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The following operating data has been provided to Erica Chavez by her
audit client, Grimes Hardware. Sales commissions average 6 percent of

2002 % 2003 % Change (%)

Sales $18,000 100% 22,000 100% 22%

Cost of sales 10,000 11,000
Sales commissions 1,080 1 100
Gross profit 6,920 9,900
Operating expenses 3,200 3,600
Income before taxes 3,720 6,300
Income taxes 1,200 2,000
Net income $2,520 4,300
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a. Complete the vertical and horizontal analysis by calculating the

correct percentages.

b. Why are both vertical and horizontal analysis important inputs to

analytical procedures?

c. Assuming sales commissions have been accurately

computed based on 2003 sales, what are the possible explanations for any
abnormalities produced by your percentage calculations?

2. The following financial data have been extracted from

the records of Blackwell Wholesale Tires:

2003 2002

Sales $15,660 14,980

Cost of sales 7,800 7,400
Ending inventory 6,200 4,300
Accounts receivable-trade 2,200 1,300
Total current assets 12,300 10,100
Total current liabilities 7,300 4,980
Customer payment terms:
Industry averages:
Gross margin 51%
Current ratio 2:1
Inventory turnover 2.5
Accounts receivable turnover 11.0
Based on the above data, in which areas do you recommend concentrating audit
resources for the 2003 audit? Support your answer by citing the relevant
3. Louis Hernandez set the following materiality thresholds
for the Sanders Wholesale audit:

Individual item materiality - income statement:

$30,000 (5% of unaudited net income, $600,000)
Individual item materiality - balance sheet:
(2% of unaudited net assets, $3,500,000)$70,000
Aggregate materiality (20% of individual item)
Income statement $6,000
Balance sheet $14,000


a. What factors should Hernandez have considered in

setting the above thresholds? Why is the aggregate
threshold set at 20% rather than, say 10% or 5%?
b. In the process of testing Sanders internal controls,
Hernandez discovered significant weaknesses that, in
his opinion, may have materially impacted the
financial statements. Moreover, the application of
analytical procedures revealed the likelihood of a
material overstatement of unaudited net income and net
assets. What effect should these findings have on the
materiality thresholds?

4. For each of the listed scenarios, determine whether

inherent risk or control risk or both should be assessed
at a high level. Then describe an appropriate audit
approach. In developing your approach, consider whether
the auditor should decrease reliance on internal evidence
and suggest specific kinds of audit evidence you would
recommend in the circumstances.

Situation 1.

In planning the audit of Jayco Corporation, Charles Lawson,

the in-charge senior auditor found Jaycos internal controls to
be effective in all transaction cycles. Analytical procedures
revealed that Jaycos operating income declined 30% in 2000,
based on unaudited data. Increased competition from imports,
combined with more stringent emission requirements, contributed
to the decline. Lawson is concerned, however, that Jayco
reported operating income while its nearest competitors reported
losses. He notes that Jayco is not showing a capacity loss
notwithstanding a significant decrease in production and fixed
overhead absorption. Ending inventories seem high relative to
cost of goods sold for the year.
Situation 2.

Although the internal controls for Montrose, Inc., a local

cable broadcasting company, are effective for the revenue cycle,
they are lacking in the expenditure cycle. Of particular
concern to Eva Bresky, the in-charge auditor, is the absence of
internal control over the processing of invoices from and
payments to network providers. The Montrose engagement is an
initial audit for Breskys firm and a first audit for Montrose.
Analytical procedures do not reveal any apparent abnormalities.