4.

27

a.

Incorrect

b.
c.
d.

Correct
Incorrect
Incorrect

a.

Incorrect

b.

Correct

c.

Incorrect

d.

Incorrect

a.

True.

b.
c.

True.
True.

d.

Correct

4.33

a.
b.
c.
d.

Incorrect
Incorrect
Correct
Incorrect

Audit documentation need to document compliance with GAAS.

Extracts of contracts should go in the permanent file.
Independence is not really a working paper matter.
Materiality judgments will affect the amount of evidence shown in
audit documentation.

4.35

a.

Incorrect

b.

Incorrect

c.

Incorrect

d.

Correct

Internal control analysis for the current year would be in the

administrative or current file.
The latest engagement letter would be in the administrative or current
file.
Memoranda of conference with management would be in the
administrative or current file.
Excerpts of the corporate charter and by-laws would not change often
and would be in the permanent file.

4.39

a.
b.
c.
d.

Incorrect
Correct
Incorrect
Incorrect

These are functions of a client's computer system.

Auditors can use the computer with ease.
Machine operations do not leave "visible" evidence.
Computer auditing is meant to gather good evidence with the least
quantity of storage.

4.40

a.
b.

Incorrect
Correct

c.

Incorrect

The ratio of cost/sales does not increase.

The numerator (cost of goods sold) increases relatively less than the
denominator (sales) increases.
The ratio of cost/sales does not remain unchanged.

4.28

4.31

Analytical procedures are performed after the engagement letter is

obtained.
This is the "attention-directing" purpose.
All the assertions are always important.
This answer could be good even though it evokes the control risk
assessment standard, but restriction to inventory makes it a poor choice.
Physical production statistics are not a source of information for
"comparison of current account balances with prior periods."
A client's budgets and forecasts are sources of information for
"comparison of current account balances with expected balances."
Published industry ratios are not a source of information for "evaluation
of current account balances with relation to predictable historical
patterns."
The company's own historical financial statements are not a good
source of information for "evaluation of current account balances in
relation to nonfinancial information."
The successor must take responsibility for obtaining the client's consent
for the predecessor to give information about prior audits.
Cooperation from the predecessor is expected.
Cooperation includes obtaining copies of some or all of the predecessor
auditor's documentation.
All of the above are expected.

4.42

4.43

4.44

a.

Incorrect

b.

Correct

c.

Incorrect

d.

Incorrect

a.

Incorrect

b.

Incorrect

c.

Incorrect

d.

Correct

a.

Incorrect

b.

Incorrect

c.

Incorrect

d.

Correct

The audit report should not mention the fact that Costanza used a specialist,
unless the specialists findings affect the auditors conclusions.
Costanza should only mention the use of the specialist when the
specialists findings affect the auditors conclusions.
Costanza need not mention the use of a specialist if the auditor decides
not to take responsibility for the specialists findings.
Costanzas report should only mention the specialist if Vandalay does
not agree with the specialists findings, resulting in an opinion other
than unqualified.
Interviewing internal auditors about their reporting responsibilities
would assist the audit team in determining whether the internal auditors
were objective, but would provide little evidence of related-party
transactions.
Reviewing accounting records for nonrecurring transactions occurring
throughout the year would raise suspicions of fraud, but not necessarily
related-party transactions.
Inspecting communications with the clients legal counsel regarding
recorded contingent liabilities would be helpful in determining
contingent liabilities.
Scanning the minutes for significant transactions with members of the
Board of Directors would be helpful in identifying transactions with
parties related to the client.
A report to the audit committee on the results of testing of internal
control over cash receipts would typically occur after the entire period
could be tested, and therefore would be written after the balance sheet
date.
Confirmation letters to vendors confirming the amounts they owe to the
client are part of substantive procedures performed on balance sheet
account amounts.
An attorneys letter regarding contingent liabilities would be written as
close to the end of fieldwork as practicable.
An engagement letter would be written before accepting an
engagement, and therefore before the balance sheet date.

4.48

Audit Simulation: Preliminary Analytical Procedures

E X H I B I T 4.482
ALPHA.COM, INC.
PRELIMINARY ANALYTICAL PROCEDURES DATA
COMPARATIVE, COMMONSIZE FINANCIAL STATEMENTS
Prior Year
(Audited)
Common
Balance
Change
REVENUE AND EXPENSE:
Sales (net)
$9,000,000
8.00%
Cost of goods sold
6,296,000
11.18
Gross margin
2,704,000
0.59%
General expense
2,044,000
2.01
Depreciation
300,000
11.33
Operating income
$360,000
6.39%
Interest expense
60,000
25.00
Income taxes (40%)
120,000
2.67
Net income
$180,000
2.67%
ASSETS:
Cash
$600,000
15.13%
Accounts receivable
500,000
80.00
Allowance doubtful accounts(40,000)
125.00
Inventory
1,500,000
10.00
Total current assets
$2,560,000
11.36%
Fixed assets
3,000,000
50.00
Accum depreciation
(1,500,000)
22.27
Total assets
$4,060,000
35.88%
LIABILITIES AND EQUITY:
Accounts payable
$450,000
26.67%
Bank loans, 8%
0
Accrued interest
60,000
33.33
Accruals and other
50,000
36.00
Total current liabilities
$560,000
284.29%
Long-term debt, 10%
600,000
33.33
Total liabilities
$1,160,000
120.00%

Current Year
(Unaudited)
Common
Size

Balance

Change
Percent
Size

100.00%

$9,720,000

100.00%

69.96

7,000,000

72.02

30.04%

2,720,000

27.98%

Amount

$ 720,000
704,000
16,000

22.71

$2,003,000

20.61

(41,000)

3.33

334,000

3.44

34,000

4.00%

$383,000

3.94%

$23,000

0.67

75,000

0.77

15,000

1.33

123,200

1.27

3,200

2.00%

$184,800

1.90%

$4,800

14.78%

690,800

12.52%

90,800

12.32

900,000

16.31

400,000

0.99

(90,000)

1.63

(50,000)

36.95

1,350,000

24.47

(150,000)

51.67%

$290,800

63.05%

$2,850,800

73.89

4,500,000

81.57

1,500,000

36.95

(1,834,000)

33.24

(334,000)

100.00%

$5,516,800

100.00%

$1,456,800

11.08%

$330,000

5.98%

($120,000)

0.00
1.48

1,750,000
40,000

31.72
0.73

1,750,000
(20,000)

1.23

32,000

0.58

(18,000)

13.79%
14.78
28.57%

$2,152,000
400,000
$2,552,000

39.01%
7.25
46.26%

$1,592,000
(200,000)
$1,392,000

Capital stock
Retained earnings
Total liabilities
and equity

2,000,000
0.00
900,000
7.20

49.26

2,000,000

36.25

22.17

964,800

17.49

$4,060,000
35.88%

100.00%

$5,516,800

100.00%

64,800
$1,456,800

4.48

Audit Simulation: Preliminary Analytical Procedures (Continued)

E X H I B I T 4.483
ALPHA.COM, INC.
SELECTED FINANCIAL RATIOS
Prior
Year
Balance Sheet Ratios
Current ratio
4.57
Days sales in receivables
18.40
Doubtful accounts ratio
0.0800
Days sales in inventory
85.77
Debt/equity ratio
0.40
Operations Ratios
Receivables turnover
19.57
Inventory turnover
4.20
Cost of goods sold/sales
69.96%
Gross margin %
30.04%
Return on beginning equity
6.62%
Financial Distress Ratios (Altman)
Working capital/Total assets
0.49
Retained earnings/Total assets
0.22
EBIT/Total assets
0.09
Market value equity/Total debt
2.59
Net sales/Total assets
2.22
Discriminant Z Score
4.96
Market value of equity
$3,000,000

Current
Year

Percent
Change

1.32
30.00
0.1000
69.43
0.86

71.02%
63.04%
25.00%
19.05%
115.19%

12.00
5.19
72.02%
27.98%
6.37%

38.67%
23.54%
2.95%
6.86%
3.71%

0.13
0.17
0.07
1.18
1.76
3.09
$3,000,000

74.29%
21.11%
21.70%
54.55%
20.52%
37.67%

In the ALPHA.COM example in Exhibits 43 and 44, the market value of the equity in the calculations is
$3 million.

4.48

Audit Simulation: Preliminary Analytical Procedures (Continued)

Current
(Unaudited)

Potential
Error

Current as
Affected (?)

REVENUE AND EXPENSE:

Sales (net)
Cost of goods sold

$9,720,000
7,000,000

($300,000)
( 216,000)

$ 9,420,000
6,784,000

Gross margin
General expense
Depreciation

$2,720,000
2,003,000
334,000

($ 84,000)
18,000
( 4,000)

$2,636,000
2,021,000
330,000

Operating income
Interest expense
Income taxes (40%)

$ 383,000
75,000
123,200

($ 98,000)
35,000
( 53,200)

$ 285,000
110,000
70,000

Net income

$ 184,800

($ 79,800)

$ 105,000

ASSETS:
Cash
Accounts receivable
Allowance doubtful accounts
Inventory
Tax receivable

$ 690,800
900,000
(90,000)
1,350,000

$
0
( 300,000)
0
216,000
53,200

$ 690,800
600,000
(90,000)
1,566,000
53,200

Total current assets

Fixed assets
Accumulated depreciation

$2,850,000
4,500,000
(1,834,000)

($ 30,800)
0
4,000

$2,820,000
4,500,000
(1,830,000)

TOTAL ASSETS

$5,516,800

($ 26,800)

$5,490,000

LIABILITIES AND EQUITY:

Accounts payable
Bank loans, 8%
Accrued interest
Accruals and other

$ 330,000
1,750,000
40,000
32,000

0
0
35,000
18,000

$ 330,000
1,750,000
75,000
50,000

Total current liabilities

Long-term debt, 10%

$2,152,000
400,000

$ 53,000
0

$2,205,000
400,000

TOTAL LIABILITIES
Capital stock
Retained earnings

$2,552,000
2,000,000
964,800

$ 53,000
0
(79,800)

$2,605,000
2,000,000
885,000

TOTAL LIABILITIES & EQUITY

$5,516,800

($ 26,800)

$5,490,000

4.48

Audit Simulation: Preliminary Analytical Procedures (Continued)

SOLUTION EXPLANATION:
Many of the conclusions are based on the prior year being the best indicator of current year
"accurate" figures.
1.

Sales and Accounts Receivable may be overstated $300,000. ALPHA.COM, INC.s

"more liberal return privileges" may have caused early recording of sales and receivables.
A $300,000 error will bring the accounts receivable back near the prior year gross total.

2.

If $300,000 sales were recorded too early, the related Cost of Goods Sold should be
restored to Inventory. Apparently the COGS is 72 percent of sales. The adjustment could
be $216,000. HOWEVER, if the proper COGS ratio is approximately 70% as in the prior
year instead of 72%, the COGS may be overstated (and the inventory understated) by
another $188,400 (2% x $9,420,000).

3.

The Allowance for Bad Debts may need to be higher than the prior year because of credit
and return terms. Leave it at $90,000 on $600,000 receivables, although this 15 percent
ratio is much higher than the prior year (8%). HOWEVER, if eight percent is the more
appropriate ratio, the allowance (and bad debt expense) may be overstated by $42,000
(7% x $600,000).

4.

Expense accruals might have been omitted in the amount of $18,000, which would bring
the accrued expenses up to the prior year amount ($50,000).

5.

Depreciation expense appears to have been calculated on the basis of the planned capital
addition of $1,700,000 instead of the actual recorded amount of $1,500,000. ($1,500,000
for 25 years, 1/2 year, no salvage is $30,000 in addition to the prior year $300,000.)

6.

The bank loan interest accrual for the 4th quarter ($35,000 = $1,750,000 x .08 x 1/4 year)
appears to have been overlooked. Interest expense for the six months should be $70,000
($1,750,000 x .08 x 1/2 year) plus the $40,000 on the long term debt, for a total of
$110,000 instead of $75,000.

7.

The income-reducing potential errors have a tax effect (40%) of $53,200. Since
ALPHA.COM, INC. apparently paid the taxes based on the unaudited income, a tax
refund receivable will arise with the final tax return.

Although the problem information is not explicit, ALPHA.COM, INC. apparently paid dividends
of $120,000 (same as prior year). If this is not the case, a $120,000 unexplained debit is buried in
the retained earnings account. If it is not a dividend, it might be a misclassified loss or a prior
period adjustment.

4.49

Analytical Procedures Ratio Relationships

a.

The current ratio was made larger than it should have been. The current asset numerator
was made larger (fictitious accounts receivable larger than the inventory removed) while
the current liability denominator did not change. (However, if the income tax effect of
the error is included, the current liabilities change by a greater proportion that the current
assets change, and it turns out that the current ratio was made smaller !)

b.

In this case the relative rate of change is important, because both the numerator and
denominator of the current ratio are changed by the same amount.
1.

Current ratio (before) was greater than 1:1--the incorrect accounting makes the
ratio larger than it should be.
Example:

2.

Current ratio (before) was equal to 1:1--the incorrect accounting does not
change the ratio.
Example:

3.

Before $100,000 / $100,000 = 1:1

After $ 90,000 / $ 90,000 = 1:1

Current ratio (before) was less than 1:1--the incorrect accounting makes the ratio
smaller than it should be.
Example:

c.

Before $100,000 / $20,000 = 5.0:1

After $ 90,000 / $10,000 = 9.0:1

Before $ 20,000 / $100,000 = 0.2:1

After $ 10,000 / $ 90,000 = 0.11:1

Effect of unrecorded purchase counted in physical inventory, assuming the accounts are
adjusted to include the inventory on hand.
Inventory is not misstated.
Cost of goods sold is understated.
Gross profit is overstated.
Net income is overstated.
The effect on the ratios compared to what they would have been without the error:
Current ratio:
Greater than 1:1 before.
Equal to 1:1 before.
Less than 1:1 before.

The error of recording the inventory and not

the current payable makes the ratio larger.
The error makes the ratio larger.
The error makes the ratio larger.

Gross margin ratio: The error makes it larger.

Cost of goods sold ratio: The error makes it smaller.
Receivables turnover:

The error does not affect either the sales numerator or the
receivables denominator, so the ratio is not affected.

4.49

Analytical Procedures Ratio Relationships (Continued)

d.

In this case the net receivables amount is correct. The proper adjustment should be to
reduce gross receivables and the allowance for doubtful accounts by an equal amount.
Current ratio:

Not affected because the current asset and current

liability totals are not affected.

Day's sales in receivables:

Not affected when the net receivables is used to

calculate the ratio.

Doubtful account ratio:

The improper accounting causes the ratio to be larger

than it should be. (Proper accounting would cause the
allowance numerator to be reduced to a greater
extent, by a faster rate, than the receivables
denominator.)

Receivables turnover:

Not affected when the net receivables is used to

calculate the ratio.

Return on beginning equity:

Not affected because the income is measured

properly with adequate allowance for doubtful
accounts.

Working capital/Total assets:

Not affected because both terms are measured

properly.

4.58

Horizontal and Vertical Analysis

TO:
FROM:
DATE:
SUBJECT:

Current Audit Documentation File

Auditor
Retail Company audit--preliminary analytical review

Revenue and Current Ratio

Sales decreased 10%, and the company may be tempted to misstate accounts in order to avoid
reporting an income decrease. The requirement to maintain a 2:1 current ratio presents temptation
to overstate current asset accounts and understate current liability accounts.
Sales, Sales Returns, and Accounts Receivable
Both sales and accounts receivable are down. The days' sales in receivables and receivables
turnover ratios confirm the relative decrease. The allowance for doubtful accounts ratio is
approximately in line with last year. Even though the sales decline might tempt people to record
invalid sales, there is not much room to hide them in accounts receivable. If the allowance for
doubtful accounts should be 8%, as last year, the allowance should be $32,000, indicating a $2,000
understatement in the allowance and $2,000 overstatement of net realizable value of accounts
receivable.
Inventory and Cost of Goods Sold
Cost of goods sold as a percent of sales is down from 70 percent to about 65 percent. If 70 percent
is more accurate, cost of goods sold might be understated by $405,000, or almost 76 percent of the
$530,000 operating income (before taxes, interest expense, and other revenue and expense).
The related inventory accounts may therefore be overstated, perhaps as much as $405,000. The
trial balance shows inventory increased $440,000 (29 percent). The days' sales in inventory and
inventory turnover ratios confirm the relative increase of inventory dollars.
We should audit the physical inventory and inventory pricing carefully.
Accruals and Expenses
The depreciation expense is the same as last year, but $1,000,000 new assets are in the Equipment
account. We need to recalculate depreciation expense. Either the company forgot to record
depreciation on new assets, the assets are fictitious and have not been put on the depreciation
schedule, or the assets were acquired so late in the year that fractional depreciation is immaterial.
Interest expense on the new bank loan appears not to have been paid or accrued. The interest
expense in the trial balance seems to be interest on the long term debt at 10 percent. According to
the problem information, interest since July 1 at 11% on $750,000 (expense = $41,250) should
have been recorded.
Other accruals are smaller than last year, and general expenses are only slightly lower. Maybe
some accrued expenses did not get recorded. We need to be sure to conduct the search for
unrecorded liabilities and expenses. If the ratio of accruals to expense for last year (0.03) is
relevant for this year, the accruals should be about $60,000 instead of $10,000.
Liabilities
It looks like there was an error in the prior year audited financial statements. $100,000 of the
long-term debt should have been classified as "current portion of long-term debt." None is
classified as a current liability in the current year unaudited financial statements.
Retained Earnings
We were told that no dividends have been declared or paid, but the ending retained earnings is not
equal to the beginning retained earnings plus net income. There is a $100,000 discrepancy that

could be dividends, a prior period adjustment, or a loss improperly debited to retained earnings.
Maybe the books just do not balance!
4.58

Horizontal and Vertical Analysis (Continued)

A constructed cash flow statement (attached) shows an unexplained $100,000 cash "shortage."
Maybe a loss or expense was debited directly to retained earnings.
Going Concern Consideration
The company appears to have used operating cash flow and new bank loans ($750,000) to finance
asset purchases ($1,000,000) and long term debt repayment ($100,000). Current liabilities
increased much more than current assets (inventory increase), and the current ratio declined from
4.57 to 2.00. Likewise the total debt to equity ratio increased from .35 to .56
Overstatement of the inventory, omission of accrued expenses, and misclassification of the current
portion of long term debt would cause the current ratio to be 2:1, exactly as required by the loan
agreement, instead of less than 2:1. The existence of the loan agreement requirement make the
risk of misstatement higher under these conditions.
While the company does not seem to be in dire financial straits, we ought to review the cash flow
budget for next year.
Retail Company
Cash Flow Statement
Operations:
Net income
Depreciation
Decrease net accounts receivable
Increase inventory
Increase accounts payable
Decrease accruals

$ 294,000
300,000
90,000
(440,000)
150,000
( 60,000)

Cash Flow from Operations

$ 334,000

Investing Activities:
Additions to fixed assets
Financing Activities:
New loan acquisition
Debt repayment

( 1,000,000)
$ 750,000
( 100,000)

Financing Cash Flow

Net Cash Increase

650,000
$ ( 16,000)

Beginning Cash Balance

Ending Cash Balance
Reported Cash Balance

600,000
$ 584,000
484,000

Unexplained Cash Difference

$ 100,000

4.58

Horizontal and Vertical Analysis (Continued)

Retail Company

Summary of Potential Problems

Reported (unaudited)
Added bad debt allowance
Overstated inventory
Interest accrual
Expense accrual
Depreciation expense
Unidentified RE debit
Reclassify long term debt
Income tax reduction*
Adjusted

Income
$ 294,000
( 2,000)
( 405,000)
( 41,250)
( 50,000)
(100,000)
(100,000)
279,300
$(124,950)

Adjusted current ratio

*Refund of taxes paid plus refund from tax loss carryback.

Current
Assets
$ 2,794,000
(
2,000)
( 405,000)

Current
Liabilities
$ 1,400,000
41,250
50,000

279,300
$ 2,666,300
1.68:1

100,000
_________
$1,591,250