Bohrer, CPA is considering the following factors in assessing audit risk at the financial statement level in planning the audit of Waste Remediation Services (WRS), Inc.'s financial statements for the year ended December 31, 2011. WRS is a privately-held company that contracts with municipal governments to close landfills. Audit risk at the financial statement level is influenced by the risk of material misstatements, which may be indicated by factors related to the entity, management, and the industry environment. 1. This was the first year WRS operated at a profit since 2006 because the municipalities received increased federal and state funding for environmental purposes. 2. WRS's Board of Directors is controlled by Tucker, the majority shareholder, who also acts as the chief executive officer. 3. The internal auditor reports to the controller and the controller reports to Tucker. 4. The accounting department has experienced a high rate of turnover of key personnel. 5. WRS's bank has a loan officer who meets regularly with WRS's CEO and controller to monitor WRS's financial performance. 6. WRS's employees are paid bi-weekly. 7. Bohrer has audited WRS for five years. 8. During 2011, WRS changed its method of preparing its financial statements from the cash basis to generally accepted accounting principles. 9. During 2011, WRS sold one half of its controlling interest in Sanitation Equipment Leasing (SEL) Co. WRS retained a significant interest in SEL. 10. During 2011, litigation filed against WRS in 2001 alleging that WRS discharged pollutants into state waterways was dropped by the state. Loss contingency disclosures that WRS included in prior years' financial statements are being removed for the 2011 financial statements. 11. During December 2011, WRS signed a contract to lease disposal equipment from an entity owned by Tucker's parents. This related party transaction is not disclosed in WRS's notes to its 2011 financial statements. 12. During December 2011, WRS increased its casualty insurance coverage on several pieces of sophisticated machinery from historical cost to replacement cost. 13. WRS recorded a substantial increase in revenue in the fourth quarter of 2011. Inquiries indicated that WRS initiated a new policy and guaranteed several municipalities that it would refund state and federal funding paid to WRS on behalf of the municipality if it failed a federal or state site inspection in 2012. 14. An initial public offering of WRS stock is planned in 2012. Required For each of the 14 factors listed above, indicate whether the item would likely increase audit risk, decrease audit risk, or have no effect on audit risk.*
> Janetta Corp. has an EBIT rate of $975,000 per year that is expected to continue in perpetuity. The unlevered cost of equity for the company is 14 percent, and the corporate tax rate is 35 percent. The company also has a perpetual bond issue outstanding
> New equity issues are generally only a small portion of all new issues. At the same time, companies continue to issue new debt. Why do companies tend to issue little new equity but continue to issue new debt?
> When personal taxes on interest income and bankruptcy costs are considered, the general expression for the value of a levered firm in a world in which the tax rate on equity distributions equals zero is: VL = VU + {1 – [(1 – tC) / (1 – tB)}] × B – C ( B
> ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $750,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $375,000 and the interest rate on its debt is 8 perc
> An outstanding issue of Public Express Airlines debentures has a call provision attached. The total principal value of the bonds is $250 million, and the bonds have an annual coupon rate of 9 percent. The company is considering refunding the bond issue.
> Do you think preferred stock is more like debt or equity? Why?
> Good Time Company is a regional chain department store. It will remain in business for one more year. The probability of a boom year is 60 percent and the probability of a recession is 40 percent. It is projected that the company will generate a total ca
> As mentioned in the text, some firms have filed for bankruptcy because of actual or likely litigation-related losses. Is this a proper use of the bankruptcy process?
> Star, Inc., a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 35 percent debt. Currently there are 6,000 shares outstanding and the price per share is $58. EBIT is expected to remain
> Illinois Industries has decided to borrow money by issuing perpetual bonds with a coupon rate of 7 percent, payable annually. The one-year interest rate is 7 percent. Next year, there is a 35 percent probability that interest rates will increase to 9 per
> Bowdeen Manufacturing intends to issue callable, perpetual bonds with annual coupon payments. The bonds are callable at $1,175. One-year interest rates are 9 percent. There is a 60 percent probability that long-term interest rates one year from today wil
> What are the direct and indirect costs of bankruptcy? Briefly explain each.
> Fountain Corporation’s economists estimate that a good business environment and a bad business environment are equally likely for the coming year. The managers of Fountain must choose between two mutually exclusive projects. Assume that
> Refer to the observed capital structures given in Table 17.3 of the text. What do you notice about the types of industries with respect to their average debt–equity ratios? Are certain types of industries more likely to be highly levera
> Kolby Corp. is comparing two different capital structures. Plan I would result in 900 shares of stock and $65,700 in debt. Plan II would result in 1,900 shares of stock and $29,200 in debt. The interest rate on the debt is 10 percent. Ignoring taxes, wha
> Is there an easily identifiable debt–equity ratio that will maximize the value of a firm? Why or why not?
> A company is contemplating a long-term bond issue. It is debating whether to include a call provision. What are the benefits to the company from including a call provision? What are the costs? How do these answers change for a put provision?
> Steinberg Corporation and Dietrich Corporation are identical firms except that Dietrich is more levered. Both companies will remain in business for one more year. The companies’ economists agree that the probability of the continuation of the current exp
> What are the sources of agency costs of equity?
> Kolby Corp. is comparing two different capital structures. Plan I would result in 900 shares of stock and $65,700 in debt. Plan II would result in 1,900 shares of stock and $29,200 in debt. The interest rate on the debt is 10 percent. a. Ignoring taxes,
> How would you answer in the following debate? Q : Isn’t it true that the riskiness of a firm’s equity will rise if the firm increases its use of debt financing? A : Yes, that’s the essence of MM Proposition II. Q : And isn’t it true that, as a firm incre
> New Business Ventures, Inc., has an outstanding perpetual bond with a 10 percent coupon rate that can be called in one year. The bond makes annual coupon payments. The call premium is set at $150 over par value. There is a 60 percent chance that the inte
> Money, Inc., has no debt outstanding and a total market value of $275,000. Earnings before interest and taxes, EBIT, are projected to be $21,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 25 percent
> What are the main differences between corporate debt and equity? Why do some firms try to issue equity in the guise of debt?
> Edwards Construction currently has debt outstanding with a market value of $85,000 and a cost of 9 percent. The company has EBIT of $7,650 that is expected to continue in perpetuity. Assume there are no taxes. a. What is the value of the company’s equity
> How does the existence of financial distress costs and agency costs affect Modigliani and Miller’s theory in a world where corporations pay taxes?
> Rolston Corporation is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, Rolston would have 265,000 shares of stock outstanding. Under Plan II, there would be 185,000 shares of stock outst
> Explain what is meant by business and financial risk. Suppose Firm A has greater business risk than Firm B. Is it true that Firm A also has a higher cost of equity capital? Explain.
> KIC, Inc., plans to issue $5 million of bonds with a coupon rate of 8 percent and 30 years to maturity. The current market interest rates on these bonds are 7 percent. In one year, the interest rate on the bonds will be either 10 percent or 6 percent wit
> The yields on nonconvertible preferred stock are lower than the yields on corporate bonds. Why is there a difference? Which investors are the primary holders of preferred stock? Why?
> Dream, Inc., has debt outstanding with a face value of $6 million. The value of the firm if it were entirely financed by equity would be $17.85 million. The company also has 350,000 shares of stock outstanding that sell at a price of $38 per share. The c
> What steps can stockholders take to reduce the costs of debt?
> Rolston Corporation is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, Rolston would have 265,000 shares of stock outstanding. Under Plan II, there would be 185,000 shares of stock outst
> List the three assumptions that lie behind the Modigliani–Miller theory in a world without taxes. Are these assumptions reasonable in the real world? Explain.
> Candle box Inc. is going to elect six board members next month. Betty Brown owns 17.4 percent of the total shares outstanding. How confident can she be of having one of her candidate friends elected under the cumulative voting rule? Will her friend be el
> Preferred stock doesn’t offer a corporate tax shield on the dividends paid. Why do we still observe some firms issuing preferred stock?
> Dream, Inc., has debt outstanding with a face value of $6 million. The value of the firm if it were entirely financed by equity would be $17.85 million. The company also has 350,000 shares of stock outstanding that sell at a price of $38 per share. The c
> Due to large losses incurred in the past several years, a firm has $2 billion in tax loss carryforwards. This means that the next $2 billion of the firm’s income will be free from corporate income taxes. Security analysts estimate that it will take many
> Suppose the company in Problem 1 has a market-to-book ratio of 1.0. a. Calculate return on equity, ROE, under each of the three economic scenarios efore any debt is issued. Also calculate the percentage changes in ROE for economic expansion and recessio
> In a world with no taxes, no transaction costs, and no costs of financial distress, is the following statement true, false, or uncertain? Moderate borrowing will not increase the required return on a firm’s equity. Explain.
> The shareholders of Motive Power Corp. need to elect three new directors to the board. There are 13,000,000 shares of common stock outstanding, and the current share price is $10.50. If the company uses cumulative voting procedures, how much will it cost
> What are the differences between preferred stock and debt?
> Tom Scott is the owner, president, and primary salesperson for Scott Manufacturing. Because of this, the company’s profits are driven by the amount of work Tom does. If he works 40 hours each week, the company’s EBIT will be $550,000 per year; if he work
> Do you agree or disagree with the following statement? A firm’s stockholders will never want the firm to invest in projects with negative net present values. Why?
> The shareholders of the Stackhouse Company need to elect seven new directors. There are 850,000 shares outstanding currently trading at $43 per share. You would like to serve on the board of directors; unfortunately no one else will be voting for you. Ho
> Cynthia Roberts, CPA, expresses the following viewpoint: "I do not believe in performing tests of controls and substantive tests of transactions for the sales and collection cycle. As an alternative, I send a lot of negative confirmations on every audit
> Explain what is meant by independent checks on performance and give five specific examples.
> Following are six situations that involve the audit risk model as it is used for planning audit evidence requirements. Numbers are used only to help you understand the relationships among factors in the risk model. /.:. Required a. Explain what each of t
> Jeanne Maier, CPA, believes that it is appropriate to obtain an understanding of internal control about halfway through the audit, after she is familiar with the client's operations and the way the system actually works. She has found through experience
> The following questions concern analytical procedures in the sales and collection cycle. Choose the best response. a. As a result of analytical procedures, the auditor determines that the gross profit percentage has declined from 30% in the preceding yea
> Under what circumstances is it acceptable to confirm accounts receivable before the balance sheet date?
> Describe what is meant by acceptable audit risk. Explain why each of the following statements is true: Required a. A CPA firm should attempt to achieve the same audit risk for all audit clients when circumstances are similar. b. A CPA firm should decrea
> The following are concepts discussed in this chapter: 1. Preliminary judgment about materiality 2. Control risk 3. Risk of fraud 4. Estimated total misstatement in a segment 5. Planned detection risk 6. Estimate of the combined misstatement 7. Acceptable
> Chapter 8 introduced the eight parts of the planning phase of an audit. Which part is the evaluation of materiality and risk?
> Explain why materiality is important but difficult to apply in practice.
> You are evaluating audit results for assets in the audit of Roberts Manufacturing. You set the preliminary judgment about materiality at $50,000. The account balances, tolerable misstatement, and estimated overstatements in the accounts are shown next. a
> State the six transaction-related audit objectives.
> Explain the relationship between acceptable audit risk and the legal liability of auditors.
> Discuss whether email responses and oral responses are confirmations. How can an auditor verify the addresses for confirmations sent by mail, and confirmations sent electronically?
> Explain what is meant by a proof of cash receipts and state its purpose.
> The following is the description of sales and cash receipts for the Lady's Fashion Fair, a retail store dealing in expensive women's clothing. Sales are for cash or credit, using the store's own billing rather than credit cards. Each salesclerk has her o
> The following are independent situations for which you will recommend an appropriate audit report on internal control over financial reporting as required by PCAOB auditing standards: 1. The auditor identified a material misstatement in the financial sta
> In Chapter 15, one of the points brought out was the need to obtain a representative sample of the population. How can this concept be reconciled with the statement in this chapter that the emphasis should be on confirming larger and older balances becau
> The following internal controls were tested in prior audits. Evaluate each internal control independently and determine which controls must be tested in the current year's audit of the December 31, 2011 financial statements. Be sure to explain why testin
> Explain what is meant by the term acceptable audit risk. What is its relevance to evidence accumulation?
> Describe why auditors generally evaluate entity-level controls before evaluating transaction-level controls.
> Explain the purpose of footing and cross-footing the sales journal and tracing the totals to the general ledger.
> What is meant by setting a preliminary judgment about materiality? Identify the most important factors affecting the preliminary judgment.
> For each of the eight types of evidence discussed in Chapter 7, identify whether it is applicable for risk assessment procedures, tests of controls, substantive tests of transactions, analytical procedures, and tests of details of balances.
> Describe the three broad objectives management has when designing effective internal control.
> List five analytical procedures for the sales and collection cycle. For each test, describe a misstatement that could be identified.
> What is the auditor's responsibility for obtaining an understanding of internal control? How does that responsibility differ for audits of public and nonpublic companies?
> Anthony, CPA, prepared the flowchart (given below) which portrays the raw materials purchasing function of one of Anthony's clients, Medium-Sized Manufacturing Company, from the preparation of initial documents through the vouching of invoices for paymen
> During the prior-year audits of McKimmon Inc., a private company, the auditor did tests of controls for all relevant financial statement assertions. Some of the related controls are manual while others are automated. Describe the extent the auditor can r
> The following are partial descriptions of internal controls for companies engaged in the manufacturing business: 1. When Mr. Clark orders materials, he sends a duplicate purchase order to the receiving department. During the delivery of materials, Mr. Sm
> In Part I of the case, you performed preliminary analytical procedures for Pinnacle. The purpose of Part II is to identify factors influencing risks and the relationship of risks to audit evidence. During the planning phase of the audit, you met with Pin
> Explain how prenumbered shipping documents and sales invoices can be useful controls for preventing misstatements in sales.
> The division of the following duties is meant to provide the best possible controls for the Meridian Paint Company, a small wholesale store: †1. Approve credit for customers included in the customer credit master file. †2. Input shipping and billing info
> The following questions deal with audit risk and evidence. Choose the best response. a. As the acceptable level of detection risk decreases, an auditor may (1) Reduce substantive testing by relying on the assessments of inherent risk and control risk. (
> Whitehead, CPA, is planning the audit of a newly obtained client, Henderson Energy Corporation, for the year ended December 31, 2011. Henderson Energy is regulated by the state utility commission and because it is a publicly traded company the audited fi
> Using the audit risk model, state the effect on control risk, inherent risk, acceptable audit risk, and planned evidence for each of the following independent events. In each of the events a to j, circle one letter for each of the three independent varia
> Distinguish the auditor's responsibility for testing controls in an integrated audit of a public company from the responsibility to test controls in an audit of a nonpublic company.
> Below are ten independent risk factors: 1. The client lacks sufficient working capital to continue operations. 2. The client fails to detect employee theft of inventory from the warehouse because there are no restrictions on warehouse access and the clie
> The following are independent internal controls commonly found in the acquisition and payment cycle. Each control is to be considered independently. 1. At the end of each month, an accounting clerk accounts for all prenumbered receiving reports (document
> Explain why auditors usually emphasize the detection of fraud in the audit of cash receipts. Is this consistent or inconsistent with the auditor's responsibility in the audit? Explain.
> What is the purpose of risk assessment procedures and how do they differ from the four other types of audit tests?
> Following are six situations that involve the audit risk model as it is used for planning audit evidence requirements in the audit of inventory. Required a. Explain what low, medium, and high mean for each of the four risks and planned evidence. b. Fill
> Distinguish between a test of control and a substantive test of transactions. Give two examples of each.
> You are evaluating audit results for current assets in the audit of Quicky Plumbing Co. You set the preliminary judgment about materiality for current assets at $15,000 for overstatements and at $22,500 for understatements. The preliminary and actual est
> What is the purpose of using nonstatistical sampling for tests of controls and substantive tests of transactions?
> Although the planning went well, the actual testing yielded some surprises. When conducting tests of controls over acquisitions and additions to the perpetual inventory, the staff person performing the tests found that the exception rates for several key
> The following are the eight balance-related audit objectives, six tests of details of balances for accounts receivable, and seven tests of controls or substantive tests of transactions for the sales and collection cycle: Balance-Related Audit Objective D
> What is the purpose of tests of controls? Identify specific accounts on the financial statements that are affected by performing tests of controls for the acquisition and payment cycle.
> The following are audit procedures in the sales and collection cycle: 1. Add the columns on the aged trial balance and compare the total with the general ledger. 2. Examine a sample of shipping documents to determine whether each has a sales invoice numb
> Evaluate the following statement: "In many audits in which accounts receivable is material, the requirement of confirming customer balances is a waste of time and would not be performed by competent auditors if it were not required by auditing standards.
> The following misstatements are sometimes found in the sales and collection cycle's account balances: 1. The accounts receivable trial balance total does not equal the amount in the general ledger. 2. Several accounts receivable in the accounts receivabl
> Describe what is meant by a sampling unit. Explain why the sampling unit for verifying the occurrence of recorded sales differs from the sampling unit for testing for the possibility of omitted sales.
> The following are audit procedures from different transaction cycles: 1. Use audit software to foot and cross-foot the cash disbursements journal and trace the balance to the general ledger. 2. Select a sample of entries in the acquisitions journal and t
> Distinguish between accuracy tests of gross accounts receivable and tests of the realizable value of receivables.
> State the purpose of footing the total column in the client's accounts receivable trial balance, tracing individual customer names and amounts to the accounts receivable master file, and tracing the total to the general ledger. Is it necessary to trace e
