Chapter 4 Pre-Builts

Audit standards distinguish auditors' responsibility for planning procedures for detecting noncompliance with laws and regulations having a direct effect on financial statements versus planning procedures for detecting noncompliance with laws and regulations that do not have a direct effect on financial statements. b. For each of the following instances of noncompliance, explain why they are either direct-effect (D) or indirect-effect (I) noncompliance: 1. A manufacturer inflates expenses on its corporate tax return. 2. A retailer pays men more than women for performing the same job. 3. A coal mining company fails to place proper ventilation in its mines. 4. A military contractor inflates the overhead applied to a combat vehicle. 5. An insurance company fails to maintain required reserves for losses. 6. An exporter pays a bribe to a foreign government official so that government will buy its products. 7. A company backdates its executive stock options to lower the exercise price. 8. A company fails to fund its pension plan in accordance with ERISA.

1. Direct-effect 2. Indirect-effect 3. Indirect-effect 4. Direct-effect 5. Direct-effect 6. Indirect-effect 7. Direct-effect 8. Direct-effect

1. Unintentional omissions of amounts or disclosures is considered a(n) ________. 2.In _______, the financial statements are intentionally misleading. 3. ______ is another term for misappropriation of assets. 4. Mistakes in data processing can easily result in _______. 5. Financial statements can be misstated due to errors, ______, or noncompliance with laws or regulations.

1. error 2. fraud 3. Defalcation 4. errors 5. fraud

The following situations represent errors and frauds that could occur in financial statements. Required: State how the ratio in question would compare (higher, equal, or lower) to what the ratio should have been had the error or fraud not occurred. a. The company recorded fictitious sales with credits to sales revenue accounts and debits to accounts receivable. Inventory was reduced, and cost of goods sold was increased for the profitable "sales." Is the current ratio higher than, equal to, or lower than what it should have been? b. The company recorded cash disbursements by paying trade accounts payable but held the checks past the year-end date, meaning that the "disbursements" should not have been shown as credits to cash and debits to accounts payable. Is the current ratio higher than, equal to, or lower than what it should have been? Consider cases in which the current ratio before the improper "disbursement" recording was (1) higher than 1:1, (2) equal to 1:1, and (3) lower than 1:1. c. The company uses a periodic inventory system for determining the balance-sheet amount of inventory at year-end. Very near the year-end, merchandise was received, placed in the stockroom, and counted, but the purchase transaction was neither recorded nor paid until the next month. What was the effect of this on inventory, cost of goods sold, gross profit, and net income? How were these ratios affected compared to what they would have been without the error: current ratio [remember three possible cases from part (b)], gross margin ratio, cost of goods sold ratio, inventory turnover, and receivables turnover? d. The company is loath to write off customer accounts receivable even though the financial vice president makes entirely adequate provision for uncollectible amounts in the allowance for bad debts. The gross receivables and the allowance both contain amounts that should have been written off long ago. How are these ratios affected compared to what they would have been if the old receivables had been properly written off: current ratio, days' sales in receivables, doubtful account ratio, receivables turnover, return on beginning equity, and working capital/total assets? e. Since last year, the company has reorganized its lines of business and placed more emphasis on its traditional products while selling off some marginal businesses merged by the previous management. Total assets are 10 percent less than they were last year, but working capital has increased. Retained earnings remained the same because the disposals created no gains, and the net income after taxes is still near zero, which is the same as last year. Earnings before interest and taxes (EBIT) remained the same, a small positive EBIT. The total market value of the company's equity has not increased, but that is better than the declines of the past several years. Proceeds from the disposals have been used to retire long-term debt. Net sales have decreased 5 percent because the sales' decrease resulting from the disposals has not been overcome by increased sales of the traditional products. Is the discriminant Z-score of the current year higher or lower than the one of the prior year? (See Appendix 4A for the Z-score formula.)

a. Higher b. In this case, the relative rate of change is important because both the numerator and denominator of the current ratio are changed by the same amount. 1. Current ratio (before) was higher than 1:1—the incorrect accounting makes the ratio larger than it should be. 2. Current ratio (before) was equal to 1:1—the incorrect accounting does not change the ratio. 3. Current ratio (before) was less than 1:1—the incorrect accounting makes the ratio smaller than it should be. c. Effect of unrecorded purchase counted in physical inventory, assuming the accounts are adjusted to include the inventory on hand. Inventory is not misstated. Cost of goods sold is understated. Gross profit is overstated. Net income is overstated. The effect on the ratios compared to what they would have been without the error: Higher than 1:1 - before The error of recording the inventory but not the current payable makes the ratio larger. Equal to 1:1 before The error makes the ratio higher. Less than 1:1 before The error makes the ratio higher. Gross margin ratio The error makes it higher. Cost of goods sold ratio The error makes it lower. Inventory turnover The error understates purchases and cost of goods sold, which is the numerator in inventory turnover. Therefore, the ratio is understated. Receivables turnover The error does not affect either the sales numerator or thereceivables denominator, so the ratio is not affected. d. Current ratio Not affected because the current asset and current liabilitytotals are not affected. Day's sales in receivables Not affected when the net receivables is used to calculate the ratio. Doubtful account ratio The improper accounting causes the ratio to be larger than it should be.(Proper accounting would cause the allowance numerator to be reduced to agreater extent, and by a faster rate than the receivables denominator.) Receivables turnover Not affected when the net receivables is used to calculate the ratio. Return on beginning equity Not affected because the income is measured properly withadequate allowance for doubtful accounts. Working capital/Total assets Not affected because both terms are measured properly. e. Working capital (WC) /Total assets (TA) - The ratio is higher because WC is higher and TA is smaller. Retained earnings / Total assets - The ratio is larger because retained earnings remained the same while TA is smaller. Earnings BIT / Total assets - The ratio is larger, because EBIT is about the same as last year, and TA is smaller. Market equity / Total debt - The ratio is higher because market equity is the same while total debt is lower. Net sales / Total assets - The ratio is higher because net sales have decreased less (5%)than the total assets have decreased (10%).

Johnson & Company, CPAs, audited Guaranteed Savings & Loan Company. M. Johnson had the assignment of evaluating the collectability of real estate loans. Johnson was working on two particular loans: (1) a $4 million loan secured by Smith Street Apartments and (2) a $5.5 million construction loan on Baker Street Apartments now being built. The appraisals performed by Guaranteed Appraisal Partners Inc. showed values in excess of the loan amounts. On inquiry, Bumpus, the S&L vice president for loan acquisition, stated, "I know the Smith Street loan is good because I myself own 40 percent of the partnership that owns the property and is obligated on the loan."Johnson then wrote in the audit documentation: (1) the Smith Street loan appears collectible as Bumpus personally attested to knowledge of the collectability as a major owner in the partnership obligated on the loan; (2) the Baker Street loan is assumed to be collectible because it is new and construction is still in progress; and (3) the appraised values all exceed the loan amounts. a. Do you perceive any problems with related-party involvement in the evidence used by Johnson? b. Do you perceive any problems with Johnson's reasoning or the appropriateness of evidence used in that reasoning?

A. Yes, there are problems. Verbal assurance of collectability from Bumpus, the S&L officer with an investment in the Smith Street property, is the weakest type of information. Bumpus is a related party and information from him ought to be regarded as biased. Another problem lies in the appraisal company. With the name of Guaranteed Appraisal Partners, Inc., the appraisers may be related, even owned by, the client, Guaranteed Savings & Loan Company. The audit team's general knowledge of financial institution difficulties in real estate lending and the widespread problems with appraisers should alert them to the possible relation of the appraisers to the client. Further investigation should be carried out to identify the appraisers. B. Yes, there are problems. In addition to the dubious related-party sources of information just mentioned, Johnson's "assumption" about the collectability of the Baker Street loan is unwarranted. Auditors are not entitled to "assume" collectability on any grounds with supporting evidence. The fact that a loan is new or construction is still in progress is no reason to "assume" collectability.

If sales were overstated by recording a false credit sale at the end of the year, where could you find the false "dangling debit"?

Accounts Receivable.

Analytical procedures used when planning an audit should concentrate on:

Accounts and relationships that can represent specific potential problems and risks in the financial statements.

Errors versus Fraud Read the overview below and complete the activities that follow. Misstatements can be of two types. The first--an error--is deemed to be unintentional. The second type--fraud--is deemed to be an intentional act. CONCEPT REVIEW:Auditors have the responsibility to plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. Misstatements are classified as either unintentional (error) or intentional (fraud).

Errors 1. Mistake in gathering data 2. Unreasonable estimates from misinterpretation of facts Frauds 1. Misappropriation of assets 2. Fraudulent financial reporting

The risk of material misstatement is composed of which audit risk components?

Inherent risk and control risk.

Weyman Z. Wannamaker is the chief financial officer of Cogburn Company. He prides himself on being able to manage the company's cash resources to minimize the interest expense. Consequently, on the second business day of each month, Weyman pays down or draws cash on Cogburn's revolving line of credit at First National Bank in accordance with his cash requirements forecast.You are the auditor. You find the information on this line of credit in the following table.You inquired at First National Bank and learned that Cogburn Company's loan agreement specifies payment on the first day of each month for the interest due on the previous month's outstanding balance at the rate of "prime plus 1.5 percent." The bank gave you a report that showed the prime rate of interest was 8.5 percent for the first six months of the year and 8.0 percent for the last six months. a. Determine an audit estimate of the amount of interest expense you expect to find as the balance of the interest expense account related to these notes payable.

Notes Payable Balances Auditors' Interest Calculation Date Balance Rate Time Interest Jan 1 $150,000 10.0% 1 month $1,250.00 Feb 1 $200,000 10.0% 1 month $1,666.00 Apr 1 $225,000 10.0% 1 month $1,875.00 May 1 $285,000 10.0% 1 month $2,375.00 Jun 1 $375,000 10.0% 1 month $3,125.00 Jul 1. $375,000 9.5% 1 month $2,968.75 Aug 1 $430,000 9.5% 1 month $3,404.17 Sep 1 $290,000 9.5% 1 month $2,295.83 Oct 1 $210,000 9.5% 1 month $1,662.50 Nov 1 $172,000 9.5% 1 month $1,361.67 Dec 1 $95,000 9.5% 1 month. $752.08 $250,583 9.75% 12 months $24,403.33 Weighted Average $24,432

Which of the following is a specific audit procedure that would be completed in response to a particular fraud risk in an account balance or class of transactions?

Performing procedures such as inventory observation and cash counts on a surprise or unannounced basis.

The likelihood that material misstatements may have entered the accounting system and not been detected and corrected by the client's internal control is referred to as:

Risk of material misstatement.