16-30(39) (Analytical Procedures)

The audit of Humbird Company, a manufacturer of bicycle racks and golf carts, is almost
finished. Gene Beam is the most experienced auditor on this audit and is in charge of per- forming
analytical procedures.

Required
a. Why is it important that analytical procedures be performed by experienced auditors?
b. What are some analytical procedures that Beam might perform?
c. How can these procedures be useful at this stage of the audit?

16-32(41) (Contingencies)

An audit client is being sued for $500,000 for discriminatory hiring practices.

Required
Indicate the appropriate action the auditor should take for each of the following
independent responses to the letter of audit inquiry:
a. The lawyer stated that there is only a remote chance that the client will lose. The client did
not accrue any contingent loss or disclose this situation.
b. The lawyer stated the client will probably lose, and the amount of loss could be anywhere
between $250,000 and $500,000, with no amount within that range being more likely than
another. The client disclosed this situation but did not accrue a loss.
c. The lawyer stated that there is a reasonable possibility that the client will lose. The client
disclosed this situation but did not accrue a loss.
d. The lawyer stated the client will probably lose between $250,000 and $500,000, but most
likely will lose $400,000. The client accrued a $250,000 contingent loss and disclosed the
situation.

16-33(42) (Contingencies)

Each of the following is an independent situation related to a contingency:

1. The lawyer refused to furnish the requested information.
=> Scope limitation => audit opinion
2. The lawyer was unable to form an opinion on the probability or amount of a pending
lawsuit, but the auditor believes that the amount could be material.
3. The client stated that it had not consulted lawyers during the past year.
4. The client refuses to accrue for, or disclose, a pending lawsuit related to the infringement
of a patent that is the basis of its major product. It is afraid that it will lose customers. The
plaintiff is suing for $2,500,000, which represents 50% of owner’s equity. The lawyer
believes that the case can be settled for less than the damages claimed.

Required
What should the auditor do in each case?

16-34(43) (Summary of Possible Adjustments)

During the course of the audit of Nature Sporting Goods for the year ended December 31,
2007, the auditor discovered the following:
  The accounts receivable confirmation work revealed one pricing error.The book value of
$12,955.68 should be $11,984.00.The pro- jected error based on this difference is $14,465.
 Nature Sporting Goods had understated the accrued vacation pay by $13,000.A review of
the prior year documentation indicates the following uncorrected errors:
a. Accrued vacation pay was understated by $9,000.
b. Sales and accounts receivable were overstated by an estimated $60,000 due to
cutoff errors.

Required
Prepare a summary of a possible adjustments schedule like the one in Exhibit 16.4, and
draw your conclusion about whether the aggregate effect of these errors is material. Nature
Sporting Goods has made no adjustments to the trial balance numbers shown in Exhibit 16.4.
(Note that the retained earnings balance is the beginning balance.) Ignore the errors shown in the
exhibit.The income tax rate is 40% for the current and prior year.

16-35(44) (Going Concern)

A staff auditor has just returned from a continuing professional education workshop on
current auditing standards. One of her managers has asked her to prepare a training session for the
rest of the staff. In particular, he wants her to discuss the standard related to the client’s ability to
continue as a going concern.

Required
a. Describe the auditor’s responsibility for assessing each client’s ability to continue as a
going concern.
b. Describe the effect on the financial statements and on the auditor’s report for each of the
following independent situations:
1. The auditor has substantial doubt as to whether the client is a going concern.
2. The auditor believes the footnote describing the going concern problem is inadequate.
3. In the prior year statements, a going concern problem had been disclosed and was
referred to in the auditor’s prior year report, but the uncertainty has been eliminated
this year. Comparative statements will be issued.
4. The auditor concludes that the client is likely to continue in existence for at least one
more year. The same conclusion had been reached in prior years.
5. The client was forced into bankruptcy by creditors after year end but before the audit
was completed.

16-36(45) (Going Concern)

This is the third year of an audit of GreenLawns. The company has carved out a new
market niche for the delivery of lawn and garden supplies, including links with local companies
that pro- vide lawn services. The company issued stock two years ago and raised sufficient capital
to continue operations through this year. The company is currently trading at 5 times revenue. The
company has shown no profits in its first three years. Revenue growth has been 100%, 65%, and
30%, respectively, over the last three years. The current year revenue is at $220 million. The
auditor has examined current cash flow and has serious reservations about the ability of the
company to remain a going concern. The company has responded with the following management
plan:
• Another public offering of stock to raise $200 million in capital. The stock offering will be
equal to 30% of the existing stock outstanding.
 • Sign an agreement with at least 50 more local distributors during the year.
• Improve warehousing and distribution to cut at least 20% off the distribution costs.
• Increase sales by 50% through more advertising, coupons, and better marketing to existing
customers.
• Improve profit margins by using its purchase power to sign more attractive purchase
agreements with vendors, but stay away from major brand vendors such as Scott’s, Ortho
products, and so on.

Required
a. What is the auditor’s responsibility to evaluate the effectiveness of management’s plan?
What action does the auditor take if he or she does not believe management’s plan will be
effective?
b. Assume that the auditor modifies the opinion on the financial statements. What does this
action say to the users of the financial statements about the confidence in management’s
ability? Is the auditor engaged to attest to the quality of management?
c. What is the required disclosure regarding management’s plans?
d. For each element in management’s plan, indicate the auditor’s responsibility to assess the
element. Indicate audit procedures that should be performed to assess each part of
management’s plans.

16-38(47) (Accounting Estimates)

Consider the following areas in which estimates are made in the preparation of financial
statements:
• Pension obligation
• Other post-retirement benefits
• Warranty liability
• Reserve for uncollectible loans (financial institution)
• Allowance for doubtful accounts (manufacturing company)
• Allowance for returned goods (catalog company like Land’s End or
• L.L. Bean that have a guaranteed-period warranty on catalog sales)

Required
For each area:
1. Identify the factors inherent in the account that might significantly affect the dollar
estimate of the account balance.
2. For each factor identified, briefly discuss the importance of the item to the overall account
estimate. For example, how important is the interest rate assumption to the overall
estimate of the pension liability? Hint: You may want to perform a sensitivity analysis to
assess the importance of each factor.
3. For each factor identified, briefly describe audit evidence that should be gathered to
determine how the factor should be used in making the accounting estimate. For example,
how should the auditor determine the proper interest rate assumption in estimating the
account balance?
4. Assuming there are differences between the auditor’s estimate and management’s
estimate, indicate how the auditor can determine whether management is attempting to
“manage” or “smooth earnings” or whether there is a genuine disagreement on the correct
factor to be used in making the estimate.
16-39(48) (Audit Communications)
Several communications involve the client and auditor.
Required
For each of the following communications, indicate who signs the letter, who receives it,
whether it is required or optional, when it should be sent, and its purpose:
a. Lawyer’s response to a letter of audit inquiry
b. Management representation letter c. Engagement letter
c. Management letter

*16-40(49) (Subsequent Events)

Milton Green, CPA, is auditing the financial statements of Taylor Corporation for the year
ended December 31, 2007. Green plans to complete the fieldwork and sign the auditor’s report
about March 10, 2008. He is concerned about events and transactions occurring after December
31, 2007 that may affect the 2008 financial statements.

Required
a. What are the general types of subsequent events that require Green’s consideration and
evaluation?
b. What are the auditing procedures Green should consider perform- ing to gather evidence
concerning subsequent events?

16-41(50) (Subsequent Events)

The auditor is auditing financial statements for the year ended December 31, 2007 and is
completing the audit in early March 2008.The following situations have come to the audi- tor’s
attention:
1. On February 12, 2008, the client agreed to an out-of-court settlement of a property damage
suit resulting from an accident caused by one of its delivery trucks. The accident occurred
on November 20, 2007. An estimated loss of $30,000 was accrued in the 2007 financial
statements. The settlement was for $50,000.
2. Same facts as in part (1), except the accident occurred January 1, 2008, and no loss was
accrued.
3. The client is a bank. A major commercial loan customer filed for bankruptcy on February
26, 2008.The bankruptcy was caused by an adverse court decision on February 15, 2008
involving a product liability lawsuit initiated in 2007 arising from products sold in 2005.
4. The client purchased raw materials that were received just before year end. The purchase
was recorded based on its estimated value. The invoice was not received until January 31,
2008, and the cost was substantially different than was estimated.
5. On February 2, 2008, the board of directors took the following actions:
(a) Approved officers’ salaries for 2008.
(b) Approved the sale of a significant bond issue.
(c) Approved a new union contract containing increased wages and fringe benefits for
most of the employees. The employees had been on strike since January 2, 2008.
6. A major customer was killed in a boating accident on January 25, 2008 in Mexico. The
customer had pledged his boat as collateral. The boat, which was destroyed in the
accident, was not insured. The allowance for doubtful accounts is not adequate to cover
the anticipated loss.

Required
 For each of the preceding independent subsequent events (which are to be considered
material):
1. Indicate and explain whether the financial statements should be adjusted only, adjusted
and disclosed, disclosed only, or neither adjusted nor disclosed.
2. Describe how the auditor would have learned about each of these situations.

16-42(51) (Subsequent Discovery of Omitted Procedures)

During the course of an interoffice quality review, it was discovered that the auditors had
failed to consider whether inventory costs of a wholesale client exceeded their market value. The
review took place six months after the audit report had been issued. Some prices had apparently
been falling near year end. Inventory is a major item in the financial statements, but the auditor
does not know whether the market price
declines were material.

Required
a. What procedures could the auditor now perform to resolve this audit problem?
b. What should the auditor do if it turns out that inventory was materially overstated?