For each of the following scenarios, perform the three steps in the materiality process: (1) determine overall materiality, (2) determine tolerable misstatement, and (3) evaluate the audit findings. Scenario 1: Murphy & Johnson is a privately owned manufacturer of small motors for lawnmowers, tractors, and snowmobiles. The components of its financial statements are (1) income before taxes = $21 million, (2) total assets = $550 million, and (3) total revenues = $775 million. a. Determine overall materiality, and determine tolerable misstatement. Justify your decisions. b. During the course of the audit, Murphy & Johnson’s CPA firm detected two misstatements that aggregated to an overstatement of income of $1.25 million. Evaluate the audit findings. Justify your decisions. Scenario 2: Delta Investments provides a group of mutual funds for investors. The components of its financial statements are (1) income before taxes = $40 million, (2) total assets = $4.3 billion, and (3) total revenues = $900 million. a. Determine overall materiality, and determine tolerable misstatement. Justify your decisions. b. During the course of the audit, Delta’s CPA firm detected two misstatements that aggregated to an overstatement of income of $5.75 million. Evaluate the audit findings. Justify your decisions. Scenario 3: Swell Computers is a public company that manufactures desktop and laptop computers. The components of the financial statements are (1) income before taxes = $500,000, (2) total assets = $2.2 billion, and (3) total revenues = $7 billion. a. Determine overall materiality and tolerable misstatement. Justify your decisions. b. During the course of the audit, Swell’s CPA firm detected one misstatement that resulted in an overstatement of income by $1.5 million. Evaluate the audit findings. Justify your decisions.
> What roles do information systems and systems of internal control play in the high level model of business discussed in the chapter, and why might it be important for an auditor to understand these roles?
> Compare and contrast management’s responsibility for the entity’s financial statements with the auditor’s responsibilities for detecting errors and fraud in the financial statements.
> Discuss how the events that have so dramatically affected auditors and the public accounting profession since the Enron scandal may in some sense be “healthy” for the profession.
> Briefly discuss the key events that led up to the Sarbanes-Oxley Act of 2002 and the creation of the PCAOB.
> Give one example each of compliance, operational, and forensic audits.
> List and briefly describe the four categories of Principles Underlying an Audit Conducted in Accordance with GAAS.
> Identify three of the documents required by the Securities Exchange Act of 1934 that are commonly encountered by auditors. Briefly describe the purpose of each of these documents.
> Why is independence such an important standard for auditors? How does auditor independence relate to the agency relationship between owners and managers discussed in Chapter 1?
> Discuss why auditing standards are important for evaluating whether an auditor has done an adequate audit, especially when the auditor fails to detect a material misstatement in the financial statements.
> The firm of Le and Lysius was conducting the audit of Coomes Molding Corporation for the fiscal year ended October 31. Michelle Le, the partner in charge of the audit, decides that MUS is the appropriate sampling technique to use in order to audit Coomes
> Risk of material misstatement refers to a combination of which two components of the audit risk model? a. Audit risk and inherent risk. b. Audit risk and control risk. c. Inherent risk and control risk. d. Control risk and detection risk.
> Audit sampling involves applying an audit procedure to less than 100 percent of the population for the purpose of evaluating some characteristic of the population. The fact that an audit involves sampling is noted in the scope paragraph of the auditor’s
> Following are examples of control deficiencies that may represent significant deficiencies or material weaknesses. For each of the following scenarios, indicate whether the deficiency is a significant deficiency or material weakness. Justify your decisio
> Following are examples of control deficiencies that may represent significant deficiencies or material weaknesses. For each control deficiency, indicate whether it is a significant deficiency or material weakness. Justify your decision. a. The entity use
> Following are three examples of controls for accounts that you have determined are significant for the audit of ICFR. For each control, determine the nature, timing, and extent of testing of the control’s design and operating effectiven
> Ken Smith, the partner in charge of the audit of Houghton Enterprises, identified the following significant deficiencies during the audit of the December 31, 2018, financial statements: 1. Controls for granting credit to new customers were not adequate.
> Cook, CPA, has been engaged to audit the financial statements of General Department Stores, Inc., a continuing audit entity, which is a chain of medium-sized retail stores. General’s fiscal year will end on June 30, 2018, and General’s management has ask
> The Audit Committee of a small manufacturing company that sells its products globally has directed internal audit to perform specific annual reviews to monitor manual journal entries, with a particular focus on potential management override activities. I
> Auditors use various tools to document their understanding of an entity’s internal control system, including narrative descriptions, internal control questionnaires, and flowcharts. Required: a. Identify the relative strengths of each tool. b. Briefly d
> Assume that you are an audit senior in charge of planning the audit of an entity that your firm has audited for the previous four years. During the audit planning meeting with the manager and partner in charge of the engagement, the partner noted that th
> Johnson, CPA, has been engaged to audit the financial statements of Rose, Inc., a publicly held retailing company. Before assessing control risk, Johnson is required to obtain an understanding of Rose’s control environment. Required: a. Identify additio
> The existence of audit risk is recognized by the statement in the auditor’s standard report that the auditor a. Obtains reasonable assurance about whether the financial statements are free of material misstatement. b. Assesses the accounting principles u
> An auditor is required to obtain sufficient understanding of each component of an entity’s internal control system to plan the audit of the entity’s financial statements and to assess control risk for the assertions embodied in the account balance, trans
> Arthur, CPA, is auditing The Home Improvement Store as of December 31, 2018. As with all audit engagements, Arthur’s initial procedures are to analyze the entity’s financial data by reviewing trends in significant rati
> At December 31, 2018, Earth Wear has $5,890,000 in a liability account labeled “Reserve for returns.” The footnotes to the financial statements contain the following policy: “At the time of sale, the
> Audit documentation is the auditor’s record of work performed and conclusions reached on an audit engagement. Required: a. What are the functions of audit documentation? b. List and describe the various types of audit documents. c. What factors affect t
> The confirmation process is defined as the process of obtaining and evaluating a direct communication from a third party in response to a request for information about a particular item affecting financial statement assertions. Required: a. List the fac
> Inspection of records and documents relates to the auditor’s examination of entity accounting records and other information. One issue that affects the reliability of documentary evidence is whether the documents are internal or external. Following are e
> Evidence comes in various types and has different degrees of reliability. Following are some statements that compare various types of evidence. a. A bank confirmation versus observation of the segregation of duties between cash receipts and recording pay
> For each of the audit procedures listed in Problem 5-32, identify the category (assertions about classes of transactions and events or assertions about account balances) and the primary assertion being tested. Data from Problem 5-32: For each of the fo
> For each of the following specific audit procedures, indicate the type of audit procedure it represents: (1) inspection of records or documents, (2) inspection of tangible assets, (3) observation, (4) inquiry, (5) confirmation, (6) recalculation, (7) rep
> Management assertions about classes of transactions are a. Occurrence. b. Completeness. c. Authorization. d. Accuracy. e. Cutoff. f. Classification. g. Presentation. For each management assertion, indicate an example of a misstatement that could occur fo
> Which of the following concepts are pervasive in the application of auditing standards? a. Internal control. b. Expected misstatement. c. Control risk. d. Materiality and audit risk.
> Assume that your firm is considering accepting New Skin Pharma as a new audit client. New Skin is a start-up biotech firm that has publicly traded stock on NASDAQ. Your audit partner has asked you to perform some preliminary work for the firm’s client ac
> Management fraud (e.g., fraudulent financial reporting) is a relatively rare event. However, when it does occur, the frauds (e.g., Enron and WorldCom) can have a significant effect on shareholders, employees, and other parties. AU-C 240, Consideration of
> Industry conditions can be a source of business risks for an entity. Describe how each of the following industry conditions can result in business risks. a. The entity’s market characteristics (e.g., demand, capacity, etc.) and competition. b. The cyclic
> In developing an understanding of the entity and its environment, the auditor can obtain information from numerous sources, such as knowledge from prior audits and discussions with management. List five additional potential sources (internal or external)
> For each of the following situations, explain how risk of material misstatement should be assessed and what effect that assessment will have on detection risk. a. Johnson, Inc., is a fast-growing trucking company operating in the southeastern part of the
> When planning a financial statement audit, a CPA must understand audit risk and its components. The firm of Pack & Peck evaluates the risk of material misstatement (RMM) by disaggregating RMM into its two components: inherent risk and control risk.
> You are considering acceptable audit risk at the financial statement level. For each of the following independent scenarios, based only on the information provided, indicate the effect on acceptable audit risk compared to a typical private company audit.
> The CPA firm of Quigley & Associates uses a qualitative approach to implementing the audit risk model. Audit risk is categorized using two terms: very low and low. The risk of material misstatement and detection risk are categorized using three terms
> The CPA firm of Lumley & Lu uses a quantitative approach to implementing the audit risk model. Calculate detection risk for each of the following hypothetical clients. Client No. Audit Risk Risk of Material Misstatement Detection Risk 5% 20% 2 5
> Suppose that you are the auditor of a major retail client who has reported the following income before taxes (IBT) for the first two quarters of the year: 1st quarter = $1,200,000 and 2nd quarter = $1,500,000. You are in the process of establishing overa
> Briefly discuss why auditors must often exercise creativity and innovation in auditing financial statements. Give an example different from the one offered in the chapter’s conclusion.
> Section 301 of the Sarbanes-Oxley Act requires that public companies have an audit committee. Independent auditors are increasingly involved with audit committees. Required: a. Describe what an audit committee is. b. Identify the reasons why audit commi
> A CPA has been asked to audit the financial statements of a publicly held company for the first time. All preliminary verbal discussions and inquiries among the CPA, the company, the predecessor auditor, and all other necessary parties have been complete
> Parker is the in-charge auditor for the upcoming annual audit of FGH Company, a continuing audit client. Parker will supervise two assistants on the engagement and will visit the entity before the fieldwork begins. Parker has completed the engagement let
> The audit committee of the board of directors of Rebel Corporation asked Tish & Field, CPAs, to audit Rebel’s financial statements for the year ended December 31, 2018. Tish & Field explained the need to make an inquiry of the predecessor auditor and re
> You are the audit manager for Ken-Ron Enterprises. Your firm has been the entity’s auditor for 15 years. Your firm normally uses a range of 3% to 5% of income before taxes to calculate overall materiality and 50–75% of
> Dale Boucher, the owner of a small electronics firm, asked Sally Jones, CPA, to conduct an audit of the company’s records. Boucher told Jones that the audit was to be completed in time to submit audited financial statements to a bank as part of a loan ap
> Audits can be categorized into five types: (1) financial statement audits, (2) audits of internal control, (3) compliance audits, (4) operational audits, and (5) forensic audits. Required: For each of the following descriptions, indicate which type of a
> Using the audit report included in Chapter 1, identify and briefly explain the phrases or words that indicate to the users that the financial statements are not necessarily an “exact” representation of the results of operations and financial position of
> Many companies post their financial statements and auditor’s report on their home pages, generally under a heading labeled “investor relations.” Use one of the Internet search engines to do the following: a. Visit Intel’s (www.intel.com) and Microsoft’s
> Discuss why the emergence of advanced audit technologies, such as audit data analytics, is placing an even greater premium on auditors’ knowledge of fundamental business, accounting, and auditing concepts, and on their ability to exercise professional ju
> John Josephs, an audit manager for Tip, Acanoe & Tylerto, was asked to speak at a dinner meeting of the local Small Business Administration Association. The president of the association has suggested that he talk about the various phases of the audit pro
> You were recently hired by the CPA firm of Honson & Hansen. Within two weeks, you were sent to the first-year staff training course. The instructor asks you to prepare answers for the following questions: a. How is audit evidence defined? b. How does aud
> Green bloom Garden Centers is a small, privately held corporation that has two stores in Orlando, Florida. The Green bloom family owns 100 percent of the company’s stock, and family members manage the operations. Sales at the company’s stores have been g
> The auditor should consider audit risk when planning and performing an audit of financial statements. Audit risk should also be considered together in determining the nature, timing, and extent of auditing procedures and in evaluating the results of thos
> An auditor is examining the financial statements of a wholesale cosmetics distributor with an inventory consisting of thousands of individual items. The distributor keeps its inventory in its own distribution center and in two public warehouses. An elect
> Kachelmeier, CPA, is auditing the financial statements of Big Z Wholesaling, Inc., a continuing audit client, for the year ended January 31, 2018. On January 5, 2018, Kachelmeier observed the tagging and counting of Big Z’s physical inventory and made ap
> Abbott Corporation does not conduct a complete annual physical count of purchased parts and supplies in its principal warehouse but instead uses statistical sampling to estimate the year-end inventory. Abbott maintains a perpetual inventory record of par
> Rasch is the partner-in-charge of the audit of Bonner Distributing Corporation, wholesaler that owns one warehouse containing 80 percent of its inventory. Rasch is reviewing the working papers that were prepared to support the firm’s opinion on Bonner’s
> Yardley, CPA, prepared the flowchart below, which portrays the raw materials purchasing function of one of Yardley’s entities, a medium-size manufacturing company, from the preparation of initial documents through the vouching of invoic
> James, who was engaged to examine the financial statements of Talbert Corporation, is about to audit payroll. Talbert uses a computer service center to process weekly payroll as follows. Each Monday Talbert’s payroll clerk inserts data
> What role does the SEC play in the establishment of accounting and auditing standards for public companies?
> Why is studying auditing different from studying other accounting topics? How might understanding auditing concepts prove useful for consultants, business managers, and other business decision makers?
> Consider the special case solved in the text where = 1 and utility takes the log form. Suppose the real interest rate is 5 percent. Let’s give this consumer a financial profile that might look like that of a middle- aged college professor contemplating
> What is the policy trilemma, and why are countries restricted to one side of the triangle?
> Does the level of the exchange rate matter in the long run? Why or why not?
> What are three sources of saving that can be used to finance investment? What is “crowding out”?
> Using the Country Snapshots data file (snapshots.pdf), study the macroeconomic performance of Mexico, Indonesia, and Korea after the financial crises in each region. How large were the declines in GDP per worker in each country, and how quickly did the r
> What determines the price- earnings ratio for a stock? What does this imply about detecting bubbles in the stock market?
> Let’s use the arbitrage equation to determine the price of a patent in a simple setting. Let R denote the interest rate, let pi denote the price of an “idea” that is under patent, and let Prof denote the extra profit that can be earned by a firm that own
> Summarize the key facts about the behavior of the personal saving rate during recent decades, and place these facts in their macroeconomic context.
> What information does an impulse response function convey?
> Consider the complete dynamic response of the economy to a temporary rise in government purchases in the AS/AD framework. (a) Draw the AS/AD graph associated with this shock. (b) Plot the impulse response function of GDP to this shock, according to the A
> How are interest rates and growth rates related according to the neoclassical consumption model, and why?
> What key simplifying assumption allows us to use the labor market block of a DSGE model to study the immediate impact of shocks on the economy in that framework?
> Consider the Euler equation for consumption for log utility, equation (16.8), and answer the following questions: (a) If the real interest rate is 5 percent and
> Consider the neoclassical consumption model with log utility and
> Between 1970 and 1995, the dollar depreciated sharply versus the Japanese yen, while the average value of this exchange rate did not change much between 1995 and 2016. What might explain these facts?
> Why do economists use the terms “investment” and “capital” in very different contexts (physical investment and physical capital versus financial investment and financial capital)?
> In the simple theory developed in the chapter, why is the stock price equal to the dividend divided by interest rate (net of the capital gain)?
> What economic decisions do agents make in DSGE models?
> Are TFP shocks a reasonable explanation for the business cycles we see in modern economies? Why and why not?
> How much can the government borrow?
> Consider the complete dynamic response of the economy to a temporary rise in financial frictions in the AS/AD framework. (a) Draw the AS/AD graph associated with this shock. (b) Plot the impulse response function of GDP to this shock, according to the AS
> What is the Euler equation for consumption, and what is its economic interpretation?
> Summarize the main implications of the neoclassical consumption model for consumption and saving.
> What is a lifetime utility function, and in what sense does it exhibit diminishing returns?
> What is the relationship between real business cycle models and DSGE models?
> What do each of the letters in DSGE stand for, and what do these concepts mean?
> Why does a change in the foreign real interest rate lead to a shift of the AD curve?
> How and why are net exports and investment similar in the short- run model? Does this similarity make the IS curve steeper or flatter?
> Why do interest rates and exchange rates move in the same direction in the short run?
> Why would we expect the law of one price to hold in principle? Why might it fail to hold in practice?
> What is the difference between a nominal exchange rate and a real exchange rate?
> Suppose there is a temporary decline in the tax rate that households pay on their labor income. Analyze the effect of this shock in the labor market diagram of a standard DSGE model (with no sticky prices or wages). (a) What happens to the labor demand s
> Discuss the extent to which the U.S. trade deficit and net foreign debt are serious economic problems.
> Suppose there are two countries in the world, and one is better than the other at producing every good. Will the countries trade? Why or why not?
