipped. Some organizations put a bar code on the shipping container that
identifies the contents. The bar code can be scanned by the customer to record receipt of the
order.
Packing slips.
Inventory picking tickets.
Shipping instructions.
6. Ship and Verify Shipment of Goods Most goods are shipped to customers via common
carriers such as independent trucking lines, railroads, or airfreight companies. The shipper
prepares a bill of lading that describes the packages to be conveyed by the common carrier to the
customer, the shipping terms, and the delivery address. The bill of lading is a formal legal
document that conveys responsibility to the shipper. A representative of the common carrier
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9-3
signs the bill of lading, acknowledging receipt of the goods. The shipping department confirms
the shipment by (1) completing the packing slip and returning it to the billing department, (2)
electronically recording everything shipped and transmitting the shipping information to the
billing department, or (3) preparing independent shipping documents, a copy of which is sent to
the billing department.
7. Prepare and Send the Invoice Invoices are normally prepared when notice is received that
goods were shipped. The invoice should include items such as the terms of sale, payment terms,
and prices for merchandise shipped. The invoice will serve as an important document in terms of
audit evidence.
Invoice
9. Receive Payments The proper recording of all revenue receipts is crucial to the ultimate
valuation of both cash and accounts receivable. This part of the revenue process is typically
considered to be part of the cash receipts and cash management cycle, and is discussed in detail
in Chapter 10.
9-36
a.
The SEC staff has determined that the following criteria must be met before revenue can be
recognized:
Research may be required for sales arrangements that are out of the ordinary. The SEC and
AICPA have published documents that provide criteria for recognition of such revenue
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9-4
transactions. For some clients, the auditor may also need to consider the international accounting
standards that address revenue recognition.
b.
9-5
Scenario Key Issues Additional Information Revenue Recognition
and Criteria
period may last as long Sales contract and right location for evaluation.
as 6 months. Since of return. The promotion does not
most of the placements seem to meet the criteria
result in a sale, the Realizability of past for revenue recognition.
client wants to sales; examine
recognize revenue receivables.
when the goods are
placed at the client’s
location.
6. Jackson Company phased out Confirm management If the company is
Products line of business and intent and business plan. remaining in its original
sold most of the line of business, or a
manufacturing Determine terms of the similar line, then revenue
equipment. Should the equipment sale. should be recognized by
sale of the equipment producing and selling
be recognized as those products, not by
revenue? selling machinery. The
machinery should be sold
and a separate line item
should be established to
recognize the gain/loss on
sale of equipment.
9-37
One example would be where a company receives purchase orders for products it manufactures.
At the end of its fiscal quarters, customers may not yet be ready to take delivery of the products
for various reasons. These reasons may include, but are not limited to, a lack of available space
for inventory, having more than sufficient inventory in their distribution channels, or delays in
customers’ production schedules. The company receiving the purchase order might try to set up
situations so as to recognize revenue prematurely. For example, because of the purchase order,
the company may want to recognize revenue for the sale of its products once it has completed
manufacturing and segregates the inventory of the products in its own warehouse from its own
products. Alternatively, the company might ship the products to a third-party warehouse but
retain title to the product and have payment by the customer is dependent upon ultimate delivery
to a customer-specified site. The staff believes that delivery generally is not considered to have
occurred unless the customer has taken title and assumed the risks and rewards of ownership.
9-38
Revenue recognition should ordinarily be considered a fraud risk factor because over half of
frauds that have been studied involved improper revenue recognition by either recognizing
revenue early or recording fictitious revenue.
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9-6
There are many reasons management may want to report higher profits by overstating revenue.
Bankruptcy may be imminent, for example, because of operating losses, technology changes in
the industry causing the company’s products to become obsolete, or a general decline in the
industry. Executives may be pressured to meet their own or analysts’ earnings expectations. The
company may need additional financing. Bonuses or stock options may be dependent on
reaching a certain earnings goal. A merger may be pending and management wants to negotiate
the highest price possible.
9-39
Recent fraud investigations undertaken by the SEC and others have uncovered a wide variety of
methods used to inflate revenue:
A professionally skeptical auditor should question revenue trends that seem too good to be true
or that exactly meet projections. How was management able to meet the numbers? Extending
substantive audit procedures at clients where there is a heightened risk of fraudulent revenue
transactions would be an appropriate response.
9-40
Identifying fraud risk factors involves the auditor doing the following:
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9-7
• Determining whether the company’s accounting is being investigated by organizations such
as the SEC
• Considering management compensation schemes, especially those that rely on stock options
and therefore current stock prices
• Determining whether accounting functions are centralized, and if not centralized, assessing if
the decentralization is appropriate (see the Auditing in Practice feature “Risks Related to
Decentralized Accounting Functions: The Case of WorldCom” for a relevant example)
• Assessing whether the company engages in complex sales arrangements when simple
transactions would suffice
• Assessing whether the company has a history of aggressive accounting interpretations
• Determining whether an uninterrupted history of continued growth in earnings per share or
revenue might provide incentives to continue to show that growth
• Determining if the client has numerous manual journal entries affecting the revenue process
(assuming that process is automated)
9-41
An internal control questionnaire is an approach used for documenting a client’s controls. The
questionnaire includes a section for a narrative description and a series of questions. Each
negative answer in the questionnaire represents a potential internal control deficiency. Given a
negative answer, the auditor should consider the effect of the response on the initial assessment
of control risk. For example, a negative response to the question regarding the existence of a
segregation of duties between those receiving cash and those authorizing write-offs or
adjustments of accounts indicates that a risk exists that an individual could take cash receipts and
cover up the fraud by writing off a customer’s balance.
A controls matrix is an alternative approach to documenting a client’s controls. The matrix can
be designed any number of ways but would typically contain a description of the relevant
controls, the financial statement assertions affected by the controls, how the auditor plans to test
the controls, and the results of control testing.
9-42
Sending monthly statements and establishing a separate group to handle customer inquiries
enhances controls as follows:
• Each customer receives a statement and can verify the statement for accuracy and timeliness
of the client's update of records. The customer has a basis to follow-up on potential errors in
the accounts, such as failure to post a payment or a dispute about returned merchandise.
• Establishing a separate group to handle customer inquiries creates a segregation of duties.
The individuals handling customer inquiries and following up to reach a proper disposition of
customer complaints do not handle cash or have access to the normal recording of accounts
receivable. The group thus acts as a double check on the accuracy of the normal accounts
receivable processing.
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9-8
9-43
If appropriate controls are not in place, the sales returns reserve can be misstated. This could
occur due to either error or fraud. At Medicis, the company had a practice of reserving for most
of its estimated product returns at replacement cost, instead of at gross sales price – an approach
that was not in conformity with GAAP. For example, if there are not controls related to ensuring
that competent personnel with appropriate knowledge of GAAP, then the personnel may
determine the reserve amount using a non-GAAP approach. Another control in this area would
be to require some type of management review of the sales returns reserve calculation process.
Therefore if the reserve was not appropriately determined, the review should identify the issue.
9-44
3. F. To provide assurance that all invoiced goods that have been shipped are recorded as
sales, daily sales summaries should be compared with invoices. For example, a sale that has not
been recorded will result in a sales summary that does not include certain sales invoices.
4. K. A comparison of the amounts posted to the accounts receivable ledger with the control
total for invoices will provide assurance that all invoices have been posted to a customer account.
5. I. Comparing customer orders with an approved customer list will provide assurance that
credit sales are made only to customers that have been granted credit.
6. B. Requiring an approved sales order before goods are released from the warehouse will
provide assurance that goods are not removed for unauthorized orders.
7. D. A comparison by shipping clerks of goods received from the warehouse with the
approved sales orders will provide assurance that goods shipped to customers agree with goods
ordered by customers.
8. L. A comparison of sales invoices with shipping documents and approved sales orders will
detect invoices that do not have the proper support. Accordingly, it will help prevent the
recording of fictitious transactions.
9. P. Comparing amounts posted to the accounts receivable ledger with the validated bank
deposit will detect improper postings to accounts receivable since any differences in amounts
will be investigated.
10. C. Misappropriations of customer’s checks will be detected when customers indicate that
they have made payments for items shown as payable on their monthly statement. Note that
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9-9
replies O and P will only detect this misappropriation in the unlikely event that the perpetrator
does not dispose of the remittance advice.
11. C. Miss-postings of payments made will be detected when customers indicate that they have
made payments for items shown as payable on their monthly statement.
12. P. Crediting more than one account for a cash receipt will be detected when the total of
amounts posted to the accounts receivable ledger is compared with the validated bank deposit
slip.
13. S. An independent reconciliation of the bank account will reveal improper total recording of
receipts in the cash receipts journal because unlocated differences between bank and book
balances will occur and be investigated.
14. P. Comparing total amounts posted to the accounts receivable ledger with the validated bank
deposit will detect a difference between total cash receipts and the amount credited to the
accounts receivable ledger.
15. N. Requiring the approval of the supervisor of the sales department for goods received will
provide assurance that invalid transactions granting credit for sales returns are not recorded. Note
that using prenumbered credit memos (reply M) will only be effective if the sequence is
accounted for and if credit memos may be compared in some form to actual returns.
9-45
The auditor can compare the client’s revenue trend with economic conditions and industry
trends. Cash flow from operations can be compared with net income over a period of time. Ratio
and trend analysis and reasonableness tests can be performed. Some of the ratios the auditor
might want to compute include:
• Gross margin analysis, including a comparison with industry averages and previous year’s
averages for the client
• Turnover of receivables (ratio of credit sales to average net receivables) or the number of
days’ sales in accounts receivable
• Average balance per customer
• Receivables as a percentage of current assets
• Aging of receivables
• Allowance for uncollectible accounts as a percent of accounts receivable
• Bad debt expense as a percent of net credit sales
• Sales in the last month to total sales
• Sales discounts to credit sales
• Returns and allowances as a percentage of sales
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9-10
Some basic trend analyses include:
9-46
• The significant increases in number of day’s sales in receivables and inventory from 2013.
They are also significantly higher than their major competitor in 2014.
• The percent increases in receivables (106%) and inventory (60%) in 2014 far exceed the
increases in sales (9%).
• The number of day’s sales in receivables (29) does not make sense given that the banks
usually pay within two weeks of shipment.
In prior years, the number of day’s sales in receivables and inventory had remained very stable
and compared favorably with their competitor and their customers’ banks payment time-line.
The 2014 results are obviously unexpected and indicate potential problems with receivables and
inventory.
• Inquiring of management about factors that might explain the increases in receivables and
inventory.
• Vouching sales recorded near year-end to supporting customer orders and shipping records to
be sure they are legitimate, agree with customer order quantities, and are recorded in the
proper accounting period.
• Verifying that the receivable subsidiary records agree with the control account balance.
• Expanding confirmation and subsequent collection work.
• Verifying that the inventory records agree with the control account balance.
• Insist on a complete physical inventory at or near year-end and carefully observing the
inventory and making test counts to compare with the client’s counts, especially for the high-
dollar items.
• Carefully reviewing journal entries made prior to year-end closing.
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9-11
d. This case is based on an actual situation in which one of the authors was involved. The CFO
had embezzled several millions of dollars by having checks drawn on the company’s regular
cash account for deposit in another cash account the CFO was able to control. These checks
required dual signatures – the CFO’s and the CEO’s. Unfortunately the CEO trusted the CFO
and did not question the purposes of these checks he signed. The CFO then recorded journal
entries just before year-end debiting receivables and inventory and crediting cash.
e. When performing preliminary analytical procedures, if the client’s results are unexpected or
look too good to be true the auditor should have a heightened degree of professional skepticism
and be sure to select appropriate substantive procedures. Further, when obtaining explanations
from client management, the auditor should not just accept those explanations but should obtain
sufficient and appropriate evidence to corroborate those explanations. And, before going the
client for explanations of unexpected results, the auditor should first identify possible
explanations.
9-47
a. The change in sales person commission is very important because it changes the emphasis of
the sales person to making sales with little regard for credit, quality, or other issues that affect the
long-term profitability of the company. Specifically, the change:
This incentive scheme should cause the auditors to have a heightened level of professional
skepticism related to sales. The auditor should carefully review sales returns and allowances and
cash collections after year end, comparing them to prior years. The allowance for doubtful
accounts balance likely will need to be a higher percent of receivables than in prior years.
Therefore, the auditor must be sure the allowances appears reasonable in light of likely sales to
less credit-worthy customers. An allowance for sales returns may need to be established if it
appears returns are materially higher in early 2015 than in prior years.
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9-12
b. Analytical information:
% Change from Prior Year
2011 2012 2013 2014
Sales 0.10 0.08 0.11 0.24
Net Income 0.36 0.11 0.24 0.31
Stock Price 0.41 -0.21 0.47 0.68
Economic Growth in Areas
Served 0.04 0.05 0.04 0.01
Percent of Heating Market by
SSS 0.06 0.02 0.13 0.30
Accounts Receivable -0.06 0.15 0.07 0.41
Gross Margin 0.01 0.02 0.01 0.15
Insights:
• The percent increase in sales was over twice that of previous years.
• Net income increased by a greater percentage than did sales or gross margin.
• The economic growth index remained basically unchanged from the previous year.
• The percent increase in market share was greater than the percent increase in sales.
• The percent of sales in the last quarter of the year was higher than in previous years.
• The gross margin percent increased significantly. It had remained fairly constant in the three
previous years.
• The number of day’s sales in receivables increased 14% over 2013.
• The stock price impounds information that the market has about the company. In other
words, the market may know something about the company (especially problems) that the
auditor may not have discovered.
• The market is an indication of expectations and perhaps of motivations by management to
meet pre-determined performance objectives.
d. There are a number of factors that are high fraud risk indicators. These factors primarily relate
to the motivation aspect of the fraud triangle and include:
• Motivation – the changes in the sales person commission plan provides significant
motivations for fraud. The sales person also has more power to negotiate prices. When
considering this motivation, the auditor might find the following financial changes to be
somewhat troubling.
• Financial Changes:
9-13
o The stock price has more than doubled in the past two years.
o Accounts receivable are growing faster than the market and faster than sales.
o It is doubtful that the client has actually reduced administrative expense.
e. Specific substantive audit procedures should address the heightened risk of fraud and might
include the following:
9-48
If the risk of material misstatement is assessed low, the auditor can plan less extensive
substantive testing, or can be more flexible about when the procedures are applied. If the risk is
greater than originally assessed, the auditor will need to adjust the nature, timing, and/or extent
of the planned substantive testing. One of the factors impacting the risk of misstatement is the
effectiveness of the internal controls. If the internal controls are operating effectively, the auditor
will be in a position to plan less extensive substantive testing, or can be more flexible about
when the procedures are applied, or can use less rigorous procedures. Further, if internal controls
are effective, the auditor may be able to rely more on substantive analytical procedures and
perform less substantive detail testing.
9-49
Panel A of Exhibit 9.8 makes the point that because of differences in risk, the “box of evidence”
to be filled for testing the completeness of revenue at the low risk client (Client A) is smaller
than the “box of evidence” to be filled for testing this same assertion at a high risk client (Client
B). Panel B of Exhibit 9.8 illustrates the different levels of assurance that the auditor will obtain
from tests of controls and substantive procedures for the two assertions. Panel B makes the point
that because of the higher risk associated with the completeness of revenue at Client B, the
auditor will want to design the audit so that more of the assurance or evidence is coming from
direct tests of account balances. Note that the relative percentages are judgmental in nature; the
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9-14
examples are simply intended to give you a sense of how an auditor might select an appropriate
mix of procedures.
9-50
1. The company has changed auditors. Contact the predecessor audit firm to determine
their understanding of the reason for the
change.
3. Current management does not have Determine the extent to which stock option
a long history with the company, but plans or bonuses are dependent upon specific
has a reputation as a turn-around artist. levels of achieved performance.
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9-15
a. Areas of Inherent Risk: b. Audit Procedures to Address Risk Areas:
4. There is evidence of significant Inquire as to the nature and extent of related
related party transactions. party transactions. The auditor should expand
audit work to identify all related parties and
investigate any unusual sales transactions to
determine if they may be with related parties.
5. Although not a direct sales item, the Review procedures utilized by the company to
company has slashed research and record the return of merchandise. Determine
development and laid off a number of approach used to adequately identify defective
employees. This could result in a products to determine the status of the product
greater number of defective products (scrap, close-out, re-work, etc.)
and returned merchandise.
Develop tests to review receipt of returned
merchandise near year-end to determine if
credit memos have been issued on a prompt
basis and in the correct time period.
6. Sales have been increasing at 20% Understand trends in the industry, such as new
per year. It is doubtful that the product introductions, profitability of
company can maintain such growth competitors, etc. to determine the competitive
rates without the introduction of a advantaged enjoyed by the client.
substantial number of new products.
However, cutting the research and Review sales contracts to understand the
development budget is likely to potential business reason why this client might
hamper the introduction of technically be obtaining a higher level of success than is
innovative new products. obtained by competitors.
9-16
a. Areas of Inherent Risk: b. Audit Procedures to Address Risk Areas:
those described above.)
7. The plant does not appear to be kept Expand, as discussed above, the review of
up to date. A large amount of procedures for merchandise return. Perform an
inventory is sitting near the receiving extensive review of merchandise returns after
dock. year-end.
9-51
A lower risk of material misstatement because of effective controls means the auditor can place
some reliance on the client’s internal controls and does not need to obtain as much
evidence/assurance from substantive tests. Therefore, the nature, timing, and extent of
substantive tests related to accounts receivable could be affected in the following ways:
• Nature—the auditor may consider using negative rather than positive confirmations.
• Timing—the accounts can be confirmed prior to year-end, placing some, but not complete,
reliance on the internal control system to bring the receivables balance to year-end
accurately. The auditor may need to perform some additional procedures for the roll-forward
period.
9-52
Auditors often debate this question. Many auditors believe that a minimum amount of re-
performance of the control is necessary in some instances in order to determine that the person
performing the control actually performed the procedure indicated. In other words, the person
did not simply initial the document. The auditor gathers evidence through re-performance that
the control was operating effectively.
Other auditors believe that controls are independent and the auditor can judge the general
conscientiousness with which employees carry out their duties. If the employees appear to be
conscientious, there would be no need to re-perform the procedures unless there is evidence
generated through substantive tests or otherwise, that the control procedures are not operating
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9-17
effectively. Instead of testing controls through re-performance, the auditors would use some set
of tests comprising inquiry, observation, and/or examination of documentation
The authors’ position is that some minimal amount of re-performance is necessary in areas where
there are higher risks of misstatement. In lower risk areas, some set of tests comprising inquiry,
observation, and/or examination of documentation may be sufficient. The extent of re-
performance may be dependent on the auditor's assessment of the overall control environment,
and other entity-wide components of internal control. While re-performance is a very effective
test, it is also more costly to perform than other testing procedures. The auditor needs to balance
the costs of gathering the evidence with the risk of material misstatement.
9-53
2. Sales and accounts receivable may 2a. Review the control procedures used by the
be stated incorrectly. If the sales are department to implement authorized prices and
billed for more than authorized, the maintain security of the price list from
accounts receivable may not be unauthorized changes.
collectible. If sales are billed for less
than the authorized amount, the 2b. Take a sample of sales invoices and trace the
customers may not complain and the price charged per unit to a copy of the authorized
organization will understate sales and price list maintained by the sales department.
receivables. However, the authorized
prices will never be collected. The 2c. Submit a sample of invoices (test data) to the
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9-18
a. Potential Misstatement if Not b. Auditing Procedure to Test Effectiveness of
Implemented Control.
company is simply less profitable. system and determine that all items are invoiced
according to authorized prices.
3. Shipments might not be recorded 3. Review the client's control procedures used to
and sales would be understated. There periodically account for all items. Test a sample of
is also some chance that shipments the client's accounting to determine that all items
could be recorded twice resulting in an were properly accounted for.
overstatement of sales and receivables.
4. Accounts receivable may be 4a. Observe that the segregation of duties
overstated because customer described in the control procedure actually exists.
complaints are not adjusted.
4b. Review a sample of customer complaints to
determine the procedures used to follow-up and
correct the complaints.
5. Sales returns may be understated 5a. Review the procedures and make inquiries as
and accounts receivable may be to procedures utilized for handling returned
overstated if the receipts are not merchandise.
promptly recorded.
5b. Select a sample of receipt documents and
Inventory may be overstated if quality follow through the processing to determine that:
control does not review the
merchandise to determine its quality. (1) credit memos were issued on a timely basis;
6. Sales and accounts receivable could 6a. For a sample of invoices, examine shipping
be misstated in either direction, but it documents and packing slip for evidence of items
is more likely that an understatement shipped. Determine how any discrepancies were
would go undetected because handled.
customers may not complain about not
being billed for all items shipped. 6b. Consider testing the computer program by
submitting fictitious data to determine that the
proper action is taken.
7. Sales and accounts receivable could 7a. Select a sample of invoices and re-compute the
be misstated as described in #6 above. freight charge to determine if it is computed in
accordance with the company policy.
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9-19
a. Potential Misstatement if Not b. Auditing Procedure to Test Effectiveness of
Implemented Control.
9-54
Type of a. b.
Exception Report
1. This exception report provides The auditor would not be concerned
information about the volume of sales about the volume of transactions on
transactions over the specified limit. this report. The use of the exception
The credit manager can use the report report is a strong control procedure.
to verify (probably on a test basis)
that the transaction was authorized by
someone in the credit department or
by the credit manager. The auditor
would want to verify that follow-up
action is taken by the credit manager
to gain assurance that the control
procedure was operating effectively
throughout the year.
2. The auditor would review the report It is difficult to tell if the auditor
to determine if there may be an would be concerned without
unusual credit risk for a particular knowing more about the size of the
customer. The auditor may, company. In most likelihood, the
depending on other risk factors transactions would be unusual for
present in the audit, determine that all the company (otherwise an
the transactions are independent. exception report would not be
generated) and thus would merit
some investigation on the auditor's
part to understand the nature of the
transactions.
3. The auditor is concerned with Yes, the auditor would most
problem accounting areas. Numerous definitely be concerned if a large
exception reports of this type signals number of such reports occurred.
a potential problem relating to the Either there are problems with
correct recording of sales. quality of merchandise or the
shipping process is out of control.
Customers may become dissatisfied.
That dissatisfaction may be reflected
in the ability to collect accounts
receivable.
4. The auditor is looking for evidence Numerous exception reports may
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9-20
that the accounting system and the signal a number of things (either
organization's overall control system good or bad). The auditor would
is functioning effectively. want to make inquiries of the client
to determine the causes of the
problems reflected in the exception
report.
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Type of Possible Misstatement Assertion Effect on substantive
Failure tests
f. Lack of Sales and accounts Existence / Expand confirmations of
customer receivable overstated. Even Occurrence receivable as of yearend.
order. though shipped, if customer Verify existence of
did not order the items, this customer by looking them
is not a valid receivable or up in the telephone book
sale. Could indicate and reviewing credit
fraudulent sales. report. Watch for unusual
sales returns after year-
end.
g. Lack of If not shipped, sales, Existence / Expand confirmations of
shipping accounts receivable, and cost Occurrence receivable and inventory
document. of sales are overstated. test counting as of yearend.
Inventory is understated. Expand review of
subsequent collections.
h & i. Wrong Same as a. Same as a. Same as a.
price or
quantity.
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9-23
9-56
Controls the auditor might examine to determine that "all transactions are recorded correctly, and
in the correct time period" might include:
To test whether these controls are operating effectively, the auditor can take a sample of sales
transactions and obtain evidence (through inquiry, observation, examination of documentation
and/or reperformance) on the operations of the control.
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The deficiencies included a failure to perform adequate substantive analytical audit procedures to
test revenue and a failure to perform sufficient procedures “to test the allowance for doubtful
accounts”. It appears that the audit firm had not gathered appropriate and sufficient evidence to
determine whether recorded revenue was accurate or whether customers could pay their bills.
Although these procedures should have been performed, it is possible (as was the case for
Kyoto’s audits) that the recorded amounts could be accurate. However, the accuracy of the
“unaudited” amounts does not excuse the audit deficiencies.
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For unusual or complex sales transactions, it is advisable to confirm receivables with customer
personnel most familiar with unusual sales agreements and ask about any side agreements that
could affect revenue recognition. Accounts payable personnel would not be aware of these
details.
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a.
and accounts receivable are valid. 2. Trace sales invoices to customer orders and
bills of lading.
customers.
sales journal.
sales journal.
board meetings.
Valuation/ allocation: Sales and accounts 1. Verify clerical accuracy of sales invoices
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receivable are properly valued and recorded and agreement of sales invoices with supporting
recognized in accordance with GAAP. 2. Trace sales invoices to sales journal and
customer’s ledger.
customers.
doubtful accounts.
Presentation and disclosure: Pledged, 1. Obtain confirmations from banks and other
Revenue recognition policies have been 3. Review work performed in other audit areas.
b.
1. Determine that all goods that were shipped were billed in the proper time period. In addition,
the auditor will normally test for the effectiveness of control procedures, such as proper credit
authorization and correctness of billing when selecting a sample such as described. Thus, the
auditor will usually use the sample selected as basis to perform dual-purpose tests.
Completeness.
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9-26
2. Determine that only authorized prices changes are made to the computerized price list thus
indirectly addressing the assertion that all invoices are properly billed at authorized prices.
Valuation.
4. Determine that credit is authorized in accordance with company policy. In addition, when
reviewing the credit policy, the auditor can make a determination as to the sufficiency of the
policy in minimizing potential bad debts. That is, it is not sufficient to determine only that the
company complies with an authorization policy: the auditor must also determine that the policy
is well conceived. Valuation.
5. Determine that all goods that were shipped were billed. Completeness.
6. Determine that all recorded invoices are valid and are supported by independent shipping
documents providing evidence of shipment. Existence.
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An aged trial balance lists each customer's balance with columns to show the age of the unpaid
invoices.
The aged trial balance can be used to select customer balances for confirmation; to identify any
amounts due from officers, employees, or other related parties or any non-trade receivables that
need to be separately disclosed in the financial statements. The auditor can identify overdue
customers' balances. These can be discussed with the credit manager to help determine the
adequacy of the allowance for doubtful accounts. Credit balances due customers can be
identified and, if significant, they should be reclassified as a liability. Subsequent collections can
be noted on the trial balance.
The accuracy of the aged trial balance can be tested by selecting a sample of the customers and
review their subsidiary accounts to be sure the aging was done properly. The trial balance should
also be footed and cross-footed. The accuracy can often be tested using generalized audit
software.
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Positive confirmations are letters sent to a sample of customers asking them to sign and return
the letters directly to the auditor whether or not they agree with the indicated balance. Negative
confirmations request the customer to respond directly to the auditor only if they disagree with
the indicated balance.
Positive confirmations are considered to be more reliable for two basic reasons. (1) The
assumption that a negative confirmation that is not returned represents a correct receivable
balance is not always valid. There are a number of reasons it may not be returned, such as the
customer lost or ignored it, the difference was in the customer's favor and they did not want this
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9-27
changed, or the customer did not understand the request and threw it away. (2) Follow-up
procedures are performed when positive confirmations are not returned to provide some evidence
that the receivable exists and is accurate
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a.
The auditor should send a second request. If that fails, trace subsequent collections into the
records and the checking account; vouch the unpaid invoices to supporting documents, such as
customer's order, shipping document, and sales invoice. If the balance is individually significant,
the auditor may call the customer or have the client call, to urge the customer to respond to the
confirmation.
b.
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Substantive procedures are adjusted when specific fraud risk factors are present. Potential fraud
risk factors in the revenue cycle include:
• Excessive credit memos or other credit adjustments to accounts receivable after the end of the
fiscal year
• Customer complaints and discrepancies in accounts receivable confirmations (e.g., disputes
over terms, prices, or amounts)
• Unusual entries to the accounts receivable subsidiary ledger or sales journal
• Missing or altered source documents or the inability of the client to produce original
documents in a reasonable period of time
• A lack of cash flow from operating activities when income from operating activities has been
reported
• Unusual reconciling differences between the accounts receivable subsidiary ledger and control
account
• Sales to customers in the last month of the fiscal period at terms more favorable than previous
months
• Predated or postdated transactions
• Large or unusual adjustments to sales accounts just prior to or just after the fiscal year end
The following fraud-related audit procedures can be used to respond to these fraud risk factors:
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documents, customer purchase orders, cash receipts, and written correspondence between the
client and the customer
• Analyze and review credit memos and other accounts receivable adjustments for the period
subsequent to the balance sheet date
• Analyze all large or unusual sales made near year end, and vouch to original source documents
• Confirm terms of the transaction directly with the customer, such as the absence of side
agreements, acceptance criteria, delivery and payment terms, the right to return the product, and
refund policies
• Compare the number of weeks of inventory in distribution channels with prior periods for
unusual changes that may indicate channel stuffing
• Scan the general ledger, accounts receivable subsidiary ledger, and sales journal for unusual
activity
• Perform analytical reviews of credit memo and write-off activity by comparing to prior
periods. Look for unusual trends or patterns such as large numbers of credit memos pertaining to
one customer or salesperson, or those processed shortly after the close of the accounting period.
• Analyze recoveries of written-off accounts
• Inquire of the company’s non-accounting personnel (e.g., sales and marketing personnel or
even in-house legal counsel) about sales or shipments near year end and whether they are aware
of any unusual terms or conditions in connection with these sales
If any of these procedures were part of the original audit program, the auditor should consider
expanding the extent of testing, or in some way modifying the timing or nature of testing, if
significant fraud risk factors are identified.
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a. Customers may not be inclined to report understatement errors when returning the
confirmation.
d. The auditor may choose interim testing when internal controls are effective.
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9-65
a. Neither auditor is correct. Both approaches are necessary to determine that all recorded sales
are valid and that all shipments have been properly invoiced. The combination of the two
procedures should give the auditor strong confidence that sales are properly stated if the
company has strong control procedures and the audit tests do not yield any exceptions.
b. The second auditor is testing the completeness assertion - that all shipments have been
properly invoiced in a timely manner. The auditor will also likely be testing the effectiveness of
control procedures associated with the sales transaction, but those procedures were not
specifically mentioned in the scenario.
If the auditors described above also tested the operation of important control procedures, the
tests described would be dual-purpose tests.
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• Request written confirmations from tenants with accounts in January arrears.
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The auditor can use membership records and the fee structure to estimate what membership fee
revenue should be (i.e., perform substantive analytical procedures). The number of members by
class of membership (member in industry, educator, student, etc.) could be determined from the
membership records or annual membership directory. A comparison of revenue this year with
last year adjusted for changes in fees and numbers of members should also approximate the
actual revenue. Any significant difference between the auditor’s expectation and the client’s
recorded revenue should investigated by the auditor.
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Customer Conclusion/procedure
2
a. Meehan Marine Sales, Inc.
2
b. West Coast Ski Center, Inc.
4
c. Fish & Ski World, Inc.
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• Mail positive accounts receivable confirmation requests directly to all customers with old
balances.
• Investigate all exceptions noted on confirmations.
• Obtain authenticated deposit slips directly from the bank and compare the detail with the cash
receipts journal.
• Compare individual customers' names, dates, and amounts shown on the customer's
remittance advices with the names, dates, and amounts recorded in the cash receipts journal,
individual customer ledger accounts, and deposit slips (if practicable).
• Verify the propriety of non-cash credits to accounts receivable (for example, sales discounts,
sales returns, and bad debt write-offs).
• Perform a surprise inspection of deposits.
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• Foot the cash receipts journal, the customers' ledger accounts and the accounts receivable
control account.
• Reconcile the total of the individual customers' accounts with the accounts receivable control
account.
• Compare information in copies of monthly customers' statements with information in
customers' ledger accounts.
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• Foot the unpaid invoice file to be sure it agrees with the general ledger accounts receivable
balance.
• Select and print confirmation requests. Information from both files will be needed - customer
name and address from the first file and unpaid amounts from the second file.
• Print a report of all customers whose balance exceeds the credit limit or who have no credit
limit.
• Create an aged trial balance by customer.
• Print out unpaid invoices dated just before and just after year-end for testing sales cut-off.
• Print out the purchase and payment history for customers who have unusually large or old
balances.
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a.
The key point to recognize is that there is a pattern of errors in the confirmation non-responses.
There are cases of extended credit terms where goods were not returned, where credit is to be
issued but the goods have not been returned, there is a related party transaction, and there are
some new customers that simply have not responded. The nature of the non-confirmations should
heighten the auditor’s professional skepticism of the possibility that fraud could be taking place.
The auditor in charge would want to communicate those concerns to the staff auditors and
encourage the staff auditors to be very skeptical, particularly when examining internal
documentation. The fraud could be taking place through billing for goods not actually shipped,
double billing of goods (without extending the necessary credit), or sales to fictitious entities.
The work that would be needed to complete the work on confirmations would include the
following audit procedures:
• Review subsequent cash collections from each of the open accounts. Identify all
subsequent payments that can be identified as applicable to the year-end account
balances. Identify any items not satisfied through subsequent payments as open items for
further follow-up.
• For all items without unusual circumstances, follow up on unpaid amounts by examining
underlying supporting documentation including:
- customer purchase order
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9-32
- bill of lading or other independent proof of shipping
- invoice
If the open items are indicated as re-billings, trace the amount of the rebilling to
the issuance of the credit memo and from the credit memo into the general ledger
to see that the proper credit had been applied.
Identify dollar amounts that cannot be satisfied through the above two procedures.
If no supporting documentation can be found, classify the items as errors and
extrapolate to the population as a whole.
• Examine receiving reports for items returned prior to a specific time before year-end, (the
actual time period would be somewhat dependent on the lag between receipts and the
issuance of credit memos per examination of previous receipts of goods and issuance of
credit.)
• Examine all terms of the related party transaction with Beaver Dam. Examine other
transactions with the same company to determine the extent of disclosure needed to fairly
present the financial statements.
• Examine documentation for all transactions labeled as `special terms’, such as those with
Hi-Tech Companies. For these companies, as well as others not responding, verify the
existence of the company through examination of Dun & Bradstreet reports on the
company, or through business directories. Confirm the special terms of the sale with the
company. Depending on the nature of the terms, consider seeking a legal opinion on the
terms of the contract, the obligation of the seller, and so forth from outside legal counsel.
• For all companies not responding, obtain a current credit rating from Dun & Bradstreet
(or some similar service). Review the client’s credit file and obtain audited financial
statements to assist in determining collectibility and existence of the receivable.
• Consider all items not cleared as errors and project the amount of error to the financial
statements as a whole. Based on the results, consider the amount of additional auditing
procedures that need to be performed.
b.
Assuming that many of the above items could not be cleared to the auditor’s satisfaction,
there would be concern that more items with similar problems exist in the population.
The auditor would first classify all uncleared items as misstatements and would then
project the total to the population as a whole to determine if the projected errors and
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9-33
upper error limit were material to the financial statements. Assuming the amount would
be material, the auditor would perform the following procedures:
• Identify all companies that have received extended credit. This could be done by (a)
inquiry of company personnel, (b) review of large dollar accounts still outstanding, or ( c)
through an examination of all accounts with a dollar amount past due.
• Depending on the number of companies with such terms, either take a sample or select all
companies and examine all documentation regarding the extended credit. The
documentation would include purchase orders, shipping documents, memos extending
the credit, and sales invoice. Confirm the terms of the extended credit with the companies
identified. For each company selected, review the credit file, outside credit evaluations,
and recent correspondence with the customer to determine the probability of collection.
Develop an estimate (or a range of estimate) of uncollectible accounts.
• Prepare an aging of all accounts past due. Compare the aging with previous years.
Compute a first estimate of uncollectible accounts by using a non-collectible percentage
off of the aging balance that had proven to be accurate in the past. Consider current
economic conditions to determine if the estimate should be adjusted for deteriorating
economic conditions.
• Ask the client to schedule all transactions with related parties. Examine the underlying
documentation to determine the nature of the transactions and develop a memorandum
outlining the appropriate disclosure for a footnote in the financial statements.
• Expand the audit work for all accounts past due. Consider expanding the confirmation
work through another statistical sample. Perform alternative procedures on all companies
that do not respond to the confirmation request.
• Prepare a list of all questionable transactions. Document the nature of the question, the
parties involved, etc. to determine if there is a pattern of misstatement. Based on the
pattern, identify all other account balances fitting that pattern. Schedule the open account
balances fitting that pattern and examine underlying documentation to determine whether
or not the item is misstated.
• Perform extended cut-off tests of sales and receivables near year-end to determine that
items were recorded in the correct time period. Examine a sample (or all) items during a
period covering the last 15 days of the year and the first 10 days of the subsequent year to
determine whether or not all items that had been billed had been shipped.
• Physically examine all items that have been marked as ’billed, but held pending customer
orders’ to determine that the goods had been physically separated, are in shipping
condition, and are not obsolete. Confirm the terms with the purchaser. Obtain an opinion
from legal counsel on the validity of the sales contract. Gather additional information to
determine the likelihood of default by the customer. Consider the likelihood of default in
determining whether or not a sale should have been recorded.
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9-34
• Based on the extended work, develop a revised estimate of uncollectible accounts, as well
as accounts that should not yet be recorded as sales and receivables.
• Document the nature of the work performed and the audit conclusions in a memorandum
for the working papers.
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a. Revenue is an inherently risky account as the transactions making up the account can be quite
complex and subject to client judgment. In the case of Zynga, the company is recognizing
revenue for the sale of virtual products and there is not generally accepted accounting guidance
on how to account for such revenue. Further, while Zynga’s auditors have identified what seem
to be reasonable approaches to recording the revenue, each option requires significant
management judgment, which is prone to bias. Thus, a significant inherent risk at Zynga is the
timing of revenue recognition.
b. There are likely many incentives for management to overstate revenue. Management may
want to meet or beat expectations of the market and analysts. Management may have
compensation arrangements which are based, in part, on revenue numbers. If a company is
preparing to go public, it may want to present as positive of a picture as possible.
e. In auditing Zynga’s revenue, the auditor needs to obtain evidence of the sales transactions
(purchases by customers). Further, the auditor is going to need support that the estimates used by
management in determining how much revenue to recognize are reasonable. Given the relative
“newness” of this type of revenue stream the auditor may only have limited data (from the client
and external sources) to use in determining the veracity of client estimates.
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9-73
a. The auditor is always concerned with whether side agreements exist as such side agreements
would make it improper for Tvia to recognize revenue on a sale. The difficulty for the auditors in
this case is that Silva concealed the side agreements from Tvia's CEO, its CFO, and the
Company's auditors. However, when there is a heightened risk of misstatement auditors might
decide to send sales confirmation requests that ask about the details and terms of the sale.
b. When there are past due accounts and unusual transactions the auditors should be especially
alert to the need to exercise an appropriate level of professional skepticism. The auditors will
generally want to inquire of management (although doing so would not have helped in this case)
and send confirmations to the customers, as well as determine the ability of the customer to
actually make their payments. Because this customer was an international customer the audit
firm might need to work with its affiliate in China to obtain the appropriate and sufficient
evidence.
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b. First, consider that the prior problem indicates that weaknesses existed in the past, which
heightens risk. However, the fact that the problems were disclosed and a remediation plan was
put in place somewhat mitigates that risk. So, the extent to which the remediation plan was
actually implemented would have been important in determining the audit plan for 2005. So, the
auditor should have gathered information about the extent to which the new contract review
process has been used, and they should have examined the new documentation evidencing proof
of delivery. Second, consider that the problems associated with the internal control deficiencies
in revenue manifested themselves in fourth quarter revisions to the financial statements, which
should have led the auditor to heighten their 2005 risk assessment in terms of management
attempts to manipulate earnings. Thus, inherent risk associated with sales transactions should
have been heightened going forward.
• comparing quarter-to-quarter changes in sales during the current year, and comparing those
to prior years and industry averages
• comparing revenue, deferred revenue, and cost of sales figures for reasonableness in relation
to one another for the company, and the same figures for competitors
• comparing cash flow from operations with net income
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9-36
• calculating receivables and aging of receivables by product type and geographic region, by
quarter and same quarter across years
• calculating gross margin percentages
• analyzing the timing of contracts, with particular emphasis on fourth quarter contracts (or end
of other quarter contracts)
• reading contracts to ensure timely identification and accurate accounting treatment of non-
standard contracts
• reviewing documents retained evidencing proof of delivery and final acceptance
• sampling recorded sales transactions and vouch to source documents
• matching sales with electronic shipping documents or customer orders
• reviewing monitoring controls concerning management’s review of revenue transactions
9-75
a. Putnam’s critical mistake was in not being forceful and proactive the very first time the
problems were encountered. Once he had “caved” to HBOC once, it would have been difficult to
convincingly threaten HBOC in the future. Plus, once Putnam allowed the inappropriate
accounting and issued the first incorrect audit review opinion, HBOC could use that against
Putnam, convincing him that he would also “lose” upon discovery of the problems.
b. Although the facts are not publicly disclosed, one has to assume that in the booming time
period of the late 1990’s, the tone at Andersen was to make clients happy, and to retain their
business. Thus, it is possible that Putnam would have been discouraged from behaving forcefully
to HBOC. In terms of Putnam acquiescing to the obviously inappropriate sale/purchase
transaction in Q3 1998, the situation seems unbearably inappropriate. By that point, Putnam had
to have known that without the transactions being recorded, the true financial results of HBOC
would lead to its downfall. Putnam may have been hoping that if he allowed this transaction,
then perhaps the company could maintain its profitability and “no harm would come of it”.
c. The main element of corporate governance that failed was the audit committee. They
displayed a lack of knowledge of the risks in the software industry at the time. They should have
been more proactive in understanding the types of transactions that the company was engaged in,
and the common risks associated with those transactions. They should not have relied so
extensively on the unsubstantiated representations of Putnam.
d. Putnam and the engagement team did not follow up on unreturned confirmations and the very
low response rate should have caused concern. In addition, the dramatic decline in the number of
confirmations sent from 1996 to 1997 without justification is problematic. Further, the
engagement team’s response to the problems noted in the confirmations that were returned was
inadequate. It should have led to much deeper investigation into the side letter issue.
e. When Putnam learned of the upcoming merger with McKesson during Fall 1998, he would
have realized that McKesson was relying on the inappropriately aggressive earnings stream that
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9-37
HBOC had developed over the past several years. Certainly McKesson would have felt
differently about the acquisition had it known about the improprieties. There must have been
tremendous pressure on him not to say anything because he had acquiesced for so long to
Gilbertson. Yet, if any situation were to bring Putnam to disclose the problems, this would have
been it. Moving forward with the acquisition under false pretenses put Andersen LLP as an audit
firm at tremendous risk. While students may develop alternative strategies, we present one
possible way that Putnam could have used the McKesson acquisition to reveal what he knew
about the problems at HBOC.
Step 1. Structure the problem. Putnam knew that McKesson would rely on the misstated
financials of HBOC during the acquisition process. He also knew that there was an upcoming
audit committee meeting at which he could speak up if he so desired.
Step 2. Assess the consequences. The potential consequences were that (a) McKesson
would acquire HBOC, HBOC’s financial position would improve enough that the fraud would be
irrelevant, and further earnings management would be unnecessary, thus causing the past
problems to become essentially irrelevant, or (b) McKesson would acquire HBOC, the fraud
would be revealed, and Andersen and Putnam would be at risk of litigation and SEC sanction, or
(c) McKesson would not acquire HBOC because of the problems detected during their due
diligence process.
Step 3. Assess the risk and uncertainties. The risks associated with possibility (a) are that
this outcome is a relatively low probability event (in hindsight), although at the time Putnam may
have thought otherwise. The risks associated with possibility (b) are the exact things that
ultimately happened in real life, i.e., fraud revelation, followed by massive stock devaluation and
securities fraud charges. The risks associated with possibility (c) are that Andersen would be
fired from the audit by HBOC, and Putnam would be damaged financially or professionally
through the loss of the client.
Step 4. Evaluate information/audit evidence gathering activities. Possibilities (a) and (b)
require no additional actions on the part of Putnam, so we will focus on Possibility (c) for the
rest of the solution. Assuming that Putnam decided to pursue this possibility, how could he do an
“about face” and finally reveal the problems to, for example, the audit committee? One
possibility would be to increase testing via the confirmation process during the Fall of 1998 in
anticipation of the year-end audit.
Step 5. Conduct sensitivity analyses. This step is not particularly relevant for the decision at
hand. If Putnam chose the course of action to finally reveal what he knew, there would be little
sensitivity analyses to conduct, because gathering evidence on the other possibilities does not
lend itself to actual evidence gathering. Rather, those possibilities involve assessments of
probabilities of those events occurring.
Step 6. Gather information/audit evidence. If Putnam had chosen to increase testing via
the confirmation process, he could have instructed the team to gather significant audit evidence
about accounts receivables and the allowance for doubtful accounts during Fall 1998. Knowing
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9-38
what he would find, he could then either pressure Gilbertson to reveal the issues, or he could
himself report what he knew to the audit committee.
Step 7. Made decision about audit problem. It is clear from the actual outcome what
Putnam actually decided to do, i.e., nothing and hope for the best. If Putnam had revealed what
he knew to the audit committee and McKesson during Fall 1998, McKesson would probably not
have engaged in the acquisition. Perhaps HBOC could have fixed their accounting problems
“behind the scenes” and the fraud revelation could have been avoided. However, it seems that
the fraud had gone on so long, and the amounts of the deception were so large that anything that
Putnam did at this late stage would have been futile in preventing the downfall of HBOC and its
management team. But by doing something, even very late in the process, Putnam could have
salvaged his reputation to some extent and possibly avoided or minimized the negative outcome
he ultimately received from the SEC. The message is clear: Putnam should have stood up for
what was right at the outset of the problems at HBOC. By not confronting Gilbertson forcefully
when he initially learned of the problems, Putnam got caught up in a downward spiral of poor
professional decision making, with terrible consequences.
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It is apparent from the case that the audit manager for some reason was unwilling to challenge
Putnam or his views. The publicly disclosed documents do not enable an understanding of the
personal characteristics of Putnam or the engagement manager, so it is difficult to draw
inferences about the personal dynamic that existed between the two auditors. However, Ira
Chaleff’s ideas should give students a sense of things that an individual in an organization who is
not in the “leadership” role can still do to have a positive effect in an otherwise bad situation.
While individual answers will of course vary, we present a potential approach to moving
through the seven steps in resolving the difficult ethical issue encountered by the HBOC
engagement manager.
(1) Identify the ethical issue. The issue is that the manager knows that HBOC is
misrepresenting its financial results to shareholders, and by very significant amounts. Still, if the
manager takes on the issue against the preference of Putnam, there may be personal
repercussions such as a poor performance evaluation or dismissal from the job. Further, the
manager may consider the fact that if HBOC does not “make their numbers” as they have so
prominently advertised to the investment community, shareholders may actually “lose” because
of the associated decline in share price.
(2) Determine who are the affected parties and identify their rights. Affected parties include
shareholders (right to receive accurate investment information), the audit committee and board of
directors (right to receive an accurate portrayal of the accounting function of the organization, as
well as a performance appraisal of Gilbertson), the SEC (the right to receive accurate financial
reports), Andersen as a Firm (the right to have a client that will not tarnish the Firm’s
reputation), McKesson shareholders (the right to purchase a company with full and complete
disclosure about its true financial condition), and the individual auditors on the HBOC
engagement (the right to have their professional opinions respected and followed).
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9-39
(3) Determine the most important rights. Shareholders at HBOC and McKesson because they
are the most numerous and stand to lose most directly from the problems. Further, they are not in
any way at fault, unlike the members of the audit committee, board, or individual auditors.
(6) Assess the possible consequences, including an estimation of the greatest good for the
greatest number. The greatest good for the greatest number accrues to the action associated
with alerting the SEC, assuming that direct intervention with Putnam or Andersen as a Firm goes
ignored.
(7) Decide on the appropriate course of action. The most appropriate course of events would
be to follow through the potential actions in sequence, beginning with persuasive conversations
with Putnam and Andersen as necessary, and ultimately alerting the SEC if necessary. The
manager should not simply “walk away” from the situation by resigning. If they do resign, they
should at least alert the SEC anonymously.
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9-40
• Bricks were apparently shipped as disk drives.
• Shipments to company warehouses were recorded as sales but were not invoiced to
customers until shipped from those warehouses to the customers.
• Management's bullish forecasts when the industry was having hard times.
• Mr. Wiles' management style, which intimidated lower management personnel and motivated
them to create sales when there were none.
• Potentially inadequate audit evidence obtained to support the auditor's opinion.
d. Substantive audit procedures that could have uncovered the fraud include:
Application Activities
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This problem provides an opportunity for the students to be exposed to the Disciplinary Orders
of the PCAOB and to more fully understand the actions and behaviors of auditors that are the
subject of such Orders. The instructor may choose to have all students read the same case or to
assign different cases to groups of students. The following identifies the key revenue related
issues discussed in the Disciplinary Order. The Disciplinary Orders generally include the
relevant information for Parts (a) and (b). Part (c) is generally the opinion of the students and
responses will vary; although several of the cases do indicate that the auditor did not exercise an
appropriate level of professional skepticism.
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9-41
This case provides an example related to proper accounting and auditing for contract related
revenue.
This case provides a great deal of discussion on revenue related issues. The issues include: (1)
recording revenue related to software sales, (2) determining the allowance for doubtful accounts,
and (3) responding to a heightened risk of fraud.
The primary revenue related issues are in the context of the audit of Triad Industries, Inc. There
are issues related to inter-company revenue transactions and the confirmation of accounts
receivable.
The primary revenue related issues address accounting for and auditing consignments and
product returns
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a. and b.
A key issue is that the client (TPC) booked fictitious sales revenues. The client recorded the
fictitious sales by making top-side journal entries to sales and accounts receivable. When
company needed additional sales to meet its monthly target, its practice was to book a top-side
sales entry to meet that target.
From an overall perspective, the auditors failed to obtain sufficient competent evidential matter,
failed to exercise due professional care in the planning and performance of their audits, and
failed to properly supervise the audits.
The following is an excerpt from the AAER concerning the audit of TPC’s revenues.
22. E&YUK failed to reconcile TPC’s accounts receivable general ledger account to a detailed
accounts receivable subsidiary ledger. See AU § 326.19. E&YUK was told by TPC that this
detailed ledger was unavailable, but did not adequately question this assertion. Instead, E&YUK
reconciled the general ledger account to a summary listing of aged debt by customer. Had
E&YUK reconciled to TPC’s detailed ledger, they would have seen that the general ledger
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9-42
balance, inflated due to premature and fictitious revenue recognition, was far greater than the
subsidiary ledger balance.
23. E&YUK failed to properly confirm accounts receivable. For fiscal year 2004 E&YUK relied
entirely on alternative procedures, and was able to validate only 7% of its sample through that
testing. E&YUK supplemented this by checks to delivery notes, but its work papers do not
clearly document whether this covered the entire sample or only part thereof. For the fiscal year
2005 audit, 59% of the confirmation sample value was never validated through confirmations or
alternative procedures. For the fiscal year 2006 audit, 26% of the sample was never validated.
24. E&YUK failed to properly document in its work papers, and in its Summary Review
Memoranda (“SRM”) submitted to E&YUS, the results of its AR testing. With respect to the
2005 audit, E&YUK’s SRM contains no discussion of its confirmation of receivables,
notwithstanding the fact that E&YUK had been unable to confirm roughly 60% of items tested.
25. During fiscal years 2004-6, TPC booked fictitious revenues via monthly top-side journal
entries. Any top-side journal entry to sales should have been a red flag to the audit teams under
Respondents’ supervision requiring further investigation. See AU §§ 316.58-62. Notwithstanding
purported documentation in E&YUK’s work papers that they had reviewed and agreed to
supporting documentation all “non-standard or significant” journal entries, E&YUK failed to
detect and investigate TPC’s monthly top-side journal entries to revenue.
Paragraphs 28- 39 also provide relevant and interesting discussion about the auditor’s
responsibilities in this case.
c. Of course, the students are responding to this question with the benefit of hindsight. However,
the AAER does present a description that suggests that the auditors were greatly lacking in
professional skepticism.
The AAER does not provide enough discussion to definitively determine why the auditor may
have conducted the audits in a manner that did not comply with professional standards. The
students often hypothesize a number of reasons including wanting to keep the client happy. As
for the sanctions against the auditors, some students may find the sanctions reasonable, while
others may want to see harsher sanctions given the pervasive nature of the violations.
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a. Conditional sales
These transactions are recorded as revenues even though the sales involve unresolved
contingencies or the terms of the sale are amended subsequently by side letter agreements, which
often eliminate the customer’s obligation to keep the merchandise.
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Some companies record sales by shipping goods to alleged customers and then providing funds
to the customers to pay back to the company. In other cases, companies record loan proceeds as
revenues.
c. Premature revenues before all the terms of the sale were completed
Generally this fraud involves recording sales after the goods are ordered, but before they were
shipped to the customer.
To increase revenues, the accounting records are held open beyond the balance sheet date to
record sales of the subsequent accounting period in the current period.
Revenues are overstated by accelerating the estimated percentage of completion for projects in
process.
f. Consignment sales
Revenues are recorded for consignment shipments or shipments of goods for customers to
consider on a trial basis.
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The response to this question will vary depending on current events. An example reported in The
Wall Street Journal in May 2012 involved German sportswear and equipment maker Adidas.
The article reports that senior employees at Adidas (managing director, chief operating officer)
diverted company products to secret warehouses and recorded them as fraudulent sales.
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Students often find this research project to be very engaging. They find the life details of the
fraudster, Philip Musica, quite fascinating. The infamous accounting fraud at McKesson &
Robbins, Inc. involved fictitious inventories and accounts receivable that comprised more than
20 percent of McKesson & Robbins’ purported assets as of December 31, 1937. In response to
the fraud, the SEC recommended that non-officer members of the client’s board nominate the
auditors and that auditors be elected by and address their report to the company’s shareholders.
In 1939, the American Institute of [Certified Public] Accountants appointed its first standing
committee on auditing procedures. The committee’s first standard, Statements on Auditing
Procedure No. 1, “Extensions of Auditing Procedure,” made observing inventory and confirming
accounts receivable—two procedures that would have helped detect the McKesson & Robbins
fraud—standard audit procedures.
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Academic Research Cases
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a. This study examines revenue recognition practices and earnings management. The author
notes there are two primary mechanisms that companies can use to manipulate earnings through
revenue recognition: accounts receivable (accrual) and deferred revenue (deferral). Companies
have incentives to meet earnings benchmarks and the author examines three primary benchmarks
that financial statement users can use to evaluate companies performance: consensus analyst
earnings forecast, prior year earnings, and break-even net income (i.e. avoidance of a loss). The
author examines how companies manage earnings through these two different revenue
recognition practices to avoid missing these three different benchmarks. The author also
examines how SOX has changed these practices.
b. The results suggest that companies use discretion in revenue recognition practices to avoid
missing consensus analyst earnings forecasts. Specifically, companies appear to manage
earnings through both accounts receivable (revenue accruals) and deferred revenue when their
earnings would otherwise just miss the consensus forecast. However, the authors do not find
evidence that companies use discretion in revenue recognition practices to manage earnings in
order to avoid earnings decreases or losses.
The results further suggest that managers have preferences as to the way they use discretion
in revenue recognition to manage earnings. In the pre-SOX era, managers preferred to exercise
discretion in deferred revenue relative to accounts receivable. The author notes this preference
arises because managing earnings through deferred revenue has fewer future cash flow
consequences. For example, when companies use accounts receivable to manage earnings, there
is a risk that customers may not actually pay the cash related to the sale; this risk is not present
with revenue deferrals because the company has already received the cash. However, SOX
appears to have mitigated this preference; in the post-SOX era, managers appear to exercise
discretion in both accounts to avoid missing consensus analyst earnings forecasts.
Additionally, the author provides descriptive evidence that many tech companies have deferred
revenue on their balance sheets.
c. Overall, as the author notes, the results in this study suggest that auditors should be more
cognizant of the discretion afforded to management in revenue recognition. The results of this
paper indicate that managers have and use significant discretion in revenue recognition, even
post SAB 101 (1999) and in the post-SOX era (2002). The results indicate that the procedures
performed by auditors may not be sufficient to detect material misstatements. These results are
especially important post SAB 99 (1999), where management and auditors need to consider both
quantitative materiality and qualitative materiality. If management is using inappropriate
discretion in its revenue recognition decisions in order to avoid missing an earnings benchmark,
then the related misstatement is qualitatively material. Auditors need to ensure they have
sufficient mechanisms in place to detect and correct these qualitatively material misstatements.
This research identifies two audit areas where auditors may need to devote additional focus:
gross accounts receivable and deferred revenue.
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9-45
This study is also important in the context of professional skepticism, especially given the
aforementioned qualitative materiality considerations. Regardless of the quantitative materiality
of discretionary revenue amounts recorded in accounts receivable and deferred revenue, auditors
need to carefully scrutinize these amounts. If financial statement users consider whether a
company meets consensus analyst earnings forecasts in their investing and lending decisions,
then the earnings management suggested by this study is material. It is important for auditors to
exercise professional skepticism in planning and performing testwork over revenue recognition
in both A/R and deferred revenue.
Finally, the pre-SOX vs. post-SOX comparison is important to the audit profession. This
indicates that the SOX has not curbed earnings management with respect to earnings
management. Rather, financial statements in the post-SOX era appear to contain qualitatively
material misstatements that have more significant long-term consequences for shareholders.
Auditors always need to consider the impact of their decisions and management decisions on
financial statement users.
d. Relationships
The author examines the relationship between three earnings benchmarks (consensus analyst
expectations, prior year earnings, and break-even net income) and two different earnings
management tools related to revenue recognition (accounts receivable and deferred revenue).
The author develops an empirical model in order to determine whether firms with pre-managed
earnings that just miss earnings benchmarks engage in earnings management through the
manipulation of revenue. This model examines how abnormal changes in accounts receivable
and deferred revenue are related to instances where a firm’s pre-managed earnings 1) just miss a
benchmark and 2) just beat a benchmark.
Analyst Expectations
The author finds that abnormal changes in accounts receivable are more positive for pre-
managed earnings that just miss analyst expectations and more negative for pre-managed
earnings that just beat analyst expectations. The first result suggests that companies manage
earnings through revenue accruals in situations when doing so may allow them to meet the
consensus analyst earnings expectation. The second result suggests that companies smooth
earnings through accrued revenue when they just beat the consensus analyst earnings
expectation. Additionally, the author finds that abnormal changes in deferred revenue are more
negative for pre-managed earnings that just miss analyst expectations. This suggests that
companies manage earnings through revenue deferrals in situations when doing so may allow
them to meet the consensus analyst earnings expectation. Overall, the author notes that 70.7%
(71.4%) of firms with pre-managed earnings that just missed the consensus analyst earnings
forecast were able to use discretion in accounts receivable (deferred revenue) to meet or beat this
benchmark.
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9-46
Management Preferences
The author also uses the model to examine whether companies appear to have a preference for
one revenue recognition earnings management over the other. Over the entire sample period, he
finds that there is a significant relationship between just missing the consensus analyst forecast
and both abnormal revenue accruals (increases in A/R) and abnormal revenue deferrals
(decreases in deferred revenue). This overall result is the same in the post-SOX era. In the pre-
SOX era, there was a significant relationship between just missing the consensus forecast and
abnormal decreases in deferred revenue; however, there was no such relationship between just
missing the consensus forecast and abnormal increases in A/R. The author argues that earnings
management through deferred revenue is more costly to shareholders because it involves more
real earnings management. Therefore, the results suggest that managers preferred the earnings
management tool that imposed the least real costs on their firms in the pre-SOX era; however,
this preference disappeared in the post-SOX era.
e. The author does not identify any limitations of this research. However, some limitations may
include:
• Data limitations inherent in any archival study
• Design choices that require cut-offs (e.g. just miss, just beat) can have a large impact
on the results, since the effect sizes appear to be small.
• It is not clear SOX would have altered management’s preference with respect to the
way they use discretion in revenue recognition to manage earnings.
9-84
a. The authors examine the relation between a company’s past and expected future losses, as well
as negative cash flows, and the likelihood that the company will manipulate revenues in violation
of GAAP (H2). The authors also examine (1) whether there is a direct relation between the
extent of a company’s previous and future losses and its ratio of accounts receivable to sales
(H1), and (2) the relation between the ratio of accounts receivable to sales and the likelihood of
revenue manipulation in violation of GAAP (H3).
Companies that have reported multiple years of losses or negative cash flows cannot be valued
by analysts with the standard application of discounted cash flow calculations. Analysts rely
more on the use of revenue valuations in these instances. As a result, it is suggested that loss
companies, wanting to increase their market value, may overstate revenue, usually through the
accounts receivable account.
b. To start, the authors document that revenues are value relevant for firms reporting negative
cash flows or report negative earnings. Most importantly, this study indicates that there is a
positive relation between the history of past and expected future losses (or negative cash flows)
and the likelihood that companies will manipulate revenue in violation of GAAP. Companies
with longer past and anticipated future losses, have a higher ratio of accounts receivable to sales,
suggesting that firms overstate revenues to inflate their market value. Also, companies that
manipulate revenues in violation of GAAP have a higher loss ratio than companies that
manipulate nonrevenue accounts.
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9-47
An interesting finding related to the role of auditing indicates that audit firm industry experience
is negatively related to revenue manipulation by company management.
c. The issue is important because it provides a possible indicator for auditors to use to identify a
firm that may be manipulating the revenue accounts.
The indication that a loss company is more likely to manipulate revenue accounts provides a
cost-efficient indicator for the auditor to use to possibly identify companies that may need
additional investigation of the revenue accounts. This adds value to the audit by possibly
increasing the quality and relevance of the procedures performed.
d. The data set consists of Compustat-listed companies from 1992-2005. Relevant financial and
price data were obtained from Compustat and CRSP. Financial restatement data was retrieved
from Lexus and GAO databases. In total, the data set consists of 22,821 firm-years, representing
3,997 firms. The number of restated fiscal years totals 521, of which 262 years represent
restatements of revenues. The authors’ approach to analysis includes both regression analysis
and analysis using a probit model.
The authors also reviewed relevant literature to gain insights on issues related to past research of
earnings management especially with young firms.
e. As with any analysis using archival data, there are possible limitations related to the sample
and / or the analysis. For example, some firms may have manipulated revenue in order to avoid
a loss and thus would not be part of the sample of loss firms based on earnings. Further, the
authors have an assumption of perfect foresight by managers related to whether the company
would suffer net losses in the future; however, the authors do provide additional analysis related
to this limitation.
9-85
Note to instructor: This answer is based upon the FYE 2009 annual reports for Ford and Toyota
as they appeared in the 8th edition. An updated solution as of FYE 2012 will be posted to the
Cengage website as soon as the applicable annual reports become available.
a. Key Revenue Cycle Accounts: Automotive sales, financial services revenues, automotive
receivables (and associated allowance), finance receivables, warranties.
Critical accounting estimates:
Ford considers “an accounting estimate to be critical if: 1) the accounting estimate requires us to
make assumptions about matters that were highly uncertain at the time the accounting estimate
was made, and 2) changes in the estimate that are reasonably likely to occur from period to
period, or use of different estimates that we reasonably could have used in the current period,
would have a material impact on our financial condition or results of operations.
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9-48
Management has discussed the development and selection of these critical accounting estimates
with the Audit Committee of our Board of Directors. In addition, there are other items within
our financial statements that require estimation, but are not deemed critical as defined
above. Changes in estimates used in these and other items could have a material impact on our
financial statements.”
Items involving critical estimates include: warranties, pensions, other postretirement benefits,
impairments of goodwill and long lived assets, valuation of deferred tax assets, accumulated
depreciation on vehicles subject to operating leases, and the allowance for credit losses.
b. “The preparation of financial statements in accordance with U.S. GAAP requires us to make
estimates and assumptions that affect our reported amounts of assets and liabilities, our
disclosure of contingent assets and liabilities at the date of the financial statements, and our
revenue and expenses during the periods reported. Estimates are used to account for certain
items such as marketing accruals, warranty costs, employee benefit programs, etc. Estimates are
based on historical experience, where applicable, and assumptions that we believe are reasonable
under the circumstances. Due to the inherent uncertainty involved with estimates, actual results
may differ.”
This note alerts the financial statement user to the inherent uncertainty of some of the key
accounts that affect the revenue cycle accounts. To the extent that these amounts are inherently
uncertain and lack verifiability, fluctuations and differences from expectations create audit risk
for the audit firm: they are attesting to a single number, when in fact that number may not be
known with great certainty.
c. Both companies provide high quality information concerning this key balance sheet account.
Toyota provides particularly helpful information concerning sensitivity tests. In terms of auditor
responsibility for disclosures of this nature, auditors review the adequacy of disclosures made in
the footnotes. They read the footnotes and think about whether they are useful and fully
informative. Ultimately this is a judgment call on the part of the audit firm, but they are expected
by users of the financial statements to require management to provide additional disclosures or
more meaningful disclosures where necessary. Further, depending on the given financial
statement account, GAAP may require certain disclosures, and it is the audit firm’s responsibility
to be sure that such requirements are fulfilled.
d.
• Continued or increased price competition resulting from industry overcapacity, currency
fluctuations, or other factors.
Evidence: sales trends, market comparisons, plans to reduce and manage fixed costs.
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9-49
• Increased competition from banks or other financial institutions seeking to increase their
share of financing Ford vehicles.
Evidence: trends in the financing side of the business in terms of leasing and loan
origination volume and rates therein
• Collection and servicing problems related to finance receivables and net investment in
operating leases.
Evidence: focus on management estimates used in the allowance for credit losses,
including sensitivity tests therein
Global Economic and Financial Market Crisis. Beginning in 2008, the global economy
entered a period of very weak economic growth, led by the recession in the United States and
followed by declines in other major markets around the world. The financial market crisis set off
a series of events that generated conditions more severe than those experienced in several
decades. The characteristics of the financial crisis were unique, in part due to the complex
structure of housing-related securities that were at the epicenter of the financial market turmoil.
A steep housing correction, especially in the U.S. and U.K. markets, along with downward
valuations of mortgage-backed and related securities, combined to foster a crisis in confidence.
Although several other factors contributed to current economic and financial conditions, the
influence of these financial developments was very prominent. The interrelationships among
financial markets worldwide ultimately resulted in a synchronous global economic downturn, the
effects of which became evident in the fourth quarter of 2008 as major markets around the world
all suffered setbacks.
While the economic outlook is improving, it is rebounding from a very low base and with a
range of possible outcomes due to the uncertain financial market environment and dependence
upon ongoing policy responses. The consumer and commercial sectors of the global economy
appear to be improving, although recovery remains fragile due to continuing tightness in the
credit markets, weak labor markets in many countries, and uncertainty regarding the timing and
magnitude by which governments and central banks will remove stimulus programs. Although
the housing market is stabilizing in the worst hit markets, such as the United States, the United
Kingdom, and Spain, challenges remain associated with rising foreclosure rates and excess
housing stocks.
In 2009, global industry vehicle sales volume is estimated to have declined to about 64.3
million units, down about 4 million units or 6% from 2008 levels. Global industry sales volume
is projected to increase from the depressed 2009 levels, to a range of 65 million units to 75
million units for 2010.
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9-50
Excess Capacity. According to CSM Worldwide, an automotive research firm, in 2009 the
estimated automotive industry global production capacity for light vehicles (about 86 million
units) exceeded global production by about 29 million units. In North America and Europe, the
two regions where the majority of revenue and profits are earned in the industry, excess capacity
was an estimated 96% and 37%, respectively, with North America in particular driven up from
recent rates of around 43% due to the industry conditions in that market last year. According to
production capacity data projected by CSM Worldwide, global excess capacity conditions could
continue for several years at an average of 21 million units per year during the 2010-2014 period.
Pricing Pressure. Excess capacity, coupled with a proliferation of new products being
introduced in key segments by the industry, will keep pressure on manufacturers' ability to
increase prices on their products. In addition, the incremental new U.S. manufacturing capacity
of Japanese and Korean manufacturers in recent years has contributed, and is likely to continue
to contribute, to pricing pressure in the U.S. market. The reduction of real prices for similarly
contented vehicles in the United States has become more pronounced since the late 1990s, and
we expect that a challenging pricing environment will continue for some time to come.
Consumer Spending and Credit. Limited ability to increase vehicle prices has been offset in
recent years, at least in part, by the long-term trend toward purchase of higher-end, more
expensive vehicles and/or vehicles with more features. The current retrenchment in consumer
spending is likely to dampen that trend in the near-term. Over the long term, spending on new
vehicles is expected to resume its correlation with growth in per capita incomes. Emerging
markets also will contribute an increasing share of global industry sales volume and revenue, as
growth in wholesales (i.e., volume) will be greatest in emerging markets in the next decade. We
believe, however, the mature automotive markets (e.g., North America, Western Europe, and
Japan) will retain the largest share of global revenue over the coming decade.
Commodity and Energy Price Increases. Commodity prices have resumed upward movement
since early 2009. Despite weak demand conditions, oil prices increased from around $40 per
barrel in January to $80 per barrel in December of 2009. With the global economic outlook
improving and financial investment returning to commodity and oil markets, we expect
commodity and oil prices to continue trending upward with potentially higher volatility. Higher
fuel prices, combined with efforts to achieve environmental policy objectives, are likely to
continue to generate demand for more fuel-efficient vehicles.
Currency Exchange Rate Volatility. The ongoing deleveraging in financial markets has
generated significant volatility in currencies as well. Recently, the U.S. dollar has gained some
ground against the British pound and euro.
Other Economic Factors. The eventual implications of significant fiscal stimulus, including
higher government deficits generating potentially higher long-term interest rates, could drive a
higher cost of capital over our planning period. Higher interest rates and/or taxes to address the
higher deficits may also impede real GDP growth and, therefore, vehicle sales over our planning
period.”
This discussion highlights a variety of concerns related to the revenue cycle, including:
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9-51
• Global economic crisis leading to reduced sales volumes and continued weakness in sales
over the near term
• Pricing pressure from US manufacture of foreign competitors (e.g., Toyota and Korean car
makers in the US) will reduce profitability in a formerly profitable sector of their business
• Excess capacity in the overall car market implies that there is considerable risk related to
impairment of property plant and equipment
• Consumer spending is down and prices of commodities are up, so profits are continually
being squeezed
• Exchange rate volatility and general unpredictability of the political landscape (e.g., US
Federal stimulus money that helped Ford sales during 2009)
Each of these factors highlights the difficult economic market that Ford faces. It leads to
difficulties in achieving profit and bonus targets, which may increase the risk that some
managers may try to stretch their numbers to achieve targets. Therefore, careful consideration of
the link between profitability, production targets, and performance measures (and achievement
thereof) should be a focus for the audit firm (PwC).
ACL
9-86
a. This cross-sectional analysis can be performed using either Excel (or compatible
spreadsheet) or ACL.
Using Excel:
• Download the FloorMart data file from the web site www.cengage.com/accounting/rittenberg
• Add two columns for each store:
o Calculate Inventory per square foot
o Calculate Sales per square foot
• Sort the Inventory per square foot column in descending sequence.
• Sort the Sales per square foot column in descending sequence.
• Note in steps 3 and 4, stores 121 and 122 are significantly greater than the rest of the stores.
Using ACL:
• Download the FloorMart data file from the book’s web site and import it into ACL.
• Add two columns using the Expr… Inventory / Sq Ft and Sales / Sq Ft.
• Sort each of those new columns in descending order. The results are the same as above.
b. Special attention needs to be paid to these two stores. Some of the audit steps would
be:
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9-52
1. Inquire of corporate management about these two stores and their managers.
Have they had any problems with them in the past? Are they aware of any
fraud at these stores? Do these stores usually perform better than the other
stores? Why?
2. Have the internal auditors investigated the controls at these stores? If so,
review their working papers and inquire of the internal auditors about their
findings.
3. Compare current year results with prior years for these two stores.
4. Include these two stores with other stores selected and observe the physical
inventory procedures and make test counts of the inventory at these two
stores. The client likely uses perpetual inventory records and takes a physical
inventory at different times of the year at different stores. The client should
require that the physical inventory at these two stores be taken at or near year-
end.
5. Review the cutoff of sales transactions. Since the auditor will be on the
premises at or near year-end, the cash register tapes should be compared with
the recorded sales to be sure they are recorded in the proper period.
9-87
This is a good problem to use for classroom demonstration. Data files are in italics. ACL
icons, commands, and equations in bold. Field names are in FULL CAPS.):
Audit
Program Approach
Step
To Begin Open a new project by choosing File, New, Project or click the New Project icon.
Name the project Husky AR.
Import the following tables (files) and change the field type for CUSTNUM and
INVNUM from Numeric to ASCII using Edit, Table Layout and double-clicking
on the field name. This must be done so files can be joined using these fields.
HUSKY Unpaid Invoices 2013, name it Unpaid
HUSKY Shipping File 2013, name it Shipping File
HUSKY Credit Limit 2013, name it Credit Limit.
With the Unpaid file as the active window, choose Analyze, Statistical, Statistics
and choose to get statistics on AMOUNT.
Results: There are a total of 200 records with a net value $4,263,919.52 that agrees
with information obtained from the client’s records provided in the problem. Also
note there is one invoice with a negative $22,659.74 amount. The customer paid for
the merchandise and has returned it. HUSKY owes them the money or replacement
merchandise.
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Audit
Program Approach
Step
2. Objective: Identify customer balances greater than their credit limit or for which
there are no credit limits.
Using the Customer Balances file, click the Join icon. Select the Credit Limit file as
the secondary table. Click to presort the secondary table. Select CUSTNUM for the
primary keys and the secondary keys. Select the primary fields CUSTNUM and
AMOUNT and select the secondary fields CRLIMIT and CUSTNUM. Name the
new file Balances with Credit Limits.
Using the Balances with Credit Limits file, choose DATA, Extract Data, If and
enter the expression AMOUNT > CRLIMIT. Name the new file Over Limit.
Results: Customer 174 does not have a credit limit. Customers 121, 141, 166, 181,
and 184 exceed their credit limits.
Using the Unpaid file, click the JOIN icon. Select the Shipping File as the
secondary file. Select INVNUM as the primary keys and secondary keys. Select
INVNUM, INVDATE, CUSTNUM, and AMOUNT as the primary fields. Select
INVNUB, SHIPNUM, and DATESHIP as the secondary fields. Name the new file
Unpaid with Shipping Info.
Using the Unpaid with Shipping Info file, choose DATA, Extract Data, IF and
enter the expression SHIPNUM > 62050 (The auditor has verified that this is the
last shipping number used.) Name the new file Cutoff Errors. Results: Invoices
169980, 169981, and 169982 were recorded in December 2013 but not shipped until
January 2014. The total amount of these invoices is $26,729.71.
Note: Results can also be found by sorting the file by shipping date and noting the
three invoices were not shipped until 2014.
Use the Unpaid file. Choose ANALYZE, Age, and age on INVDATE. Set the
cutoff date to December 31, 2013. Choose the AMOUNT field to total. Set the
Aging Periods to 0 and 45. Print the Age Analysis Report
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Solution manual for Auditing: A Risk-Based Approach to Conducting a Quality Audit Johnstone
Audit
Program Approach
Step
To get a list of these 4 records, double-click on the > 45 box.
5. Objective: Stratify customer balances and describe how this information could be
used to help determine which balances to confirm.
Results: The report shows that over half of the dollars are composed of 24 customer
balances greater than $50,000. These along with a random selection of the other
balances should be confirmed.
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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