Ch.

6 & 7 Textbook Exercises

Name

Comprehensive Question 6-26

(Audit programs and assertions) Assume that you are responsible for developing an
audit program for a manufacturing client that sells to over 1,400 customers. You want to
ensure your audit program addresses all relevant assertions for sales and accounts
receivable. Address the following question in the context of the audit sales and
receivables for this manufacturing client.
Required
A. What is the purpose of an audit program?
An audit program "documents decision about the audit procedures that the auditor
believes are necessary to obtain reasonable assurance that the financial statements
are presented fairly in all material respects" (Boynton & Johnson, 2006, p. 251). The
audit program is required and is part of generally accepted auditing standards. The
audit program includes procedures to be performed, who performed them, and
when. The program also includes a cross-reference to working papers. The working
papers are a way for the auditor to document both their work and any evidence
collected. " Generally accepted auditing standards describe working papers as
records kept by the auditor of the procedures applied, the tests performed, the
information obtained, and the pertinent conclusion reached in the audit" (Boynton &
Johnson, 2006, p. 254). For example, evidence obtained when auditing accounts
receivable might include prior year work papers to trace beginning balances to or a
sampling of sales invoice to vouch debits to.
B. Explain why auditors translate audit assertions into specific audit
objectives when developing an audit program.
Assertions are used to "make decisions about the assessment of risk by considering
the types of potential misstatements that may occur, and design audit procedures
that are appropriate to the assertion and to the risk assessment" (Boynton &
Johnson, 2006, p. 187). The assertions, or audit objectives, provide a framework for
auditors to follow during the audit program. That framework allows the auditor "to
identify the relevant transactions, account balances, and disclosures in the financial
statements for a transaction cycle that is being audited" (Boynton & Johnson, 2006,
p. 231). For example, when auditing the revenue cycle, the auditor could establish

transaction objectives such as occurrence, completeness, accuracy, cutoff, and

classification. When auditing account balances, the auditor might establish
objectives such as existence, completeness, rights and obligations, and valuation
and allocation. Finally, when auditing disclosures, the auditor may establish
objectives such as occurrence, completeness, and classification. All these objectives
are actually assertions outlined in GAAP.
C. If you are auditing the existence and occurrence assertion, what specific
audit objectives should be accomplished by developing an audit
program? Explain the purpose of each audit objective.
Specific audit objectives that should be accomplished in auditing the existence and
occurrence assertion when developing an audit program includes the following:
Transaction Audit Objective- Occurrence: All sales, receivables, and cash receipts
have been recorded during the period the transaction occurred in and revenue is
recognized correctly. Transaction Audit Objective- Cutoff: All sales, receivables, and
cash receipts have been recorded in the correct period and sales revenue has not
been recognized that should be in a subsequent period.
Balance Audit Objective- Existence: All accounts receivables are valid amounts and
do actually exist.
D. If you are auditing the valuation or allocation assertion, what specific audit
objectives should be accomplished by developing an audit program?
Explain the purpose of each audit objective.
Specific audit objectives that should be accomplished in auditing the valuation or
allocation assertion when developing an audit program include the following:
Transaction Audit Objective- Accuracy: All sales, receivables, and cash receipts have
been accurately recorded with the correct amount.
Balance Sheet Objective- Valuation and Allocation: Accounts receivable are
recorded at the net realizable value and appropriate allowance for doubtful accounts
is recorded properly.

Case 7-25 (Part b)

(New Client Acceptance) Comprehensive Case: Mt. Hood Furniture, Inc.
Company Background Information: Your employer, Reddy & Abel, LLP, Certified
Public Accountants (who is registered with the PCAOB and audits public companies),
has been approached by a prospective client, Mt. Hood Furniture, Inc., about your firm
taking on their account. The firm has adopted procedures for the acceptance and
retention of clients following the AICPA guidelines for quality control in an accounting
practice. The firm requires that a partner interview all prospective clients to determine
what services the client needs and the ability of the firm to provide those services. As
the prospective senior on the engagement, you accompanied the partner on the
interview. The following is a summary of your notes from the interviews with senior
management.
Notes from Client Interview: Mt. Hood Furniture, Inc. is an Oregon corporation
incorporated in 1961. The company is a regional manufacturer of office furniture and
cabinetry. The product line includes desks, chairs, filing cabinets, bookcases,
credenzas, and European-style cabinets. Approximately 80 percent of fiscal year 20X3
net sales were in office furniture and 20 percent in cabinetry. The cabinetry unit
underwent major retooling commencing in 20X2, which approximated 85 percent of the
capital expenditures that year. The retooling was financed with significant long-term
debt. The improvements enabled the company to manufacture ready-to-assemble
furniture products, and develop a modular ready-to-install cabinet line, which has
resulted in an increase in sales. The company has developed new, award-winning
designs in office furniture, designs that stress the efficient and ergonomic use of
technology. Many opportunities exist to expand sales of the existing product lines.
Management estimates that the current physical plant can support up to $50 million in
sales without significant additions of manufacturing and distribution capacity. Additional
sales up to $50 million are expected to result in additional costs associated with the
variable cost of production and variable overheads but should not require increases in
fixed costs.
Office furniture is a highly competitive, multibillion-dollar annual market. With a strong
economy the market has grown about 15 percent per year over the last two years;
however, industry experts expect this growth to slow down in the years ahead. Mt. Hood
does not have significant market share and competes with a number of nationally
recognized companies. Mt. Hood's primary advantages are competitive pricing and
consistently high-quality products. Its low-profit margins are part of a pricing strategy to
build market share by undercutting the competition. The custom office cabinetry grants
the company a wider profit margin and substantial sales growth potential. This is a
unique product line; it offers a custom-built look that is not readily available from other

manufacturers. Demand is steadily growing. The company plans to expand its

marketing in this niche.
The company's manufacturing and executive offices are located in facilities leased from
the founder, adjacent to shipping and transportation facilities in the Pacific Northwest.
Two adjacent buildings house the corporation, with the offices located above the
warehouse. The company purchases raw materials including coil steel, bar stock,
hardware, laminated particleboard, casters, fabric, rubber and plastic products, and
shipping cartons. Materials are delivered to the dock by common carriers or by
suppliers' trucks. Finished products are shipped FOB from the warehouse or picked up
by the customer. Mt. Hood has a delivery truck for smaller, local orders.
The company has 180 employees involved in manufacturing operations and 20 in the
executive offices. The company's workforce is stable and highly skilled. Many of the
employees have been with the company for more than 15 years. The company's work
environment and solid reputation have allowed it to attract and keep employees in a
tight marketplace. Mt. Hood offers both pension and profit-sharing plans; the plans have
been in place for over 25 years.
The company distributes its products through a small network of approximately 150
office furniture dealers in major U.S. cities. Recently, the company placed its product
with several national chains and warehouse-club chains. Most of the sales growth over
the last two years is attributed to this new distribution channel; it represented 35 percent
of year-20X3 sales. Their largest single customer accounts for 8 percent of sales. The
company also produces a catalogue and has an information web site with an order link.
The office cabinetry line offers custom orders for on-site installation. Customers include
major hotels and professional and corporate offices. Today 20 percent of sales come
from this line, and the chief operating officer would like to see this line grow to a total of
$25 million in sales in the next three to five years. Individuals, which comprise about 5
percent of total sales, can order directly from Mt. Hood Furniture using the company's
web site. A large showroom is maintained at the corporate offices; customers may also
place orders at the showroom.
Mt. Hood Furniture is subject to a variety of federal, state, and local laws and
regulations relating to the use, storage, handling, generation, transportation, treatment,
emission, discharge, disposal and remediation of, and exposure to, hazardous and
nonhazardous substances, materials, and wastes. In particular, the U.S. Environmental
Protection Agency standards for the wood furniture manufacturing industry require
reduction of emissions of certain volatile organic compounds found in the coatings,
stains, and adhesives used by Mt. Hood. Company officers believe that Mt. Hood's
operations are in substantial compliance with all environmental laws.

Mt. Hood Furniture, Inc. is family owned and not publicly traded; 1 million shares of $1
par common stock are authorized. Major stockholders include the founder, who recently
retired as chairman of the board, Robert S. Saws. He holds 30 percent of the
outstanding shares. Mr. Saws is 70 years old and until his retirement was closely
involved in all major decisions affecting the company. He personally signed corporate
checks and supervised the company's operations. He is very proud of his company's
strong reputation for being ethical and for meeting its commitments and promises. His
son, Conrad P. Saws, has worked in the business for the last 15 years, is the current
president and chairman of the board, and under his father's guidance during the last 5
years, has assumed the responsibility of overseeing the business's day-to-day
operations. Conrad is also a 30 percent owner. Other family members own an additional
30 percent of the business. The chief operating officer (COO) and chief financial officer
(CFO) are the only nonfamily owners at 5 percent each.
Mt. Hood's senior management is comprised of Conrad Saws, the president and
chairman of the board; James Doyle, the COO; and Julia Anderson, the CFO. Doyle
joined the company two years ago after working for 13 years in the industry for a major
office furniture manufacturer. Anderson has worked for the company for about 15
months. She was an audit manager with Reddy and Able prior to joining Mt. Hood
Furniture, Inc.
The board of directors includes the retired chairman (Robert Saws), the president and
current chairman (Conrad Saws), a family member with a business background in the
retail residential furniture sector (Howard Saws), another family member trained in
architecture and interior design (Catherine Saws), and the senior president of a large
regional bank. During the on-site interview, you and Mr. Reddy met with Robert Saws
privately for over two hours, then were introduced to and interviewed individually the
other members of the senior management team. Each of these interviews extended
beyond an hour and allowed Mr. Reddy the opportunity to explore the business goals
driving the company.
Robert and Conrad Saws have been the driving force behind the company's success
over its long history. They made it clear they know and understand the industry. In their
view, succeeding in the increasingly competitive office furniture marketplace
necessitates that the company focus its resources on taking calculated risks to increase
its market share and name recognition. They also believe the company must specialize
its product lines. They see the office cabinetry niche as one the company can develop
more fully so that this product line will be able to cater to the growing preference for a
customized office work environment at reasonable cost. They explained that Mt. Hood
has two general directions in production. The fastest growing sales are in product lines
marketed through warehouse outlets. In this market, price and availability are the
overriding purchase determinates. The dynamics of the workplace dictate the other

growing sales line: office furniture that caters to a technology-based work environment
where increasing the productivity and flexibility of increasingly expensive office space is
the driver. They are confident the company has assembled a management team
capable of improving profitability and sales.
When asked about the change in accounting firms, Conrad Saws informed Mr. Reddy
that the prior accountant was very skilled at completing the audit to meet debt
covenants, but the company needed an accounting firm capable of helping Mt. Hood
move beyond the present. This included assistance with financial planning (both
personal and for the company), developing better performance measures for the
company, and improving the incentive compensation plan for key employees. Beginning
this year, the company put a bonus plan in place for key executives based on sales
growth. They saw no reason for any scope limitations, and they expect the firm of
Reddy & Abel to offer suggestions to facilitate the firm's desire to successfully negotiate
the expansion. They also said that they would contact their previous auditor and grant
them permission to talk candidly with Reddy and Abel about the potential change in
auditors. Mr. Saws' banker and attorney separately recommended Reddy & Abel as a
firm capable of understanding the forces driving business success, and capable of
forming a mutually beneficial working relationship. Robert Saws also volunteered that
his niece is a senior accountant with Reddy & Abel. She owns a few shares of Mt. Hood
Furniture, and is also the executor of Mr. Saws' will.
The interview with the other senior management team members added details to the
company's business position. The COO explained that the current information systems
have been stressed by the company's growth over the past three years. Significant
computer system improvements are in process (which represents major capital
expenditures in 20X3). The timeline for completing the implementation of a new
database system indicates that it should go on-line in the second quarter of year 20X4.
The upgrade is a major capital expenditure and is seen as a vehicle for improving
information throughput and providing timely information on the company's financial
performance. The company expects to spend between $75,000 and $85,000 in 20X4 to
complete the project. Maintaining the physical plant at its current production capacity is
estimated to run $250,000 to $400,000 per year.
The CFO is concerned about improving cash flow from operations and speeding up the
operating cycle, changes that could involve reassessing Mt. Hood's credit and payment
terms. The COO is worried that tightening credit terms would hinder sales growth. The
president is adamant about maintaining sufficient inventory to make sure orders can be
shipped with minimal backorders. The CFO commented that the major reason for the
audit is to satisfy a debt covenant of the lender and explained the company's debt
maturities are accelerating, hampering cash flows available for investing to expand
sales. In expanding capacity to grow sales beyond $50 million, the CFO suggests that

the company consider venture capital to grow the company until it is ready for an IPO.
In the past, the major lender has been the primary financial statement user, along with
several creditors, but the CFO plans to show the financial statements and in-house
projections to potential venture capitalists as well. Current planned expansion costs are
estimated to require about $3 million in land, manufacturing, and distribution facilities,
which could raise revenues to $100 million.
Other Information: After the interview, Mr. Reddy contacted the prior auditor, Mr. Will B.
Dunn, CPA, regarding the potential change in auditor. Mr. Dunn was not surprised that
Mt. Hood Furniture was considering a change in auditor. He had been Robert Saws'
accountant for nearly 30 years. In recent years, Conrad had taken more responsibility
and had been more aggressive about growing the company. Mt. Hood hired outside
management for the first time in company history, and with the hiring of a CFO for the
first time, he had expected this phone call. Mr. Dunn expressed no concern about the
integrity of management. Several years ago, Mr. Dunn said that Conrad Saws had
raised several questions with Mr. Dunn about revenue recognition on some possible
bill-and-hold sales in advance of negotiating a sales agreement with a national office
supply and furniture chain. No problems were noted in the subsequent audit. Mr. Dunn
expressed concern about the current accounting system that was expected to be
replaced in 20X4. Audit adjustments in the last few years resulted from cutoff problems,
from an adjustment due to an error in counting inventory, and from discussions over bad
debt reserves. Dunn noted that Ms. Anderson was challenged by an accounting staff
that needed more training and an accounting system that was having difficulty keeping
up with the company's recent trend associated with the increased volume of
transactions. Finally, he noted that if Mr. Reddy's firm was selected as auditor, he would
cooperate by allowing Mr. Reddy to review his working papers to the extent needed to
prepare for the upcoming audit. Discussions with Mt. Hood Furniture's banker and
outside legal counsel confirmed that company management had a reputation of acting
with integrity and honesty.
Financial Information: Audited financial results for 20X1 and 20X2, along with
unaudited financial information for 20X3 are included in Chapter 8 (Figure) as part of
Problem 8-18 along with relevant industry statistics.
Required
b. Draft an engagement letter for partner review. You may assume that the fee estimate
for audit services will run between $20,000 and $25,000, and the fee for tax services is
estimated between $7,500 and $10,000. Separate proposals may be presented at a
later date for additional services based on audit findings.

REDDY AND ABEL CERTIFIED PUBLIC ACCOUNTANTS

Mr. Conrad P. Saws, President
Mt. Hood Furniture, Inc.
1 Auditor Lane
Audit, Oregon 12345
Dear Mr. Saws,
Reedy and Abel Certified Public Accountants have a clear understanding of the
services needed by Mt. Hood Furniture, Inc. The company staff is proficient in doing
audits and has all the materials to avail a quality and timely delivery.
The audit standards apply by the company will be in accordance with the Generally
Accepted Accounting Principles and in compliance with the PCAOBs requirements. The
audit will also adhere to local laws and regulations as related to environmental laws.
The audit will examine the financial statements of Mt. Hood Furniture, Inc. and verify
that the information provided in the financial statements is clear of any misstatements.
The examination does not detect all material frauds.
The statements that will need presented are the income statement, retained
earnings statement, and the cash flows statement for 20X3. The audit conducted may
not detect different instances of material fraud. The financial statements verification will
assist the auditor in forming an opinion on the statements representation. The opinion
will state if the financial statements are conformed to the generally accepted accounting
principles and should an opinion be unable to be formed, that will be stated in the report
given to you following the audit.
Reddy and Abel Certified Public Accountants uses procedures that will incorporate
adequate records concerning operations, accounting transactions, inventories, and will
validate this information provided to us from management, customers, and bank
statements. We rely on the information that is provided from Mt. Hood Furniture, Inc. to
be accurate and complete in nature. If the auditor needs additional written
representations, the auditor will ask management to provide this documentation.
The estimated fees for services discussed concerning the audit will range from
$20,000 and $25,000 and for the tax return will range from $7,500 and $10,000. In the
event that additional services may be required, a separate proposal will be presented at

a date to be later specified. These additional services may relate to the audits findings
upon completion.
Reddy and Abel Certified Public Accountants would like to take this opportunity to
thank you for allowing us to complete your auditing services and hopes that this letter
adequately identifies the terms and conditions of our engagement. Please let us know if
you have any questions or concerns concerning this letter and we will be happy to
assist you.
At a suitable time, please return a copy of this engagement letter for our records
confirming your services with our company with both a signature and date.
Sincerely,
Reddy and Abel Certified Public Accountants
________________________________
Mr. Conrad P. Saws, President

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