ADV FIN ACCN TEST 3

Consolidation entry T

Eliminates the cumulative Translation adjustment included in the Investment account under the *equity method*, and eliminates the cumulative translation adjustment carried on the parent's book - Dr. Cumulative translation adjustment --- Cr. Investment

Consolidation of a foreign subsidiary

Step 1: Translate foreign sub's trial balance from foreign currency into U.S. dollars and calculate the translation adjustments or remeasurement gains or losses. Step 2: On the parent's book, if the parent uses the Equity method and the current rate method is used in step 1, the translation adjustment is included in the Investment account to update the foreign currency investment to its U.S. dollar equivalent - Dr. Investment -- Cr. Cumulative translation adjustment Step 3: Make consolidation worksheet - Consolidation entry E2 - Consolidation entry T

Allocation of income

The allocation of income is not necessarily based on the relative capital balances. It is a separately negotiated item.

Alternative techniques

The assignment process is merely a series of mechanical steps reflecting the change in each partner's capital balance resulting from the provisions of the partnership agreement. The number of different allocation procedures that could be employed is limited solely by the partners' imagination. Although interest, compensation allowances, and various ratios are the predominant factors encountered in practice, numerous other possibilities exist.

In obtaining an understanding of an entity's internal control, an auditor is required to obtain knowledge about the: - the design of controls - operating effectiveness of controls

- the design of controls: YES - operating effectiveness of controls: NO In obtaining an understanding of an entity's internal control, an auditor is required to obtain knowledge about the design of controls and whether they have been implemented. The auditor is not required to obtain knowledge about the "operating effectiveness of controls" as part of obtaining an understanding of internal control.

How to calculate performance materiality

1) calculate overall materiality 2) calculate perf. mat. based on overall materiality

See Bradford example from class

Altman and Bradford

Anti-dilutive securities and warrants: - Effect on Diluted EPS calculation

Anti-dilutive securities Excluded from the diluted EPS calculations Warrants Assume that the proceeds of conversion are used to buy treasury stock at the stock's fair value

Limited partnerships (LPs)

At least one general partner Personally liable for the obligations of the partnership Has management responsibility One or more limited partners Are liable only to the extent of their capital contribution Do not have any management authority

According to the U.S. Supreme Court, information is material if:

there is a substantial likelihood that the information would be viewed by a reasonable investor as having significantly altered the total mix of available information.

Which statement is true regarding the three fraud risk factors (incentives/pressures, opportunity, and rationalization/attitude)? A. The auditor should determine whether and to what extent fraud risk factors are present as part of the final overall review stage of the audit. B. The fraud risk factors should be discussed by engagement personnel during planning. C. The existence of all three fraud risk factors indicates that fraud has occurred. D. Lack of observation of all three fraud risk factors indicates that fraud has not occurred.

B. The fraud risk factors should be discussed by engagement personnel during *planning*

An auditor is required to document the auditor's understanding of the: I. Entity's control activities that help ensure management directives are carried out. II. Entity's control environment factors that help the auditor plan the engagement.

Both 1 and 2 The auditor should document key elements of the understanding of the entity and its environment, including each of the five components of internal control. The five components include the entity's control activities and the entity's control environment.

Which of the following most accurately describes the process of a walkthrough? A. Testing and documenting the results of tests of selected controls. B. Inspection of selected documents, records, and internal control documentation. C. Observation of an entity's activities and operations. D. Following a transaction from its origination until it is reflected in the financial statements.

D. Following a transaction from its origination until it is reflected in the financial statements. The primary objective of a walkthrough is to help the auditor obtain evidence about the *design and implementation of internal control* rather than obtaining evidence about whether the controls are operating effectively.

Things to pay attention to in preparing consolidated statement of cash flows - in year of acquisition - in all years

In the year of acquisition - The net cash outflow to acquire the subsidiary (cash paid less subsidiary cash acquired) is reported as cash flow from investing activities - The change in the balance sheet accounts should NOT include the subsidiary's balances before acquisition In all years - For the indirect calculation of cash flow from operating activities, the starting point is consolidated net income, which includes both the controlling and non-controlling interests - Dividends paid to the outside owners (includes the owners for the parent, as well as non-controlling interest for the sub) are cash outflows

See example from class 23

SWISSCO

In a business combination, how to calculate parent and sub's basic EPS?

Subsidiary Basic EPS = (sub's net income - *amortization* - sub's preferred stock dividends) / weighted-average number of common stocks outstanding Parent (or consolidated) Basic EPS = (*net income attributable to the parent* - parent's preferred stock dividends) / weighted-average number of common stocks outstanding

Tests of details

Substantive tests that concentrate on the details of items contained in the account balance and disclosure.

When obtaining an understanding of an entity's internal controls, an auditor should concentrate on the *substance of the controls rather than their form* because:

Management may establish appropriate procedures but NOT enforce compliance with them "Substance over form" concerns relate to controls that appear on the surface to exist but in reality are not operating effectively. When obtaining an understanding of a client's internal controls, an auditor should concentrate on the substance of controls rather than the form because even when appropriate procedures are established, management may not enforce compliance.

Alternative way to calculate remeasurement loss

Net monetary assets + Net non-monetary assets = Shareholders' equity Δ net monetary assets = Δ shareholders' equity - Δ net non-monetary assets Δ net monetary assets = (Δ common stock + Δ APIC + NI - Dividends) - Δ net non-monetary assets Two sides of this equation equal under the foreign currency When translating it into USD We apply the last year's current rate to the beginning net monetary assets We apply the current year's current rate to the ending net monetary assets We apply historical rate to non-monetary assets, common stock, APIC and dividends NI is calculated using a composite rate Thus the two sides of the equation won't equal under USD To make it equal, we plug in Remeasurement gain/loss Remeasurement loss can alternatively be calculated as:

The purpose of applying analytical procedures in planning the audit is to:

The purpose of applying analytical procedures in planning the audit is to assist in planning the nature, timing, and extent of auditing procedures that will be used to obtain audit evidence for specific account balances or classes of transactions. To accomplish this, the analytical procedures used in planning the audit should focus on: (a) enhancing the auditor's understanding of the client's business and the transactions and events that have occurred since the last audit date (b) identifying areas that may represent specific risks relevant to the audit

Review: Consolidated cash flow statement

Consolidated balance sheet + Consolidated income statement = Consolidated cash flow statement Begin with consolidated net income Calculate the change in balance sheet items In the year of acquisition, exclude the sub's balance before acquisition Cash paid out to acquire the sub (cash paid less sub's cash acquired) is investing cash outflows Dividends paid to the outside owners are financing cash outflows

Summary - some general rules

Consolidated net income attributable to the parent company owners along with the number of outstanding parent shares provides the basis for calculating parent basic EPS. -- Use the parent's separate NI, that does not include its income from investment in the sub. If potentially dilutive items exist on the sub's individual statements, then the portion of the sub's net income included in consolidated net income may not be appropriate for the computation of parent diluted EPS. In this situation, we: -- Compute the sub's diluted EPS. -- The earnings used in the computation are used in the determination of parent (or consolidated) EPS.

Subchapter S corporation (S Corp)

Created as a corporation; owners do not face unlimited liability No double taxation To qualify: Can have only one class of stock, and ownership is limited to 100 stockholders Owners limited to individuals, estates, and certain tax-exempt entities and trusts (no corporate owners allowed) Problem: Growth potential is limited because of the restriction on the number and type of owners

Limited liability partnerships (LLPs)

Has most of the characteristics of a general partnership, except that it significantly reduces partners' liabilities Owners are usually responsible for contractual debts of the business Owners are liable only for their own acts and omissions, and those of individuals they directly supervise, but not for acts of professional negligence or malpractice committed by other partners No double taxation

Limited liability companies (LLCs)

LLC's are a new type of organization for U.S., and are classified as partnerships for tax purposes Owners do not face unlimited liability Taxes "flow-through" to the partners, but the entire income of the business is subject to self-employment tax at the individual partner level In contrast to S Corps, the number and type of owners are not usually restricted

Temporal method Overview

Monetary balance sheet items are remeasured at current rate. Non-monetary balance sheet items are remeasured at historical rates. On the cash flow statement, operating CF is taken from the remeasured income statement. The remeasurement loss is added back to NI. Increases in A/R and A/P are remeasured at the average rate. The increase in inventory is determined by the remeasurement of COGS.

Allocation of income

Partnership revenues and expenses must be closed out at the end of each fiscal period and the net income allocated to each partners' capital account. Articles of partnership should stipulate an established procedure for assignment of income. If no arrangement is specified, state partnership laws dictate that all partners receive an equal allocation of income or loss. Journal entry - Dr. Income summary --- Cr. Xxx, capital --- Cr. Yyy, capital

Consolidation entry E2

The excess of fair value over book value, denominated in foreign currency, must be translated into the parent's reporting currency Under the current rate method, the excess FV is translated at the current exchange rate with a resulting translation adjustment relative to the excess The cumulative translation adjustment related to excess is recorded in consolidation entry E2 - Dr. Assets/liabilities --- Cr. Cumulative Translation Adjustment

What is functional currency?

The primary currency of the foreign entity's operating environment

5 components of internal control

"CRIME" 1. Control Environment 2. Risk Assessment 3. Control Activities 4. Information and Communication 5. Monitoring

How to prepare the consolidated statement of cash flows?

Consolidated balance sheet + Consolidated income statement = Consolidated cash flow statement No need to adjust for intra-entity transactions The intra-entity cash flows are already eliminated from the balance sheet and income statement

Review

Current Rate Method (used when Foreign Reporting Currency is the functional currency) All non-equity accounts are exposed to the Current Rate Gains / Losses go to OCI, and eventually realized as CTA (plug) on the B/S. Translated R/E insulated from exchange rate movements. Income statement items - weighted avg. rate Temporal Method (used when the US Dollar is the functional currency) Only monetary accounts (and revalued non-monetary accounts) are exposed to the Current Rate Gains / Losses go to I/S. R/E is the Plug. Income statement items - non B/S - weighted avg. rate // B/S - historical rate

Which of the following factors is most relevant when an auditor considers the client's organizational structure in the context of control risk? A. Management's attitude toward information processing and accounting departments. B. The organization's recruiting and hiring practices. C. Physical proximity of the accounting function to upper management. D. The suitability of the client's lines of reporting.

D. The suitability of the client's lines of reporting. Choice "D" is correct. The suitability of the client's lines of reporting is an important part of the organizational structure, which in turn is a key component of the control environment. Since the control environment has a pervasive effect on the auditor's risk assessment, consideration of the suitability of the client's lines of reporting is quite relevant in evaluating control risk. Choice "A" is incorrect. Management's attitude toward the information processing and accounting departments may have some impact on the auditor's assessment of control risk (especially if management tends to override controls), but it is not particularly relevant with respect to consideration of the client's organizational structure. Choice "B" is incorrect. The organization's recruiting and hiring practices are not particularly relevant with respect to consideration of the client's organizational structure. Choice "C" is incorrect. The physical proximity of the accounting function to upper management is not particularly relevant with respect to consideration of the client's organizational structure, especially since electronic communications are commonly used.

How do we calculate remeasurement COGS?

First, calculate purchases in local currency based on change in inventory Beginning inventory + purchase - COGS = Ending inventory COGS = Beginning inventory + purchase - ending inventory Use the corresponding foreign exchange rates to remeasure inventory and purchases to reporting currency

IFRS and translations

IFRS and US GAAP are consistent on most points. Significant differences between IFRS and U.S. GAAP relate to: The hierarchy of factors used to determine the functional currency and The method used to translate the foreign currency statements of a subsidiary located in a hyperinflationary country.

Alternative method to calculate Translation Adjustment (change in CTA - current method)

Net assets = common stock + APIC + R/E Δ net assets = Δ common stock + Δ APIC + Δ R/E Δ net assets = Δ common stock + Δ APIC + NI - Dividends Two sides of this equation equal under the foreign currency When translating it into USD We apply the last year's current rate to the beginning net asset We apply the current year's current rate to the ending net asset We apply historical rate to common stock, APIC and dividends (NI is calculated using a composite rate) Thus the two sides of the equation won't equal under USD To make it equal, we plug in TA The translation adjustment can be derived as the amount needed to bring the balance sheet back into balance, or (see pic)

Review Consolidation of a foreign subsidiary

Step 1: translate the foreign sub's trail balance from foreign currency to USD Current rate method Temporal method Step 2: on the parent's book If the parent uses the equity method & current rate method is used in step 1: - Dr. Investment --- Cr. Cumulative translation adjustment Step 3: on consolidation worksheet Under the temporal method: consolidate the same way as before Under the current rate method: consolidation entry E2 -- If the parent uses the equity method: consolidation entry T

Translation adjustment vs. remeasurement gains/losses

Translation adjustment Δ net assets = Δ common stock + Δ APIC + NI - Dividends Remeasurement gain/loss Δ net monetary assets = (Δ common stock + Δ APIC + NI - Dividends) - Δ net non-monetary assets

Review

Two methods to translate the foreign sub's financial statements from its local currency to the parent's reporting currency Current rate method (used when the functional currency is the foreign sub's local currency) All assets and liabilities are translated using the current rates Equity accounts (except retained earnings) are translated using the historical rates Income statement items are usually translated at the average rates Gains/losses from translation go to OCI, and eventually realized as CTA (plug) on the B/S Temporal method (used when the functional currency is the parent's reporting currency, or in other words USD) Only monetary accounts are remeasured using the current rate Non-monetary accounts and equity accounts (except retained earnings) are remeasured using the historical rates Income statement items are usually remeasured using the average rates, except non-monetary items are remeasured using the historical rates Gains/losses from remeasurement go to I/S and realized as remeasurement gains/losses (plug)

How do we calculate remeasurement gain/loss?

Two stages: First, calculate the balance sheet items, so that the only account missing is R/E R/E is the plug to balance the balance sheet Second, Ending R/E = Beg. R/E - Div + NI NI = Ending R/E - Beg. R/E + Div Remeasure all the items on the income statement --- Calculate COGS Remeasurement gain/loss is the difference between NI and the rest of its components

More about step 2 - Consolidation of a foreign subsidiary: If the parent uses the equity method

Under the temporal method Remeasurement gain/loss is already included in the sub's NI, so there is no need to do anything else The regular journal entry when sub reports NI: - Dr. Investment (@sub's NI*%ownership) --- Cr. Equity in sub earnings Under the current rate method Translation Adjustment increases the sub's equity, but is not included in NI -- Reminder from Ch. 1 that when sub reports OCI, we: ---- Dr. Investment (@sub's OCI*%ownership) ------- Cr. OCI Now, CTA is part of the OCI, thus: - Dr. Investment (@CTA*%ownership) --- Cr. CTA

Analytical procedures

evaluations of financial information made by a study of plausible relationships among data, and they include comparisons between current year and prior year financial information.

distinguishing factor between fraud and error

intent

Tracy, senior accountant at JFM CPA Firm, is determining the performance materiality for her client in Year 2. Tracy expects that there will be a high likelihood of uncorrected and undetected misstatements. JFM CPA Firm's materiality guidelines advise the auditor to set performance materiality in the range of 50 percent to 70 percent of overall materiality based on the likelihood of misstatement. Tracy has calculated overall materiality at $140,000. Tracy will most likely set performance materiality closest to:

$70k (use lower % b/c high chance of misstatement) $140,000 (overall materiality) × 0.5 (lower range provided in audit firm guidance) = $70,000. Tracy believes that there is a high likelihood of uncorrected and undetected misstatements. Therefore, Tracy most likely will use a percentage closer to the lower end of the range provided in firm guidance. Generally, if there is a *high likelihood of misstatements then the auditor sets materiality at a lower amount*, which *results in the auditor looking closer* at audit evidence Generally, the lower range of materiality is used when there is a high likelihood of uncorrected and undetected misstatements, and a higher percentage will be used when there is a low likelihood of uncorrected and undetected misstatements.

Diluted EPS

(net income - preferred stock dividends + effect of conversion) / (weighted-average number of common stocks outstanding + effect of conversion) Complex capital structure (has dilutive securities, or securities that can be converted to common stock) Example: if the firm has convertible debt paying out interest of $6,000 per year, convertible into 1,000 shares. Tax rate is 40%. Numerator: + $6,000*(1-40%) = $3,600 (avoidable interest) Denominator: + 1,000

Basic EPS

(net income - preferred stock dividends) / weighted-average number of common stocks outstanding For a simple capital structure

Which of the following controls is least likely to be relevant to a financial statement audit? A. Procedures that prevent the excess use of materials in production. B. Policies that relate to compliance with income tax regulations. C. Use of computer passwords to limit access to data files. D. Generation of production statistics used to evaluate variances.

A. Procedures that prevent the excess use of materials in production. Choice "A" is correct. Procedures to reduce inefficiency on the production line relate to operational objectives, and not necessarily to financial reporting objectives. Choices "B", "C", and "D" are incorrect. Compliance with income tax regulations, use of passwords to limit data access, and generation of reports to facilitate variance analysis are all important controls related to financial reporting.

More about step 3 - Consolidation of a foreign subsidiary: Under the current rate method

Assets and liabilities are translated using the current rate, which is affected by the change in exchange rate Some consolidate entries are affected by changes in exchange rate S: eliminate the sub's equity accounts at the beginning of the period - Use the numbers from the sub's USD financial statements A: the difference between FV and BV - Use the historical rates I: the parent's income from sub earnings is in USD D: the sub's dividends are translated at the historic rates - Use the number from the sub's USD statement of RE E: the sub's depreciation expense and accumulated depreciation - Need consolidation entry E2 to revalue the excess of FV over BV for the change in exchange rate If the parent uses the equity method - Also need consolidation entry T to eliminate the Translation Adjustment recorded in the parent's Investment account

Current rate method

Assumes that a foreign operation represents a foreign currency net asset B/S 1. All assets and liabilities are translated at the current rate 2. Equity (except retained earnings) is translate at historical rate I/S 1. All income statement items are translated at the average rate Statement of cash flows 1. Operating cash flows depend on the income statement 2. Investing and financing cash flows are translated at historical rate Currency translation adjustments are recognized in Other Comprehensive Income

Effect of an alteration in the specific individuals composing a partnership

Automatically leads to legal dissolution

Which of the following represents an inherent limitation of internal controls? A. Bank reconciliations are not performed on a timely basis. B. The CEO can request a check with no purchase order. C. Customer credit checks are not performed. D. Shipping documents are not matched to sales invoices.

B) An inherent limitation of internal control exists when, although good controls are instituted, management can override those controls. When the CEO requests a check with no purchase order, this is an example of management override. Failure to institute proper controls, such as not requiring customer credit checks, is not an inherent limitation of internal control.

Which of the following statements is not correct about materiality? A. The concept of materiality recognizes that some matters are important for fair presentation of financial statements in conformity with GAAP, while other matters are not important. B. An auditor considers materiality for the financial statements as a whole in terms of the largest aggregate level of misstatements that could be material to any one of the financial statements. C. Materiality judgments are made in light of surrounding circumstances and necessarily involve both quantitative and qualitative judgments. D. An auditor's consideration of materiality is influenced by the auditor's perception of the needs of a reasonable person who will rely on the financial statements.

B. An auditor considers materiality for the financial statements as a whole in terms of the largest aggregate level of misstatements that could be material to any one of the financial statements. Materiality levels include an overall level for each statement; however, because the statements are interrelated, and for reasons of efficiency, the auditor ordinarily considers materiality for planning purposes in terms of the smallest aggregate level of misstatements that could be considered material to any one of the financial statements.

Analytical procedures used in planning an audit should focus on: A. Reducing the scope of tests of controls and substantive tests. B. Providing assurance that potential material misstatements will be identified. C. Enhancing the auditor's understanding of the client's business. D. Assessing the adequacy of the available audit evidence.

C. Enhancing the auditor's understanding of the client's business (and the transactions and events that have occurred since the last audit date)

Of the following nonfinancial information, what would an auditor most likely consider in performing analytical procedures during the planning phase of an audit? A. Turnover of personnel in the accounting department. B. Objectivity of audit committee members. C. Square footage of selling space. D. Management's plans to repurchase stock.

C. Square footage of selling space. When performing analytical procedures, the auditor considers relevant nonfinancial information, which generally is related to financial data in some way. For example, a relationship might exist between the square footage of selling space and the level of sales. Choice "A" is incorrect. The auditor would consider the turnover of accounting personnel when assessing control risk and the risk of fraud, not when performing analytical procedures during planning. Choice "B" is incorrect. The auditor would consider the integrity of members of the audit committee when deciding whether to accept the engagement and when assessing control risk and the risk of fraud, not when performing analytical procedures during planning. Choice "D" is incorrect. The auditor would consider management's plans to repurchase stock when assessing control risk and when considering appropriate disclosure, not when performing analytical procedures during planning.

In planning an audit, the auditor's knowledge about the design of relevant internal controls should be used to: A. Identify the types of potential misstatements that could occur. B. Assess the operational efficiency of internal control. C. Determine whether controls have been circumvented by collusion. D. Document the assessed level of control risk.

Choice "A" is correct. Knowledge about the design and implementation of relevant internal controls should be used to identify types of misstatements that could occur. Choice "B" is incorrect. The operating efficiency of a control is not significant to the auditor; the auditor is concerned with operating effectiveness. Also, the auditor is not required to assess operating effectiveness during the planning stage of the audit. Choice "C" is incorrect. Determining whether a control has been circumvented by collusion is not a normal part of the audit planning process. Choice "D" is incorrect. *Assessment of control risk* (and documentation of that assessment) must be *based on tests of controls*, and not solely on knowledge about the design of controls.

Which of the following procedures would an auditor most likely perform in planning a financial statement audit? A. Inquiring of the client's legal counsel concerning pending litigation. B. Comparing the financial statements to anticipated results. C. Examining computer generated exception reports to verify the effectiveness of internal controls. D. Searching for unauthorized transactions that may aid in detecting unrecorded liabilities.

Choice "B" is correct. A requirement during planning is to perform analytical procedures, which involve comparisons of recorded amounts to expectations. Choice "A" is incorrect. Inquiry of the client's legal counsel is typically performed near the end of fieldwork. Choice "C" is incorrect. Tests of controls are performed after audit planning is complete. Choice "D" is incorrect. The search for unrecorded liabilities is generally performed at or after yearend.

Which of the following procedures most likely would provide an auditor with evidence about whether an entity's internal control activities are suitably designed to prevent or detect material misstatements? A. Reperforming the activities for a sample of transactions. B. Performing analytical procedures using data aggregated at a high level. C. Vouching a sample of transactions directly related to the activities. D. Observing the entity's personnel applying the activities.

Choice "D" is correct. *Observation and inspection may be used to evaluate the design of controls.* Observation of entity personnel applying control activities is a procedure that would likely provide evidence about the design of the activities. Choice "A" is incorrect. *Reperforming* control activities provides the auditor with evidence about the *operating effectiveness of specific control activities, but not the design effectiveness*. Choice "B" is incorrect. Analytical procedures would not provide the auditor with evidence about the design of specific control activities. Choice "C" is incorrect. Vouching a sample of transactions directly related to control activities would not provide the auditor with evidence about the design of specific control activities.

Journal entries for cash and noncash contributions

If partners invest only cash amounts - Dr. Cash --- Cr. Xxx, capital --- Cr. Yyy, capital If partners invest noncash assets (e.g., inventory, land, equipment) - Dr. Assets (@ fair value) --- Cr. Xxx, capital --- Cr. Yyy, capital

Highly Inflationary Economies

In highly inflationary economies, the Temporal method is required (A country's cumulative 3 year inflation exceeds 100%)

Should proper accounting depend on the forms of business

Accounting procedures are normally standardized for assets, liabilities, revenues, and expenses regardless of the legal form of a business *Partnership accounting mainly differs in the way it handles the partners' capital accounts*. Specifically: The equity section of a partnership consists of capital balances for each partner -- Profits/losses for each period are allocated to each partner's capital account -- Withdrawals by partners reduce their capital accounts The articles of partnership, rather than either laws or official rules, provide much of the underlying basis for partnership accounting

Partnership has both advantages and disadvantages

Advantages Ease of formation and dissolution Flexibility to make virtually any arrangements defining the partners' relationships to each other -- Profits, losses and management operating decisions, shared independently of ownership percentages Taxes "flow-through" to the partners - no double taxation Disadvantages Unlimited liability and mutual agency Any partner can be held personally liable for all debts of the business Any partner has right to incur liabilities in the name of the partnership Inability to participate in various corporate tax benefits

Current rate method - Assets and Liabs; revs and exps

All assets and liabilities are translated at the current rate All revenues and expenses are translated at the exchange rate in effect at the date of accounting recognition. The weighted average exchange rate is used when revenues and expenses have been recognized evenly throughout the year. However, when an income account, such as a gain or loss, occurs at a specific point in time, the exchange rate as of that date is applied. Depreciation and amortization expenses also are translated at the average rate for the year. These expenses accrue evenly throughout the year even though the journal entry could be delayed until year-end for convenience.

Which of the following statements is correct regarding internal control? A. A welldesigned internal control environment ensures the achievement of an entity's control objectives. B. An inherent limitation to internal control is the fact that controls can be circumvented by management override. C. A welldesigned and operated internal control environment should detect collusion perpetrated by two people. D. Internal control is a necessary business function and should be designed and operated to detect all errors and fraud

Choice "B" is correct. *Since management generally has the authority to implement and assign responsibilities under the internal controls, they will generally also have the ability to circumvent those internal controls.* This is an inherent limitation of internal control. *Human error is another inherent limitation of internal control* Choice "A" is incorrect. Although the design of an internal control system is important, it needs to be paired with the proper implementation and monitoring, and even then cannot ensure that the entity's internal control objectives will be met. Choice "C" is incorrect. Internal control structures generally rely in some manner on segregation of duties. Because of this, collusion by two or more people can generally destroy this segregation of duties and thus potentially cause circumvention of the internal controls that may not be immediately detected. Choice "D" is incorrect. No internal control system can guarantee the detection of all errors and fraud. The purpose of an internal control system is to significantly reduce the likelihood that errors or fraud will be committed and go undetected.

Which of the following factors is most likely to affect the extent of the documentation of the auditor's understanding of a client's system of internal controls? A. The industry and the business and regulatory environments in which the client operates. B. The degree to which information technology is used in the accounting function. C. The relationship between management, the board of directors, and external stakeholders. D. The degree to which the auditor intends to use internal audit personnel to perform substantive tests.

Choice "B" is correct. *The more complex the IT system, the more extensive the documentation (such as flowcharts, narratives, questionnaires, decision tables, etc.)*. The less complex the IT system, more limited documentation, such as a memorandum, may be sufficient. Choice "A" is incorrect. The industry and the business and regulatory environments in which the client operates are separate from a clients system of internal controls. Choice "C" is incorrect. The relationship between management, the board of directors, and external stakeholders would be part of the auditor's general understanding of the entity and its environment and would not affect the extent of internal control documentation. Choice "D" is incorrect. The degree to which the auditor intends to use internal audit personnel to perform substantive tests does not impact the documentation of the auditor's understanding of a client's system of internal controls.

According to PCAOB standards, when would a company be LEAST likely to reevaluate established materiality levels or tolerable misstatements? A. There is a substantial likelihood that misstatements of amounts less than the materiality level established for the financial statements as a whole would influence the judgment of a reasonable investor. B. The client has stated that it will not be able to respond to the auditor's request for evidence within the prescribed timeframe. C. Materiality levels and tolerable misstatement were originally based on estimated or preliminary financial statement amounts that differ significantly from actual amounts. D. Changes that occurred after the materiality levels were originally set are likely to affect investor's perceptions about the company's financial statements

Choice "B" is correct. The client's request for an extension to submit documentation generally would not have an impact on established materiality levels or tolerable misstatements. Choice "A" is incorrect. If there is a belief that misstatements of an amount below the current materiality level would influence the judgment of a reasonable investor, then by definition, materiality is not at its correct level. Materiality is defined in part by the level at which information begins to influence the judgment of a reasonable person. Choice "C" is incorrect. If materiality levels were based on preliminary or estimated data, they should be revised when the actual amounts are known. Choice "D" is incorrect. If changes have occurred that will likely affect the investor's perception about the financial information, the materiality level should be revised accordingly.

Which of the following types of control best describes procedures to ensure appropriate systems software acquisition? A. Application. B. Physical. C. General. D. Monitoring.

Choice "C" is correct. *General controls are policies and procedures that relate to many applications and support the effective functioning and proper operation of the information system.* General controls include procedures to ensure appropriate systems software acquisition. Choice "A" is incorrect. *Application controls apply to the processing of individual transactions* and help to ensure that transactions occurred, are authorized, and are completely and accurately processed and reported. Choice "B" is incorrect. *Physical controls relate to safeguarding assets*, such as using security devices to limit access to programs and restricted areas. Choice "D" is incorrect. *Monitoring controls help assess the quality of internal control*

If an auditor is obtaining an understanding of an issuer's information and communication component of internal control, which of the following factors should the auditor assess? A. The integrity and ethical values of top management. B. The philosophy and operating style of management to promote effective internal control over financial reporting. C. The classes of transactions in the issuer's operations that are significant to the issuer's financial statements. D. The oversight responsibility over financial reporting and internal control by the board or audit committee.

Choice "C" is correct. The classes of transactions in the issuer's operations that are significant to the issuer's financial statements are typically assessed when the auditor is obtaining an understanding of the information and communication component of internal control. Choice "A" is incorrect. The integrity and ethical values of top management are typically assessed when the auditor is obtaining an understanding of the control environment component of internal control. Choice "B" is incorrect. The philosophy and operating style of management to promote effective internal control over financial reporting are typically assessed when the auditor is obtaining an understanding of the control environment component of internal control. Choice "D" is incorrect. The oversight responsibility over financial reporting and internal control by the board or audit committee is typically assessed when the auditor is obtaining an understanding of the control environment component of internal control.

Which of the following statements is correct concerning materiality in a financial statement audit? A. Analytical procedures performed during an audit's review stage usually decrease materiality levels. B. If the materiality amount used in evaluating audit findings increases from the amount used in planning, the auditor should apply additional substantive tests. C. The auditor's materiality judgments generally involve quantitative, but not qualitative, considerations. D. Materiality levels are generally considered in terms of the smallest aggregate level of misstatement that could be considered material to any one of the financial statements.

Choice "D" is correct. Because the financial statements are interrelated, materiality levels are generally considered in terms of the smallest level of misstatement that could be material to any one of the financial statements. Choice "A" is incorrect. Analytical procedures are performed during an audit's review stage to evaluate the overall financial statement presentation and to assess the conclusions reached. They generally would not result in a change in materiality levels. Choice "B" is incorrect. If the materiality amount used in evaluating audit findings increases from the amount used in planning, the auditor should consider whether the audit plan needs to be modified. Typically, an increase in materiality levels would result in a decrease in audit risk, which would result in less substantive testing, not more. Choice "C" is incorrect. Qualitative considerations may lead to situations in which misstatements that do not exceed materiality limits are still likely to influence the economic decisions of users. In such cases, an otherwise immaterial misstatement is deemed to be material.

Which of the following statements is correct concerning an auditor's responsibility to report fraud? A. The auditor is required to communicate to those charged with governance all minor fraudulent acts perpetrated by lowlevel employees, even if the amounts involved are inconsequential. B. The disclosure of material management fraud to principal stockholders is required when both senior management and the board of directors fail to acknowledge the fraudulent activities. C. Fraudulent activities involving senior management of which the auditor becomes aware should be reported directly to the SEC. D. The disclosure of fraudulent activities to parties other than the client's senior management and those charged with governance is not ordinarily part of the auditor's responsibility.

Choice "D" is correct. The disclosure of fraudulent activities to parties other than the client's senior management and those charged with governance is not ordinarily part of the auditor's responsibility. Choice "A" is incorrect. Only fraud that causes a material misstatement of the financial statements or fraud involving senior management should be reported to those charged with governance. Choice "B" is incorrect. The disclosure of fraudulent activities to parties other than the client's senior management and those charged with governance is not ordinarily part of the auditor's responsibility. Although there are certain exceptions to this rule, disclosure to stockholders is not one of them. Choice "C" is incorrect. Fraudulent activities involving senior management of which the auditor becomes aware should be reported directly to those charged with governance, not to the SEC. (Only in certain limited circumstances would fraud be disclosed to the SEC via required regulatory reports.)

If new information becomes available that could require a reevaluation of the quantitative level of materiality applied during an audit of an issuer, then the auditor should: A. Not change the materiality level once it has been established. B. Lower the materiality level, but not raise it. C. Raise the materiality level, but not lower it. D. Raise or lower the materiality level as appropriate to the situation.

D. Raise or lower the materiality level as appropriate to the situation.

Indirect method - CF from operating activities

Indirect method - cash flow from operating activities Starts with accrual basis net income and makes adjustments to derive cash flows from operating activities Three kinds of adjustments *1) Items that affect net income but have no cash effect* -- Depreciation -- Amortization *2) Items that affect net income and cash but not from an operating activity* -- Gain or loss on sale of property and equipment *3) Operating items for which the income effect differs from the cash flow effect (look at change in current assets and current liabilities)* -- Increases in current assets or decreases in current liabilities: negative adjustment to net income -- Decreases in current assets or increases in current liabilities: positive adjustment to net income

Net exposure, temporal vs current rate method

Temporal method Net exposure = cash + marketable securities + receivables - liabilities Current rate method Net exposure = total assets - total liabilities

What if partners withdraw assets from the business?

Often, the articles of partnership allow withdrawals on a regular periodic basis To record withdrawal of cash by partners - Dr. Xxx, drawing - Dr. Yyy, drawing --- Cr. Cash To close out drawing accounts into the individual partner's capital accounts at year-end - Dr. Xxx, capital - Dr. Yyy, capital --- Cr. Xxx, drawing --- Cr. Yyy, drawing

See examples from class 22

PINTO and Salida Company - consolidated CF Em Co and Bat - consolidated EPS

contributions that have liabilities attached

Reduce the increase in the capital account balance by the amount of the liability

Currency translation adjustments: temporal method vs. current rate method

Temporal method Remeasurement gains or losses in Net Income. First calculate the 12/31 R/E needed to balance B/S. The 12/31 R/E is used to calculate NI. The remeasurement gain/loss is the plug in the I/S. Current rate method Translation adjustment in OCI. First calculate NI. It is used to calculate 12/31 R/E. Then the translation adjustment is the plug in the B/S.

In a business combination, how to calculate parent and sub's diluted EPS?

SUBSIDIARY Diluted EPS = (sub's net income - *amortization* - sub's preferred stock dividends + effect of sub's conversion) / (weighted-average number of common stocks outstanding + effect of sub's conversion) PARENT (or consolidated) Diluted EPS = (*adjusted net income attributable to the parent* - parent's preferred stock dividends + effect of parent's conversion) / (weighted-average number of common stocks outstanding + effect of parent's conversion)

Definition of partnership

Section 6 of Uniform Partnership Act: A partnership is defined as "an association of two or more persons to carry on a business as co-owners for profit."

Steps to make a statement of cash flow using indirect method

Steps to make a statement of cash flow using indirect method Calculate changes for all non-cash balance sheet accounts Decompose changes if necessary Classify as Operating (O), Investing (I) or Financing (F) Adjust net income (Operating section) Finalize the Statement

Articles of partnership

The articles of partnership, rather than either laws or official rules, provide much of the underlying basis for partnership accounting Articles of partnership should always clearly describe the: Name and address of each partner Business location Nature of the business Rights and responsibilities of each partner Initial contribution to be made by each partner and the method to be used for valuation Specific method by which profits and losses are to be allocated Periodic withdrawal of assets by each partner Procedure for admitting new partners Method for arbitrating partnership disputes Life insurance provisions enabling remaining partners to acquire the interest of any deceased partner Method for settling a partner's share in the business upon withdrawal, retirement, or death

If partners invest intangible assets (e.g., expertise, patient list)

The bonus method Starts with the known fair value of net identifiable assets, and allocates capital based on the partners' agreement - Dr. Assets --- Cr. Xxx, capital --- Cr. Yyy, capital The goodwill method Starts with the known contributed capital, and recognize as goodwill intangible contribution made by a partner - Dr. Assets - Dr. Goodwill --- Cr. Xxx, capital --- Cr. Yyy, capital

James and Joyce form a partnership. James contributes cash of $70,000, and Joyce invests only $10,000. Joyce, however, is an accomplished graphic artist, a skill that is considered especially valuable to this business. After negotiations, James and Joyce have decided to start the business with equal capital balances. What journal entry records the formation of the partnership under (a) the bonus method,

The bonus method The bonus method simply splits the $80,000 capital evenly between the two partners. Joyce received a capital bonus of $30,000 (the $40,000 recorded capital balance in excess of the $10,000 cash contribution) from James in recognition of her artistic abilities she contributed.

How to accounting for capital contributions?

The determination of an appropriate valuation for each capital balance is more than just an accounting exercise. The totals in the individual capital accounts often influence the assignment of profits and losses to the partners. The capital account balance is sometimes one factor in determining the final distribution that will be received by a partner at the time of withdrawal or retirement. Ending capital balances sometimes indicate the allocation to be made of any assets that remain following the liquidation of a partnership. If one or more of the partners transfers noncash assets, fair value is used to record the assets.

James and Joyce form a partnership. James contributes cash of $70,000, and Joyce invests only $10,000. Joyce, however, is an accomplished graphic artist, a skill that is considered especially valuable to this business. After negotiations, James and Joyce have decided to start the business with equal capital balances. What journal entry records the formation of the partnership under (b) the goodwill method?

The goodwill method Joyce's artistic talent has an apparent value of $60,000, a figure that should be included as part of this partner's capital investment.

More about step 3 - Consolidation of a foreign subsidiary: Under the temporal method

The non-monetary items are remeasured using the historic exchange rates => the consolidation entries are unaffected by changes in the exchange rate Consolidate the same way as before S: eliminate the sub's equity accounts at the beginning of the period -- Use the numbers from the sub's USD financial statements A: the difference between FV and BV -- Use the historical rates I: the parent's income from sub earnings is in USD D: the sub's dividends are remeasured at the historic rates -- Use the number from the sub's USD statement of RE E: the sub's depreciation expense and accumulated depreciation -- Use the historical rates

Temporal Method

To produce the same result as if the foreign subsidiary's books of record had been maintained in the functional currency Balance sheet 1. Monetary items (i.e., assets and liabilities carried on the foreign operation's balance sheet at a current or future value), for example cash, marketable securities, receivables, and most liabilities, are remeasured at the current rate into the functional currency 2. Nonmonetary items (i.e., assets and liabilities carried on the foreign operation's balance sheet at historical cost) are remeasured at historical rate 3. Equity (except retained earnings) is remeasured at historical rate Income statement 1. Non-balance sheet related items are remeasured at average rate 2. Balance sheet related items (e.g., depreciation, amortization, cost of goods sold) are remeasured at historical rate Statement of cash flows 1. Operating cash flows depend on the income statement 2. Investing and financing cash flows are remeasured at historical rate

Tinker, Evers, and Chance form a partnership. The articles of partnership stipulates that each partner is allowed to withdraw $10,000 in cash annually from the business. Each partner has taken the allowed amount of drawing during the year. What are the journal entries to record the withdrawal?

To record withdrawal of cash by partners: - Dr. Tinker, drawing 10,000 - Dr. Evers, drawing 10,000 - Dr. Chance, drawing 10,000 --- Cr. Cash 30,000 To close out drawing accounting into the individual partner's capital account at year-end: - Dr. Tinker, capital 10,000 - Dr. Evers, capital 10,000 - Dr. Chance, capital 10,000 --- Cr. Tinker, drawing 10,000 --- Cr. Evers, drawing 10,000 --- Cr. Chance, drawing 10,000

Core issues in translation

Two core issues Which exchange rate to use? How should translation gains and losses be accounted for? Three possible exchange rates Current rate -- Exchange rate at the balance sheet date Historical rate --Exchange rate on the date a transaction occurs Average rate -- Average exchange rate for a period of time Two possible ways to account for translation gains and losses Recognized as a component of net income Recognized as a component of comprehensive income Two major methods Temporal method (also called remeasurement) Current rate method (also called translation)