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Auditing I

Chapter 5
Group 4 (Telolet) Accounting Class 4:
Amellia Samantha / 008201500036
Fajar Widya Kusumah / 008201400035
Ginsi Trianesti / 008201500117
Lyra Raisa / 008201500122
Muhammad Ihsan / 008201500124
Exercise 5-10
 What are the purposes for using preliminary analytical procedures.
The purposes for using analytical procedures at the planning stage
of an audit are
(1) to enhance the auditor’s understanding of the client’s business
and the transactions and events that have occurred since the last
(2) to identify areas that may represent risks relevant to the audit.
Exercise 5-12
 Significant differences between the auditor’s expectation an the client’s book value
require explanation through quantification, corroboration, and evaluation.
Quantification involves determining whether the explanation or
error can explain the observed difference. This may require the
recalculation of the expectation after considering the additional
information. For example, a client may offer the explanation that the
inventory account increased by a certain percentage as compared
to the prior year due to a 12 percent increase in raw materials prices.
The auditor should compute the effects of the raw materials price
increase and determine the extent to which the price increase
explains (or does not explain) the increase in the inventory account.
Exercise 5-12
Corroboration: Auditors must corroborate explanations for
unexpected differences by obtaining sufficient appropriate audit
evidence linking the explanation to the difference and substantiating
that the information supporting the explanation is reliable. This
evidence should be of the same quality as the evidence obtained to
support tests of details. Common corroborating procedures include
examination of supporting evidence, inquiries of independent
persons, and evaluating evidence obtained from other auditing
 Evaluation involves the effective use of professional scepticism,
combined with the desire to obtain sufficient appropriate audit
evidence, similar to other auditing procedures. The auditor should
evaluate the results of the substantive analytical procedures to
conclude whether the desired level of assurance has been
achieved. If the auditor obtains evidence that a misstatement exists
and can be sufficiently quantified, the auditor makes note of his or
her proposed adjustment to the client’s financial statements.
Exercise 5-13
 Why does the ‘audit testing hierarchy’ begin with tests of controls
and substantive analytical procedures.
The Audit Testing Hierarchy starts with tests of controls and
substantive analytical procedures because they are generally both
more effective and more efficient than starting with tests of details
(i.e. substantive tests of transactions and substantive tests of account
balances and disclosures).
Exercise 5-15
 List and discuss the four categories of financial ratios that are
presented in the chapter.
Short-term liquidity ratios are indicators of the entity’s ability to meet its
current obligations when they become due.
Activity ratios indicate how effectively the entity's assets are
Profitability ratios are indicators of the entity’s success or failure for a
given period.
Coverage ratios provide information on the long-term solvency of the
entity, including the ability of the entity to continue as a going
Exercise 5-22
Months Monthly Sales Historical Estimated
(in 000s) $ Return Rate Returns
July 73,300,000 0.004 293,200
August 82,800,000 0.006 496,800
September 93,500,000 0.01 935,000
October 110,200,000 0.015 1,653,000
November 158,200,000 0.025 3,955,000
December 202,500,000 0.032 6,480,000
Gross Margin % x 0.425
Auditor $€5,870,525
Exercise 5-22
B. We can establish a tolerable difference by applying a
percentage (50-75%) to the planning materiality set for
EarthWear of €1,788,000. This results in a tolerable
difference of €894,000.

C. The expectation of €5,870,525 is approximately

€20,000 less the book value of €5,890,000. Since this
amount is less than the tolerable difference of €894,000,
the analytical procedure supports the fair presentation
of the reserve for returns account.
Exercise 5-22
D. If the difference between the auditor’s expectation
and the book value is greater than the tolerable
misstatement, the auditor should consider performing
the following audit procedures:
• Review the general journal and general ledger for any
unusual entries.
• Re-evaluate the historical return rates.
• Re-evaluate the gross profit margin.
• Ask the client to adjust the books.
Exercise 5-23
 A. Indicate the potential risks the ratio and/or historical patterns
may present.
 Quick Ratio: Over the years, the industry’s quick ratio has consistently
increase, while The Home Improvement Store’s Quick Ratio increased
to an amount that would have sufficiently covered the current
liabilities, but plummeted the next year and continued to decrease.
The historical pattern has no trend, and if the quick ratio continues to
decrease, the company will not have enough liquid assets to cover
the current liabilities
 Days of inventory on hand: The inventory turnover ratio for The Home
Improvement Store started out high, indicating that the entity is good at
liquidating inventory. However, throughout the years, the ratio began to
decrease and only began to increase in 2014. Even though the ratio
may have been higher than the industry ratio for the majority of the
years, the historical pattern is indicative of a continued decline in the
inventory turnover ratio, potentially stifling the liquidation of inventory
 Inventory/Current Assets: Because the inventory percentage fluctuates
through high percentages over the years for The Home Improvement
Store, this indicates an inability to properly liquidate the company’s
inventory. This slow liquidation process could indicate that the goods
kept by the company are becoming obsolete compared to the
Exercise 5-23
 Return on Assets: Over the years, the percentage of Return on Assets
for The Home Improvement Store decreased substantially and
suddenly increased in2014. The decreasing percentages indicates a
decreasing net income for the company, potentially leading to an
insufficient return earned for stockholders and creditors. Although the
Industry’s Return on Assets fluctuates and indicates vastly different
values of return earned for stockholders and creditors, the changes in
percentages are not nearly as drastic as the decrease shown for The
Home Improvement Store.
 Debt to Equity: Although the debt-to-equity ratio for The Home Improvement
Store started out incredibly small compared to the Industry, it increase
exponentially in the following years and indicated that the entity would be
unable to fulfill its long-term debt obligations due to the ratio being more than
two times the Industry ratio. Although it began to decline in 2014, there is no
way of knowing from its historical pattern if the trend of high leverage for the
entity will continue to affect the company’s ability to meet its long-term debt
Exercise 5-23
 B. Indicate one or two plausible explanations of why The Home
Improvement Store’s ratios or historical patterns differ from those
of the industry
It is possible that The Home Improvement Store had poor
inventory management which led to their stock piling up and not
liquidating properly. Additionally, a decrease in their profit could
have resulted from their decrease in sales indicated by their high