09 ch08 207-246.qxd:aeb12 - universal site containing ... · initial audit planninginvolves four...

LEARNING OBJECTIVESAfter studying this chapter,you should be able to

AUDIT PLANNING AND ANALYTICAL PROCEDURES

8CHAPTER

8-1 Discuss why adequateaudit planning isessential.

8-2 Make client acceptancedecisions and performinitial audit planning.

8-3 Gain an understanding ofthe client’s business andindustry.

8-4 Assess client business risk.

8-5 Perform preliminaryanalytical procedures.

8-6 State the purposes ofanalytical procedures andthe timing of eachpurpose.

8-7 Select the mostappropriate analyticalprocedure from amongthe five major types.

8-8 Compute commonfinancial ratios.

THE FALL OF ENRON: DID ANYONE UNDERSTAND THEIR BUSINESS?

The bankruptcy of Enron Corporation, at one time the nation’s largest energy wholesalingcompany, represents the biggest corporate collapse in American history. Despite being listed asNo. 7 on the Fortune 500 list with a market capitalization of $75 billion before its collapse, themeltdown of Enron was rapid. The fall began in October 2001 when Enron officials reported ashocking $618 million quarterly loss related to allegedly mysterious and hidden related partypartnerships with company insiders. Then, in early November 2001, company officials wereforced to admit that they had falsely claimed almost $600 million in earnings dating back to1997, requiring the restatement of four years of audited financial statements. By the end of2001, the company was in bankruptcy.

Enron was created in 1985 out of a merger of two gas pipelines, and was a pioneer in tradingnatural gas and electricity in the newly deregulated utilities markets. In its earlier years, Enronmade its money from hard assets like pipelines. However, by the end of the 1990s, 80% ofEnron’s earnings came from a more vague business known as “wholesale energy operationsand services.” Enron had built new markets, such as trading of weather securities. In early2001, speculation about Enron’s business dealings began to surface. One highly regardedinvestment banker publicly stated that no one could explain how Enron actually made money.

In the wake of the collapse, many wonder how these issues could go undetected for so long.Many point to the incredibly complicated business structure at Enron and Enron’s related vagueand confusing financial statements. “What we are looking at here is an example of superblycomplex financial reports. They didn’t have to lie. All they had to do was to obfuscate it with sheercomplexity,” noted John Dingell, U.S. Congressman from Michigan. Others even allege that themen running the company never even understood their business concept because it was toocomplicated.

Apparently, the complexity and uncertainty surrounding Enron’s business and financialstatements fooled their auditors, too. Enron’s auditor faced a flurry of attacks, class actionlawsuits, and a criminal indictment that ultimately led to the firm’s demise. In December 2001congressional testimony, the audit firm’s CEO admitted that the firm’s professional judgment“turned out to be wrong” and that they mistakenly let Enron keep the related entities separatewhen they should have been consolidated.

Several lessons will likely come out of the Enron disaster. One to be underscored for auditors isthe paramount importance of understanding the company’s business and industry to identifysignificant business risks that increase the risk of material misstatements in the financialstatements. Without that understanding, it will be almost impossible to identify the next Enron.

Source: Adapted from Bethany McLean, “Why Enron Went Bust,” Fortune (December 24, 2001), pp. 58–68.

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There are three main reasons why the auditor should properly plan engagements:to enable the auditor to obtain sufficient appropriate evidence for the circumstances, tohelp keep audit costs reasonable, and to avoid misunderstandings with the client.Obtaining sufficient appropriate evidence is essential if the CPA firm is to minimizelegal liability and maintain a good reputation in the business community. Keepingcosts reasonable helps the firm remain competitive. Avoiding misunderstandings withthe client is necessary for good client relations and for facilitating high-quality work atreasonable cost. Suppose that the auditor informs the client that the audit will be com-pleted before June 30 but is unable to finish it until August because of inadequatescheduling of staff. The client is likely to be upset with the CPA firm and may even suefor breach of contract.

Figure 8-1 presents the eight major parts of audit planning. Each of the first sevenparts is intended to help the auditor develop the last part, an effective and efficientoverall audit plan and audit program. The first four parts of the planning phase of anaudit are studied in this chapter. The last four are studied separately in later chapters.

Before beginning our discussion, we briefly introduce two risk terms: acceptableaudit risk and inherent risk. These two risks significantly influence the conduct and costof audits. Much of the early planning of audits deals with obtaining information tohelp auditors assess these risks.

Acceptable audit risk is a measure of how willing the auditor is to accept that thefinancial statements may be materially misstated after the audit is completed and anunqualified opinion has been issued. When the auditor decides on a lower acceptableaudit risk, it means that the auditor wants to be more certain that the financial state-ments are not materially misstated. Zero risk is certainty, and a 100 percent risk is com-plete uncertainty.

Inherent risk is a measure of the auditor’s assessment of the likelihood that thereare material misstatements in an account balance before considering the effectivenessof internal control. If, for example, the auditor concludes that there is a high likelihoodof material misstatement in an account such as accounts receivable, the auditor con-cludes that inherent risk for accounts receivable is high.

Assessing acceptable audit risk and inherent risk is an important part of auditplanning because it helps determine the amount of evidence that will need to be accu-mulated and staff assigned to the engagement. For example, if inherent risk for inven-tory is high because of complex valuation issues, more evidence will be accumulated inthe audit of inventory, and more experienced staff will be assigned to perform testingin this area.

208 PART TWO / THE AUDIT PROCESS

PLANNING

As the chapter story illustrates, Enron’s complex and confusing business structurehelped disguise material misstatements in Enron financial statements for several

years. Gaining an understanding of the client’s business and industry is one of the mostimportant steps in audit planning. This chapter explains audit planning in detail,including gaining an understanding of the client’s business and industry, assessingclient business risk, and performing preliminary analytical procedures.

OBJECTIVE 8-1

Discuss why adequate audit planning is essential.

The auditor must adequately plan the work and must properly supervise any assistants.

The first generally accepted auditing standard of field work requires adequate plan-ning.

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Initial audit planning involves four things, all of which should be done early in theaudit:

1. The auditor decides whether to accept a new client or continue serving an exist-ing one. This determination is typically made by an experienced auditor who isin a position to make important decisions. The auditor wants to make this deci-sion early, before incurring any significant costs that cannot be recovered.

2. The auditor identifies why the client wants or needs an audit. This informationis likely to affect the remaining parts of the planning process.

3. To avoid misunderstandings, the auditor obtains an understanding with theclient about the terms of the engagement.

4. The auditor develops an overall strategy for the audit, including engagementstaffing and any required audit specialists.

Even though obtaining and retaining clients is not easy in a competitive professionsuch as public accounting, a CPA firm must use care in deciding which clients areacceptable. The firm’s legal and professional responsibilities are such that clients wholack integrity or argue constantly about the proper conduct of the audit and fees cancause more problems than they are worth. Some CPA firms now refuse any clients incertain high-risk industries, such as savings and loans, health, and casualty insurancecompanies, and may even discontinue auditing existing companies in those industries.Some smaller CPA firms will not do audits of publicly held clients because of the risk of

CHAPTER 8 / AUDIT PLANNING AND ANALYTICAL PROCEDURES 209

ACCEPT CLIENT AND PERFORM INITIAL AUDIT PLANNING

OBJECTIVE 8-2

Make client acceptance decisionsand perform initial audit planning.

Set materiality andassess acceptable auditrisk and inherent risk

Understand internal control and assess control risk

Develop overall auditplan and audit program

Gather information to assess fraud risks

Accept client and perform initial audit planning

Perform preliminaryanalytical procedures

Assess client business risk

Understand the client’s business and industry

FIGURE 8-1 Planning an Audit and Designing an Audit Approach

Client Acceptance and Continuance



litigation or because of costs associated with registering the audit firm with thePCAOB. Stated in terms of acceptable audit risk, an auditor is unlikely to accept a newclient or continue serving an existing client if acceptable audit risk is below the riskthreshold the firm is willing to accept.

New Client Investigation Before accepting a new client, most CPA firms investigate thecompany to determine its acceptability. They do this by examining, to the extent possi-ble, the prospective client’s standing in the business community, financial stability, andrelations with its previous CPA firm. For example, many CPA firms use considerablecaution in accepting new clients in newly formed, rapidly growing businesses. Many ofthese businesses fail financially and expose the CPA firm to significant potential liability.

For prospective clients that have previously been audited by another CPA firm, thenew (successor) auditor is required by SAS 84 (AU 315) to communicate with thepredecessor auditor. The purpose of the requirement is to help the successor auditorevaluate whether to accept the engagement. The communication may, for example,inform the successor auditor that the client lacks integrity or that there have been dis-putes over accounting principles, audit procedures, or fees.

The burden of initiating the communication rests with the successor auditor, butthe predecessor auditor is required to respond to the request for information. However,the confidentiality requirement in the Code of Professional Conduct requires that thepredecessor auditor obtain permission from the client before the communication canbe made. In the event of unusual circumstances such as legal problems or disputesbetween the client and the predecessor, the predecessor’s response can be limited tostating that no information will be provided. If a client will not permit the communi-cation or the predecessor will not provide a comprehensive response, the successorshould seriously consider the desirability of accepting a prospective engagement, with-out considerable other investigation.

Even when a prospective client has been audited by another CPA firm, a successormay make other investigations by gathering information from local attorneys, otherCPAs, banks, and other businesses. In some cases, the auditor may even hire a profes-sional investigator to obtain information about the reputation and background of thekey members of management. Such extensive investigation is appropriate when therehas been no previous auditor, when a predecessor auditor will not provide the desiredinformation, or if any indication of problems arises from the communication.

Continuing Clients Many CPA firms evaluate existing clients annually to determinewhether there are reasons for not continuing to do the audit. Previous conflicts overthe appropriate scope of the audit, the type of opinion to issue, fees, or other mattersmay cause the auditor to discontinue association. The auditor may also drop a clientafter determining the client lacks integrity. Under the AICPA Code of ProfessionalConduct rules on independence, if the client files a lawsuit against a CPA firm or viceversa, the firm cannot perform the audit. Similarly, if there are unpaid fees for servicesperformed more than 1 year previously, the CPA firm cannot do the current year audit.

Even if none of the previously discussed conditions exist, the CPA firm may decidenot to continue doing audits for a client because of excessive risk. For example, a CPAfirm might decide that considerable risk of a regulatory conflict exists between a gov-ernmental agency and a client, which could result in financial failure of the client andultimately lawsuits against the CPA firm. Even if the engagement is profitable, the long-term risk may exceed the short-term benefits of doing the audit.

Investigating new clients and reevaluating existing ones is an essential part ofdeciding acceptable audit risk. For example, assume a potential client operates in a rea-sonably risky industry, that its management has a reputation of integrity, but is alsoknown to take aggressive financial risks. If the CPA firm decides that acceptable auditrisk is extremely low, it may choose not to accept the engagement. If the CPA firmconcludes that acceptable audit risk is low but the client is still acceptable, the firm may










accept the engagement but increase the fee proposed to the client. Audits with a lowacceptable audit risk will normally result in higher audit costs, which should bereflected in higher audit fees.

Two major factors affecting acceptable audit risk are the likely statement users andtheir intended uses of the statements. The auditor is likely to accumulate more evi-dence when the statements are to be used extensively, as is often the case for publiclyheld companies, those with extensive indebtedness, and companies that are to be soldin the near future.

The most likely uses of the statements can be determined from previous experiencewith the client and discussions with management. Throughout the engagement, theauditor may get additional information about why the client is having an audit and thelikely uses of the financial statements. This information may affect the auditor’s accept-able audit risk.

A clear understanding of the terms of the engagement should exist between the clientand the CPA firm. SAS 108 (AU 310) requires that auditors document their under-standing with the client in an engagement letter, including the engagement’s objec-tives, the responsibilities of the auditor and management, and the engagement’s limita-tions. An example of an engagement letter for the audit of a private company isprovided in Figure 8-2 (p. 212).

The engagement letter may also include an agreement to provide other servicessuch as tax returns or management consulting. It should also state any restrictions tobe imposed on the auditor’s work, deadlines for completing the audit, assistance to beprovided by the client’s personnel in obtaining records and documents, and schedulesto be prepared for the auditor. It often includes an agreement on fees. The engagementletter also serves the purpose of informing the client that the auditor cannot guaranteethat all acts of fraud will be discovered.

For audits of nonpublic companies, the engagement letter is typically signed bymanagement. For public companies, the Sarbanes–Oxley Act explicitly shifts responsi-bility for hiring and firing of the auditor from management to the audit committee.Auditors of public companies must now obtain an understanding of the terms of theengagement with the audit committee and document that understanding in the auditfiles. The engagement letter for a public company will also include the agreement forthe audit of the effectiveness of internal control over financial reporting, and may alsoinclude any nonaudit services that must be preapproved by the audit committee.

Engagement letter information is important in planning the audit principallybecause it affects the timing of the tests and the total amount of time the audit andother services will take. For example, if the deadline for submitting the audit report issoon after the balance sheet date, a significant portion of the audit must be done before


Identify Client’s Reasons for Audit

Obtain an Understandingwith the Client

ALL THAT GLITTERSISN’T GOLD

Auditors often must rely on the evaluation of spe-cialists to value gold and other extractive minerals.Allegedly, the gold samples on which the original dis-covery was based had been “salted” with gold, andthe samples had been destroyed, preventing inde-pendent verification. However, a separate, independ-ent analysis of the discovery by another companyindicated insignificant amounts of gold, resulting in a90 percent decline in the value of Bre-X shares.

Source: Adapted from William C. Symonds and MichaelShari, “After Bre-X, the Glow is Gone,” Business Week(April 14, 1997), pp. 38–39.

Gold! Just as the discovery of gold at Sutter’s Millstarted the 1849 gold rush in California, theannouncement of a major gold discovery in Indonesiain 1993 sent Bre-X Minerals, Ltd., shares soaring onthe Toronto stock exchange. The discovery had beenbilled as the “gold discovery of the century,” and fightsemerged over who had the rights to mine the gold.

Plenty of intrigue surrounded the gold find. Firedestroyed all the geologists’ records of the find, andthe exploration manager mysteriously plunged from ahelicopter in an alleged suicide just before theannouncement that the gold discovery appeared tobe a fraud.



This will confirm our understanding of the arrangements for our audit of the financial statements of Babb Clothing Co. for the year ending December 31, 2007.

We will audit the company’s financial statements for the year ending December 31, 2007, for the purpose of expressing an opinion on the fairness with which they present, in all material respects, the financial position, results of operations, and cash flows in conformity with generally accepted accounting principles.

We will conduct our audit in accordance with generally accepted auditing standards. Those standards require that we obtain reasonable, rather than absolute, assurance that the financial statements are free of material misstatement, whether caused by error or fraud. Accordingly, a material misstatement may remain undetected. Also, an audit is not designed to detect error or fraud that is immaterial to the financial statements; therefore, the audit will not necessarily detect misstate-ments less than this materiality level that might exist because of error, fraudulent financial reporting, or misappropriation of assets. If, for any reason, we are unable to complete the audit or are unable to form or have not formed an opinion, we may decline to express an opinion or decline to issue a report as a result of the engagement.

Although an audit includes obtaining an understanding of internal control sufficient to plan the audit and to determine the nature, timing, and extent of audit procedures to be performed, it is not designed to provide assurance on internal control or to identify significant deficiencies. However, we are responsible for ensuring that the audit committee is aware of any significant deficiencies that come to our attention.

The financial statements are the responsibility of the company’s management. Management is also responsible for (1) establishing and maintaining effective internal control over financial reports, (2) identifying and ensuring the company complies with the laws and regulations applicable to its activities, (3) making all financial records and related information available to us, and (4) providing to us at the conclusion of the engagement a representation letter that, among other things, will confirm management’s responsibility for the preparation of the financial statements in conformity with generally accepted accounting principles, the availability of financial records and related data, the completeness and availability of all minutes of the board and committee meetings, and to the best of its knowledge and belief, the absence of fraud involving management or those employees who have a significant role in the entity’s internal control.

The timing of our audit and the assistance to be supplied by your personnel, including the preparation of schedules and analyses of accounts, are described on a separate attachment. Timely completion of this work will facilitate the completion of our audit.

As part of our engagement for the year ending December 31, 2007, we will also prepare the federal and state income tax returns for Babb Clothing Co.

Our fees will be billed as work progresses and are based on the amount of time required at various levels of responsibility, plus actual out-of-pocket expenses. Invoices are payable upon presen-tation. We will notify you immediately of any circumstances we encounter that could significantly affect our initial estimate of total fees of $135,000.

If this letter correctly expresses your understanding, please sign the enclosed copy and return it to us. We appreciate the opportunity to serve you.

HILYER AND RIDDLE, CPAsMacon, Georgia 31212

June 14, 2007Mr. Chuck Milsaps, PresidentBabb Clothing Co.4604 Oakley St. Macon, Georgia 31212

Dear Mr. Milsaps:

Yours very truly:

Alan Hilyer

Alan HilyerPartner

Accepted:

By: Chuck MilsapsDate: 6-21-07

FIGURE 8-2 Engagement Letter


the end of the year. If unexpected circumstances arise or if client assistance is not avail-able, arrangements must be made to extend the amount of time for the engagement.Client-imposed restrictions on the audit can affect the procedures performed and pos-sibly even the type of audit opinion issued.

After understanding the client’s reasons for the audit, the auditor should develop a pre-liminary audit strategy. This strategy considers the nature of the client, including areaswhere there is greater risk of significant misstatements. The auditor also considersother factors such as the number of client locations and the past effectiveness of clientcontrols in developing a preliminary approach to the audit. The planned strategy helpsthe auditor determine the resources required for the engagement, including engage-ment staffing.

Select Staff for Engagement The auditor must assign the appropriate staff to theengagement to meet generally accepted auditing standards and to promote audit effi-ciency. The first general standard states the following:

Staff must therefore be assigned with that standard in mind, and those assigned tothe engagement must be knowledgeable about the client’s industry. Larger auditengagements are likely to require one or more partners and staff at several experiencelevels. Specialists in such technical areas as statistical sampling and computer riskassessment may also be assigned. On smaller audits, only one or two staff membersmay be needed.

A major consideration of staffing is the need for continuity from year to year.Continuity helps the CPA firm maintain familiarity with the technical requirementsand closer interpersonal relations with client personnel. An inexperienced staff assis-tant is likely to become the most experienced nonpartner on the engagement within afew years.

Consider a computer manufacturing client with extensive inventory of computersand computer parts where inherent risk for inventory has been assessed as high. It isessential for the staff person doing the inventory portion of the audit to be experiencedin auditing inventory. The auditor should also have a good understanding of the com-puter manufacturing industry. The CPA firm may decide to engage a specialist if noone within the firm is qualified to evaluate whether the inventory is obsolete.

Evaluate Need for Outside Specialists As the story involving the gold claim at Bre-Xillustrates, if the audit requires specialized knowledge, it may be necessary to consult aspecialist. SAS 73 (AU 336) establishes the requirements for selecting specialists andreviewing their work. Examples include using a diamond expert in evaluating thereplacement cost of diamonds and an actuary for determining the appropriateness ofthe recorded value of insurance loss reserves. Another common use of specialists isconsulting with attorneys on the legal interpretation of contracts and titles.

The auditor must have a sufficient understanding of the client’s business to recognize whether a specialist is needed. The auditor needs to evaluate the specialist’sprofessional qualifications and understand the objectives and scope of the specialist’swork. The auditor should also consider the specialist’s relationship to the client,including circumstances that might impair the specialist’s objectivity. The use of a spe-cialist does not affect the auditor’s responsibility for the audit and the audit reportshould not refer to the specialist unless the specialist’s report results in a modificationof the audit opinion.


The audit must be performed by a person or persons having adequate technical training and proficiency as anauditor.

Develop Overall Audit Strategy


A thorough understanding of the client’s business and industry and knowledge aboutthe company’s operations are essential for doing an adequate audit. The second stan-dard of field work states:

The nature of the client’s business and industry affects client business risk and therisk of material misstatements in the financial statements. (Client business risk is therisk that the client will fail to meet its objectives. It is discussed further later in thechapter.) In recent years, several factors have increased the importance of understand-ing the client’s business and industry:

• Information technology connects client companies with major customers and sup-pliers. As a result, auditors need greater knowledge about major customers andsuppliers and related risks.

• Clients have expanded operations globally, often through joint ventures or strate-gic alliances.

• Information technology affects internal client processes, improving the quality andtimeliness of accounting information.

• The increased importance of human capital and other intangible assets hasincreased accounting complexity and the importance of management judgmentsand estimates.

• Auditors need a better understanding of the client’s business and industry to pro-vide additional value-added services to clients. For example, audit firms oftenprovide assurance and consulting services related to information technology andrisk management services for nonpublic audit clients that require an extensiveknowledge of the client’s industry.

Auditors consider these factors using a strategic systems approach to understandingthe client’s business. Figure 8-3 provides an overview of the approach to understandingthe client’s business and industry. Next, we will discuss several aspects of this approach.

The three primary reasons for obtaining a good understanding of the client’s industryand external environment are:

1. Risks associated with specific industries may affect the auditor’s assessment ofclient business risk and acceptable audit risk—and may even influence audi-tors against accepting engagements in riskier industries, such as the savingsand loan and health insurance industries.

2. Certain inherent risks are typically common to all clients in certain indus-tries. Familiarity with those risks aids the auditor in assessing their relevance


UNDERSTAND THE CLIENT’S BUSINESS AND INDUSTRY

OBJECTIVE 8-3

Gain an understanding of theclient’s business and industry.

The auditor must obtain a sufficient understanding of the entity and its environment, including its internal con-trol, to assess the risk of material misstatement of the financial statements whether due to error or fraud, andto design the nature, timing, and extent of further audit procedures.

Industry and ExternalEnvironment









MANY CPA FIRMS ORGANIZE TO FOCUS

ON INDUSTRIES

Consumer and Industrial Products & Services;Financial Services; and Technology Info-Com andEntertainment. Organizing along industry lines helpsCPA firms, such as PricewaterhouseCoopers, betterunderstand their clients’ businesses and providevalue-added services.

A high level of knowledge of a client’s industry andbusiness is so critical to conducting quality auditsand providing tax and consulting services that manyCPA firms are organized to focus on industry lines.PricewaterhouseCoopers, LLP has organized its prac-tice using multidisciplinary teams across 22 industrysectors. These teams fall under one of three clusters:


to the client. Examples include potential inventory obsolescence in the fashion clothing industry, accounts receivable collection inherent risk in theconsumer loan industry, and reserve for loss inherent risk in the casualtyinsurance industry.

3. Many industries have unique accounting requirements that the auditor mustunderstand to evaluate whether the client’s financial statements are in accor-dance with generally accepted accounting principles. For example, if the auditoris doing an audit of a city government, the auditor must understand govern-mental accounting and auditing requirements. Unique accounting require-ments exist for construction companies, railroads, not-for-profit organizations,financial institutions, and many other organizations.

Many auditor litigation cases (like those described in Chapter 5) result from the auditor’s failure to fully understand the nature of transactions in the client’s indus-try. For example, several major accounting firms paid large settlements to the federalgovernment related to audits of failed savings and loans. In some of these audits, theauditors failed to understand the nature of significant real estate transactions.

The auditor must also understand the client’s external environment, includingsuch things as economic conditions, extent of competition, and regulatory require-ments. For example, auditors of utility companies need more than an understanding ofthe industry’s unique regulatory accounting requirements. They must also know howrecent deregulation in this industry has increased competition and how fluctuations inenergy prices impact firm operations. To develop effective audit plans, auditors of allcompanies must have the expertise to assess external environment risks.

The auditor should understand factors such as major sources of revenue, key cus-tomers and suppliers, sources of financing, and information about related parties thatmay indicate areas of increased client business risk. For example, many technologyfirms are dependent on one or a few products that may become obsolete due to new


Understand Client'sBusiness and Industry

Industry andExternal Environment

Business Operationsand Processes

Management andGovernance

Objectives andStrategies

Measurement andPerformance







FIGURE 8-3 Strategic Systems Understanding of the Client’s Business and Industry

Business Operations and Processes


technologies or stronger competitors. Dependence on a few major customers mayresult in material losses from bad debts or obsolete inventory.

Tour the Plant and Offices A tour of the client’s facilities is helpful in obtaining a betterunderstanding of the client’s business operations because it provides an opportunity toobserve operations firsthand and to meet key personnel. By viewing the physical facili-ties, the auditor can assess physical safeguards over assets and interpret accounting datarelated to assets such as inventory in process and factory equipment. With such first-hand knowledge, the auditor is better able to identify inherent risks, such as unusedequipment or potentially unsalable inventory. Discussions with nonaccountingemployees during the tour and throughout the audit also help the auditor learn moreabout the client’s business to aid in assessing inherent risk.

Identify Related Parties Transactions with related parties are important to auditorsbecause generally accepted accounting principles require that they be disclosed in thefinancial statements if they are material. A related party is defined in SAS 45 (AU 334)as an affiliated company, a principal owner of the client company, or any other partywith which the client deals, where one of the parties can influence the management oroperating policies of the other. A related party transaction is any transaction betweenthe client and a related party. Common examples include sales or purchase transac-tions between a parent company and its subsidiary, exchanges of equipment betweentwo companies owned by the same person, and loans to officers. A less common exam-ple is the exercise of significant management influence on an audit client by its mostimportant customer.

A transaction with a related party is not an arm’s-length transaction. Therefore,there is a risk that they may not be valued at the same amount as a transaction with anindependent third party. For example, a company may be able to purchase inventoryfrom a related company at more favorable terms than from an outside vendor. Mostauditors assess inherent risk as high for related parties and related party transactions,both because of the accounting disclosure requirements and the lack of independencebetween the parties involved in the transactions.

Because material related party transactions must be disclosed, all related partiesneed to be identified and included in the permanent files early in the engagement. (Thedisclosure requirements include the nature of the related party relationship; a descrip-tion of transactions, including dollar amounts; and amounts due from and to relatedparties.) Having all related parties included in the permanent audit files, and makingsure all auditors on the team know who the related parties are, helps auditors identifyundisclosed related party transactions as they do the audit. Common ways of identify-ing related parties include inquiry of management, review of SEC filings, and examin-ing stockholders’ listings to identify principal stockholders.

Because of the lack of independence between related parties, the Sarbanes–OxleyAct prohibits related party transactions that involve personal loans to any director orexecutive officer of a public company. Banks and other financial institutions, however,are permitted to make normal loans, such as residential mortgages, to their directorsand officers using market rates.

Because management establishes a company’s strategies and business processes, anauditor should assess management’s philosophy and operating style and its ability toidentify and respond to risk, as these significantly influence the risk of material mis-statements in the financial statements. For example, in one of the major financialaccounting scandals of the late 1990s, the significant annual increase in sales and earn-ings reported by Sunbeam was ultimately determined to be based on various improperaccounting techniques encouraged by the CEO.

A firm’s governance includes its organizational structure, as well as the activities ofthe board of directors and the audit committee. An effective board of directors helps










ensure that the company takes only appropriate risks, while the audit committee,through oversight of financial reporting, can reduce the likelihood of overly aggressiveaccounting. To gain an understanding the client’s governance system, the auditor shouldunderstand the corporate charter and bylaws, consider the company’s code of ethics,and read the corporate minutes.

Corporate Charter and Bylaws The corporate charter is granted by the state in whichthe company is incorporated and is the legal document necessary for recognizing a cor-poration as a separate entity. It includes the exact name of the corporation, the date ofincorporation, the kinds and amounts of capital stock the corporation is authorized toissue, and the types of business activities the corporation is authorized to conduct. Thebylaws include the rules and procedures adopted by the stockholders of the corpora-tion. They specify such things as the fiscal year of the corporation, the frequency ofstockholder meetings, the method of voting for directors, and the duties and powers ofthe corporate officers.

Code of Ethics Companies frequently communicate the entity’s values and ethicalstandards through policy statements and codes of conduct. In response to require-ments in the Sarbanes–Oxley Act, the SEC requires each public company to disclosewhether it has adopted a code of ethics that applies to senior management, includingthe CEO, CFO, and principal accounting officer or controller. A company that has notadopted such a code must disclose this fact and explain why it has not done so. TheSEC also requires companies to promptly disclose amendments and waivers to thecode of ethics for any of those officers. Auditors should gain knowledge of the com-pany’s code of ethics and examine any changes and waivers of the code of conduct thathave implications about the governance system and related integrity and ethical valuesof senior management.

Minutes of Meetings The corporate minutes are the official record of the meetings ofthe board of directors and stockholders. They include key authorizations and sum-maries of the most important topics discussed at these meetings and the decisions madeby the directors and stockholders. Common authorizations in the minutes include com-pensation of officers, new contracts and agreements, acquisitions of property, loans, anddividend payments. Examples of other information relevant to the audit include discus-sions about litigation, a pending issue of stock, or a potential merger.

The auditor should read the minutes to obtain authorizations and other informa-tion that is relevant to performing the audit. This information should be included inthe audit files by making an abstract of the minutes or by obtaining a copy and under-lining significant portions. Before the audit is completed, the auditor must follow-upon this information to be sure that management has complied with actions taken bythe stockholders and the board of directors. As an illustration, the authorized compen-sation of officers should be traced to each individual officer’s payroll record as a test ofwhether the correct total compensation was paid. Similarly, the auditor should com-pare the authorizations of loans with notes payable to make certain that these liabilitiesare recorded. Litigation, pending stock issues, and merger information may need to beincluded in footnotes.

Strategies are approaches followed by the entity to achieve organizational objectives.Auditors should understand client objectives related to:

1. Reliability of financial reporting2. Effectiveness and efficiency of operations 3. Compliance with laws and regulations

Auditors need knowledge about operations to assess client business risk andinherent risk in the financial statements. For example, product quality can have a








Client Objectives and Strategies


significant impact on the financial statements through lost sales and through war-ranty and product liability claims. One auto manufacturer recently recalled more than$3 billion of tires, which affected the financial statements of the auto company and itstire supplier.

As part of understanding the client’s objectives related to compliance with laws andregulations, the auditor should become familiar with the terms of its contracts andother legal obligations. These can include such diverse items as long-term notes andbonds payable, stock options, pension plans, contracts with vendors for future deliveryof supplies, government contracts for completion and delivery of manufactured prod-ucts, royalty agreements, union contracts, and leases. Most contracts are of primaryinterest in individual parts of the audit and, in practice, receive special attention duringthe different phases of the detailed tests. For example, the provisions of a pension planwill receive substantial emphasis as a part of the audit of the unfunded liability for pen-sions. The auditor should review and abstract the documents early in the engagement togain a better perspective of the organization and to better assess inherent risks. Later,these documents can be examined more carefully as a part of the tests of individualaudit areas.

A client’s performance measurement system includes key performance indicators thatmanagement uses to measure progress toward its objectives. These indicators go beyondfinancial statement figures, such as sales and net income, to include measures tailored tothe client and its objectives. Such key performance indicators may include market share,sales per employee, unit sales growth, unique visitors to a Web site, same-store sales, andsales per square foot for a retailer.

Inherent risk of financial statement misstatements may be increased if the clienthas set unreasonable objectives or if the performance measurement system encouragesaggressive accounting. For example, a company’s objective may be to obtain the leadingmarket share of industry sales. If management and salespeople are compensated basedon achieving this goal, there is increased incentive to record sales before they have beenearned or record sales for nonexistent transactions. In such a situation, the auditor islikely to increase assessed inherent risk and the extent of testing for the occurrencetransaction-related audit objective for sales.

Performance measurement includes ratio analysis and benchmarking against keycompetitors. As part of understanding the client’s business, the auditor should performratio analysis or review the client’s calculations of key performance ratios. Performingpreliminary analytical procedures is the fourth step in the planning process and is dis-cussed later in this chapter.

The auditor uses knowledge gained from the strategic understanding of the client’sbusiness and industry to assess client business risk, the risk that the client will fail toachieve its objectives. Client business risk can arise from any of the factors affecting theclient and its environment, such as new technology eroding a client’s competitiveadvantage, or a client failing to execute its strategies as well as its competitors.

The auditor’s primary concern is the risk of material misstatements in the finan-cial statements due to client business risk. For example, companies often make strate-gic acquisitions or mergers that depend on successfully combining the operations oftwo or more companies. If the planned synergies do not develop, the fixed assets andgoodwill recorded in the acquisition may be impaired, affecting the fair presentationin the financial statements.

Figure 8-4 summarizes the relationship among the client’s business and industry,client business risk, and the auditor’s assessment of the risk of material financial









ASSESS CLIENT BUSINESS RISK

OBJECTIVE 8-4

Assess client business risk.








statement misstatements. The auditor’s assessment of client business risk considersthe client’s industry and other external factors, as well as the client’s business strate-gies, processes and other internal factors. The auditor also considers managementcontrols that may mitigate business risk, such as effective risk assessment practicesand corporate governance. Remaining risk after considering the effectiveness of topmanagement controls is sometimes called residual risk. After evaluating client busi-ness risk, the auditor can then assess the risk of material misstatement in the financialstatements, and then apply the audit risk model to determine the appropriate extentof audit evidence. Use of the audit risk model is discussed in Chapter 9.

Management is a primary source for identifying client business risks. In publiccompanies, management should conduct thorough evaluations of relevant client busi-ness risks that affect financial reporting to be able to certify quarterly and annual finan-cial statements, and to evaluate the effectiveness of disclosure controls and proceduresnow required by the Sarbanes–Oxley Act.

Sarbanes–Oxley requires management to certify that it has designed disclosurecontrols and procedures to ensure that material information about business risks arecommunicated to management. These procedures cover a broader range of informa-tion than is covered by an issuer’s internal controls for financial reporting. The pro-cedures should capture information that is relevant to assess the need to disclose



Assess ClientBusiness Risk

Assess Risk ofMaterial Misstatements

Industry and External Environment

Business Operations and Processes

Management and Governance

Objectives and Strategies

Measurement and Performance

FIGURE 8-4 Understanding the Client’s Business and Industry, Client Business Risk,and Risk of Material Misstatement

ENTERPRISE RISKMANAGEMENT: THE NEW

PARADIGM

adopts a broader perspective that integrates andcoordinates risk management across the entire enter-prise. ERM provides a framework for management toeffectively deal with uncertainty and associated risksand opportunities, with the ultimate goal of enhanc-ing and protecting shareholder value. An effectivelyimplemented ERM system enables auditors toimprove the assessment of client business risks.

Source: Paul L. Walker, William G. Shenkire, and ThomasL. Barton, “ERM in Practice,” Internal Auditor (August2003), pp. 51–55.

As companies plan risk management strategies,today’s corporate stakeholders are keenly aware of themassive bankruptcies and shareholder losses thathave occurred in recent years. Numerous risk-relatedissues have surfaced as a result of scandals at companies such as Enron and WorldCom, leavingmany shareholders, executives, and boards wonderingwhat risk exposures their organizations face.

Enterprise risk management (ERM) has emergedas a new paradigm for managing risk. Instead of rely-ing on a traditional, “silo-based” strategy, where eacharea of the organization manages its own risks, ERM










developments and risks that pertain to the company’s business. For example, if a sub-sidiary engages in significant hedging activities, controls should exist so that topmanagement is informed of and discloses this information. Inquiries of managementabout client business risks it has identified, in advance of certifying quarterly andannual financial statements, may provide a significant source of information forauditors about client business risks affecting financial reporting.

The Sarbanes–Oxley Act also requires management to certify that it has informedthe auditor and audit committee of any significant deficiencies in internal control,including material weaknesses. Such information enables auditors to better evaluatehow internal controls may affect the likelihood of material misstatements in financialstatements.

Auditors perform preliminary analytical procedures to better understand the client’sbusiness and to assess client business risk. One such procedure compares client ratiosto industry or competitor benchmarks to provide an indication of the company’s per-formance. Such preliminary tests can reveal unusual changes in ratios compared toprior years, or to industry averages, and help the auditor identify areas with increasedrisk of misstatements that require further attention during the audit.

The Hillsburg Hardware Co. example is used to illustrate the use of preliminaryanalytical procedures as part of audit planning. This is followed by a summary of theaudit planning process, and further discussion of the use of analytical proceduresthroughout the audit.

Table 8-1 presents key financial ratios for Hillsburg Hardware Co., along with com-parative industry information that auditors might consider during audit planning.


PERFORM PRELIMINARY ANALYTICAL PROCEDURES

OBJECTIVE 8-5

Perform preliminary analyticalprocedures.

HILLSBURG INDUSTRY HILLSBURG INDUSTRYSELECTED RATIOS 12/31/07 12/31/07 12/31/06 12/31/06

Short-Term Debt-Paying Ability

Cash ratio 0.06 0.22 0.06 0.20Quick ratio 1.57 3.10 1.45 3.00Current ratio 3.86 5.20 4.04 5.10

Liquidity Activity Ratios

Accounts receivable turnover 7.59 12.15 7.61 12.25Days to collect accounts receivable 48.09 30.04 47.96 29.80Inventory turnover 3.36 5.20 3.02 4.90Days to sell inventory 108.63 70.19 120.86 74.49

Ability to Meet Long-Term Obligations

Debt to equity 1.73 2.51 1.98 2.53Times interest earned 3.06 5.50 3.29 5.60

Profitability Ratios

Gross profit percent 27.85 31.00 27.70 32.00Profit margin 0.05 0.07 0.05 0.08Return on assets 0.09 0.09 0.08 0.09Return on common equity 0.26 0.37 0.24 0.35

TABLE 8-1 Examples of Planning Analytical Procedures


These ratios are based on the Hillsburg Hardware Co. financial statements. (See theglossy insert in this textbook.) Hillsburg’s Annual Report to Shareholders describedthe company as a wholesale distributor of hardware equipment to independent,high-quality hardware stores in the midwestern United States. The company is aniche provider in the overall hardware industry, which is dominated by nationalchains like Home Depot and Lowe’s. Hillsburg’s auditors identified potentialincreased competition from national chains as a specific client business risk.Hillsburg’s market consists of smaller, independent hardware stores. Increased com-petition could affect the sales and profitability of these customers, likely affectingHillsburg’s sales and the value of assets such as accounts receivable and inventory. Anauditor might use ratio information to identify areas where Hillsburg faces increasedrisk of material misstatements.

The profitability measures indicate that Hillsburg is performing fairly well,despite the increased competition from larger national chains. Although lower thanthe industry averages, the liquidity measures indicate that the company is in goodfinancial condition, and the leverage ratios indicate additional borrowing capacity.Because Hillsburg’s market consists of smaller, independent hardware stores, thecompany holds more inventory and takes longer to collect receivables than the indus-try average.

In identifying areas of specific risk, the auditor is likely to focus on the liquidityactivity ratios. Inventory turnover has improved but is still lower than the industryaverage. Accounts receivable turnover has declined slightly and is lower than the indus-try average. The collectibility of accounts receivable and inventory obsolescence arelikely to be assessed as high inherent risks and will therefore likely warrant additionalattention in the current year’s audit. These areas likely received additional attentionduring the prior year’s audit as well.

A major purpose of audit planning is to gain an understanding of the client’s businessand industry, which is used to assess acceptable audit risk, client business risk and therisk of material misstatements in the financial statements. Figure 8-5 (p. 222) summa-rizes the four major parts of audit planning discussed in this section and the key components of each part, with a brief illustration of how a CPA firm applied each com-ponent to a continuing client, Hillsburg Hardware Co.

There are four additional parts of audit planning that are discussed in subsequentchapters. The four subsequent parts are:

• Set materiality and assess acceptable audit risk and inherent risk (Chapter 9)• Understand internal control and assess control risk (Chapter 10)• Gather information to assess fraud risks (Chapter 11)• Develop an overall audit plan and audit program (Chapter 13)

Analytical procedures are one of the eight types of evidence introduced in Chapter 7.Because of the increased emphasis on analytical procedures in professional practice,this section moves beyond the preliminary analytical procedures discussed earlier inthis chapter to discuss the uses of analytical procedures throughout the audit.

Analytical procedures are defined by SAS 56 (AU 329) as evaluations of financialinformation made by a study of plausible relationships among financial and nonfinancialdata . . . involving comparisons of recorded amounts to expectations developed by theauditor. This definition is more formal than the description of analytical proceduresused in Chapter 7, but both say essentially the same thing. Analytical procedures usecomparisons and relationships to assess whether account balances or other data appearreasonable relative to the auditor’s expectations.


SUMMARY OF THE PARTS OF AUDIT PLANNING











Assess clientbusiness risk

Understand theclient's businessand industry

Accept clientand performinitial planning

New clientacceptanceand continuance

Performpreliminaryanalyticalprocedures

Identify client’sreasons for audit

Obtain anunderstandingwith the client

Understand client'sindustry and external environment

Understand client'soperations, strategies,and performancesystem

Assess clientbusiness risk

Evaluate managementcontrols affectingbusiness risk

Assess risk ofmaterialmisstatements

Hillsburg is a continuing audit client. No circumstanceswere identified in the continuation review to causediscontinuance.

There are two primary reasons. Company is publiclytraded and audit is required by bank due to large notes payable outstanding.

Obtained an engagement letter before starting field work.

Anthony and Franklin subscribe to industry publications.Moore reviewed industry data and reports in severaldatabases and online sources.

See Figure 8-3 (p. 215). Moore discussed with CEO andCFO, read minutes, and reviewed other key reports andperformance indicators.

Moore used her understanding of the client andindustry to evaluate business risk.

Moore reviewed management and governance controlsand their effect on business risk.

Moore used her assessment of client business risk andmanagement controls to identify audit areas withincreased risk of misstatement.

Moore compared 12-31-07 unaudited balancesto the prior year. She calculated key ratios and comparedthem with prior years and industry averages. All significantdifferences were identified for follow-up.

MAJOR PARTOF

PLANNING

SUBPARTS OFPLANNING APPLICATION TO HILLSBURG HARDWARE CO.

Staff theengagement

Partner—Joe AnthonyManager—Leslie FranklinSenior—Fran MooreAssistant—Mitch Bray and one person to be named later

FIGURE 8-5 Key Parts of Planning: Accept Client and Perform Initial Planning, Understand the Client’s Business andIndustry, Assess Client Business Risk, and Perform Preliminary Analytical Procedures Applied to Hillsburg Hardware Co.


The emphasis on analytical procedures in the SAS 56 definition is on expectationsdeveloped by the auditor. For example, the auditor might compare current-yearrecorded commission expense to total recorded sales multiplied by the average com-mission rate as a test of the overall reasonableness of recorded commissions. For thisanalytical procedure to be relevant and reliable, the auditor has likely concluded thatrecorded sales are correctly stated, all sales earn a commission, and that the averageactual commission rate is readily determinable.

Analytical procedures may be performed at any of three times during an engagement:

1. Analytical procedures are required in the planning phase to assist in determiningthe nature, extent, and timing of audit procedures. This helps the auditor identifysignificant matters requiring special consideration later in the engagement. Forexample, the calculation of inventory turnover before inventory price tests aredone may indicate the need for special care during those tests. Analytical proce-dures done in the planning phase typically use data aggregated at a high level,and the sophistication, extent, and timing of the procedures vary among clients.For some clients, the comparison of prior-year and current-year account bal-ances using the unaudited trial balance may be sufficient. For other clients, thepro cedures may involve extensive analysis of quarterly financial statementsbased on the auditor’s judgment.

2. Analytical procedures are often done during the testing phase of the audit as asubstantive test in support of account balances. These tests are often done inconjunction with other audit procedures. For example, the prepaid portion ofeach insurance policy might be compared with the same policy for the previ-ous year as a part of doing tests of prepaid insurance. The assurance providedby analytical procedures depends on the predictability of the relationship, aswell as the precision of the expectation and the reliability of the data used todevelop the expectation.

3. Analytical procedures are also required during the completion phase of the audit.Such tests serve as a final review for material misstatements or financial prob-lems and help the auditor take a final “objective look” at the audited financialstatements. Typically, a senior partner with extensive knowledge of the client’sbusiness conducts the analytical procedures during the final review of the auditfiles and financial statements to identify possible oversights in an audit.


ANALYTICAL PROCEDURES

OBJECTIVE 8-6

State the purposes of analyticalprocedures and the timing of each purpose.

USING ANALYTICALPROCEDURES EFFECTIVELY

◆ Compare unaudited balances with independentexpectations of what those balances should be.

◆ Examine patterns of discrepancies, rather thananalyze each discrepancy separately.

◆ Identify reasonable explanations for unexpectedfluctuations from knowledge of the client andindustry before inquiring of the client’s manage-ment.

◆ Evaluate management’s explanations carefully,including considering how each explanationaffects all account balances in question.

Source: Adapted from Timothy B. Bell and Arnold M.Wright, “When Judgment Counts,” Journal ofAccountancy (November 1997), pp. 73–77.

According to an article in the Journal of Accountancy,auditors often face potentially serious judgment prob-lems while performing analytical procedures. Auditorscan encounter judgment problems when they:

◆ Allow unaudited account balances or ratios tounduly influence expectations of what currentbalances should be.

◆ Do not fully consider the pattern reflected by sev-eral unusual fluctuations when trying to explainwhat caused them.

◆ Place reliance on management’s explanationsabout unusual fluctuations without first develop-ing independent explanations.

The authors of the article also offer the followingrecommendations to auditors performing analyticalprocedures:


Figure 8-6 shows the purposes of analytical procedures during each of the threephases. The shaded boxes indicate when a purpose is applicable in each phase. Morethan one purpose may be indicated. Notice how analytical procedures are done duringthe planning phase for all four purposes, while procedures during the other two phasesare used primarily to determine appropriate audit evidence and to reach conclusionsabout the fair presentation of financial statements.

The usefulness of analytical procedures as audit evidence depends significantly on theauditor developing an expectation of what a recorded account balance or ratio shouldbe, regardless of the type of analytical procedures used. Auditors develop an expecta-tion of an account balance or ratio by considering information from prior periods,industry trends, client-prepared budgeted expectations, and nonfinancial information.The auditor typically compares the client’s balances and ratios with expected balancesand ratios using one or more of the following types of analytical procedures. In eachcase, auditors compare client data with:

1. Industry data2. Similar prior-period data3. Client-determined expected results4. Auditor-determined expected results5. Expected results using nonfinancial data

Suppose that you are doing an audit and obtain the following information about theclient and the average company in the client’s industry:

Client Industry______________ ______________2007 2006 2007 2006

Inventory turnover 3.4 3.5 3.9 3.4Gross margin percent 26.3% 26.4% 27.3% 26.2%

If we look only at client information for the two ratios shown, the company appears tobe stable with no apparent indication of difficulties. However, if we use industry datato develop expectations about the two ratios for 2007, we should expect both ratiosfor the client to increase. Although these two ratios by themselves may not indicate


Compare Client andIndustry Data

FIVE TYPES OF ANALYTICAL PROCEDURES

OBJECTIVE 8-7

Select the most appropriate analytical procedure from among the five major types.

Phase

Purpose (Required)Planning Phase

(Required)Completion PhaseTesting Phase

Understand the client’sindustry and business

Assess going concern

Indicate possible misstatements(attention directing)

Reduce detailed tests

Primary purpose

Secondary purpose

Primary purpose

Secondary purpose

Secondary purpose

Primary purposeSecondary purpose

Primary purpose

FIGURE 8-6 Timing and Purposes of Analytical Procedures


significant problems, this data illustrates how developing expectations using industry datamay provide useful information about the client’s performance and potential misstate-ments. Perhaps the company has lost market share, its pricing has not been competitive, it has incurred abnormal costs, or perhaps it has obsolete items in inventory or madeerrors in recording purchases. The auditor needs to determine if either of the last twooccurred to have reasonable assurance that the financial statements are not misstated.

Dun & Bradstreet, Robert Morris Associates, and other analysts accumulate finan-cial information for thousands of companies and compile the data for different lines ofbusiness. Many CPA firms purchase this information for use as a basis for industrycomparisons in their audits.

The most important benefits of industry comparisons are to aid in understandingthe client’s business and as an indication of the likelihood of financial failure. They areless likely to help auditors identify potential misstatements. The ratios in RobertMorris Associates, for example, are primarily of a type that bankers and other creditexecutives use in evaluating whether a company will be able to repay a loan. That sameinformation is useful to auditors in assessing the relative strength of the client’s capitalstructure, its borrowing capacity, and the likelihood of financial failure.

However, a major weakness in using industry ratios for auditing is the differencebetween the nature of the client’s financial information and that of the firms makingup the industry totals. Because the industry data are broad averages, the comparisonsmay not be meaningful. Often, the client’s line of business is not the same as the indus-try standards. In addition, different companies follow different accounting methods,and this affects the comparability of data. For example, if most companies in the indus-try use FIFO inventory valuation and straight-line depreciation and the audit clientuses LIFO and double-declining-balance depreciation, comparisons may not be mean-ingful. This does not mean that industry comparisons should be avoided. Rather, it isan indication of the need for care in interpreting the results. One approach to over-come the limitations of industry averages is to compare the client to one or morebenchmark firms in the industry.

Suppose that the gross margin percentage for a company has been between 26 and 27percent for each of the past 4 years but has dropped to 23 percent in the current year.This decline in gross margin should be a concern to the auditor if a decline is notexpected. The cause of the decline could be a change in economic conditions. But, itcould also be caused by misstatements in the financial statements, such as sales or pur-chase cutoff errors, unrecorded sales, overstated accounts payable, or inventory costingerrors. The decline in gross margin is likely to result in an increase in evidence in one ormore of the accounts that affect gross margin. The auditor needs to determine the causeof the decline to be confident that the financial statements are not materially misstated.

A wide variety of analytical procedures allow auditors to compare client data withsimilar data from one or more prior periods. Here are some common examples:

Compare the Current Year’s Balance with that of the Preceding Year One of the easiestways to perform this test is to include the preceding year’s adjusted trial balance resultsin a separate column of the current year’s trial balance spreadsheet. The auditor caneasily compare the current year’s balance and previous year’s balance to decide, early inthe audit, whether an account should receive more than the normal amount of atten-tion because of a significant change in the balance. For example, if the auditor observesa substantial increase in supplies expense, the auditor should determine whether thecause was an increased use of supplies, an error in the account due to a misclassifica-tion, or a misstatement of supplies inventory.

Compare the Detail of a Total Balance with Similar Detail for the Preceding Year Ifthere have been no significant changes in the client’s operations in the current year,much of the detail making up the totals in the financial statements should also remain


Compare Client Data withSimilar Prior-Period Data


unchanged. By briefly comparing the detail of the current period with similar detail ofthe preceding period, auditors often isolate information that needs further examina-tion. Comparison of details may take the form of details over time, such as comparingthe monthly totals for the current year and preceding year for sales, repairs, and otheraccounts, or details at a point in time, such as comparing the details of loans payable atthe end of the current year with the detail at the end of the preceding year. In each ofthese examples, the auditor should first develop an expectation of a change or lackthereof before making the comparison.

Compute Ratios and Percent Relationships for Comparison with Previous YearsComparing totals or details with previous years has two shortcomings. First, it fails toconsider growth or decline in business activity. Second, relationships of data to otherdata, such as sales to cost of goods sold, are ignored. Ratio and percent relationshipsovercome both shortcomings. For example, the gross margin is a common percentrelationship used by auditors.

Table 8-2 includes a few ratios and internal comparisons to show the widespreaduse of ratio analysis. In all these cases, the comparisons should be made with calcula-tions made in previous years for the same client. Many of the ratios and percents usedfor comparison with previous years are the same ones used for comparison with indus-try data. For example, auditors often compare current year gross margin with industryaverages, as well as margins for previous years.

Numerous potential comparisons of current- and prior-period data extendbeyond those normally available from industry data. For example, the percent of eachexpense category to total sales can be compared with that of previous years. Similarly,in a multiunit operation such as a retail chain, internal data comparisons for each unitcan be made with previous periods.

Auditors often prepare common-size financial statements for one or more years thatdisplay all items as a percent of a common base, such as sales. Common-size financialstatements allow for comparison between companies or for the same company over dif-ferent time periods, revealing trends and providing insight into how different compa-nies compare. Common-size income statement data for the past three years forHillsburg Hardware are included in Figure 8-7. The auditor should calculate incomestatement account balances as a percent of sales when the level of sales has changed fromthe prior year—a likely occurrence in many businesses. Hillsburg’s sales have increasedsignificantly over the prior year. Note that accounts such as cost of goods sold, sales


Ratio or Comparison Possible Misstatement

Raw material turnover for a manufacturing company Misstatement of inventory or cost of goods sold or obsolescence of raw material inventory

Sales commissions divided by net sales Misstatement of sales commissions

Sales returns and allowances divided by gross sales Misclassified sales returns and allowances or unrecorded returns or allowances subsequent to year-end

Cash surrender value of life insurance (current year) Failure to record the change in cash surrenderdivided by cash surrender value of life insurance value or an error in recording the change(preceding year)

Each of the individual manufacturing expenses as a Significant misstatement of individual expensespercent of total manufacturing expense within a total

TABLE 8-2 Internal Comparisons and Relationships



HILLSBURG HARDWARE CO.COMMON-SIZE INCOME STATEMENT

Three Years Ending December 31, 2007

SalesLess: Returns and allowances

Net salesCost of goods sold

Gross profit

Selling expenseSalaries and commissionsSales payroll taxesTravel and entertainmentAdvertisingSales and promotional literatureSales meetings and trainingMiscellaneous sales expense

Total selling expense

Administration expenseExecutive and office salariesAdministrative payroll taxesTravel and entertainmentComputer maintenance and suppliesStationery and suppliesPostageTelephone and faxRentLegal fees and retainersAuditing and related servicesDepreciationBad debt expenseInsuranceOffice repairs and maintenanceMiscellaneous office expenseMiscellaneous general expense

Total administrative expenses

Total selling and administrative expenses

Earnings from operations

Other income and expenseInterest expenseGain on sale of assets

Earnings before income taxesIncome taxesNet income

$144,3281,242

143,086103,241

39,845

7,7391,4221,1102,611

322925681

14,810

5,524682562860763244722312383303

1,4523,323

723844644324

17,665

32,475

7,370

2,409

5,6811,747

$ 3,934

(000)Preliminary

100.870.87

100.0072.15

27.85

5.410.990.781.820.220.650.48

10.35

3.860.480.390.600.530.170.510.220.270.211.012.320.510.590.450.23

12.35

22.70

5.15

1.68

3.971.222.75

(720) (0.50)

% ofNet Sales

2007

$132,4211,195

131,22694,876

36,350

7,0441,298

9251,920

425781506

12,899

5,221655595832658251626312321288

1,4433,394

760538621242

16,757

29,656

6,694

2,0350

4,6591,465

$ 3,194

(000)Audited

100.910.91

100.0072.30

27.70

5.370.990.701.460.320.600.39

9.83

3.980.500.450.630.500.190.480.240.250.221.102.590.580.410.470.18

12.77

22.60

5.10

1.550.00

3.551.122.43

% ofNet Sales

2006

$123,7371,052

122,68588,724

33,961

6,5981,198

7971,790

488767456

12,094

5,103633542799695236637312283265

1,5053,162

785458653275

16,343

28,437

5,524

2,1730

3,3511,072

$ 2,279

(000)Audited

100.860.86

100.0072.32

27.68

5.380.980.651.460.400.620.37

9.86

4.160.520.440.650.570.190.520.250.230.221.232.580.640.370.530.22

13.32

23.18

4.50

1.770.00

2.730.871.86

% ofNet Sales

2005

FIGURE 8-7 Hillsburg Hardware Common-Size Income Statement



Compare Client Data withAuditor-DeterminedExpected Results

salaries, and commissions have also increased significantly but are fairly consistent as apercent of sales, which we expect for these accounts.

The auditor is likely to require further explanation and corroborating evidence forthe changes in advertising, bad debt expense, and office repairs and maintenance.

• Note that advertising expense has increased as a percent of sales. One possibleexplanation is the development of a new advertising campaign.

• The dollar amount of bad debt expense has not changed significantly but hasdecreased as a percent of sales. The auditor needs to gather additional evidence todetermine whether bad debt expense and the allowance for doubtful accounts areunderstated.

• Repairs and maintenance expense has also increased. Fluctuations in this accountare not unusual if the client has incurred unexpected repairs. The auditor shouldinvestigate major expenditures in this account to determine whether they includeany amounts that should be capitalized as a fixed asset.

Most companies prepare budgets for various aspects of their operations and financialresults. Because budgets represent the client’s expectations for the period, auditorsshould investigate the most significant differences between budgeted and actual results,as these areas may contain potential misstatements. The absence of differences mayindicate that misstatements are unlikely. For example, audits of local, state, and federalgovernmental units commonly use this type of analytical procedure.

When client data are compared with budgets, there are two special concerns. First,the auditor must evaluate whether the budgets were realistic plans. In some organiza-tions, budgets are prepared with little thought or care and therefore are not realisticexpectations. Such information has little value as audit evidence. A discussion ofbudget procedures with client personnel is used to satisfy this concern. The secondconcern is the possibility that current financial information was changed by client per-sonnel to conform to the budget. If that has occurred, the auditor will find no differ-ences in comparing actual data with budgeted data, even if there are misstatements inthe financial statements. Assessing control risk and detailed audit tests of actual dataare usually done to minimize this concern.

Another common comparison of client data with expected results occurs when theauditor calculates the expected balance for comparison with the actual balance. In this typeof analytical procedure, the auditor makes an estimate of what an account balanceshould be by relating it to some other balance sheet or income statement account or accounts or by making a projection based on some historical trend. Here are twoexamples:

1. The auditor may make an independent calculation of interest expense on long-term notes payable by multiplying the ending monthly balance in notespayable by the average monthly interest rate (see Figure 8-8). This independentestimate based on the relationship between interest expense and notes payableis used to test the reasonableness of recorded interest expense.

2. The auditor may calculate the moving average of the allowance for uncol-lectible accounts receivable as a percent of gross accounts receivable, and thenapply it to the balance of gross accounts receivable at the end of the audit year.By using such historical trends, the auditor can determine an expected valuefor the current allowance.

Suppose that you are auditing a hotel. You may develop an expectation for total rev-enue from rooms by multiplying the number of rooms, the average daily rate for eachroom, and the average occupancy rate. You can then compare your estimate withrecorded revenue as a test of the reasonableness of recorded revenue. The sameapproach can be applied to create estimates in other situations, such as tuition revenue at universities (average tuition multiplied by enrollment), factory payroll

Compare Client Data withClient-Determined Expected Results

Compare Client Data withExpected Results UsingNonfinancial Data

09_CH08_207-246.QXD:AEB12.QXD 1/5/07 2:31 PM 8

Hillsburg Hardware Co.Overall Test of Interest Expense

12/31/07

Interest expense per general ledger

Schedule DateN-3

Computation of estimate:

Short-term loans:

Long-term loans:

2Balance outstanding at month-end:Jan. Feb.Mar.Apr.MayJuneJulyAug.Sept.Oct.Nov.Dec. Total

Beginning balanceEnding balance

Average (�12) 2,420,250 @ 10.5% 254,126

2,950,0003,184,0003,412,0003,768,0002,604,0001,874,0001,400,0001,245,0001,046,000

854,0002,526,0004,180,000

29,043,000

26,520,00024,120,00050,640,000

2

3

Average (�2) 25,320,000 @ 8.5% 2,152,2004

Estimated total interest expense

Difference

Legend and CommentsAgrees with general ledger and working trial balance.Obtained from general ledger.Estimated based on examination of several notes throughout theyear with rates ranging from 10% to 11%.Agrees with permanent file schedule of long-term debt.Difference not significant. Indicates that interest expense per books is reasonable.

1

2

3

4

5

2

12,408,642

2,406,326

52,316

Prepared by 3/06/08TM

Approved by 3/12/08JW

FIGURE 8-8 Hillsburg Hardware Overall Tests of Interest Expense December 31, 2007

(total hours worked times the wage rate), and cost of materials sold (units sold timesmaterials cost per unit).

The major concern in using nonfinancial data, however, is the accuracy of thedata. In the hotel example, you should not use an estimated calculation of hotel revenue as audit evidence unless you are satisfied with the reasonableness of thecount of the number of rooms, average room rate, and average occupancy rate.Obviously, the accuracy of the occupancy rate is more difficult to evaluate than theother two items.



Auditors’ analytical procedures often include the use of general financial ratios duringplanning and final review of the audited financial statements. These are useful forunderstanding recent events and the financial status of the business and for viewing thestatements from the perspective of a user. The general financial analysis may be effec-tive for identifying possible problem areas, where the auditor may do additional analy-sis and audit testing, as well as business problem areas in which the auditor can provideother assistance. When using these ratios, auditors must be sure to make appropriatecomparisons. The most important comparisons are to those of previous years for thecompany and to industry averages or similar companies for the same year.

Ratios and other analytical procedures are normally calculated using spreadsheetsand other types of audit software, in which several years of client and industry data canbe maintained for comparative purposes. Ratios can be linked to the trial balance sothat calculations are automatically updated as adjusting entries are made to the client’sstatements. For example, an adjustment to inventory and cost of goods sold affects alarge number of ratios, including inventory turnover, the current ratio, gross margin,and other profitability measures.

We next examine some widely used financial ratios. The following computationsare based on the 2007 financial statements of Hillsburg Hardware Co., which appear inthe glossy insert to the textbook. These ratios were prepared from the trial balance inFigure 6-4 on page 148.

Companies need a reasonable level of liquidity to pay their debts as they come due,and these three ratios measure liquidity. It is apparent by examining the three ratiosthat the cash ratio may be useful to evaluate the ability to pay debts immediately,whereas the current ratio requires the conversion of assets such as inventory andaccounts receivable to cash before debts can be paid. The most important differencebetween the quick and current ratios is the inclusion of inventory in current assets forthe current ratio.

If a company does not have sufficient cash and cash-like items to meet its obliga-tions, the key to its debt-paying ability is the time it takes the company to convert lessliquid current assets into cash. This is measured by the liquidity activity ratios.


Short-term Debt-PayingAbility

COMMON FINANCIAL RATIOS

OBJECTIVE 8-8

Compute common financialratios.

Cash ratiocash + marketable securities

current liabilities

Quick ratio

cash + marketable securities +net accounts receivable

current liabilities

Current ratiocurrent assets

current liabilities

=

=

=

828

13,2160.06

828 + 18,957 + 945

13,2161.57

51,027

13,2163.86

=

=

=

Liquidity Activity RatiosAccounts receivableturnover

net sales

average gross receivablesDays to collectreceivables

365 days

accounts receivable turnoverInventoryturnover

cost of goods sold

average inventoryDays to sellinventory

365 days

inventory turnover

=

=

=

=

143,086

((18,957 + 1,240) + (16,210 + 1,311))/2

365 days

3.36108.63 days=

103,241

(29,865 + 31,600)/2

365 days

7.5948.09 days=

� 7.59

� 3.36


The activity ratios for accounts receivable and inventory are especially useful toauditors, who often use trends in the accounts receivable turnover ratio to assess thereasonableness of the allowance for uncollectible accounts. Auditors use trends in theinventory turnover ratio to identify potential inventory obsolescence. Average days tocollect is a different way of looking at the average accounts receivable turnover data.The same is true of average days to sell compared to average inventory turnover.

A company’s long-run solvency depends on the success of its operations and on itsability to raise capital for expansion, as well as its ability to make principal and interestpayments. Two ratios are key measures creditors and investors use to assess a com-pany’s ability to pay its debts.

The debt-to-equity ratio shows the extent of the use of debt in financing a com-pany. If the debt-to-equity ratio is too high, it may indicate that the company has usedup its borrowing capacity and has no cushion for additional debt. If it is too low, it maymean that available leverage is not being used to the owners’ benefit.

The ability to make interest payments depends on the company’s ability to gener-ate positive cash flow from operations. The times interest earned ratio shows whetherthe company can comfortably make its interest payments, assuming that earningstrends are stable.

A company’s ability to generate cash for payment of obligations, expansion, and divi-dends is heavily dependent on profitability. The most widely used profitability ratio isearnings per share. Auditors calculate additional ratios to provide further insights intooperations.

Gross profit percent shows the portion of sales available to cover all expenses andprofit after deducting the cost of the product. Auditors find this ratio especially useful forassessing misstatements in sales, cost of goods sold, accounts receivable, and inventory.

Profit margin is similar to gross profit margin but subtracts both cost of goods soldand operating expenses in making the calculations. This ratio enables auditors to assesspotential misstatements in operating expenses and related balance sheet accounts.

Return on assets and return on common equity are measures of overall profit -ability of a company. These ratios show a company’s ability to generate profit for each dollar of assets and equity.


Profitability Ratios

Ability to Meet Long-termDebt Obligations13,216 + 25,688

22,4631.73

7,370

2,4093.06

=

=

Debt to equitytotal liabilities

total equity

Times interest earnedoperating income

interest expense

=

=

Earnings per sharenet income

average common shares outstanding

Gross profit percentnet sales cost of goods sold

net sales

Profit marginoperating income

net sales

Return on assetsincome before taxes

average total assets

common equityincome before taxes preferred dividends

average stockholders equity

=

=−

=

=

=−

’

Return on

3,934

5,000 0.79

143,086 103,241

143,08627.85%

7,370

143,0860.05

5,681

(61,367 + 60,791)/20.09

5,681 0

(22,463 + 20,429)/20.26

=

−=

=

=

−=


SUMMARY The first part of this chapter discussed audit planning, including understanding the client’sbusiness and industry and performing preliminary analytical procedures to assess clientbusiness risk and the risk of material misstatements in the financial statements. Analyticalprocedures are the evaluation of recorded accounting information by computing ratiosand developing other plausible relationships for comparison to expectations developed bythe auditor. These analytical procedures are used in planning to understand the client’sbusiness and industry and throughout the audit to identify possible misstatements, reducedetailed tests, and to assess going-concern issues. The use of analytical procedures hasincreased because of their effectiveness at identifying possible misstatements at a low cost,and they are required in the planning and completion phases of the audit.

ESSENTIAL TERMS


of business activities the corporation isauthorized to conduct

Corporate minutes—the official record ofthe meetings of a corporation’s board ofdirectors and stockholders, in whichcorporate issues, such as the declarationof dividends and the approval of con -tracts, are documented

Engagement letter—an agreementbetween the CPA firm and the client as tothe terms of the engagement for theconduct of the audit and related services

Inherent risk—a measure of the auditor’sassessment of the likelihood that there arematerial misstatements in a segmentbefore considering the effectiveness ofinternal control

Initial audit planning—involves decidingwhether to accept or continue doing theaudit for the client, identifying the client’sreasons for the audit, obtaining anengage ment letter, and developing anaudit strategy

Related party—affiliated company, prin -cipal owner of the client company, or anyother party with which the client deals,where one of the parties can influence themanagement or operating policies of theother

Related party transaction—any trans ac -tion between the client and a related party

Acceptable audit risk—a measure of howwilling the auditor is to accept that thefinancial statements may be materiallymisstated after the audit is completed andan unqualified opinion has been issued

Audit strategy—overall approach to theaudit that considers the nature of theclient, risk of significant misstatements,and other factors such as the number ofclient locations and past effectiveness ofclient controls

Budgets—written records of the client’sexpectations for the period; a comparisonof budgets with actual results may indicatewhether or not misstatements are likely

Bylaws—the rules and procedures adoptedby a corporation’s stockholders, includingthe corporation’s fiscal year and the dutiesand powers of its officers

Client business risk—the risk that theclient will fail to achieve its objectivesrelated to (1) reliability of financialreporting, (2) effectiveness and efficiencyof operations, and (3) compliance withlaws and regulations

Corporate charter—a legal documentgranted by the state in which a company isincorporated that recognizes a corpora -tion as a separate entity; it includes thename of the corporation, the date ofincorporation, capital stock the corpora -tion is authorized to issue, and the types

REVIEW QUESTIONS8-1 (Objective 8-1) What benefits does the auditor derive from planning audits?

8-2 (Objective 8-1) Identify the eight major steps in planning audits.


8-3 (Objective 8-2) What are the responsibilities of the successor and predecessor auditorswhen a company is changing auditors?

8-4 (Objective 8-2) What factors should an auditor consider prior to accepting anengagement? Explain.

8-5 (Objective 8-2) What is the purpose of an engagement letter? What subjects should becovered in such a letter?

8-6 (Objective 8-2) Who is considered the client when auditing public companies?

8-7 (Objective 8-2) Which services must be preapproved by the audit committee of apublic company?

8-8 (Objective 8-3) Explain why auditors need an understanding of the client’s industry.What sources are commonly used by auditors to learn about the client’s industry?

8-9 (Objective 8-3) When a CPA has accepted an engagement from a new client who is amanufacturer, it is customary for the CPA to tour the client’s plant facilities. Discuss theways in which the CPA’s observations made during the course of the plant tour will be ofhelp in planning and conducting the audit.

8-10 (Objective 8-3) An auditor often tries to acquire background knowledge of the client’sindustry as an aid to audit work. How does the acquisition of this knowledge aid theauditor in distinguishing between obsolete and current inventory?

8-11 (Objective 8-3) Define what is meant by a related party. What are the auditor’srespon sibilities for related parties and related party transactions?

8-12 (Objective 8-3) Which types of loans to executives are permitted by the Sarbanes–Oxley Act?

8-13 (Objective 8-3) Your firm has done the audit of the Rogers Company for several yearsand you have been assigned the audit responsibility for the current audit. How will yourreview of the corporate charter and bylaws for this audit differ from that of the audit of aclient who was audited by a different CPA firm in the preceding year?

8-14 (Objective 8-3) For the audit of Radline Manufacturing Company, the audit partnerasks you to carefully read the new mortgage contract with the First National Bank andabstract all pertinent information. List the information in a mortgage that is likely to berelevant to the auditor.

8-15 (Objective 8-3) Identify two types of information in the client’s minutes of the boardof directors meetings that are likely to be relevant to the auditor. Explain why it is impor -tant to read the minutes early in the engagement.

8-16 (Objective 8-3) Identify the three categories of client objectives. Indicate how eachobjective may affect the auditor’s assessment of inherent risk and evidence accumulation.

8-17 (Objective 8-3) What is the purpose of the client’s performance measurement system?Give examples of key performance indicators for the following businesses: (1) a chain ofretail clothing stores; (2) an Internet portal; (3) a hotel chain.

8-18 (Objective 8-4) Define client business risk and describe several sources of clientbusiness risk. What is the auditor’s primary concern when evaluating client business risk?

8-19 (Objective 8-4) Describe top management controls and their relation to clientbusiness risk. Give examples of effective management and governance controls.

8-20 (Objectives 8-5, 8-6) What are the purposes of preliminary analytical procedures?What types of comparisons are useful when performing preliminary analytical procedures?

8-21 (Objective 8-6) When are analytical procedures required on an audit? What is theprimary purpose of analytical procedures during the completion phase of the audit?



8-22 (Objective 8-7) Gale Gordon, CPA, has found ratio and trend analysis relativelyuseless as a tool in conducting audits. For several engagements, he computed the industryratios included in publications by Robert Morris Associates and compared them withindustry standards. For most engagements, the client’s business was significantlydifferent from the industry data in the publication and the client automatically explainedaway any discrepancies by attributing them to the unique nature of its operations. Incases in which the client had more than one branch in different industries, Gordon foundthe ratio analysis no help at all. How can Gordon improve the quality of his analyticalprocedures?

8-23 (Objective 8-7) At the completion of every audit, Roger Morris, CPA, calculates alarge number of ratios and trends for comparison with industry averages and prior-yearcalculations. He believes the calculations are worth the relatively small cost of doing thembecause they provide him with an excellent overview of the client’s operations. If theratios are out of line, Morris discusses the reasons with the client and often makessuggestions on how to bring the ratio back in line in the future. In some cases, thesediscussions with management have been the basis for management consultingengagements. Discuss the major strengths and shortcomings in Morris’s use of ratio andtrend analysis.

8-24 (Objective 8-8) Name the four categories of financial ratios and give an example of aratio in each category. What is the primary information provided by each financial ratiocategory?

MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS8-25 (Objectives 8-1, 8-3) The following questions concern the planning of theengagement. Select the best response.

a. Which of the following is an effective audit planning procedure that helps preventmisunderstandings and inefficient use of audit personnel?(1) Arrange to make copies, for inclusion in the audit files, of those client supporting

documents examined by the auditor.(2) Arrange to provide the client with copies of the audit programs to be used during

the audit.(3) Arrange a preliminary conference with the client to discuss audit objectives, fees,

timing, and other information.(4) Arrange to have the auditor prepare and post any necessary adjusting or reclassi -

fication entries prior to final closing.

b. When auditing related party transactions, an auditor places primary emphasis on(1) confirming the existence of the related parties.(2) verifying the valuation of related party transactions.(3) evaluating the disclosure of the related party transactions.(4) ascertaining the rights and obligations of the related parties.

c. Which of the following will most likely indicate the existence of related parties?(1) Writing down obsolete inventory prior to year end.(2) Failing to correct weaknesses in the client’s internal control structure.(3) An unexplained increase in gross margin.(4) Borrowing money at a rate significantly below the market rate.

d. When using the work of a specialist, the auditor may identify and refer to the specialistin the auditor’s report if the(1) auditor expresses a qualified opinion as a result of the specialist’s findings.(2) specialist is not independent of the client.(3) auditor wishes to indicate a division of responsibility.(4) specialist’s work provides the auditor greater assurance of reliability.



8-26 (Objective 8-2) The following questions pertain to client acceptance. Choose the bestresponse.

a. In assessing whether to accept a client for an audit engagement, a CPA should consider

Client Business Risk Acceptable Audit Risk

(1) Yes Yes(2) Yes No(3) No Yes(4) No No

b. When approached to perform an audit for the first time, the CPA should makeinquiries of the predecessor auditor. This is a necessary procedure because thepredecessor may be able to provide the successor with information that will assist thesuccessor in determining whether(1) the predecessor’s work should be used.(2) the company follows the policy of rotating its auditors.(3) in the predecessor’s opinion internal control of the company has been satisfac tory.(4) the engagement should be accepted.

c. A successor would most likely make specific inquiries of the predecessor auditor regarding (1) specialized accounting principles of the client’s industry.(2) the competency of the client’s internal audit staff.(3) the uncertainty inherent in applying sampling procedures.(4) disagreements with management as to auditing procedures.

8-27 (Objectives 8-5, 8-6, 8-7, 8-8) The following questions concern the use of analyticalprocedures during the planning phase of an audit. Select the best response.

a. Analytical procedures used in planning an audit should focus on identifying(1) material weaknesses of internal control.(2) the predictability of financial data from individual transactions.(3) the various assertions that are embodied in the financial statements.(4) areas that may represent specific risks relevant to the audit.

b. For all audits of financial statements made in accordance with generally acceptedauditing standards, the use of analytical procedures is required to some extent

In the As a In thePlanning Stage Substantive Test Completion Stage

(1) Yes No Yes(2) No Yes No(3) No Yes Yes(4) Yes No No

c. Which of the following is least likely to be comparable between similar corporationsin the same industry line of business?(1) Accounts receivable turnover(2) Earnings per share(3) Gross profit percent(4) Return on assets before interest and taxes

d. Which of the following situations has the best chance of being detected when a CPAcompares 2007 revenues and expenses with the prior year and investigates all changesexceeding a fixed percent?(1) An increase in property tax rates has not been recognized in the company’s 2007

accrual.(2) The cashier began lapping accounts receivable in 2007.(3) Because of worsening economic conditions, the 2007 provision for uncollectible

accounts was inadequate.(4) The company changed its capitalization policy for small tools in 2007.



DISCUSSION QUESTIONS AND PROBLEMS8-28 (Objectives 8-2, 8-3, 8-4, 8-5) The following are various activities an auditor doesduring audit planning.

1. Send an engagement letter to the client.2. Tour the client’s plant and offices.3. Compare key ratios for the company to industry competitors.4. Review management’s risk management controls and procedures.5. Identify potential related parties that may require disclosure.6. Review the corporate charter and bylaws.7. Identify whether any specialists are required for the engagement.8. Review accounting principles unique to the client’s industry.9. Determine the likely users of the financial statements.

For each procedure, indicate which of the first four parts of audit planning the procedureprimarily relates to: (1) accept client and perform initial audit planning; (2) understand theclient’s business and industry; (3) assess client business risk; (4) perform preliminaryanalytical procedures.

8-29 (Objective 8-3) Generally accepted accounting principles set certain requirements fordisclosure of related parties and related party transactions. Similarly, the SASs setrequirements for the audit of related parties and related party transactions. For thisproblem, you are expected to research appropriate SFASs and SASs.

a. Define related party as used for generally accepted accounting principles and explainthe disclosure requirements for related parties and related party transactions.

b. Explain why disclosure of related party transactions is relevant information fordecision makers.

c. List the types of related parties who are most likely to be involved in related partytransactions.

d. List several different types of related party transactions that can take place in a company.

e. Discuss ways the auditor can determine the existence of related parties and relatedparty transactions.

f. For each type of related party transaction, discuss different ways the auditor canevaluate whether it is recorded on an arm’s-length basis, assuming that the auditorknows the transactions exist.

g. Assume that you know the material related party transactions occurred and weretransacted at significantly less favorable terms than ordinarily occur when business isdone with independent parties. The client refuses to disclose these facts in thefinancial statements. What are your responsibilities?

8-30 (Objective 8-3) The minutes of the board of directors of the Marygold CatalogCompany for the year ended December 31, 2007, were provided to you.

MEETING OF FEBRUARY 15, 2007Ruth Jackson, chairman of the board, called the meeting to order at 4:00 pm. Thefollowing directors were in attendance:

John Aronson Licorine PhillipsFred Brick Lucille RenoldsOron Carlson J. T. SmithHomer Jackson Raymond WerdRuth Jackson Ronald Wilder

The minutes of the meeting of October 11, 2006, were read and approved.Homer Jackson, president, discussed the new marketing plan for wider distribution

of catalogs in the southwestern U.S. market. He made a motion for approval ofincreased expenditures of approximately $500,000 for distribution costs that wasseconded by Wilder and unanimously passed.


Required

Required


The unresolved dispute with the Internal Revenue Service over the tax treatment ofleased office buildings was discussed with Cecil Makay, attorney. In Mr. Makay’sopinion, the matter will not be resolved for several months and may result in anunfavorable settlement.

J. T. Smith moved that the computer equipment that was no longer being used inthe Kingston office, because of new equipment acquired in 2006, be donated to theKingston vocational school for use in their repair and training program. JohnAronson seconded the motion and it unanimously passed.

Annual cash dividends were unanimously approved as being payable April 30,2007, for stockholders of record April 15, 2007, as follows:

Class A common—$10 per shareClass B common—$5 per share

Officers’ bonuses for the year ended December 31, 2006, were approved for paymentMarch 1, 2007, as follows:

Homer Jackson—President $130,000Lucille Renolds—Vice president 60,000Ronald Wilder—Controller 60,000Fred Brick—Secretary-treasurer 45,000

Meeting adjourned 6:30 pm.Fred Brick, Secretary

MEETING OF SEPTEMBER 16, 2007

Ruth Jackson, chairman of the board, called the meeting to order at 4:00 pm. Thefollowing directors were in attendance:

John Aronson Licorine PhillipsFred Brick Lucille RenoldsOron Carlson J. T. SmithHomer Jackson Raymond WerdRuth Jackson Ronald Wilder

The minutes of the meeting of February 15, 2007, were read and approved.Homer Jackson, president, discussed the improved sales and financial condition for

2007. He was pleased with the results of the catalog distribution and cost control forthe company. No action was taken.

The nominations for officers were made as follows:

President—Homer JacksonVice president—Lucille RenoldsController—Ronald WilderSecretary-treasurer—Fred Brick

The nominees were elected by unanimous voice vote.Salary increases of 5%, exclusive of bonuses, were recommended for all officers for

the year 2008. Homer Jackson moved that such salary increases be approved, secondedby J. T. Smith, and unanimously approved.

Salary

2007 2008

Homer Jackson, President $240,000 $252,000Lucille Renolds, Vice president 160,000 168,000Ronald Wilder, Controller 160,000 168,000Fred Brick, Secretary-treasurer 120,000 126,000

Ronald Wilder moved that the company consider adopting a pension/profit-sharing plan for all employees as a way to provide greater incentive for employees tostay with the company. Considerable discussion ensued. It was agreed withoutadoption that Wilder should discuss the legal and tax implications with attorney Cecil



Makay and a CPA firm reputed to be knowledgeable about pension and profit-sharingplans, Able and Better, CPAs.

Ronald Wilder discussed expenditure of $58,000 for acquisition of a new computersystem for the Kingston office to replace equipment that was purchased in 2006 andhas proven ineffective. A settlement has been tentatively reached to return theequipment for a refund of $21,000. Wilder moved that both transactions be approved,seconded by Jackson, and unanimously adopted.

Fred Brick moved that a loan of $360,000, from the Kingston Federal Bank andTrust, be approved. The interest is floating at 2% above prime. The loan iscollateralized by accounts receivable, with the loan balance not to exceed 75% ofcurrent accounts receivable. Seconded by Phillips and unanimously approved.

Lucille Renolds, chair of the audit committee, moved that the CPA firm of Mossand Lawson be selected again for the company’s annual audit and related tax work forthe year ended December 31, 2007. Seconded by Aronson and unanimously approved.

Meeting adjourned 6:40 pm.Fred Brick, Secretary

a. How do you, as the auditor, know that all minutes have been made available to you?

b. Read the minutes of the meetings of February 15 and September 16. Use the followingformat to list and explain information that is relevant for the 2007 audit:

Information Relevant to 2007 Audit Audit Action Required

1.2.

c. Read the minutes of the meeting of February 15, 2007. Did any of that informationpertain to the December 31, 2006, audit? Explain what the auditor should have doneduring the December 31, 2006, audit with respect to 2007 minutes.

8-31 (Objective 8-6) Analytical procedures are an important part of the audit process andconsist of the evaluation of financial information by the study of plausible relationshipsamong financial and nonfinancial data. Analytical procedures may be done duringplanning, as a substantive test, or as a part of the overall review of an audit.

The following are various statements regarding the use of analytical procedures:

1. Not required during this stage.2. Should focus on enhancing the auditor’s understanding of the client’s business and

the transactions and events that have occurred since the last audit date.3. Should focus on identifying areas that may represent specific risks relevant to the

audit.4. Do not result in detection of misstatements.5. Designed to obtain evidential matter about particular assertions related to account

balances or classes of transactions.6. Generally use data aggregated at a lower level than the other stages.7. Should include reading the financial statements and notes to consider the adequacy

of evidence gathered.8. Involve reconciliation of confirmation replies with recorded book amounts.9. Use the preliminary or unadjusted working trial balance as a source of data.

10. Expected to result in a reduced level of detection risk.

For each of the 10 statements, select the stage of the audit for which the statement is mostaccurate using the following responses:

1. Planning the audit2. Substantive testing3. Overall review4. Statement is not correct concerning analytical procedures.*

8-32 (Objectives 8-5, 8-6, 8-7, 8-8) In auditing the financial statements of a manufacturingcompany that were prepared using information technology, the CPA has found that the


Required

Required


traditional audit trail has been obscured. As a result, the CPA may place increased emphasison analytical procedures of the data under audit. These tests, which are also applied inauditing visibly posted accounting records, include the computation of ratios that arecompared with prior-year ratios or with industrywide norms. Examples of analyticalprocedures are the computation of the rate of inventory turnover and the computation ofthe number of days in receivables.

a. Discuss the advantages to the CPA of the use of analytical procedures in an audit.

b. In addition to the computations described, list ratios that an auditor may computeduring an audit on balance sheet accounts and related income accounts. For each ratiolisted, name the two (or more) accounts used in its computation.

c. When there has been a significant change in a ratio when compared with the pre -ceding year, the auditor considers the possible reasons for the change. Give thepossible reasons for the following significant changes in ratios:(1) The rate of inventory turnover (ratio of cost of sales and average inventory) has

decreased from the preceding year’s rate.(2) The number of days’ sales in receivables (ratio of average daily accounts receivable

and sales) has increased over the prior year.*

8-33 (Objectives 8-3, 8-7, 8-8) Your comparison of the gross margin percent for JonesDrugs for the years 2004 through 2007 indicates a significant decline. This is shown by thefollowing information:

2007 2006 2005 2004

Sales (thousands) $14,211 $ 12,916 $ 11,462 $10,351CGS (thousands) 9,223 8,266 7,313 6,573_______ _______ _______ _______Gross margin $ 4,988 $ 4,650 $ 4,149 $ 3,778Percent 35.1 36.0 36.2 36.5

A discussion with Marilyn Adams, the controller, brings to light two possible explana -tions. She informs you that the industry gross profit percent in the retail drug industrydeclined fairly steadily for 3 years, which accounts for part of the decline. A second factorwas the declining percent of the total volume resulting from the pharmacy part of thebusiness. The pharmacy sales represent the most profitable portion of the business, yet thecompetition from discount drugstores prevents it from expanding as fast as the nondrugitems such as magazines, candy, and many other items sold. Adams feels strongly that thesetwo factors are the cause of the decline.

The following additional information is obtained from independent sources and theclient’s records as a means of investigating the controller’s explanations:

Jones Drugs ($ in thousands)Industry Gross

________________________________ Profit Percent forDrug Cost of Nondrug Cost of Retailers of Drugs

Drug Sales Nondrug Sales Goods Sold Goods Sold and Related Products

2007 $5,126 $9,085 $3,045 $6,178 32.72006 5,051 7,865 2,919 5,347 32.92005 4,821 6,641 2,791 4,522 33.02004 4,619 5,732 2,665 3,908 33.2

a. Evaluate the explanation provided by Adams. Show calculations to support yourconclusions.

b. Which specific aspects of the client’s financial statements require intensive investi -gation in this audit?

8-34 (Objectives 8-7, 8-8) In the audit of the Worldwide Wholesale Company, you didextensive ratio and trend analysis. No material exceptions were discovered except for thefollowing:


Required

Required

* AICPA adapted.


1. Commission expense as a percent of sales has stayed constant for several years buthas increased significantly in the current year. Commission rates have not changed.

2. The rate of inventory turnover has steadily decreased for 4 years.3. Inventory as a percent of current assets has steadily increased for 4 years.4. The number of days’ sales in accounts receivable has steadily increased for 3 years.5. Allowance for uncollectible accounts as a percent of accounts receivable has steadily

decreased for 3 years.6. The absolute amounts of depreciation expense and depreciation expense as a

percent of gross fixed assets are significantly smaller than in the preceding year.

a. Evaluate the potential significance of each of the exceptions just listed for the fair pres -entation of financial statements.

b. State the follow-up procedures you would use to determine the possibility of materialmisstatements.

8-35 (Objectives 8-3, 8-5) As part of the analytical procedures of Mahogany Products, Inc.,you perform calculations of the following ratios:

Industry MahoganyAverages Products___________ __________

Ratio 2007 2006 2007 2006

1. Current ratio 3.30 3.80 2.20 2.602. Days to collect receivables 87.00 93.00 67.00 60.003. Days to sell inventory 126.00 121.00 93.00 89.004. Purchases divided by accounts payable 11.70 11.60 8.50 8.605. Inventory divided by current assets .56 .51 .49 .486. Operating income divided by tangible assets .08 .06 .14 .127. Operating income divided by net sales .06 .06 .04 .048. Gross profit percent .21 .27 .21 .199. Earnings per share $14.27 $13.91 $2.09 $1.93

For each of the preceding ratios:

a. State whether there is a need to investigate the results further and, if so, the reason forfurther investigation.

b. State the approach you would use in the investigation.

c. Explain how the operations of Mahogany Products appear to differ from those of theindustry.

8-36 (Objectives 8-3, 8-5, 8-7) Following are the auditor’s calculations of several key ratiosfor Cragston Star Products. The primary purpose of this information is to understand theclient’s business and assess the risk of financial failure, but any other relevant conclusionsare also desirable.

Ratio 2007 2006 2005 2004 2003

1. Current ratio 2.08 2.26 2.51 2.43 2.502. Quick ratio .97 1.34 1.82 1.76 1.643. Times interest earned 3.50 3.20 4.10 5.30 7.104. Accounts receivable turnover 4.20 5.50 4.10 5.40 5.605. Days to collect receivables 86.90 66.36 89.02 67.59 65.186. Inventory turnover 2.03 1.84 2.68 3.34 3.367. Days to sell inventory 179.80 198.37 136.19 109.28 108.638. Net sales divided by tangible assets .68 .64 .73 .69 .679. Profit margin .13 .14 .16 .15 .14

10. Return on assets .09 .09 .12 .10 .0911. Return on equity .05 .06 .10 .10 .1112. Earnings per share $4.30 $4.26 $4.49 $4.26 $4.14

a. What major conclusions can be drawn from this information about the company’sfuture?


Required

Required

Required


b. What additional information would be helpful in your assessment of this company’sfinancial condition?

c. Based on the preceding ratios, which aspects of the company do you believe shouldreceive special emphasis in the audit?

8-37 (Objectives 8-3, 8-4) The Internet has dramatically increased global e-commerceactivities. Both traditional “brick and mortar” businesses and new dot-com businesses usethe Internet to meet business objectives. For example, eBay successfully offers onlineauctions as well as goods for sale in a fixed price format.

a. Identify business strategies that explain eBay’s decision to offer goods for sale at fixedprices.

b. Describe three business risks related to eBay’s operations.

c. Acquisitions by eBay include PayPal, an online payment service, and Skype, aninternet communications company. Discuss possible reasons why eBay made thesestrategic acquisitions.

d. Identify possible risks that can lead to material misstatements in the eBay financialstatements if business risks related to its operations, including recent acquisitions, arenot effectively managed.

CASES8-38 (Objectives 8-2, 8-3, 8-4) Winston Black was an audit partner in the firm of Henson,Davis & Company. He was in the process of reviewing the audit files for the audit of a newclient, McMullan Resources. McMullan was in the business of heavy construction. Blackwas conducting his first review after the field work was substantially complete. Normally,he would have done an initial review during the planning phase as required by his firm’spolicies; however, he had been overwhelmed by an emergency with his largest and mostimportant client. He rationalized not reviewing audit planning information because (1)the audit was being overseen by Sarah Beale, a manager in whom he had confidence, and(2) he could “recover” from any problems during his end-of-audit review.

Now, Black found that he was confronted with a couple of problems. First, he found thatthe firm may have accepted McMullan without complying with its new-client acceptanceprocedures. McMullan came to Henson, Davis on a recommendation from a friend ofBlack’s. Black got “credit” for the new business, which was important to him because itwould affect his compensation from the firm. Because Black was busy, he told Beale toconduct a new-client acceptance review and let him know if there were any problems. Henever heard from Beale and assumed everything was okay. In reviewing Beale’s preauditplanning documentation, he saw a check mark in the box “Contact prior auditors” butfound no details indicating what was done. When he asked Beale about this, she respondedwith the following:

“I called Gardner Smith [the responsible partner with McMullan’s prior audit firm]and left a voicemail message for him. He never returned my call. I talked to TedMcMullan about the change, and he told me that he informed Gardner about thechange and that Gardner said, “Fine, I’ll help in any way I can.” Ted said Gardner sentover copies of analyses of fixed assets and equity accounts, which Ted gave to me. Iasked Ted why they replaced Gardner’s firm, and he told me it was over the taxcontingency issue and the size of their fee. Other than that, Ted said the relationshipwas fine.”

The tax contingency issue that Beale referred to was a situation in which McMullan hadentered into litigation with a bank from which it had received a loan. The result of thelitigation was that the bank forgave several hundred thousand dollars in debt. This was awindfall to McMullan, and they recorded it as a gain, taking the position that it wasnontaxable. The prior auditors disputed this position and insisted that a contingent tax


Required


liability existed that required disclosure. This upset McMullan, but the company agreed inorder to receive an unqualified opinion. Before hiring Henson, Davis as their new auditors,McMullan requested that Henson, Davis review the situation. Henson, Davis believed thecontingency was remote and agreed to the elimination of the disclosure.

The second problem involved a long-term contract with a customer in Montreal. UnderGAAP, McMullan was required to recognize income on this contract using the percentage-of-completion method. The contract was partially completed as of year-end and had amaterial effect on the financial statements. When Black went to review the copy of thecontract in the audit files, he found three things. First, there was a contract summary thatset out its major features. Second, there was a copy of the contract written in French. Third,there was a signed confirmation confirming the terms and status of the contract. The spacerequesting information about any contract disputes was left blank, indicating no suchproblems.

Black’s concern about the contract was that to recognize income in accordance withGAAP, the contract had to be enforceable. Often, contracts contain a cancellation clausethat might mitigate enforceability. Because he was not able to read French, Black couldn’ttell whether the contract contained such a clause. When he asked Beale about this, sheresponded that she had asked the company’s vice president for the Canadian division aboutthe contract and he told her that it was their standard contract. The company’s standardcontract did have a cancellation clause in it, but it required mutual agreement and couldnot be cancelled unilaterally by the buyer.

a. Evaluate and discuss whether Henson, Davis & Company complied with generallyaccepted auditing standards in their acceptance of McMullan Resources as a newclient. What can they do at this point in the engagement to resolve deficiencies if theyexist?

b. Evaluate and discuss whether sufficient audit work has been done with regard toMcMullan’s Montreal contract. If not, what more should be done?

c. Evaluate and discuss whether Black and Beale conducted themselves in accordancewith generally accepted auditing standards.

8-39 (Objectives 8-3, 8-4, 8-7) Solomon is a highly successful, closely held Boston,Massachusetts, company that manufactures and assembles automobile specialty parts thatare sold in auto parts stores in the East. Sales and profits have expanded rapidly in the pastfew years, and the prospects for future years are every bit as encouraging. In fact, theSolomon brothers are currently considering either selling out to a large company or goingpublic to obtain additional capital.

The company originated in 1980 when Frank Solomon decided to manufacture tooledparts. In 1995, the company changed over to the auto parts business. Fortunately, it hasnever been necessary to expand the facilities, but space problems have recently becomesevere and expanded facilities will be necessary. Land and building costs in Boston arecurrently extremely inflated.

Management has always relied on you for help in its problems because the treasurer issales-oriented and has little background in the controllership function. Salaries of allofficers have been fairly modest in order to reinvest earnings in future growth. In fact, thecompany is oriented toward long-run wealth of the brothers more than toward short-runprofit. The brothers have all of their personal wealth invested in the firm.

A major reason for the success of Solomon has been the small but excellent sales force.The sales policy is to sell to small auto shops at high prices. This policy is responsible forfairly high credit losses, but the profit margin is high and the results have been highlysuccessful. The firm has every intention of continuing this policy in the future.

Your firm has been auditing Solomon since 1990, and you have been on the job for thepast 3 years. The client has excellent internal controls and has always been cooperative. Inrecent years, the client has attempted to keep net income at a high level because ofborrowing needs and future sellout possibilities. Overall, the client has always beenpleasant to deal with and willing to help in any way possible. There have never been anymajor audit adjustments, and an unqualified opinion has always been issued.


Required


In the current year, you have completed the tests of the sales and collection area. Thetests of controls and substantive tests of transactions for sales and sales returns andallowances were excellent, and extensive confirmations yielded no material misstatements.You have carefully reviewed the cutoff for sales and for sales returns and allowances andfind these to be excellent. All recorded bad debts appear reasonable, and a review of theaged trial balance indicates that conditions seem about the same as in past years.

a. Evaluate the information in the case (see below) to provide assistance to managementfor improved operation of its business. Prepare the supporting analysis using anelectronic spreadsheet program (instructor option).

b. Do you agree that sales, accounts receivable, and allowance for doubtful accounts areprobably correctly stated? Show calculations to support your conclusion.

12-31-07(Current Year) 12-31-06 12-31-05 12-31-04

Balance Sheet

Cash $ 49,615 $ 39,453 $ 51,811 $ 48,291Accounts receivable 2,366,938 2,094,052 1,756,321 1,351,470Allowance for doubtful accounts (250,000) (240,000) (220,000) (200,000)Inventory 2,771,833 2,585,820 2,146,389 1,650,959Current assets 4,938,386 4,479,325 3,734,521 2,850,720Fixed assets 3,760,531 3,744,590 3,498,930 3,132,133Total assets $8,698,917 $8,223,915 $7,233,451 $5,982,853Current liabilities $2,253,422 $2,286,433 $1,951,830 $1,625,811Long-term liabilities 4,711,073 4,525,310 4,191,699 3,550,481Owners’ equity 1,734,422 1,412,172 1,089,922 806,561Total liabilities and owners’ equity $8,698,917 $8,223,915 $7,233,451 $5,982,853

Income Statement Information

Sales $6,740,652 $6,165,411 $5,313,752 $4,251,837Sales returns and allowances (207,831) (186,354) (158,367) (121,821)Sales discounts allowed (74,147) (63,655) (52,183) (42,451)Bad debts (248,839) (245,625) (216,151) (196,521)Net sales $6,209,835 $5,669,777 $4,887,051 $3,891,044Gross margin $1,415,926 $1,360,911 $1,230,640 $1,062,543Net income after taxes $ 335,166 $ 322,250 $ 283,361 $ 257,829

Aged Accounts Receivable

0 – 30 days $ 942,086 $ 881,232 $ 808,569 $ 674,01431 – 60 days 792,742 697,308 561,429 407,27161 – 120 days 452,258 368,929 280,962 202,634>120 days 179,852 146,583 105,361 67,551Total $2,366,938 $2,094,052 $1,756,321 $1,351,470

INTEGRATED CASE APPLICATION—PINNACLE MANUFACTURING: PART I8-40 (Objectives 8-3, 8-4, 8-5)

Introduction

This case study is presented in six parts. Each part deals largely with the material in thechapter to which that part relates. However, the parts are connected in such a way that incompleting all six, you will gain a better understanding of how the parts of the audit areinterrelated and integrated by the audit process. The parts of this case appear in thefollowing textbook chapters:

• Part I—Perform analytical procedures for different phases of the audit, Chapter 8.• Part II—Understand factors influencing risks and the relationship of risks to audit

evidence, Chapter 9.


Required


• Part III—Understand internal control and assess control risk for the acquisition andpayment cycle, Chapter 10.

• Part IV—Design tests of controls and substantive tests of transactions, Chapter 14.• Part V—Determine sample sizes using audit sampling and evaluate results, Chapter 15.• Part VI—Design, perform, and evaluate results for tests of details of balances, Chapter

16.

Background Information

One of the partners of the CPA firm you work for has engaged a new audit client, PinnacleManufacturing, for the year ended December 31, 2007. Pinnacle is a medium-sizedcorporation, with its headquarters located in Detroit, Michigan. The company is made upof three divisions. The first division, Welburn, has been in existence for 35 years andcreates powerful diesel engines for boats, trucks, and commercial farming equipment. Thesecond division, Solar-Electro, was recently acquired from a high-tech manufacturingfirm based out of Dallas, Texas. Solar-Electro produces state-of-the-art, solar-poweredengines. The solar-powered engine market is relatively new, and Pinnacle’s topmanagement believes that the Solar-Electro division will be extremely profitable in thefuture when highly anticipated EPA regulations make solar-powered engines mandatoryfor certain public transportation vehicles. Finally, the third division, Machine-Tech,engages in a wide variety of machine service and repair operations. This division, also newto Pinnacle, is currently in its second year of operations. Pinnacle’s board of directors hasrecently considered selling the Machine-Tech division in order to focus more on coreoperations—engine manufacturing. However, before any sale will be made, the board hasagreed to evaluate this year’s operating results. Excellent operating results may have theeffect of keeping the division a part of Pinnacle for the next few years. The vice presidentfor Machine-Tech is committed to making it profitable.

PART IThe purpose of Part I is to perform preliminary analytical procedures. You have been askedto focus your attention on two purposes of analytical procedures: assess going concern andindicate where there is an increased likelihood of misstatements.

a. Calculate at least five ratios that are useful to assess going concern using Pinnacle’sfinancial statements, which are included in Figure 8-9 (p. 245). Document the ratiosin a format similar to the following:

Ratio 2007 2006 2005

Current ratio

b. Based on your calculations, assess the likelihood (high, medium, or low) that Pinnacleis likely to fail financially in the next 12 months.

c. Go to the Pinnacle link on the textbook Web site (www.prenhall.com/arens) and openthe Pinnacle income statement, which is located in the Pinnacle Income Statementworksheet of the Pinnacle_Financials Excel file. Use the income statement infor -mation to prepare a common-size income statement for all three years. See Figure 8-7(p. 227) for an example. Use the information to identify accounts for which youbelieve there is a concern about material misstatements. Use a format similar to thefollowing:

Estimate of $ AmountAccount Balance of Potential Misstatement

d. Use the three divisional income statements in the Pinnacle_Financials Excel file onthe Web site to prepare a common-size income statement for each of the threedivisions for all three years. Each division’s income statement is in a separate


Required


worksheet in the Excel file. Use the information to identify accounts for which youbelieve there is a concern about material misstatements. Use a format similar to theone in requirement c.

e. Explain whether you believe the information in requirement c or d provides the mostuseful data for evaluating the potential for misstatements. Explain why.

f. Your aging analysis of accounts receivable and discussions with management indicatethat collections of accounts receivable have been somewhat slower than in theprevious year. Evaluate whether or not you believe the allowance for uncollectibleaccounts is fairly valued. If you believe the account is misstated, calculate the potentialmisstatement.


Pinnacle Manufacturing CompanyIncome Statement

For the Year ended December 31

Net salesCost of goods sold

Gross profitOperating expenses

Income from operationsOther revenues and gainsOther expenses and lossesIncome before income tax

Income taxNet income for the yearEarnings per share

$ 149,245,176104,807,96644,437,21038,265,7086,171,502

— 1,897,3464,274,1561,013,7453,260,411

3.26

2007

$ 137,579,66496,595,90840,983,75634,985,2935,998,463

— 2,128,9053,869,5581,399,0012,470,557

2.47

2006

$ 125,814,27288,685,36137,128,91132,383,5724,745,339

— 2,085,1772,660,1621,166,5531,493,609

1.49

2005

Pinnacle Manufacturing CompanyBalance Sheet

As of December 31

AssetsCurrent assets

Cash and cash equivalentsNet receivablesInventoryOther current assets

Total current assetsProperty, plant and equipmentTotal assets

LiabilitiesCurrent liabilities

Accounts payableShort/current long-term debtOther current liabilities

Total current liabilitiesLong-term debtTotal liabilities

Stockholders’ equityCommon stockAdditional paid-in capitalRetained earningsTotal stockholders’ equityTotal liabilities & stockholders’ equity

$ 6,714,1569,601,883

28,031,323149,807

44,497,16958,489,606

$ 102,986,775

$ 11,277,98812,935,495

1,712,67525,926,15821,234,86147,161,019

1,000,00013,667,51741,158,23955,825,756

$ 102,986,775

$ 6,369,4317,495,528

22,206,259124,527

36,195,74553,596,113

$ 89,791,858

$ 8,200,0597,868,4071,536,835

17,605,30119,427,83137,033,132

1,000,00013,667,51738,091,20952,758,726

$ 89,791,858

$ 7,014,3876,901,225

21,975,220114,558

36,005,39050,668,463

$ 86,673,853

$ 6,466,4128,411,0171,463,088

16,340,51719,460,80035,801,317

1,000,00013,667,51736,205,01950,872,536

$ 86,673,853

2007 2006 2005

FIGURE 8-9 Pinnacle Manufacturing Financial Statements


ACL PROBLEM8-41 (Objectives 8-5 and 8-7) This problem requires the use of ACL software, which isincluded in the CD attached to the text. Information about installing and using ACL andsolving this problem can be found in Appendix, pages 859–863. You should read all of thereference material preceding instructions about “Quick Sort” before locating the appropriatecommand to answer questions a-c. For this problem use the “Inventory” file in the“Inventory_Review” subfolder under tables in Sample_Project. The suggested command orother source of information needed to solve the problem requirement is included at the end ofeach question.

a. Obtain and print statistical information for both Inventory Value at Cost and MarketValue. Determine how many inventory items have positive, negative, and zero values forboth Inventory Value at Cost and Market Values. (Statistics)

b. Use Quick Sort Ascending and Descending for both Inventory Value at Cost and MarketValue. (Quick Sort) Use this information and the information from part a to identify anyconcerns you have in the audit of inventory.

c. Calculate the ratio of Inventory Value at Cost to Market Value and sort the result fromlow to high. (Computed Fields and Quick Sort) Identify concerns about inventoryvaluation, if any.

INTERNET PROBLEM 8-1: OBTAIN CLIENT BACKGROUND INFORMATIONReference the CW site. Planning is one of the most demanding and important aspects of anaudit. A carefully planned audit increases auditor efficiency and provides greater assurancethat the audit team addresses the critical issues. Auditors prepare audit planningdocuments that summarize client and industry background information and discussaccounting and auditing issues related to the client’s financial statements.

Your assignment is to find and document information for inclusion in the auditplanning memorandum. Obtain the necessary information by downloading a publiccompany’s most recent annual report from its Web site (the company will be selected byyou or your instructor). You may also use other sources of information such as recent 10-Kfilings to find additional information. You should address the following matters in fourbrief bulleted responses:

• Brief company history.• Description of the company’s business (for example, related companies, competitors).• Key accounting issues identified from a review of the company’s most recent annual

report. (Note: Do not concentrate solely on the company’s basic financial statements.Careful attention should be given to Management’s Discussion and Analysis as well asthe Footnotes.)

• Necessary experience levels (that is, years of experience, industry experience) requiredof the auditors to be involved in the audit.



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