Auditing A Risk Based Approach To Conducting A Quality Audit 9Th Edition Johnstone Solutions Manual Full Chapter PDF

Auditing A Risk-Based Approach to
Conducting a Quality Audit 9th Edition

Johnstone Solutions Manual
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Solutions for Chapter 12
True-False Questions
12-1 F
12-2 T
12-3 T
12-4 T
12-5 T
12-6 T
12-7 T
12-8 F
12-9 T
12-10 F
12-11 T
12-12 F
12-13 F
12-14 T
12-15 T
12-16 T
Multiple-Choice Questions
12-17 D
12-18 A
12-19 D
12-20 A
12-21 B
12-22 D
12-23 B
12-24 C
12-25 A
12-26 D
12-27 C
12-28 A
12-29 B
12-30 C
12-31 C
12-32 B
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12-1
Review and Short Case Questions
12-33
The existence and valuation assertions related to long-lived assets are usually the more relevant
assertions. Organizations may have incentives to overstate their long-lived assets and may do so
by including fictitious long-lived assets on the financial statements. Alternatively, organizations
may capitalize costs, such as repairs and maintenance costs, which should be expensed. Concerns
regarding valuation include whether the organization properly and completely recorded
depreciation and properly recorded any asset impairments. The valuation issues typically involve
management estimates that may be subject to management bias.
Identifying and focusing on the relevant assertions will allow the auditor to be more efficient in
the performance of the audit (i.e., the auditor will not over-audit the lower risk assertions).
12-34
Depreciation expense relates to the expensing of a fixed asset over its life. For natural resources,
the related expense account would be referred to as depletion expense (the expense associated
with the extraction of natural resources). For intangible assets with a definite life, the related
expense account would be referred to as amortization expense.
12-35
The five management assertions relevant to long-lived assets are as follows:
1. Existence or occurrence. The long-lived assets exist at the balance sheet date. The focus is
typically on additions during the year.
2. Completeness. Long-lived asset account balances include all relevant transactions that have
taken place during the period.
3. Rights and obligations. The organization has ownership rights for the long-lived assets as of
the balance sheet date.
4. Valuation or allocation. The recorded balances reflect the balance that is in accordance with
GAAP (includes appropriate cost allocations and impairments).
5. Presentation and disclosure. The long-lived asset balance is reflected on the balance sheet in
the noncurrent section. The disclosures for depreciation methods and capital lease terms are
adequate.
12-36
Asset impairment is a term used to describe management’s recognition that a significant portion
of fixed assets is no longer as productive as had originally been expected. When assets are
impaired, the assets should be written down to their expected economic value.
Much of the inherent risk associated with long-lived assets is due to the importance of
management estimates, such as estimating useful lives and residual values and determining
12-2
whether asset impairment has occurred. Inherent risk related to asset impairment stems from the
following factors:
• Normally, management is not interested in identifying and writing down assets.

• Sometimes, management wants to write down every potentially impaired asset to a minimum
realizable value (although this will cause a one-time reduction to current earnings, it will lead
to higher reported earnings in the future).
• Determining asset impairment, especially for intangible assets, requires a good information
system, a systematic process, good controls, and professional judgment.
Other inherent risks associated with long-lived assets and related expenses include:
• Incomplete recording of asset disposals

• Obsolescence of assets
• Incorrect recording of assets, due to complex ownership structures
• Amortization or depreciation schedules that do not reflect economic impairment or use of the
asset
12-37
Natural resources present unique risks. First, it is often difficult to identify the costs associated
with discovery of the natural resource. Second, once the natural resource has been discovered, it
is often difficult to estimate the amount of commercially available resources to be used in
determining a depletion rate. Third, the client may be responsible for restoring the property to its
original condition (reclamation) after the resources are removed. Reclamation costs may be
difficult to estimate.
12-38
Intangible assets should be recorded at cost. However, the determination of cost for intangible
assets is not as straightforward as it is for tangible assets, such as equipment. As with tangible
long-lived assets, management needs to determine if the book values of patents and other
intangible assets have been impaired. Thus, there is a great deal of estimation by management
associated with intangible assets.
12-39
a. Management’s motivation to overstate fixed assets is similar to other circumstances in

which fraud is perpetrated:
• Increase reported earnings

• Boost stock price
• Improve ability of the company to acquire another company
• Avoid a violation of company debt covenants
12-3
b. The auditor should also consider the other two components of the fraud triangle–
opportunity and rationalization–when assessing fraud risk associated with long-lived assets.
12-40
A skeptical auditor will understand that management can manage earnings in a number of ways,
including:
• Improperly recording repairs and maintenance costs that should be expensed as fixed assets.
• Lengthening the estimated useful lives and/or increasing estimated residual value of
depreciable assets without economic justification as was done in the Waste Management
fraud.
The auditor becomes aware of management’s potential by considering relevant fraud risk factors,
including incorporating information related to internal control effectiveness–in particular the
control environment.
12-41
Potential fraud schemes related to long-lived assets include:
• Sales of assets are not recorded and proceeds are misappropriated.

• Assets that have been sold are not removed from the books.
• Inappropriate residual values or lives are assigned to the assets, resulting in miscalculation of
depreciation.
• Amortization of intangible assets is miscalculated.
• Costs that should have been expensed are improperly capitalized.
• Impairment losses on long-lived assets are not recognized.
• Fair value estimates are unreasonable or unsupportable.
12-42
Typically, the more relevant assertions (areas of higher risk) for tangible long-lived assets (e.g.,
property, plant, and equipment) include existence and valuation. For these assertions, the
appropriate internal controls could include:
• The use of a computerized property ledger. The property ledger should uniquely identify
each asset. In addition the property ledger should provide detail on the cost of the property,
the acquisition date, depreciation method used for both book and tax, estimated life,
estimated scrap value (if any), and accumulated depreciation to date.
• Authorization procedures to acquire new assets. In particular, the use of a capital budgeting
committee to analyze the potential return on investment is a strong control procedure.
• Periodic physical inventory of the assets and reconciliation with the recorded assets.
• Formal procedures to account for the disposal of assets.
12-4
• Periodic review of asset lives and adjustments of depreciation methods to reflect the changes
in estimated useful lives.
12-43
The more relevant assertions for intangible assets include valuation and presentation and
disclosure. For intangible assets, controls should be designed to:
• Provide reasonable assurance that decisions are appropriately made as to when to capitalize or
expense research and development expenditures (presentation and disclosure).
• Develop amortization schedules that reflect the remaining useful life of patents or copyrights
associated with the asset (valuation).
• Identify and account for intangible-asset impairments (valuation).
Management should have a monitoring process in place to review valuation of intangible assets.
For example, a pharmaceutical company should have fairly sophisticated models to predict the
success of newly developed drugs and monitor actual performance against expected performance
to determine whether a drug is likely to achieve expected revenue and profit goals. Similarly, a
software company should have controls in place to determine whether capitalized software
development costs will be realized.
Specific examples of controls include:
• Management authorizations are required for intangible asset transactions.

• Documentation regarding intangible assets should be maintained and such documentation
should include:
o Manner of acquisition (e.g., purchased, developed internally)
o Basis for the capitalized amount
o Expected period of benefit
o Amortization method
• Amortization periods and calculations should be approved and periodically reviewed by
appropriate personnel.
12-44
Analytical procedures that would be helpful in performing preliminary analytical procedures

related to depreciation expense include analysis of the following relationships in the light the
expectations developed by the auditor:
• Current depreciation expense as a percentage of the previous year's depreciation expense,
• Fixed assets (by class) as a percentage of previous year's assets. The relative increase in this
percentage can be compared with the relative increase in depreciation expense as a test of
overall reasonableness.
12-5
• Depreciation expense (by asset class) as a percentage of assets each year. This ratio can
indicate changes in the age of equipment or changes in depreciation policy, or computation
errors.
• Accumulated depreciation (by class) as a percentage of gross assets each year. This ratio
provides information on the overall reasonableness of the account and may indicate problems
of accounting for fully depreciated equipment.
• Average age of equipment (by class). This ratio provides additional insight on the age of
assets and may be useful in modifying depreciation estimates.
12-45
Ratios and expected relationships that auditors can use when performing preliminary analytical
procedures include:
• Review and analyze gains/losses on disposals of equipment (gains indicate depreciation lives
are too short, losses indicate the opposite).
• Perform an overall estimate of depreciation expense.
• Compare capital expenditures with the client’s capital budget, with an expectation that capital
expenditures would be in line with the capital budget.
• Compare depreciable lives used by the client for various asset categories with that of the
industry. Large differences may indicate earnings management.
• Compare the asset and related expense account balances in the current period to similar items
in the prior audit and determine whether the amounts appear reasonable in relation to other
information you know about the client, such as changes in operations
Ratios that the auditor should plan to review, after developing independent expectations, include:
• Ratio of depreciation expense to total depreciable long-lived tangible assets. This ratio
should be predictable and comparable over time unless there is a change in depreciation
method, basis, or lives. The auditor should plan to analyze any unexpected deviation and
assess whether any changes are reasonable.
• Ratio of repairs and maintenance expense to total depreciable long-lived tangible assets.
This ratio may fluctuate because of changes in management’s policies (for example,
maintenance expenses can be postponed without immediate breakdowns or loss of
productivity). The auditor should plan to analyze any unexpected deviation with this
consideration in mind.
12-6
12-46
Panel B of Exhibit 12.3 illustrates the different levels of assurance that the auditor could obtain
from tests of controls and substantive procedures. The reason for the differing approaches is due
to the different levels of risk of material misstatement associated with each of the clients. Panel
B makes the point that because of the higher risk associated with the existence of equipment at
Client B, the auditor will want to design the audit so that more of the assurance is coming from
tests of details. In contrast, the risk associated with the existence of equipment at Client A is
lower and therefore the auditor would be willing to obtain more assurance from tests of controls
and substantive analytics, and less assurance from substantive tests of details. Note that the
relative percentages are judgmental in nature; the examples are simply intended to give you a
sense of how an auditor might select an appropriate mix of procedures.
12-47
For many organizations, long-lived assets involve only a few assets of relatively high value. In
these settings, the time and effort needed to perform tests of controls in order to reduce
substantive testing may exceed the time required to simply perform the substantive tests. Thus,
the most efficient approach would be to use a substantive approach, using test of details, for
testing.
12-48
Control Procedure Purpose of Control Impact on Substantive Audit

Procedure (a) Procedures (b)
1. Periodic physical Provide reasonable Auditor should expand
inventory of assets. assurance that records procedures either by taking a
reflect equipment on-hand sample from the property ledger
and in use. Relates to and verifying existence or take a
existence and tour of plant and identify idle
completeness. equipment for future review (or
both procedures.)
2. Policy to classify Provide reasonable Auditor would have to review
equipment and compute assurance of consistent use each equipment life for
depreciation. of depreciation methods consistency and rationale for the
based on experience of life chosen.
client. Relates to valuation.
3. Policy on minimum Promote processing There is no particular effect on
amounts that are to be efficiency by expensing the audit except that the
capitalized. small dollar value items. property, plant and equipment
ledger would have substantially
larger items as the smaller dollar
items would have been
expensed..
12-7
Control Procedure Purpose of Control Impact on Substantive Audit
Procedure (a) Procedures (b)
4. Method for designating Provide reasonable Auditor would expand
scrap or idle equipment for assurance that the records production facilities tour with
disposal. are updated for changes in special emphasis on identifying
productive life of assets. obsolete or non-productive
Relates to valuation. assets. The items identified
would be discussed with
management in order to
determine if adjustments are
needed.
5. Differentiate major Provide reasonable Expand review of repairs and
renovations from repair assurance that the proper maintenance expense.
and maintenance. accounting since major Investigate all large expenditures
renovations may extend to determine if they are more
the life of the asset and appropriately classified as
should be debited to renovations.
accumulated depreciation.
6. Self-construction of Provide reasonable Perform a detailed review of all

assets. assurance of proper self-constructed assets.
accounting for self-
constructed assets.
7. Systematic review for Provide reasonable Auditor would have to review
asset impairment. assurance of proper asset productivity each year and
accounting for asset make inquiries of client of the
impairment (valuation accounting for impaired assets.
issues). Company Auditor would be more alert to
performing the review on a declining productivity indicators
consistent basis is a strong or changes in product mix that
control because it might affect asset values.
eliminates many of the
"big bath" write-offs.
8. Management Provide reasonable Auditor should review asset
periodically reviews assurance of asset disposals for potential impact on
disposals for potential valuation. choice of economic lives for
impact on changing asset assets.
lives for depreciation
purposes.
12-8
12-49
Test of controls over tangible long-lived assets could include:
• Examine documentation corroborating that a tangible long-lived asset budget is prepared and
used.
• Examine relevant documentation for management's approval process of the tangible long-
lived asset budget.
• Examine a sample of tangible long-lived asset requisition forms for management's approval.
• Inspect copies of the vouchers used to document departmental request for sale, retirement, or
scrapping of tangible long-lived assets for management's approval.
• Test depreciation shown in the general ledger to the amounts shown in the tangible long-
lived asset ledger. (This might be performed as a dual purpose test.)
• Review or recompute a sample of depreciation calculations.
• Agree the posting of depreciation expense to the general ledger.
• Inspect the tangible long-lived asset ledger for adequate detail to support the tangible long-
lived asset accounts.
• Verify that the tangible long-lived asset ledger is periodically balanced to the general ledger.
• Verify accuracy of calculations on a sample of tangible long-lived asset requisition forms.
• Check for the existence of a written policy which establishes whether a budget request is to
be considered a capital expenditure or a routine maintenance expenditure.
• Confirm the existence of approved vouchers for entries which remove assets from the
tangible long-lived asset ledger.
• Inspect documentation of tangible long-lived asset requisition forms for authenticity.
• Test a sample of maintenance expenditures to evaluate compliance with the written policy
which establishes whether an item is to be considered a capital expenditure or a routine
maintenance expenditure.
• Evaluate the effectiveness and appropriateness of the written policy used to distinguish
capital expenditures from maintenance expenditures.
• Compare costs and prices on a sample of tangible long-lived asset requisition forms to
established list prices to determine reasonableness.
• Compare sale or scrap prices on a sample of vouchers used to document departmental
requests for sale, retirement, or scrapping of tangible long-lived assets to established list
prices to determine reasonableness.
• Review tangible long-lived asset budget reports and note management's explanation of any
significant variances.
• Scan the tangible long-lived asset ledger for unusually large or small items.
• Through review of relevant documentation and inquiry of appropriate personnel determine
that tangible long-lived asset records are maintained by persons other than those who are
responsible for custody and use of the assets.
• Agree the identification numbers of a sample of fixed assets to those shown in the tangible
long-lived asset ledger.
• Through review of relevant documentation and inquiry of appropriate personnel, verify that
periodic physical inventories of tangible long-lived assets are taken for purposes of
12-9
reconciliation to the tangible long-lived asset ledger as well as appraisal for insurance
purposes.
• Through review of relevant documentation and inquiry of appropriate personnel, substantiate
that periodic physical inventories of tangible long-lived assets are taken under the
supervision of employees who are not responsible for the custody of record keeping for the
tangible long-lived assets.
• Through review of relevant documentation and inquiry of appropriate personnel, investigate
whether significant discrepancies between the tangible long-lived asset ledger and physical
inventories are reported to management.
12-50
CONTROL POSSIBLE TESTS OF CONTROLS

Management authorizations are required for For selected intangible asset transactions
intangible asset transactions. inquire of management as to the authorization
process and review documentation of the
appropriate authorizations.
Documentation regarding intangible assets For selected intangible assets, review
should be maintained and such documentation documentation and assess reasonableness of
should include: management estimates
o Manner of acquisition (e.g., purchased,
developed internally),
o Basis for the capitalized amount,
o Expected period of benefit, and
amortization method.
Amortization periods and calculations should For selected items, inquire of management
be approved and periodically reviewed by regarding this process, review documentation
appropriate personnel. supporting the process, and recompute
calculations.
12-51
To detect fictitious assets, the auditor should have traced recent acquisitions to the fixed-asset
accounts and to original source documents; doing so would have enabled the auditor to realize
that such documents did not exist. For improper depreciation, the auditor should have compared
depreciation expense over a period of time, adjusted for the volume of business and the number
of trucks used. The decrease in depreciation per truck should have led to more detailed
investigation, including tests of depreciation on each truck. For the impairment issue, the auditor
should have compared current earnings with future expected earnings that were predicted when
the goodwill was initially recorded. A dramatic decrease in current earnings signals the need for
an impairment adjustment. For the impaired assets, the auditor should have noted (a) the relative
age of the assets (net book value has decreased), (b) idle equipment during a tour of the factory,
and (c) should have traced apparently idle assets to the books. For the assets overvalued at
acquisition, the auditor should have determined if the company had used a reputable and certified
12-10
independent appraiser. If the auditor had doubts, he or she should have hired an appraiser to form
an independent opinion.
12-52
Compute the average balance: ($380,500 + $438,900) / 2 = $409,700

Adjust for the salvage value: $409,700 * .9 = $368,730
Compute the annual depreciation expense: $368,730 / 6 = $61,455.
Once the auditor has developed an expectation of the account balance, the auditor will compare
that expectation with the amount recorded by the client. If the difference between the two
amounts is less than the threshold (based on level of materiality) set by the auditor, the auditor
would conclude that the recorded depreciation expense is reasonable. Although the problem did
not provide details on the auditor’s threshold, it is reasonable to believe that the difference
between the auditor’s expectation and the client’s recorded amount in this problem would be
below that auditor’s threshold. Thus, the auditor would likely conclude that the recorded
depreciation expense of $60,500 appears reasonable. Given the results of this substantive
analytical procedure, the auditor will likely not need to perform any additional substantive tests
of details.
12-53
The audit approaches applicable to identifying and determining the proper accounting of fully
depreciated or idle facilities would include:
• The auditor should tour the client facilities and make inquiries concerning idle equipment.
The auditor should note all idle equipment to be subsequently traced to the property ledger.
Discussions with management about these issues will also be helpful.
• Generalized audit software could be used to develop a schedule of fully depreciated assets. A
sample could be taken and the auditor could attempt to physically observe the asset and
determine whether it is in production and whether a scrap value is appropriate.
12-54
The client has a policy that apparently has been used for a number of years. Assignment of assets
to classes for depreciation purposes is common and represents an expedient method of dealing
with depreciation issues. The auditor can determine the reasonableness of the classification
schemes by:
• Reviewing previous data on the asset's productive life (within each category
• Reviewing IRS guidelines for classification and reasonableness in comparison with the
company's categories and life guidelines
12-11
• Noting significant gains/losses on disposal.
12-55
The general concept of valuing impaired assets consists of two major approaches:
• Estimating the future economic benefits to be derived from the asset. The auditor would
evaluate management’s assumptions and estimates for reasonableness.
• Obtaining an independent appraisal of current value. The auditor could either assess the
competence and independence of the appraiser hired by management and the reasonableness
of the assumptions used or the auditor could obtain an independent appraisal of the value of
the asset.
12-56
The auditor must make sure the appraisal is reasonable. The auditor should consider the
qualifications and certification of the appraiser and appropriateness of the assumptions used by
the appraiser. The auditor may also need to use a specialist/expert to assist with these audit
procedures.
12-57
General substantive procedures for leases include:
• Obtain copies of lease agreements, read the agreements, and develop a schedule of lease
expenditures.
• Review the lease expense account, select entries to the account, and determine if there are
entries that are not covered by the leases obtained from the client. Review to determine if the
expenses are properly accounted for.
• Review the relevant criteria from FASB ASC to determine which leases meet the
requirement of capital leases.
• For all capital leases, determine that the assets and lease obligations are recorded at their
present value. Determine the economic life of the asset. Calculate amortization expense and
interest expenses, and determine any adjustments to correct the financial statements.
• Develop a schedule of all future lease obligations or test the client’s schedule by reference to
underlying lease agreements to determine that the schedule is correct.
• Review the client’s disclosure of lease obligations to determine that it is in accordance with
GAAP.
12-58
a. Items 1 through 6 would have been found in the following way:
1. The company's policies for depreciating equipment are available from several sources:
12-12
• The prior-year's audit working papers and permanent file.
• Footnote disclosure in the annual report and SEC Form 10-K.
• Company procedures manual.
• Detailed fixed asset records.
• Inquiry of relevant client personnel.
2. The ten-year lease contract would be found when supporting data for current year's
equipment additions were examined. Also, it may be found by a review of company lease and
contract files.
3. The building wing addition would be apparent by the addition to buildings during the
year. The use of the low construction bid amount would be found when support for the addition
was examined. When it was determined that this inappropriate method was followed, the actual
costs were determined by reference to construction work orders and supporting data. The wing
was also physically observed by the auditor.
4. The paving and fencing was discovered when support was examined for the addition to
land. These costs should be charged to Land Improvements and depreciated.
5. The details of the retirement transactions were determined by examining the sales
agreement, cash receipts documentation, and related detailed fixed asset record. This
examination would be instigated by the recording of the retirement in the machinery account or
the review of cash receipts records.
6. The auditor would become aware of a new plant in several ways:
• Volume would increase.

• Account details such as cash, inventory, prepaid expenses, and payroll would be attributed to
the new location.
• The transaction may be indicated in documents such as the minutes of the board, press
releases, and reports to the stockholders.
• Property tax and insurance bills examined show the new plant.
• Inquiry of appropriate client personnel.
One or more of these factors would lead the auditor to investigate the reasons and
circumstances involved. Documents from the city and appraisals would be examined to
determine the details involved.
b. The appropriate adjusting journal entries are as follows:
1. No entry necessary.
2. This is an operating lease because it is cancelable with a 60 day notice and should not
have been capitalized.
12-13
Dr. Prepaid rent $ 5,000
Dr. Lease liability 35,400
Dr. Allowance and depreciation-- 2,020
machinery and equipment
Cr. Machinery and equipment 40,400
Cr. Depreciation expense 2,020
To correct initial recording of lease.
Dr. Equipment rent expense $ 3,750

Cr. Prepaid rent $3,750
To record nine months of rent:
9/12 x $5,000 = $3,750
3. The wing should have been recorded at its cost to the company.
Dr. (Accounts originally credited) $1,500

Cr. Buildings $1,500
To correct initial recording of a new wing at its cost rather than the outside bid.
Dr. Depreciation expense $ 290

Cr. Allowance for depreci-
ation--buildings $ 290
To correct depreciation for excess cost.
Depreciation on beginning balance.

120,000/25 = 4,800
Depreciation recorded on addition

5,150 - 4,800 = 350
Correct depreciation for addition:

Remaining useful life of addition at the beginning of the year is 12 ½ years (60,000/120,000 x 25
=
12 ½ years; (25 – 12 ½ = 12 ½)
Depreciation = $16,000/12 ½ / 2 = $640

Correction = $640 - $350 = $290
4. The paving and fencing are land improvements and should be depreciated over their
useful lives.
Dr. Land improvements $5,000

Cr. Land $5,000
To correct initial recording of paving and fencing.
12-14
Dr. Depreciation expense $ 250
Cr. Allowance for depreci-
ation--Land Improvements $250
To record first year's depreciation on paving and fencing.
$5,000/10 / 2 = $250
5. The cost and allowance for depreciation should have been removed from the accounts
and a gain or loss on sale recorded separately into income.
Cost of asset $48,000

Allowance for depreciation:
Through 2013: 48,000/10 x 7 ½ $36,000
For 2014: (48,000/10)/2 2,400
38,400
Net book value 9,600
Cash proceeds 26,000
Gain on sale $16,400
Depreciation expense for 2014 should be $2,400 rather than the $3,500 that was recorded.
The correcting entry is:
Dr. Allowance for depreciation--

Machinery and Equipment $39,500
(36,000 + 3,500)
Cr. Machinery and Equipment $22,000
Cr. Depreciation expense
(3,500 – 2,400) 1,100
Cr. Gain on sale 16,400
6. Donated property should be capitalized at its fair market value.
Dr. Land $10,000

Dr. Buildings 40,000
Cr. Contributed capital-
Donated Property $50,000
To record land and buildings for new plant donated by Crux City.
Dr. Depreciation expense $800

Cr. Allowance for depreciation-
-Buildings $ 800
To record depreciation on new plant.
$40,000/25 / 2 = $800
12-15
12-59
a. Impairment of assets refers to long-lived assets and certain identifiable intangibles to be held
and used by an entity for which events or changes in circumstances indicate that the carrying
amount of an asset may not be recoverable. In performing the review for recoverability, the
entity should estimate the future cash flows expected to result from the use of the asset and
its eventual disposition. If the sum of the expected future cash flows (undiscounted and
without interest charges) is less than the carrying amount of the asset, an impairment loss is
recognized. Otherwise, an impairment loss is not recognized. Measurement of an impairment
loss for long-lived assets and identifiable intangibles that an entity expects to hold and use
should be based on the fair value of the asset.
b. Management’s motivation will depend on the specific facts and circumstances. In some
settings, management may follow the so-called big bath theory and take very large write-offs
when any write-off occurs. The rationale for this approach is that the market seems to be
forgiving, especially if there is a change in management and the new management can blame
the problems on the previous management. If the write-off is large, then it decreases the
amount of assets that might be charged against earnings in the future. In some settings, the
investment public is skeptical of the large write-offs and has recognized such write-offs as a
symbol of management failure. Thus, managers will resist taking any write-offs unless there
is compelling evidence that there has been impairment in assets.
However, it is important to recognize that management will want to understate expenses, and
thus overstate income, and so will want to understate the right. The auditor has to be aware of
management’s incentives when assessing the nature and type of potential misstatements.
c.
Step 1. Identify the ethical issue. The ethical issue is that the auditor believes that her estimate is
correct, and knows that it is materially lower than management’s estimate of the impairment.
Step 2. Determine who are the affected parties and identify their rights. There are various
affected parties:
• shareholders, who have a right to accurate financial information
• the audit committee and board, who have a right to know that the auditor and management
are having a material disagreement
• management, who has a right to uphold their own valid, defensible professional opinions
• the auditor and audit firm, who have a right to exercise their own professional judgment and
to minimize potential litigation against themselves
• tax authorities, who have a right to expect that management will make tax deductions that are
reasonable and appropriate
Step 3. Determine the most important rights. The most important rights are likely those of
shareholders, followed by the audit committee and board as major players in the corporate
12-16
governance of the company. The tax authorities represent society in general, so their rights are
also quite important.
Step 4. Develop alternative courses of action. The auditor could pursue various courses of action:
a. Try again to convince management that the auditor’s estimates are

superior.
b. Alert the audit committee of the disagreement and let them help to resolve
it.
c. Threaten management with a qualified audit opinion if they refuse to
acquiesce to the auditor’s preference.
d. Resign from the engagement.
Step 5. Determine the likely consequences of each proposed course of action.
a. Trying to convince management may or may not work. If it does work, then
the situation is resolved. If it does not work, the relationship between the
auditor and management will likely become even more strained.
b. Alerting the audit committee is required by professional standards. While it
may annoy management, the auditor can fall back on the fact that they are
required to discuss such issues with the audit committee.
c. Threatening management will obviously strain the relationship with the
auditor, but it may be successful in getting management to see the auditor’s
point of view.
d. Resigning is the last resort as it is a fairly extreme measure, and will result in
public disclosure of the disagreement for the company, and loss of revenue for
the audit firm.
Step 6. Assess the possible consequences, including an estimation of the greatest good for the
greatest number. The auditor is required via professional standards to alert the audit committee,
and doing so will likely enable the auditor to (a) re-think their estimate if the audit committee
convincingly challenges their calculations, or (b) use the interaction to convince management to
use the correct valuation in the impairment. Ultimately, the process of interacting with the audit
committee and management will enable all parties to determine the most appropriate impairment
calculation. The revelation of that amount to shareholders and tax authorities will result in the
greatest good for the greatest number.
Step 7. Decide on the appropriate course of action. The auditor should first try to convince
management to change the estimate, and even if they succeed in doing so the auditor must alert
the audit committee to the situation.
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1. The main difficulty that the auditor faces in determining whether the charges are reasonable is
to understand management’s estimation procedures and to decide if they are reasonable. The
auditor will have to understand the following types of decisions:
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• Which third party offers were used in the calculations? How did management choose which
offers to use if there were multiple offers?
• What is the appropriate discount rate for the discounted future cash flow calculations?
• Is it appropriate to completely write off the Falkirk, Scotland assets? Or is management
possibly setting up a cookie jar reserve by doing so?
2. The consequences of the auditor’s decisions are associated with providing reasonable
assurance that no fixed assets are inappropriately over-valued on the balance sheet (with
resulting under-expensing of impairment charges on the income statement) or under-valued on
the balance sheet (with resulting over-expensing of impairment charges on the income statement).
3. The risks are those associated with inaccurate financial reporting, particularly if the
impairment charges are material to the client’s financial statements. The uncertainties involve the
estimates, for example, is a 7% discount rate correct, or should it be 5%?
4. The auditor can gather various types of evidence:

• Documentation of management’s estimation process and assumptions
• Documentation that includes third-party offers and negotiations
• Confirmations with third parties
• Comparisons of fixed asset values with competitors
• Understanding and documenting management’s potential motivations for under- or over-
expensing the impairment charges
• Obtaining current market values of assets.
Contemporary and Historical Cases
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a. IRG’s lease accounts and fixed asset accounts (including related deprecation charges)
were misstated.
b. While the textbook feature does not provide information specifically related to
management motivation, students will likely note that the company recently went public and may
have intentionally misstated the financial statements so that the public offering would be more
successful. The motivation, coupled with opportunity due to weak internal controls, is often
highlighted by students.
c. Typical controls that affect multiple assertions for long-lived assets include:
• Formal budgeting process with appropriate follow-up variance analysis
• Written policies for acquisition and disposals of long-lived assets, including required
approvals
• Limited physical access to assets, where appropriate
• Periodic comparison of physical assets to subsidiary records
• Periodic reconciliations of subsidiary records with the general ledger
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Further, controls should be in place to:
• Identify existing assets, inventory them, and reconcile the physical asset inventory with the
property ledger on a periodic basis (existence).
• Provide reasonable assurance that all purchases are authorized and properly valued
(valuation).
• Appropriately classify new equipment according to its expected use and estimate of useful
life (valuation).
• Periodically reassess the appropriateness of depreciation categories (valuation).
• Identify obsolete or scrapped equipment and write the equipment down to scrap value
(valuation).
• Review management strategy and systematically assess the impairment of assets (valuation).
With respect to the lease accounts, the company should have policies and procedures requiring
review all of leases by a qualified lease accountant to provide reasonable assurance over proper
recording of those transactions.
d. The auditors should have gained an understanding of the client’s internal controls over
these long-lived assets. If the controls were not well designed (or determined not to be operating
effectively), the auditors should have increased the assurance they needed regarding whether the
asset accounts were materially misstated. For the lease audit, the auditors could perform the
following:
• Obtain copies of lease agreements, read the agreements, and develop a schedule of lease
expenditures.
• Review the lease expense account, select entries to the account, and determine if there are
entries that are not covered by the leases obtained from the client. Review to determine if the
expenses are properly accounted for.
• Review the relevant criteria from FASB ASC to determine which leases meet the
requirement of capital leases.
• For all capital leases, determine that the assets and lease obligations are recorded at their
present value. Determine the economic life of the asset. Calculate amortization expense and
interest expenses, and determine any adjustments to correct the financial statements.
• Develop a schedule of all future lease obligations or test the client’s schedule by reference to
underlying lease agreements to determine that the schedule is correct.
• Review the client’s disclosure of lease obligations to determine that it is in accordance with
GAAP.
As for the tangible long-lived assets, a great deal of this chapter is focused on appropriate
substantive procedures for both the asset and expense accounts. Further, Exhibit 12-4 outlines
possible procedures that the auditor could have performed.
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a. Yes, it would be highly unusual for debits to fixed assets to come from journal entries.
Most debits to fixed assets should come from purchases of the assets and should be evidenced by
invoices and contracts. The auditor should view significant amounts of debits to fixed asset as
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high risk and should investigate all of the entries if the aggregate amount could be significant or
material.
b. No, entries to depreciation expense and accumulated depreciation should normally come
from journal entries. However, the journal entries should come from an automated computer
program. Thus, the auditor should trace the summary entries back to the detail computation for
specific items.
c. An explanation of “Capitalization of line capacity per CFO, amounts were originally

incorrectly recorded as an expense” is a highly unusual transaction. The auditor should be highly
skeptical because it does not appear to be supported by outside, objective evidence. The client
claims it is misclassified as an expense. The auditor should seek the following evidence:
• Ask the client to examine the original invoice, contract, and other information associated
with the original payment for the goods, services, or fixed asset.
• The auditor should examine the invoice to determine the nature of the purchase.
• The auditor should determine that the document that is examined was not used to support
other purchases, that is, the auditor should be suspicious of the information because it is all
obtained internally. The auditor should be concerned that one invoice might serve as support
for this journal entry and another purchase.
• The auditor should use GAS to prepare a list of all other purchases from the vendor. The
auditor should trace the purchases to invoices and to proper recording in the accounts.
• The auditor should consider confirming the total amount of purchases with the outside
vendor.
Significant differences should be recorded as misstatements and projected to the statements as a

whole. If the auditor has suspicions that other such misstatements might exist in the accounts, the
auditor should use GAS to schedule all entries to the account balance that comes from other than
the purchase journal and should investigate all of the entries in a similar manner.
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a. The statement of facts for this case reveals that company management had made
promises (earnings expectations) to investors and Wall Street that were not going to materialize,
thereby suggesting the motivation for management. Further, it is likely that the controls in place
were not very effective. While Safety-Kleen had policies prohibiting the types of fraudulent
entries that were being made, presumably there was no monitoring or review of adherence to
these policies. And students can often see how management might provide rationalizations for
the fraud (for example, not our fault the numbers are not being meant, we shouldn’t suffer
because of something outside of our control, etc.).
b. It is important to note that this response has the benefit of hindsight. However, analytical
procedures (either preliminary or substantive) should have noted the increases in quarter end
adjustments, with rather significant adjustments occurring in the 3rd and 4th quarters of 1999.
Further, the 2000 1st quarter adjustment was quite a bit larger than the previous 1st quarter
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adjustment. The case states that these adjustments in 1999 were significantly higher than the
adjustments in previous. We assume that these balances in 1999 and 2000 were different than
what an auditor, knowledgeable of the industry, would expect. Therefore, the auditor should
have followed up on these unexpected account balances to determine if there was supporting
documentation to validate the balances. The statement of facts for the case indicates that for the
$7.3 million of fraudulent adjustments to capitalize the tires on the company's trucks and the fuel
in the tanks, a company executive sketched these adjustments on graph paper, without any
analysis or documentation to support them.
The problem states that one of the adjusting entries was recorded twice. The use of GAS or other
procedures should have identified this duplicate recording.
Further, the auditor should likely have selected capitalized items and reviewed documentation to
determine whether the capitalization was appropriate or whether the items (such as salary
expense) should have been expensed.
Students might also expect that audit work in the area of payroll expenses might have identified
an unexpected decrease in payroll expenses and that follow-up of this unexpected result might
have identified the inappropriate capitalization.
Application Activities
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The point of this exercise is to get students to access online financial reports, to see the
relationship to conceptual auditing topics involving impairments, and to read and interpret
financial statement disclosures. Further, discussing each student’s findings in a small group or
even as an entire class may prove beneficial in stimulating conversation about the nature of
impairment charges, their causes, their magnitudes, and implications for the external auditor in
terms of assessing reasonableness of the estimates made by management.
There are many recent examples that students might find including:
• Best Buy, for the fiscal year ended March 3, 2012

• Sears Holding Corporation, for the fiscal year ended January 28, 2012
• AT&T Inc., for the fiscal year ended December 31, 2011
For a less recent example, consider that Starbuck’s recorded a $224 million impairment charge in
2009, and that was following a $325 million impairment charge in 2008. These impairment
charges were associated with a significant slowdown in the Company’s expansion, with fewer
store openings attributed to reduced demand and a steep decline in discretionary consumer
spending related to the recession. Note 2 of Starbuck’s Annual Report provides a nice summary
of the Company’s restructuring plan.
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While the judgments that management made may vary across the selected companies, typical
judgments that management makes concern expected useful lives of long-lived assets,
undiscounted cash flows, and anticipated changes in economic conditions and operating
performance. Necessarily, these types of estimates are by definition uncertain. Thus, the job of
the auditor is to assess their reasonableness and to be professionally skeptical of the numbers
produced by management based upon these estimates.
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DRG Audits- Excerpts from PCAOB Order
DRG reported in the notes to its 2008 financial statements that it had incurred advertising
expenses during 2008 and that it had capitalized approximately $840,000 of those expenses as
"direct response advertising" pursuant to AICPA Statement of Position ("SOP") 93-7, Reporting
on Advertising Costs (December 29, 1993). DRG's capitalized direct response advertising
balance for 2008 represented an increase of over 350% from the prior year and constituted 21%
of DRG's total reported assets.
SOP 93-7 provides that a company may only capitalize advertising expenses as direct response
advertising if (1) the primary purpose of the advertising "is to elicit sales to customers who could
be shown to have responded specifically to the advertising;" and (2) the advertising "results in
probable future benefits." In addition, SOP 93-7 states that direct response advertising costs
reported as assets are to be "amortized on a cost-pool-by-cost-pool basis over the period during
which the future benefits are expected to be received.”
During the 2008 audit, JSW failed to exercise due professional care and failed to obtain
sufficient audit evidence to conclude that DRG was appropriately capitalizing, as opposed to
expensing, the costs it reported as direct response advertising. Specifically, JSW failed to obtain
audit evidence indicating that sales were to customers responding specifically to the advertising.
Nor did JSW obtain sufficient competent audit evidence indicating that the advertising would
result in probable future benefits to DRG. In addition, JSW failed to perform any procedures to
evaluate whether DRG was appropriately amortizing the amounts it capitalized as direct response
advertising. Indeed, JSW's work papers include a schedule, provided by DRG, indicating that the
company was not amortizing those amounts.
DDM Audits- Excerpts from PCAOB Order
As of year-end 2008, more than 75% of DDM's total reported assets were classified as intangible
assets and consisted mostly of website and platform development costs for an unlaunched
product. During the 2008 audit, JSW failed to ensure that the engagement team appropriately
tested DDM's intangible asset balance for impairment. The work papers reflect that
management's basis for not recognizing an impairment on its intangible assets in 2008 was a cash
flow projection. JSW, however, performed no procedures to assess the reasonableness of the
cash flow projection, including the relevance, sufficiency, and reliability of the data supporting
the projection and the assumptions management made in formulating the projection. In addition,
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the untested cash flow projection was inconsistent with JSW's conclusion that there was
substantial doubt as to DDM's ability to continue operating as a going concern.
Sanctions
Accordingly, it is hereby ORDERED that: A. Pursuant to Section 105(c)(4)(E) of the Act and
PCAOB Rule 5300(a)(5), Jewett, Schwartz, Wolfe & Associates, P.L. is hereby censured.
Pursuant to Section 105(c)(4)(A) of the Act and PCAOB Rule 5300(a)(1), the registration of
Jewett, Schwartz, Wolfe & Associates, P.L. is revoked.
After five (5) years from the date of this Order, Jewett, Schwartz, Wolfe & Associates, P.L. may
reapply for registration by filing an application pursuant to PCAOB Rule 2101.
Student discussion as to the severity and appropriateness of the sanctions can be quite lively.
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The following excerpts from the speech provide useful points of discussion including the
difficulty of measuring intangible assets, the potential for abuse, and the constraints imposed by
the accounting standards.
One of the biggest measurement dilemmas relates to intangible assets. We know that they are there. While the value of
Facebook’s tangible assets is relatively limited, its business concept is immensely valuable (although 25% less immense
than a month ago).
Likewise, the money-making potential of pharmaceutical patents is often quite substantial. However, both types of intangible
assets go unrecorded (or under-recorded) on the balance sheet. Under strict conditions, IAS 38 Intangible Assets allows for
limited capitalisation of Development expenditures, but we know the standard is rudimentary because it is based on
historical cost, which may not reflect the true value of the intangible asset.
The fact is that it is simply very difficult to identify or measure intangible assets. High market-to-book ratios may provide
indications of their existence and value. However, after the excesses of the dot.com bubble, there is understandable
reluctance to record them on the balance sheet.
Pragmatism also means we need to look very carefully at any possible undesirable use of our standards. Whenever we are
confronted with a high degree of uncertainty, we should act with great caution. I just gave the example of intangible assets.
We know they are there, but measurement is a big problem. If our standards were to provide too much room for recognition
of intangible assets, the potential for mistakes or abuse would be immense.
In such circumstances, it is better for our standards to require more qualitative reporting than pseudo-exact quantitative
reporting.
By the way, people always tell us we should not set our standards from an anti-abuse perspective. I think that is nonsense. If
we see ample scope for abuse in a standard, we had better do something about it. There are sufficient temptations and
incentives for creative accounting as it is.
These excerpts highlight the difficulty of auditing intangible assets—if the asset is difficult to
measure, it will be difficult to audit. Estimation and uncertainty make audits of intangibles
extremely challenging and highlight the importance of professional skepticism.
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Academic Research Cases
12-67
a. From late 2004 to mid-2006 more than 250 U.S. firms uncovered and corrected
accounting errors related to operating leases. The underlying issue was that the accounting
method used was in violation of generally accepted accounting principles (GAAP). Many of
these companies filed restated financial statements with the SEC, while many other companies
elected to use a less visible current-period catch-up adjustment. GAAP allows companies to
avoid formal restatements when the error is deemed immaterial by management and the
independent auditor. This setting is one where materiality considerations are likely to be the
dominant influence on whether the correct the error through a restatement or through a catch-up
adjustments. Accordingly, this setting allows for the authors to test the role of various materiality
related factors (quantitative and qualitative) in explaining which correction method a company
used. (The authors also consider whether the method previously used by other companies in the
same industry influences the materiality decisions, and hence the correction method used.)
Regulatory bodies provide general guidance on assessing materiality however, they are vague at
best. That leaves the question of materiality to the judgment of company management and the
auditor.
b. The results of the research indicate that the materiality judgment (and hence the judgment
regarding the correction method) is based on more than a purely quantitative approach (for
example, 5 percent of net income). Qualitative factors such as scaled magnitude of the error,
presence of other identified errors, and the importance of leasing activities to firm operations
play an important role in the determination of materiality. Firms’ materiality assessments are also
heavily associated with the prior actions of other firms.
c. In settings where a decision has to made as how to correct an error, there is likely a fair
amount of negotiation between the auditor and the client (preparer). Auditors and their clients
will find it useful to understand the determinants of this decision and whether their own
decisions seem reasonable given the evidence in this paper. It may be that auditors provide some
recommendations to clients on this issue; evidence in this paper could be used to support the
auditor’s recommendation and potentially help avoid placing the auditor in a legal liability
situation.
At least in the setting examined in the paper, it appears that materiality assessments are pretty
consistent across firms. However, the auditing standard setters might consider providing more
specific materiality guidelines for auditors to follow. This would reduce the amount of judgment
required on behalf of the auditor and management, and may be useful in other settings requiring
materiality assessments. The financial statements of companies would be more consistent and
provide more meaningful information to the investors who are comparing company financials
thereby increasing the value of audited financial statement.
d. The initial sample of companies to use for this research was gathered from the investment
newsletter “Analysts’ Accounting Observer” supplemented by companies found in wire service
press releases and SEC filings. The final sample consisted of 244 firms which included 150 firms
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that used restatements to correct lease accounting errors and 91 that used current-period
adjustments. To gain insights in to the factors that affected a company’s decision regarding its
lease correction method, the authors use a logistic regression model of the likelihood that
restatement is used to correct the discovered lease accounting errors. Explanatory variables in the
model included quantitative factors, qualitative factors, and contextual variables.
e. The archival research method used for this paper is subject to certain limitations. For
example, some disclosures regarding correction of the error were not specific as to the dollar
amount of the error and thus were not included in the analysis. Further, there may be variables
other than the ones examined that influenced companies’ corrections methods and if these
variables were included, the results might be different. Further, data limitations do not allow for
the authors to provide evidence on whether auditors differ in the determinants (and weights
placed on those determinants) of error correction decisions and materiality assessments.
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a. This paper addresses the issue of client negotiation in an asset write-down setting. Asset
write-downs can be highly judgmental audit areas, and the amounts reported in financial
statement for such highly judgmental audit areas are a product of auditor-client negotiation. This
paper specifically addresses how an auditor characteristic (negotiation experience) and a client
characteristic (negotiation style) can impact the outcomes of negotiation and thus impact the
amounts reported in the financial statements. The authors examine how these characteristics
influence auditors’ perceptions of negotiation outcomes at the beginning of negotiations. Namely,
the authors ask the participants to predict the ultimate outcome of a negotiation prior to engaging
in dialogue with the client. This study examines the impact of the aforementioned characteristics
on the level of this prediction
b. The authors find that auditor negotiation experience effects auditors’ predictions of the
ultimate outcome of negotiations, but only in situations where the client uses a contentious
negotiating style. Specifically, higher auditor negotiation experience leads auditors to predict a
higher ultimate write-down when a client uses a contentious negotiating style. However, when a
client uses a collaborative negotiating style, auditor negotiation experience does not affect
auditors’ predictions of the ultimate write-down. The authors note these results suggest that
auditor negotiation experience reaps benefits when it is needed most (i.e. when the client is
difficult to deal with). Similarly, the authors show that the effect of client negotiation style on
auditors’ perceived outcomes is contingent on auditor negotiation experience. Specifically, they
note that inexperienced auditors perceive a lower ultimate negotiated write-down when dealing
with a contentious client, rather than a collaborative client. However, experienced auditors
perceived negotiated write-downs are not affected by clients’ negotiation styles.
c. This paper shows that a client’s negotiation style can affect the amounts reported in the
financial statements. This finding indicates that auditors may benefit from considering clients’
negotiation styles in their decision-making. For example, auditors may benefit from considering
client negotiation style in resource management decisions. The authors note that audit firms
could benefit from assigning auditors with greater negotiation experience to negotiate with
clients who are known to be contentious during client-auditor negotiations. Further, the results
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suggest that audit firms could implement policies that encourage inexperienced auditors to seek
assistance in negotiating with contentious clients.
Additionally, auditors can consider client negotiation style in the client acceptance and the
evidence evaluation (completion) stages of the audit. With respect to client acceptance, audit
firms may increase efficiency and profitability by considering the risks and potential resource
demands on engagements for clients that are known to be contentious in negotiation. Further,
audit firms can enhance their risk management procedures through enhanced reviews of final
audited financial statements for clients with contentious financial statements. For example, firms
may consider enhanced concurring review for such clients.
d. The authors perform an experiment using 20 partners (12.1 years of experience) and 76
managers (7.2 years of experience) from a Big 4 CPA firm in China during a regular training
session. The authors randomly assigned each auditor to one of two groups: 1) contentious client
negotiating style and 2) collaborative negotiating style. The authors distributed materials
indicating the audit team identified an audit adjustment for an additional asset write-down of
$1.8 million, where the materiality level for the overall financial statements was $1.9 million.
Participants in the contentious group were told that the CFO had previously adopted a tough
stand, was typically reluctant to record audit adjustments, and had expressed reservations in
recording the current adjustment. Participants in the collaborative group were told that the CFO
had previously been reasonable, was generally open to discussions of audit adjustments, and had
expressed willingness to consider the current audit adjustment. The authors then asked the
participants in both groups the following question: “Suppose that you have had a few rounds of
discussions with the client’s manager. Indicate the amount of the proposed audit adjustment that
you believe will ultimately be recorded in the client’s audited financial statements.” As part of
the experiment, the authors measured auditor negotiation experience by asking each participant
to indicate the number of auditor-client interactions they had completed in the past three years to
resolve 1) a complex and material financial reporting issue and 2) a complex financial reporting
issue that approached materiality. The authors averaged the responses to these two questions to
calculate a measure of negotiating experience.
Using the data collected, the authors measured the effects of auditor negotiation
experience and client negotiation style on the perceived amount of the ultimate audit adjustment.
The authors find that when the client negotiating style is contentious, auditor negotiation
experience has a significant effect on the perceived amount. However, auditor negotiation
experience has no such effect when the negotiating style is collaborative. Similarly, the authors
find that when auditor negotiation experience is low, client negotiating style has a significant
effect on the perceived amount. However, client negotiating style has no such effect when
auditor negotiation experience is high.
e. The authors self-identify four limitations of this study:

• The authors use a self-reported measure of negotiation experience to measure auditor
expertise. Self-reported measures are susceptible to bias, and experience does not necessarily
constitute expertise.
• The audit adjustment used in the study was not quantitatively material. The results may have
been different if this adjustment was quantitatively material
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• This study does not consider several key considerations that can affect auditor-client
negotiations: concern over losing the client, auditors’ preferred write-downs and goals,
auditors’ strategies.
• The authors do not measure an actual outcome of an actual negotiation; rather, they only
measure auditors’ perceived outcome. This measure does not consider the iterative, rich, and
complex nature of negotiation.
Additional weaknesses to consider may include:

• This experiment was performed in China. Cultural differences could limit the generalizability
of these results.
• The authors do not appear to control for the position of the participants (i.e. manager vs.
partner)
• The authors do not explain why auditor negotiation experience might even matter in
negotiations with a collaborative client. For example, if a client is collaborative, then there
may be no reason to believe negotiation will matter. Without this tension, the contribution of
this research is limited.
• The results indicate that while an auditor’s negotiation experience and a client’s negotiating
style may effect auditor-client negotiations, the results do not indicate that auditors allow
material misstatements to go uncorrected. Thus, while the results are interesting, there is no
evidence that the characteristics examined in this study have a meaningful effect on the
outcomes of audits.
Ford and Toyota
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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.
1a.
Net property, Assets of discontinued /held for sale operations, depreciation, impairment charges.
1b.
The following are excerpted from Ford’s public filing.
Depreciation and Amortization

Property and equipment are stated at cost and depreciated primarily using the straight-line
method over the estimated useful life of the asset. Useful lives range from 3 years to 36 years.
The estimated useful lives generally are 14.5 years for machinery and equipment, and 30 years
for buildings and land improvements. Maintenance, repairs, and rearrangement costs are
expensed as incurred. Beginning January 1, 2006, we changed our method of amortization for
special tools from an activity-based method (units-of-production) to a time-based method. The
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time-based method amortizes the cost of special tools over their expected useful lives using a
straight-line method or, if the production volumes for major product programs associated with
the tools are expected to materially decline over the life of the tool, an accelerated method
reflecting the rate of decline. For 2006, this change in method decreased Automotive cost of sales
by $135 million.
Asset Impairments
Held-for-Sale and Discontinued Operations. We perform an impairment test on an asset group to
be discontinued, held for sale, or otherwise disposed of when management has committed to the
action and the action is expected to be completed within one year. We estimate fair value to
approximate the expected proceeds to be received, less transaction costs, and compare it to the
carrying value of the asset group. An impairment charge is recognized when the carrying value
exceeds the estimated fair value.
Held-and-Used Long-Lived Assets. We monitor the carrying value of long-lived asset groups
held and used for potential impairment when certain triggering events have occurred. These
events include current period losses combined with a history of losses or a projection of
continuing losses. When a triggering event occurs, a test for recoverability is performed,
comparing projected undiscounted future cash flows (utilizing current cash flow information and
expected growth rates) to the carrying value of the asset group. If the test for recoverability
identifies a possible impairment, the asset group's fair value is measured relying primarily on the
discounted cash flow methodology. Additionally, we consider various market multiples (e.g.,
revenue and earnings before interest, taxes, and depreciation and amortization ("EBITDA")) and
consult with external valuation experts. An impairment charge is recognized for the amount by
which the carrying value of the asset group exceeds its estimated fair value.
1c.
Students may determine a variety of ratios that are useful, and the process of having students
identify their own ratios should help them understand that auditors need to tailor standard
analytics to individual clients. Below we present several ratios that we developed:
2009 numbers 2009 numbers

used to used to calculate
Ford calculate ratio Toyota ratio
Land,
buildings,
machinery,
construction in
process/total (175,027-28,880)
assets: 0.27 52,927/194,850 0.49 /295,857
Accumulated
depreciation/tot
al assets: 0.18 35,404/194,850 0.34 99,677/295,857
Depreciation
& Amortization 0.04 4,094/105,893 0.08 15,221/195,192
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expense of auto
sector/total auto
sales
These ratios show that:
o Ford has fewer physical assets to total assets compared to Toyota.

o Ford has less depreciated assets to total assets compared to Toyota.
o Ford has lower depreciation expense to total product sales compared to Toyota.
It may be helpful to point out to students that in the actual audits of Ford and Toyota, the auditors
will have the above financial information by segment and geographic region, so disaggregating
the above ratios in those ways will be helpful in understanding where potential problems may lie
in reported numbers. Further, comparing ratios over a longer time horizon would be helpful in
understanding and predicting trends in relevant accounts. Finally, the auditors may want to
compare the client’s ratios to relevant industry averages.
2a.
Monetary value of impairment: $5.3 billion

Cause of the impairment and key assumptions/estimates: According to Footnote 15, the
reasons for the impairment and the key assumptions/estimates were as follows:
“During the second quarter of 2008, higher fuel prices and the weak economic climate in the
United States and Canada resulted in a more pronounced and accelerated shift in consumer
preferences away from full-size trucks and traditional sport utility vehicles ("SUVs") to smaller,
more fuel-efficient vehicles. This shift in consumer preferences combined with lower-than-
anticipated U.S. industry demand and greater-than-anticipated escalation of commodity costs
resulted in impairment charges related to Ford North America's long-lived assets and Ford
Credit's operating lease portfolio.” “Based upon the financial impact of rapidly-changing U.S.
market conditions during the second quarter of 2008, we projected a decline in net cash flows for
the Ford North America segment. As a result, in the second quarter of 2008 we tested the long-
lived assets for impairment and recorded in Automotive cost of sales a pretax charge of $5.3
billion, representing the amount by which the carrying value of the assets exceeded the estimated
fair value. See Note 4 for further discussion of the fair value used in the impairment.”
In general, key assumptions and estimates of this nature generally involve business projections
(particularly in terms of assumptions about the level of product acceptance in the marketplace),
the growth rate (the expected rate at which a business unit’s earnings stream is projected to grow
beyond the planning period), economic projections (assumptions regarding industry sales,
pricing estimates, industry volumes, inflation, interest rates, and prices of raw materials), and
discount rates (the rate at which expected future cash flows are brought to present value).
2b.
The audit firm is obligated to assess whether the key assumptions that management employs in
determining fair value and impairments are reasonable, despite their obvious subjectivity. The
12-29
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the extent to which they agree with management’s estimates, and any potential write down.
These estimates pose risk to the audit firm to the extent that, if the estimates are materially
incorrect, and the audit firm issues an unqualified opinion, then the audit firm has inappropriately
assured third party users of the appropriateness of the estimates when in fact they are not
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work, the causes contributing to this reduction in efficiency may be
grouped about the following main factors:
(1) The physical discomfort of the mask arising from causes such
as pressure on the head and face, due to improperly fitting
facepieces and harness, the noseclip, and the mouthpiece.
(2) Abnormal conditions of vision, due to poor optical qualities in
eye pieces and restrictions of vision, both as to total field and
binocular field.
(3) Abnormal conditions of respiration, among them being (a) the
unnatural channels of respiration caused by wearing the box
respirator, (b) increase in dead air space in respiratory circuit, and (c)
the increase in resistance to both inhalation and exhalation, the last
two mentioned being present to a greater or less degree in all types
of mask.
Of these general subdivisions the various phases of the first two
are so evident that no further discussion will be given. The effects of
the changed conditions of respiration are, however, less obvious,
and it may be of interest to present in a general way the results of
the research along this line, particularly as regards the harmful
effects of increasing the resistance and dead air space in the
respiratory tract above the normal.
The function of respiration is to supply oxygen to and remove
carbon dioxide from the blood as it passes through the lungs. This
interchange of gases takes place in the alveoli, a myriad of thin-
walled air sacs at the end of the respiratory tract where the air is
separated by a very thin membrane through which the gases readily
pass. The volume and rate, or in other words, the minute-volume, of
respiration is automatically controlled by the nerve centers in such a
way that a sufficient amount of air is supplied to the lungs to maintain
by means of this interchange a uniform percentage of its various
constituents as it leaves the lungs. It will be readily seen therefore,
that anything which causes a change in the composition of the air
presented to the blood in the alveoli will bring about abnormal
conditions of respiration.
Inasmuch as the gaseous interchange between the lungs and the
blood takes place only in the terminal air sacs it follows that, at the
end of each respiration, the rest of the respiratory tract is filled with
air low in oxygen and high in carbon dioxide, which on inspiration is
drawn back into the lungs, diluting the fresh air. The volume of these
passages holding air which must be re-breathed is known as the
anatomical dead air space.
Similarly, when a mask is worn the facepiece chamber and any
other parts of the air passage common to inspiration and expiration
become additional dead air space contributing a further dilution of
oxygen content and contamination by carbon dioxide of the inspired
air in addition to that occasioned by the anatomical dead space,
which of course, is always present and is taken care of by the
functions normally controlling respiration.
Major R. G. Pearce who directed a large amount of the research
along this line, sums up the harmful effects of thus increasing the
dead air space as follows:
1. Interpretation from the physiological standpoint:
(a) A larger minute-volume of air is required when breathing
through dead air space. This, interpreted on physiological grounds,
means that the carbon dioxide content of the arterial blood is higher
than normal. The level to which the content of carbon dioxide in the
arterial blood may rise is limited. Anything which wastefully increases
the carbon dioxide level of the blood decreases the reserve so
necessary to a soldier when he is asked to respond to the demand
for exercise which is a part of his daily life.
(b) A larger minute-volume of air must be pulled through the
canister, which offers resistance proportional to the volume of air
passing through it. If resistance is a factor of harm, dead air space
increases that harm, since dead air space increases the volume of
air passing through the canister.
(c) As will be noted below, the effect of resistance is a tendency
to decrease the minute-volume of air breathed. Dead air space
increases the minute-volume. Accordingly, if breathing is
accomplished against resistance and through a large volume of dead
air space, the volume of air breathed is reduced more in proportion
to the actual needs of the body than when breathing against
resistance without the additional factor of dead space; this, again,
causes the level of carbon dioxide in the blood and tissues to be
raised to a higher level than normal, and thus again there is some
reserve power wasted.
2. Interpretation from the standpoint of the canister.
The life of the canister depends on the volume of the gas-laden
air passed through it. The dead space increases the minute-volume
of air passed through the canister and, therefore, shortens its life.
Physiologically, the reason for the harmful effects of breathing
resistance is more involved:
“The importance of resistance to breathing lies
in: (1) the effect on the circulation of the blood, and
(2) the changes in the lung tissue, which seriously
interfere with the gas exchange between the outside
air and the blood. Data have been presented to
draw attention to the seriousness of resistance to
inspiration. In these reports, it was suggested that
the deleterious effects on the body consist in
changes in the blood pressure, increased work of
the right side of the heart, and an increase in the
blood and lymph content of the lungs. Resistance
also decreases the minute-volume of air breathed
and thereby increases the percentage of carbon
dioxide in the expired air. The foregoing changes
are all deleterious.
“Although the chief problem of resistance in gas
mask design concerns inspiration, nevertheless
resistance to expiration is an important factor. The
expired air of the lungs contains carbon dioxide for
which means of escape must be provided. The
expiratory act is more passive than the inspiratory
act, and resistance to expiration is, therefore, more
keenly felt than resistance to inspiration. It is then
imperative that the exhale valve be so arranged as
to allow for the escape of the entire amount of air
during the time of expiration with the least possible
resistance. The data of the laboratory indicate that
seldom, if ever, do expiratory rates rise above a
velocity of 150 to 175 per minute. The effect of
resistance to exhalation upon the vital organs of the
body is not dissimilar to that of inspiration.”
CHAPTER XIII
ABSORBENTS[27]
The absorbents used in both the British and American gas mask canister, which
afforded a degree of protection far superior to that of any other allied or enemy nation
except Germany, consisted of a mixture of charcoal and soda-lime, as described in the
preceding chapter. In general, a gas mask absorbent must have certain requirements.
These are: absorptive activity, absorptive capacity, versatility, mechanical strength,
chemical stability, low breathing resistance, ease of manufacture and availability of raw
materials.
Absorptive activity, or a very high rate of absorption, is one of the more important
properties of a satisfactory absorbent. A normal man when exercising violently
breathes about 60 liters of air per minute, and since inhalation occupies but slightly
more than half of the breathing cycle, the actual rate at which gas passes through the
canister during inhalation is about 100 liters per minute. Calculated on the basis of the
regular army canister, this corresponds to an average linear air velocity of about 80 cm.
per second. On the average, therefore, a given small portion of the air remains in
contact with the gas absorbent for only about 0.1 second. Besides this, the removal of
the toxic material must be surprisingly complete. Though the concentration entering the
canister may occasionally be as high as one half per cent, even the momentary
leakage of 0.001 per cent (ten parts per million) would cause serious discomfort and
the prolonged leakage of smaller amounts would have serious results in the case of
some gases. The activity of the present gas mask charcoal is shown by the fact that it
will reduce a concentration of 7000 parts per million of chloropicrin to less than 0.5 part
per million in less than 0.03 second.
Of equal importance is the absorptive capacity. That is, the absorbent must be able
to absorb and hold large amounts of gas per unit weight of absorbent. Its life must be
measured in days against ordinary concentrations of gas. It is further necessary that
the gas be held firmly and not in any loose combination which might give up minute
traces of gas when air is, for long periods of time, breathed in through a canister which
has previously been exposed to gas.
The absorbents used must be of a type which can be relied upon to give adequate
protection against practically any kind of toxic gas (versatility). The need of this is
apparent when the difficulty of having separate canisters for various gases is
considered, as well as the difficulty in rapidly and accurately identifying the gases and
the possible introduction of new and unknown gases. Fortunately, practically all of the
toxic gases are very reactive chemically or have relatively high boiling points and can
therefore be absorbed in large amounts by charcoal.
Absorbents must be mechanically strong in order to retain their structure and
porosity under conditions of transport and field use. Further, they must not be subject
to abrasion for the production of a relatively small amount of fines would tend to plug
the canister or to cause channels through which the gas would pass without being
absorbed.
Since the canister is filled several months before it is first used in the trenches, and
since the canister may be used over a period of months before it is discarded, it is
obviously the ultimate activity and capacity (not the initial efficiency) which determines
the value of an absorbent. It must therefore have a very considerable degree of
chemical stability. By this is meant that the absorbent itself is not subject to chemical
deterioration, that it does not react with carbon dioxide, that it does not disintegrate or
become deliquescent even after being used and that it has no corrosive action on the
metal container.
In a good general absorbent there must be a proper balance between its various
essential qualities, and hence the most suitable mixture will probably always be a
compromise.
Charcoal
The fact that charcoal would condense in its pores or adsorb certain gases, holding
them firmly, had been known for a long time.[28] In general, it was known that so-called
animal charcoal was the best for decolorizing sugar solutions, that wood charcoal was
the best for adsorbing gases and that coke had very little adsorbing or decolorizing
power. No one knew the reason for these facts and no one could write a specification
for charcoal. The ordinary charcoal used in the scientific laboratory was cocoanut
charcoal, since Hunter had discovered more than fifty years ago that this was the best
charcoal for adsorbing gases.
Raw Materials[29]
The first charcoal designed to offer protection against chlorine and phosgene was
made by carbonizing red cedar. Since this had little value against chloropicrin, attention
was turned to cocoanut shell as the source of raw material. This charcoal fulfilled the
above conditions for a satisfactory absorbent better than any other form tested. It must
not be supposed, however, that investigation of carbon stopped with these
experiments. In the search for the ideal carbon, practically almost every hard vegetable
substance known was tested. Next to cocoanut shells, the fruit pits, several common
varieties of nuts abundant in the United States, and several tropical nuts (especially
cohune nuts), were found to make the best carbon. Pecan nuts, and all woods ranging
in hardness from iron wood down to ordinary pine and fir, were found to be in the
second class of efficiency. Among other substances tested were almonds, Arabian
acorns, grape seeds, Brazil nut husks, balsa, osage orange, Chinese velvet bean,
synthetic carbons (from coal, lamp-black, etc.), cocoa bean shell, coffee grounds, flint
corn, corn cobs, cotton seed husks, peanut shells and oil shale. While many of these
substances might have been used in an emergency, none of them would produce
carbon as efficient, volume for volume, as that of the cocoanut shell and other hard
nuts.
Some idea of the scale of charcoal production may be seen from the requirement
for cocoanut shells. When we first began to build masks our demands for
carboniferous materials ranged from 40 to 50 tons a day of raw material; by the end of
the war, we were in need of a supply of 400 tons of cocoanut shells per day. This
demand would absorb the entire cocoanut production of tropical America five times
over. (The total production of cocoanuts in Central America, the West Indies and the
Caribbean Coast of South America amounted to 131,000,000 nuts annually, equal to a
supply of 75 tons of shells daily.) It was equal to one-tenth of the total production of the
Orient, which amounted to 7,450,200,000 nuts annually. This large demand always
made a reserve supply of charcoal material practically impossible. The “Eat More
Cocoanut” campaign started by the Gas Defense more than doubled the American
consumption of cocoanut in a brief space of time and in October, 1918, with the help of
importation of shell, we averaged about 150 tons of shells per day, exclusive of the
Orient.
The first heating of cocoanut shells to make charcoal reduces their weight 75 per
cent. It was evident, therefore, that we could more economically ship our oriental
supply in the form of charcoal produced on the other side of the Pacific Ocean. A
charcoal plant was established in the Philippine Islands and agents were sent to all
parts of the Oriental countries to purchase enormous supplies of shells. While the work
was only gaining momentum when the Armistice was signed, the plant actually shipped
300 tons of cocoanut shell carbon to the United States and had over 1000 tons on
hand November 11, 1918.
In the search for other tropical nuts, it was found that the cohune or corozo nut was
the best. These nuts are the fruit of the manaca palm tree. They grow in clusters, like
bananas or dates, one to four clusters to a tree, each cluster yielding from 60 to 75
pounds of nuts. They grow principally on the west coast of Central America in low,
swampy regions from Mexico to Panama but are also found along the Caribbean
coast. The chief virtue of the cohune nut from the charcoal point of view was its
extreme thickness of shell; this nut is 3 inches or more in length and nearly 2 inches in
diameter but the kernel is very small. Four thousand tons per month were being
imported at the time of the Armistice. A disadvantage in the use of cohune nuts was
that their husks contained a considerable amount of acid which rotted the jute bags
and also caused the heaps of nuts to heat in storage.
A third source of tropical material was in the ivory nuts used in considerable
quantities in this country by the makers of buttons. There is a waste of 400-500 tons
per month of this material, which was used after screening out the dust. This material
is rather expensive, because it is normally used in the manufacture of lactic acid.
Another great branch of activity in securing carbon supplies was concerned with the
apricot, peach and cherry pits and walnut shells of the Pacific Coast. A nation-wide
campaign on the part of the American Red Cross was started on September 13, 1918.
Between this time and the Armistice some 4,000 tons of material were collected. Thus
the slogan “Help us to give him the best gas mask” made its appeal to every person in
the United States.
A Theory of Charcoal Action

It has been pointed out that the first charcoal was made from red cedar. While this
was very satisfactory when tested against chlorine, it was of no value against
chloropicrin. In order to improve the charcoal still further it was desirable to have some
theory as to the way charcoal acted. It was generally agreed that fine pores were
essential. The functioning of charcoal depends upon its adsorptive power and this in
turn upon its porosity. The greater the ratio of its surface to its mass, that is, the more
highly developed and fine grained its porosity, the greater its value. Another factor,
however, seemed to play a rôle. As a pure hypothesis, at first, Chaney assumed that
an active charcoal could only be secured by removing the hydrocarbon which he
assumed to be present after carbonization. Being difficultly volatile, these
hydrocarbons prevent the adsorption of other gases or vapors on the active material.
To prove this, red cedar charcoal was heated in a bomb connected with a pump which
drew air through the bomb. Although the charcoal had been carbonized at 800°,
various gases and vapor began to come off at 300°, and when cooled, condensed to
crystalline plates.
This experiment not only proved the existence of components containing hydrogen
in the charcoal, but also showed that one way of removing the hydrocarbon film on the
active carbon was to treat with an oxidizing agent.
In the light of the later experimental work Chaney feels that there are two forms of
elementary carbon—“active” and “inactive”; the active form is characterized by a high
specific adsorptive capacity for gas while the inactive form lacks this property. In
general the temperature of formation of the active form is below 500-600° C. The form
is easily attacked by oxidizing agents—while the latter is relatively stable. The
combination of active carbon with an adsorbed layer or layers of hydrocarbon is known
as “primary” carbon. Anthracite and bituminous coal are native primary carbons, while
coke contains a considerable amount of inactive carbon, resulting from the
decomposition of hydrocarbon during its preparation.
Preparation of Active Charcoal

“On the basis of the above discussion, the preparation of active charcoal will
evidently involve two steps:
“First.—The formation of a porous, amorphous base carbon at a relatively low
temperature.
“Second.—The removal of the adsorbed hydrocarbons from the primary carbon,
and the increase of its porosity.
“The first step presents no very serious difficulties. It involves, in the case of woods
and similar materials, a process of destructive distillation at relatively low temperatures.
The deposition of inactive carbon, resulting from the cracking of hydrocarbons at high
temperatures, must be avoided. The material is therefore charged into the retorts in
thin layers, so that the contact of the hydrocarbon vapors with hot charcoal is avoided
as much as possible. Furthermore, most of the hydrocarbon is removed before
dangerous temperatures are reached. A slight suction is maintained to prevent outward
leaks, but no activation by oxidation is attempted, as this can be carried on under
better control and with less loss of material in a separate treatment.
Fig. 67. Dorsey Reactor

for Activating Cocoanut Charcoal with Steam.
“The second step, that is, the removal of the absorbed hydrocarbons from the
primary carbon, is a much more difficult matter. Prolonged heating, at sufficiently high
temperatures, is required to remove or break up the hydrocarbon residues. On the
other hand, volatilization and cracking of the hydrocarbons at high temperatures is
certain to produce an inactive form of carbon more or less like graphite in its visible
characteristics, which is not only inert and non-adsorbent, but is also highly resistant to
oxidation. The general method of procedure which has yielded the best results, is to
remove the adsorbed hydrocarbons by various processes of combined oxidation and
distillation, whereby the hydrocarbons of high boiling points are broken down into more
volatile substances and removed at lower temperatures, or under conditions less likely
to result in subsequent deposition of inactive carbon. Thin layers of charcoal and rapid
gas currents are used so that contact between the volatilized hydrocarbons and the hot
active charcoal may be as brief as possible. In this way cracking of the hydrocarbons
at high temperature, with consequent deposition of inactive carbon, is largely avoided.
“While the removal of the hydrocarbons by oxidation and distillation is the main
object of the activation process, another important action goes on at the same time,
namely, the oxidation of the primary carbon itself. This oxidation is doubtless
advantageous, up to a certain point, for it probably at first enlarges, at the expense of
the walls of solid carbon, cavities already present in the charcoal, thus increasing the
total surface exposed. Moreover, the outer ends of the capillary pores and fissures
must be somewhat enlarged by this action and a readier access thus provided to the
inner portions of the charcoal. However, as soon as the eating away of the carbon wall
begins to unite cavities, it decreases, rather than increases, the surface of the
charcoal, and a consequent drop in volume activity, that is in the service time, of the
charcoal, is found to result.
“It is obvious, therefore, that conditions of activation must be so chosen and
regulated as to oxidize the hydrocarbons rapidly and the primary carbon slowly. Such a
differential oxidation is not easy to secure since the hydrocarbons involved have a very
low hydrogen content, and are not much more easily oxidized than the primary carbon
itself. Furthermore, most of the hydrocarbons to be removed are shut up in the interior
of the granule. On the one hand, a high enough temperature must be maintained to
oxidize the hydrocarbons with reasonable speed; on the other hand, too high a
temperature must not be employed, else the primary carbon will be unduly consumed.
The permissible range is a relatively narrow one, only about 50 to 75°. The location of
the optimum activating temperature depends upon the oxidizing agent employed and
upon other variables as well; for air, it has been found to lie somewhere between 350
and 450°, and for steam between 800 and 1000°.
“The air activation process has the advantage of operating at a conveniently low
temperature. It has the disadvantage, that local heating and an excessive consumption
of primary carbon occur, so that a drop in volume activity results from that cause before
the hydrocarbons have been completely eliminated. As a consequence, charcoal of the
highest activity cannot be obtained by the air activation process.”
The steam activation process has the disadvantage that it operates at so high a
temperature that the regulation of temperature becomes difficult and other technical
difficulties are introduced. It has the advantage that local heating is eliminated. The
hydrocarbons can, therefore, be largely removed without a disproportionate
consumption of primary carbon. This permits the production of a very active charcoal.
It has the further advantage that it worked well with all kinds of charcoal. Inferior
material, when treated with steam, gave charcoal nearly as good as the best steam-
treated cocoanut charcoal. Because of the shortage of cocoanut, this was a very
important consideration.
Fig. 68.—Section of Raw Cocoanut Shell.
Magnified 146½ diameters.
The air, steam and also carbon dioxide-steam activation processes have all been
employed on a large scale by the Chemical Warfare Service for the manufacture of gas
mask carbon.
Fig. 69.—Section of Carbonized Cocoanut Charcoal.
Magnified 146½ Diameters.
Fig. 70.—Two-Minute Charcoal not Activated.

Magnified 732 Diameters.
“The above considerations are illustrated fairly well by the

photo-micrographs shown in Figs. 68 to 71. Fig. 68 shows a
section of the original untreated cocoanut shell crosswise to the
long axis of the shell. In it can be seen the closely packed, thick-
walled so-called ‘stone-cells’ characteristic of all hard and dense
nut shells. Fig. 69 is a photograph of a similar section through the
same cocoanut shell after it has been carbonized. As these
photographs are all taken with vertical illumination against a dark
background, the cavities, or voids, and depressions all appear
black, while the charcoal itself appears white. It is clear from this
photograph that much of the original grosser structure of the shell
persists in the carbonized products. Figs. 70 and 71 are more
highly magnified photographs of a carbonized charcoal before
and after activation, respectively. As before, all the dark areas
represent voids of little or no importance in the adsorptive activity
of the charcoal, while the white areas represent the charcoal
itself. In Fig. 70 (unactivated) the charcoal itself between the voids
it seen to be relatively compact, while in Fig. 71 (activated) it is
decidedly granular. This granular structure, just visible at this high
magnification (1000 diameters), probably represents the grosser
porous structure on which the adsorption really depends. These
photographs, therefore, show how the porosity is increased by
activation.”
Fig. 71.—31-Minute Steam Activated Charcoal.

Magnified 732 Diameters.
The great demand for charcoal, and the need for activating other than cocoanut
charcoal led to the development of the Dressler tunnel kiln, which seemed to offer
many advantages over the Dorsey type of treater.
Fig. 72.—Sectional View of Dressler Tunnel Kiln,

Adapted to Activation of Charcoal.
“The Dressler tunnel kiln is a type used in general ceramic

work. The furnace consists essentially of a brick kiln about 190 ft.
long, 12 ft. broad, and 9 ft. high, lined with fire brick. Charcoal is
loaded in shallow, refractory trays in small tram cars, about 120
trays to the car. The cars enter the kiln through a double door and
the charcoal remains in the hot zone at a temperature of about
850° C. for about 4 hrs., depending upon the nature of the
material charged. Water is atomized into this kiln, and a positive
pressure maintained in order to exclude entrance of air. The kiln is
gas-fired and the charcoal is activated by the steam in the
presence of the combustion gases.
“Under such treatment the charcoal is given a high degree of
activation without the usual accompanying high losses. Seemingly
the oxidizing medium used, together with the operating
conditions, produce a deep penetration of the charcoal particles
without increasing the extensive surface combustion experienced
in the steam activators. The capacity of such a type furnace is
limited only by the size of the installation.
“The advantages of this type furnace may be tabulated as follows:
1—High quality of product.

2—Small weight and volume losses.
3—Large capacity per unit.
4—Minimum initial cost and maintenance of installation.
5—Simplicity and cheapness of operation.
6—Adaptability to activation of all carbon materials.
7—Availability of furnaces of this general type already constructed.”
Substitutes for Nut Charcoal

The first experiments were made with a special anthracite coal (non-laminated and
having conchoidal fracture). This had a life of 560 minutes as against 360 minutes for
air treated cocoanut charcoal and 800-900 minutes for steam-treated charcoal.
When the Gas Defense Service tried to activate anthracite on a large scale in
vertical gas retorts at Derby, Connecticut, the attempt was a failure. They carbonized at
900° and then turned on the steam with the result that the steam-treated coal had a
slightly greater density than the untreated, which was wrong, and had a shiny
appearance in parts with roughened deposits in other parts. When the hydrocarbons
are decomposed at high temperatures, the resulting carbon is somewhat graphitic, is
itself inactive, is not readily oxidized, and impairs or prevents the activation of the
normal carbon upon which it is deposited. This discovery made it possible to treat
anthracite successfully. The conditions must be such as to minimize high temperature
cracking, to carry off or oxidize the hydrocarbons as fast as formed, and especially to
prevent the gases from cooler portions of the treater coming in contact with carbon at a
much higher temperature. With these facts in mind, a plant was built at Springfield
which produced 10 tons a day of 150-300 minute charcoal from raw anthracite. This
was one-third of the total production at that time and was mixed with the nut charcoal
made at Astoria, thereby preventing an absolute shortage of canister-filling material in
October, 1918.
It was next shown that the cocoanut charcoal fines resulting from grinding and
screening losses and amounting to 50 per cent of the product, could be very finely
ground, mixed with a binder, and baked like ordinary carbon products. By avoiding gas-
treating in the bake, the resulting charcoal is nearly as good as that from the original
shell. A recovery plant for treating the cocoanut fines was built at Astoria. The product
was called “Coalite.”
The great advantage of cocoanut shell as a source of charcoal is that it is very
dense and consequently it is possible to convert it into a mass having a large number
of fine pores, whereas a less dense wood, like cedar, will necessarily give more larger
pores, which are of relatively little value. The cocoanut charcoal is also pretty resistant
to oxidation which seems to make selective oxidation a more simple matter. By
briquetting different woods, it is possible to make charcoal from them which is nearly
equal to that from cocoanut shell.
By heating lamp-black with sulfur and briquetting, it was possible to make a
charcoal having approximately the same service time as cocoanut charcoal. A charcoal
was made by emulsifying carbon black with soft pitch, which gave the equivalent of
400 minutes against chloropicrin before it had been steam-treated. This looked so
good that the plans were drawn for making a thousand pounds or more of this product
at Washington to give it a thorough test. This was not done on account of the cessation
of all research work. The possible advantage of this product was the more uniform
distribution of binder.
Instead of steam-treating anthracite coal direct, it was also pulverized, mixed with a
binder, and baked into rods which were then ground and activated with steam. The
resulting material, which was known as Carbonite, had somewhat less activity than the
lamp-black mixes but was very much cheaper. A plant was built to bake 40 tons a day
of this material, which would yield 10 tons a day of active carbon after allowing for
grinding losses and steam treatment. The plant was guaranteed to furnish an
absorbent having a life of 600 minutes against chloropicrin.
German Charcoal
After the Armistice was signed, Chaney took up the question of how the Germans
made their charcoal. The German charcoal was made from coniferous wood and was
reported to be as good as ours, in spite of the fact that they were using inferior
materials. Inside of a month Chaney had found out how the German charcoal was
made, had duplicated their material, and had shown that it was nothing like as good as
our charcoal. The Germans impregnated the wood with zinc chloride, carbonized at red
heat, and washed out most of the zinc chloride. When this zinc chloride was found in
the German charcoal, it was assumed that it had been added after the charcoal had
been made. It was therefore dissolved out with hydrochloric acid, thereby improving
the charcoal against chloropicrin. The German charcoal was then tested as it stood,
including the fines, against American charcoal, 8 to 14 mesh. The most serious error,
however, was in testing only against a high concentration of chloropicrin. The German
charcoal contains relatively coarse pores which condense gases at high concentrations
very well but which do not absorb gases strongly at low concentrations. The result was
that the German charcoal was rated as being four or five times as good as it really
was.
German Charcoal. ×200.
Fig. 73.—Charcoal from Spruce Wood.
Comparison of Charcoal
The following table shows a comparison of charcoals from different sources. The
method of activation was identical and the times of treatment were those approximately
giving the highest service time. The results against chloropicrin, therefore, represent
roughly the relative excellence of the charcoal obtainable from various raw materials,
using this method of activation:
Comparison of Various Active Charcoals Activated in

Laboratory
Steam Accelerated
Apparent
Treatment Chloropicrin
Density
at 900° Test Results
Base
Weight
Material Weight Service
Primary Activated Time Loss
Absorbed Time
Carbon Carbon Min. Per
Per Cent Min.
Cent
Sycamore 0.158 0.080 18 53 41 7.3
Cedar 0.223 0.097 60 88 78 16.0
Mountain 0.420 0.236
mahogany 60 44 32 16.3
Ironwood 0.465 0.331 60 44 31 20.8

Brazil nut 0.520 0.316 120 71 46 32.2
Ivory nut 0.700 0.460 120 70 48 47.0
Cohune nut 0.659 0.502 120 48 51 53.4
Babassu 0.540 0.322
210 68 85 58.7
nut
Cocoanut 0.710 0.445 120 60 61 58.4
Cocoanut 0.710 0.417 180 75 72 64.4
Briquetted Materials
Sawdust 0.542 0.365 120 66 53 40.0
Carbon 0.769 0.444
240 64.3 53 50.5
black
Bituminous 0.789 0.430
165 61 58.3 46.8
coal
Anthracite 0.830 0.371
480 81 53 40.7
coal
“In conclusion, it will be of interest to compare the charcoals
manufactured and used by the principal belligerent nations, both
with one another and with the above mentioned laboratory
preparations. Data on these charcoals are given in the following
table:
Comparison of Typical Production Charcoals

of the Principal Belligerent Nations
Service
Time
Country Apparent Corr.
Date Raw Material Remarks
Density to 8-
14
Mesh
Nov. Cocoanut Air
U. S. A. 0.60 10
1917 activated
June, Mixed nuts, Steam
U. S. A. 0.58 18
1918 etc. activated
Nov. Cocoanut Steam
U. S. A. 0.51 34
1918 activated
Wood Long
England 1917 0.27 6
distillation
England Aug. Peach 0.54 16
1918 stones,
etc.
France 1917-18 Wood 0.23 2
Wood Chemical
and
Germany Early ? 3
steam
treatment
Wood Chemical
June, and
Germany 0.25 33
1917 steam
treatment
Service
Time
Country Apparent Corr.
Date Raw Material Remarks
Density to 8-
14
Mesh
Wood Chemical
June, and
Germany 0.24 42
1918 steam
treatment
“It is at once evident that the service time of most of these
charcoals is very much less than was obtained with the laboratory
samples. However, in the emergency production of this material
on a large scale, quantity and speed were far more important than
the absolute excellence of the product. It will be noted, for
instance, that the cocoanut charcoal manufactured by the United
States, even in November, 1918, was still very much inferior to
the laboratory samples made from the same raw material. This
was not because a very active charcoal could not be produced on
a large scale, for even in May, 1918, the possibility of
manufacturing a 50-min. charcoal on a large scale had been
conclusively demonstrated, but this activation would have
required two or three times as much raw material and five times
as much apparatus as was then available, due to the much longer
time of heating, and the greater losses of carbon occasioned
thereby.
“It should furthermore be pointed out that the increase in the
chloropicrin service time of charcoal from 18 to 50 min. does not
represent anything like a proportionate increase in its value under
field service conditions. This is partly due to the fact that the
increased absorption on the high concentration tests is in reality
due to condensation in the capillaries, which, as has been pointed
out, is not of much real value. More important than this, however,
is the fact that most of the important gases used in warfare are
not held by adsorption only, but by combined adsorption and
chemical reaction, for which purpose an 18-min. charcoal is, in
general, almost as good as a 50-min. charcoal.”
Typical Absorptive Values of Different Charcoals

Against Various Gases

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Auditing A Risk-Based Approach to

Conducting a Quality Audit 9th Edition

The five management assertions relevant to long-lived assets are as follows:

• Normally, management is not interested in identifying and writing down assets.

• Incomplete recording of asset disposals

a. Management’s motivation to overstate fixed assets is similar to other circumstances in

• Increase reported earnings

Potential fraud schemes related to long-lived assets include:

• Sales of assets are not recorded and proceeds are misappropriated.

Specific examples of controls include:

• Management authorizations are required for intangible asset transactions.

Analytical procedures that would be helpful in performing preliminary analytical procedures

• Current depreciation expense as a percentage of the previous year's depreciation expense,

Control Procedure Purpose of Control Impact on Substantive Audit

6. Self-construction of Provide reasonable Perform a detailed review of all

Test of controls over tangible long-lived assets could include:

CONTROL POSSIBLE TESTS OF CONTROLS

Compute the average balance: ($380,500 + $438,900) / 2 = $409,700

General substantive procedures for leases include:

a. Items 1 through 6 would have been found in the following way:

6. The auditor would become aware of a new plant in several ways:

• Volume would increase.

b. The appropriate adjusting journal entries are as follows:

To correct initial recording of lease.

Dr. Equipment rent expense $ 3,750

Dr. (Accounts originally credited) $1,500

Dr. Depreciation expense $ 290

Depreciation on beginning balance.

Depreciation recorded on addition

Correct depreciation for addition:

Depreciation = $16,000/12 ½ / 2 = $640

Dr. Land improvements $5,000

Cost of asset $48,000

The correcting entry is:

Dr. Allowance for depreciation--

6. Donated property should be capitalized at its fair market value.

Dr. Land $10,000

Dr. Depreciation expense $800

a. Try again to convince management that the auditor’s estimates are

Step 5. Determine the likely consequences of each proposed course of action.

4. The auditor can gather various types of evidence:

Contemporary and Historical Cases

c. An explanation of “Capitalization of line capacity per CFO, amounts were originally

Significant differences should be recorded as misstatements and projected to the statements as a

• Best Buy, for the fiscal year ended March 3, 2012

DRG Audits- Excerpts from PCAOB Order

DDM Audits- Excerpts from PCAOB Order

e. The authors self-identify four limitations of this study:

Additional weaknesses to consider may include:

Ford and Toyota

The following are excerpted from Ford’s public filing.

Depreciation and Amortization

2009 numbers 2009 numbers

These ratios show that:

o Ford has fewer physical assets to total assets compared to Toyota.

Monetary value of impairment: $5.3 billion

A Theory of Charcoal Action

Preparation of Active Charcoal

Fig. 67. Dorsey Reactor

Fig. 70.—Two-Minute Charcoal not Activated.

“The above considerations are illustrated fairly well by the

Fig. 71.—31-Minute Steam Activated Charcoal.

Fig. 72.—Sectional View of Dressler Tunnel Kiln,