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.
> 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
> 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
> 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.
> 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
> The following are common audit procedures for tests of sales and cash receipts: 1. Compare the quantity and description of items on duplicate sales invoices with related shipping documents. 2. Trace recorded cash receipts in the accounts receivable maste
> What is meant by using bases for setting a preliminary judgment about materiality? How will those bases differ for the audit of a manufacturing company and a government unit such as a school district?
> The following questions concern audit risk. Choose the best response. a. Some account balances, such as those for pensions and leases, are the result of complex calculations. The susceptibility to material misstatements in these types of accounts is defi
> Explain why inherent risk is set for segments rather than for the overall audit. What is the effect on the amount of evidence the auditor must accumulate when inherent risk is increased from medium to high for a segment?
> Distinguish between a positive and a negative confirmation and state the circumstances in which each should be used. Why do CPA firms sometimes use a combination of positive and negative confirmations on the same audit?
> Explain the causes of an increased or decreased planned detection risk.
> The following sales procedures were encountered during the annual audit of Marvel Wholesale Distributing Company: Customer orders are received by the sales order department. A clerk computes the approximate dollar amount of the order and sends it to the
> Distinguish between substantive tests of transactions and tests of details of balances. Give one example of each for the acquisition and payment cycle.
> What is the relationship of each of the following to the sales and collection cycle: flowcharts, assessing control risk, tests of controls, and tests of details of balances?
> Auditors develop overall audit plans to ensure that they obtain sufficient appropriate audit evidence. The timing and extent of audit procedures auditors use is a matter of professional judgment, which depends upon a number of factors. Decisions about th
> The following are selected transaction-related audit objectives and audit procedures for sales transactions: Transaction-Related Audit Objectives 1. Recorded sales exist. 2. Existing sales are recorded. 3. Sales transactions are correctly included in the
> The following are commonly performed tests of controls and substantive tests of transactions audit procedures in the sales and collection cycle: 1. Account for a sequence of shipping documents and examine each one to make sure that a duplicate sales invo
> The following questions concern audit objectives and management assertions for accounts receivable. Choose the best response. a. When evaluating the adequacy of the allowance for uncollectible accounts, an auditor reviews the entity's aging of receivable
> Items 1 through 9 are selected questions of the type generally found in internal control questionnaires used by auditors to obtain an understanding of internal control in the sales and collection cycle. In using the questionnaire for a client, a "yes" re
> When performing an integrated audit of a public company, what are the auditors responsibilities related to internal control as required by PCAOB standards?
> The following questions deal with audit evidence for the sales and collection cycle. Choose the best response. a. An auditor is performing substantive tests of transactions for sales. One step is to trace a sample of debit entries from the accounts recei
> Management must identify the framework used to evaluate the effectiveness of internal control over financial reporting. What framework is used by most U.S. public companies?
> Describe how the nature of evidence used to evaluate the control environment differs from the nature of evidence used to evaluate control activities.
> The following questions deal with materiality. Choose the best response. a. Which one of the following statements is correct concerning the concept of materiality? (1) Materiality is determined by reference to guidelines established by the AICPA. (2) Ma
> The following are audit procedures from different transaction cycles: 1. Examine duplicate copy of shipping documents for evidence that quantities were verified before shipment. 2. Select a sample of payroll checks and agree hours to employee time record
