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38. Jon Hampton, president and CEO of Plasticks, Inc., is living a life-style beyond his means.

He has several short positions to cover with his stock brokers. His creditors are becoming especially aggressive in collecting his debts. Unable to cut back his spending, he borrowed the needed funds from the corporation. In order to make the transactions as complex as possible for any auditor, he used a wholly-owned subsidiary and several banks as tools to move the funds. The usual procedure was to have Plasticks issue a note to his subsidiary, Extrusions, Inc. Extrusions discounts the note at one of the banks and transfers the money to Plasticks. Plasticks then loans the funds to Extrusions, which loan them to Jon Hampton. Although Hampton pledges his stock to Plasticks as collateral, the stocks true value rests upon Hamptons ability to repay the loans. In this case the loans receivable make up 40% of Plasticks total assets. Hampton becomes insolvent due to his bad investing decisions in the stock market. Required: What audit procedures would have alerted the auditor to the risk in this situation and the identification of the fraud? This is an illustration of the risks involved with related party transactions. The auditor would have performed audit procedures to identify any related party transactions, including any transaction with the shareholder or a subsidiary such as Extrusions. Independent confirmations would have been sent to Plasticks banks requesting confirmation of both cash balances as well as any loan balances. The confirmations would reveal the loan to Extrusions, and a review of the intercompany cash transfers would show the cash distribution to Plasticks, and ultimately to the CEO. Having identified the related party transactions, the auditors would have obtained an understanding of the transactions and obtained and evaluated sufficient evidence to be persuaded that the financial statement disclosure was adequate. The examination of related party transactions would include examining the minutes of the Board of Directors for approval, examination of the collateral (which in this case would have included an analysis of Plasticks financial statements) and tracing the loan proceeds to reveal their ultimate disposition. 39. [LO 3] Winton Marx, a producer of motorcycle parts, has experienced poor income, due to foreign competition. In a move to try to undercut a possible proxy fight with dissident stockholders, Geoff Daniels, the companys CEO, formed a shell company known as Turbo Repair Shops, Inc. The company was supposedly a regional chain of motorcycle repair shops and fictitious documents were created showing fabricated Winton Marx sales. As a result Winton Marx sales were significantly increased over the preceding year, as compared to other industry competitors who showed declines and losses. Required: What audit procedures would have alerted the auditor to the risk in this situation and the identification of the fraud? Auditors should have done a study of the business and the industry before undertaking the audit. This would have indicated the severe competition and declining trends in industry earnings. Analytical procedures should have highlighted the sales increase and heavy sales to a new customer. Risk resolution procedures for the unusually high Turbo sales would require examination of documentation related to the sales to the new customer, including examination of subsequent cash receipts from Turbo and analysis of outstanding receivables. 40. [LO 2] For the year ended 2010, Jocelyn Morris, CPA, has been engaged to audit Rogers, Inc, who is a continuing client. Jocelyn has assessed the control risk for the company at the maximum for all financial statement assertions involving investments. Jocelyn determines that Rogers is unable to exercise significant influence over any investee and there are no related parties. Morris receives an investment analysis from Rogers management revealing the following: There is a notation indicating that all securities are either in the treasurers safe or held by an independent bank custodian. Investments are classified as current or noncurrent. The beginning and ending balances are shown at cost and market. Unamortized premiums or discounts are associated with bonds. The face amount of bonds or number of shares of stock are given for the beginning and ending of the year. Accrued investment income for each investment at the beginning and ending of the year is presented. Investment income earned and collected is presented. Valuation allowances at the beginning and ending of the year are shown. Any sales or additions to portfolios for the year include date, number of shares, face amount of bonds, proceeds, cost, and realized gain/loss. Required: Explain the objective for each of the listed primary financial statement assertions relative to investments. Assertion Objective Existence Completeness Valuation/allocation Determine that the custodian identified in a confirmation holds the securities. Determine that all collections and income from investments are recorded. Determine that the market value of the investments is fairly stated, including gain/loss recognition recording. Presentation and Disclosure and Determine that investment presentation is in conformity with GAAP. 41. Required: Using the information given in the Problem 40 scenario, identify several additional substantive auditing procedures that Jocelyn Morris should consider applying in her audit of Rogers investments. [LO 2, 4] Examine the contractual terms of the bonds. Inspect securities on hand in the presence of the custodian. Determine that sales and purchases were properly approved by the Board of Directors. Determine whether any investments are pledged as collateral or have liens. If so, are these recorded? Trace payments for purchases to cancelled checks and proceeds from sales to cash receipt entries. Examine brokers advices and confirm transactions with broker. Examine any supporting evidence for transactions that occurred between the balance sheet date and the inspection date. These include such documents as broker advices. Obtain confirmations from issuers or trustees for investments in nonpublic entities. Compute unrealized gains/losses and determine if they are properly recorded and classified, with respect to the types of portfolios. Recompute

amortization of discounts/premiums on bonds and determine if they are properly recorded. Recalculate gains and losses on dispositions and determine if they are properly recorded. Confirm the investments held by the custodian. Tie out the custodian confirmation to the statements prepared by the broker. Reconcile the custodian statements to the general ledger. Independently verify the valuations assigned to the investments. 42. [LO 5, 7] Glendas Exercise Equipment, Inc. leases its warehouse from Country Leasing Company. The terms of the lease provide for minimum lease payments of $390,000 every six months payable at the beginning of each bi-annual period. The initial lease term runs for sixteen years with no renewal or purchase options. Glenda is responsible for paying property taxes and also needed repairs to the warehouse. The cost of the warehouse to Country was $3,600,000 and the market value at the date of completion was $5,200,000. Explicit interest rate state in the lease is 10%. The lease was signed and occupation occurred on January 3, 2010. Whitehall & Associates, CPAs have audited the accounts of Glenda for four years. The company has a December 31 year-end. Melinda Halsey is in charge of the 2010 audit and she has asked you to audit the Country warehouse lease. Required: What are the general objectives in the audit of the Country warehouse lease? The audit of the lease should be primarily focused on the valuation, presentation and disclosure of the lease. The procedures should include a calculation by the auditor to determine if the lease meets capital lease accounting criteria. 43. [LO 5, 7] You have been engaged to audit the financial statements of Quinn Corporation for the year ended December 31, 2010. During the year Quinn obtained a long-term loan from a local bank. The finance terms are as follows: 1. The loan is secured by inventory and accounts receivable of the company. 2. The companys debt-to equity ratio should not exceed 2:1. 3. Monthly installment payments will begin July 1, 2010. 4. The company must get permission from the bank before paying dividends. In addition to this loan, you learn that the company borrows short-term funds from the company president. The amounts are material and just prior to year-end. Required: (a) What procedures (other than internal control) should you use when auditing the described loans? Independent confirmation of the loan balance and compliance with loan covenants, Review of managements debt compliance analysis and comparison with the terms of the loan agreement, Review of the cash flow forecast for the next year (b) What questions do you expect should be answered by the financial statement disclosures that you find with respect to the presidents loan? The amount, timing and repayment terms of the related party loan must be disclosed. 44. [LO 5, 7] Bartel and James formed a corporation called Financial Magic Services, Inc. In the corporation, Stan Bartel is a CPA (audits and tax services) and Morgan James is a casualty insurance underwriter. Bartel accepted an audit engagement with Ralston Company. Ralston had total assets of $750,000 and total liabilities of $275,000.During the audit, Bartel found that Ralstons building with a book value of $300,000 was pledged as collateral for a 10-year note amounting to $225,000. The client did not mention the lien, but Bartel found that the values of all other financial statements were satisfactory, so he issued an unqualified opinion. About 60 days after the audit, Bartel learned that an insurance company, who was unaware of the lien, was planning to loan $175,000 in the form of a first mortgage on the building. Bartel talked to James, a CPCU (Chartered Property Casualty Underwriter), who agreed to notify the insurance company. Required: What does this situation suggest about important ethical and professional issues that may relate to auditing client debt? Bartel should have disclosed the terms of the lien and 10 year note in the balance sheet and footnotes to the audited financial statements of Ralston. If Bartel did not, Bartel may face legal exposure for professional negligence. Having made such disclosure in the footnotes, there is no reason to believe there is any problem with the unqualified opinion. The insurance company planning to loan Ralston $175K in exchange for a first mortgage would perform a title search as part of its underwriting process, and the preceding encumbrance for the 10 year note would be identified in that process as part of the underwriting of the $175K loan. Ralston is neither obligated to assist in the insurance companys underwriting process, nor can Bartel divulge details of Ralstons finances without Ralstons permission. The disclosure to James violates Rule 301 of the AICPAs Code of Professional Conduct and state and federal laws regarding confidentiality of information. Activity Assignments 45. Find the financial statement note for cash for American Eagle Outfitters and compare it to the cash note disclosure for Host Hotels and Resorts shown in the chapter. How do the two note disclosures compare? Why do you think Host Hotels and Resorts needs to provide so much more disclosure on cash? Student responses will vary with the American Eagle Outfitters financial statement selected for the comparison. Note 3 of the 10K for the year ended January 20. 2010 covered cash and cash equivalents, short-term investments and long term investments. At the time, there were no cash balances that were restricted. The cash note disclosure for Host Hotels and Resorts shown in the chapter includes a table disclosing restricted cash balances and doesnt include disclosures regarding any investments. 46. Go to the 10K for Tiffany and Co. and find information related to hedging for foreign currency. What audit steps would be performed on these accounts and disclosures? Note J in the notes to the financial statements in the 10K for the year ended 3-30-2010 entitled Hedging Instruments describes foreign exchange forward contracts. Audit procedures to be performed on these accounts and disclosures would include a review of the contracts, confirmation with counterparties or custodians and procedures such as recalculation and independent verification to test the values assigned to these contract. 47. Find the debt description in the

financial statement notes and management discussion and analysis (MD&A) in the 10K of The Boeing Corporation. How many paragraphs or pages is the debt-related disclosure in the MD&A? In the financial statements? List the types of information included in the two disclosure sources noting when they are the same and different. The 10K for the year ended 12-31-2009 discusses debt in Note 13 on pages 83-85. The debt discussion in the MD&A analysis is at page 43 under the caption Contractual Obligations where there is a table showing various maturities and three paragraphs of discussion. The financial statements disclose only totals for the various categories of long term debt. The breadth of coverage of the two disclosures is different and they are difficult to compare. The most notable difference is that the MD&A analysis gives additional forward-looking information about maturities. 48. Continuing with the 10K The Boeing Corporation, look for disclosure on leases. Does Boeing have operating leases? Capital leases? For what? Referring again to the 10K for 12-31-2009, capital and operating lease obligations are listed in the table of maturities at page 41 of the MD&A. The notes to the financial statements include lease disclosures in Note 9 (property plant and equipment) and in Note 11 (future lease commitments). Note 9 mentions equipment and Note 11 mentions aircraft, but there is not much of a description of what is being leased.