Audit Planning and Materiality: Concept Checks P. 209

Chapter 7
Audit Planning and Materiality
 Concept Checks
P. 209
1. The eight major steps in planning audits are:
1. Accept client and perform initial planning

2. Understand the client’s business and industry
3. Perform preliminary analytical procedures
4. Set preliminary judgment of materiality and performance materiality
5. Identify significant risks due to fraud or error
6. Assess inherent risk
7. Understand internal control and assess control risk
8. Finalize overall audit strategy and audit plan
2. Prior to accepting a client, the auditor should investigate the client. The
auditor should evaluate the client’s standing in the business community,
financial stability, and relations with its previous CPA firm. The primary
purpose of new client investigation is to ascertain the integrity of the client
and the possibility of fraud. The auditor should be especially concerned with
the possibility of fraudulent financial reporting since it is difficult to uncover.
The auditor does not want to needlessly expose himself or herself to the
possibility of a lawsuit for failure to detect such fraud.
3. The five elements of a strategic understanding of the client’s business are:
1. Industry and External Environment – Understand risks and accounting

requirements unique to the client’s industry.
2. Business Operations and Processes – Considers factors such as
key customers and suppliers, sources of financing, and
manufacturing operations.
3. Management and Governance – Encompasses the organizational
structure and the activities of the board of directors and audit
committee.
4. Client Objectives and Strategies – Understand the client’s strategic
plan and objectives related to financial reporting, effectiveness and
efficiency of operations, and compliance with laws and regulations.
5. Measurement and Performance – Understand key performance
indicators used by management to assess progress toward its
objectives.
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7-1
P. 218
1. The preliminary judgment about materiality is the maximum amount by

which the auditor believes the financial statements could be misstated and
still not affect the decisions of reasonable users. Several factors affect the
preliminary judgment about materiality and are as follows:
1. Materiality is a relative, rather than an absolute, concept.
2. Benchmarks are needed for evaluating materiality.
3. Qualitative factors affect materiality decisions.
4. If the financial statements are widely distributed to users, the
preliminary judgment of materiality will probably be set lower
than if the financial statements are not widely distributed.
5. The level of acceptable audit risk will also affect the preliminary
judgment of materiality.
2. A preliminary judgment about materiality is set for the financial statements as

a whole. Performance materiality is the maximum amount of misstatement
that would be considered material for an individual segment of the audit, or
account balance. The amount of performance materiality for any given
segment or account is dependent upon the preliminary judgment about
materiality. Ordinarily, performance materiality for any given segment or
account would have to be lower than the preliminary judgment about
materiality. In many cases, it will be considerably lower because of the
possibility of misstatements in different accounts that, in total, cannot exceed
the prelimi nary judgment about materiality.
3. Known misstatements are those where the auditor can determine the actual
amount of the misstatement. Likely misstatements are from differences in
management’s and the auditor’s judgment about an estimate, or from the
projection of sample misstatements to the population being tested. If the
auditor tests a sample of $100,000 of inventory and finds misstatements
totaling $5,000, the likely misstatement if the account balance is $500,000 is
$25,000 ($5,000/100,000 x $500,000).
 Review Questions
7-1 There are three primary benefits from planning audits: it helps the auditor
obtain sufficient appropriate evidence for the circumstances, helps keep audit
costs reasonable, and helps avoid misunderstandings with the client.
7-2 The new auditor (successor) is required by auditing standards to communicate

with the predecessor auditor. This enables the successor to obtain information
about the client so that he or she may evaluate whether to accept the engagement.

7-2
7-2 (continued)
The predecessor is required to respond to the successor ’s request for

information; however, the response may be limited to stating that no information
will be given. The successor auditor should be wary if the predecessor is reluctant
to provide information about the client.
7-3 While assessing acceptable audit risk, an auditor needs to identify his
client’s reasons for audit. As this assessment is influenced by the intended uses
of statements, the auditor is likely to accumulate more evidence when the
statements are to be used extensively, as is often the case for publicly held
companies, those with extensive indebtedness, and companies that are to be
sold in the near future. The most likely uses of the statements can be determined
from previous experience with the client and discussions with management.
Throughout the engagement, the auditor may get additional information about
why the client is having an audit and the likely uses of the financial statements.
7-4 Because the Sarbanes–Oxley Act of 2002 explicitly shifts responsibility for
hiring and firing of the auditor from management to the audit committee for public
companies, the audit committee is viewed as “the client” in those engagements.
7-5 There are five major aspects of a client’s business and industry that an
auditor has to be aware of in order to form a strategic understanding:
1. Industry and external environment
2. Business operations and processes
3. Management and governance
4. Objectives and strategies
5. Measurement and performance to understand the client’s business
and industry.
7-6 Volatility in stock and bond markets can result when factors such as the
globalization of business, technological advances, and regulatory actions create
uncertainty about the future profitability of certain industries and/or specific
companies. Uncertainty about future cash flows makes it more difficult for
auditors to develop expectations about financial reporting results or evaluate
management’s estimates for reasonableness, and can also create incentives and
pressures for management to misreport. For example, a loss of sales revenue
may place undue pressure on management to meet revenue targets, increasing
fraud risk. Technological advances can result i n rapid changes in IT infrastructure
and financial reporting systems, making it difficult to maintain and assess the
effectiveness of internal controls over financial reporting, particularly automated
controls. In addition, changes in regulations, such as tax laws, create uncertainly
and make it even more important for companies to have highly qualified
employees in financial reporting roles. The auditor may also need to consider
including specialists on the engagement team. If the impact of any of these
factors on a company is sufficiently negative, the auditors should closely evaluate
the entity’s ability to continue as a going concern. There may be instances where
the auditor’s report should be modified to include an explanatory paragraph
7-3
7-6 (continued)
describing the auditor’s substantial doubt about the entity’s ability to continue as a
going concern.
In summary, profitability, internal controls, and incentives and opportunities
to misreport can all change rapidly in the current environment, making it
imperative that the auditor understand these factors in addition to the client’s
industry and operating environment.
7-7 Companies frequently communicate the entity’s values and ethical

standards through policy statements and codes of conduct. Due to requirements
of Sarbanes–Oxley Act, the SEC requires each public company to disclose
whether it has adopted a code of ethics that applies to senior management. A
company that has not adopted such a code must disclose this fact and explain
why it has not done so. The SEC also requires companies to promptly disclose
amendments and waivers to the code of ethics for any of those officers. Auditors
should gain knowledge of the company’s code of ethics and examine any
changes and waivers of the code of conduct that have implications about the
governance system and related integrity and ethical values of senior
management.
7-8 A related party is defined by auditing standards as an affiliated company,

principal owner of the client company, or any other party with which the client deals
where one of the parties can influence the management or operating policies of
the other.
Material related party transactions must be disclosed in the financial
statements by management. Therefore, the auditor must identify related parties
and make a reasonable effort to determine that all material related party
transactions have been properly disclosed in the financial statements . Because
instances of fraudulent financial reporting often involve transactions with related
parties, auditors should be alert for the presence of fraud risk.
7-9 Tour Client Facilities and Operations - a tour of the client’s facilities is
helpful in obtaining a better understanding of the client’s business operations
because it provides an opportunity to observe operations firsthand and to meet
key personnel. By viewing the physical facilities, the auditor can assess physical
safeguards over assets and interpret accounting data related to assets such as
inventory in process and factory equipment.
Identify Related Parties - transactions with related parties are important to

auditors because accounting standards require that they be disclosed in the
financial statements if they are material. A related party is defined in auditing
standards as an affiliated company, a principal owner of the client company, or
any other party with which the client deals, where one of the parties can influence
the management or operating policies of the other. A related party transaction is
any transaction between the client and a related party.
7-10 Information in the client’s minutes that is likely to be relevant to the auditor
includes the following:
7-4
7-10 (continued)
1. Declaration of dividends
2. Authorized compensation of officers
3. Acceptance of contracts and agreements
4. Authorization for the acquisition of property
5. Approval of mergers
6. Authorization of long-term loans
7. Approval to pledge securities
8. Authorization of individuals to sign checks
9. Reports on the progress of operations
10. Discussion about outstanding litigation and other contingencies
It is important to read the minutes early in the engagement to identify items

that need to be followed up on as a part of conducting the audit. For instance, if
a long-term loan is authorized in the minutes, the auditor will want to make
certain that the loan is recorded as part of long-term liabilities.
7-11 Three primary reasons for obtaining a good understanding of the client’s
industry and external environment are as follows:
1. Risks associated with specific industries may affect the auditor’s
assessment of client business risk and acceptable audit risk and
may even influence auditors against accepting engagements in
riskier industries.
2. Familiarity with those risks aids the auditor in determi ning their
relevance to the client when assessing client business risk and risk
of material misstatement. Examples include potential inventory
obsolescence in the fashion clothing industry, accounts receivable
collection risk in the consumer loan industry, and loss reserve risk
in the casualty insurance industry.
3. Unique accounting requirements that the auditor must understand
to evaluate whether the client’s financial statements are in
accordance with accounting standards. For example, if the auditor
is doing an audit of a city government, the auditor must understand
governmental accounting and auditing requirements. Unique
accounting requirements exist for construction companies,
railroads, not-for-profit organizations, financial institutions, and
many other organizations.
7-12 The purpose of a client’s performance measurement system is to measure

the client’s progress toward specific objectives. Performance measurement
includes ratio analysis and benchmarking against key competitors .
Performance measurements for a chain of retail clothing stores could

include gross profit by product line, sales returns as a percentage of clothing
sales, and inventory turnover by product line. An Internet portal’s performance
measurements might include number of website hits or search engine speed. A

7-5
7-12 (continued)
hotel chain’s performance measures include occupancy percentages and
average room rate.
7-13 Gordon could improve the quality of his analytical tests by:
1. Making internal comparisons to ratios of previous years or to budget

forecasts.
2. In cases where the client has more than one branch in different
industries, computing the ratios for each branch and comparing
these to the industry ratios.
7-14 The decrease of the current ratio indicates a liquidity problem for Harper
Company since the ratio has dropped to a level close to the requirements of the
bond indenture. Special care should be exercised by the auditor to determine
that the 2.05 ratio is proper since management would be motivated to hide any
lower ratio. The auditor should expand procedures to test all current assets for
proper cutoff and possible overstatement and to test all current liabilities for
proper cutoff and possible understatement.
7-15 Materiality is defined as the magnitude of misstatements that individually,

or when aggregated with other misstatements, could reasonably be expected to
influence the economic decisions of users made on the basis of the financial
statements.
“Obtain reasonable assurance,” as used in the audit report, means that
the a uditor does not guarantee or insure the fair presentation of the
financial statements. There is some risk that the financial statements contain
a material misstatement.
7-16 Materiality is important because if financial statements are materially

misstated, users’ decisions may be affected, and thereby cause financial loss
to them. It is difficult to apply because there are often many different users of
the financial statements. The auditor must therefore make an assessment of the
likely users and the decisions they will make. Materiality is also difficult to apply
because it is a relative concept. Auditing standards offer little specific guidance
regarding the application of materiality. The auditor must, therefore, exerci se
considerable professional judgment in the application of materiality.
7-17 Because materiality is relative rather than absolute, it is necessary to

have benchmarks for establishing whether misstatements are material. For
example, in the audit of a manufacturing company, the auditor might use as
benchmarks: net income before taxes, total assets, current assets, and
working capital. For a governmental unit, such as a school district, there is no
net income before taxes, and therefore that would not be an available
benchmark. Instead, the primary benchmarks would likely be fund balances, total
assets, and perhaps total revenue.

7-6
7-18 The following qualitative factors are likely to be considered in evaluating
materiality:
a. Amounts involving fraud are usually considered more important
than unintentional errors of equal dollar amounts.
b. Misstatements that are otherwise minor may be mate rial if there
are possible consequences arising from contractual obligations.
c. Misstatements that are otherwise immaterial may be material if
they affect a trend in earnings.
7-19 During an audit, auditors may change their preliminary judgement about
materiality, and this is referred to as the revised judgement about materiality.
Auditors are likely to make the revision because of changes in one of the
factors used to determine the preliminary judgment; that is, the auditor decides
that the preliminary judgment was too large or too small. For example, a
preliminary judgment about materiality is often determined before year -end and
is based on prior years’ financial statements or annualized interim financial
statement information. The judgment may be re-evaluated after current financial
statements are available. Or, client circumstances may have changed due to
qualitative events such as the issuance of debt, which created a new class of
financial statement users.
7-20 There are several possible answers to the question. One example is:
Cash $ 500 Overstatement
Fixed assets $3,000 Overstatement
Long-term loans $1,500 Understatement
Note: Cash and fixed assets are tested for overstatement and long -term
loans for understatement because the auditor’s objective in this case is
to test for overstatements of owner’s equity.
The least amount of performance materiality was allocated to cash and

long-term loans because they are relatively easy to audit. The majority of the
total allocation was to fixed assets because there is a greater likelihood of
misstatement of fixed assets in a typical audit.
7-21 When allocating the preliminary judgment about materiality for the
financial statements as a whole to individual segments, the auditor considers
both efficiency and effectiveness of the audit. An auditor might set a lower level
of performance materiality for a particular account balance if it is easy to audit and
no misstatements are expected (e.g., notes payable), or if the auditor expects
that a misstatement of a lower amount in a particular account or transaction
might influence an investor (e.g., disclosure of a related party transaction).
7-22 If performance materiality for accounts receivable is $40,000 and the

auditor finds a $55,000 overstatement of a receivable balance, the auditor
would document the misstatement and evaluate results of the remaining audit
procedures in accounts receivable. The $55,000 overstatement is an example
7-7
of a known misstatement. The auditor could request the client make an
adjustment to correct the overstatement or make a note of the overstatement
for follow-up at a later point in the audit. If accounts receivable testing was
performed using sampling techniques, the auditor would also project total
known misstatements to the population and may perform additional tests
depending on the outcome.
Discussion Questions And Problems
7-23 1. 1 (1) Accept client and perform initial audit planning.

2. 1 (1) Accept client and perform initial audit planning
4. 1 (2) Understand the client’s business and industry
5. 3 (4) Perform preliminary analytical procedures
6. 2 (3) Assess client business risk
7. 4 (2) Understand the client’s business and industry
8. 3 (2) Understand the cli ent’s business and industry
10.3 (4) Perform preliminary analytical procedures
7-24 a. A related party transaction occurs when one party to a transaction

has the ability to impose contract terms that would not have
occurred if the parties had been unrelated. Accounting standards
conclude that related parties consist of all affiliates of an enterprise,
including (1) its management and their immediate families, (2) its
principal owners and their immediate families, (3) investments
accounted for by the equity method, (4) beneficial employee trusts
that are managed by the management of the enterprise, and (5)
any party that may, or does, deal with the enterprise and has
ownership, control, or significant influence over the management or
operating policies of another party to the extent that an arm’s-length
transaction may not be achieved.
b. (1) Related party transaction. Canyon Outdoor has entered into

an operating lease with a company owned by one of the
directors on Canyon’s board. Because the board has control
and significant influence over management of Canyon, the
lease transaction may not be at arm’s length.
(2) Not a related party transaction. The fact that Canyon Outdoor
has purchased inventory items for many years from Hessel
Boating Company is a normal business transaction between
two independent parties. Neither party has an ownership
interest in the other party, and neither has an ability to
exercise control or significance influence over the other.

7-8
7-24 (continued)
(3) Related party transaction. The financing provided by Cameron
Bank and Trust through the assistance of Suzanne may not
be at arm’s length given Suzanne’s husband has control
and significant influence over Canyon Outdoors and may be
able to influence the transaction through his wife’s
employment at the bank or thro ugh his influence over
Canyon’s management.
(4) Not a related party transaction. Just because the two owners
are neighbors does not mean that either has significant
influence or control over the other. Mere acquaintance does
not suggest the transactions would not be at arm’s length.
(5) Not a related party transaction. The declaration and approval
of dividends payable to sha reholders is a normal board
function.
c. When related party transactions or balances are material, the

following disclosures are required:
1. The nature of the relationship or relationships.

2. A description of the transaction for the period reported on,
including amounts if any, and such other information deemed
necessary to obtain an understanding of the effect on the
financial statements.
3. The dollar volume of transactions and the effects of any
change in the method of establishing terms from those used
in the preceding period.
4. Amounts due from or to related parties, and if not otherwise
apparent, the terms and manner of settlement.
d. Auditors can determine the existence of material transactions with

related parties by performing the following procedures:
1. Obtain background information about the client in the manner

discussed in this chapter to enhance understanding of the
client’s industry and business; i.e., examine corporate charter
bylaws, minutes of board meetings, material contracts, etc.
2. Perform analytical procedures of the nature discussed in
Chapters 7 and 8 to evaluate the possibility of business failure
and assess areas where fraudulent financial reporting is likely.
3. Review and understand the client’s legal obligations in the
manner discussed in this chapter to become familiar with the
legal environment in which the client operates.

7-9
7-24 (continued)
4. Review the information available in the audit files, such as
permanent files, audit programs, and the preceding year ’s
audit documentation for the existence of material non-arm’s-
length transactions. Also discuss with tax and management
personnel assigned to the client their knowledge of
management involvement in material transactions.
5. Discuss the possibility of fraudulent financial reporting with
company counsel after obtaining permission to do so from
management.
6. When more than one CPA firm is involved in the audit,
exchange information with them about the nature of material
transactions and the possibility of fraudulent financial reporting.
7. Investigate whether material transactions occur close to
year-end.
8. In all material transactions, evaluate whether the parties are
economically independent and have negotiated the transaction
on an arm’s-length basis, and whether each transaction was
transacted for a valid business purpose.
9. Whenever there are material non-arm’s-length transactions,
each one should be evaluated to determine its nature and
the possibility of its being recorded at the improper amount.
The evaluation should consider whether the transaction was
transacted for a valid business purpose, was not unduly
complex, and was presented in conformity with its substance.
10. When management is indebted to the company in a material
amount, evaluate whether management has the financial ability
to settle the obligation. If collateral for the obligation exists,
evaluate its acceptability and value.
11. Inspect entries in public records concerning the proper
recording of real property transactions and personal property
liens.
12. Make inquiries with related parties to determine the possibility
of inconsistencies between the client’s and related parties’
understanding and recording of transactions that took place
between them.
13. Inspect the records of the related party to a material transaction
that is recorded by the client in a questionable manner.
14. When an independent party, such as an attorney or bank, is
significantly involved in a material transaction, ascertain from
them their understanding of the nature and purpose of the
transaction.

7-10
7-25 a. BBH Automotive faces the following business risks:
1. A decline in demand for their products due to the projected
decrease in demand for sedans
2. Potential obsolescence of their parts if they are not able to
adapt to produce parts for autonomous vehicles
3. Uncertainty in potential liability related to the product recall
4. Uncertainly related to the litigation resulting from an accident
allegedly caused by the defective part, and the possible loss
and damages
5. Loss of consumer confidence as a result of the recall,
possibly resulting in an additional decline in sales
c.
BUSINESS RISK IMPACT ON FINANCIAL STATEMENTS

Decline in demand for products Decrease in revenue and related expenses,
possible decrease in profitability if prices are
lowered; potential write-down of inventory if
prices are lowered
Obsolescence of parts Potential write-down of inventory if there is

excess inventory or if prices are lowered
Potential liability related to Potential contingent liability recorded on the

product recall balance sheet (if loss is probable and can be
estimated) or otherwise disclosed in a
footnote
Uncertainty related to litigation Potential contingent liability recorded on the
balance sheet (if loss is probable and can be
estimated), or otherwise disclosed in a
footnote
Loss of consumer confidence Most likely a decrease in sales revenue and
associated expenses, and a possible
decrease in profitability if prices are lowered.
If management determines the company is
not likely to be able to continue as a going
concern, management would need to
disclose this information in the financial
statements

7-11
7-25 (continued)
d. The article discusses the importance of automotive manufacturers
selecting the vehicles and service offerings that will allow for
economies of scale. In terms of the types of vehicles, the authors of
the article predict that there will be a mix of vehicle size, including
“pods” for short trips, and mobile offices for longer trips. The article
suggests that OEMs should choose to specialize in certain vehicle
types rather than try to supply parts for all types.
The authors also predict that, rather than individuals owning
cars, vehicles will be available for different “missions”. For example,
an individual might call for a pod if they just need a short trip. Or a
group traveling across town might call for a larger vehicle. OEMs
can specialize in parts for certain missions as well.
Potential questions for the CEO of BBH Automotive include
the following:
1. How is BBH preparing for the introduction of autonomous
vehicles?
2. Is BBH projecting a decline in demand for their products as
demand for sedans declines?
3. Has BBH researched and identified a market niche that will
allow for economies of scale?
4. Will BBH be able to rapidly change their production facilities
to address the new demands related to autonomous
vehicles?
5. What is the range of the potential exposure of BBH related to
the product recall?
6. What is the likely outcome, including estimated damages,
related to the lawsuit?
7. How is BBH regaining consumer confidence following the
product recall?
e. The partner and senior manager should also understand any press
around the product recall and litigation. Traditional news is a good
source of information, and social media would provide a sense of
consumer sentiment. In terms of the future of the automotive
industry, there is a significant amount of information available on
autonomous vehicles from various sources, including from
automotive trade publications. Also, there is extensive research
related to mobility and urban planning that will be relevant to the
future of the automotive industry as well.

7-12
7-26 a. First, the minutes of each meeting refer to the minutes of a previous
meeting. The auditor should ensure that they have been provided
access to all noted minutes, including the next year’s minutes,
probably for March 2020, to make sure the previous minutes
referred to were those from October 21, 2019.
Additionally, the auditor will request the client to include a
statement in the client representation letter stating that all minutes
were provided to the auditor.
b.
INFORMATION RELEVANT
TO 2019 AUDIT AUDIT ACTION REQUIRED
March 5:
1. Increase in annual Calculate the total dividends and determine that
dividend payment. dividends paid to shareholders are properly reflected in
the financial statements.
2. Approval of additional During analytical procedures, an increase in administrative

administration expenses expenses should be included in the auditor’s expectation
to open offices in of the expense balance. The auditor should be alert for
Portland. other potential commitments that may have been made
to open offices in the Northwest region.
3. Approval to engage in Determine the status of any potential acquisition or

negotiations for a merger negotiations. Be alert for any commitments that
potential acquisition. may have been made as part of the negotiations
process that may warrant financial statement
disclosure.
4. Potential negative Evaluate the status of any resolution of negotiations with

findings from EPA the EPA regarding findings in their report. Determine if
investigation. any final determinations have been made about
potential fines. Evaluate the need for recording any
provisions for a loss contingency or disclosure of the
status of the negotiations.

7-13
7-26 (continued)
5. Officers’ bonuses. Determine whether bonuses were accrued at 12-31-18

and were paid in 2019. Consider the tax implications of
unpaid bonuses to officers.
6. Discussion at the Determine what, if any, decisions made at either

Audit Committee meeting have any impact on the audit of the financial
and Compensation statements.
Committee.
October 21: During analytical procedures, both the decrease in

1. Reduction in sales and revenues and the decreases in labor and shipping
the related cutback in costs should be included in the auditor’s expectation
labor and shipping costs. of the related account balances. The auditor should
be alert to the fact that the drop in operating
performance might create undue incentives and
pressures that could highlight the risk of fraud.
2. Approval of the Examine acquisition documentation and financing

acquisition and related documentation to understand the impact to the
financing. financial statements for recording the acquisition and
the debt transaction. Consider what commitments and
contingencies exist and evaluate the appropriateness
of the recording of the acquisition transaction and
related disclosures.
3. Consideration of a new Determine if the new incentive stock option plan has
incentive stock option been approved. If so, consider accounting treatments
plan. required to reflect any commitments on the part of the
company and evaluate the tax implication of the plan
and need for related disclosure.
4. Identification of Discuss the deficiencies in internal control with
deficiencies in internal management and evaluate the impact of any
control. remediation activities to address the deficiencies.
Evaluate the impact of remediation on the auditor’s
tests of controls and need for substantive procedures.
5. Resolution of the EPA Examine the EPA resolution agreement and determine
report findings. if provision has been recorded for the expected costs
to modify the air handling equipment. Consider the
need for any additional disclosures of this resolution.
6. Discussion at the Audit Determine what, if any, decisions made at either
and Compensation meeting have any impact on the audit of the financial
Committee. statements.

7-14
7-26 (continued)
c. The auditor should have obtained and read the March minutes,
before completing the 12-31-18 audit. Two items were especially
relevant and require follow-up for the 12-31-18 audit: the
investigation by the EPA and approval for the 12-31-18 bonuses.
7-27 a. Gross margin percentage for drug and nondrug sales is as follows:
DRUGS NONDRUGS
2019 40.6% 32.0%

2018 42.2% 32.0%
2017 42.1% 31.9%
2016 42.3% 31.8%
The explanation given by A nand is correct in part, but appears to

be overstated. The gross margin percentage for nondrugs is
approximately consistent. For drugs, the percent dropped significantly
in the current year, far more than the industry decline. The percent
had been extremely stable before 2019. In dollars, the difference is
approximately $82,000 (42.2% – 40.6% x $5,126,000), which appears
to be significant. Of course, the decline in Jones’ prices may be
greater than the industry due to exceptional competition.
b. As the auditor, you cannot accept A nand’s explanation if $82,000

is material. The decline in gross margin could be due to an
understatement of drug inventory, a theft of drug inventory, or
understated sales. Further investigation is required to determine if
the decline is due to competitive factors or to a misstatement of
income.
7-28 a. 1. Commission expense could be overstated during the current

year or could have been understated during each of the past
several years. Or, sales may have been understated during
the current year or could have be en overstated in each of
the past several years.
2. Obsolete or unsalable inventory may be present and may
require markdown to the lower of cost or market.
3. Especially when combined with 2 above, there is a high
likelihood that obsolete or unsalable inventory may be
present. Inventory appears to be maintained at a higher level
than is necessary for the company.
4. Collection of accounts receivable appears to be a problem.
Additional provision for uncollectible accounts may be
necessary.
5. Especially when combined with 4 above, the allowance for
uncollectible accounts may be understated.
6. Depreciation expenses may be understated for the year.
7-15
7-28 (continued)
b. ITEM 1 – Make an estimated calculation of total commission expense

by multiplying the standard commission rate times commission
sales for each of the last two years. Compare the resulting amount
to the commission expense for that year. For whichever year appears
to be out of line, use audit software to recompute commissions on
sales, comparing the amounts to the commissions recorded.
ITEMS 2 AND 3 – Use audit software to compute turnover by

product line to identify slow-moving products. In addition, select a
sample of the larger inventory items (by dollar value) and use audit
software to identify subsequent transactions for these items. Note
the ability of the company to sell the items and the selling prices
obtained by the client. For any items that the client is selling below
cost plus a reasonable markup to cover selling expenses, or for
items that the client has been unable to sell, propose that the
client mark down the inventory to market value.
ITEMS 4 AND 5 – Select a sample of the larger and older accounts
receivable and use audit software to identify subsequent
payments and credits for each of these accounts. For the larger
accounts that show no substantial payments, examine credit
reports and recent financial statements to determine the
customers’ ability to pay. Discuss each account for which
substantial payment has not been received with the credit
manager and determine the need for additional allowance for
uncollectible accounts.
ITEM 6 – Discuss the reason for the reduced depreciation expense
with the client personnel responsible for the fixed assets accounts.
If they indicate that the change resulted from a preponderance of
fully depreciated assets, test the detail records to determine that
the explanation is reasonable. If no satisfactory explanation is given,
use audit software to expand the tests of depreciation by
recomputing depreciation on individual items until satisfied that
the provision is reasonable for the year.

7-16
7-29 a. The direct projection of error = (misstatements/amount
sampled) x population value. ($10,000/$1,000,000) x
$2,500,000 = $25,000
b. No, the overall financial statements are not acceptable.
Including the projected error for inventory, the total
overstatement errors are $58,000, which exceeds materiality of
$50,000.
c. The auditor should either propose an audit adjustment so that
the unadjusted statement amount is less than materiality, and/or
perform more testing to obtain a better estimate of the
population misstatements. The additional testing will likely foc us
on receivables and inventory because they have the largest
estimated misstatements.
7-30 a. The direct projection of error = (misstatements/amount sampled) x

population value.
($10,000/$1,000,000) x $2,500,000 = $25,000
b. No, the overall financial statements are not acceptable. Including

the projected error for inventory, the total overstatement errors
are $58,000, which exceeds materiality of $50,000.
c. The auditor should either propose an audit adjustment so that

the unadjusted statement amount is less than materiality,
and/or perform more testing to obtain a better estimate of the
population misstatements. The additional testing will likely focus on
receivables and inventory because they have the largest estimated
misstatements.
7-31 a. Ling should consider the overall audit assurance desired,

expected misstatements in a particular segment, and the cost of
obtaining audit evidence (efficiency).
b. Ling set performance materiality for cash at the lowest amount
because cash can be completely audited, typically there are no
misstatements, and the evidence is mostly objective versus
subjective (e.g., not based on estimates or complex calculations).
c. Ling set performance materiality for inventory at a lower amount
because there are concerns about obsolescence and because
inventory turnover is a ratio of interest to analysts. Auditing
standards suggest auditors should consider setting a lower
materiality for segments of the audit where there is increased
scrutiny.
d. Performance materiality is the highest for accounts receivable
because the account is large and requires sampling to test the
balance. In addition, Ling has determined that MT, Inc., has strong
credit policies and customers generally pay their balance on time.
7-17
7-31 (continued)
e. Setting materiality at a lower level results in collecting more audit
evidence.
7-32 a. The profession has not established clear-cut guidelines as to the

appropriate preliminary estimates of materiality. These are matters
of the auditor’s professional judgment.
The illustrative materiality guidelines in Fig 7-6 (p. 213)
are used in applying materiality for the problem. Other guidelines
may be equally acceptable.
STATEMENT PERCENT DOLLAR RANGE

COMPONENT GUIDELINES (IN MILLIONS)
Earnings from continuing

operations before taxes 3 - 6% $12.5 - $ 25.1
Current assets 3 - 6% $67.6 - $135.2
Current liabilities 3 - 6% $36.5 - $72.9
Total assets 1 - 3% $38.6 - $115.8
b. The allocation to the individual accounts is not shown. The

difficulty of the allocation is far more important than the actual
allocation. There are several ways the allocation could be done.
The most likely way would be to allocate only on the basis of the
balance sheet rather than the income statement. Even then the
allocation could vary significantly. One way would be to allocate
the same amount to each of the balance sheet accounts on the
consolidated statement of financial position. Using a materiality
level of 5 percent of earnings from continuing operations before
income taxes ($20,880,350) and the same dollar allocation to each
account excluding retained earnings, the allocation would be
approximately $994,000 to each account. There are 21 account
summaries included in the statement of financial position, which is
divided into $20,880,350.
An alternative is to assume an equal percentage
misstatement in each of the accounts. Doing it in that manner,
total assets should be added to total liabilities and owners’ equity,
less retained earnings. The allocation would be then done on a
percentage basis.
c. Auditors generally use before tax net earnings instead of after tax
net earnings to develop a preliminary judgment about materiality
given that transactions and accounts being audited within a
segment are presented in the accounting records on a pretax
basis. Auditors generally project total misstatements for a
segment and accumulate all projected total misstatements across
segments on a pretax basis and then compute the tax effect on an
aggregate basis to determine the effects on after tax net earnings.
7-18
7-32 (continued)
d. By allocating 75% of the preliminary estimate to accounts

receivable, inventories, and accounts payable, there is far less
materiality to be allocated to all other accounts. Given the total
dollar value of those accounts, this may be a reasonable
allocation. The effect of such an allocation would be that the
auditor might be able to accumulate sufficient appropriate
evidence with less total effort than would be necessary under part
b. Under part b., it would likely be necessary to audit, on almost a
100% basis, accounts receivable, inventories, and accounts
payable. On most audits it would be expensive to do that much
testing in those three accounts.
It would likely be necessary to audit accounts such as cash
and temporary investments on a 100% basis. That would not be
costly on most audits because the effort to do so would be small
compared to the cost of auditing receivables, inventories, and
accounts payable.
e. It is necessary for you to be satisfied that the actual estimate of

misstatements is less than the preliminary judgment about
materiality for all of the benchmarks. First you would reevaluate
the preliminary judgment for earnings. Assuming no change is
considered appropriate, you would likely require an adjusting entry
or an expansion of certain audit tests.
7-33 ACL Problem
a. The following is a printout of the Statistics command for Invoice

Amount:
Field : invoice_amount
Number Total Average
Positive : 4,082 46,400,198.71 11,367.03
Zeros : 0
Negative : 0 0.00 0.00
Totals : 4,082 46,400,198.71 11,367.03
Abs Value: 46,400,198.71
Range : 44,178.67
Highest : 44,379.67 41,986.89 40,404.44 39,840.77 39,117.53
Lowest : 201.00 256.57 335.98 370.50 379.95
There are no negative amounts.
b. The total amount of outstanding invoices is $893,619.03.
c. A number of the invoices have been outstanding for more than

three months, indicating potential problems with collectibility.

7-19
7-33 (continued)
d. The statistical information will be useful in identifying the range of
invoice values, including outstanding invoices, to identify
confirmation and other tests of the existence of accounts
receivable. The analysis of outstanding invoices by days
outstanding will assist in evaluating the allowance for doubtful
accounts.
 Case
7-34 (see text web site for Excel solutions for parts d. and e - Filename
P40.xls)
a.
PINNACLE MANUFACTURING―PART I
% Change % Change
Account Balance 2015–2016 2014–2015
Net sales 1.45% 2.70%
Cost of goods sold 2.85% 4.18%
Operating expenses 2.51% 2.40%
Income from operations 1.87% 23.10%
Net receivables 51.30% 8.61%
Inventory 26.23% 1.05%
Accounts payable 37.09% 24.71%
Long-term debt 9.30%  0.17%
b.
Amounts (in thousands)
________________________
Ratios 2016 2015 2014
Current assets 53,172 41,625 41,406
Current ratio: Current liab. 30,413 21,527 18,942
1.75 1.93 2.19
Debt to equity Debt 54,833 43,868 41,322
Equity 60,602 59,392 58,353
90.5% 73.9% 70.8%
Net Inc. bef tax 2,093 1,897 3,059
Net Inc. bef tax/salesSales 150,738 148,586 144,686
1.4% 1.3% 2.1%
Gross margin % Gross profit 41,453 42,331 42,698
Sales 150,738 148,586 144,686
27.5% 28.5% 29.5%
Inventory turnover COGS 109,285 106,255 101,988
Ave. inventory 28,887 25,404 25,272
3.8 4.2 4.0
7-20
7-34 (continued)
c. While Pinnacle continues to experience some growth in net sales in 2016

over 2015, that growth is less than the growth in 2015 over 2014.
Unfortunately, cost of goods sold continues to increase at higher rates
than increases in sales resulting in lower gross margin percentages in
2016, although the increase in cost of goods sold in 2016 over 2015 was
not as significant as the increase in 2015 over 2014.
Apparently Pinnacle management made changes that have reduced overall
operating expenses given the 2.51% decline in operating expenses in 2016 over
2015. Those changes resulted in an increase in income from operations in 2016
relative to the decrease experienced in 2015 and a slight increase in net income
before taxes in 2016 over 2015.
While profitable, the review of changes in balance sheet accounts indicates

that receivables are increasing at significant rates (51.30% in 2016) relative to
increases in sales of only 1.45%. This buildup in receivables may lead to
significant collection challenges in 2016 and beyond. Similarly, buildup of
inventory may lead to excess amounts of inventory, especially if sales do not
continue to increase beyond 2016. Concerns about inventory obsolescence are
likely to be increasing given the slower inventory turnover in 2016.
The reduction in the current ratio suggests that liquidity is decreasing in 2016
relative to prior years. The increase in accounts payable to finance the inventory
buildup in addition to increases in long-term debt suggests that management is
increasing its borrowings to provide cash flow during a time where cash
collections from receivables appear to be slowing as receivables continue to
build. Increased borrowings (both short-term and long-term) will place greater
needs on managing cash flow and liquidity in 2016 and beyond.
d. See page 8-27 for Pinnacle’s common-size income statement. For the
overall financial statements, the focus is on all accounts except direct
expenses. For the direct expenses, it is better to use the disaggregated
information. The suggested solution was prepared using Excel (Filename
P840.xls).
Estimate of $ Amount
Account Balance of Potential Misstatement
Salaries & Wages Salary and wages expenses are lower
this year relative to prior years. Need to
determine if salaried workers were laid off
or terminated and extent that number of
hourly workers or overtime was reduced
in 2016.
Property taxes Decrease of $155,000 when property
increased
Bad debts See requirement g. for an analysis
7-21
7-34 (continued)
Depreciation expense Increase of almost $700,000, perhaps
partly due to new building and equipment
purchases
Federal Income Taxes FIT as a % of NIBT was 45% in 2015.
45% of 2016 NIBT is $941.9 million.
Actual FIT for 2016 was $883.4 million.
Difference of $585,000
Interest expense Short-term plus long-term interest bearing
debt increased by 22%, from $32.6 million
in 2015 to $39.8 million in 2016, but
interest expense decreased. If interest
rates have not changed, interest expense
would be expected to increase by a
similar amount to $2,804,800 ($2,299,000
x 1.22). Potential misstatement of
$622,900 ($2,804,800 - $2,181,900)
e. See pages 8-28 to 8-30 for common-size income statement for each of
Pinnacle’s three divisions. The suggested solution was prepared using
Excel (Filename P40.xls). For disaggregated information it is best to
ignore the allocated expenses.
Welburn:
Security Decrease of $70,000 or .36% of sales
relative to .43% in 2015 and 2014.
Solar-Electro:
Payroll benefits Increased almost $50,000 while salaries
and wages decreased. Potential
misallocation between divisions.
Legal Service Large increase may be indicative of other
issues affecting disclosures and asset or
liability valuation.
Miscellaneous Increase of over $190,000 needs
investigation.

7-22
7-34 (continued)
(part of requirement d.)
Pinnacle Manufacturing Company
Income Statement - All Divisions
For the Year Ended December 31
2016 2016 2015 2015 2014 2014
Dollar % of Dollar % of Dollar % of
Value Sales Value Sales Value Sales
Sales 150,918,731 100.00% 148,764,555 100.00% 144,860,245 100.00%
Sales Returns and Allowances 181,103 0.12% 178,518 0.12% 173,832 0.12%
Cost of Sales* 109,284,780 72.41% 106,255,499 71.43% 101,988,165 70.40%
Gross Profit 41,452,848 27.47% 42,330,538 28.45% 42,698,248 29.48%
OPERATING EXPENSES-Allocated
Salaries-Management 2,281,266 1.51% 2,387,993 1.61% 2,295,081 1.58%
Salaries-Office 315,169 0.21% 296,681 0.20% 306,856 0.21%
Licensing and certification fees 190,650 0.13% 172,883 0.12% 162,279 0.11%
Security 550,603 0.36% 637,580 0.43% 630,353 0.44%
Insurance 93,197 0.06% 103,842 0.07% 108,491 0.07%
Medical benefits 23,721 0.02% 29,453 0.02% 28,810 0.02%
Ad vertising 162,512 0.11% 178,009 0.12% 165,678 0.11%
Business publications 6,989 0.00% 5,555 0.00% 774 0.00%
Property ta xes 22,585 0.01% 178,009 0.12% 175,692 0.12%
Bad debts 841,699 0.56% 1,034,060 0.70% 992,094 0.68%
Depreciation expense 5,336,783 3.54% 4,641,982 3.12% 4,367,565 3.02%
Accounting fees 273,956 0.18% 297,777 0.20% 299,789 0.21%
Total operating expenses -Allocated 10,099,130 6.69% 9,963,824 6.70% 9,533,462 6.58%
OPERATING EXPENSES-Direct
Salaries-Sales 14,970,669 9.92% 15,327,777 10.30% 14,904,392 10.29%
Wages Rental 491,794 0.33% 595,389 0.40% 575,725 0.40%
Wages-Mechanics 1,113,539 0.74% 1,339,626 0.90% 1,333,411 0.92%
Wages-Warehouse 4,891,065 3.24% 5,340,271 3.59% 5,473,249 3.78%
Garbage collection 27,649 0.02% 29,771 0.02% 37,969 0.03%
Payroll benefits 2,657,889 1.76% 2,937,730 1.97% 2,894,300 2.00%
Rent- Warehouse 802,855 0.53% 764,346 0.51% 758,345 0.52%
Telephone 32,402 0.02% 45,173 0.03% 57,867 0.04%
Utilities 262,393 0.17% 267,005 0.18% 274,365 0.19%
Postage 89,763 0.06% 133,518 0.09% 151,278 0.10%
Linen service 17,282 0.01% 12,350 0.01% 16,083 0.01%
Repairs and maintenance 166,985 0.11% 168,405 0.11% 178,213 0.12%
Cleaning service 89,800 0.06% 81,589 0.05% 78,088 0.05%
Legal service 396,016 0.26% 190,540 0.13% 152,238 0.11%
Fuel 286,547 0.19% 341,192 0.23% 279,512 0.19%
Travel and entertainment 103,389 0.07% 103,842 0.07% 100,479 0.07%
Pension expense 228,555 0.15% 237,350 0.16% 127,011 0.09%
Office supplies 149,828 0.10% 148,340 0.10% 171,109 0.12%
Miscellaneous 300,188 0.20% 105,931 0.07% 144,012 0.10%
Total operating expenses -Direct 27,078,608 17.94% 28,170,145 18.94% 27,707,646 19.13%
Total Operating Expenses 37,177,738 24.63% 38,133,969 25.63% 37,241,108 25.71%
Operating Income 4,275,110 2.83% 4,196,569 2.82% 5,457,140 3.77%
Other Expense-Interest 2,181,948 1.45% 2,299,217 1.55% 2,397,953 1.66%
Income Before Taxes 2,093,162 1.39% 1,897,352 1.28% 3,059,187 2.11%
Federal Income Taxes 883,437 0.59% 858,941 0.58% 1,341,536 0.93%
Net Income 1,209,725 0.80% 1,038,411 0.70% 1,717,651 1.19%
* Details of manufacturing expenses are
not included in this schedule.

7-23
7-34 (continued)
Income Statement - Welburn Division
2016 2015 2014
2016 % of 2015 % of 2014 % of
Div. Div. Div.
$ Value Sales $ Value Sales $ Value Sales
Sales 122,585,513 100.00% 120,830,903 100.00% 117,639,471 100.00%
Cost of Sales* 90,373,709 73.72% 87,905,900 72.75% 84,375,503 71.72%
Gross Profit 32,084,131 26.17% 32,800,028 27.15% 33,142,274 28.17%
Salaries-Management 1,851,775 1.51% 1,934,168 1.60% 1,858,914 1.58%
Salaries-Office 255,833 0.21% 240,298 0.20% 248,539 0.21%
Security 446,938 0.36% 516,406 0.43% 510,552 0.43%
Insurance 75,647 0.06% 84,103 0.07% 87,868 0.07%
Ad vertising 131,917 0.11% 144,181 0.12% 134,193 0.11%
Property ta xes 17,873 0.01% 144,181 0.12% 142,304 0.12%
Bad debts 687,885 0.56% 831,572 0.69% 797,823 0.68%
Accounting fees 223,534 0.18% 240,196 0.20% 241,817 0.21%
Salaries-Sales 12,579,213 10.26% 12,694,443 10.51% 12,343,793 10.49%
Wages Rental - - -
Wages-Mechanics - - -
Wages-Warehouse 4,006,809 3.27% 4,325,377 3.58% 4,433,082 3.77%
Garbage collection - - -
Rent- Warehouse 670,746 0.55% 623,389 0.52% 618,494 0.53%
Telephone 25,901 0.02% 36,045 0.03% 46,175 0.04%
Utilities 194,700 0.16% 216,266 0.18% 222,226 0.19%
Postage 77,924 0.06% 108,136 0.09% 122,519 0.10%
Linen service 14,126 0.01% 10,510 0.01% 13,685 0.01%
Legal service 115,735 0.09% 131,334 0.11% 104,934 0.09%
Fuel 217,964 0.18% 276,343 0.23% 226,387 0.19%
Pension expense 187,891 0.15% 192,240 0.16% 102,872 0.09%
Office supplies 121,617 0.10% 120,149 0.10% 138,590 0.12%
Miscellaneous 57,147 0.05% 57,910 0.05% 78,729 0.07%
Total operating expenses 28,640,218 23.36% 29,488,860 24.41% 28,768,033 24.45%
OPERATING INCOME 3,443,913 2.81% 3,311,168 2.74% 4,374,241 3.72%


7-24
7-34 (continued)
Income Statement - Solar-Electro Division
2016 2015 2014
2016 % of 2015 % of 2014 % of
Div. Div. Div.
Sales 22,605,731 100.00% 21,680,289 100.00% 21,126,896 100.00%
Cost of Sales* 17,008,377 75.24% 16,156,496 74.52% 15,507,635 73.40%
Gross Profit 5,553,529 24.57% 5,485,020 25.30% 5,581,505 26.42%
Salaries-Management 338,015 1.50% 352,230 1.62% 338,525 1.60%
Salaries-Office 46,697 0.21% 43,759 0.20% 45,259 0.21%
Security 81,580 0.36% 94,046 0.43% 92,980 0.44%
Insurance 13,808 0.06% 15,319 0.07% 16,005 0.08%
Ad vertising 24,078 0.11% 26,255 0.12% 24,436 0.12%
Business publications 874 0.00% 542 0.00% 76 0.00%
Property ta xes 3,264 0.01% 26,255 0.12% 25,913 0.12%
Bad debts 120,493 0.53% 157,730 0.73% 151,328 0.72%
Depreciation expense 889,483 3.93% 684,667 3.16% 644,192 3.05%
Accounting fees 39,666 0.18% 44,689 0.21% 44,992 0.21%
Salaries-Sales 2,192,482 9.70% 2,402,414 11.08% 2,336,053 11.06%
Wages Rental - - -
Wages-Mechanics - - -
Wages-Warehouse 695,918 3.08% 787,698 3.63% 807,312 3.82%
Payroll benefits 478,669 2.12% 433,321 2.00% 426,916 2.02%
Rent- Warehouse 103,983 0.46% 109,403 0.50% 108,544 0.51%
Telephone 4,730 0.02% 6,567 0.03% 8,412 0.04%
Utilities 53,278 0.24% 39,383 0.18% 40,468 0.19%
Postage 7,131 0.03% 19,695 0.09% 22,315 0.11%
Linen service 2,578 0.01% 1,490 0.01% 1,941 0.01%
Legal service 268,954 1.19% 45,950 0.21% 36,714 0.17%
Fuel 53,975 0.24% 50,326 0.23% 41,229 0.20%
Pension expense 34,297 0.15% 33,988 0.16% 18,187 0.09%
Office supplies 22,199 0.10% 21,880 0.10% 25,238 0.12%
Miscellaneous 234,892 1.04% 42,982 0.20% 58,433 0.28%
OPERATING INCOME -253,366 -1.12% -41,967 -0.19% 179,392 0.85%


7-25
7-34 (continued)
Income Statement - Machine-Tech Division
2016 2015 2014
2016 % of 2015 % of 2014 % of
Div. Div. Div.
Sales 5,727,487 100.00% 6,253,363 100.00% 6,093,878 100.00%
Cost of Sales* 1,902,694 33.22% 2,193,103 35.07% 2,105,027 34.54%
Gross Profit 3,815,188 66.61% 4,045,490 64.69% 3,974,469 65.22%
Salaries-Management 91,476 1.60% 101,595 1.62% 97,642 1.60%
Salaries-Office 12,638 0.22% 12,624 0.20% 13,057 0.21%
Security 22,086 0.39% 27,128 0.43% 26,820 0.44%
Insurance 3,742 0.07% 4,420 0.07% 4,618 0.08%
Medical benefits 795 0.01% 1044 0.02% 1022 0.02%
Ad vertising 6,517 0.11% 7,573 0.12% 7,048 0.12%
Property ta xes 1,448 0.03% 7,573 0.12% 7,475 0.12%
Bad debts 33,321 0.58% 44,759 0.72% 42,942 0.70%
Accounting fees 10,756 0.19% 12,891 0.21% 12,983 0.21%
Total operating expenses -Allocated 456,844 7.98% 449,103 7.18% 427,840 7.02%
OPERATING EXPENSES-Direct 198978
Salaries-Sales 198,978 3.47% 230,922 3.69% 224,543 3.68%
Wages Rental 491,794 8.59% 595,389 9.52% 575,724 9.45%
Wages-Mechanics 1,113,539 19.44% 1,339,627 21.42% 1,333,411 21.88%
Wages-Warehouse 188,339 3.29% 227,196 3.63% 232,853 3.82%
Rent- Warehouse 28,126 0.49% 31,554 0.50% 31,306 0.51%
Telephone 1,771 0.03% 2,560 0.04% 3,280 0.05%
Utilities 14,415 0.25% 11,357 0.18% 11,670 0.19%
Postage 4,708 0.08% 5,688 0.09% 6,445 0.11%
Linen service 579 0.01% 350 0.01% 457 0.01%
Legal service 11,327 0.20% 13,255 0.21% 10,590 0.17%
Fuel 14,608 0.26% 14,522 0.23% 11,897 0.20%
Pension expense 6,368 0.11% 11,121 0.18% 5,951 0.10%
Office supplies 6,012 0.10% 6,312 0.10% 7,281 0.12%
Miscellaneous 8,141 0.14% 5,035 0.08% 6,856 0.11%
Total operating expenses-Direct 2,273,781 39.70% 2,669,019 42.68% 2,643,122 43.37%
OPERATING INCOME 1,084,563 18.94% 927,368 14.83% 903,507 14.83%


7-26
7-34 (continued)
f. Both the companywide and the divisional income statements are useful,
but for different purposes. The companywide information is useful for
identifying material fluctuations in the financial statements. However, the
disaggregated information is more helpful in identifying the source of the
fluctuations.
g. Estimate of Potential
Understatement in Allowance
2016 2015 2014

A/R Turnover
Sales 150,738 148,586 144,686
Average accounts receivable 10,831 8,278 7,936
Turnover 13.9 17.9 18.2
Days Sales Outstanding

365 365 365 365
Turnover 13.9 17.9 18.2
Days 26.3 20.4 20.1
2016 2015 2014

Bad Debt Expense as
percentage of gross sales: .56% .70% .68%
In the prior two years, bad debt expense as a percentage of gross sales has
approximated .7%. In 2016, the days sales outstanding increased 28.92% from
20.4 days to 26.3 days. If you increase the .7% by 28.92%, bad debts as a
percentage of sales would increase from .7% to .9%, which would suggest an
estimated bad debt expense of $1,358,269.
The difference between recorded bad debt expense of $841,699 and the
expected bad debt expense of $1,358,269 would require an increase of $516,570
to bad debt expense and the allowance for doubtful accounts.

7-27
Analysis of Inventory Balance
% Change % Change
Account Balance 2015-2016 2014-2015
Net sales 1.45% 2.70%
Ratios 2016 2015 2014

Sales 150,738 148,586 144,686
27.5% 28.5% 29.5%
Ave. inventory 28,887 25,404 25,272
3.8 4.2 4.0
Days Inventory Outstanding

365 365 365
Inventory Turnover 3.8 4.2 4.0
96.1 86.9 91.3
The significant buildup of inventories in 2016, despite slower growth in sales
creates significant concerns about the potential for inventory obsolescence.
Inventory is sitting in the warehouse longer in 2016 (by almost 10 days) relative
to 2015. More extensive analysis regarding inventory obsolescence will be
needed.
Analysis of Short-Term and Long-Term Debt
% Change % Change
Short-term/Current LTD 49.3% 6.47%
Long-term Debt 9.3% -0.17%
Interest Expense -5.1% -4.1%
Accounts payable and short-term/current borrowings are up significantly. The
increase of 37.09% in accounts payable is much greater than the increase in the
ending inventory balance. And, short-term/Current LTD is up almost 50%, with
long-term debt up about 9.3%. Despite increases in short-term and long-term
debt, interest expense declined almost 5% in 2016. Additional work will be done
to address the potential for material misstatements in these accounts.
h. There is a low to moderate risk that Pinnacle will fail financially in the next
twelve months. The company has been profitable the past three years, is
generating cash flows, and most of the ratios indicate no severe financial
difficulties. Several ratios, such as the current ratio and debt to equity have
deteriorated somewhat, but not enough to cause significant concerns.

7-28
 Integrated Case Application – Pinnacle Manufacturing
7-35 (see text website for Excel solutions for parts a., b., d., and e - Filename
P839.xls)
a. See Excel file for complete solutions. Select percentage changes are
listed below.
PINNACLE MANUFACTURING―PART I
% Change % Change
Account Balance 2018–2019 2017–2018
Net sales 1.72% 2.70%
Operating expenses -1.93% 2.40%
Income from operations 6.16% -23.10%
Net receivables 47.82% 8.61%
Long-term debt 7.69% - 0.17%
b. See Excel file for solutions. Select ratios are presented below.
Amounts (in thousands)

___________________________
Ratios 2019 2018 2017
Current assets 52,572 41,625 41,406
Current ratio: Current liab. 30,413 21,527 18,942
1.73 1.93 2.19
Ave. inventory 28,737 25,404 25,272
3.8 4.2 4.0
Debt to equity Debt 54,473 43,868 41,322
Equity 60,962 59,392 58,353
89.4% 73.9% 70.8%
Net Sales 151,138 148,586 144,686
27.7% 28.5% 29.5%
c. While Pinnacle continues to experience some growth in net sales

in 2019 over 2018, that growth is less than the growth in 2018 over
2017. Unfortunately, cost of goods sold continues to increase at
higher rates than increases in sales resulting in lower gross margin
percentages in 2019, although the increase in cost of goods sold in
2019 over 2018 was not as significant as the increase in 2018 over
2017.

7-29
7-35 (continued)
Apparently Pinnacle management made changes that have

reduced overall operating expenses given the 1.93% decline in
operating expenses in 2019 over 2018. Those changes resulted in an
increase in income from operations in 2019 relative to the decrease
experienced in 2018 and a slight increase in net income before
taxes in 2019 over 2018.
While profitable, the review of changes in balance sheet
accounts indicates that net receivables are increased significantly
rates (47.82% in 2019) relative to an increase in sales of only
1.72%. This buildup in receivables may lead to significant collection
challenges in 2019 and beyond. Similarly, buildup of inventory may
lead to excess amounts of inventory, especially if sales do not
continue to increase beyond 2019. Concerns about inventory
obsolescence are likely to increase given the slower inventory
turnover in 2019.
The reduction in the current ratio suggests that liquidity is
decreasing in 2019 relative to prior years. The increase in accounts
payable to finance the inventory buildup in addition to increases in
long-term debt suggests that management is increasing borrowings to
provide cash flow during a time whe n cash collections from
receivables appear to be slowing as receivables continue to build.
Increased borrowings (short-term and long-term) will place greater
needs on managing cash flow and liquidity in 2019 and beyond.
d. See page 8-28 for Pinnacle’s common-size income statement. For
the overall financial statements, the focus is on all accounts except
direct expenses. For the direct expenses, it is better to use the
disaggregated information. The suggested solution was prepared
using Excel (Filename P839.xls).
Salaries & Wages Salary and wages expenses are lower
as a percentage of sales this year relative
to prior years. Need to determine if
salaried workers were laid off or
terminated, and whether the number of
hourly workers or overtime was reduced
in 2019.
Property taxes Decreased in total and as a percentage of
sales while property increased
Bad debts See requirement g. for an analysis
Depreciation expense Increase of almost $700,000, perhaps
partly due to new building and equipment
purchases
7-30
7-35 (continued)
Legal service expense Legal service fees increased significantly
in 2019 relative to 2018 and 2017. This
could indicate possible litigation against
the company or a significant contract the
company is entering into.
Federal Income Taxes FIT as a % of NIBT was 45% in 2018.
45% of 2019 NIBT is $1,022,923.
Recorded FIT for 2019 was $703,437
(31% of NIBT). Difference of $319,486
Interest expense Short-term (Notes Payable and Current
Portion of LTD) plus long-term interest
bearing debt increased by 21%, from
$32.6 million in 2018 to $39.4 million in
2019, but interest expense decreased. If
interest rates have not changed, interest
expense would be expected to increase
by a similar amount to $2,782,053
($2,299,217 x 1.21). Potential
misstatement of $600,105 ($2,782,053 -
$2,181,948)
e. See pages 8-28 to 8-30 for common-size income statement for each
of Pinnacle’s three divisions. The suggested solution was prepared
using Excel (Filename P39.xls). For disaggregated information it is
best to ignore the allocated expenses.
Welburn:
Salaries and wages As noted for the company as a whole,
salaries, wages, and payroll benefits
declined as a percentage of sales, which
may be due to the reasons discussed
above or may be due to a failure to accrue
at the end of the year.
Solar-Electro:
Payroll benefits Increased almost $50,000 while salaries
and wages decreased. Potential
misallocation between divisions.
Legal Service Large increase may be indicative of other
issues affecting disclosures and asset or
liability valuation.
Miscellaneous Increase of over $190,000 needs
investigation.
7-31
7-35 (continued)
(part of requirement d.)

Income S tatement - All Divisions
2019 2019 2018 2018 2017 2017
Dollar % of Dollar % of Dollar % of
Value S ales Value S ales Value S ales
Sales 151,318,731 100.00% 148,764,555 100.00% 144,860,245 100.00%
Cost of Sales* 109,284,780 72.22% 106,255,499 71.43% 101,988,165 70.40%
Gross Profit 41,852,848 27.66% 42,330,538 28.45% 42,698,248 29.48%
OPERATING EXPENS ES -Allocated
Salaries-M anagement 2,281,266 1.51% 2,387,993 1.61% 2,295,081 1.58%
Salaries-Office 315,169 0.21% 296,681 0.20% 306,856 0.21%
Security 600,604 0.40% 637,580 0.43% 630,353 0.44%
Insurance 93,197 0.06% 103,842 0.07% 108,491 0.07%
M edical benefits 23,721 0.02% 29,453 0.02% 28,810 0.02%
Advertising 162,512 0.11% 178,009 0.12% 165,678 0.11%
Property taxes 92,585 0.06% 178,009 0.12% 175,692 0.12%
Bad debts 841,699 0.56% 1,034,060 0.70% 992,094 0.68%
Accounting fees 273,956 0.18% 297,777 0.20% 299,789 0.21%
Total operating expenses-Allocated 10,219,130 6.75% 9,963,824 6.70% 9,533,462 6.58%
OPERATING EXPENS ES -Direct
Salaries-Sales 14,970,669 9.89% 15,327,777 10.30% 14,904,392 10.29%
Wages Rental 491,794 0.33% 595,389 0.40% 575,725 0.40%
Wages-M echanics 1,113,539 0.74% 1,339,626 0.90% 1,333,411 0.92%
Wages-Warehouse 4,991,066 3.30% 5,340,271 3.59% 5,473,249 3.78%
Rent- Warehouse 802,855 0.53% 764,346 0.51% 758,345 0.52%
Telephone 32,402 0.02% 45,173 0.03% 57,867 0.04%
Utilities 262,393 0.17% 267,005 0.18% 274,365 0.19%
Postage 89,763 0.06% 133,518 0.09% 151,278 0.10%
Linen service 17,282 0.01% 12,350 0.01% 16,083 0.01%
Legal service 396,016 0.26% 190,540 0.13% 152,238 0.11%
Fuel 286,547 0.19% 341,192 0.23% 279,512 0.19%
Pension expense 228,556 0.15% 237,350 0.16% 127,011 0.09%
Office supplies 149,828 0.10% 148,340 0.10% 171,109 0.12%
M iscellaneous 300,180 0.20% 105,931 0.07% 144,012 0.10%
Total Operating Expenses 37,397,738 24.71% 38,133,969 25.63% 37,241,108 25.71%
Operating Income 4,455,110 2.94% 4,196,569 2.82% 5,457,140 3.77%
Other Expense-Interest 2,181,948 1.44% 2,299,217 1.55% 2,397,953 1.66%
Income Before Taxes 2,273,162 1.50% 1,897,352 1.28% 3,059,187 2.11%
Federal Income Taxes 703,437 0.46% 858,941 0.58% 1,341,536 0.93%
Net Income 1,569,725 1.04% 1,038,411 0.70% 1,717,651 1.19%
* Details of manufacturing expenses are not
included in this schedule.

7-32
7-35 (continued)
(part of requirement e.)

Income S tatement - Welburn Division
2019 2019 2018 2018 2017 2017
% of Div. % of Div. % of Div.
$ Value S ales $ Value S ales $ Value S ales
Sales 122,985,513 100.00% 120,830,903 100.00% 117,639,471 100.00%
Cost of Sales* 90,373,709 73.48% 87,905,900 72.75% 84,375,503 71.72%
Gross Profit 32,484,131 26.41% 32,800,028 27.15% 33,142,274 28.17%
Salaries-M anagement 1,851,775 1.51% 1,934,168 1.60% 1,858,914 1.58%
Salaries-Office 255,833 0.21% 240,298 0.20% 248,539 0.21%
Security 496,938 0.40% 516,406 0.43% 510,552 0.43%
Insurance 75,647 0.06% 84,103 0.07% 87,868 0.07%
Advertising 131,917 0.11% 144,181 0.12% 134,193 0.11%
Property taxes 67,873 0.06% 144,181 0.12% 142,304 0.12%
Bad debts 687,885 0.56% 831,572 0.69% 797,823 0.68%
Accounting fees 223,534 0.18% 240,196 0.20% 241,817 0.21%
Salaries-Sales 12,579,213 10.23% 12,694,443 10.51% 12,343,793 10.49%
Wages Rental - - -
Wages-M echanics - - -
Wages-Warehouse 4,106,809 3.34% 4,325,377 3.58% 4,433,082 3.77%
Rent- Warehouse 670,746 0.55% 623,389 0.52% 618,494 0.53%
Telephone 25,901 0.02% 36,045 0.03% 46,175 0.04%
Utilities 194,700 0.16% 216,266 0.18% 222,226 0.19%
Postage 77,924 0.06% 108,136 0.09% 122,519 0.10%
Linen service 14,126 0.01% 10,510 0.01% 13,685 0.01%
Legal service 115,735 0.09% 131,334 0.11% 104,934 0.09%
Fuel 217,964 0.18% 276,343 0.23% 226,387 0.19%
Pension expense 187,891 0.15% 192,240 0.16% 102,872 0.09%
Office supplies 121,617 0.10% 120,149 0.10% 138,590 0.12%
M iscellaneous 57,147 0.05% 57,910 0.05% 78,729 0.07%
OPERATING INCOME 3,643,913 2.96% 3,311,168 2.74% 4,374,241 3.72%


7-33
7-35 (continued)
Income S tatement - S olar-Electro Division
2019 2019 2018 2018 2017 2017
Sales 22,605,731 100.00% 21,680,289 100.00% 21,126,896 100.00%
Cost of Sales* 17,008,377 75.24% 16,156,496 74.52% 15,507,635 73.40%
Gross Profit 5,553,529 24.57% 5,485,020 25.30% 5,581,505 26.42%
Salaries-M anagement 338,015 1.50% 352,230 1.62% 338,525 1.60%
Salaries-Office 46,697 0.21% 43,759 0.20% 45,259 0.21%
Security 81,580 0.36% 94,046 0.43% 92,980 0.44%
Insurance 13,808 0.06% 15,319 0.07% 16,005 0.08%
Advertising 24,078 0.11% 26,255 0.12% 24,436 0.12%
Business publications 874 0.00% 542 0.00% 76 0.00%
Property taxes 23,264 0.10% 26,255 0.12% 25,913 0.12%
Bad debts 120,493 0.53% 157,730 0.73% 151,328 0.72%
Accounting fees 39,666 0.18% 44,689 0.21% 44,992 0.21%
Salaries-Sales 2,192,482 9.70% 2,402,414 11.08% 2,336,053 11.06%
Wages Rental - - -
Wages-M echanics - - -
Wages-Warehouse 695,918 3.08% 787,698 3.63% 807,312 3.82%
Rent- Warehouse 103,983 0.46% 109,403 0.50% 108,544 0.51%
Telephone 4,730 0.02% 6,567 0.03% 8,412 0.04%
Utilities 53,278 0.24% 39,383 0.18% 40,468 0.19%
Postage 7,131 0.03% 19,695 0.09% 22,315 0.11%
Linen service 2,578 0.01% 1,490 0.01% 1,941 0.01%
Legal service 268,954 1.19% 45,950 0.21% 36,714 0.17%
Fuel 53,975 0.24% 50,326 0.23% 41,229 0.20%
Pension expense 34,297 0.15% 33,988 0.16% 18,187 0.09%
Office supplies 22,199 0.10% 21,880 0.10% 25,238 0.12%
M iscellaneous 234,892 1.04% 42,982 0.20% 58,433 0.28%
OPERATING INCOME -273,366 -1.21% -41,967 -0.19% 179,392 0.85%


7-34
7-35 (continued)
Income Statement - Machine-Tech Division
2019 2019 2018 2018 2017 2017
Sales 5,727,487 100.00% 6,253,363 100.00% 6,093,878 100.00%
Cost of Sales* 1,902,694 33.22% 2,193,103 35.07% 2,105,027 34.54%
Gross Profit 3,815,188 66.61% 4,045,490 64.69% 3,974,469 65.22%
Salaries-M anagement 91,476 1.60% 101,595 1.62% 97,642 1.60%
Salaries-Office 12,638 0.22% 12,624 0.20% 13,057 0.21%
Security 22,086 0.39% 27,128 0.43% 26,820 0.44%
Insurance 3,742 0.07% 4,420 0.07% 4,618 0.08%
M edical benefits 795 0.01% 1044 0.02% 1022 0.02%
Advertising 6,517 0.11% 7,573 0.12% 7,048 0.12%
Property taxes 1,448 0.03% 7,573 0.12% 7,475 0.12%
Bad debts 33,321 0.58% 44,759 0.72% 42,942 0.70%
Accounting fees 10,756 0.19% 12,891 0.21% 12,983 0.21%
Total operating expenses-Allocated 456,844 7.98% 449,103 7.18% 427,840 7.02%
Salaries-Sales 198,978 3.47% 230,922 3.69% 224,543 3.68%
Wages Rental 491,794 8.59% 595,389 9.52% 575,724 9.45%
Wages-M echanics 1,113,539 19.44% 1,339,627 21.42% 1,333,411 21.88%
Wages-Warehouse 188,339 3.29% 227,196 3.63% 232,853 3.82%
Rent- Warehouse 28,126 0.49% 31,554 0.50% 31,306 0.51%
Telephone 1,771 0.03% 2,560 0.04% 3,280 0.05%
Utilities 14,415 0.25% 11,357 0.18% 11,670 0.19%
Postage 4,708 0.08% 5,688 0.09% 6,445 0.11%
Linen service 579 0.01% 350 0.01% 457 0.01%
Legal service 11,327 0.20% 13,255 0.21% 10,590 0.17%
Fuel 14,608 0.26% 14,522 0.23% 11,897 0.20%
Pension expense 6,368 0.11% 11,121 0.18% 5,951 0.10%
Office supplies 6,012 0.10% 6,312 0.10% 7,281 0.12%
M iscellaneous 8,141 0.14% 5,035 0.08% 6,856 0.11%
OPERATING INCOME 1,084,563 18.94% 927,368 14.83% 903,507 14.83%


7-35
7-35 (continued)
f. Both the companywide and the divisional income statements are

useful, but for different purposes. The companywide information is
useful for identifying material fluctuations in the financial statements.
However, the disaggregated information is more helpful in identifying
the source of the fluctuations.
h. Estimate of Potential
Understatement in Allowance
2019 2018 2015

A/R Turnover
Sales 151,138 148,586 144,686
Average accounts receivable 10,681 8,278 7,936
Turnover 14.2 17.9 18.2
Days Sales Outstanding

365 365 365 365
Turnover 14.2 17.9 18.2
Days 25.7 20.4 20.1
2019 2018 2017

Bad Debt Expense as
percentage of gross sales: .56% .70% .68%
In the prior two years, bad debt expense as a percentage of gross sales has
approximated .7%. In 2019, the days sales outstanding increased 25.98% from
20.4 days to 25.7 days. If you increase the .7% by 25.98%, bad debts as a
percentage of gross sales would increase from .7% to approximately .88%,
which would suggest an estimated bad debt expense of $1,331,604 (gross sales
of $151,318,731 x 0.88%).
The difference between recorded bad debt expense of $841,699 and the expected
bad debt expense of $1,331,604 would require an increase of $489,905 to bad
debt expense and the allowance for doubtful accounts.
Analysis of Inventory Balance

% Change % Change
Net sales 1.72% 2.70%

7-36
7-35 (continued)
Ratios 2019 2018 2017

Net Sales 151,137 148,586 144,686
27.5% 28.5% 29.5%
Ave. inventory 28,737 25,404 25,272
3.8 4.2 4.0
Days Inventory Outstanding

365 365 365
Inventory Turnover 3.8 4.2 4.0
96.1 86.9 91.3
The significant buildup of inventories in 2019, despite slower

growth in sales creates significant concerns about the potential for
inventory obsolescence. Inventory is sitting in the warehouse longer
in 2019 (by almost 10 days) relative to 2018. More extensive analysis
regarding inventory obsolescence will be needed.
Analysis of Short-Term and Long-Term Debt

% Change % Change
Short-term/Current LTD 49.3% 6.47%
Long-term Debt 7.7% -0.17%
Interest Expense -5.1% -4.1%
Accounts payable and short-term/current borrowings are up

significantly. The increase of 37.09% in accounts payable is much
greater than the increase in the ending inventory balance. And, the
sum of short-term debt plus the current portion of long-term debt is
up almost 50%, with long-term debt up about 7.7%. Despite
increases in short-term and long-term debt, interest expense
declined almost 5% in 2019. Additional work will be done to
address the potential for material misstatements in these
accounts.
h. There is a low to moderate risk that Pinnacle will fail financially in

the next twelve months. The company has been profitable the past
three years, is generating cash flows, and most of the ratios indicate
no severe financial difficulties. Several ratios, such as the current
ratio and debt to equity have deteriorated somewhat, but not
enough to cause significant concerns.

7-37

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Chapter 7

Audit Planning and Materiality

1. The eight major steps in planning audits are:

1. Accept client and perform initial planning

3. The five elements of a strategic understanding of the client’s business are:

1. Industry and External Environment – Understand risks and accounting

Copyright © 2020 Pearson Education Ltd.

1. The preliminary judgment about materiality is the maximum amount by

2. A preliminary judgment about materiality is set for the financial statements as

7-2 The new auditor (successor) is required by auditing standards to communicate

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The predecessor is required to respond to the successor ’s request for

7-7 Companies frequently communicate the entity’s values and ethical

7-8 A related party is defined by auditing standards as an affiliated company,

Identify Related Parties - transactions with related parties are important to

It is important to read the minutes early in the engagement to identify items

7-12 The purpose of a client’s performance measurement system is to measure

Performance measurements for a chain of retail clothing stores could

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1. Making internal comparisons to ratios of previous years or to budget

7-15 Materiality is defined as the magnitude of misstatements that individually,

7-16 Materiality is important because if financial statements are materially

7-17 Because materiality is relative rather than absolute, it is necessary to

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The least amount of performance materiality was allocated to cash and

7-22 If performance materiality for accounts receivable is $40,000 and the

Discussion Questions And Problems

7-23 1. 1 (1) Accept client and perform initial audit planning.

7-24 a. A related party transaction occurs when one party to a transaction

b. (1) Related party transaction. Canyon Outdoor has entered into

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c. When related party transactions or balances are material, the

1. The nature of the relationship or relationships.

d. Auditors can determine the existence of material transactions with

1. Obtain background information about the client in the manner

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BUSINESS RISK IMPACT ON FINANCIAL STATEMENTS

Obsolescence of parts Potential write-down of inventory if there is

Potential liability related to Potential contingent liability recorded on the

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2. Approval of additional During analytical procedures, an increase in administrative

3. Approval to engage in Determine the status of any potential acquisition or

4. Potential negative Evaluate the status of any resolution of negotiations with

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5. Officers’ bonuses. Determine whether bonuses were accrued at 12-31-18

6. Discussion at the Determine what, if any, decisions made at either

October 21: During analytical procedures, both the decrease in

2. Approval of the Examine acquisition documentation and financing

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2019 40.6% 32.0%

The explanation given by A nand is correct in part, but appears to

b. As the auditor, you cannot accept A nand’s explanation if $82,000

7-28 a. 1. Commission expense could be overstated during the current

b. ITEM 1 – Make an estimated calculation of total commission expense

ITEMS 2 AND 3 – Use audit software to compute turnover by

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7-30 a. The direct projection of error = (misstatements/amount sampled) x