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 ma or accounts included in the revenue cycle are! "ales "ales-#elated $xpenses and %iabilities! o "ales #eturns & 'llo(ances o Warranty $xpense and %iability o "alesperson )ommissions 'ccounts #eceivable 'llo(ance for *oubtful 'ccounts *oubtful 'ccounts $xpense )ash

+nderstanding the relationships bet(een the accounts allo(s the auditor to develop a more efficient audit approach. 's sho(n in ,igure 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. ,or example, most companies (ill ma/e an estimate of the (arranty expense liability based on a percentage of sales and (ill then ad ust the expense and liability as experience dictates. "imilarly, 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 allo(ance for doubtful accounts. 10-0. ,or the accounts receivable account, the more relevant assertions are typically existence and valuation. While the auditor (ill li/ely gather evidence related to each of the assertions for accounts receivable, the more relevant assertions are the ones (here there is higher ris/ of misstatement and for (hich the auditor (ill li/ely need more evidence. 1dentifying (hich assertions are more relevant helps the auditor plan a more efficient audit by having the auditor focus more attention on the assertions (here there are more ris/s.

11.2The ma or activities involved in generating and recording of a sales transaction and related documents include! Activities 1. #eceipt of customer purchase order or generation of sales order based on customer in3uiry. 2. 1n3uiry of current inventory status. 0. 6eneration of bac/order -(here applicable and desired by customer.. 2. )redit approved for shipment. 8. "hipping and pac/ing instructions and documents prepared. 9. "hipping department records goods shipped and sends verification bac/ to billing for generation of invoice. Documents Generated 1. 4urchase order -from customer. or sales order. 2. 5o document. #esponse is made to in3uiry. 0. 7ac/order confirmation sent to customer. 2. )onfirmation number or formal signature to sales person for entry on sales order. 8. 4ac/ing slips. 1nventory pic/ing tic/ets. "hipping instructions. 9. 7ill of lading -shipping document given to shipper.. 4ac/ing slip or some similar document used to capture shipping information to send bac/ to billing function. :. 4reparation of invoice. ;. <onthly statement sent to clients. =. 4ayment is received. :. 1nvoice ;. <onthly statement of open items =. Turnaround document or another document prepared to list payments received.

10-8. #evenue recognition should ordinarily be considered a fraud ris/ factor because over half of frauds that have been studied involved improper revenue recognition by either recognizing revenue early or recording fictitious revenue. 10-9. The "$) staff has determined that the follo(ing criteria must be met before revenue can be recognized! 4ersuasive evidence of an arrangement exists, *elivery has occurred or services have been rendered,

The seller>s price to the buyer is fixed or determinable, and )ollectibility is reasonably assured.

#esearch may be re3uired for sales arrangements that are out of the ordinary. The "$) and '1)4' have published documents that provide criteria for recognition of such revenue transactions. 10-:. #ecent fraud investigations underta/en by the "$) uncovered a (ide variety of methods used to inflate revenue! #ecognition of revenue on shipments that never occurred. ?idden @side lettersA giving customers an irrevocable right to return the product. #ecording consignment sales as final sales. $arly recognition of sales that occurred after the end of the fiscal period. "hipment of unfinished product. "hipment of product before customers (anted or agreed to delivery. )reation of fictitious invoices. "hipment to customers that did not place an order. "hipment of more product than the customer ordered. #ecording shipments to the company>s o(n (arehouse as sales. "hipping goods that have been returned and recording the reshipment as a sale of ne( goods before issuing credit for the returned sale.

10-;. There are many reasons management may report higher profits by overstating revenue. 7an/ruptcy 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. $xecutives may be pressured to meet their o(n or analysts> earnings expectations. The company may need additional financing. 7onuses or stoc/ options may be dependent on reaching a certain earnings goal. ' merger may be pending and management (ants to negotiate the highest price possible. 10-= The auditor can compare the client>s revenue trend (ith economic conditions and industry trends. )ash flo( from operations can be compared (ith net income over a period of time. #atio and trend analysis and reasonableness tests can be performed. "ome of the ratios the auditor might (ant to compute include! 6ross margin analysis, including a comparison (ith 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 'verage balance per customer #eceivables as a percentage of current assets 'ging of receivables

'llo(ance for uncollectible accounts as a percent of accounts receivable 7ad debt expense as a percent of net credit sales "ales in the last month to total sales "ales discounts to credit sales #eturns and allo(ances as a percentage of sales

"ome basic trend analyses include! <onthly sales analysis compared (ith past years and budgets, 1dentification of spi/es in sales at the end of 3uarters or the end of the year, Trends in discounts allo(ed 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 (ith some underlying economic factor or event. ,or example, revenue from room rental for a motel can be estimated using the average room rate and average occupancy rate. 'lternatively, the revenue from an electrical utility company should be related to revenue rates approved by a 4ublic "ervice )ommission -(here applicable. and demographic information about gro(th in households and industry in the service area being served. 10-10. The audit steps associated (ith an integrated audit for the revenue cycle include the follo(ing! 1. )ontinually update information on business ris/, including the identification of any fraud ris/ factors noted during preliminary audit planning. +pdate audit planning for ne( ris/ information. 2. 'nalyze potential motivations to misstate sales, as (ell as the existence of other fraud indicators, and determine the most li/ely method that sales might be misstated. 0. 4erform preliminary analytical procedures to determine if unexpected relationships exist in the accounts, and document ho( the audit testing should be modified because of the unusual relationships.

2. *evelop an understanding of the internal controls in the revenue cycle that are designed to address the ris/s identified in the three previous steps, including the applicability of entity-level controls to the revenue cycle. This understanding (ill include a revie( of the client>s documentation of internal controls.

8. *etermine 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. 9. *evelop a plan for testing internal controls and perform the tests of /ey controls in the revenue cycle. -,or non-public companies, the auditor can choose to not test controls, but must determine (here material misstatements could occur if controls are not present.. :. 'nalyze the results of the tests of controls. 1f deficiencies are identified, assess those deficiencies to determine (hether they are significant deficiencies or material (ea/nesses. *etermine (hether the preliminary control ris/ assessment should be modified -should control ris/ be assessed at a higher level. and document the implications for substantive testing. *etermine the impact of these deficiencies, and any revision in the control ris/ assessment, on planned substantive audit procedures by determining the types of misstatements that are most li/ely to occur. 1f no control deficiencies are identified, assess (hether the preliminary control ris/ 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 (ill be less than (hat is li/ely re3uired in circumstances (here deficiencies in internal control (ere identified. ;. 4erform 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 (ill include procedures to address fraud ris/s.

10-11 ,or non-public companies, the auditor can choose to not test controls, but must still have an understanding of the client>s controls and determine (here material misstatements could occur if controls are not present. The audit (ill be based solely on substantive procedures. <ost li/ely, the ma ority of the evidence (ill come from direct tests of account balances and transactions rather than substantive analytics. The auditor (ill not obtain any evidence related to the operating effectiveness of controls. 10-12. 1nherent ris/s associated (ith sales include! #ecognizing revenue in the (rong accounting period. The impact of unusual terms, and (hether title has passed to the customer. 6oods recorded as sales have been shipped and (ere ne( goods.

The proper treatment of sales transactions made (ith recourse or that have an abnormal or unpredictable amount of returns.

The primary ris/ associated (ith receivables is that the net amount sho(n is not collectible, either because the recorded receivables do not represent bona fide claims or there is an insufficient allo(ance for uncollectible accounts. Bther ris/s affecting receivables include! "ales of receivables made (ith recourse and recorded as sales transactions rather than financing transactions. #eceivables pledged as collateral against specific loans (ith restricted use. *isclosures of such restrictions are re3uired. )ollection of a receivable is contingent on specific events that cannot currently be estimated.

10-10. 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.

"ome companies create high expectations and may not pay much attention to ho( the goals are achieved, but rather (hether they are achieved. "imilarly, representations to the financial press by management or stoc/ analysts regarding performance expectations create incentives to meet those expectations, because failure to do so can cause the company>s stoc/ price to drop. 10-12. "ending monthly statements and establishing a separate group to handle customer in3uiries enhances controls as follo(s! $ach customer receives a statement and can verify the statement for accuracy and timeliness of the clientCs update of records. The customer has a basis to follo(-up on potential errors in the accounts, such as failure to post a payment or a dispute about returned merchandise. $stablishing a separate group to handle customer in3uiries creates a segregation of duties. The individuals handling customer in3uiries and follo(ing 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 chec/ on the accuracy of the normal accounts receivable processing.

10-18. <onitoring controls that may be effective in the revenue cycle include!

)omparison of sales and cost of sales (ith budgeted amounts, -#is/ of fictitious sales, or sales recorded before cost of sales. $xception reports to management for unusual transactions or dollar amounts. "uch reports are investigated and corrective action, if needed, is ta/en. -#is/ that inappropriate items are authorized, or there is override of other controls., )omputer generation of transaction volumes that exceed pre-specified norms. -#is/ that normal controls built into the computer process fails.. 1nternal audit of the revenue cycle and applicable controls -#is/ that normal controls fail to operate.. #evie( by divisional and departmental management of internal controls and the 3uality of exception reports for management decision ma/ing. -#is/ that exception reports are not analyzed for the source of the problem, and that corrective action is ta/en on a timely basis., )omputer reports reconciling all transactions entered into the system (ith transactions processed. -#is/! inappropriate items are processed, or some items are processed more than once.. <onitoring of accounts receivable for 3uality, e.g. aging of accounts receivable by 3uality of the customer as assigned by an outside rating service. -#is/! overstatement of accounts receivable. 4eriodic computer reports of all transactions processed that exceed previously stated edit rules, -for example, a scarf report.. -#is/! there (as an override of normal edit controls.. 1ndependent follo(-up of customer complaints. -#is/! normal controls have failed that (ould have been brought to the company>s attention by customer complaints..

10-19. 'uditors often debate this 3uestion. <any auditors believe that a minimum amount of reperformance of the control is necessary in some instances in order to determine that the person performing the control actually performed the procedure indicated. 1n other (ords, the person did not simply initial the document. The auditor gathers evidence through re-performance that the control (as operating effectively. Bther auditors believe that controls are independent and the auditor can udge the general conscientiousness (ith (hich employees carry out their duties. 1f the employees appear to be conscientious, there (ould be no need to re-perform the procedures unless there is evidence generated through substantive tests or other(ise, that the control procedures are not operating effectively. 1nstead of testing controls through reperformance, the auditors (ould use some set of tests comprising in3uiry, observation, andDor examination of documentation The authors> position is that some minimal amount of re-performance is necessary in areas (here there are higher ris/s of misstatement. 1n lo(er ris/ areas, some set of tests comprising in3uiry, observation, andDor examination of documentation may be sufficient. The extent of re-performance may be dependent on the auditorCs assessment of the overall control environment, including the conscientiousness (ith (hich 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 (ith the ris/ of misstatement. 10-1:. Typical tests of controls include in3uiry 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. "ome examples of tests of controls include! Manual testingETa/e a sample of recorded transactions and determine that the control policies and procedures (ere follo(ed. This is an example of examination of documentation. Computerized testing of computer controlsETest 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 controlsE<anagement should have controls in place to assist them in monitoring sales. ,or example, management may have set targets for gross profit by product line and receive (ee/ly reports on actual results. <anagement 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 (ith personnel responsible for this monitoring -in3uiry., revie( these reports -examination of documentation., determine if there (ere deviations based on the reports -examination of documentation., and determine (hat actions management too/ after investigating the problem -in3uiry andDor examination of documentation..

10-1;. 1f the ris/ of material misstatement is assessed lo(, the auditor can plan less extensive substantive testing, or can be more flexible about (hen the procedures are applied. 1f the ris/ is greater than originally assessed, the auditor (ill need to ad ust the nature, timing, andDor extent of the planned substantive testing. Bne of the factors impacting the ris/ of misstatement is the effectiveness of the internal controls. 1f the internal controls are operating effectively, the auditor (ill be in a position to plan less extensive substantive testing, or can be more flexible about (hen the procedures are applied, or can use less rigorous procedures 10-1=. 'udit procedures are designed to obtain evidence to satisfy a specific audit ob ective that is developed to address one or more of managementCs assertions. ,or example, the auditor confirms accounts receivable to obtain evidence about the audit ob ective of establishing that the recorded receivables are bona fide claims on customers that, in turn, addresses managementCs assertion that the receivables exist. 10-20. $vidence obtained about accounts receivable provides evidence about sales and visa versa because of the double entry boo//eeping system. When evidence indicates one half of a sales transaction is properly recorded, the other half is li/ely to be correct, also. 1f 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. ' sample of sales transactions should be reprocessed for(ard and vouched bac/ in examining evidence of internal control effectiveness as (ell as testing for completeness and existence of sales and accounts receivable. $vidence from this examination can directly affect the nature, timing and extent of other substantive audit tests to be performed. "ince so many frauds have involved improper revenue recognition, substantial attention must be given to the audit of revenue as (ell accounts receivable. 10-22. 'uditing revenue provides a good opportunity to test the completeness assertion for both sales and accounts receivable. The auditor is loo/ing for a population that (ill provide evidence that a sale too/ 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, (hich can ta/e such forms as bills of lading, a manual or computerized shipping log, or copies of sales orders (hich are initialed after shipment. 1f the related population is pre-numbered, selecting a sample of transactions from that population and tracing them into the accounting records (ill provide strong evidence about the completeness of sales and accounts receivable . 10-20. The sample should be selected from the population that represents that sales transactions occurred, usually pre-numbered shipping documents. 7y selecting a sample from this population and tracing the selected transactions into the sales records, the auditor is able to test (hether sales transactions are being recorded. 10-22. ,or unusual or complex sales transactions, it is advisable to confirm receivables (ith customer personnel most familiar (ith unusual sales agreements and as/ about any side agreements that could affect revenue recognition. 'ccounts payable personnel (ould not be a(are of these details. 10-28. Bverstatements. 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. +nderstatements are less li/ely to be detected by direct tests of the details that ma/e 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 li/ely to be included in the sample. 10-29. ' lo(er ris/ 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 follo(ing (ays! 5ature - 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. $xtent - if positive confirmations are used, fe(er of them need to be sent.

10-2:. 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 (or/ less overtime after year-end. The disadvantages are! an increased ris/ 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 (or/ needed for the roll-for(ard period to reduce that ris/ to an acceptable level. 10-2;. 1ndividual unpaid invoices may be confirmed to improve the response rate from customers. )ustomers may not be able or are reluctant to confirm a balance made up of numerous invoices. 10-2=. 'n aged trial balance lists each customerCs balance (ith columns to sho( the age of the unpaid invoices. The aged trial balance can be used to select customer balances for confirmationF to identify any amounts due from officers, employees, or other related parties or any nontrade receivables that need to be separately disclosed in the financial statements. The auditor can identify overdue customersC balances. These can be discussed (ith the credit manager to help determine the ade3uacy of the allo(ance for doubtful accounts. )redit balances due customers can be identified and, if significant, they should be reclassified as a liability. "ubse3uent 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 revie( their subsidiary accounts to be sure the aging (as done properly. The trial balance should also be footed and cross-footed. The accuracy can often be tested using generalized audit soft(are. 10-00. 4ositive confirmations are letters sent to selected customers as/ing them to sign and return the letters directly to the auditor (hether or not they agree (ith the indicated balance. 5egative confirmations re3uest the customer to respond directly to the auditor only if they disagree (ith the indicated balance. 10-01. 4ositive confirmations are considered to be more reliable for t(o basic reasons. -1. The assumption that a negative confirmation that is not returned represents a correct receivable balance is not al(ays valid. There are a number of reasons it may not be returned, such as the customer lost or ignored it, the difference (as in the customerCs favor and they did not (ant this changed, or the customer did not understand the re3uest and thre( it a(ay. -2. ,ollo(-up procedures are performed (hen positive confirmations are not returned to provide some evidence that the receivable exists and is accurate

10-02. a.

b.

The auditor should send a second re3uest. 1f that fails, trace subse3uent collections into the records and the chec/ing accountF vouch the unpaid invoices to supporting documents, such as customerCs order, shipping document, and sales invoice. 1f the balance is individually significant, the auditor may call the customer or have the client call, to urge them to respond to the confirmation. +sually there is no follo(-up on unreturned negative confirmations - they are assumed to represent correct balances. 'n exception occurs (hen several customers return negative confirmations indicating they disagree (ith their balances and the auditor determines the customers are correct. This is an indication that the controls (ere not as effective as assessed and the auditor may decide it is necessary to perform follo(-up procedures on those that (ere not returned.

10-00. When the information being sent to the customer is verified by the auditor, the auditor controls the mailing, the confirmations are returned to the auditorCs office, not the clientCs, the information the customers are as/ed to confirm is ob ective, and they can verify the information from their o(n records and not have to call the client to determine (hat the amounts should be. 10-02. When there are a large number of small balances, the ris/ of material misstatement is lo(, and the auditor believes the customers (ill give proper attention to the auditorCs re3uest. 10-08. ' confirmation exception is a statement made by a customer on the confirmation response indicating a disagreement (ith 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. <isstatements need to be pro ected to the entire population of receivables before determining (hether there may be a material misstatement in the account balance. Timing differences do not represent misstatements in the account balance. 10-09. "ubse3uent collections of unpaid year-end balances provide strong evidence that the receivables existed and (ere accurate. "ome auditors believe this provides stronger evidence than confirmations and, (hen most of the receivables are collected before the end of the audit, place more reliance on this audit test than on confirmations. 10-0:. )utoff tests are procedures applied to transactions selected from those recorded during the cutoff period - ust before and ust after the balance sheet date. to provide evidence as to (hether the transactions have been recorded in the proper period. They provide evidence about proper cutoff, existence and completeness of the sale and receivable. 10-0;. ,raud indicators that might be identified by direct tests of revenue might include! unusual amounts of sales near the end of the year, sales (ith unusual terms, sales made to companies (ith only 4B 7ox numbers, special contract sales,

'udit procedures that could be used to determine if sales are fraudulent include! year-end cutoff tests, revie( of ma or sales contracts, sample of sales made near the end of the year to determine their validity, revie( of all large dollar value sales ta/ing place near the end of the year, confirmations (ith customers, generalized audit soft(are selection and analysis of sales made to common 4B box numbers, or to ne( customers.

10-0=. The allo(ance for doubtful accounts is based on management estimates. ' useful test of these estimates is to trac/ the history of annual (rite-offs and provisions for bad debts. 1f they (ere approximately e3ual over a period of years, these estimates (ould appear to be reasonable. The provision for bad debts can be recomputed by the auditor using managementCs formula. The auditor should, ho(ever, be alert to circumstances that may cause history to be a bad predictor of current expectations. ,or 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: 10-20. 10-21. 10-22. 10-20. 10-22. 10-28. 10-29. 10-2:. 10-2;. 10-2=. 10-80. 10-81. 10-82. 10-80. a. d. d. c. c. d. d b. c. a. c. a. c. b.

Discussion and Research Questions: 10-82. a. The "$) has emphasized that revenue recognition should be based on t(o /ey concepts! $arned, i.e. the revenue earning process has been completed, and #ealizable, i.e. the amounts recognized are li/ely to be realized.

The "$) has determined the follo(ing criteria must be met in applying the concept! b. Scenario 1. 'B% 4ersuasive evidence of an arrangement exists, *elivery has occurred or services have been rendered, The seller>s price to the buyer is fixed or determinable, )ollectibility is reasonably assured. "cenarios Revenue Reco!nition and Criteria 'B% proposes to 4attern of payments, #ecognize revenue on a recognize 00G of the G of customers failing to monthly basis as the fees up front rather than meet contract terms. provision of the service is from monthly service. the primary service being performed. 'B% (ants to recognize the mar/eting of the product as a primary service, but mar/eting is a precursor to the actual service performed. <achinery is completed. )ontract H right of refusal. 1f all the evidence gathered #e3uest is by customer Whether the customer has verifies the client story and to hold the machinery inspected the goods. the customer is a valid because factory is not $xpected delivery date. customer, an argument can finished. )redit rating of customer be made for current and validity of customer. recognition. 5e( product. The client must be able to reasonably estimate the amount of goods that (ill be returned. 'ffects both sales and receivables. "hould revenue be recognized because of the special discounts and unusually large end of year salesI "ales made to date. #eturns made to date. 'nalysis of returns by client, i.e. customer dissatisfaction, problems (ith product 3uality, etc. The auditor should search for the existence of Jside deals> that might allo( the customer to return goods. #evie( returns subse3uent to year-end. )onfirm terms of sales 1t is appropriate to recognize the sales if an ade3uate allo(ance for returns and uncollectible receivables can be estimated. Key Issues Additional In ormation

2. 7ill and ?old

0. *etermine ade3uate allo(ance for returns.

2. Bmer, Tech. 4ossibility of )hannel "tuffing.

#evenue is earned and realizable if no unusual rights of return existF including no unusual Jside deals> (ith customers.

Scenario

Key Issues

Additional In ormation and receivables (ith ma or customers (ith unpaid year-end balances. ?istory of sales after pilot tests. "ales contract and right of return. #ealizability of past salesF examine receivables.

Revenue Reco!nition and Criteria

8. $lectric )ity

9. Kac/son 4roducts

6oods are placed at customer>s location on a pilot test. The pilot period may last as long as 9 months. "ince most of the placements result in a sale, the client (ants to recognize revenue (hen the goods are placed at the client>s location. )ompany phased out line of business and sold most of the manufacturing e3uipment. "hould the sale of the e3uipment be recognized as revenueI

1t is difficult to recognize revenue (hen the product is placed at a customer>s location for evaluation. The promotion does not seem to meet the "$)>s t(o criteria.

)onfirm management intent and business plan. *etermine terms of the e3uipment sale.

1f the company is remaining in its original line of business, or a similar line, then revenue should be recognized by producing and selling those productsF not by selling machinery. The machinery should be sold and a separate line item should be established to recognize the gainDloss on sale of e3uipment.

10-88 a. The most telling analytical results are The significant increases in number of day>s sales in receivables and inventory from 200=. They are also significantly higher than their ma or competitor in 2010. The percent increases in receivables -109G. and inventory -90G. in 2010 far exceed the increases in sales -=G.. The number of day>s sales in receivables -2=. does not ma/e sense given that the ban/s usually pay (ithin t(o (ee/s of shipment. 1n prior years, the number of day>s sales in receivables and inventory had remained very stable and compared favorably (ith their competitor and their customers> ban/s payment time-line. The 2010 results are obviously unexpected and indicate potential problems (ith receivables and inventory. b 4ossible explanations are! #ecording fictitious sales near year-end. 7uilding up inventory in anticipation of an employees> stri/e.

<a/ing sales closer to year-end than in prior years. "hipping more boats near year-end than customers ordered. #ecording fictitious inventory.

c. 1n3uiries and follo(-up procedures include! 1n3uiring of management about a possible stri/e or other factors that might explain the increases in receivables and inventory. Louching sales recorded near year-end to supporting customer orders and shipping records to be sure they are legitimate, agree (ith customer order 3uantities, and are recorded in the proper accounting period. Lerifying that the receivable subsidiary records agree (ith the control account balance. $xpanding confirmation and subse3uent collection (or/. Lerifying that the inventory records agree (ith the control account balance. 1nsist on a complete physical inventory at or near year-end and carefully observing the inventory and ma/ing test counts to compare (ith the client>s counts, especially for the high-dollar items. )arefully revie(ing ournal entries made prior to year-end closing. d. This case is based on an actual situation in (hich one of the author>s (as involved. The ),B had embezzled several millions of dollars of cash by having chec/s dra(n on the company>s regular cash account for deposit in another cash account the ),B (as able to control. These chec/s re3uired dual signatures H the ),B>s and the )$B>s. +nfortunately the )$B trusted the ),B and did not 3uestion the purposes of these chec/s he signed. The ),B then recorded ournal entries ust before year-end debiting receivables and inventory and crediting cash. 10-89. a. This cross-sectional analysis can be performed using either $xcel -or compatible spreadsheet. or ')%. "sin! #$cel! 1. *o(nload the FloorMart data file from the (eb site http!DD(((.cengage.comDaccountingDrittenberg. 2. 'dd t(o columns for each store! a. )alculate 1nventory per s3uare foot b. )alculate "ales per s3uare foot 0. "ort the 1nventory per s3uare foot column in descending se3uence. 2. "ort the "ales per s3uare foot column in descending se3uence. 8. 5ote in steps 0 and 2, stores 121 and 122 are significantly greater than the rest of the stores. "tore 1nventory D "3uare ,oot "ales D "3uare ,oot

121 122 5ext largest

12.10 12.18 ;.00

2=:.;9 029.=9 20:.81

"sin! AC%! 1. *o(nload the FloorMart data file from the textboo/ (eb site and import it into ')%. http!DD(((.cengage.comDaccountingDrittenberg. 2. 'dd t(o columns using the #$prM Inventory & S' (t and Sales & S' (t. 0. "ort each of those ne( columns in descending order. The results are the same as above. b. "pecial attention needs to be paid to these t(o stores. "ome of the audit steps (ould be! 1. 1n3uire of corporate management about these t(o stores and their managers. ?ave they had any problems (ith them in the pastI 're they a(are of any fraud at these storesI *o these stores usually perform better than the other storesI WhyI 2. ?ave the internal auditors investigated the controls at these storesI 1f so, revie( their (or/ing papers and in3uire of the internal auditors about their findings. 0. )ompare current year results (ith prior years for these t(o stores. 2. 1nclude these t(o stores (ith other stores selected and observe the physical inventory procedures and ma/e test counts of the inventory at these t(o stores. The client li/ely uses perpetual inventory records and ta/es a physical inventory at different times of the year at different stores. The client should re3uire that the physical inventory at these t(o stores be ta/en at or near yearend. 8. #evie( the cutoff of sales transactions. "ince the auditor (ill be on the premises at or near year-end, the cash register tapes should be compared (ith the recorded sales to be sure they are recorded in the proper period.

10-8:. a. The change in sales person commission is very important because it changes the emphasis of the sales person to ma/ing sales (ith little regard for credit, 3uality, or other issues that affect the long-term profitability of the company. "pecifically, the change! 5egates sales returns as an important compensation factor, Ta/es out realizability, i.e. the sales commission is not affected by (hether the customer pays, There is no penalty for selling poor 3uality products. ' commission is granted even if the product 3uality is poor. The auditor should carefully revie( sales returns and allo(ances and cash collections after year end, comparing them to prior years. The allo(ance for doubtful accounts balance li/ely (ill need to be a higher percent of receivables than in prior years. Therefore, the auditor must be sure the allo(ances appears reasonable in light of

li/ely sales to less credit-(orthy customers. 'n allo(ance for sales returns may need to be established if it appears returns are materially higher in early 2011 than in prior years. b. 'nalytical information!
Sales Net Income Stock Price Economic Growth in reas Ser!e" Percent o$ %eatin& 'arket () SSS cco*nts +ecei!a(le Gross 'ar&in % Change from Prior Year 2007 2008 2009 0.10 0.08 0.11 0.36 0.11 0.24 0.41 -0.21 0.47 0.04 0.0# 0.04 0.06 0.02 0.13 -0.06 0.1# 0.07 0.01 0.02 0.01 2010 0.24 0.31 0.68 0.01 0.30 0.41 0.1#

Insi!hts: The percent increase in sales (as over t(ice that of previous years. 5et income increased by a greater percentage than did sales or gross margin. The economic gro(th index remained basically unchanged from the previous year. The percent increase in mar/et share (as greater than the percent increase in sales. The percent of sales in the last 3uarter of the year (as higher than in previous years. The gross margin percent increased significantly. 1t had remained fairly constant in the three previous years. The number of day>s sales in receivables increased 12G over 200=. c. The auditor is often interested in loo/ing at the stoc/ price because! d. The stoc/ price impounds information that the mar/et has about the company. 1n other (ords, the mar/et may /no( something about the company -especially problems. that the auditor may not have discovered. The mar/et is an indication of expectations and perhaps of motivations by management to meet pre-determined performance ob ectives.

There are a number of factors that are high fraud ris/ indicators including! Motivation H the changes in the sales person commission plan provides significant motivations for fraud. The sales person also has more po(er to negotiate prices. Financial Changes! o 6ross margin is increasing. o <ar/et share is increasing. o "toc/ price has more than doubled in the past t(o years. o 'ccounts receivable are gro(ing faster than the mar/et and faster than sales. o 1t is doubtful that the client has actually reduced administrative expense.

e.

"pecific audit procedures that might be performed include! )onfirm accounts receivable using 44" sampling and positive confirmations. "chedule all receivables collections subse3uent to year-end. #evie( returns made during the last 3uarter and the first part of the subse3uent year to better develop an estimate of returns. Ta/e a statistical sample of sales and! o #evie( the sales contract, o #evie( subse3uent collection or return of goods from the sale, +se 6'" to analyze sales commission by sales person. 1nvestigate the pattern of sales made to customers by the highest commission sales people. *etermine (hether the customers paid for the sale. )ompare results H especially gro(th and profitability (ith competitors in the industry and area. 4erform cutoff tests at year-end. $xamine sales invoices for a sample of sales made in the last 3uarter. *etermine validity of sale and the realizability of the receivable.

10-8;. Bb ective of 'udit Test! a. *etermine that all goods that (ere shipped (ere billed in the proper time period. 1n addition, the auditor (ill normally test for the effectiveness of control procedures, such as proper credit authorization and correctness of billing (hen selecting a sample such as described. Thus, the auditor (ill usually use the sample selected as basis to perform dual-purpose tests. )ompleteness. *etermine 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. Laluation. *etermine that invoiced amounts are correctly computed. Laluation. *etermine that credit is authorized in accordance (ith company policy. 1n addition, (hen revie(ing the credit policy, the auditor can ma/e 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 (ith an authorization policy! the auditor must also determine that the policy is (ell conceived. Laluation. *etermine that all goods that (ere shipped (ere billed. )ompleteness. *etermine that all recorded invoices are valid and are supported by independent shipping documents providing evidence of shipment. $xistence.

b.

c. d.

e. f.

10-8=. 1. 2. ). 1nvoices posted to incorrect customer accounts (ill be detected by analyzing customer responses to monthly statements that include errors, particularly statements (ith errors not in favor of the customer. 6. The comparison of shipping documents (ith sales invoices (ill detect goods that have been shipped but not billed (hen no sales invoice is located for a particular shipping document. ,. To provide assurance that all invoiced goods that have been shipped are recorded as sales, daily sales summaries should be compared (ith invoices. ,or example, a sale that has not been recorded (ill result in a sales summary that does not include certain sales invoices.

0.

2.

N. ' comparison of the amounts posted to the accounts receivable ledger (ith the control total for invoices (ill provide assurance that all invoices have been posted to a customer account. 1. )omparing customer orders (ith an approved customer list (ill provide assurance that credit sales are made only to customers that have been granted credit.

8.

9.

7. #e3uiring an approved sales order before goods are released from the (arehouse (ill provide assurance that goods are not removed for unauthorized orders. *. ' comparison by shipping cler/s of goods received from the (arehouse (ith the approved sales orders (ill provide assurance that goods shipped to customers agree (ith goods ordered by customers. %. ' comparison of sales invoices (ith shipping documents and approved sales orders (ill detect invoices that do not have the proper support. 'ccordingly, it (ill help prevent the recording of fictitious transactions. 4. )omparing amounts posted to the accounts receivable ledger (ith the validated ban/ deposit (ill detect improper postings to accounts receivable since any differences in amounts (ill be investigated.

:.

;.

=.

10. ). <isappropriations of customer>s chec/s (ill be detected (hen customers indicate that they have made payments for items sho(n as payable on their monthly statement. 5ote that replies B and 4 (ill only detect this misappropriation in the unli/ely event that the perpetrator does not dispose of the remittance advice.

11. ). <iss-postings of payments made (ill be detected (hen customers indicate that they have made payments for items sho(n as payable on their monthly statement. 12. 4. )rediting more than one account for a cash receipt (ill be detected (hen the total of amounts posted to the accounts receivable ledger is compared (ith the validated ban/ deposit slip. 'n independent reconciliation of the ban/ account (ill reveal improper total recording of receipts in the cash receipts ournal because unlocated differences bet(een ban/ and boo/ balances (ill occur and be investigated.

10. ".

12. 4.

)omparing total amounts posted to the accounts receivable ledger (ith the validated ban/ deposit (ill detect a difference bet(een total cash receipts and the amount credited to the accounts receivable ledger. 18. 5. #e3uiring the approval of the supervisor of the sales department for goods received (ill provide assurance that invalid transactions granting credit for sales returns are not recorded. 5ote that using prenumbered credit memos -reply <. (ill only be effective if the se3uence is accounted for and if credit memos may be compared in some form to actual returns. 10-90. a) Areas o Inherent Ris*: 1. The company has changed auditors. b) Audit +rocedures to Address Ris* Areas: )ontact the predecessor audit firm to determine their understanding of the reason for the change. 's part of the process of accepting the engagement, in3uire about the integrity of management and financial pressures facing the firm. $nsure that all auditors understand these factors (hen gathering evidence during the conduct of the audit engagement. 1n3uire of management as to the nature of the dispute and the firmCs current policy regarding the recognition of income from items not shipped. 1n3uire of the predecessor auditor of their understanding of the nature of the transactions and their opinion on the accounting dispute. "elect a sample of invoices to determine the clientCs approach to recognizing income during

2. There (as a dispute (ith the predecessor auditor regarding the recognition of income on goods that had not been shipped.

a) Areas o Inherent Ris*:

b) Audit +rocedures to Address Ris* Areas: the current period. 4lan the audit approach at year-end to pay special attention to the invoicing of goods not shipped. 4lan extra procedures to ensure a proper cutoff of sales is obtained.

0. )urrent management does not have a long history (ith the company, but has a reputation as a turn-around artist.

*etermine the extent to (hich stoc/ option plans or bonuses are dependent upon specific levels of achieved performance. #evie( articles in the financial press to become a(are of predictions made by <r. *reason regarding current performance and predicted year-end results for *rea Tech to understand potential pressure to achieve stated results.

2. There is evidence of significant related party transactions.

1n3uire as to the nature and extent of related party transactions. The auditor should expand audit (or/ to identify all related parties and investigate any unusual sales transactions to determine if they may be (ith related parties. #evie( all ma or related party transactions and determine the appropriate financial statement disclosure.

8. 'lthough 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.

#evie( procedures utilized by the company to record the return of merchandise. *etermine approach used to ade3uately identify defective products to determine the status of the product -scrap, close-out, re-(or/, etc.. *evelop tests to revie( 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. 1nvestigate the return of merchandise after year-end to determine if the amounts are unusual and (ould ustify an extra allo(ance for returned merchandise to be recorded. #evie( return transactions as part of the transactions testing during the year to

a) Areas o Inherent Ris*:

b) Audit +rocedures to Address Ris* Areas: determine if returned merchandise is accounted for in accordance (ith stated policies. +nderstand trends in the industry, such as ne( product introductions, profitability of competitors, etc. to determine the competitive advantaged en oyed by the client. #evie( sales contracts to understand the potential business reason (hy this client might be obtaining a higher level of success than is obtained by competitors. 4lan audit tests (ith a high degree of s/epticism -as is indicated above for many of the audit tests - this ris/ identifier only confirms the need for more audit tests li/e those described above.. *iscuss (ith management the cutbac/ in #&* and the potential impact on remaining competitive.

9. "ales have been increasing at 20G per year. 1t is doubtful that the company can maintain such gro(th rates (ithout the introduction of a substantial number of ne( products. ?o(ever, cutting the research and development budget is li/ely to hamper the introduction of technically innovative ne( products.

:. The plant does not appear to be /ept up to date. ' large amount of inventory is sitting near the receiving doc/. The inventory may indicate the fear regarding the cutting of research and development is true.

$xpand, as discussed above, the revie( of procedures for merchandise return. 4erform an extensive revie( of merchandise returns after year-end. $xpand the tests of accounts receivable at yearend. 1f there are significant merchandise returns, the customers should indicate large differences (hen their accounts are confirmed.

10-91. a. ,actors to consider in setting the credit policy! The past history (ith each customer, -volume, payment profile, etc.. Trends in the industry. ,or example, have there been consolidations in the shoe industry that eliminate many of the mom and pop shoe stores. )urrent economic conditions. Butside credit ratings by credit bureaus such as *un and 7radstreet. 'nalysis of the customerCs financial statements -for larger customers..

 )urrent credit balance (ith the company. <anagementCs sales plans and trade-offs considered bet(een increased sales and credit ris/. <uch of the information on the customerCs past history should be readily available in the clientCs computer system. ,urther, the advent of net(or/ing the development of public databases ma/e it possible for clients to access directly the credit ran/ings of the credit agency firms -if a subscriber member. and such information can be do(nloaded into the clientCs credit files and considered as an element of the parameters to be accessed in a credit policy. b) Control +rocedures: 1. 'bility to change the parameters used to establish credit should be limited only to those authorized to do so (ithin the credit department. c) Audit +rocedures to ,est Control +rocedures: 1. #evie( policies used to establish the accountability for those allo(ed to change credit parameters. 1a. #evie( data processing procedures to limit access to data files -such as pass(ord control.. Test the access by attempting to utilize pass(ords, etc. -' more complete discussion of such tests is deferred until chapter 10.. 1b. *etermine the extent of supervisory revie( of all changes to parameters. *etermine the ade3uacy of such revie(s and procedures used to follo(up on discrepancies. 2.'ll changes to the credit parameters 2. "ee audit step 1b. should be revie(ed by the supervisor of the credit department. 0. 4eriodic internal audits should revie( the correctness of the program for computing credit authorization. 0. #evie( internal audit reports for activity regarding the credit approval process. <eet (ith the director of internal auditing to discuss audit plans and results.

2. The credit department should periodically 2. 1n3uire about the process used by the revie( the credit authorizations to determine credit department to revie( if the program is (or/ing according to authorizations. #evie( evidence of established procedures and (hether the procedures being performed. algorithms should be updated.

c) Audit +rocedures to ,est Control +rocedures: 8. $xception reports should be generated for all 8. 1n3uire as to the existence of such instances in (hich credit (as approved exception reports. Ta/e a sample of the beyond that authorized by the computer reports and revie( for evidence of application. The exception reports should be credit department revie( and follo(revie(ed by the supervisor of the credit up action. function. 9. *ata processing should implement access 9. "ee "tep 1a above. controls, such as pass(ords to restrict access to the credit program and parameters. :. #eports should be prepared highlighting credit approvals. :. 1n3uire as to the existence of such reports. *etermine if such reports are revie(ed by the credit department.

b) Control +rocedures:

10-92. "tudents may come up (ith a number of possible controls. The solution provided belo( is adapted from examples provided in )B"B>s Guidance on Monitoring Internal Control Systems. "ome of the control activities could also serve as monitoring controls.
-b.ective Ris* and Relevant (inancial Statement Assertions #1"N! Bverstatement due to sales agents that grant future credits to customer for unsold goods '""$#T1B5! $xistence Control #nvironment Controls <anagement and philosophy, including tone at the top are clear that such actions are unacceptable. Approach to testin! Control Activities Approach to testin!

#ecognize revenue in accordance (ith appropriate revenue recognition criteria

#evie( evidence of the communication of this philosophy -e.g., ne(sletters.. 1n3uire of company personnel ho( they perceive management>s philosophy. #evie( training course materials.

4eriodic revie( by sales manager and ),B and sales trends and sales returns trends

Bbtain evidence of sales manager and ),B participation in the revie(. $xamine the trend analysis. 1n3uire of the sales manager about the revie( process.

Training on the topic is provided to sales personnel

)ode of conduct is signed by all sales personnel

"elect various sales personnel and obtain evidence to verify their participation in training. ,or a sample of sales personnel, revie( documentation. 1n3uire of selected sales personnel their understanding of relevant sections of the )ode.

"ales person compensation is revie(ed 3uarterly by the sales manager and ad usted if returns exceed a threshold.

$xamine the documentation revie(ed by the sales manager. $xamine evidence of any ad ustments to compensation.

10-90. a) +otential Misstatement i /ot Implemented 1. The recording of transactions (ill not be misstated. ?o(ever, the collectibility of accounts receivable may be impaired. Thus, it is possible that net accounts receivable may be overstated. b) Auditin! +rocedure to ,est # ectiveness o Control) 1a. #evie( procedures to implement the computer program and determine the extent that the credit department tests and monitors the correctness of the authorization program. 1b. )onsider testing the program by submitting transactions against it and see if the transactions are processed correctly. -This is discussed in )hapter ; as the test data approach.. 1c. Ta/e a sample of sales transactions over O10,000 and revie( to determine (hether there is evidence that authorization had been obtained. 1d. Ta/e a sample of sales transactions less than O10,000 and, for each transaction, determine (hether credit should be granted based on the parameters contained in the computer program.

a) +otential Misstatement i /ot Implemented

b) Auditin! +rocedure to ,est # ectiveness o Control) -This is not li/ely to be done if the auditor does step 1a or 1b.. 2a. #evie( the control procedures used by the department to implement authorized prices and maintain security of the price list from unauthorized changes. 2b. Ta/e 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. "ubmit a sample of invoices -test data. to the system and determine that all items are invoiced according to authorized prices. 0. #evie( the clientCs control procedures used to periodically account for all items. Test a sample of the clientCs accounting to determine that all items (ere properly accounted for. 2a. Bbserve that the segregation of duties described in the control procedure actually exists. 2b. #evie( a sample of customer complaints to determine the procedures used to follo(-up and correct the complaints. 8a. #evie( the procedures and ma/e in3uiries as to procedures utilized for handling returned merchandise.

2. "ales and accounts receivable may be stated incorrectly. 1f the sales are billed for more than authorized, the accounts receivable may not be collectible. 1f sales are billed for less than the authorized amount, the customers may not complain and the organization (ill understate sales and receivables. ?o(ever, the authorized prices (ill never be collected. The company is simply less profitable. 0. "hipments might not be recorded and sales (ould be understated. There is also some chance that shipments could be recorded t(ice resulting in an overstatement of sales and receivables. 2. 'ccounts receivable may be overstated because customer complaints are not ad usted.

8. "ales returns may be understated and accounts receivable may be overstated if the receipts are not promptly recorded.

8b. "elect a sample of receipt documents and 1nventory may be overstated if 3uality follo( through the processing to determine that! control does not revie( the merchandise to determine its 3uality. -1. credit memos (ere issued on a timely basisF -2. 3uality control tested the returned merchandise and sent a memo to accounting recommending proper classification. -0. revie( inventory record to determine the receipt -and the physical ob ect. (as properly accounted for in accordance (ith 3uality control instructions.

a) +otential Misstatement i /ot Implemented 9. "ales and accounts receivable could be misstated in either direction, but it is more li/ely that an understatement (ould go undetected because customers may not complain about not being billed for all items shipped.

b) Auditin! +rocedure to ,est # ectiveness o Control) 9a. ,or a sample of invoices, examine shipping documents and pac/ing slip for evidence of items shipped. *etermine ho( any discrepancies (ere handled. 9b. )onsider testing the computer program by submitting fictitious data to determine that the proper action is ta/en.

:. "ales and accounts receivable could :a. "elect a sample of invoices and re-compute the be misstated as described in P9 above. freight charge to determine if it is computed in accordance (ith the company policy. :b. )onsider testing the computer program by submitting fictitious data to determine if the calculation is made correctly. 10-92 a. "trengths and Wea/nesses "trengths! 1. ' cash register is used to record -most. sale transactions. 2. The company has a clear set of procedures for using credit cards. 0. The company has an ;00 number to obtain authorizations for all credit charges in excess of O80.00. 2. The store manager batches all the credit card transactions and reconciles them (ith the credit card sales recorded on the cash register. Wea/nesses! The ma or (ea/ness in the scenario described is that the control procedures are circumvented, or ust ignored during busy times. <ost notably! 1. 'll transactions are not rung up on the cash register as they occur -they (ould have to be rung up later by one of the cler/s or the store manager.. 2. The credit card receipts are not pre-numbered and credit sales could easily be lost (hen they are not rung up on the cash register and the receipt stored in the cash register. b. 4otential ,inancial "tatement $ffect! The largest ris/ is that credit sales (ill not be recorded. This could occur through either carelessness or could occur as part of a conspiracy of one of the cler/s and a

customer. "ales (ould be understated and inventory (ould be overstated because the transactions (ere not recorded. 10-98. 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 (as authorized by someone in the credit department or by the credit manager. The auditor (ould (ant to verify that follo(-up action is ta/en by the credit manager to gain assurance that the control procedure (as operating effectively throughout the year. The auditor (ould not be concerned about the volume of transactions on this report. The use of the exception report is a strong control procedure. The auditor (ould revie( the report to determine if there may be an unusual credit ris/ for a particular customer. The auditor may, depending on other ris/ factors present in the audit, determine that all the transactions are independent. 1t is difficult to tell if the auditor (ould be concerned (ithout /no(ing more about the size of the company. 1n most li/elihood the transactions (ould be unusual for the company -other(ise an exception report (ould not be generated. and thus (ould merit some investigation on the auditorCs part to understand the nature of the transactions. The auditor is concerned (ith problem accounting areas. 5umerous exception reports of this type signals a potential problem relating to the correct recording of sales. Qes, the auditor (ould most definitely be concerned if a large number of such reports occurred. $ither there are problems (ith 3uality of merchandise or the shipping process is out of control. )ustomers may become dissatisfied. That dissatisfaction may be reflected in the ability to collect accounts receivable. The auditor is loo/ing for evidence that the accounting system and the organizationCs overall control system is functioning effectively. 5umerous exception reports may signal a number of things -either good or bad.. The auditor (ould (ant to ma/e in3uiries of the client to determine the causes of the problems reflected in the exception report.

b. 2. a.

b.

0.

a.

b.

2.

a. b.

10-99. ,ype o (ailure a. 5o evidence price and 3uantity chec/ed. +ossible Misstatement "ales and accounts receivable may be over or understated at year-end. )ustomers may not have had a chance to get pricing andDor 3uantity errors corrected for sales near year-end. 'llo(ance for doubtful accounts may not be ade3uate. Assertion Laluation -6ross. # ect on substantive tests) $xtend confirmation and subse3uent collection (or/. )onfirm as of year-end rather than at an interim date.

b. %ac/ of credit approval.

Laluation -5et.

$xtend revie( of subse3uent collections, obtain credit reports on customers (ith large overdue balances, revie( customer correspondence files. $xtend confirmations as of yearend, concentrate sales cutoff testing on sales recorded ust before year-end.

c. #ecording sales before shipped.

"ales, accounts receivable and possibly cost of sales (ould be overstated. 1nventory may be understated, especially in a perpetual system. Kust the opposite of c. above.

$xistenceD Bccurrence

d. #ecording sales after they should have been. e. +ntimely recording of sales. f. %ac/ of customer order.

)ompleteness

)oncentrate sales cutoff testing on sales recorded early in the follo(ing year. $xpand cutoff testing of sales ust before and after year-end.

"ales, accounts receivable and possibly cost of sales and inventory may be misstated. "ales and accounts receivable overstated. $ven though shipped, if customer did not order the items, this is not a valid receivable or sale. )ould indicate fraudulent sales. 1f not shipped, sales, accounts receivable, and cost of sales are overstated.

$xistenceD occurrence, cutoff & completeness $xistenceD occurrence

$xpand confirmations of receivable as of year end. Lerify existence of customer by loo/ing them up in the telephone boo/ and revie(ing credit report. Watch for unusual sales returns after year-end. $xpand confirmations of receivable and inventory test counting as of year end. $xpand

g. %ac/ of shipping document.

$xistenceD occurrence

,ype o (ailure h & i. Wrong price or 3uantity. 10-9:.

+ossible Misstatement 1nventory is understated. "ame as a.

Assertion

# ect on substantive tests) revie( of subse3uent collections.

"ame as a.

"ame as a.

The auditor can gain assurance that sales transactions are properly valued in one of t(o (ays! 1. 2. The auditor could ta/e a sample of recorded sales and trace the sales prices to the 3uarterly price printouts and, if necessary, to the sales department>s list of all changes. The auditor could obtain the current price list table that is incorporated into the computer system. 1f there is a large volume of prices, a sample of those prices could be selected and compared to the 3uarterly printouts. 1f there are any changes, the changes could be traced to the sales department>s list of changes for authorization.

10-9;. a. 5either auditor is correct. 7oth approaches are necessary to determine that all recorded sales are valid and that all shipments have been properly invoiced. The combination of the t(o 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, ho(ever, is not sufficient by itself. There may be recorded sales that occurred outside the normal processing, or there may be problems (ith the proper cut-off of sales transactions at year-end. Thus, the professional standards re3uire 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 (ill also li/ely be testing the effectiveness of control procedures associated (ith the sales transaction, but those procedures (ere not specifically mentioned in the scenario.

c. ' dual purpose test is one that is effective in addressing t(o ob ectives! 1. 2. control procedures are operating effectivelyF and the transactions are recorded correctly, in the proper time period, and so forth.

1f the auditors described above also tested the operation of important control procedures, the tests described (ould be dual-purpose tests. 10-9=. To substantiate the validity of gross apartment rents, ,inney (ould - 4hysically examine the rental property or revie( architectural blueprints to ascertain the total number of rental units. )ompare the total number of validated rental units (ith the total number of rent charges on the schedule of gross apartment rents -"chedule '.. ,or occupied units, vouch the individual apartment rental charges per lease agreements to the individual rental charges on "chedule '. ,or 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... ,oot the gross apartment rent schedule -"chedule '. and compare the total (ith the figure indicated on the rent reconciliation. To substantiate the validity of the vacancies, ,inney (ould - 4hysically examine the apartments that (ere vacant during the month. )ompare the rental charge -validated in the gross apartment rents procedures above. for each vacant apartment (ith the schedule of vacancies -"chedule 7.. ,oot the schedule of vacancies -"chedule 7. and compare the total (ith the total indicated on the rent reconciliation. To substantiate the validity of unpaid Kanuary rents, ,inney (ould H Trace unpaid rents from individual tenant apartment ledger cards to "chedule ). ,oot the unpaid rents schedule -"chedule ). and compare the total (ith the amount sho(n on the rent reconciliation. $xamine the collection file for evidence of collection attempts. #e3uest (ritten confirmations from tenants (ith accounts in Kanuary arrears. To substantiate the validity of the prepaid rent collected, ,inney (ould Trace the receipt to the individual tenant apartment ledger card. )ompare the amount collected (ith the lease terms. To substantiate the validity of the cash collected, ,inney (ould - ,oot the client-prepared rent reconciliation. #econcile the cash receipts per the rent reconciliation (ith the boo/s and records. )onfirm and reconcile the special ban/ account balance. -'1)4' adapted.

10-:0. a. 'ccounts #eceivable "ales O28,0=0 O28,0=0

To record sales invoice P 098=1 this (as shipped in 200= but not recorded until 2010. "ales 'ccounts #eceivable O =,200 O =,200

To remove sales invoice P 098=2 this (as shipped in 2010but recorded in 200=. b. The sales should not be recorded until title is transferred upon delivery. 1t is often difficult to determine (hen customers receive shipments. "ome companies estimate the average time for delivery and record the sales based upon that estimate. c. 1f 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 boo/ing 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. )urrent assets and o(nerCs e3uity (ill only be overstated by the gross profit of such sales, net of income taxes. 1f the shipped items are included in inventory and not cost of goods, current assets and o(nerCs e3uity (ill be overstated by the total sales value of such sales, net of income taxes. 1n either case, the auditor must determine if such overstatements are material. 10-:1. The auditor can use membership records and the fee structure to estimate (hat 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. ' comparison of revenue this year (ith last year ad usted for changes in fees and numbers of members should also approximate the actual revenue. 10-:2. a. 1f the emphasis is on the existence of sales, the auditor is loo/ing for recorded sales that should not have been recorded and should select a sample of sales recorded during the last fe( days of the fiscal year and vouch them bac/ to evidence that the shipments too/ place - the bills of lading. 1n this (ay, sales (hich are recorded prematurely (ill li/ely be detected. b. 1f the primary emphasis is on the completeness of sales, the auditor is loo/ing for shipments that did not get invoiced or recorded and should select a sample of bills of lading issued during the last fe( business days of the fiscal year and trace them to the

sales invoices and entries into the sales ournal and select sales recorded after the balance sheet date and trace them to shipping documents. 10-:0.
Customer a. <eehan <arine "ales, 1nc. b. West )oast "/i )enter, 1nc. c. ,ish & "/i World, 1nc. Conclusion&procedure 2 2 2

10-:2. 1n order to determine (hether lapping exists, "tanley (ould test the aging of accounts receivable and then H 10-:8. a. 1t is more difficult to test for completeness than existenceDoccurrence of an account balance or class of transactions because the auditor is loo/ing for unrecorded transactions or account balances that have left something out. The auditor should consider the ris/ of a material misstatement that transactions have been improperly omitted from the financial statements. When the auditor assesses the ris/ 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 (hen <ail positive accounts receivable confirmation re3uests directly to all customers (ith old balances. 1nvestigate all exceptions noted on confirmations. Bbtain authenticated deposit slips directly from the ban/ and compare the detail (ith the cash receipts ournal. )ompare individual customersC names, dates, and amounts sho(n on the customerCs remittance advices (ith the names, dates, and amounts recorded in the cash receipts ournal, individual customer ledger accounts, and deposit slips -if practicable.. Lerify the propriety of non-cash credits to accounts receivable -for example, sales discounts, sales returns, and bad debt (rite-offs.. 4erform a surprise inspection of deposits. ,oot the cash receipts ournal, the customersC ledger accounts and the accounts receivable control account. #econcile the total of the individual customersC accounts (ith the accounts receivable control account. )ompare information in copies of monthly customersC statements (ith information in customersC ledger accounts.

b.

aggregated (ith 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. 1t is inappropriate to place complete reliance on internal controls and responses from management about such occurrences. 7ecause of the uni3ue 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 ris/ to an acceptable level (ithout some reliance on internal accounting controls. R'+ =029S 1f pre-numbered sales documents are used, the auditor (ill need to do extensive testing such as tracing bills of lading to sales invoices, the sales ournal, and the accounts receivable records andDor testing of the se3uence of sales invoices listed in the sales ournal, loo/ing for missing numbers that cannot be accounted for as being properly voided. #egression analysis might be used to relate sales by month by product line (ith the related cost of sales and comparing recorded sales (ith production records for a manufacturer or occupancy records for a fe( months, if these records are believed to be reliable. $xtensive cut-off tests of sales and cash receipts should be performed, concentrating on those recorded after year-end. 10-:9. 6eneralized audit soft(are could be used in the follo(ing (ays! 10-::. a. b. )onfirm positively not only the amounts of all the outstanding notes but also the interest rate, date, due date, and collateral on the notes. The examination of notes receivable arising from e3uipment sales and the interest thereupon must result in evidence that the notes receivable and accrued interest represent existing obligations o(ed to the client on *ecember 01 -existence.! that the notes receivable and interest (ill be collectible at their stated value -valuation.! that ,oot the unpaid invoice file to be sure it agrees (ith the general ledger accounts receivable balance. "elect and print confirmation re3uests. 1nformation from both files (ill be needed - customer name and address from the first file and unpaid amounts from the second file. 4rint a report of all customers (hose balance exceeds the credit limit or (ho have no credit limit. )reate an aged trial balance by customer. 4rint out unpaid invoices dated ust before and ust after year-end for testing sales cut-off. 4rint out the purchase and payment history for customers (ho have unusually large or old balances.

the notes are presented properly on the balance sheet -presentation and disclosure.F and that all transactions for ne( notes received, notes collected, and accrued interest are recorded in the proper period -existence and completeness.. Therefore, the assistant should perform the follo(ing additional audit procedures! 1. 1nspect each note document on hand in the immediate presence of the custodian -from (hom a receipt should be obtained for the return of the notes. in order to chec/ its amount, ma/er, issue date, due date, interest rate, and collateral! and to determine (hether the client is its payee or endorsee. #econcile confirmation reply differences and follo( upon notes for (hich no replies are received. ,or all notes not paid by the end of the field (or/, evaluate the value of the collateral and the li/elihood that the ma/er -especially if the client is the endorsee of the customer. (ill pay the note (hen due for the purpose of determining the ade3uacy of the allo(ance for bad debts. )ompare the result (ith past experience. Bn a test basis examine the original documents -agreement to purchase, shipping documents, and invoice copy. for sales upon (hich notes are outstanding and sales upon (hich notes (ere received and collected or (ritten off -chec/ for proper authorization.. )ross-chec/ unusual variations in the terms of agreement and observe (hether 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 (ith the examination of the inventory -if )lar/ maintains one.. Test the balance of the accrued interest receivable account by applying the data concerning interest rates and interest collections to the notes receivable balance. 1n3uire of management regarding policies, agreements, and unusual transactions. Bbtain a representation letter covering the validity of the notes, contingent liabilities, ade3uacy of the allo(ance for bad debts, the pledging of notes as collateral to liabilities, and other material matters concerning other phases of the audit. <a/e an over-all evaluation of the validity of the accounts, using /no(n ratios (here possible. "ignificant amounts of notes from customers controlled by officers or from customers that are subsidiaries should be treated apart from other notesF verify that repayments of such notes are bona fide by seeing that chec/s (ere deposited promptly and that notes are not rene(ed shortly after the year-end.

2. 0.

2.

8. 9.

:. ;.

c.

5otes not on hand but carried as outstanding on *ecember 01 could be!

1. 2. 0.

't the cashierCs des/ to be mailed for collection. $xamine, count, and list notes on hand. But for collection (ith an agent but not yet collected. )onfirm (ith the collection agent, usually the ban/. 4ledged as collateral and hence in the hands of a lender. *iscuss (ith management, examine loan agreement, and confirm (ith lender -if not already done.. *iscounted and hence in the hands of a lender. Trace the proceeds to cash receipts and into ban/ account. )hec/ to see if an account for discounted notes receivable has been established. )onfirm (ith lender in order to determine (hether a contingent liability still exists -because the note is not due yet. or (hether a current liability has resulted from nonpayment of the note and presentation of notice of protest to )lar/. )ollected directly from the ma/er already -bet(een the year-end and the date of document inspection. by the )ompany and hence in the hands of the ma/er. Trace collection to cash receipts and into ban/ account, and examine confirmation from ma/er for a statement that the note has been paid even though it (as outstanding at *ecember 01 -if not already done... )ollected already by the ban/ and the proceeds deposited in the ban/ account but not recorded on the boo/s. The note (ould be in the mail to or in the hands of the ma/er. $xamine cutoff ban/ statement or the year-end ban/ reconciliation, and examine the confirmation from the ma/er for a statement that the note has been paid even though it (as outstanding at *ecember 01 -if not already done.. 1n the hands of the ma/er if the note (as canceled because the e3uipment purchased by the ma/er (as returned. $xamine confirmation for a statement that the e3uipment purchased has been returned. Lerify the return by chec/ing the reconciliation of the physical and boo/ inventories. The result of a posting error in the ournal and control account. ,oot and compare (ith agreements to purchase, correspondence and other original documents. $xamine confirmations for a statement that the amount of a note has been overstated -if not already done..

2.

8.

9.

:.

;.

10-:;.

This is a good problem to use for classroom demonstration. *ata files are in italics. ')% icons, commands, and e3uations in bold) ,ield names are in ,+%% )'4"..!

Audit +ro!ram Step To 7egin

Approach Bpen a ne( pro ect by choosing (ile0 /ew0 +ro.ect0 or clic/ the /ew +ro.ect icon. 5ame the pro ect Hus y !". 1mport the follo(ing tables -files. and change the field type for )+"T5+< and 15L5+< from 5umeric to '")11 using #dit0 ,able %ayout and double-clic/ing on the field name. This must be done so files can be oined using these fields. H#S$% #npaid Invoices &''(, name it #npaid H#S$% Shipping File &''(, name it Shipping File H#S$% Credit )imit &''(* name it Credit )imit.

Bb ective! ,oot the file and agree to the general ledger. With the #npaid file as the active (indo(, choose Analy1e0 Statistical0 Statistics0 and choose to get statistics on '<B+5T. Results! There are 200 records (ith a net value -O2,290,=1=.82. that agrees (ith information obtained from the client>s records provided in the problem. 'lso note there is one invoice (ith a negative O22,98=.:2 amount. The customer paid for the merchandise and has returned it. ?+"NQ o(es them the money or replacement merchandise.

Bb ective! 1dentify customer balances greater than their credit limit or for (hich there are no credit limits. "ummarize amounts in the #npaid file by customer number by choosing Analy1e0 Summari1e) "ummarize on )+"T5+<. )lic/ the Butput tab at the top of the (indo( and choose @,ile.A 5ame this file Customer +alances. +sing the Customer +alances file, clic/ the 2oin icon. "elect the Credit )imit file as the secondary database. )lic/ to presort the secondary file. <atch both 4rimary ,ields and "econdary ,ields on )+"T5+<. )hoose the fields )+"T5+<, '<B+5T, )#%1<1T to include in the resulting file. 5ame the ne( file +alances ,ith Credit )imits. +sing the +alances ,ith Credit )imits file, choose DA,A0 #$tract Data0 I and enter the expression AM-"/, 3 CR%IMI,) 5ame the ne( file -ver )imit. Results! )ustomer 1:2 does not have a credit limit. )ustomers 121, 121, 199, 1;1, and 1;2 exceed their credit limits. The auditor should discuss these (ith the credit manager, revie(ed for subse3uent collections. )ustomer 1:2 should be chec/ed to be sure it is a legitimate customer.

Bb ective! 4erform sales cutoff test. +sing the #npaid file, clic/ the 2-I/ icon. "elect the Shipping File as the secondary file. <atch on 15L5+<. "elect 15L5+<, 15L*'T$, )+"T5+<, '<B+5T, and "?145+< for the output. 5ame the ne( file #npaid ,ith Shipping Info. +sing the #npaid ,ith Shipping Info file, choose DA,A0 #$tract Data0 I( and enter the expression S4I+/"M 3 56787 -The auditor has verified that this is the last shipping number used.. 5ame the ne( file Cutoff .rrors. Results! 1nvoices 19==;0, 19==;1, and 19==;2 (ere recorded in *ecember 200= but not shipped until Kanuary 2010. The total amount of these invoices is O29,:2=.:1. The client should be as/ed to remove these sales and cost of sales from 200= and recorded in the follo(ing Kanuary.

Bb ective! 1dentify unpaid invoices over 28 days old. +se the #npaid file. )hoose A/A%9:#0 A!e0 and age on 15L*'T$. "et the cutoff date to *ecember 01, 200=. )hoose the AM-"/, field to total. "et the 'ging 4eriods to 0 and 28. 4rint the 'ge 'nalysis #eport To get a list of these 2 records, double-clic/ on the T 28 box. Results! 2 records totaling O:=,01:.10 older than 28 days. These should be discussed (ith the credit manager and chec/ed for subse3uent collections.

Bb ective! "tratify customer balances and describe ho( this information could be used to help determine (hich balances to confirm. +sing the Customer +alances file, choose A/A%9:#0 Strati y0 stratify on '<B+5T. "et the minimum at 0 and maximum at 80,000. Results: The report sho(s that over half of the dollars are composed of 22 customer balances greater than O80,000. These along (ith a random selection of the other balances should be confirmed.

10-:=. a. The /ey thing to recognize is that there is a pattern of errors in the confirmation nonresponses. There are cases of extended credit terms (here goods (ere not returned, (here credit is to be issued but the goods have not been returned, there is a related party transaction, and there are some ne( customers that simply have not responded. The nature of the non-confirmations should heighten the auditor>s a(areness of the possibility that fraud could be ta/ing place. The auditor in charge of the examination

(ould (ant to communicate those concerns to the staff auditors and encourage the staff auditors to be very s/eptical, particularly (hen examining internal documentation. The fraud could be ta/ing place through billing for goods not actually shipped, double billing of goods -(ithout extending the necessary credit., or sales to fictitious entities. The (or/ that (ould be needed to complete the (or/ on confirmations (ould include the follo(ing audit procedures! 1. #evie( subse3uent cash collections from each of the open accounts. "chedule all subse3uent payments that can be identified as applicable to the year-end account balances. "chedule any items not satisfied through subse3uent payments as open items for further follo(-up. ,or all items (ithout unusual circumstances, follo( up on unpaid amounts by examining underlying supporting documentation including! - customer purchase order - bill of lading or other independent proof of shipping - invoice 1f 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. "chedule dollar amounts that cannot be satisfied through the above t(o procedures. 1f no supporting documentation can be found, classify the items as errors and extrapolate to the population as a (hole. 0. $xamine receiving reports for items returned prior to a specific time before year-end, -the actual time period (ould be some(hat dependent on the lag bet(een receipts and the issuance of credit memos per examination of previous receipts of goods and issuance of credit.. $xamine all documentation on Qun/el )ompany regarding extended credit terms. $xamine underlying documentation as to ho( the extended terms (ere given. )onsider confirming the extended terms -as opposed to account balance. (ith the controller of Qun/el. $xamine all terms of the related party transaction (ith 7eaver *am. $xamine other transactions (ith the same company to determine the extent of disclosure needed to fairly present the financial statements. $xamine documentation for all transactions labeled as Uspecial terms>, such as those (ith ?i-Tech )ompanies. ,or these companies, as (ell as others not responding, verify the existence of the company through examination of *un & 7radstreet reports on the company, or through business directories. )onfirm the

2.

2.

8.

9.

special terms of the sale (ith the company. *epending on the nature of the terms, consider see/ing a legal opinion on the terms of the contract, the obligation of the seller, and so forth from outside legal counsel. :. ,or all companies not responding, obtain a current credit rating from *un & 7radstreet -or some similar service.. #evie( the client>s credit file and obtain audited financial statements to assist in determining collectibility and existence of the receivable. )onsider all items not cleared as errors and pro ect the amount of error to the financial statements as a (hole. 7ased on the results, consider the amount of additional auditing procedures that need to be performed.

;.

b. 'ssuming that many of the above items could not be cleared to the auditor>s satisfaction, there (ould be concern that more items (ith similar problems exist in the population. The auditor (ould first classify all uncleared items as errors and (ould then pro ect the total to the population as a (hole to determine if the pro ected errors and upper error limit (ere material to the financial statements. 'ssuming the amount (ould be material, the auditor (ould perform the follo(ing procedures! 1. 1dentify all companies that have received extended credit. This could be done by -a. in3uiry of company personnel, -b. revie( of large dollar accounts still outstanding, or ; through an examination of all accounts (ith a dollar amount past due. *epending on the number of companies (ith such terms, either ta/e a sample or select all companies and examine all documentation regarding the extended credit. The documentation (ould include purchase orders, shipping documents, memos extending the credit, and sales invoice. )onfirm the terms of the extended credit (ith the companies identified. ,or each company selected, revie( the credit file, outside credit evaluations, and recent correspondence (ith the customer to determine the probability of collection. *evelop an estimate -or a range of estimate. of uncollectible accounts. 4repare an aging of all accounts past due. )ompare the aging (ith previous years. )ompute a first estimate of uncollectible accounts by using a noncollectible percentage off of the aging balance that had proven to be accurate in the past. )onsider current economic conditions to determine if the estimate should be ad usted for deteriorating economic conditions. 's/ the client to schedule all transactions (ith related parties. $xamine 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.

2.

0.

2.

8.

$xpand the audit (or/ for all accounts past due. )onsider expanding the confirmation (or/ through another statistical sample. 4erform alternative procedures on all companies that do not respond to the confirmation re3uest. 4repare a list of all 3uestionable transactions. *ocument the nature of the 3uestion, the parties involved, etc. to determine if there is a pattern of misstatement. 7ased on the pattern, identify all other account balances fitting that pattern. "chedule the open account balances fitting that pattern and examine underlying documentation to determine (hether or not the item is misstated. 4erform extended cut-off tests of sales and receivables near year-end to determine that items (ere recorded in the correct time period. $xamine a sample -or all. items during a period covering the last 18 days of the year and the first 10 days of the subse3uent year to determine (hether or not all items that had been billed had been shipped. 4hysically examine all items that have been mar/ed as >billed, but held pending customer orders> to determine that the goods had been physically separated, are in shipping condition, and are not obsolete. )onfirm the terms (ith the purchaser. Bbtain an opinion from legal counsel on the validity of the sales contract. 6ather additional information to determine the li/elihood of default by the customer. )onsider the li/elihood of default in determining (hether or not a sale should have been recorded. 7ased on the extended (or/, develop a revised estimate of uncollectible accounts, as (ell as accounts that should not yet be recorded as sales and receivables.

9.

:.

;.

=.

10. *ocument the nature of the (or/ performed and the audit conclusions in a memorandum for the (or/ing papers.

Cases: 10-;0. a. <ini"cribe inflated its financial statements by! 1. "hipping more units before year-end than (ere ordered by customers. 2. #ecording shipments from "ingapore that too/ t(o (ee/s to reach the customer as a sale (hen shipped rather than (hen title transferred (hen received by the customer. 0. *efective drives returned by customers (ere boo/ed as inventory rather than sales returns. They (ere reshipped and returned several times. 2. 7ric/s (ere apparently shipped as dis/ drives. 8. "hipments to company (arehouses (ere recorded as sales but (ere not invoiced to customers until shipped from those (arehouses to the customers. 'mong the factors leading to <ini"cribeCs inflated financial statements (ere! 1. <anagementCs bullish forecasts (hen the industry (as having hard times. 2. <r. WilesC management style, (hich intimidated lo(er management personnel and motivated them to create sales (hen there (ere none. 0. 4otentially inade3uate audit evidence obtained to support the auditorCs opinion. The red flags include! 1. "ales returns percentage (ell belo( the industry average. 2. '(areness of the management environment and style based on discussions (ith <r. WilesC subordinates. 0. 1ncreased sales and profitability, (hich (as counter to the trend in the industry. 2. 'n unusual level of sales activity ust prior to year-end and of sales returns after year-end. 5ormal audit procedures that could have uncovered the fraud include! 1. 'nalytical procedures such as! -a. )omparing <ini"cribeCs sales returns percentage (ith that of the industry. -b. 'nalysis of sales by month compared to prior years. "ales recorded in the last month (ere li/ely significantly greater than in the first month of the year. -c. )omparing the trend of <ini"cribeCs sales and profits (ith the trend of the industry. 2. )ut-off tests of sales recorded prior to year-end and sales returns ust after yearend.

b.

c.

d.

10-;1. a. The follo(ing internal control deficiencies or management deficiencies are evident! 1. 2. 0. 2. 8. 9. :. ;. b. 5o sales revenue detail is reported to corporate offices. The data base system is not utilized to its full potential. "ufficient data is contained for multiple performance evaluating measurements. $mphasis on turnover as an indicator of profitability, to the exclusion of margin. 7onus -sales incentive. plan predicated on only one source of performance measurement. "ale prices are not updated in the data base. "ales cler/s are permitted to override the master price list. 1nade3uate segregation of duties related to sale of damaged goods. 5o revie( by corporate offices of local store advertising.

The follo(ing indicators may have signaled the presence of fraud! 1. 2. 0. 2. $xcessive sales of damaged goods. 1nade3uate margin on recorded sales. +nusual sales activity at year end and sales return activity at the beginning of the next year. 1nventory differences disclosed by physical inventory and resultant reconciliation to perpetual records.

c.

The follo(ing controls are needed to detect the fraud! 1. 2. 0. 2. $xception reporting of sales at other than master price. $xception reporting of VsaleV merchandise sold at master price. )onfirmation of sales returns. )omplete documentation of damaged goods, including photographs.

d.

The responsibilities of the internal auditing department are as follo(! 1. 2. 0. The internal auditor should be alert to the possibility of fraud. The internal auditor should be alert to conditions and activities -such as (ea/ control. (here frauds are most li/ely to occur. When the internal auditor suspects fraud! a. 'ppropriate authorities should be informed. b. #ecommendations for investigation may be made. c. ,ollo( up should be made to ensure audit responsibilities have been met. 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.

2.

10-;2. 1. ' variety of possible ideas might be generated by students! differences in common practices regarding the (riting and enforcing of contracts difficulties in communication bet(een the subsidiary and the parent company differences in expectations regarding necessary documentation of internal controls differences in the training and size of management, (hich may lead to variation in the implementation and enforcement of existing controls, among othersM.

2. ,irst consider that the prior problem indicates that (ea/nesses existed in the past, (hich heightens ris/. ?o(ever, the fact that the problems (ere disclosed and a remediation plan (as put in place mitigates that ris/. "o, the extent to (hich the remediation plan (as actually implemented (ill be /ey in determining the audit plan for 2008. "o, the auditor should gather information about the extent to (hich the ne( contract revie( process has been used, and they should examine the ne( documentation evidencing proof of delivery. "econd, consider that the problems associated (ith the internal control (ea/nesses in revenue manifested themselves in fourth 3uarter revisions to the financial statements, (hich should lead the auditor to heighten their 2008 ris/ assessment in terms of management attempts to manipulate earnings. Thus, inherent ris/ associated (ith sales transactions should be heightened going for(ard. 0. #egarding potential analytics, the follo(ing may be helpful! comparing 3uarter-to-3uarter 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 flo( from operations (ith net income calculate receivables and aging of receivables by product type and geographic region, by 3uarter and same 3uarter across years calculate gross margin percentages

2. 4otential substantive tests include! analyzing the timing of contracts, (ith particular emphasis on fourth 3uarter contracts -or end of other 3uarter contracts. reading contracts to ensure timely identification and accurate accounting treatment of non-standard contracts revie( documents retained evidencing proof of delivery and final acceptance sample recorded sales transactions and vouch to source documents match sales (ith electronic shipping documents or customer orders

revie( monitoring controls concerning management>s revie( of revenue transactions

10-;0 1.4utnam>s critical mista/e (as in not being forceful and proactive the very first time the problems (ere encountered. Bnce he had @cavedA to ?7B) once, it (ould have been difficult to convincingly threaten ?7B) in the future. 4lus, once 4utnam allo(ed the inappropriate accounting and issued the first incorrect audit revie( opinion, ?7B) could use that against 4utnam, convincing him that he (ould also @loseA upon discovery of the problems. 2. 'lthough the facts are not publicly disclosed, one has to assume that in the booming time period of the late 1==0>s, the tone at 'ndersen (as to ma/e clients happy, and to retain their business. Thus, it is possible that 4utnam (ould have been discouraged from behaving forcefully to ?7B). 1n terms of 4utnam ac3uiescing to the obviously inappropriate saleDpurchase transaction in W0 1==;, the situation seems unbearably inappropriate. 7y that point, 4utnam had to have /no(n that (ithout the transaction going through, the true financial results of ?7B) (ould lead to its do(nfall. 4utnam may have been hoping that if he allo(ed this transaction, then perhaps the company could maintain its profitability and @no harm (ould come of itA. 0. The main element of corporate governance that failed (as the audit committee. They displayed a lac/ of /no(ledge of the ris/s in the soft(are industry at the time. They should have been more proactive in understanding the types of transactions that the company (as engaged in, and the common ris/s associated (ith those transactions. They should not have relied so extensively on the unsubstantiated representations of 4utnam. 2. 4utnam and the engagement team did not follo( up on unreturned confirmations and the very lo( response rate should have caused concern. 1n addition, the dramatic decline in the number of confirmations sent from 1==9 to 1==: (ithout ustification is problematic. ,urther, the engagement team>s response to the problems noted in the confirmations that (ere returned (as inade3uate. 1t should have led to much deeper investigation into the side letter issue. 8. When 4utnam learned of the upcoming merger (ith <cNesson during the ,all of 1==;, he (ould have realized that <cNesson (as relying on the inappropriately aggressive earnings stream that ?7B) had developed over the past several years. )ertainly <cNesson (ould have felt differently about the ac3uisition had it /no(n about the improprieties. There must have been tremendous pressure on him not to say anything because he had ac3uiesced for so long to 6ilbertson. Qet, if any situation (ere to bring 4utnam to disclose the problems, this (ould have been it. <oving for(ard (ith the ac3uisition under false pretenses put 'ndersen %%4 as an audit firm at tremendous ris/. While students may develop alternative strategies, (e present one possible (ay that 4utnam could have used the <cNesson ac3uisition to reveal (hat he /ne( about the problems at ?7B).

Step ;) Structure the problem) 4utnam /ne( that <cNesson (ould rely on the misstated financials of ?7B) during the ac3uisition process. ?e also /ne( that there (as an upcoming audit committee meeting at (hich he could spea/ up if he so desired. Step 6) Assess the conse'uences) The potential conse3uences (ere that -a. <cNesson (ould ac3uire ?7B), ?7B)>s financial position (ould improve enough that the fraud (ould be irrelevant, and further earnings management (ould be unnecessary, thus causing the past problems to become essentially irrelevant, or -b. <cNesson (ould ac3uire ?7B), the fraud (ould be revealed, and 'ndersen and 4utnam (ould be at ris/ of litigation and "$) sanction, or -c. <cNesson (ould not ac3uire ?7B) because of the problems detected during their due diligence process. Step <) Assess the ris* and uncertainties) The ris/s associated (ith possibility -a. are that this outcome is a relatively lo( probability event -in hindsight., although at the time 4utnam may have thought other(ise. The ris/s associated (ith possibility -b. are the exact things that ultimately happened in real life, i.e., fraud revelation, follo(ed by massive stoc/ devaluation and securities fraud charges. The ris/s associated (ith possibility -c. are that 'ndersen (ould be fired from the audit by ?7B), and 4utnam (ould be damaged financially or professionally through the loss of the client. Step =) #valuate in ormation&audit evidence !atherin! activities) 4ossibilities -a. and -b. re3uire no additional actions on the part of 4utnam, so (e (ill focus on 4ossibility -c. for the rest of the solution. 'ssuming that 4utnam decided to pursue this possibility, ho( could he do an @about faceA and finally reveal the problems to, for example, the audit committeeI Bne possibility (ould be to increase testing via the confirmation process during the ,all of 1==; in anticipation of the year-end audit. Step 8) Conduct sensitivity analyses) This step is not particularly relevant for the decision at hand. 1f 4utnam chose the course of action to finally reveal (hat he /ne(, there (ould be little sensitivity analyses to conduct, because gathering evidence on the other possibilities does not lend itself to actual evidence gathering. #ather, those possibilities involve assessments of probabilities of those events occurring. Step 5) Gather in ormation&audit evidence) 1f 4utnam 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 allo(ance for doubtful accounts during ,all 1==;. Nno(ing (hat he (ould find, he could then either pressure 6ilbertson to reveal the issues, or he could himself report (hat he /ne( to the audit committee.

Step >) Made decision about audit problem) 1t is clear from the actual outcome (hat 4utnam actually decided to do, i.e., nothing and hope for the best. 1f 4utnam had revealed (hat he /ne( to the audit committee and <cNesson during the ,all of 1==;, <cNesson (ould probably not have engaged in the ac3uisition. 4erhaps ?7B) could have fixed their accounting problems @behind the scenesA and the fraud revelation could have been avoided. ?o(ever, it seems that the fraud had gone on so long, and the amounts of the deception (ere so large that anything that 4utnam did at this late stage (ould have been futile in preventing the do(nfall of ?7B) and its management team. 7ut by doing something, even very late in the process, 4utnam could have salvaged his reputation to some extent and possibly avoided or minimized the negative outcome he ultimately received from the "$). The message is clear! 4utnam should have stood up for (hat (as right at the outset of the problems at ?7B). 7y not confronting 6ilbertson forcefully (hen he initially learned of the problems, 4utnam got caught up in a do(n(ard spiral of poor professional decision ma/ing, (ith terrible conse3uences. ;7?@= 1t is apparent from the case that the audit manager for some reason (as un(illing to challenge 4utnam or his vie(s. The publicly disclosed documents do not enable an understanding of the personal characteristics of 4utnam or the engagement manager, so it is difficult to dra( inferences about the personal dynamic that existed bet(een the t(o auditors. ?o(ever, 1ra )haleff>s ideas should give students a sense of things that an individual in an organization (ho is not in the @leadershipA role can still do to have a positive effect in an other(ise bad situation. While individual ans(ers (ill of course vary, (e present a potential approach to moving through the seven steps in resolving the difficult ethical issue encountered by the ?7B) engagement manager. A;B Identi y the ethical issue) The issue is that the manager /no(s that ?7B) is misrepresenting its financial results to shareholders, and by very significant amounts. "till, if the manager ta/es on the issue against the preference of 4utnam, there may be personal repercussions such as a poor performance evaluation or dismissal from the ob. ,urther, the manager may consider the fact that if ?7B) does not @ma/e their numbersA as they have so prominently advertised to the investment community, shareholders may actually @loseA because of the associated decline in share price. A6B Determine who are the a ected parties and identi y their ri!hts) 'ffected parties include shareholders -right to receive accurate investment information., the audit committee and board of directors -right to receive an accurate portrayal of the accounting function of the organization, as (ell as a performance appraisal of 6ilbertson., the "$) -the right to receive accurate financial reports., 'ndersen as a ,irm -the right to have a client that (ill not tarnish the ,irm>s reputation., <cNesson shareholders -the right to purchase a company (ith full and complete disclosure about its true financial condition., and the individual auditors on the ?7B) engagement -the right to have their professional opinions respected and follo(ed..

A<B Determine the most important ri!hts) "hareholders at ?7B) and <cNesson because they are the most numerous and stand to lose most directly from the problems. ,urther, they are not in any (ay at fault, unli/e the members of the audit committee, board, or individual auditors. A=B Develop alternative courses o action) 'ppeal further to 4utnam, trying to encourage him to @do the right thingA. 'ppeal to higher levels at 'ndersen, alerting the ,irm to the ris/s being assumed by 4utnam. 'lerting the "$). #esigning from the ob, or from 'ndersen. A8B Determine the li*ely conse'uences o each proposed course o action) 'ppeal further to 4utnam, trying to encourage him to @do the right thingA. %i/ely conse3uences! un/no(n, depending on 4utnam>s personality and the ability of the manager to deliver the message in an effective manner. 'ppeal to higher levels at 'ndersen, alerting the ,irm to the ris/s being assumed by 4utnam. %i/ely conse3uences! un/no(n, depending on ho( the ,irm vie(s the importance of the engagement. 't the time, 'ndersen (as internally going through a do(n(ard spiral of audit 3uality and @tone at the topA, so the manager>s concerns may have been ignored. 'lerting the "$). %i/ely conse3uences! immediate regulatory attention and li/ely reductions in share price. #esigning from the ob, or from 'ndersen. "hareholders of <cNesson and ?7B) (ould not have been aided, but the manager>s reputation (ould not have been tarnished by association (ith the scandal. A5B Assess the possible conse'uences0 includin! an estimation o the !reatest !ood or the !reatest number) The greatest good for the greatest number accrues to the action associated (ith alerting the "$), assuming that direct intervention (ith 4utnam or 'ndersen as a ,irm goes ignored. A>B Decide on the appropriate course o action) The most appropriate course of events (ould be to follo( through the potential actions in se3uence, beginning (ith persuasive conversations (ith 4utnam and 'ndersen as necessary, and ultimately alerting the "$) if necessary. The manager should not simply @(al/ a(ayA from the situation by resigning. 1f they do resign, they should at least alert the "$) anonymously. 10.;8 !C) Case / 0 !ccounts "eceiva1le2 The solutions to the problems in the ')% 'ppendix are at the end of the solutions to )hapter 1;.

(ord Motor Company and ,oyota Motor Corporation: Revenue Cycle Issues
;a) Chat are the *ey revenue cycle accounts or (ordD Chat are the critical accountin! policies and estimates or these accountsD 'utomotive sales, financial services revenues, automotive receivables -and associated allo(ance., finance receivables, (arranties. )ritical accounting policies! /-,# 6) S"MMAR9 -( ACC-"/,I/G +-%ICI#S 'utomotive sales consist primarily of revenue generated from the sale of vehicles. "ales are recorded (hen the ris/s and re(ards of o(nership are transferred to our customers -generally dealers and distributors.. ,or the ma ority of our sales, this occurs (hen products are shipped from our manufacturing facilities. When vehicles are shipped to customers or modifiers on consignment, revenue is recognized (hen the vehicle is sold to the ultimate customer. We also sell vehicles to daily rental car companies sub ect to guaranteed repurchase options. These vehicles are accounted for as operating leases. 't the time of transfer, the proceeds are recorded as deferred revenue in !ccrued lia1ilities and deferred revenue. The difference bet(een the proceeds and the guaranteed repurchase amount is recognized in !utomotive sales over the term of the lease, using a straight-line method. 'lso at the time of transfer, the cost of the vehicles is recorded as an operating lease in -ther current assets. The difference bet(een the cost of the vehicle and the estimated auction value is depreciated in !utomotive cost of sales over the term of the lease. 't *ecember 01, 200: and 2009, included in !ccrued lia1ilities and deferred revenue (as O0.2 billion and O0.9 billion, respectively, and included in -ther current assets (as O2.= billion and O0.2 billion, respectively, for these vehicles. 1ncome generated from cash and cash e3uivalents, investments in mar/etable securities, loaned securities and other miscellaneous receivables is reported in !utomotive interest income and other non-operating income34e5pense2* net . Revenue Reco!nition E (inancial Services Sector #evenue from finance receivables -including direct financing leases. is recognized using the interest method. )ertain 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. #ental revenue on operating leases is recognized on a straight-line basis over the term of the lease. 1nitial 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. 1ncome generated from cash and cash e3uivalents, investments in mar/etable securities, and other miscellaneous receivables is reported in Financial Services revenues. Mar*etin! Incentives and Interest Supplements <ar/eting incentives, including customer and dealer cash payments and costs for special financing and leasing programs paid to the ,inancial "ervices sector, are recognized by the 'utomotive 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 mar/eting incentives that are approved as of the balance sheet date and are expected to be effective at the beginning of the subse3uent period. The ,inancial "ervices sector identifies payments for special financing and leasing programs as interest supplements or other support costs and recognizes them consistent (ith the earnings process of the underlying receivable or operating lease. Supplier +rice Ad.ustments We fre3uently negotiate price ad ustments (ith our suppliers throughout a production cycle, even after receiving production material. These price ad ustments relate to changes in design specifications or to

other commercial terms such as economics, productivity, and competitive pricing. We recognize price ad ustments (hen (e reach final agreement (ith our suppliers. 1n general, (e avoid direct price changes in consideration of future businessF ho(ever, (hen these occur, our policy is to defer the financial statement impact of any such price change given explicitly in consideration of future business (here guaranteed volumes are specified. Carranty and #$tended Service +lans $stimated (arranty costs and additional service actions are accrued for at the time the vehicle is sold to a dealer, including costs for basic (arranty coverage on vehicles sold, product recalls, and other customer service actions. ,ees 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 or Credit %osses The allo(ance 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 receiva1les* net and 6et investment in operating leases. The allo(ance is based on factors such as historical trends in credit losses and recoveries -including /ey metrics such as delin3uencies, repossessions, and ban/ruptcies., the composition of our present portfolio -including vehicle brand, term, ris/ evaluation, and ne(Dused vehicles., trends in historical and pro ected used vehicle values and economic conditions. 'dditions to the allo(ance for credit losses are recorded as charges to the Financial Services provision for credit and insurance losses. ,inance receivables and lease investments are charged to the allo(ance for credit losses at the earlier of the time an account is deemed to be uncollectible or the account is 120 days delin3uent, ta/ing into consideration the financial condition of the borro(er or lessee, the value of the collateral, recourse to guarantors and other factors. #ecoveries on finance receivables and lease investments previously charged off as uncollectible are credited to the allo(ance for credit losses. Sales o Receivables ,ord )redit securitizes finance receivables and net investment in operating leases and sells retail installment sale contracts in (hole-loan sale transactions to fund operations and to maintain li3uidity. <ost of its securitizations do not meet the criteria for off-balance sheet treatment. 's a result, the securitized assets and associated debt remain on its balance sheet and no gain or loss is recorded for these transactions. ,ord )redit records its sales of receivables as off-balance sheet (hen each of the follo(ing criteria is met! X The receivables are isolated from the transferor -i.e., ,ord )redit transfers the receivables to ban/ruptcyremote special purpose entities -V"4$sV. or other independent entities.. X The receivables are transferred to an entity that has the right to pledge or exchange the assets, or to a 3ualifying "4$ (hose beneficial interest holders have the right to pledge or exchange their beneficial interests. 1n its off-balance sheet transactions, ,ord )redit generally uses a 3ualifying "4$ or it sells the receivables to an independent entity. 1n either case, ,ord )redit does not restrict the transferee from pledging or exchanging the receivables or beneficial interests. X The transferor does not maintain control over the receivables -i.e., ,ord )redit is not permitted to regain control over the transferred receivables or cause the return of specific receivables, other than through a VcleanupV call, an optional repurchase of the remaining transferred financial assets at a point (here the cost of servicing the outstanding assets becomes burdensome in relation to the benefits.. ,or off-balance sheet sales of receivables, gains or losses are recognized in the period in (hich the sale occurs. ,ord )redit retains certain interests in receivables sold in off-balance sheet securitization transactions. 1n determining the gain or loss on each sale of finance receivables, the investment in the sold receivables pool is allocated bet(een the portions sold and retained based on their relative fair values at the date of sale. #etained 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 (ith unrealized gains recorded, net of tax, as a separate component of !ccumulated other comprehensive income34loss2. #esidual 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. ,ord )redit does not retain any interests in the (hole-loan sale transactions but continues to service the sold receivables. 1n both off-balance sheet securitization transactions and (hole-loan sales, ,ord )redit 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. ,ord )redit establishes a servicing asset or liability (hen the servicing fee does not ade3uately compensate for retaining the servicing rights. 1nterest supplement payments due from affiliates related to receivables sold in off-balance sheet securitizations or (hole-loan sale transactions are recorded, on a present value basis, as a receivable in -ther assets on its balance sheet at the time the receivables are sold. 4resent value accretion is recognized in Financial Services revenues. )ritical accounting estimates! Carranty and Additional Service Actions 6ature of .stimates "e7uired. The estimated (arranty and additional service action costs are accrued for each vehicle at the time of sale. $stimates are principally based on assumptions regarding the lifetime (arranty costs of each vehicle line and each model year of that vehicle line, (here little or no claims experience may exist. 1n addition, the number and magnitude of additional service actions expected to be approved, and policies related to additional service actions, are ta/en into consideration. *ue to the uncertainty and potential volatility of these estimated factors, changes in our assumptions could materially affect net income. !ssumptions and !pproach #sed. Bur estimate of (arranty and additional service action obligations is reevaluated on a 3uarterly basis. $xperience has sho(n that initial data for any given model year can be volatileF therefore, our process relies upon long-term historical averages until sufficient data are available. 's actual experience becomes available, it is used to modify the historical averages to ensure that the forecast is (ithin the range of li/ely outcomes. #esulting accruals are then compared (ith present spending rates to ensure that the balances are ade3uate to meet expected future obligations. Allowance or Credit %osses The allo(ance for credit losses is ,ord )reditCs estimate of the probable credit losses inherent in finance receivables and operating leases at the date of the balance sheet. )onsistent (ith its normal practices and policies, ,ord )redit assesses the ade3uacy of its allo(ance for credit losses 3uarterly and regularly evaluates the assumptions and models used in establishing the allo(ance. 7ecause credit losses can vary substantially over time, estimating credit losses re3uires a number of assumptions about matters that are uncertain. 6ature of .stimates "e7uired. ,ord )redit estimates the probable credit losses inherent in finance receivables and operating leases based on several factors. "etail Installment and )ease 8ortfolio. The retail installment and lease portfolio is evaluated using a combination of models and management udgment, and is based on factors such as historical trends in credit losses and recoveries -including /ey metrics such as delin3uencies, repossessions, and ban/ruptcies., the composition of our present portfolio -including vehicle brand, term, ris/ evaluation, and ne(Dused vehicles., trends in historical and pro ected used vehicle values, and economic conditions. $stimates from models may not fully reflect losses inherent in the present portfolio, and an element of the allo(ance for credit losses is established for the imprecision inherent in loan loss models. #easons for

imprecision include changes in economic trends and conditions, portfolio composition and other relevant factors. ;b) Chat does (ord say in (ootnote 6 about its use o accountin! estimatesD Chat ris* do these estimates pose or the auditorD F"se o #stimates The preparation of financial statements in accordance (ith +.". 6''4 re3uires us to ma/e 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. $stimates are used (hen accounting for certain items such as mar/eting accruals, (arranty costs, employee benefit programs, etc. $stimates are based on historical experience, (here applicable, and assumptions that (e believe are reasonable under the circumstances. *ue to the inherent uncertainty involved (ith estimates, actual results may differ.A This note alerts the financial statement user to the inherent uncertainty of some of the /ey accounts that affect the revenue cycle accounts. To the extent that these amounts are inherently uncertain and lac/ verifiability, fluctuations and differences from expectations create audit ris/ for the audit firm! they are attesting to a single number, (hen in fact that number may not be /no(n (ith great certainty. 6) Compare (ord and ,oyotaGs ootnotes on inance receivables) Chich company provides more in ormative disclosuresD Chat is the audit irmGs responsibility re!ardin! the in ormativeness o the disclosuresD Toyota>s disclosures are more informative, particularly in terms of maturities of receivables and sensitivity analyses regarding /ey economic assumptions and adverse changes in economic assumptions. 'uditors revie( the ade3uacy of disclosures made in the footnotes, so the auditors on the ,ord audit should consider (hether disclosures are ade3uate, and (hy ,ord management has chosen not to disclose as much information about its finance receivables as Toyota management has done. <) "se the inancial ratios provided in an earlier chapter appendi$ or (ord and ,oyota) Chat are the ratios most relevant to the revenue cycleD "ales gro(th, 3uic/ ratio, current ratio, margins -i.e., all profitability ratios., revenue per employee, receivable turnover. =) (ord lists a variety o ris* actors associated with its business) Review those0 and identi y which relate most to the revenue cycle) Chat evidence mi!ht the auditor !ather to understand how those ris*s may a ect the inancial statement line items associated with the revenue cycleD )ontinued decline in mar/et share, accompanied by the fact that ,ord has very significant fixed costs, thereby contributing to problems (ith profitability. o $vidence! mar/et share data, profitability data, going concern discussions (ith management. )ontinued or increased price competition, combined (ith industry overcapacity. ,ord and its competitors offer mar/eting incentives to compete, but these incentives are obviously expensive and reduce revenue. o $vidence! data on mar/eting incentive levels, compared to industry averages. <ar/et shift a(ay from the highly profitable "+L and truc/ sales.

$vidence! "ales data by product lineF profit margins by product lineF ,ord plans to shift production into more profitable sectors. *ecline in industry sales, particularly in the +" and $urope resulting from slo( economic gro(th etc., again coupled (ith the fact that ,ord has very significant fixed costs. o $vidence! sales trends, mar/et comparisons, plans to reduce and manage fixed costs. %o(er than anticipated mar/et acceptance of ne( or existing products. o $vidence! 4roduct sales dataF management plans to mitigate this ris/. Wor/ stoppages or other interruptions of supplies can affect ,ord>s ability to manufacture products. o $vidence! *ata on pervasiveness of (or/ stoppages, management>s assessment of the li/elihood of such occurrences in the future, plans to mitigate such (or/ stoppages. *iscovery of defects in vehicles resulting in higher (arranty costs. o $vidence! Warranty estimates, and auditor evaluation of (hether the reserve for (arranties is ade3uate. %o(er than anticipated residual values or higher than expected return volumes for leased vehicles, (hich may affect the valuation of financing receivables. o $vidence! %easing information, auditor evaluation of management>s assumptions used to calculate receivable and allo(ance valuation. 1ncreased competition from ban/s or other financial institutions to increase their share of financing ,ord vehicles, (hich may affect the revenue flo(s on the financing side of ,ord>s business. o $vidence! )ompetition information, management plans to compete. )hanges in interest rates, (hich may affect ,ord>s interest rate exposure related to financing receivables. o $vidence! )onducting sensitivity analyses on various interest rate possibilities as they relate to valuation of finance receivables and associated allo(ance accounts. )ollection and servicing problems related to finance receivables and net investment in operating leases. o $vidence! *ata trac/ing collecting and servicing problems, and auditor evaluation of ho( those problems are factored into allo(ance account valuations. o

8) Read (ordGs FMana!ement Discussion and AnalysisH section that relatin! to the revenue cycle) Chat are the main points that (ord mana!ement raises re!ardin! its ability to !enerate revenue and pro its in the near termD Chat does their statement imply about the ris*s associated with auditin! (ord Motor Co)D They indicate concerns about the negative effects of ,ord and overall industry excess capacity and pricing pressure. They indicate plans to follo( the follo(ing strategies to reverse their negative financial trends! 'ggressively restructure to operate profitably at the current demand and changing model mix o 4ersonnel reductions o 4lant closings 'ccelerate development of ne( products our customers (ant and value ,inance our plan and improve our balance sheet

Wor/ together effectively as one team o 1ntensive and coordinated planning effort to achieve their plans and goals.

The concern (ith excess capacity implies that there is considerable ris/ related to the impairment of property, plant, and e3uipment. 'ctive restructuring implies that the company may incur large separation costs related to retirement or lay-offs of employees.