Individual Ch. 5, 6, & 7 Textbook Exercises

Comprehensive question 5-30

(Assertions) In planning the audit of a client’s financial statements, an auditor identified the following issues that need audit attention.

1.       The allowance for doubtful accounts is fairly presented in amount.
2.       All accounts payable owed as of the balance sheet date are included in the financial statements.

3.       All purchase returns recorded in the general ledger are valid.
4.       There is a risk that purchases made in the last week of the month might be recorded in the following period.

5.       The client may have factored accounts receivable. The client has used special-purpose entities to finance a building. Neither the building nor the debt is included in the financial statements.

6.       A retail client values its inventory using the retail method of accounting.

7.       A construction client uses the percentage of completion method for recognizing revenues.
8.       A client has a defined benefit pension plan and does not have competent employees to write footnote disclosures.

9.       A client acquired a subsidiary company and paid a high amount of goodwill when the stock market, and resulting values, were at all-time highs.
10.   A client financed the acquisition of assets using preferred stock that pays a 3 percent dividend and must be redeemed from the shareholders next year.

Required

Identify the assertion for items 1 through 11 above.

Comprehensive question 6-22

(Audit evidence) During the course of an audit, the auditor examines a wide variety of documentation. Listed below are some forms of documentary evidence and the sources from which they are obtained.

1.    Bank statement sent directly to the auditor by the bank
2.    Creditor monthly statement obtained from client’s files.
3.    Vouchers in client’s unpaid voucher file.

4.    Duplicate sales invoices in filled order file.
5.    Time tickets filed in payroll department.
6.    Credit memo in customer’s file.
7.    Material requisitions filed in storeroom.
8.    Bank statement in client’s files.

9.    Management working papers in making accounting estimates.
10.  Paid checks returned with bank statement in (1) above.

11.  Letter in customer file from collection agency on collectibility of balance.

12.  Memo in customer file from treasurer authorizing the write-off of the account

Required

a.    Classify the evidence by source into one of four categories: (1) directly from outsiders, (2) indirectly from outsiders, (3) internal but validated externally, and (4) entirely internal.

b.    Comment on the reliability of the four sources of documentary evidence.

Our text pretty much name direct external sources as the most reliable one. Consequently, it seems to me that the order, in which the sources are currently numbered, would be the actual reliability scale of which sources are more reliable. In other words the most reliable is (1), and least reliable is (4).

Comprehensive question 7-22

(Understanding the entity and its environment) You have just been assigned as in-charge accountant on HipStar, Inc. a new audit client in the recording industry. HipStar is an emerging growth company that finds new recording artists, records their music, and distributes the music directly to consumers exclusively over the Internet. The company does not produce CDs or tapes and does not distribute the artist’s music through traditional distribution channels. In order to better understand HipStar, you have set out to understand the following:

1.    Industry conditions

2.    The regulatory environment

3.    Other external factors affecting the business

4.    The entity’s business operations

5.    The entity’s investing activities and financing activities

6.    The entity’s financial reporting activities

7.    The entity’s objectives, strategies, and related business risks

8.    How the entity measures and reviews its financial performance.

Required

For each of these eight categories (1) describe the knowledge and understanding you want to obtain about HipStar to develop a knowledgeable perspective about the entity and (2) identify how this knowledge might assist in assessing the risk of material misstatement. Use the following format:

Key Categories

Describe the knowledge used to develop a knowledgeable perspective about HipStar

Identify how this knowledge might assist in assessing the risk of material misstatement

1.     Industry conditions

Music distribution and recording business online are not an easy task and heavy competition is inevitable. How is HipStar level of competition?

With so many websites available nowadays on the Internet, what details are making HipStar website different and an extraordinary experience for users? Is music easy to download? Can customers play the music on different types of equipment?

How is the price affected by the competition?

Poor industry conditions pressure upper level personnel into make bad decisions, for example, in trying to accomplish short-term goals, which can affect transactions and account balances. Understanding this can heighten an auditor’s awareness in assessing possible material misstatement that can be created from such conditions.

2.     Regulatory environment

Is the company satisfying legal rules in other countries?

Are the songs satisfying copyright laws?

Possible illegal acts that can have direct and material effects on the financial statement can be the result of complex regulations that increase risk of noncompliance.

3.     Other external factors affecting the business

What types of financing are available and/or are being used? Does the company have enough funding to support business functions?

Deterioration of an economy and the stock market, usually lead to restricting the availability of capital in debt and equity markets. Consequently, organizations look for other methods of financing, for example, hedging risks of foreign currency rates. Sudden changes in currency revaluation or interest rates in a foreign country may provide an increased risk in material misstatement.

4.     The client’s business operations

What are the costs associated with storing the music available for download?

What is the method of obtaining the rights to sell their music online?

In regard to recording artist revenue, how does HipStar obtain business from recording artists?

What are HipStar’s general and administrative costs?

Does HipStar receive revenues from other sources other than recording artists and downloaded music?

How does HipStar promote its business?

What are the methods of payment for downloading the music?

Does HipStar do business with related parties?

Some accounting principles may be new for HipStar. Consequently, there is a risk of material misstatements within the financial statements.

5.     The client’s investing activities and financing activities

Is the company involved in an merger or acquisition?

Is HipStar involved in any financing activities and/or investment?

Material misstatement in financial reporting could be the cause for HipStar to be involved in meeting expanded financial needs or in a merger integration of internal control process.

6.     The client’s financial reporting activities

Are HipStar practices industry-specific?

Is the company using proper accounting principles?

The risk of misapplication of GAAP or incorrect estimations may be increased due to complex accounting, for example, accounting for long-term contracts with the recording artists.

7.     The client’s objectives, strategies, and related business risks

Does the company have any contingency plans?

Does HipStar have any plans for expansion?

What are the company strategies and goals for acquiring new recording artists and the rights to their music?

Increased business risk often results in uncertainty in financial performance that may have implications for revenue recognition, accounting estimates, or other applications of GAAP.

8.     How the client measures and reviews the entity’s financial performance

What system does the company have in place for approving expenses?

What ratios, indicators, and reports does HipStar use?

How does HipStar measure and review its financial performance?

Seeing significant differences of actual performance from budgets, forecasts, or expected amounts may indicate a possible misapplication of GAAP.