Solutions for Chapter 10

Auditing Revenue and Related Accounts

Review Questions:

10-1. The cycle or process approach involves organizing the audit around related activities. This approach results in an effective yet efficient audit. When auditing sales transactions, for example, the auditor is also considering the impact on accounts receivable or cash.

10-2. The major accounts included in the revenue cycle are:

Sales Sales-Related Expenses and Liabilities:

o Sales Returns & Allowanceso Warranty Expense and Liabilityo Salesperson Commissions

Accounts Receivable Allowance for Doubtful Accounts Doubtful Accounts Expense Cash

Understanding the relationships between the accounts allows the auditor to develop a more efficient audit approach. As shown in Figure 10.1, the credit to sales and the debits to either accounts receivable or cash are directly related. The sales-related expenses (or liabilities) are directly tied to the sales figure. For example, most companies will make an estimate of the warranty expense liability based on a percentage of sales and will then adjust the expense and liability as experience dictates. Similarly, salesperson commissions may be directly computed as a percentage of net sales. The provision for doubtful accounts directly affects doubtful accounts expense. Write-offs of uncollectible accounts directly affects accounts receivable and the allowance for doubtful accounts.

10-3. For the accounts receivable account, the more relevant assertions are typically existence and valuation. While the auditor will likely gather evidence related to each of the assertions for accounts receivable, the more relevant assertions are the ones where there is higher risk of misstatement and for which the auditor will likely need more evidence. Identifying which assertions are more relevant helps the auditor plan a more efficient audit by having the auditor focus more attention on the assertions where there are more risks.

11-4 The major activities involved in generating and recording of a sales transaction and related documents include:

Activities Documents Generated1. Receipt of customer purchase order or

generation of sales order based on customer inquiry.

1. Purchase order (from customer) or sales order.

2. Inquiry of current inventory status. 2. No document. Response is made to inquiry.

3. Generation of backorder (where applicable and desired by customer).

3. Backorder confirmation sent to customer.

4. Credit approved for shipment. 4. Confirmation number or formal signature to sales person for entry on sales order.

5. Shipping and packing instructions and documents prepared.

5. Packing slips. Inventory picking tickets. Shipping instructions.

6. Shipping department records goods shipped and sends verification back to billing for generation of invoice.

6. Bill of lading (shipping document given to shipper).

Packing slip or some similar document used to capture shipping information to send back to billing function.

7. Preparation of invoice. 7. Invoice

8. Monthly statement sent to clients. 8. Monthly statement of open items

9. Payment is received. 9. Turnaround document or another document prepared to list payments received.

10-5. Revenue recognition should ordinarily be considered a fraud risk factor because over half of frauds that have been studied involved improper revenue recognition by either recognizing revenue early or recording fictitious revenue.

10-6. The SEC staff has determined that the following criteria must be met before revenue can be recognized:

Persuasive evidence of an arrangement exists, Delivery has occurred or services have been rendered, The seller’s price to the buyer is fixed or determinable, and

Collectibility is reasonably assured.

Research may be required for sales arrangements that are out of the ordinary. The SEC and AICPA have published documents that provide criteria for recognition of such revenue transactions.

10-7. Recent fraud investigations undertaken by the SEC uncovered a wide variety of methods used to inflate revenue:

Recognition of revenue on shipments that never occurred. Hidden “side letters” giving customers an irrevocable right to return the product. Recording consignment sales as final sales. Early recognition of sales that occurred after the end of the fiscal period. Shipment of unfinished product. Shipment of product before customers wanted or agreed to delivery. Creation of fictitious invoices. Shipment to customers that did not place an order. Shipment of more product than the customer ordered. Recording shipments to the company’s own warehouse as sales. Shipping goods that have been returned and recording the reshipment as a sale of new

goods before issuing credit for the returned sale.

10-8. There are many reasons management may report higher profits by overstating revenue. Bankruptcy may be imminent, for example, because of operating losses, technology changes in the industry causing the company’s products to become obsolete, or a general decline in the industry. Executives may be pressured to meet their own or analysts’ earnings expectations. The company may need additional financing. Bonuses or stock options may be dependent on reaching a certain earnings goal. A merger may be pending and management wants to negotiate the highest price possible.

10-9 The auditor can compare the client’s revenue trend with economic conditions and industry trends. Cash flow from operations can be compared with net income over a period of time. Ratio and trend analysis and reasonableness tests can be performed. Some of the ratios the auditor might want to compute include:

Gross margin analysis, including a comparison with industry averages and previous year’s averages for the client.

Turnover of receivables (ratio of credit sales to average net receivables) or the number of days’ sales in accounts receivable

Average balance per customer Receivables as a percentage of current assets Aging of receivables Allowance for uncollectible accounts as a percent of accounts receivable Bad debt expense as a percent of net credit sales Sales in the last month to total sales

Sales discounts to credit sales Returns and allowances as a percentage of sales

Some basic trend analyses include:

Monthly sales analysis compared with past years and budgets, Identification of spikes in sales at the end of quarters or the end of the year, Trends in discounts allowed to customers that exceed both past experience and

industry average.

Reasonableness tests are based on a simple premise: the auditor can gather a great deal of information about the correctness of an account by examining the relationship of the account with some underlying economic factor or event. For example, revenue from room rental for a motel can be estimated using the average room rate and average occupancy rate. Alternatively, the revenue from an electrical utility company should be related to revenue rates approved by a Public Service Commission (where applicable) and demographic information about growth in households and industry in the service area being served.

10-10. The audit steps associated with an integrated audit for the revenue cycle include the following:

1. Continually update information on business risk, including the identification of any fraud risk factors noted during preliminary audit planning. Update audit planning for new risk information.

2. Analyze potential motivations to misstate sales, as well as the existence of other fraud indicators, and determine the most likely method that sales might be misstated.

3. Perform preliminary analytical procedures to determine if unexpected relationships exist in the accounts, and document how the audit testing should be modified because of the unusual relationships.

4. Develop an understanding of the internal controls in the revenue cycle that are designed to address the risks identified in the three previous steps, including the applicability of entity-level controls to the revenue cycle. This understanding will include a review of the client’s documentation of internal controls.

5. Determine the important controls that need to be tested for the purposes of (a) formulating an opinion on the entity’s internal controls, and (b) reducing substantive testing for the financial statement audit.

6. Develop a plan for testing internal controls and perform the tests of key controls in the revenue cycle. (For non-public companies, the auditor can choose to not

test controls, but must determine where material misstatements could occur if controls are not present.)

7. Analyze the results of the tests of controls.

If deficiencies are identified, assess those deficiencies to determine whether they are significant deficiencies or material weaknesses. Determine whether the preliminary control risk assessment should be modified (should control risk be assessed at a higher level) and document the implications for substantive testing. Determine the impact of these deficiencies, and any revision in the control risk assessment, on planned substantive audit procedures by determining the types of misstatements that are most likely to occur.

If no control deficiencies are identified, assess whether the preliminary control risk assessment is still appropriate, determine the extent that controls can provide evidence on the correctness of account balances, and then determine planned substantive audit procedures. The level of substantive testing in this situation will be less than what is likely required in circumstances where deficiencies in internal control were identified.

8. Perform planned substantive procedures (substantive analytical procedures and direct tests of account balances) based on the potential for misstatement and the information gathered about the effectiveness of internal controls. The substantive procedures will include procedures to address fraud risks.

10-11 For non-public companies, the auditor can choose to not test controls, but must still have an understanding of the client’s controls and determine where material misstatements could occur if controls are not present. The audit will be based solely on substantive procedures. Most likely, the majority of the evidence will come from direct tests of account balances and transactions rather than substantive analytics. The auditor will not obtain any evidence related to the operating effectiveness of controls.

10-12. Inherent risks associated with sales include:

Recognizing revenue in the wrong accounting period. The impact of unusual terms, and whether title has passed to the customer. Goods recorded as sales have been shipped and were new goods. The proper treatment of sales transactions made with recourse or that have an

abnormal or unpredictable amount of returns.

The primary risk associated with receivables is that the net amount shown is not collectible, either because the recorded receivables do not represent bona fide claims or there is an insufficient allowance for uncollectible accounts. Other risks affecting receivables include:

Sales of receivables made with recourse and recorded as sales transactions rather

than financing transactions. Receivables pledged as collateral against specific loans with restricted use.

Disclosures of such restrictions are required.Collection of a receivable is contingent on specific events that cannot currently be

estimated.

10-13. The organization’s control environment greatly affects revenue and related transactions. The auditor must consider:

the integrity of management, the financial condition of the organization, the financial pressures facing the organization, and management incentives to achieve various financial goals.

Some companies create high expectations and may not pay much attention to how the goals are achieved, but rather whether they are achieved. Similarly, representations to the financial press by management or stock analysts regarding performance expectations create incentives to meet those expectations, because failure to do so can cause the company’s stock price to drop.

10-14. Sending monthly statements and establishing a separate group to handle customer inquiries enhances controls as follows:

Each customer receives a statement and can verify the statement for accuracy and timeliness of the client's update of records. The customer has a basis to follow-up on potential errors in the accounts, such as failure to post a payment or a dispute about returned merchandise.

Establishing a separate group to handle customer inquiries creates a segregation of duties. The individuals handling customer inquiries and following up to reach a proper disposition of customer complaints do not handle cash or have access to the normal recording of accounts receivable. The group thus acts as a double check on the accuracy of the normal accounts receivable processing.

10-15. Monitoring controls that may be effective in the revenue cycle include:

Comparison of sales and cost of sales with budgeted amounts, (Risk of fictitious sales, or sales recorded before cost of sales)

Exception reports to management for unusual transactions or dollar amounts. Such reports are investigated and corrective action, if needed, is taken. (Risk that inappropriate items are authorized, or there is override of other controls),

Computer generation of transaction volumes that exceed pre-specified norms. (Risk that normal controls built into the computer process fails).

Internal audit of the revenue cycle and applicable controls (Risk that normal controls fail to operate).

Review by divisional and departmental management of internal controls and the quality of exception reports for management decision making. (Risk that exception reports are not analyzed for the source of the problem, and that corrective action is taken on a timely basis),

Computer reports reconciling all transactions entered into the system with transactions processed. (Risk: inappropriate items are processed, or some items are processed more than once).

Monitoring of accounts receivable for quality, e.g. aging of accounts receivable by quality of the customer as assigned by an outside rating service. (Risk: overstatement of accounts receivable)

Periodic computer reports of all transactions processed that exceed previously stated edit rules, (for example, a scarf report.) (Risk: there was an override of normal edit controls).

Independent follow-up of customer complaints. (Risk: normal controls have failed that would have been brought to the company’s attention by customer complaints).

10-16. Auditors often debate this question. Many auditors believe that a minimum amount of re-performance of the control is necessary in some instances in order to determine that the person performing the control actually performed the procedure indicated. In other words, the person did not simply initial the document. The auditor gathers evidence through re-performance that the control was operating effectively.

Other auditors believe that controls are independent and the auditor can judge the general conscientiousness with which employees carry out their duties. If the employees appear to be conscientious, there would be no need to re-perform the procedures unless there is evidence generated through substantive tests or otherwise, that the control procedures are not operating effectively. Instead of testing controls through re-performance, the auditors would use some set of tests comprising inquiry, observation, and/or examination of documentation

The authors’ position is that some minimal amount of re-performance is necessary in areas where there are higher risks of misstatement. In lower risk areas, some set of tests comprising inquiry, observation, and/or examination of documentation may be sufficient. The extent of re-performance may be dependent on the auditor's assessment of the overall control environment, including the conscientiousness with which employees carry out their functions. While re-performance is a very effective test, it is also more costly to perform than other testing procedures. The auditor needs to balance the costs of gathering the evidence with the risk of misstatement.

10-17. Typical tests of controls include inquiry of personnel performing the control, observation of the control being performed, examination of documentation confirming that the control has been performed, and reperformance of the control. The tests could be either manual or automated. Some examples of tests of controls include:

Manual testing—Take a sample of recorded transactions and determine that the control policies and procedures were followed. This is an example of examination of documentation.

Computerized testing of computer controls—Test controls used to limit access to the computer files, select a number of prices in the system and reconcile to pre-authorized price changes. This is an example of examination of documentation.

Testing of Monitoring controls—Management should have controls in place to assist them in monitoring sales. For example, management may have set targets for gross profit by product line and receive weekly reports on actual results. Management may then investigate any reports that deviate from expected results to determine if the deviation is due to cost problems or miss-pricing of the sales. The auditor can discuss this testing approach with personnel responsible for this monitoring (inquiry), review these reports (examination of documentation), determine if there were deviations based on the reports (examination of documentation), and determine what actions management took after investigating the problem (inquiry and/or examination of documentation).

10-18. If the risk of material misstatement is assessed low, the auditor can plan less extensive substantive testing, or can be more flexible about when the procedures are applied. If the risk is greater than originally assessed, the auditor will need to adjust the nature, timing, and/or extent of the planned substantive testing. One of the factors impacting the risk of misstatement is the effectiveness of the internal controls. If the internal controls are operating effectively, the auditor will be in a position to plan less extensive substantive testing, or can be more flexible about when the procedures are applied, or can use less rigorous procedures

10-19. Audit procedures are designed to obtain evidence to satisfy a specific audit objective that is developed to address one or more of management's assertions. For example, the auditor confirms accounts receivable to obtain evidence about the audit objective of establishing that the recorded receivables are bona fide claims on customers that, in turn, addresses management's assertion that the receivables exist.

10-20. Evidence obtained about accounts receivable provides evidence about sales and visa versa because of the double entry bookkeeping system. When evidence indicates one half of a sales transaction is properly recorded, the other half is likely to be correct, also. If a customer confirms that the receivables balance is correct, evidence is also provided that the sales, represented by the unpaid invoices in that balance, are also correct.

10-21. A sample of sales transactions should be reprocessed forward and vouched back in examining evidence of internal control effectiveness as well as testing for completeness and existence of sales and accounts receivable. Evidence from this examination can directly affect the nature, timing and extent of other substantive audit tests to be performed. Since so many frauds have involved improper revenue recognition, substantial attention must be given to the audit of revenue as well accounts receivable.

10-22. Auditing revenue provides a good opportunity to test the completeness assertion for both sales and accounts receivable. The auditor is looking for a population that will provide evidence that a sale took place that should have resulted in recording a sale and either an account receivable or cash collection. This related population may be represented by shipping documents, which can take such forms as bills of lading, a manual or computerized shipping log, or copies of sales orders which are initialed after shipment. If the related population is pre-numbered, selecting a sample of transactions from that population and tracing them into the accounting records will provide strong evidence about the completeness of sales and accounts receivable .

10-23. The sample should be selected from the population that represents that sales transactions occurred, usually pre-numbered shipping documents. By selecting a sample from this population and tracing the selected transactions into the sales records, the auditor is able to test whether sales transactions are being recorded.

10-24. For unusual or complex sales transactions, it is advisable to confirm receivables with customer personnel most familiar with unusual sales agreements and ask about any side agreements that could affect revenue recognition. Accounts payable personnel would not be aware of these details.

10-25. Overstatements. This is true because if the balance is overstated, it is included in the physical representation of that balance, such as a list of customer balances, and has a good chance of being selected for testing if it contains a material overstatement. Understatements are less likely to be detected by direct tests of the details that make up an account balance because that understated item is either not on the list or is listed at an amount smaller than it should be and may not be as likely to be included in the sample.

10-26. A lower risk of material misstatement means the auditor can place some reliance on the clients system and does not need to obtain as much comfort from substantive tests. Therefore, the nature, timing, and extent of substantive tests related to accounts receivable are affected in the following ways:

Nature - the auditor may consider using negative rather than positive confirmations.

Timing - the accounts can be confirmed prior to year-end, placing some, but not complete, reliance on the internal control system to bring the receivables balance to year-end accurately.

Extent - if positive confirmations are used, fewer of them need to be sent.

10-27. The advantages are: early consideration can be given to significant matters affecting the year-end

financial statements, such as related party transactions or cutoff problems, the audit may be completed at an earlier date, and the audit staff may work less overtime after year-end.

The disadvantages are: an increased risk of material errors existing in the year-end balances and

possibly a less efficient audit because the total audit time may be greater due to the additional work needed for the roll-forward period to reduce that risk to an acceptable level.

10-28. Individual unpaid invoices may be confirmed to improve the response rate from customers. Customers may not be able or are reluctant to confirm a balance made up of numerous invoices.

10-29. An aged trial balance lists each customer's balance with columns to show the age of the unpaid invoices.

The aged trial balance can be used to select customer balances for confirmation; to identify any amounts due from officers, employees, or other related parties or any non-trade receivables that need to be separately disclosed in the financial statements. The auditor can identify overdue customers' balances. These can be discussed with the credit manager to help determine the adequacy of the allowance for doubtful accounts. Credit balances due customers can be identified and, if significant, they should be reclassified as a liability. Subsequent collections can be noted on the trial balance.

The accuracy of the aged trial balance can be tested by selecting a sample of the customers and review their subsidiary accounts to be sure the aging was done properly. The trial balance should also be footed and cross-footed. The accuracy can often be tested using generalized audit software.

10-30. Positive confirmations are letters sent to selected customers asking them to sign and return the letters directly to the auditor whether or not they agree with the indicated balance. Negative confirmations request the customer to respond directly to the auditor only if they disagree with the indicated balance.

10-31. Positive confirmations are considered to be more reliable for two basic reasons. (1) The assumption that a negative confirmation that is not returned represents a correct receivable balance is not always valid. There are a number of reasons it may not be returned, such as the customer lost or ignored it, the difference was in the customer's favor and they did not want this changed, or the customer did not understand the request and threw it away. (2) Follow-up procedures are performed when positive confirmations are not returned to provide some evidence that the receivable exists and is accurate

10-32. a. The auditor should send a second request. If that fails, trace subsequent collections into the records and the checking account; vouch the unpaid invoices to supporting documents, such as customer's order, shipping document, and sales invoice. If the balance is individually significant, the auditor may call the customer or have the client call, to urge them to respond to the confirmation.

b. Usually there is no follow-up on unreturned negative confirmations - they are assumed to represent correct balances. An exception occurs when several customers return negative confirmations indicating they disagree with their balances and the auditor determines the customers are correct. This is an indication that the controls

were not as effective as assessed and the auditor may decide it is necessary to perform follow-up procedures on those that were not returned.

10-33. When the information being sent to the customer is verified by the auditor, the auditor controls the mailing, the confirmations are returned to the auditor's office, not the client's, the information the customers are asked to confirm is objective, and they can verify the information from their own records and not have to call the client to determine what the amounts should be.

10-34. When there are a large number of small balances, the risk of material misstatement is low, and the auditor believes the customers will give proper attention to the auditor's request.

10-35. A confirmation exception is a statement made by a customer on the confirmation response indicating a disagreement with the stated balance. The auditor needs to be sure that the cause of any exception is properly identified as either a client misstatement or a timing difference. Misstatements need to be projected to the entire population of receivables before determining whether there may be a material misstatement in the account balance. Timing differences do not represent misstatements in the account balance.

10-36. Subsequent collections of unpaid year-end balances provide strong evidence that the receivables existed and were accurate. Some auditors believe this provides stronger evidence than confirmations and, when most of the receivables are collected before the end of the audit, place more reliance on this audit test than on confirmations.

10-37. Cutoff tests are procedures applied to transactions selected from those recorded during the cutoff period (just before and just after the balance sheet date) to provide evidence as to whether the transactions have been recorded in the proper period. They provide evidence about proper cutoff, existence and completeness of the sale and receivable.

10-38. Fraud indicators that might be identified by direct tests of revenue might include:

unusual amounts of sales near the end of the year, sales with unusual terms, sales made to companies with only PO Box numbers, special contract sales,

Audit procedures that could be used to determine if sales are fraudulent include:

year-end cutoff tests, review of major sales contracts, sample of sales made near the end of the year to determine their validity, review of all large dollar value sales taking place near the end of the year, confirmations with customers,

generalized audit software selection and analysis of sales made to common PO box numbers, or to new customers.

10-39. The allowance for doubtful accounts is based on management estimates. A useful test of these estimates is to track the history of annual write-offs and provisions for bad debts. If they were approximately equal over a period of years, these estimates would appear to be reasonable. The provision for bad debts can be recomputed by the auditor using management's formula. The auditor should, however, be alert to circumstances that may cause history to be a bad predictor of current expectations. For example, the credit terms may have been changed or changes in the economy may indicate that the customers are more or less able to pay their accounts than in prior years.

Multiple Choice Questions:

10-40. a.10-41. d.10-42. d.10-43. c.10-44. c.10-45. d.10-46. d10-47. b.10-48. c.10-49. a.10-50. c.10-51. a.10-52. c.10-53. b.

Discussion and Research Questions:

10-54. a. The SEC has emphasized that revenue recognition should be based on two key concepts:

Earned, i.e. the revenue earning process has been completed, and Realizable, i.e. the amounts recognized are likely to be realized.

The SEC has determined the following criteria must be met in applying the concept:

Persuasive evidence of an arrangement exists, Delivery has occurred or services have been rendered, The seller’s price to the buyer is fixed or determinable, Collectibility is reasonably assured.

b. Scenarios

Scenario Key Issues Additional Information Revenue Recognition and Criteria

1. AOL AOL proposes to recognize 30% of the fees up front rather than from monthly service.

Pattern of payments, % of customers failing to meet contract terms.

Recognize revenue on a monthly basis as the provision of the service is the primary service being performed. AOL wants to recognize the marketing of the product as a primary service, but marketing is a precursor to the actual service performed.

2. Bill and Hold

Machinery is completed. Request is by customer to hold the machinery because factory is not finished.

Contract – right of refusal.Whether the customer has inspected the goods.Expected delivery date.Credit rating of customer and validity of customer.

If all the evidence gathered verifies the client story and the customer is a valid customer, an argument can be made for current recognition.

3. Determine adequate allowance for returns.

New product. The client must be able to reasonably estimate the amount of goods that will be returned. Affects both sales and receivables.

Sales made to date.

Returns made to date.

Analysis of returns by client, i.e. customer dissatisfaction, problems with product quality, etc.

It is appropriate to recognize the sales if an adequate allowance for returns and uncollectible receivables can be estimated.

4. Omer, Tech. Possibility of Channel Stuffing.

Should revenue be recognized because of the special discounts and unusually large end of year sales?

The auditor should search for the existence of ‘side deals’ that might allow the customer to return goods.

Review returns subsequent to year-end.

Confirm terms of sales and receivables with major customers with unpaid year-end balances.

Revenue is earned and realizable if no unusual rights of return exist; including no unusual ‘side deals’ with customers.

5. Electric City

Goods are placed at customer’s location on a pilot test. The pilot period may last as long as 6 months. Since most of the placements result

History of sales after pilot tests.

Sales contract and right of return.

It is difficult to recognize revenue when the product is placed at a customer’s location for evaluation. The promotion does not seem to meet the SEC’s two

Scenario Key Issues Additional Information Revenue Recognition and Criteria

in a sale, the client wants to recognize revenue when the goods are placed at the client’s location.

Realizability of past sales; examine receivables.

criteria.

6. Jackson Products

Company phased out line of business and sold most of the manufacturing equipment. Should the sale of the equipment be recognized as revenue?

Confirm management intent and business plan.

Determine terms of the equipment sale.

If the company is remaining in its original line of business, or a similar line, then revenue should be recognized by producing and selling those products; not by selling machinery. The machinery should be sold and a separate line item should be established to recognize the gain/loss on sale of equipment.

10-55a. The most telling analytical results are

The significant increases in number of day’s sales in receivables and inventory from 2009. They are also significantly higher than their major competitor in 2010.

The percent increases in receivables (106%) and inventory (60%) in 2010 far exceed the increases in sales (9%).

The number of day’s sales in receivables (29) does not make sense given that the banks usually pay within two weeks of shipment.

In prior years, the number of day’s sales in receivables and inventory had remained very stable and compared favorably with their competitor and their customers’ banks payment time-line. The 2010 results are obviously unexpected and indicate potential problems with receivables and inventory.

b Possible explanations are: Recording fictitious sales near year-end. Building up inventory in anticipation of an employees’ strike. Making sales closer to year-end than in prior years. Shipping more boats near year-end than customers ordered. Recording fictitious inventory.

c. Inquiries and follow-up procedures include: Inquiring of management about a possible strike or other factors that might

explain the increases in receivables and inventory.

Vouching sales recorded near year-end to supporting customer orders and shipping records to be sure they are legitimate, agree with customer order quantities, and are recorded in the proper accounting period.

Verifying that the receivable subsidiary records agree with the control account balance.

Expanding confirmation and subsequent collection work. Verifying that the inventory records agree with the control account balance. Insist on a complete physical inventory at or near year-end and carefully

observing the inventory and making test counts to compare with the client’s counts, especially for the high-dollar items.

Carefully reviewing journal entries made prior to year-end closing.

d. This case is based on an actual situation in which one of the author’s was involved. The CFO had embezzled several millions of dollars of cash by having checks drawn on the company’s regular cash account for deposit in another cash account the CFO was able to control. These checks required dual signatures – the CFO’s and the CEO’s. Unfortunately the CEO trusted the CFO and did not question the purposes of these checks he signed. The CFO then recorded journal entries just before year-end debiting receivables and inventory and crediting cash.

10-56.

a. This cross-sectional analysis can be performed using either Excel (or compatible spreadsheet) or ACL.

Using Excel:1. Download the FloorMart data file from the web site

http://www.cengage.com/accounting/rittenberg.2. Add two columns for each store:

a. Calculate Inventory per square footb. Calculate Sales per square foot

3. Sort the Inventory per square foot column in descending sequence.4. Sort the Sales per square foot column in descending sequence.5. Note in steps 3 and 4, stores 121 and 122 are significantly greater than the rest

of the stores.

Store Inventory / Square Foot Sales / Square Foot121 14.10 297.86122 12.15 346.96Next largest 8.30 207.51

Using ACL:1. Download the FloorMart data file from the textbook web site and import it

into ACL. http://www.cengage.com/accounting/rittenberg.2. Add two columns using the Expr… Inventory / Sq Ft and Sales / Sq Ft.

3. Sort each of those new columns in descending order. The results are the same as above.

b. Special attention needs to be paid to these two stores. Some of the audit steps would be:

1. Inquire of corporate management about these two stores and their managers. Have they had any problems with them in the past? Are they aware of any fraud at these stores? Do these stores usually perform better than the other stores? Why?

2. Have the internal auditors investigated the controls at these stores? If so, review their working papers and inquire of the internal auditors about their findings.

3. Compare current year results with prior years for these two stores.4. Include these two stores with other stores selected and observe the physical

inventory procedures and make test counts of the inventory at these two stores. The client likely uses perpetual inventory records and takes a physical inventory at different times of the year at different stores. The client should require that the physical inventory at these two stores be taken at or near year-end.

5. Review the cutoff of sales transactions. Since the auditor will be on the premises at or near year-end, the cash register tapes should be compared with the recorded sales to be sure they are recorded in the proper period.

10-57. a. The change in sales person commission is very important because it changes the emphasis of the sales person to making sales with little regard for credit, quality, or other issues that affect the long-term profitability of the company. Specifically, the change:

Negates sales returns as an important compensation factor, Takes out realizability, i.e. the sales commission is not affected by whether

the customer pays, There is no penalty for selling poor quality products. A commission is granted

even if the product quality is poor.

The auditor should carefully review sales returns and allowances and cash collections after year end, comparing them to prior years. The allowance for doubtful accounts balance likely will need to be a higher percent of receivables than in prior years. Therefore, the auditor must be sure the allowances appears reasonable in light of likely sales to less credit-worthy customers. An allowance for sales returns may need to be established if it appears returns are materially higher in early 2011 than in prior years.

b. Analytical information: % Change from Prior Year

2007 2008 2009 2010Sales 0.10 0.08 0.11 0.24

Net Income 0.36 0.11 0.24 0.31Stock Price 0.41 -0.21 0.47 0.68Economic Growth in Areas Served 0.04 0.05 0.04 0.01Percent of Heating Market by SSS 0.06 0.02 0.13 0.30Accounts Receivable -0.06 0.15 0.07 0.41Gross Margin 0.01 0.02 0.01 0.15

Insights:The percent increase in sales was over twice that of previous years.Net income increased by a greater percentage than did sales or gross margin.The economic growth index remained basically unchanged from the previous year.The percent increase in market share was greater than the percent increase in sales. The percent of sales in the last quarter of the year was higher than in previous years. The gross margin percent increased significantly. It had remained fairly constant in the three previous years.The number of day’s sales in receivables increased 14% over 2009.

c. The auditor is often interested in looking at the stock price because:

The stock price impounds information that the market has about the company. In other words, the market may know something about the company (especially problems) that the auditor may not have discovered.

The market is an indication of expectations and perhaps of motivations by management to meet pre-determined performance objectives.

d. There are a number of factors that are high fraud risk indicators including:

Motivation – the changes in the sales person commission plan provides significant motivations for fraud. The sales person also has more power to negotiate prices.

Financial Changes:o Gross margin is increasing.o Market share is increasing.o Stock price has more than doubled in the past two years.o Accounts receivable are growing faster than the market and faster than

sales.o It is doubtful that the client has actually reduced administrative

expense.

e. Specific audit procedures that might be performed include:

Confirm accounts receivable using PPS sampling and positive confirmations. Schedule all receivables collections subsequent to year-end. Review returns made during the last quarter and the first part of the

subsequent year to better develop an estimate of returns. Take a statistical sample of sales and:

o Review the sales contract,o Review subsequent collection or return of goods from the sale,

Use GAS to analyze sales commission by sales person. Investigate the pattern of sales made to customers by the highest commission sales people. Determine whether the customers paid for the sale.

Compare results – especially growth and profitability with competitors in the industry and area.

Perform cutoff tests at year-end. Examine sales invoices for a sample of sales made in the last quarter.

Determine validity of sale and the realizability of the receivable.

10-58.

Objective of Audit Test:

a. Determine that all goods that were shipped were billed in the proper time period. In addition, the auditor will normally test for the effectiveness of control procedures, such as proper credit authorization and correctness of billing when selecting a sample such as described. Thus, the auditor will usually use the sample selected as basis to perform dual-purpose tests. Completeness.

b. Determine that only authorized prices changes are made to the computerized price list thus indirectly addressing the assertion that all invoices are properly billed at authorized prices. Valuation.

c. Determine that invoiced amounts are correctly computed. Valuation.

d. Determine that credit is authorized in accordance with company policy. In addition, when reviewing the credit policy, the auditor can make a determination as to the sufficiency of the policy in minimizing potential bad debts. That is, it is not sufficient to determine only that the company complies with an authorization policy: the auditor must also determine that the policy is well conceived. Valuation.

e. Determine that all goods that were shipped were billed. Completeness.

f. Determine that all recorded invoices are valid and are supported by independent shipping documents providing evidence of shipment. Existence.

10-59.

1. C. Invoices posted to incorrect customer accounts will be detected by analyzing customer responses to monthly statements that include errors, particularly statements with errors not in favor of the customer.

2. G. The comparison of shipping documents with sales invoices will detect goods that have been shipped but not billed when no sales invoice is located for a particular shipping document.

3. F. To provide assurance that all invoiced goods that have been shipped are recorded as sales, daily sales summaries should be compared with invoices. For example, a sale that has not been recorded will result in a sales summary that does not include certain sales invoices.

4. K. A comparison of the amounts posted to the accounts receivable ledger with the control total for invoices will provide assurance that all invoices have been posted to a customer account.

5. I. Comparing customer orders with an approved customer list will provide assurance that credit sales are made only to customers that have been granted credit.

6. B. Requiring an approved sales order before goods are released from the warehouse will provide assurance that goods are not removed for unauthorized orders.

7. D. A comparison by shipping clerks of goods received from the warehouse with the approved sales orders will provide assurance that goods shipped to customers agree with goods ordered by customers.

8. L. A comparison of sales invoices with shipping documents and approved sales orders will detect invoices that do not have the proper support. Accordingly, it will help prevent the recording of fictitious transactions.

9. P. Comparing amounts posted to the accounts receivable ledger with the validated bank deposit will detect improper postings to accounts receivable since any differences in amounts will be investigated.

10. C. Misappropriations of customer’s checks will be detected when customers indicate that they have made payments for items shown as payable on their monthly statement. Note that replies O and P will only detect this misappropriation in the unlikely event that the perpetrator does not dispose of the remittance advice.

11. C. Miss-postings of payments made will be detected when customers indicate that they have made payments for items shown as payable on their monthly statement.

12. P. Crediting more than one account for a cash receipt will be detected when the total of amounts posted to the accounts receivable ledger is compared with the validated bank deposit slip.

13. S. An independent reconciliation of the bank account will reveal improper total recording of receipts in the cash receipts journal because unlocated differences between bank and book balances will occur and be investigated.

14. P. Comparing total amounts posted to the accounts receivable ledger with the validated bank deposit will detect a difference between total cash receipts and the amount credited to the accounts receivable ledger.

15. N. Requiring the approval of the supervisor of the sales department for goods received will provide assurance that invalid transactions granting credit for sales returns are not recorded. Note that using prenumbered credit memos (reply M) will only be effective if the sequence is accounted for and if credit memos may be compared in some form to actual returns.

10-60.

a. Areas of Inherent Risk: b. Audit Procedures to Address Risk Areas:

1. The company has changed auditors. Contact the predecessor audit firm to determine their understanding of the reason for the change.

As part of the process of accepting the engagement, inquire about the integrity of management and financial pressures facing the firm. Ensure that all auditors understand these factors when gathering evidence during the conduct of the audit engagement.

2. There was a dispute with the predecessor auditor regarding the recognition of income on goods that had not been shipped.

Inquire of management as to the nature of the dispute and the firm's current policy regarding the recognition of income from items not shipped.

Inquire of the predecessor auditor of their understanding of the nature of the transactions and their opinion on the accounting dispute.

Select a sample of invoices to determine the client's approach to recognizing income during

a. Areas of Inherent Risk: b. Audit Procedures to Address Risk Areas:the current period.

Plan the audit approach at year-end to pay special attention to the invoicing of goods not shipped. Plan extra procedures to ensure a proper cutoff of sales is obtained.

3. Current management does not have a long history with the company, but has a reputation as a turn-around artist.

Determine the extent to which stock option plans or bonuses are dependent upon specific levels of achieved performance.

Review articles in the financial press to become aware of predictions made by Mr. Dreason regarding current performance and predicted year-end results for Drea Tech to understand potential pressure to achieve stated results.

4. There is evidence of significant related party transactions.

Inquire as to the nature and extent of related party transactions. The auditor should expand audit work to identify all related parties and investigate any unusual sales transactions to determine if they may be with related parties.

Review all major related party transactions and determine the appropriate financial statement disclosure.

5. Although not a direct sales item, the company has slashed research and development and laid off a number of employees. This could result in a greater number of defective products and returned merchandise.

Review procedures utilized by the company to record the return of merchandise. Determine approach used to adequately identify defective products to determine the status of the product (scrap, close-out, re-work, etc.)

Develop tests to review receipt of returned merchandise near year-end to determine if credit memos have been issued on a prompt basis and in the correct time period.

Investigate the return of merchandise after year-end to determine if the amounts are unusual and would justify an extra allowance for returned merchandise to be recorded.

Review return transactions as part of the

a. Areas of Inherent Risk: b. Audit Procedures to Address Risk Areas:transactions testing during the year to determine if returned merchandise is accounted for in accordance with stated policies.

6. Sales have been increasing at 20% per year. It is doubtful that the company can maintain such growth rates without the introduction of a substantial number of new products. However, cutting the research and development budget is likely to hamper the introduction of technically innovative new products.

Understand trends in the industry, such as new product introductions, profitability of competitors, etc. to determine the competitive advantaged enjoyed by the client.

Review sales contracts to understand the potential business reason why this client might be obtaining a higher level of success than is obtained by competitors.

Plan audit tests with a high degree of skepticism (as is indicated above for many of the audit tests - this risk identifier only confirms the need for more audit tests like those described above.)

Discuss with management the cutback in R&D and the potential impact on remaining competitive.

7. The plant does not appear to be kept up to date. A large amount of inventory is sitting near the receiving dock. The inventory may indicate the fear regarding the cutting of research and development is true.

Expand, as discussed above, the review of procedures for merchandise return. Perform an extensive review of merchandise returns after year-end.

Expand the tests of accounts receivable at year-end. If there are significant merchandise returns, the customers should indicate large differences when their accounts are confirmed.

10-61.

a. Factors to consider in setting the credit policy:

The past history with each customer, (volume, payment profile, etc.) Trends in the industry. For example, have there been consolidations in the shoe

industry that eliminate many of the mom and pop shoe stores. Current economic conditions. Outside credit ratings by credit bureaus such as Dun and Bradstreet. Analysis of the customer's financial statements (for larger customers).

Current credit balance with the company. Management's sales plans and trade-offs considered between increased sales and

credit risk.

Much of the information on the customer's past history should be readily available in the client's computer system. Further, the advent of networking the development of public databases make it possible for clients to access directly the credit rankings of the credit agency firms (if a subscriber member) and such information can be downloaded into the client's credit files and considered as an element of the parameters to be accessed in a credit policy.

b. Control Procedures: c. Audit Procedures to Test Control Procedures:

1. Ability to change the parameters used to establish credit should be limited only to those authorized to do so within the credit department.

1. Review policies used to establish the accountability for those allowed to change credit parameters.

1a. Review data processing procedures to limit access to data files (such as password control). Test the access by attempting to utilize passwords, etc. (A more complete discussion of such tests is deferred until chapter 13.)

1b. Determine the extent of supervisory review of all changes to parameters. Determine the adequacy of such reviews and procedures used to follow-up on discrepancies.

2.All changes to the credit parameters should be reviewed by the supervisor of the credit department.

2. See audit step 1b.

3. Periodic internal audits should review the correctness of the program for computing credit authorization.

3. Review internal audit reports for activity regarding the credit approval process. Meet with the director of internal auditing to discuss audit plans and results.

4. The credit department should periodically review the credit authorizations to determine if the program is working according to established procedures and whether the algorithms should be updated.

4. Inquire about the process used by the credit department to review authorizations. Review evidence of procedures being performed.

b. Control Procedures: c. Audit Procedures to Test Control Procedures:

5. Exception reports should be generated for all instances in which credit was approved beyond that authorized by the computer application. The exception reports should be reviewed by the supervisor of the credit function.

5. Inquire as to the existence of such exception reports. Take a sample of the reports and review for evidence of credit department review and follow-up action.

6. Data processing should implement access controls, such as passwords to restrict access to the credit program and parameters.

6. See Step 1a above.

7. Reports should be prepared highlighting credit approvals.

7. Inquire as to the existence of such reports. Determine if such reports are reviewed by the credit department.

10-62. Students may come up with a number of possible controls. The solution provided below is adapted from examples provided in COSO’s Guidance on Monitoring Internal Control Systems. Some of the control activities could also serve as monitoring controls.

Objective Risk and Relevant Financial Statement Assertions

Control Environment Controls

Approach to testing

Control Activities

Approach to testing

Recognize revenue in accordance with appropriate revenue recognition criteria

RISK: Overstatement due to sales agents that grant future credits to customer for unsold goods

ASSERTION: Existence

Management and philosophy, including tone at the top are clear that such actions are unacceptable.

Training on the topic is provided to sales personnel

Review evidence of the communication of this philosophy (e.g., newsletters).Inquire of company personnel how they perceive management’s philosophy.

Review training course materials.

Periodic review by sales manager and CFO and sales trends and sales returns trends

Obtain evidence of sales manager and CFO participation in the review.

Examine the trend analysis.

Inquire of the sales manager about the review process.

Code of conduct is signed by all sales personnel

Select various sales personnel and obtain evidence to verify their participation in training.

For a sample of sales personnel, review documentation.

Inquire of selected sales personnel their understanding of relevant sections of the Code.

Sales person compensation is reviewed quarterly by the sales manager and adjusted if returns exceed a threshold.

Examine the documentation reviewed by the sales manager.

Examine evidence of any adjustments to compensation.

10-63.

a. Potential Misstatement if Not Implemented

b. Auditing Procedure to Test Effectiveness of Control.

1. The recording of transactions will not be misstated. However, the collectibility of accounts receivable may be impaired. Thus, it is possible that net accounts receivable may be overstated.

1a. Review procedures to implement the computer program and determine the extent that the credit department tests and monitors the correctness of the authorization program.

1b. Consider testing the program by submitting transactions against it and see if the transactions are processed correctly. (This is discussed in Chapter 8 as the test data approach.)

1c. Take a sample of sales transactions over $10,000 and review to determine whether there is evidence that authorization had been obtained.

1d. Take a sample of sales transactions less than $10,000 and, for each transaction, determine whether credit should be granted based on the parameters contained in the computer program.

a. Potential Misstatement if Not Implemented

b. Auditing Procedure to Test Effectiveness of Control.

(This is not likely to be done if the auditor does step 1a or 1b.)

2. Sales and accounts receivable may be stated incorrectly. If the sales are billed for more than authorized, the accounts receivable may not be collectible. If sales are billed for less than the authorized amount, the customers may not complain and the organization will understate sales and receivables. However, the authorized prices will never be collected. The company is simply less profitable.

2a. Review the control procedures used by the department to implement authorized prices and maintain security of the price list from unauthorized changes.2b. Take a sample of sales invoices and trace the price charged per unit to a copy of the authorized price list maintained by the sales department.

2c. Submit a sample of invoices (test data) to the system and determine that all items are invoiced according to authorized prices.

3. Shipments might not be recorded and sales would be understated.There is also some chance that shipments could be recorded twice resulting in an overstatement of sales and receivables.

3. Review the client's control procedures used to periodically account for all items. Test a sample of the client's accounting to determine that all items were properly accounted for.

4. Accounts receivable may be overstated because customer complaints are not adjusted.

4a. Observe that the segregation of duties described in the control procedure actually exists.

4b. Review a sample of customer complaints to determine the procedures used to follow-up and correct the complaints.

5. Sales returns may be understated and accounts receivable may be overstated if the receipts are not promptly recorded.

Inventory may be overstated if quality control does not review the merchandise to determine its quality.

5a. Review the procedures and make inquiries as to procedures utilized for handling returned merchandise.

5b. Select a sample of receipt documents and follow through the processing to determine that:

(1) credit memos were issued on a timely basis;

(2) quality control tested the returned merchandise and sent a memo to accounting recommending proper classification.

(3) review inventory record to determine the receipt (and the physical object) was properly accounted for in accordance with quality control instructions.

a. Potential Misstatement if Not Implemented

b. Auditing Procedure to Test Effectiveness of Control.

6. Sales and accounts receivable could be misstated in either direction, but it is more likely that an understatement would go undetected because customers may not complain about not being billed for all items shipped.

6a. For a sample of invoices, examine shipping documents and packing slip for evidence of items shipped. Determine how any discrepancies were handled.

6b. Consider testing the computer program by submitting fictitious data to determine that the proper action is taken.

7. Sales and accounts receivable could be misstated as described in #6 above.

7a. Select a sample of invoices and re-compute the freight charge to determine if it is computed in accordance with the company policy.

7b. Consider testing the computer program by submitting fictitious data to determine if the calculation is made correctly.

10-64a. Strengths and Weaknesses

Strengths:1. A cash register is used to record (most) sale transactions.2. The company has a clear set of procedures for using credit cards.3. The company has an 800 number to obtain authorizations for all credit charges

in excess of $50.00.4. The store manager batches all the credit card transactions and reconciles them

with the credit card sales recorded on the cash register.

Weaknesses:The major weakness in the scenario described is that the control procedures are circumvented, or just ignored during busy times. Most notably:

1. All transactions are not rung up on the cash register as they occur (they would have to be rung up later by one of the clerks or the store manager.)

2. The credit card receipts are not pre-numbered and credit sales could easily be lost when they are not rung up on the cash register and the receipt stored in the cash register.

b. Potential Financial Statement Effect:

The largest risk is that credit sales will not be recorded. This could occur through either carelessness or could occur as part of a conspiracy of one of the clerks and a

customer. Sales would be understated and inventory would be overstated because the transactions were not recorded.

10-65.

1. a. This exception report provides information about the volume of sales transactions over the specified limit. The credit manager can use the report to verify (probably on a test basis) that the transaction was authorized by someone in the credit department or by the credit manager. The auditor would want to verify that follow-up action is taken by the credit manager to gain assurance that the control procedure was operating effectively throughout the year.

b. The auditor would not be concerned about the volume of transactions on this report. The use of the exception report is a strong control procedure.

2. a. The auditor would review the report to determine if there may be an unusual credit risk for a particular customer. The auditor may, depending on other risk factors present in the audit, determine that all the transactions are independent.

b. It is difficult to tell if the auditor would be concerned without knowing more about the size of the company. In most likelihood the transactions would be unusual for the company (otherwise an exception report would not be generated) and thus would merit some investigation on the auditor's part to understand the nature of the transactions.

3. a. The auditor is concerned with problem accounting areas. Numerous exception reports of this type signals a potential problem relating to the correct recording of sales.

b. Yes, the auditor would most definitely be concerned if a large number of such reports occurred. Either there are problems with quality of merchandise or the shipping process is out of control. Customers may become dissatisfied. That dissatisfaction may be reflected in the ability to collect accounts receivable.

4. a. The auditor is looking for evidence that the accounting system and the organization's overall control system is functioning effectively.

b. Numerous exception reports may signal a number of things (either good or bad). The auditor would want to make inquiries of the client to determine the causes of the problems reflected in the exception report.

10-66.

Type of Failure

Possible Misstatement Assertion Effect on substantive tests.

a. No evidence price and quantity checked.

Sales and accounts receivable may be over or understated at year-end. Customers may not have had a chance to get pricing and/or quantity errors corrected for sales near year-end.

Valuation (Gross)

Extend confirmation and subsequent collection work. Confirm as of year-end rather than at an interim date.

b. Lack of credit approval.

Allowance for doubtful accounts may not be adequate.

Valuation (Net) Extend review of subsequent collections, obtain credit reports on customers with large overdue balances, review customer correspondence files.

c. Recording sales before shipped.

Sales, accounts receivable and possibly cost of sales would be overstated. Inventory may be understated, especially in a perpetual system.

Existence/ Occurrence

Extend confirmations as of year-end, concentrate sales cutoff testing on sales recorded just before year-end.

d. Recording sales after they should have been.

Just the opposite of c. above.

Completeness Concentrate sales cutoff testing on sales recorded early in the following year.

e. Untimely recording of sales.

Sales, accounts receivable and possibly cost of sales and inventory may be misstated.

Existence/ occurrence, cutoff & completeness

Expand cutoff testing of sales just before and after year-end.

f. Lack of customer order.

Sales and accounts receivable overstated. Even though shipped, if customer did not order the items, this is not a valid receivable or sale. Could indicate fraudulent sales.

Existence/ occurrence

Expand confirmations of receivable as of year end. Verify existence of customer by looking them up in the telephone book and reviewing credit report. Watch for unusual sales returns after year-end.

g. Lack of shipping document.

If not shipped, sales, accounts receivable, and cost of sales are overstated.

Existence/ occurrence

Expand confirmations of receivable and inventory test counting as of year end. Expand

Type of Failure

Possible Misstatement Assertion Effect on substantive tests.

Inventory is understated. review of subsequent collections.

h & i. Wrong price or quantity.

Same as a. Same as a. Same as a.

10-67.

The auditor can gain assurance that sales transactions are properly valued in one of two ways:

1. The auditor could take a sample of recorded sales and trace the sales prices to the quarterly price printouts and, if necessary, to the sales department’s list of all changes.

2. The auditor could obtain the current price list table that is incorporated into the computer system. If there is a large volume of prices, a sample of those prices could be selected and compared to the quarterly printouts. If there are any changes, the changes could be traced to the sales department’s list of changes for authorization.

10-68.

a. Neither auditor is correct. Both approaches are necessary to determine that all recorded sales are valid and that all shipments have been properly invoiced. The combination of the two procedures should give the auditor strong confidence that sales are properly stated if the company has strong control procedures and the audit tests do not yield any exceptions.

The transactions approach, however, is not sufficient by itself. There may be recorded sales that occurred outside the normal processing, or there may be problems with the proper cut-off of sales transactions at year-end. Thus, the professional standards require the auditor to perform a minimal amount of substantive tests of the account balance.

b. The second auditor is testing the completeness assertion - that all shipments have been properly invoiced in a timely manner. The auditor will also likely be testing the effectiveness of control procedures associated with the sales transaction, but those procedures were not specifically mentioned in the scenario.

c. A dual purpose test is one that is effective in addressing two objectives:

1. control procedures are operating effectively; and 2. the transactions are recorded correctly, in the proper time period, and so

forth.

If the auditors described above also tested the operation of important control procedures, the tests described would be dual-purpose tests.

10-69.

To substantiate the validity of gross apartment rents, Finney would -- Physically examine the rental property or review architectural blueprints to

ascertain the total number of rental units. Compare the total number of validated rental units with the total number of rent

charges on the schedule of gross apartment rents (Schedule A). For occupied units, vouch the individual apartment rental charges per lease

agreements to the individual rental charges on Schedule A. For unoccupied (vacant) units, ascertain the reasonableness of the scheduled rent

(by reference to the last rent paid, by reference to comparable rental charges for similar units, etc.).

Foot the gross apartment rent schedule (Schedule A) and compare the total with the figure indicated on the rent reconciliation.

To substantiate the validity of the vacancies, Finney would -- Physically examine the apartments that were vacant during the month. Compare the rental charge (validated in the gross apartment rents procedures

above) for each vacant apartment with the schedule of vacancies (Schedule B). Foot the schedule of vacancies (Schedule B) and compare the total with the total

indicated on the rent reconciliation.

To substantiate the validity of unpaid January rents, Finney would – Trace unpaid rents from individual tenant apartment ledger cards to Schedule C. Foot the unpaid rents schedule (Schedule C) and compare the total with the

amount shown on the rent reconciliation. Examine the collection file for evidence of collection attempts. Request written confirmations from tenants with accounts in January arrears.

To substantiate the validity of the prepaid rent collected, Finney would Trace the receipt to the individual tenant apartment ledger card. Compare the amount collected with the lease terms.

To substantiate the validity of the cash collected, Finney would -- Foot the client-prepared rent reconciliation. Reconcile the cash receipts per the rent reconciliation with the books and records. Confirm and reconcile the special bank account balance.

(AICPA adapted)

10-70.

a. Accounts Receivable $25,390Sales $25,390

To record sales invoice # 36591 this was shipped in 2009 but not recorded until 2010.

Sales $ 9,200Accounts Receivable $ 9,200

To remove sales invoice # 36592 this was shipped in 2010but recorded in 2009.

b. The sales should not be recorded until title is transferred upon delivery. It is often difficult to determine when customers receive shipments. Some companies estimate the average time for delivery and record the sales based upon that estimate.

c. If a company uses such a policy consistently for sales and cost of sales from year to year, and shipments near year-end do not vary significantly from year to year, such a policy is often acceptable. The error created by booking sales early during the current year are thus offset by a similar error at the end of the prior year and, thus, does not significantly affect net income. Current assets and owner's equity will only be overstated by the gross profit of such sales, net of income taxes. If the shipped items are included in inventory and not cost of goods, current assets and owner's equity will be overstated by the total sales value of such sales, net of income taxes. In either case, the auditor must determine if such overstatements are material.

10-71.

The auditor can use membership records and the fee structure to estimate what membership fee revenue should be. The number of members by class of membership (member in industry, educator, student, etc.) could be determined from the membership records or annual membership directory. A comparison of revenue this year with last year adjusted for changes in fees and numbers of members should also approximate the actual revenue.

10-72.

a. If the emphasis is on the existence of sales, the auditor is looking for recorded sales that should not have been recorded and should select a sample of sales recorded during the last few days of the fiscal year and vouch them back to evidence that the shipments took place - the bills of lading. In this way, sales which are recorded prematurely will likely be detected.

b. If the primary emphasis is on the completeness of sales, the auditor is looking for shipments that did not get invoiced or recorded and should select a sample of bills of lading issued during the last few business days of the fiscal year and trace them to the

sales invoices and entries into the sales journal and select sales recorded after the balance sheet date and trace them to shipping documents.

10-73.

Customer Conclusion/procedure

a. Meehan Marine Sales, Inc.2

b. West Coast Ski Center, Inc.2

c. Fish & Ski World, Inc.4

10-74.

In order to determine whether lapping exists, Stanley would test the aging of accounts receivable and then –

Mail positive accounts receivable confirmation requests directly to all customers with old balances.

Investigate all exceptions noted on confirmations. Obtain authenticated deposit slips directly from the bank and compare the detail with

the cash receipts journal. Compare individual customers' names, dates, and amounts shown on the customer's

remittance advices with the names, dates, and amounts recorded in the cash receipts journal, individual customer ledger accounts, and deposit slips (if practicable).

Verify the propriety of non-cash credits to accounts receivable (for example, sales discounts, sales returns, and bad debt write-offs).

Perform a surprise inspection of deposits. Foot the cash receipts journal, the customers' ledger accounts and the accounts

receivable control account. Reconcile the total of the individual customers' accounts with the accounts receivable

control account. Compare information in copies of monthly customers' statements with information in

customers' ledger accounts.

10-75.

a. It is more difficult to test for completeness than existence/occurrence of an account balance or class of transactions because the auditor is looking for unrecorded transactions or account balances that have left something out.

b. The auditor should consider the risk of a material misstatement that transactions have been improperly omitted from the financial statements. When the auditor assesses the risk of omission for a particular account balance or class of transactions to be such that it is believed omissions could exist that might be material when aggregated with errors in other balances or classes, substantive tests should be

designed to obtain evidence about the completeness assertion. This includes analytical procedures and tests of details of related populations. It is inappropriate to place complete reliance on internal controls and responses from management about such occurrences. Because of the unique nature of the completeness assertion, the auditor should consider that for some transactions (e.g., revenues that are received primarily in cash, such as those of a casino or of some charitable organizations) it may be difficult to limit audit risk to an acceptable level without some reliance on internal accounting controls. [AU 9326]

If pre-numbered sales documents are used, the auditor will need to do extensive testing such as tracing bills of lading to sales invoices, the sales journal, and the accounts receivable records and/or testing of the sequence of sales invoices listed in the sales journal, looking for missing numbers that cannot be accounted for as being properly voided. Regression analysis might be used to relate sales by month by product line with the related cost of sales and comparing recorded sales with production records for a manufacturer or occupancy records for a few months, if these records are believed to be reliable. Extensive cut-off tests of sales and cash receipts should be performed, concentrating on those recorded after year-end.

10-76.

Generalized audit software could be used in the following ways:

Foot the unpaid invoice file to be sure it agrees with the general ledger accounts receivable balance.

Select and print confirmation requests. Information from both files will be needed - customer name and address from the first file and unpaid amounts from the second file.

Print a report of all customers whose balance exceeds the credit limit or who have no credit limit.

Create an aged trial balance by customer. Print out unpaid invoices dated just before and just after year-end for testing sales

cut-off. Print out the purchase and payment history for customers who have unusually

large or old balances.

10-77.

a. Confirm positively not only the amounts of all the outstanding notes but also the interest rate, date, due date, and collateral on the notes.

b. The examination of notes receivable arising from equipment sales and the interest thereupon must result in evidence that the notes receivable and accrued interest represent existing obligations owed to the client on December 31 (existence): that the notes receivable and interest will be collectible at their stated value (valuation): that the notes are presented properly on the balance sheet (presentation and disclosure);

and that all transactions for new notes received, notes collected, and accrued interest are recorded in the proper period (existence and completeness). Therefore, the assistant should perform the following additional audit procedures:

1. Inspect each note document on hand in the immediate presence of the custodian (from whom a receipt should be obtained for the return of the notes) in order to check its amount, maker, issue date, due date, interest rate, and collateral: and to determine whether the client is its payee or endorsee.

2. Reconcile confirmation reply differences and follow upon notes for which no replies are received.

3. For all notes not paid by the end of the field work, evaluate the value of the collateral and the likelihood that the maker (especially if the client is the endorsee of the customer) will pay the note when due for the purpose of determining the adequacy of the allowance for bad debts. Compare the result with past experience.

4. On a test basis examine the original documents (agreement to purchase, shipping documents, and invoice copy) for sales upon which notes are outstanding and sales upon which notes were received and collected or written off (check for proper authorization). Cross-check unusual variations in the terms of agreement and observe whether the client and customer adhered to the terms. This phase of the examination and the examination of original documents before and after the year-end to establish a cutoff should be done in connection with the examination of the inventory (if Clark maintains one).

5. Test the balance of the accrued interest receivable account by applying the data concerning interest rates and interest collections to the notes receivable balance.

6. Inquire of management regarding policies, agreements, and unusual transactions. Obtain a representation letter covering the validity of the notes, contingent liabilities, adequacy of the allowance for bad debts, the pledging of notes as collateral to liabilities, and other material matters concerning other phases of the audit.

7. Make an over-all evaluation of the validity of the accounts, using known ratios where possible.

8. Significant amounts of notes from customers controlled by officers or from customers that are subsidiaries should be treated apart from other notes; verify that repayments of such notes are bona fide by seeing that checks were deposited promptly and that notes are not renewed shortly after the year-end.

c. Notes not on hand but carried as outstanding on December 31 could be:

1. At the cashier's desk to be mailed for collection. Examine, count, and list notes on hand.

2. Out for collection with an agent but not yet collected. Confirm with the collection agent, usually the bank.

3. Pledged as collateral and hence in the hands of a lender. Discuss with management, examine loan agreement, and confirm with lender (if not already done).

4. Discounted and hence in the hands of a lender. Trace the proceeds to cash receipts and into bank account. Check to see if an account for discounted notes receivable has been established. Confirm with lender in order to determine whether a contingent liability still exists (because the note is not due yet) or whether a current liability has resulted from nonpayment of the note and presentation of notice of protest to Clark.

5. Collected directly from the maker already (between the year-end and the date of document inspection) by the Company and hence in the hands of the maker. Trace collection to cash receipts and into bank account, and examine confirmation from maker for a statement that the note has been paid even though it was outstanding at December 31 (if not already done.).

6. Collected already by the bank and the proceeds deposited in the bank account but not recorded on the books. The note would be in the mail to or in the hands of the maker. Examine cutoff bank statement or the year-end bank reconciliation, and examine the confirmation from the maker for a statement that the note has been paid even though it was outstanding at December 31 (if not already done).

7. In the hands of the maker if the note was canceled because the equipment purchased by the maker was returned. Examine confirmation for a statement that the equipment purchased has been returned. Verify the return by checking the reconciliation of the physical and book inventories.

8. The result of a posting error in the journal and control account. Foot and compare with agreements to purchase, correspondence and other original documents. Examine confirmations for a statement that the amount of a note has been overstated (if not already done).

10-78.

This is a good problem to use for classroom demonstration. Data files are in italics. ACL icons, commands, and equations in bold. Field names are in FULL CAPS.):

Audit Program

StepApproach

To Begin Open a new project by choosing File, New, Project, or click the New Project icon. Name the project Husky AR.

Import the following tables (files) and change the field type for CUSTNUM and INVNUM from Numeric to ASCII using Edit, Table Layout and double-clicking on the field name. This must be done so files can be joined using these fields.

HUSKY Unpaid Invoices 2009, name it UnpaidHUSKY Shipping File 2009, name it Shipping FileHUSKY Credit Limit 2009, name it Credit Limit.

1 Objective: Foot the file and agree to the general ledger.

With the Unpaid file as the active window, choose Analyze, Statistical, Statistics, and choose to get statistics on AMOUNT.

Results: There are 200 records with a net value ($4,263,919.52) that agrees with information obtained from the client’s records provided in the problem. Also note there is one invoice with a negative $22,659.74 amount. The customer paid for the merchandise and has returned it. HUSKY owes them the money or replacement merchandise.

2 Objective: Identify customer balances greater than their credit limit or for which there are no credit limits.

Summarize amounts in the Unpaid file by customer number by choosing Analyze, Summarize. Summarize on CUSTNUM. Click the Output tab at the top of the window and choose “File.” Name this file Customer Balances.

Using the Customer Balances file, click the Join icon. Select the Credit Limit file as the secondary database. Click to presort the secondary file. Match both Primary Fields and Secondary Fields on CUSTNUM. Choose the fields CUSTNUM, AMOUNT, CRLIMIT to include in the resulting file. Name the new file Balances with Credit Limits.

Using the Balances with Credit Limits file, choose DATA, Extract Data, If and enter the expression AMOUNT > CRLIMIT. Name the new file Over Limit.

Results: Customer 174 does not have a credit limit. Customers 121, 141, 166, 181, and 184 exceed their credit limits. The auditor should discuss these with the credit manager, reviewed for subsequent collections. Customer 174 should be checked to be sure it is a legitimate customer.

3 Objective: Perform sales cutoff test.

Using the Unpaid file, click the JOIN icon. Select the Shipping File as the secondary file. Match on INVNUM. Select INVNUM, INVDATE, CUSTNUM, AMOUNT, and SHIPNUM for the output. Name the new file Unpaid with Shipping Info.

Using the Unpaid with Shipping Info file, choose DATA, Extract Data, IF and enter the expression SHIPNUM > 62050 (The auditor has verified that this is the last shipping number used.) Name the new file Cutoff Errors. Results: Invoices 169980, 169981, and 169982 were recorded in December 2009 but not shipped until January 2010. The total amount of these invoices is $26,729.71. The client should be asked to remove these sales and cost of sales from 2009 and recorded in the following January.

4 Objective: Identify unpaid invoices over 45 days old.

Use the Unpaid file. Choose ANALYZE, Age, and age on INVDATE. Set the cutoff date to December 31, 2009. Choose the AMOUNT field to total. Set the Aging Periods to 0 and 45. Print the Age Analysis Report To get a list of these 4 records, double-click on the > 45 box.

Results: 4 records totaling $79,017.13 older than 45 days. These should be discussed with the credit manager and checked for subsequent collections.

5 Objective: Stratify customer balances and describe how this information could be used to help determine which balances to confirm.

Using the Customer Balances file, choose ANALYZE, Stratify, stratify on AMOUNT. Set the minimum at 0 and maximum at 50,000.

Results: The report shows that over half of the dollars are composed of 24 customer balances greater than $50,000. These along with a random selection of the other balances should be confirmed.

10-79.

a. The key thing to recognize is that there is a pattern of errors in the confirmation non-responses. There are cases of extended credit terms where goods were not returned, where credit is to be issued but the goods have not been returned, there is a related party transaction, and there are some new customers that simply have not responded. The nature of the non-confirmations should heighten the auditor’s awareness of the possibility that fraud could be taking place. The auditor in charge of the examination would want to communicate those concerns to the staff auditors and encourage the

staff auditors to be very skeptical, particularly when examining internal documentation. The fraud could be taking place through billing for goods not actually shipped, double billing of goods (without extending the necessary credit), or sales to fictitious entities.

The work that would be needed to complete the work on confirmations would include the following audit procedures:

1. Review subsequent cash collections from each of the open accounts. Schedule all subsequent payments that can be identified as applicable to the year-end account balances. Schedule any items not satisfied through subsequent payments as open items for further follow-up.

2. For all items without unusual circumstances, follow up on unpaid amounts by examining underlying supporting documentation including:- customer purchase order- bill of lading or other independent proof of shipping- invoice

If the open items are indicated as re-billings, trace the amount of the rebilling to the issuance of the credit memo and from the credit memo into the general ledger to see that the proper credit had been applied.

Schedule dollar amounts that cannot be satisfied through the above two procedures. If no supporting documentation can be found, classify the items as errors and extrapolate to the population as a whole.

3. Examine receiving reports for items returned prior to a specific time before year-end, (the actual time period would be somewhat dependent on the lag between receipts and the issuance of credit memos per examination of previous receipts of goods and issuance of credit.)

4. Examine all documentation on Yunkel Company regarding extended credit terms. Examine underlying documentation as to how the extended terms were given. Consider confirming the extended terms (as opposed to account balance) with the controller of Yunkel.

5. Examine all terms of the related party transaction with Beaver Dam. Examine other transactions with the same company to determine the extent of disclosure needed to fairly present the financial statements.

6. Examine documentation for all transactions labeled as `special terms’, such as those with Hi-Tech Companies. For these companies, as well as others not responding, verify the existence of the company through examination of Dun & Bradstreet reports on the company, or through business directories. Confirm the special terms of the sale with the company. Depending on the nature of the

terms, consider seeking a legal opinion on the terms of the contract, the obligation of the seller, and so forth from outside legal counsel.

7. For all companies not responding, obtain a current credit rating from Dun & Bradstreet (or some similar service). Review the client’s credit file and obtain audited financial statements to assist in determining collectibility and existence of the receivable.

8. Consider all items not cleared as errors and project the amount of error to the financial statements as a whole. Based on the results, consider the amount of additional auditing procedures that need to be performed.

b. Assuming that many of the above items could not be cleared to the auditor’s satisfaction, there would be concern that more items with similar problems exist in the population. The auditor would first classify all uncleared items as errors and would then project the total to the population as a whole to determine if the projected errors and upper error limit were material to the financial statements. Assuming the amount would be material, the auditor would perform the following procedures:

1. Identify all companies that have received extended credit. This could be done by (a) inquiry of company personnel, (b) review of large dollar accounts still outstanding, or 8 through an examination of all accounts with a dollar amount past due.

2. Depending on the number of companies with such terms, either take a sample or select all companies and examine all documentation regarding the extended credit. The documentation would include purchase orders, shipping documents, memos extending the credit, and sales invoice. Confirm the terms of the extended credit with the companies identified. For each company selected, review the credit file, outside credit evaluations, and recent correspondence with the customer to determine the probability of collection. Develop an estimate (or a range of estimate) of uncollectible accounts.

3. Prepare an aging of all accounts past due. Compare the aging with previous years. Compute a first estimate of uncollectible accounts by using a non-collectible percentage off of the aging balance that had proven to be accurate in the past. Consider current economic conditions to determine if the estimate should be adjusted for deteriorating economic conditions.

4. Ask the client to schedule all transactions with related parties. Examine the underlying documentation to determine the nature of the transactions and develop a memorandum outlining the appropriate disclosure for a footnote in the financial statements.

5. Expand the audit work for all accounts past due. Consider expanding the confirmation work through another statistical sample. Perform alternative procedures on all companies that do not respond to the confirmation request.

6. Prepare a list of all questionable transactions. Document the nature of the question, the parties involved, etc. to determine if there is a pattern of misstatement. Based on the pattern, identify all other account balances fitting that pattern. Schedule the open account balances fitting that pattern and examine underlying documentation to determine whether or not the item is misstated.

7. Perform extended cut-off tests of sales and receivables near year-end to determine that items were recorded in the correct time period. Examine a sample (or all) items during a period covering the last 15 days of the year and the first 10 days of the subsequent year to determine whether or not all items that had been billed had been shipped.

8. Physically examine all items that have been marked as ’billed, but held pending customer orders’ to determine that the goods had been physically separated, are in shipping condition, and are not obsolete. Confirm the terms with the purchaser. Obtain an opinion from legal counsel on the validity of the sales contract. Gather additional information to determine the likelihood of default by the customer. Consider the likelihood of default in determining whether or not a sale should have been recorded.

9. Based on the extended work, develop a revised estimate of uncollectible accounts, as well as accounts that should not yet be recorded as sales and receivables.

10. Document the nature of the work performed and the audit conclusions in a memorandum for the working papers.

Cases:

10-80.

a. MiniScribe inflated its financial statements by:1. Shipping more units before year-end than were ordered by customers.2. Recording shipments from Singapore that took two weeks to reach the customer

as a sale when shipped rather than when title transferred when received by the customer.

3. Defective drives returned by customers were booked as inventory rather than sales returns. They were reshipped and returned several times.

4. Bricks were apparently shipped as disk drives.5. Shipments to company warehouses were recorded as sales but were not invoiced

to customers until shipped from those warehouses to the customers.

b. Among the factors leading to MiniScribe's inflated financial statements were:1. Management's bullish forecasts when the industry was having hard times.2. Mr. Wiles' management style, which intimidated lower management personnel

and motivated them to create sales when there were none.3. Potentially inadequate audit evidence obtained to support the auditor's opinion.

c. The red flags include:1. Sales returns percentage well below the industry average.2. Awareness of the management environment and style based on discussions with

Mr. Wiles' subordinates.3. Increased sales and profitability, which was counter to the trend in the industry.4. An unusual level of sales activity just prior to year-end and of sales returns after

year-end.

d. Normal audit procedures that could have uncovered the fraud include:1. Analytical procedures such as:

(a) Comparing MiniScribe's sales returns percentage with that of the industry.(b) Analysis of sales by month compared to prior years. Sales recorded in the last month were likely significantly greater than in the first month of the year.(c) Comparing the trend of MiniScribe's sales and profits with the trend of the industry.

2. Cut-off tests of sales recorded prior to year-end and sales returns just after year-end.

10-81.

a. The following internal control deficiencies or management deficiencies are evident:

1. No sales revenue detail is reported to corporate offices.2. The data base system is not utilized to its full potential. Sufficient data is

contained for multiple performance evaluating measurements.3. Emphasis on turnover as an indicator of profitability, to the exclusion of margin.4. Bonus (sales incentive) plan predicated on only one source of performance

measurement.5. Sale prices are not updated in the data base.6. Sales clerks are permitted to override the master price list.7. Inadequate segregation of duties related to sale of damaged goods.8. No review by corporate offices of local store advertising.

b. The following indicators may have signaled the presence of fraud:

1. Excessive sales of damaged goods.2. Inadequate margin on recorded sales.3. Unusual sales activity at year end and sales return activity at the beginning of

the next year.4. Inventory differences disclosed by physical inventory and resultant

reconciliation to perpetual records.

c. The following controls are needed to detect the fraud:

1. Exception reporting of sales at other than master price.2. Exception reporting of "sale" merchandise sold at master price.3. Confirmation of sales returns.4. Complete documentation of damaged goods, including photographs.

d. The responsibilities of the internal auditing department are as follow:

1. The internal auditor should be alert to the possibility of fraud.2. The internal auditor should be alert to conditions and activities (such as weak

control) where frauds are most likely to occur.3. When the internal auditor suspects fraud:

a. Appropriate authorities should be informed.b. Recommendations for investigation may be made.c. Follow up should be made to ensure audit responsibilities have been met.

4. The internal audit function can also serve as a monitoring control through performing periodic, separate evaluations of the effectiveness of the internal controls in the revenue cycle.

10-82.

1. A variety of possible ideas might be generated by students:

differences in common practices regarding the writing and enforcing of contracts difficulties in communication between the subsidiary and the parent company differences in expectations regarding necessary documentation of internal controls differences in the training and size of management, which may lead to variation in

the implementation and enforcement of existing controls, among others….

2. First consider that the prior problem indicates that weaknesses existed in the past, which heightens risk. However, the fact that the problems were disclosed and a remediation plan was put in place mitigates that risk. So, the extent to which the remediation plan was actually implemented will be key in determining the audit plan for 2005. So, the auditor should gather information about the extent to which the new contract review process has been used, and they should examine the new documentation evidencing proof of delivery. Second, consider that the problems associated with the internal control weaknesses in revenue manifested themselves in fourth quarter revisions to the financial statements, which should lead the auditor to heighten their 2005 risk assessment in terms of management attempts to manipulate earnings. Thus, inherent risk associated with sales transactions should be heightened going forward.

3. Regarding potential analytics, the following may be helpful:

comparing quarter-to-quarter changes in sales during the current year, and comparing those to prior years and industry averages

comparing revenue, deferred revenue, and cost of sales figures for reasonableness in relation to one another for the company, and the same figures for competitors

compare cash flow from operations with net income calculate receivables and aging of receivables by product type and geographic

region, by quarter and same quarter across years calculate gross margin percentages

4. Potential substantive tests include:

analyzing the timing of contracts, with particular emphasis on fourth quarter contracts (or end of other quarter contracts)

reading contracts to ensure timely identification and accurate accounting treatment of non-standard contracts

review documents retained evidencing proof of delivery and final acceptance sample recorded sales transactions and vouch to source documents match sales with electronic shipping documents or customer orders review monitoring controls concerning management’s review of revenue

transactions

10-83 1.Putnam’s critical mistake was in not being forceful and proactive the very first time the

problems were encountered. Once he had “caved” to HBOC once, it would have been difficult to convincingly threaten HBOC in the future. Plus, once Putnam allowed the inappropriate accounting and issued the first incorrect audit review opinion, HBOC could use that against Putnam, convincing him that he would also “lose” upon discovery of the problems.

2. Although the facts are not publicly disclosed, one has to assume that in the booming time period of the late 1990’s, the tone at Andersen was to make clients happy, and to retain their business. Thus, it is possible that Putnam would have been discouraged from behaving forcefully to HBOC. In terms of Putnam acquiescing to the obviously inappropriate sale/purchase transaction in Q3 1998, the situation seems unbearably inappropriate. By that point, Putnam had to have known that without the transaction going through, the true financial results of HBOC would lead to its downfall. Putnam may have been hoping that if he allowed this transaction, then perhaps the company could maintain its profitability and “no harm would come of it”.

3. The main element of corporate governance that failed was the audit committee. They displayed a lack of knowledge of the risks in the software industry at the time. They should have been more proactive in understanding the types of transactions that the company was engaged in, and the common risks associated with those transactions. They should not have relied so extensively on the unsubstantiated representations of Putnam.

4. Putnam and the engagement team did not follow up on unreturned confirmations and the very low response rate should have caused concern. In addition, the dramatic decline in the number of confirmations sent from 1996 to 1997 without justification is problematic. Further, the engagement team’s response to the problems noted in the confirmations that were returned was inadequate. It should have led to much deeper investigation into the side letter issue.

5. When Putnam learned of the upcoming merger with McKesson during the Fall of 1998, he would have realized that McKesson was relying on the inappropriately aggressive earnings stream that HBOC had developed over the past several years. Certainly McKesson would have felt differently about the acquisition had it known about the improprieties. There must have been tremendous pressure on him not to say anything because he had acquiesced for so long to Gilbertson. Yet, if any situation were to bring Putnam to disclose the problems, this would have been it. Moving forward with the acquisition under false pretenses put Andersen LLP as an audit firm at tremendous risk. While students may develop alternative strategies, we present one possible way that Putnam could have used the McKesson acquisition to reveal what he knew about the problems at HBOC.

Step 1. Structure the problem. Putnam knew that McKesson would rely on the misstated financials of HBOC during the acquisition process. He also knew that there was an upcoming audit committee meeting at which he could speak up if he so desired.

Step 2. Assess the consequences. The potential consequences were that (a) McKesson would acquire HBOC, HBOC’s financial position would improve enough that the fraud would be irrelevant, and further earnings management would be unnecessary, thus causing the past problems to become essentially irrelevant, or (b) McKesson would acquire HBOC, the fraud would be revealed, and Andersen and Putnam would be at risk of litigation and SEC sanction, or (c) McKesson would not acquire HBOC because of the problems detected during their due diligence process.

Step 3. Assess the risk and uncertainties. The risks associated with possibility (a) are that this outcome is a relatively low probability event (in hindsight), although at the time Putnam may have thought otherwise. The risks associated with possibility (b) are the exact things that ultimately happened in real life, i.e., fraud revelation, followed by massive stock devaluation and securities fraud charges. The risks associated with possibility (c) are that Andersen would be fired from the audit by HBOC, and Putnam would be damaged financially or professionally through the loss of the client.

Step 4. Evaluate information/audit evidence gathering activities. Possibilities (a) and (b) require no additional actions on the part of Putnam, so we will focus on Possibility (c) for the rest of the solution. Assuming that Putnam decided to pursue this possibility, how could he do an “about face” and finally reveal the problems to, for example, the audit committee? One possibility would be to increase testing via the confirmation process during the Fall of 1998 in anticipation of the year-end audit.

Step 5. Conduct sensitivity analyses. This step is not particularly relevant for the decision at hand. If Putnam chose the course of action to finally reveal what he knew, there would be little sensitivity analyses to conduct, because gathering evidence on the other possibilities does not lend itself to actual evidence gathering. Rather, those possibilities involve assessments of probabilities of those events occurring.

Step 6. Gather information/audit evidence. If Putnam had chosen to increase testing via the confirmation process, he could have instructed the team to gather significant audit evidence about accounts receivables and the allowance for doubtful accounts during Fall 1998. Knowing what he would find, he could then either pressure Gilbertson to reveal the issues, or he could himself report what he knew to the audit committee.

Step 7. Made decision about audit problem. It is clear from the actual outcome what Putnam actually decided to do, i.e., nothing and hope for the best. If Putnam had revealed what he knew to the audit committee and McKesson during the Fall of 1998, McKesson would probably not have engaged in the acquisition. Perhaps HBOC could have fixed their accounting problems “behind the scenes” and the fraud revelation could have been avoided. However, it seems that the fraud had gone on so long, and the amounts of the deception were so large that anything that Putnam did at this late stage would have been futile in preventing the downfall of HBOC and its management team. But by doing something, even very late in the process, Putnam could have salvaged his reputation to some extent and possibly avoided or minimized the negative outcome he ultimately received from the SEC. The message is clear: Putnam should have stood up for what was right at the outset of the problems at HBOC. By not confronting Gilbertson forcefully when he initially learned of the problems, Putnam got caught up in a downward spiral of poor professional decision making, with terrible consequences.

10-84 It is apparent from the case that the audit manager for some reason was unwilling to challenge Putnam or his views. The publicly disclosed documents do not enable an understanding of the personal characteristics of Putnam or the engagement manager, so it is difficult to draw inferences about the personal dynamic that existed between the two auditors. However, Ira Chaleff’s ideas should give students a sense of things that an individual in an organization who is not in the “leadership” role can still do to have a positive effect in an otherwise bad situation. While individual answers will of course vary, we present a potential approach to moving

through the seven steps in resolving the difficult ethical issue encountered by the HBOC engagement manager.

(1) Identify the ethical issue. The issue is that the manager knows that HBOC is misrepresenting its financial results to shareholders, and by very significant amounts. Still, if the manager takes on the issue against the preference of Putnam, there may be personal repercussions such as a poor performance evaluation or dismissal from the job. Further, the manager may consider the fact that if HBOC does not “make their numbers” as they have so prominently advertised to the investment community, shareholders may actually “lose” because of the associated decline in share price.

(2) Determine who are the affected parties and identify their rights. Affected parties include shareholders (right to receive accurate investment information), the audit committee and board of directors (right to receive an accurate portrayal of the accounting function of the organization, as well as a performance appraisal of Gilbertson), the SEC (the right to receive accurate financial reports), Andersen as a Firm (the right to have a client that will not tarnish the Firm’s reputation), McKesson shareholders (the right to purchase a company with full and complete disclosure about its true financial condition), and the individual auditors on the HBOC engagement (the right to have their professional opinions respected and followed).

(3) Determine the most important rights. Shareholders at HBOC and McKesson because they are the most numerous and stand to lose most directly from the problems. Further, they are not in any way at fault, unlike the members of the audit committee, board, or individual auditors.

(4) Develop alternative courses of action. Appeal further to Putnam, trying to encourage him to “do the right thing”. Appeal to higher levels at Andersen, alerting the Firm to the risks being assumed by

Putnam. Alerting the SEC. Resigning from the job, or from Andersen.

(5) Determine the likely consequences of each proposed course of action. Appeal further to Putnam, trying to encourage him to “do the right thing”. Likely

consequences: unknown, depending on Putnam’s personality and the ability of the manager to deliver the message in an effective manner.

Appeal to higher levels at Andersen, alerting the Firm to the risks being assumed by Putnam. Likely consequences: unknown, depending on how the Firm views the importance of the engagement. At the time, Andersen was internally going through a downward spiral of audit quality and “tone at the top”, so the manager’s concerns may have been ignored.

Alerting the SEC. Likely consequences: immediate regulatory attention and likely reductions in share price.

Resigning from the job, or from Andersen. Shareholders of McKesson and HBOC would not have been aided, but the manager’s reputation would not have been tarnished by association with the scandal.

(6) Assess the possible consequences, including an estimation of the greatest good for the greatest number. The greatest good for the greatest number accrues to the action associated with alerting the SEC, assuming that direct intervention with Putnam or Andersen as a Firm goes ignored.

(7) Decide on the appropriate course of action. The most appropriate course of events would be to follow through the potential actions in sequence, beginning with persuasive conversations with Putnam and Andersen as necessary, and ultimately alerting the SEC if necessary. The manager should not simply “walk away” from the situation by resigning. If they do resign, they should at least alert the SEC anonymously.

10-85 ACL Case 3 – Accounts Receivable) The solutions to the problems in the ACL Appendix are at the end of the solutions to Chapter 18.

Ford Motor Company and Toyota Motor Corporation: Revenue Cycle Issues

1a. What are the key revenue cycle accounts for Ford? What are the critical accounting policies and estimates for these accounts?

Automotive sales, financial services revenues, automotive receivables (and associated allowance), finance receivables, warranties.

Critical accounting policies:

NOTE 2. SUMMARY OF ACCOUNTING POLICIESAutomotive sales consist primarily of revenue generated from the sale of vehicles. Sales are recorded when the risks and rewards of ownership are transferred to our customers (generally dealers and distributors). For the majority of our sales, this occurs when products are shipped from our manufacturing facilities. When vehicles are shipped to customers or modifiers on consignment, revenue is recognized when the vehicle is sold to the ultimate customer. We also sell vehicles to daily rental car companies subject to guaranteed repurchase options. These vehicles are accounted for as operating leases. At the time of transfer, the proceeds are recorded as deferred revenue in Accrued liabilities and deferred revenue. The difference between the proceeds and the guaranteed repurchase amount is recognized in Automotive sales over the term of the lease, using a straight-line method. Also at the time of transfer, the cost of the vehicles is recorded as an operating lease in Other current assets. The difference between the cost of the vehicle and the estimated auction value is depreciated in Automotive cost of sales over the term of the lease. At December 31, 2007 and 2006, included in Accrued liabilities and deferred revenue was $3.2 billion and $3.6 billion, respectively, and included in Other current assets was $2.9 billion and $3.2 billion, respectively, for these vehicles. Income generated from cash and cash equivalents, investments in marketable securities, loaned securities and other miscellaneous receivables is reported in Automotive interest income and other non-operating income/(expense), net.

Revenue Recognition — Financial Services SectorRevenue from finance receivables (including direct financing leases) is recognized using the interest method. Certain origination costs on receivables are deferred and amortized, using the interest method, over the term of the related receivable as a reduction in financing revenue. Rental revenue on operating leases is recognized on a straight-line basis over the term of the lease. Initial direct costs related to leases are deferred and amortized on a straight-line basis over the term of the lease. The accrual of rental payments on operating leases and interest on receivables is discontinued at the time a receivable is determined to be uncollectible. Income generated from cash and cash equivalents, investments in marketable securities, and other miscellaneous receivables is reported in Financial Services revenues.

Marketing Incentives and Interest SupplementsMarketing incentives, including customer and dealer cash payments and costs for special financing and leasing programs paid to the Financial Services sector, are recognized by the Automotive sector as revenue reductions. These revenue reductions are accrued at the later of the date the related vehicle sales to the dealers are recorded or the date the incentive program is both approved and communicated. We generally estimate these accruals using marketing incentives that are approved as of the balance sheet date and are expected to be effective at the beginning of the subsequent period. The Financial Services sector identifies payments for special financing and leasing programs as interest supplements or other support costs and recognizes them consistent with the earnings process of the underlying receivable or operating lease.Supplier Price AdjustmentsWe frequently negotiate price adjustments with our suppliers throughout a production cycle, even after receiving production material. These price adjustments relate to changes in design specifications or to

other commercial terms such as economics, productivity, and competitive pricing. We recognize price adjustments when we reach final agreement with our suppliers. In general, we avoid direct price changes in consideration of future business; however, when these occur, our policy is to defer the financial statement impact of any such price change given explicitly in consideration of future business where guaranteed volumes are specified.

Warranty and Extended Service PlansEstimated warranty costs and additional service actions are accrued for at the time the vehicle is sold to a dealer, including costs for basic warranty coverage on vehicles sold, product recalls, and other customer service actions. Fees or premiums for the issuance of extended service plans are recognized in income over the contract period in proportion to the costs expected to be incurred in performing services under the contract.

Allowance for Credit LossesThe allowance for credit losses is our estimate of the probable credit losses inherent in finance receivables and operating leases at the date of the balance sheet and is included in Finance receivables, net and Net investment in operating leases. The allowance is based on factors such as historical trends in credit losses and recoveries (including key metrics such as delinquencies, repossessions, and bankruptcies), the composition of our present portfolio (including vehicle brand, term, risk evaluation, and new/used vehicles), trends in historical and projected used vehicle values and economic conditions. Additions to the allowance for credit losses are recorded as charges to the Financial Services provision for credit and insurance losses. Finance receivables and lease investments are charged to the allowance for credit losses at the earlier of the time an account is deemed to be uncollectible or the account is 120 days delinquent, taking into consideration the financial condition of the borrower or lessee, the value of the collateral, recourse to guarantors and other factors. Recoveries on finance receivables and lease investments previously charged off as uncollectible are credited to the allowance for credit losses.

Sales of ReceivablesFord Credit securitizes finance receivables and net investment in operating leases and sells retail installment sale contracts in whole-loan sale transactions to fund operations and to maintain liquidity. Most of its securitizations do not meet the criteria for off-balance sheet treatment. As a result, the securitized assets and associated debt remain on its balance sheet and no gain or loss is recorded for these transactions.Ford Credit records its sales of receivables as off-balance sheet when each of the following criteria is met: • The receivables are isolated from the transferor (i.e., Ford Credit transfers the receivables to bankruptcy-remote special purpose entities ("SPEs") or other independent entities).• The receivables are transferred to an entity that has the right to pledge or exchange the assets, or to a qualifying SPE whose beneficial interest holders have the right to pledge or exchange their beneficial interests. In its off-balance sheet transactions, Ford Credit generally uses a qualifying SPE or it sells the receivables to an independent entity. In either case, Ford Credit does not restrict the transferee from pledging or exchanging the receivables or beneficial interests.• The transferor does not maintain control over the receivables (i.e., Ford Credit is not permitted to regain control over the transferred receivables or cause the return of specific receivables, other than through a "cleanup" call, an optional repurchase of the remaining transferred financial assets at a point where the cost of servicing the outstanding assets becomes burdensome in relation to the benefits).For off-balance sheet sales of receivables, gains or losses are recognized in the period in which the sale occurs. Ford Credit retains certain interests in receivables sold in off-balance sheet securitization transactions. In determining the gain or loss on each sale of finance receivables, the investment in the sold receivables pool is allocated between the portions sold and retained based on their relative fair values at the date of sale. Retained interests may include residual interest in securitizations, restricted cash held for the benefit of securitization investors, and subordinated securities. These interests are recorded at fair

value with unrealized gains recorded, net of tax, as a separate component of Accumulated other comprehensive income/(loss). Residual interests in securitizations represent the present value of monthly collections on the sold finance receivables in excess of amounts needed for payment of the debt and other obligations issued or arising in the securitization transactions. Ford Credit does not retain any interests in the whole-loan sale transactions but continues to service the sold receivables.In both off-balance sheet securitization transactions and whole-loan sales, Ford Credit also retains the servicing rights and generally receives a servicing fee. The fee is recognized as collected over the remaining term of the related sold finance receivables. Ford Credit establishes a servicing asset or liability when the servicing fee does not adequately compensate for retaining the servicing rights. Interest supplement payments due from affiliates related to receivables sold in off-balance sheet securitizations or whole-loan sale transactions are recorded, on a present value basis, as a receivable in Other assets on its balance sheet at the time the receivables are sold. Present value accretion is recognized in Financial Services revenues.

Critical accounting estimates:

Warranty and Additional Service ActionsNature of Estimates Required. The estimated warranty and additional service action costs are accrued for each vehicle at the time of sale. Estimates are principally based on assumptions regarding the lifetime warranty costs of each vehicle line and each model year of that vehicle line, where little or no claims experience may exist. In addition, the number and magnitude of additional service actions expected to be approved, and policies related to additional service actions, are taken into consideration. Due to the uncertainty and potential volatility of these estimated factors, changes in our assumptions could materially affect net income.

Assumptions and Approach Used. Our estimate of warranty and additional service action obligations is re-evaluated on a quarterly basis. Experience has shown that initial data for any given model year can be volatile; therefore, our process relies upon long-term historical averages until sufficient data are available. As actual experience becomes available, it is used to modify the historical averages to ensure that the forecast is within the range of likely outcomes. Resulting accruals are then compared with present spending rates to ensure that the balances are adequate to meet expected future obligations.

Allowance for Credit Losses

The allowance for credit losses is Ford Credit's estimate of the probable credit losses inherent in finance receivables and operating leases at the date of the balance sheet. Consistent with its normal practices and policies, Ford Credit assesses the adequacy of its allowance for credit losses quarterly and regularly evaluates the assumptions and models used in establishing the allowance. Because credit losses can vary substantially over time, estimating credit losses requires a number of assumptions about matters that are uncertain. Nature of Estimates Required. Ford Credit estimates the probable credit losses inherent in finance receivables and operating leases based on several factors.

Retail Installment and Lease Portfolio. The retail installment and lease portfolio is evaluated using a combination of models and management judgment, and is based on factors such as historical trends in credit losses and recoveries (including key metrics such as delinquencies, repossessions, and bankruptcies), the composition of our present portfolio (including vehicle brand, term, risk evaluation, and new/used vehicles), trends in historical and projected used vehicle values, and economic conditions. Estimates from models may not fully reflect losses inherent in the present portfolio, and an element of the allowance for credit losses is established for the imprecision inherent in loan loss models. Reasons for

imprecision include changes in economic trends and conditions, portfolio composition and other relevant factors.

1b. What does Ford say in Footnote 2 about its use of accounting estimates? What risk do these estimates pose for the auditor?

“Use of EstimatesThe preparation of financial statements in accordance with U.S. GAAP requires us to make estimates and assumptions that affect our reported amounts of assets and liabilities, our disclosure of contingent assets and liabilities at the date of the financial statements, and our revenue and expenses during the periods reported. Estimates are used when accounting for certain items such as marketing accruals, warranty costs, employee benefit programs, etc. Estimates are based on historical experience, where applicable, and assumptions that we believe are reasonable under the circumstances. Due to the inherent uncertainty involved with estimates, actual results may differ.”

This note alerts the financial statement user to the inherent uncertainty of some of the key accounts that affect the revenue cycle accounts. To the extent that these amounts are inherently uncertain and lack verifiability, fluctuations and differences from expectations create audit risk for the audit firm: they are attesting to a single number, when in fact that number may not be known with great certainty.

2. Compare Ford and Toyota’s footnotes on finance receivables. Which company provides more informative disclosures? What is the audit firm’s responsibility regarding the informativeness of the disclosures?

Toyota’s disclosures are more informative, particularly in terms of maturities of receivables and sensitivity analyses regarding key economic assumptions and adverse changes in economic assumptions. Auditors review the adequacy of disclosures made in the footnotes, so the auditors on the Ford audit should consider whether disclosures are adequate, and why Ford management has chosen not to disclose as much information about its finance receivables as Toyota management has done.

3. Use the financial ratios provided in an earlier chapter appendix for Ford and Toyota. What are the ratios most relevant to the revenue cycle?

Sales growth, quick ratio, current ratio, margins (i.e., all profitability ratios), revenue per employee, receivable turnover.

4. Ford lists a variety of risk factors associated with its business. Review those, and identify which relate most to the revenue cycle. What evidence might the auditor gather to understand how those risks may affect the financial statement line items associated with the revenue cycle?

Continued decline in market share, accompanied by the fact that Ford has very significant fixed costs, thereby contributing to problems with profitability.

o Evidence: market share data, profitability data, going concern discussions with management.

Continued or increased price competition, combined with industry overcapacity. Ford and its competitors offer marketing incentives to compete, but these incentives are obviously expensive and reduce revenue.

o Evidence: data on marketing incentive levels, compared to industry averages. Market shift away from the highly profitable SUV and truck sales.

o Evidence: Sales data by product line; profit margins by product line; Ford plans to shift production into more profitable sectors.

Decline in industry sales, particularly in the US and Europe resulting from slow economic growth etc., again coupled with the fact that Ford has very significant fixed costs.

o Evidence: sales trends, market comparisons, plans to reduce and manage fixed costs.

Lower than anticipated market acceptance of new or existing products.o Evidence: Product sales data; management plans to mitigate this risk.

Work stoppages or other interruptions of supplies can affect Ford’s ability to manufacture products.

o Evidence: Data on pervasiveness of work stoppages, management’s assessment of the likelihood of such occurrences in the future, plans to mitigate such work stoppages.

Discovery of defects in vehicles resulting in higher warranty costs.o Evidence: Warranty estimates, and auditor evaluation of whether the reserve for

warranties is adequate. Lower than anticipated residual values or higher than expected return volumes for leased

vehicles, which may affect the valuation of financing receivables.o Evidence: Leasing information, auditor evaluation of management’s assumptions

used to calculate receivable and allowance valuation. Increased competition from banks or other financial institutions to increase their share of

financing Ford vehicles, which may affect the revenue flows on the financing side of Ford’s business.

o Evidence: Competition information, management plans to compete. Changes in interest rates, which may affect Ford’s interest rate exposure related to

financing receivables.o Evidence: Conducting sensitivity analyses on various interest rate possibilities as

they relate to valuation of finance receivables and associated allowance accounts. Collection and servicing problems related to finance receivables and net investment in

operating leases. o Evidence: Data tracking collecting and servicing problems, and auditor

evaluation of how those problems are factored into allowance account valuations.

5. Read Ford’s “Management Discussion and Analysis” section that relating to the revenue cycle. What are the main points that Ford management raises regarding its ability to generate revenue and profits in the near term? What does their statement imply about the risks associated with auditing Ford Motor Co.?

They indicate concerns about the negative effects of Ford and overall industry excess capacity and pricing pressure. They indicate plans to follow the following strategies to reverse their negative financial trends:

Aggressively restructure to operate profitably at the current demand and changing model mixo Personnel reductionso Plant closings

Accelerate development of new products our customers want and value Finance our plan and improve our balance sheet Work together effectively as one team

o Intensive and coordinated planning effort to achieve their plans and goals.

The concern with excess capacity implies that there is considerable risk related to the impairment of property, plant, and equipment. Active restructuring implies that the company may incur large separation costs related to retirement or lay-offs of employees.