Solutions for Chapter 8

Tools to Gather Audit Evidence

Review Questions:

8-1. The three main tools the auditor might use in gathering and evaluating audit evidence are:

• Audit sampling
• Generalized Audit Software
• Analytical procedures

8-2. Non-sampling risk is the risk that the auditor makes an improper assessment of inherent
and/or control risk or did not apply audit procedures carefully. It can be minimized
through:
(1) Good hiring, training and supervision practices; and
(2) Careful and knowledgeable review of audit documentation and audit procedures.

Sampling risk is the risk that the misstatement projections based on the sample results
lead to the wrong conclusion about the population because of a non-representative
sample. Sampling risk can be reduced by increasing the sample size – to the extreme of
auditing the entire population therefore eliminating sampling risk altogether.

8-3. Factors to consider when choosing between statistical and nonstatistical sampling
include:
• Need to quantify and control sampling risks.
• Additional cost of designing, selecting, and evaluating a statistical sample.
• Availability of computer software to assist in designing, selecting, and/or
evaluating the sample.
• Ability of the audit staff to properly implement statistical sampling.

8-4. a. Tolerable deviation rate depends on the significance of the control procedure being
tested and the degree of reliance the auditor wishes to place on it. The auditor, in
essence, considers the effect of the failure on potential material misstatements in the
financial statements. The tolerable failure rate is the rate beyond which the failure of
an important control procedure could lead to material misstatements in the financial
statements.

b. Expected failure rate is usually based on prior year experience, knowledge of

factors likely to cause it to be different this year (such as a change in the system or
personnel), and/or expectations based on experience with other clients with similar
systems and personnel. If prior experience does not exist with the client, the auditor
can make an estimate from a preliminary sample. Alternately, the auditor could use
judgment to make a conservative estimate.

8-1
 c. Allowable risk of assessing control risk too low (sampling risk) is usually set
equal to the overall audit risk. However, the choice is a matter of audit judgments
and should be modified to reflect the business risk of the client.

8-5. a. An increase in sampling risk results in a smaller sample because the auditor is
willing to accept more risk of the audit conclusion being in error. As a general
sampling rule, the more risk the auditor is willing to take of being wrong, the smaller
will be the sample size.

b. An increase in the tolerable failure rate results in a smaller sample because the
sample does not have to be as precise - there is a bigger range between the tolerable
failure rate and expected failure rate. Additionally, the auditor has concluded the
control is less critical than otherwise - also resulting in a smaller sample size.

c. An increase in the expected failure rate results in a larger sample results because the
sample has to be more precise - there is a smaller range between the tolerable failure
rate and expected failure rate.

d. Increase in population size normally does not affect the sample size unless the
population size is relatively small; then a larger sample would be required, but not in
proportion to the increase in population size.

8-6. The achieved upper limit means that there is only a 5 percent chance that the failure rate
(the percentage of time the control procedure fails to operate properly) in the population
exceeds 7.7 percent. The auditor compares the upper limit with the tolerable rate. If it
exceeds the tolerable rate, the auditor should conclude the control procedure is not
working as effectively as expected and revise the assessment of control risk.

8-7. Identifying the audit objective helps determine the appropriate population to test. For
example, if the audit objective is to test accounts receivable for overstatement, the auditor
should select the sample from the recorded receivables. If the audit objective is to test
accounts payable for understatements, the sample should be selected from a
complementary population such as subsequent cash disbursements rather than from the
recorded payables.

8-8. It is most appropriate to use MUS sampling when testing for potential overstatement of an
account balance and few or no misstatements are expected.

8-9. Both the Most Likely Error and the Upper Error Limit (UEL) should be computed. The
appropriate factor for making a decision is to compare the upper error limit with the
tolerable error that was originally set by the auditor. If the UEL exceeds to tolerable
error, the auditor should perform additional work – either examining the pattern of
misstatements or examining a larger sample. The rationale is that the auditor – in setting
parameters for sampling – is stating that he or she is not willing to accept more than an
X% risk that the unknown errors could exceed tolerable error. If UEL exceeds tolerable
error, then the risk is higher than the auditor had initially set as acceptable. Since several
errors were found in the sample, the MUS evaluation will be very conservative and may

8-2
 lead the auditor to believe there may be a material misstatement in the population when
there is not. The auditor should consider evaluating the sample using one of the classical
variables estimation sampling methods, such as difference estimation.

8-10. When using nonstatistical sampling, the auditor must use judgment in determining the
sample size, selecting the sample, and evaluating the sample results:

a. In determining the sample size the auditor should consider the variability of the
population, risk of incorrect acceptance, tolerable misstatement, expected
misstatement, and the population size.

b. The sample may be selected any way the auditor believes is representative of the
population: haphazard or random based.

c. As is true for statistical sampling, the sample results should be projected to the
population and compared with the tolerable misstatement. The auditor should also
consider whether there is an adequate allowance for sampling error, the difference
between the projected misstatement and tolerable misstatement.

8-11. The following information is needed to design a MUS sample:

• Test of details risk (risk of incorrect acceptance).

• Tolerable misstatement.
• Expected misstatement.
• Population book value.

The test of details risk is obtained from the risk model and is related to audit risk,
inherent risk, control risk, and other substantive procedures (analytical procedures) risk.

Tolerable misstatement is related to planning materiality. In some firms, tolerable

misstatement and planning materiality are the same amount. In other firms, tolerable
misstatement is derived from, but smaller than, planning materiality.

Expected misstatement is a conservative estimate often based on prior year experience

adjusted for known changes in personnel and the internal control structure.

The population book value is usually an account balance found in the general ledger or
the total amount of a class of transactions derived from the accounting records.

8-12. When planning a test of details using MUS, some CPA firms set tolerable misstatement
equal to planning materiality. The principle of MUS is that the samples are considered to
be drawn from the financial statements as a whole, and, therefore, the precision required
relates to the financial statements as a whole. Other firms use a percentage of planning
materiality reduced by expected misstatements in other accounts.

8-13. PPS sample selection is based on random dollars or a systematic process with a random
start. Each dollar in the population has an equal chance of being selected. Items with

8-3
 larger dollar values have a better chance of being selected than items with smaller dollar
values. Therefore, the probability of selecting an item is proportional to the number of
dollars that make up that item.

8-14. All else being equal, the effect of an increase in the following on a MUS sample size is:
a. Increase in tolerable misstatement Smaller.
b. Increase in expected misstatement Larger.
c. Increase in the allowable detection risk Smaller.
d. Increase in the population Little effect.

8-15. There are two possibilities for dealing with negative balances. If there are just a few
negative items with a relatively small value, they can be treated as positive values when
selecting the sample. Otherwise, they should be separated from the other items and tested
as a separate population.

8-16. Basic precision is an allowance for sampling error and is the upper misstatement limit
when no misstatements are detected in a MUS sample. It also is a part of the upper
misstatement limit when misstatements are found. It is computed by multiplying the
sampling interval actually used to select the sample by the reliability factor related to the
risk of incorrect acceptance (detection risk).

8-17. If client misstatements are treated as timing differences or timing differences are treated
as misstatements, the auditor may come to the wrong conclusion about the population.
Timing differences and customer errors require no further investigation because they do
not indicate inaccuracies in the client's records. Client errors should be projected to the
population before arriving at a conclusion about that population.

8-18. The alternative courses of action are:

• Increase the sample size.
• Have the client correct the known misstatement.
• Analyze the causes of the misstatements and design an alternative audit strategy.
This is often the most desirable course of action.
• Change the audit objective from estimating the extent of possible misstatement in a
population to estimating what the correct population value should be. In this case, the
detection risk and tolerable error must be decreased, resulting in a significantly larger
sample size.

These alternatives are appropriate in any sampling application whether statistical or

nonstatistical.

8-19. Generalized audit software (GAS) is designed to perform common audit tasks on a variety of data
files. For example, GAS can perform such functions as footing files, selecting samples, or
performing other analytical review techniques. The major advantages of GAS exist in each of its
functions related to reading files, analyzing data, and otherwise supporting the audit effort. To be
able to do these functions electronically saves time and money, while providing the 100%
accuracy of a computer. One must note, however, that although computer error is not possible,
human error is. In this way, the way an auditor inputs data into GAS and sets up the computer to
perform functions is prone to error.

8-4
8-20. GAS has the ability to assist the auditor in evaluating whether or not internal controls are
operating effectively. A good example is the control over the amount of credit that can
be issued to a particular customer. The credit manager should have a list (or data file) of
the amount of credit allowed per customer (and for groups of customers with common
ownership). The auditor can read the existing customer files, group them according to
common ownership, and then compare the amount outstanding with the credit limit.
Accounts where the current balance exceeds the credit limit would indicate a failure of
the credit control. The auditor would want to investigate to determine the cause of the
control failure. Further, since the auditor has a list of the total amount of accounts where
the actual credit exceeds the credit limit, the auditor has a gauge of whether or not the
control failure could be material.

8-21. GAS is very useful in assisting the auditor in planning and executing statistical sampling
including:

• Developing a profile of the population to be examined. For example, developing a

graph of the dollar amounts of individual accounts and presenting them in deciles or
some other format,
• Footing the files.
• Determining sample sizes based on the auditor’s judgments regarding important
parameters.
• Randomly selecting items for auditor evaluation.
• Evaluating sample results based on misstatements or control failures identified during
the audit work.
• Identification of negative items in the account balance.
• Interfacing with word processing to print confirmations or print other information
needed to gather evidence associated with sampling procedures.
• Performing a file review indicating whether there are items in the population that
show evidence of (a) control failures, or (b) control override.

8-22 The basic assumptions that must hold in using analytical procedures are as follows:

1. The company has adequate internal controls over the account balance.
2. Detection Risk can be relatively high, thus allowing proper inferences from indirect information
to conclude about the correctness of an account balance.
3. The underlying data used in evaluating the correctness of an account balance is both relevant and
reliable – and when using internal data, that data has already been audited.
4. The relationships between the underlying data and the account balance being evaluated must be
logical and justified by current economic conditions.

8-23. A client estimate should be based on information gathered by the client, and a model
developed by the client. The client takes full responsibility for the quality of the estimate,
and should perform work to verify the veracity of the estimates. For example, the client
should periodically compare the amount of receivables written off versus the amount that
is written off as bad debt expense in creating the allowance. The auditor must be careful
to use their own assumptions and estimates in conducting analytical procedures rather

8-5
 than relying on those developed by the client. An analytical procedure is a technique used
by the auditor to assess the interrelationship of accounts or data to determine whether or
not the client’s recorded amounts appear to be reasonable.

8-24. If the auditor determines that detection risk must be very low, then the auditor is also
stating that control risk must be very high. Recall that the only way for detection risk to
be determined to be very low is that IR and CR must be very high. Given that IR and CR
are very high, then an analytical procedure – as the primary evidence in assessing the
correctness of an account balance – would not be appropriate. The relationship between
sales and cost of sales could easily be manipulated if the client does not have good
internal controls.

Multiple Choice Questions:

8-25. c
8-26. a
8-27. c
8-28. b
8-29. a
8-30. d
8-31. c
8-32. c
8-33. b
8-34. d

Discussion and Research Questions:

8-35.

See Exhibit 8.1 below for an overview

Exhibit 8.1

Audit Evidence Gathering Procedures and Audit Assertions

Financial
Statement Approaches to Gathering Evidence Regarding Financial
Assertion Statement Assertions
Existence • Sampling – take a sample and examine underling evidence,
or send out confirmations.
• Analytical procedures – comparison with previous year’s
data or other economic indicators.
• Examination – 100% review of transactions or data on a
computer system to determine proper classification.
• Computerized audit software – sorting the file to identify
the largest items, the smallest items, or the most frequent
items within it; also useful for identifying unusual
transactions.

8-6
 • Block transactions reviewed for proper classification, e.g.
cut-off tests at year-end.
Completeness • Sampling – take a sample to search for under recorded
liabilities.
• Analytical procedures – comparison with previous year’s
data or other economic indicators.
• Block transactions reviewed for proper classification, e.g.
cut-off tests at year-end.
Rights • Sampling – often done in conjunction with existence
testing, back to source document.
• Analytical procedures – to look for unusual relationships
(cash higher or lower than expected or similar anomalies in
the underlying data.)
Valuation or • Sampling – selecting items and tracing back to source
Allocation documents, e.g., purchase agreements or invoices.
• Analytical procedures – examination of models used to
predict estimated amounts such as allowance for
uncollectible accounts.
• Computerized audit software – footing the file.
• Analytical procedures – to identify anomalies in underlying
data.
Presentation and • Sampling – to verify estimates or other items for proper for
Disclosure disclosure.
• 100% review, such as reading the notes in the financial
statements.

8-36.

a. & e.
a. e.
Tolerable Expected Sample Number of Upper
Control Rate Rate Size Deviations Limit
1 5% 0% 45 0 2.9
2 5% 1% 77 3 8.2
3 10% 0% 22 1 4.8
4 5% 0.5% 77 1 4.8
5 10% 3% 52 2 6.6

b. The sample size for control 2 is larger because the expected rate is higher than for
control 2, thus requiring the sample to be more precise. The sample size for control 3
is smaller because the tolerable rate is higher and, thus, the sample does not have to
be as precise.
c. The sample sizes will be smaller because the auditor is willing to accept a higher risk
of coming to the wrong conclusion.

8-7
 d. This is a cost/benefit decision. The auditor needs to determine whether the extra
time it will take to audit the extra items for controls 1, 3, and 5 is more or less than
the time it will take to keep track of which sample item to test for which control.
e. See matrix for answer a. above.
f. The auditor can rely on controls 1, 3, 4, and 5 as planned because the upper limit is
less than the tolerable rate in each case.

8-37.
a. In any sampling application there is likely to be sampling error. The upper limit
takes sampling error into account and is the best indicator of the maximum failure
rate in the population and should be compared to the tolerable failure rate.

b. The alternative courses of action are:

• A compensating control procedure could be identified and tested. The decision to

test the compensating control procedure will depend on the perceived
effectiveness of the control and the additional cost to test the control procedure.

• A larger sample could be taken, but this is not likely to be cost-beneficial unless
the auditor has reason to believe the original sample was not representative.

• The assessment of control risk can be set higher than originally planned and the
nature, timing, and/or the extent of the related substantive tests can be modified.
If the upper limit does not exceed the tolerable failure rate by very much, this
modification could be very slight. For example, if the upper limit was 5.4% and
the tolerable rate was 5%, very little modification is needed.

• The auditor will analyze the nature of the control procedure failures and
determine the implications on the type of misstatements, or causes of
misstatements, that might occur in the financial statements and adjust the nature,
timing, and/or extent of the planned substantive testing.

8-38.

a. The supplemental information is important to answering this question. Each attribute,

by itself, is important. But, the combination of attribute failures is also important
information when one considers that the divisional manager has strong incentive to
possibly misstate. Thus, the combination of failures on attributes (1) and (3) are
critically important. Shipping documents could not be located on 5% of the sampled
items. In addition, the divisional manager is overriding the credit function to get items
approved for processing. This should provide a strong signal, coupled with the two
potential "red-flags" contained in the supplementary information to cause the auditor
to consider the possibility that fraud could be taking place and to expand substantive
tests accordingly.

8-8
Credit Approval
The credit approval process was by-passed by the divisional sales manager. The
auditor should seek to understand why the approval process was by-passed. Is there,
for example, pressure to show increased sales for the period, or is it simply the work
of the sales manager that led to the new sales and the sales manager personally
approved the credit? The auditor should also inquire as to the existence of other
sales in which credit approval has been by-passed because the divisional sales
manager made the sales. Finally, the auditor should examine the nature of the sales
and the type of customer to determine if there appears to be any extra credit risk
associated with these new customers. The auditor should then evaluate the potential
effect on the collectibility of accounts receivable. The auditor may want to inquire
of the credit department as to whether or not the sales would have been approved.

Sales Price
The auditor would be concerned with a pattern here. Five of the six exceptions are
by a senior sales manager who is giving large discounts. Evidently the seniority of
this individual allows him to override the control structure. The auditor should
review other selected transactions by this sales manager to determine the extent of
sales price reductions. The auditor should also inquire of the divisional manager as
to whether the other price deviation would have been approved. The price reductions
do not affect the fairness of the financial statement presentation - sales are simply
billed at lower prices - but it does represent a potentially serious operational problem
that should be reported to senior management.

Lack of Shipping Document

There is a concern here that 5 documents were not located. These could indicate
sales that were recorded, but never shipped. The concentration of the deviations at
year-end, coupled with other danger signals (overriding of credit approval) creates a
situation where there appears to be heavy pressure to inflate sales. The auditor
would likely expand year-end testing of the occurrence of recorded sales.

b. Substantive Audit Implications:

Lack of Credit Approval

The accounts receivable may contain more credit risk. The auditor will pay more
attention to the aging of accounts receivable, and will particularly want to investigate
the large sales that did not contain credit approval for possible non-collection. For
customers with old large unpaid balances, the auditor would likely review credit
reports, such as Dun and Bradstreet. The auditor would also likely want to send
accounts receivable confirmations to these customers and do more extensive review
of subsequent collections.

Sales Price
This is more difficult because if the invoices are priced too low, the sale is still
recorded correctly. As indicated in part “a” above, the auditor would attempt to
determine the full extent of the under-pricing of the sales and communicate the effect
to management and the audit committee.

8-9
 Lack of Shipping Documents
The fact that the absence of shipping documents related to sales recorded near the
end of the year raises an issue of either fictitious sales or sales recorded in the wrong
period. The auditor should expand the review of transactions near the end of the
year to determine that they are recorded in the correct time period.

c. The lack of credit approval and absence of shipping documents on 8% of the 100
tested transactions should lead to the conclusion that there are material weaknesses
in internal control and, if this is a public company, result in an adverse opinion on
the client’s internal controls.

8-39.

a. Specific controls that the auditor should consider include:

 all purchase orders have authorized purchase requisitions from inventory.

 all purchase orders are sequentially numbered and accounted for,
 receiving reports are prenumbered and accounted for,
 receiving clerk notes the number of items received,
 clerk compares vendor invoice with purchase order to verify price and with
receiving report to verify quantity received, (noted by checkmark verification),
 discrepancies are forwarded to purchase department for follow-up and approval,
 clerk checks the clerical accuracy of the invoice,
 payable clerk matches everything and approves for payment,
 all information is entered into the computer system for payment.

The rationale for the items identified above is that controls are a “package” that are
designed to ensure that proper goods are ordered, they are received, they are paid for at
an approved rate, and that all items that are received are set up for payment in a timely
basis. In other words, the controls act as a composite to ensure that all purchases are
properly accounted for.

b. Examples of tests that could be performed are as follows:

 Take a random sample of paid vendor invoices and trace back through the system
noting the following:
o approval by accounts payable supervisor,
o indication that the clerk performed the prescribed procedures, i.e. there is
an attached purchase order and that the goods paid for match the goods
that were received per the receiving report and were paid for at the price
authorized in the purchase order.
o all items with discrepancies had been reviewed by the purchasing
department and were properly authorized.
 Follow-up to determine the reason for any discrepancies, e.g. invoices for services
or where no purchase order was expected. Determine that proper approval for
payment was obtained.

8-10
  Take a random sample of receiving slips and trace to purchase orders and to
vendor invoices. Determine that the items had been set up for payment in a
timely fashion.

c. Determining sampling risk, tolerable rate, etc:

The purpose of this part of the question is to get students thinking about these issues.
There are a few points that need to be made:

 The tests involving determining the sequencing of documents is not a statistical

sample and thus does not involve statistical sampling.
 Payment of vendor invoices, if not properly controlled, is a high risk area for
many small businesses. Thus, the company should utilize a very low level of
sampling risk. Our suggestion would be the 5% level.
 Tolerable failure rates:
o No purchase order or receiving slip attached, and not for goods that would
otherwise be received: low tolerable failure rate, e.g. 1% because it may
indicate fraud.
o Quantities different than purchase order: this often happens because of
shipping problems or changes in production models. A higher tolerable
rate such as 5–7% could be tolerated.
o Purchase price differs from purchase order: all of these should be
approved by the purchase department. Should expect a low level of
noncompliance and a low tolerable rate, e.g. 3–4%.

 Other Considerations: The auditor needs to consider the fraud risk indicators. If
the fraud risk indicators are high, then the tolerable failure rates should be set very
low. If there is little evidence of fraud risk indicators, there are other good
monitoring controls, etc, most of the tolerable rates identified above could be set
at around the 5% level to keep the sample size lower. However, if the auditor
finds many errors at this rate, it would indicate the system is not working as
prescribed and the auditor would most likely want a lower tolerable rate because
of the increased likelihood of fraud.

8-40.
a.
Control Upper Limit of Control Failures
1 Only 25 of the 100 sales tested were over $10,000 and all were properly
approved. The auditor should use his/her judgment for this and
probably conclude this control is working effectively.
2 Since the control calls for credit approval to be noted on the customer
orders, there are five failures (the auditor must conclude there was no
credit approval for the two sales for which no customer order could be
found). The upper limit of control failure is, therefore, 10.3% and far
exceeds the tolerable failure rate of 5%.
3 The upper limit is 7.6%.
4 The upper limit is 9%.

8-11
 5 The upper limit is 3%.
6 The upper limit is 6.2%.
7 There are 6 failures. The upper limit is 11.5%.

b. The upper limit of control failures for all controls tested except 1 (sales manager
approval of sales over $10,000) and 5 (proper pricing) exceeded the tolerable failure
rate. Thus there are problems with proper credit approval, lack of supporting
shipping documents and customer orders, premature recording of sales, and billing
for larger quantities that customers ordered. These problems with internal controls
should result in an adverse opinion on internal controls.

Control c. Potential Misstatements d. Effect on rest of audit

2&6 The allowance for doubtful accounts • Carefully review the aging of the
may be understated because of the lack year-end receivables.
of proper credit approval. • Increase coverage of confirmations
and subsequent collections.
The lack of customer orders for two • Increase the extent of cutoff testing
recorded sales could mean that the sales particularly for sales recorded just
were not ordered by customers resulting prior to year-end.
in artificially inflated sales. • Review the extent of subsequent
sales returns to determine if they are
3 The lack of shipping documents could more than normal. This may require
indicate misplaced documents or that estimating sales returns and
the sales did not take place. The auditor allowances as of year-end to match
should be professionally skeptical and with the sales.
assume the worst – the sales did not take • Heightened alertness to other
place. approaches management may use to
manage its earnings, particularly in
4 Sales being recorded prior to shipment the area of accounts based on
could be an honest mistake due to the estimates
temporary employee. However, this
may result in sales recorded in the
current year that should be recorded
next year.

7 Billing for more quantities than

customers ordered results in inflated
sales and receivables.

8-12
8-41.

a. Items 1, 2, 3, 4, 6, and 8 are misstatements if a misstatement is defined as affecting

the account balance. Item 9 would also be a misstatement if credit was taken for the
discount and the customer’s account was credited in full but the client always re-bills
for discounts taken after the discount period. Items 2 and 5 do not affect income.
Item 7 is a legitimate timing difference, not a misstatement.
b. All of the items affecting the account balance in part “a” also affect pre-tax income
except for item 2.

8-42.
a. Lower stratum projected misstatement: ($600/$185,000) * $1,500,000 = $4,864.86
Plus top stratum misstatement 1,000.00
Total projected misstatement $5,864.86

b. Tolerable misstatement has been set at $25,000 so the projected misstatement is

significantly less than tolerable misstatement. No further work needs to be
performed.

c. If the results would not have been acceptable, the auditor could:
 Increase the sample size.
 Analyze the misstatements and, if a common cause of the misstatements is
discovered, design an alternative audit strategy to determine the total
misstatement that is likely in the population.
 Have the client correct the known misstatements. The correction can be
subtracted from the upper misstatement limit, which may bring it below the
tolerable misstatement.
 The auditor could change the audit objective from testing the fairness of the
account balance to estimating what the account balance should be. This would
require using a statistical sampling approach with a low acceptable risk of
incorrect acceptance and tolerable misstatement.

8-43.
a. 1. Tolerable misstatement is the maximum amount of misstatement in the population
that the auditor can accept. This is usually set at less than the planning materiality
such that when combined with projected misstatements in other accounts, the total
does not exceed planning materiality. Some firms us a decision heuristic of 75%
of planning materiality less expected misstatements in other accounts.
2. Expected misstatement is the auditor’s best conservative judgment as to the likely
misstatement in the account. It is usually based on prior year results adjusted for
any changes in risk, such as changes in personnel or the accounting system.
3. Risk of incorrect acceptance (also called Detection Risk) is the risk the auditor is
willing to take that the sample results would cause the auditor to conclude there is
no material misstatement in the account when there is a material misstatement. It
is based on the established audit risk, the assessment of the risk of material
misstatement (the client’s Control Risk and Inherent Risk). DR = AR / (IR * CR).

8-13
8-44.

The auditor should audit the sales return credits recorded in early January to determine
the amount of returns that should have been recorded in December. The auditor then can
recommend that the client record a correcting entry and, at the same time, reverse the
sales returns entries recorded in January for December returns.

8-45.
a.
Sampling Sample
Case Risks Interval Size
AR IR CR DR

1 5% 100% 50% 10% 49,784* 114**

2 10% 100% 50% 20% 76397 74
3 5% 100% 25% 20% 76397 74
4 5% 50% 20% 50% 192,857 30
5 5% 50% 10% NA*** NA
100%

* [$175,000 – ($40,000 x 1.5)] / 2.31 = 49,784

** $5,643,200 / 49,784 = 113.4
*** 100 percent DR means that the test is not needed.

b.
Increase Effect on Sample Size
1. Audit risk Decrease
2. Detection Risk Decrease
3. Tolerable misstatement Decrease
4. Expected misstatement Increase

8-46.

a. Sampling Interval = $175,000 - ($40,000 x 1.2) = $104,959

1.21

b. Maximum Sample Size = 54 = $5,643,200

$ 104,959

c. $104,959 unless you round the interval down to $100,000, then the largest random
value is $100,000.

8-14
d. Items 4, 6, 10, and 14 would be included in the sample:
Sample
Item -
Cumulative Selection
Item Book Value Amount Amount

Random Start 25,000

1 3,900 28,900
2 26,000 54,900
3 5,000 59,900
4 130,000 189,900 100,000
5 2,000 191,900
6 260,000 451,900 200,300, &
400,000
7 100 452,000
8 25,000 477,000
9 19,000 496,000
10 10,000 506,000 500,000
11 9,000 515,000
12 2,500 517,500
13 65,000 582,500
14 110,000 692,500 600,000
15 6,992 699,492

e. The probability of selecting each item is as follows:

Book
Item Value Probability of Selection

1 3,900 3.9% = 3,900 / 100,000

2 26,000 26.0% = 26,000 / 100,000
4 130,000 100.0% = 130,000 / 100,000
6 260,000 100.0%

8-15
 f. The final sample size would be less than the maximum if there are some sample
items greater than $100,000 that include more than one of the selection amounts,
such as items 6 in part d.

8-47.

a. The audit conclusion if no misstatements are found in the sample is that the
auditor is 70 percent confident that accounts receivable are not overstated by more
than $121,000 (the basic precision = 1.21 x $100,000). Because this is less than
the tolerable misstatement of $175,000, you can conclude that the account balance
is not materially overstated.

b. The audit evaluation of the sample results is as follows:

UEL Tainting Sampling Dollar

Factor Percent Interval Conclusion

Basic precision 1.21 x 100,000 = 121,000

Most likely misstatement:
Top Stratum 2,000
Lower Stratum:
1st largest tainting % 5%
2nd largest tainting % 1%
6% x 100,000 = 6,000
Total most likely 8,000
Precision gap widening:
1st largest % 0.23 x 5% = 1.15%
2nd largest % 0.18 x 1% = .18%
1.33% 100,000 = 1,330
Upper misstatement limit 130,330

c. These results are acceptable because the upper misstatement limit ($130,330) is less
than tolerable misstatement ($175,000).

d. Alternative courses of action include these:

1. Have the client correct the known misstatements. The amount of the correction
can be subtracted from the total most likely misstatement and the upper

8-16
 misstatement limit. This may bring the upper misstatement limit below tolerable
misstatement.
2. Increase the sample size.
3. Evaluate the misstatements for a common cause and identify an alternative audit
strategy to determine the extent of the problem.
4. Change the audit objective from that of a substantive test to that of estimating
what the population value should be, probably using lower risk and smaller
tolerable misstatement.

8-48.

a. Detection risk is calculated as follows:

AR = IR x CR x DR
.05 = 1.0 x .25 x .5 x DR
DR = .05/.25 = .20 or 20%

b. The sampling interval is 91,925, or rounded down to the nearest 10,000 would be
90,000:
$200,000 – ($40,000 x 1.30) = $148,000 = 91,925
1.61 1.61

c. If the selection interval is rounded down to the next 10,000, the maximum sample size
would be: $8,425,000 / $90,000 = 93.61, or 94.

The actual sample size may be smaller because there may be items containing two
or more of the sampling intervals.

d. To calculate the most likely misstatement and the upper misstatement limit, the
auditor first has to determine if each difference is a misstatement. For
misstatements, the tainting percent needs to be determined for the lower stratum
items. That analysis is as follows:

Item Dollar/Percent Misstatement Problem

1. $0 / 0% Account balance is okay, just
posted to wrong customer.
2. $20,000 / 50% Credit memo problem.
3. $75,000 / Top stratum item Cost overrun.
4. $ 5,000 / Top stratum item Cost overrun
5. $ 122 / 100 percent Credit memo problem.

8-17
 The statistical analysis:

UEL Tainting Sampling Dollar

Factor Percent Interval Conclusion

Basic precision 1.61 x 90,000 = 144,900

Most likely misstatement:
Top stratum 75,000
5,000
80,000
Lower stratum:
1st largest tainting % 100%
2nd largest tainting % 50%
150% x 90,000 = 135,000
Total most likely misstatement 215,000

Incremental Allowance:
1st largest % 0.39 x 100% = 39%
2nd largest % 0.28 x 50% = 14%
53% x 90,000 = 47,700
Upper misstatement limit (UML) $407,600

Analysis: The projected most likely misstatement and the upper misstatement limit both
exceed the tolerable misstatement. The auditor would expand audit tests on the account
balance. There are two types of misstatement patterns that should concern the auditor.
First, there appears to be a problem with timely issuance of credit memos. The auditor
should find out more about the causes of the credit memo problems and examine the
process of issuing credit memos further. Second, there is a pattern of cost overruns on
large projects. The auditor would want to expand audit work to examine a number of
other large contracts to determine whether cost overruns were applicable to other
contracts, including those that had been closed during the period (sales may be overstated
even if there is a zero accounts receivable balance).

8-18
8-49.

a. The sampling interval is [$150,000 – ($30,000 x 1.5)] / 2.31 = $45,454.54

b. Most likely misstatement:

Overstatements Understatements

Basic precision = $45,000 * 2.31 = $103,950 $103,950

Most likely misstatement:
250 / 5,000 = 5% * 45,000 = 2,250
(300) / 10,000 = 3% * 45,000 = 1,350
net = $900 over (2,250 - 1,350)
Incremental Allowance:
5% * .58 = .029: 2.9% * 45,000 = 1,305
3% * .58 = .0174: 1.74% * 45,000 = 783
Total 107,505 106,083
Less most likely:
Understatement (1,350)
Overstatement (2,250)
Upper misstatement limit $106,155 $103,833

8-50.

a. Detection Risk is 25% calculated as follows:

AR = IR x CR x DR
.05 = 1.0 x .20 x DR
DR = .05/.20 = .25 or 25%

b. The sampling interval is 91,925, or rounded down to the nearest 10,000 would be
90,000:
215,000 – (45,000 x 1.25) = 158,750 = 114,208
1.39 1.39

c. If the selection interval is rounded down to the next 10,000, the approximate
sample size would be:
9,325,000 / 110,000 = 84.77, or 85.

The actual sample size should be somewhat smaller because there are likely to be
items in excess of the sampling interval.

8-19
 d. To calculate the most likely misstatement and the upper misstatement limit, the
auditor first has to determine the percent of misstatements on the items listed in
the problem. That analysis is as follows:

Item Dollar/Percent Misstatement Problem

1. $0 / 0% Account balance is okay, just
posted to wrong customer.
2. $35,000 / 64% Credit memo problem.
3. $ 0 or $60,000/ Top stratum Quality problem.
item
4. $ 20,000 / 19% Quality problem.
5. $ 100 / 20% Credit memo problem.

The statistical analysis:

UEL Tainting Sampling Dollar

Conclusion
Factor Percent Interval

Basic precision 1.39 x 110,000 = 152,900

Most likely misstatement:
Top stratum 0

Lower stratum:
1st largest tainting % 64%
2nd largest tainting % 20%
3rd largest tainting % 19%
103% x 110,000 = 113,300
Total most likely misstatement 113,300

Incremental Allowance:
1st largest % 0.31 x 64% = 19.84%
2nd largest % 0.23 x 20% = 4.60 %
3rd largest % 0.18 x 19% = 3.42%
27.86% x 110,000 = 30,646

Upper misstatement limit (UML) $296,846

Analysis: The most likely misstatement is greater than the expected misstatement and
upper misstatement limit greater than the tolerable misstatement of $215,000 even
without considering the dispute over the $125,000 receivable that cost the client an
additional $60,000. These results indicate the likelihood of a material
overstatement in the population.

8-20
 The auditor would expand audit tests on the account balance. There are two types
of misstatements that should concern the auditor:

• First, there appears to be a problem with timely issuance of credit memos.

The auditor should find out more about the causes of the credit memo
problems and examine the process of issuing credit memos further.
• Second, there is a pattern of quality problems. The auditor would want to
expand audit work to examine subsequent returns from customers and
credit memos issued after year end to determine the extent of additional
adjustments need to correct accounts receivable.

8-51.
a. The manual calculation of sampling interval and maximum sample size follows:

Interval = ($400,000 – ($10,000 *1.5)) / 2.31 = $166,667

Maximum sample size = $8,124,998.66 / $166,667 = 48.7 or 49

b. The most likely and upper misstatement limits are as follows:

Basic precision $166,667 * 2.31 = $ 385,000.77

Most likely misstatement:

Top Stratum misstatement 2,000.00
Lower Stratum misstatement:
5,000 / 41,906.45 = 0 .119313 * 166,667 = 19,885.54

Most likely misstatement $ 21,885.54

Incremental Allowance for Sampling Error:

.119313 * .58 * 166,667 =$ 11,533.61

Upper Misstatement Limit $ 418,419.92

c. The ACL results are shown below:

8-21
 Note the results are very similar but not exactly the same:

Manual ACL
Interval $166,667 $166,320
Maximum Sample Size 48.7 or 49 48
Most likely misstatement $21,885,54 $21,844.24
Upper Misstatement Limit $418,419.92 $417,553.90

8-52.
a. Generalized Audit Software (GAS) is designed to perform common audit tasks on a
variety of data files. Most audit firms use either a “general” GAS or have custom-made
software that achieves essentially the same purpose. GAS can perform such functions as
footing files, selecting samples, or performing other analytical review techniques.

Generalized audit software is a computer program that is designed to assist the

auditor in accomplishing many of the otherwise mechanical tasks that could be
performed much more efficiently by using the power of the computer. The
programs are generalized in that they are designed to interface with a variety of
file media and record formats.

There are several types of GAS packages. A program may contain programs that
create or generate other programs, or modify themselves to perform requested
functions, or provide query frameworks to assist the auditor in interrogating a file.
The most recent trend in GAS advancements is powerful software that is run on a
microcomputer. The auditor will download a copy of the client's file into the
microcomputer for processing by the GAS. Because the GAS can be standardized
on the microcomputer, it can be developed to be more user-friendly by non-
computer specialists. The standard interface will also assist audit firms in
reducing their training cost. The two most commonly used audit software

8-22
 packages used by internal and external auditors are ACL (Audit Command
Language) and IDEA (Interactive Data Extraction and Analysis).

Some of the typical functions performed by GAS include:

• foot a file, or a field within a file,

• perform mathematical calculations (add, subtract, multiply, divide),
• use Boolean logic to help select items (logical AND, or OR, or NOR),
• use relational selection criteria such as greater than, less than, or equal to,
• compute sample size and select statistical samples for a variety of
sampling techniques such as attribute sampling, PPS sampling, and
variables sampling,
• statistically evaluate sample results,
• perform regression analysis and other analytical review,
• interface with a word processing program to print confirmations,
• develop special reports as specified by the auditor,
• extract data from a client's file for further processing and analysis by the
auditor,
• compare, merge, or match the contents of two or more files.

b. Generalized audit software may be used effectively by Boos & Baumkirchner,

Inc. in the following manner:

1. Compare data on the CPA's inventory test counts to the inventory

compilation developed by the client. The software can then list all the
differences, the amount of differences, and the physical client location of
the differences. List all items in excess of a specified dollar limit that was
not listed by the auditors in making their test counts. List the location of
all items so the auditor can make a determination as to whether further
investigation is warranted.

2. Statistically or judgmentally select items for test counting, price tests, and
other inventory valuation tests.

3. Statistically evaluate the results of the audit testing.

4. Test obsolescence by:

• reading the client's file and listing all items which have not sold
since a date to be specified by the auditor,
• reading the client's file and listing all items or parts where the
quantity on hand seems excessive.
• reading the file and computing inventory turnover for products.
Analyze, by product line and products, any items where turnover is
less than an amount pre-specified by the auditor.

8-23
 • compute net realizable value for all items in inventory (based on
selling price less expected cost of disposal) and create a print-out
of all items where NRV is less than cost. Compute a potential
adjustment.
• compare items sold since year-end and compare with year-end
balances. Create a print-out where year-end inventory appears to
be excessive in relationship to post-year end sales. (Note:
seasonal fluctuations would have to be considered in such an
analysis.)

5. Test extensions by multiplying cost x quantity. List any differences.

6. Foot the file (this should always be the first procedure when using GAS).

7. Analyze inventory by locations (create a listing of inventory by locations)

to determine if excess inventory appears to be stored at any location.

8. Develop a list of major vendors with whom the organization has done
more than a specified dollar amount of business during the year. The list
may be used for further audit investigation such as looking for related
party transactions, identifying potential sales problems associated with
quality control, or verifying accounts payable.

8-53. GAS is a highly versatile and efficient audit tool. It can assist the auditor in
accomplishing each of the tasks identified as follows:

a. Existence
Statistically select samples,
Print out confirmations, including addresses
Once audited, compute statistical inferences

Allowance for Doubtful Accounts

Credit Limits – read the file and compare the current account balance with
the authorized credit for the company, or for groups of companies, where
applicable.

Age A/R – use a proper algorithm –usually based on when invoiced. Sort
according to invoice date, sum amounts by categories, e.g. current, 30
days past due, 60 days past due, and so forth.

Analyze by Credit Rating – sort the file (much as would be done on an

Excel spreadsheet), by credit rating, and sum the amounts by credit rating
and print out.

Sample for Credit Rating – take a PPS or Attribute sample. The auditor
has to either trace to a paper document, or if the data is available

8-24
 electronically, the auditor could download the other file and perform a
credit comparison between the files.

Develop a Model. Some audit software will allow the auditor to develop a
regression analysis based on appropriate data to compute an analytical
procedure that can be compared with the client’s estimate.

Test Valuation – the auditor could calculate subsequent payments made against
each outstanding balance. GAS could also be used to import outside data, e.g.
publicly available credit ratings for all accounts. The auditor could then sort
against the credit ratings and then analyze for potential uncollectibility.

Credit Memos – Review the file for all credit memos issued after year-end (up to
the date of the audit test). Analyze the file for nature of the credit memo issued,
i.e. determine a pattern for the credit memo. Sort the items into credit memos that
were applicable to the year-end balance. If the amounts are significant, take a
MUS sample to review underlying source documentation and discuss with the
client.

b. As noted above, many of the procedures involve both sampling and file validity
analysis.

8.54.
Answers will vary, but some potential situations that might be identified include:

Testing systematic relationships between accounts e.g. interest income compared to bond
holdings or saving, interest income compared to bond obligations.

Testing logical relationships, e.g. Depreciation Expense related to prior year’s

depreciation, updated for additions and deletions of assets. This would be more efficient
than testing individual accounts.

Computing independent calculations with data, e.g. calculating total salary expense by
job title in a CPA firm, e.g. total expense for seniors in an office based on average pay
times number of people involved.

Making sophisticated estimates using regression analysis with various model parameters.

Analyzing time series data of accounts and relationships, e.g. the amount of supplies
expense related to production.

8-25
8-55. Analytical tools could be used as follows:

1. Determine interest rate, discount rate or premium, and multiply it by the face of
the bond to determine interest expense. This would be the auditor’s expectation.
The auditor would also need to set an appropriate threshold and would then
compare the expectation with amount recorded by client. The auditor would
follow up on differences exceeding the threshold.

2. Use the methodology described in the text.

3. Compare supplies expense to production expense on a yearly basis to determine if

the expense is fairly stable. In this approach, the auditor’s implicit expectation is
that the expense balance will be the similar to the prior year. The auditor will use
this expectation in completing the analytical procedure.

4. COGS tends to average about 35% of sales in fast food franchises. The auditor
could perform a cross sectional regression analysis to identify stores that are out
of line – either indicating waste, inefficiencies, or potential fraud at the stores that
are out of line. In this case, the auditor’s expectation is that the client’s COGS
will be similar to the industry average. The auditor will use this expectation in
completing the analytical procedure.

5. Salary expense. Determine number of people at each job level, length of service,
and average salary for job and service. Multiply the data to determine the
auditor’s expectation. The auditor would also set an appropriate threshold and
would then compare the expectation with the amount recorded by the client. If the
auditor’s expectation is close (based on the threshold) to the client’s recorded
amount the auditor may be satisfied with the audit evidence collected. If the
difference between the expectation and the client’s recorded amount exceeds the
threshold, the auditor will need to use appropriate procedures to follow up.

Cases:

8-56. The incorrect assumptions, statements, and inappropriate applications of sampling are as
follows:

i. Classical variables sampling is not designed for tests of controls.

ii. MUS uses each dollar in the population, not each account, as a separate sampling
unit.
iii. MUS is not efficient if many misstatements are expected because the sample size
can become larger than the corresponding sample size for classical variables
sampling as the expected amount of misstatement increases.
iv. Each account does not have an equal chance of being selected; the probability of
selection of the accounts is proportional to the accounts’ dollar amounts.
v. MUS requires special consideration for negative (credit) balances.
vi. Tolerable misstatement was not considered in calculating the sample size.

8-26
 vii. Expected (anticipated) misstatement was not considered in calculating the sample
size.
viii. The standard deviation of the dollar amounts is not required for MUS.
ix. The three selected accounts with insignificant balances should not have been
ignored or replaced with other accounts.
x. The account with the $1,000 difference was incorrectly projected as a $1,000
misstatement; projected misstatement for this difference was actually $2,500
($1,000 / $4,000 x $10,000 interval).
xi. The difference in the understated account should not have been omitted from the
calculation of projected misstatement.
xii. The reasoning (the comparison of projected misstatement with the allowance for
sampling risk) concerning the decision that the receivable balance was not
overstated was erroneous.

8-57.

Part 1 (a). The information in the problem implies that there is a 10% chance that the actual
amount of the overstatement is no greater than $213,500. The implication of the
closeness of this amount to the tolerable misstatement is that the auditor should exercise
considerable caution in concluding that the account balance is correct in all material
respects.

Appropriate Course of Action Considering Option (a). Utilitarian Theory and Rights
Theory imply that the auditor should do what is in the interests of shareholders and debt
holders in this setting, since these stakeholders have a vested financial interest in the
accuracy of the financial information. These individuals have a right to receive financial
information that is correct in all material respects. Turning to the Ethical Framework, the
auditor should consider the following steps:

1. Identify the ethical issue. By doing no more audit work, the auditor is in danger of
concluding that the account balance is materially correct when, in fact, it may not be.
The auditor should analyze the causes of the misstatements. If they appear to be
errors rather than fraud, no further action is needed. However, if the misstatements
may be the result of fraud, further action is required.
2. Determine the affected parties. As noted above, the shareholders and debt-holders
are the most significant affected parties.
3. Develop alternative courses of action. One course of action is to do nothing, i.e.,
maintain the status quo and do no more sampling. Another course of action is to do
more sampling.
4. Determine likely consequences. If the auditor does nothing, the account balance may
be correct, and in that case there is no harm done. If the account balance is materially
overstated, the stock may be over-priced, or debt-holders may be providing funds at
inappropriate interest rates. If the auditor collects a larger sample, it may be that the
account balance is correct, and in that case there is no harm done (except that audit
effort is increased, which has an associated cost). If the auditor collects a larger
sample and finds that the account balance is decidedly overstated, then the auditor

8-27
 could insist that the client write the account down to a more reasonable level, and
stakeholder rights will be protected.
5. The Rights Framework would likely eliminate the “do nothing” course of action
because of the associated downside risk, which applies to many stakeholders. The
cost of collecting additional audit evidence is likely very small in relation to the
potential benefits achieved from calculating an accurate accounts receivable balance.
6. The appropriate course of action is to collect additional audit evidence.

Appropriate Course of Action Considering Option (b). Utilitarian Theory and Rights
Theory imply that the auditor should do what is in the interests of shareholders and debt-
holders in this setting, since these stakeholders have a vested financial interest in the
accuracy of the financial information. These individuals have a right to receive financial
information that is correct in all material respects. Turning to the Ethical Framework, the
auditor should consider the following steps:

1. Identify the ethical issue. By disregarding the detected overstatements, the upper
misstatement limit calculation is incorrect. The statistical conclusion will be invalid,
i.e., the account balance is clearly materially misstated if the auditor goes along
with what the senior proposes.
2. Determine the affected parties. As noted above, the shareholders and debt-holders
are the most significant affected parties.
3. Develop alternative courses of action. One course of action is to do nothing, i.e.,
maintain the status quo and do as the senior proposes. Another course of action is to
make the correct calculations and try to convince the senior that the associated
result is appropriate. A third course of action is to bring the matter to the attention
of the manager or partner immediately and involve them in the decision making
process.
4. Determine likely consequences. If the auditor does nothing, the account balance
will clearly be misstated, and stakeholders will be materially misinformed. If the
auditor convinces the senior to revise the calculation, the account balance can be
properly adjusted (assuming that the client agrees). If the senior is not convinced,
the auditor faces the difficult choice of ignoring the issue or notifying his/her
superiors, which will likely alienate the senior. But if the manager and partner agree
with the staff auditor, then the account balance can be properly adjusted. If the staff
auditor immediately informs the manager and partner, the same (hopefully good)
outcome can occur, but the senior will very likely be alienated from the staff
auditor.
5. The Rights Framework would clearly eliminate the “do nothing” course of action
because of the associated downside risk, which applies to many stakeholders. The
option of immediately informing superiors without first allowing the senior to
change his mind will lead to inevitable alienation in the audit team. The option of
trying to convince the senior may yield a positive outcome, and it allows the senior
to “save face” and change his mind before the staff auditor goes to his/her superiors.
6. The option of trying to convince the senior (and hoping for a good outcome) seems
like the best option.

8-28
Part 2. The information in the problem implies that there is a 10% chance that the actual
amount of the overstatement is no greater than $230,000. While this amount is greater
than the original tolerable misstatement amount of $215,000, it is less than the new
amount of $250,000.

The implication of the change in the tolerable misstatement amount with regards to
whether the accounts receivable amount requires downward adjustment is that the
new amount suggests that the misstatement is not material, so no adjustment would be
required. What is very important is whether the staff auditor believes the senior’s
rationale for the change (i.e., that the client is in good financial health and has
relatively strong internal controls). If that is truly the case, then there is no ethical
dilemma.

If that is not the case, then the auditor should follow the ethical framework outlined in
the text. That decision making might proceed as follows:

1. Identify the ethical issue. By altering the tolerable amount simply so that the
misstatement will not be material, the senior allows a materially misstated amount
to be reported. The additional ethical issue is that of the senior’s deceptive and
calculating behavior, which harms the character of the engagement team and the
audit firm.
2. Determine the affected parties. As noted above, the shareholders and debtholders are
the most significant affected parties. In addition, other individuals at the audit firm
are harmed because if this behavior is allowed to occur unchecked, then their right
to working at an ethical and professionally-bound workplace is violated.
3. Develop alternative courses of action. One course of action is to do nothing, i.e.,
maintain the status quo and do as the senior proposes. Another course of action is to
convince the senior that his proposal is inappropriate. A third course of action is to
bring the matter to the attention of the manager or partner immediately and involve
them in the decision making process.
4. Determine likely consequences. If the auditor does nothing, the account balance will
clearly be misstated, and stakeholders will be materially misinformed. If the auditor
convinces the senior not to falsely recalculate materiality, the account balance can
be properly adjusted (assuming that the client agrees). If the senior is not convinced,
the auditor faces the difficult choice of ignoring the issue or notifying his/her
superiors, which will likely alienate the senior. But if the manager and partner agree
with the staff auditor, then the account balance can be properly adjusted. If the staff
auditor immediately informs the manager and partner, the same (hopefully good)
outcome can occur, but the senior will very likely be alienated from the staff
auditor.
5. The Rights Framework would clearly eliminate the “do nothing” course of action
because of the associated downside risk, which applies to many stakeholders. The
option of immediately informing superiors without first allowing the senior to
change his mind will lead to inevitable alienation in the audit team. The option of
trying to convince the senior may yield a positive outcome, and it allows the senior
to “save face” and change his mind before the staff auditor goes to his/her superiors.

8-29
 6. The option of trying to convince the senior (and hoping for a good outcome) seems
like the best option.

Part 3. Management’s incentive is generally to overstate assets, including accounts

receivable. This trend of overstatements reveals either that management is
intentionally overstating the accounts, or they have not invested in adequate internal
controls or accounting staff to assure the accurate recording of accounts receivable.
Therefore, the audit firm should consider this issue in its client continuance decision,
increasing the assessed risk profile of management. The ethical implication of this
issue is that management may not be as trustworthy as previously thought. A lack of
trust has a pervasive effect on the audit because it calls into question management’s
possible motivations to misstate other accounts, or to provide inaccurate descriptions
of facts. Auditors in this situation will carefully consider whether they want to retain
this client in the future. If the audit firm does retain the client, the auditor should
increase their professional skepticism, heighten inherent risk assessments, and
conduct a more substantive audit as a result.

8-30
FORD MOTOR COMPANY AND
TOYOTA MOTOR CORPORATION:
ANALYTICAL PROCEDURES

1. Contrast the trends between Ford and Toyota in each of the following categories:

1a. Stock valuation

Ford: P/E ratio down significantly; price to sales relatively steady; price to book rebounded after
a fall in 2005; price to tangible book steady; price to cash flow steady.

Toyota: P/E high and improving; price to sales up; price to book up; price to tangible book up;
price to cash flow steady increasing.

Comparison: The comparison paints a rather dismal picture for Ford’s stock position across all
ratios. There must be tremendous pressure on Ford management to turn around the stock price.
Likewise, there is probably tremendous pressure on Toyota management to maintain the strong
stock numbers. Either situation provides an incentive for manipulation of the financial results by
management. The

1b. Dividends

Ford: dividend payouts have ceased.

Toyota: dividend yield and the payout ratio have steadily improved.

Comparison: The comparison again paints a dismal picture for Ford’s stock position, and
indicates that cash flow is simply not available for disbursal to shareholders.

1c. Growth

Ford: After a marked decline in 2006, sales growth was again positive in 2007; the decline in net
income and EPS growth has reversed, with the net loss in 2007 smaller than that in 2006; after
increasing in 2005, capital spending has slowed each of the past two years.

Toyota: sales growth much higher in 2007 after a slight dip in 2006; net income and EPS has
grown significantly in the past three years; capital spending down significantly over the past
three years.

Comparison: Ford is clearly on a downsizing mode in which the company is trying to minimize
capital spending and moderate the problems with sales and net income growth, while Toyota
continues a positive trend in all regards. Of interest is Toyota’s slowdown in capital spending.

1d. Financial strength

8-31
Ford: quick ratio improving, current ratio improving, debt to equity ratios quite unfavorable
given the very small values in shareholder’s equity; interest coverage declined markedly in 2006
but has rebounded to a marginally acceptable level in 2007; book value per share is down in
2007 compared to 2005, but is better than 2006.

Toyota: quick and current ratios at very respectable levels, but both are down slightly over the 3
year period; debt to equity ratios steady and acceptable; interest coverage strong and steady, but
with a decline in 2007; book value per share is high and improving.

Comparison: Ford’s ratios are again much worse than Toyota’s, with the most concern probably
involving the levels of debt that Ford must handle. However, Ford’s liquidity situation is, while
not good, at least manageable. In contrast, Toyota is having no troubles with liquidity or its
ability to pay its debts in a timely manner. The book value per share for Toyota is much stronger
than Ford’s.

1e. Profitability

Ford: after a dip in 2006, margins are rebounding in 2007 after significant declines in 2006.

Toyota: margins are steady and strong throughout the 3 year period.

Comparison: Toyota’s margins are very strong and steady, whereas Ford is clearly experiencing
difficulty attaining and achieving sustained profitability.

1f. Management effectiveness

Ford: all returns ratios are very low or negative, indicating very weak management effectiveness
in terms of use of shareholder’s assets.

Toyota: all returns ratios are high, steady, and improving, indicating very strong management
effectiveness in terms of use of shareholder’s assets.

Comparison: Again, the results of Ford are quite dismal compared to those of Toyota.

1g. Efficiency

Ford: revenue per employee has increased over the three year period and has improved in 2007
after a dip in 2006; net income per employee has declined over the three year period and is
negative in 2006 and 2007; receivable turns are slow and steady at about 1.5 times per year;
inventory turns are steady at about 13 times per year; asset and PP&E turns are steady;
percentage of PP&E depreciated is about 50-60%.

Toyota: revenue per employee has slightly increased over the three year period and is very
comparable in size to Ford; net income per employee is fairly stable over the three year period
and hovers around $45K per year; receivable turns are stable over the period at about 9.5 times
per year; inventory turns are fairly steady although a bit declining over the period at about 11
times per year; asset and PP&E turns are steady; percentage of PP&E depreciated is about 60%.

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Comparison: revenue per employee is very similar between the two companies, but the
profitability on that revenue is drastically different, with Toyota being much stronger in that
regard. Toyota turns their receivables much faster than Ford, although inventory turns between
the two companies are relatively similar. Both companies have PP&E that is similarly
depreciated, indicating similarly aged plant assets.

2a. What account balances warrant the greatest concern/attention in terms of audit
planning for Ford? What questions would you ask of Ford management regarding your
concerns?

The biggest issue facing Ford is financial viability, and that problem pervades virtually all their
account balances. The audit firm should be concerned about the company’s ability to remain a
going concern and to meet its debt obligations. Regaining profitability is a major concern for
Ford. Valuation of receivables is a concern given the low turns in that account compared to
Toyota. PP&E is a concern in terms of valuation given the large size of that account in
comparison to assets as a whole, and the capital intensive nature of the business.

Regarding questions to ask of Ford, the most significant issue is how they plan to regain
profitability. As we will see in a future chapter appendix, management had entered into a
contract to sell a significant portion of its business and close a large number of North American
production facilities.

2b. What account balances warrant the greatest concern/attention in terms of audit
planning for Toyota? What questions would you ask of Toyota management regarding
your concerns?

PP&E is a valuation concern given its large relative size, and the slight slowdown in inventory
turns (and the fact that it is below that of Ford) is a concern. Regarding questions to ask of
Toyota, the audit firm should inquire about why inventory turns have slowed, and management’s
plans for improving that metric.

2c. Assume you performing preliminary audit planning and could specify any statistic that
you wanted to review for inventory and receivables, e.g. number of days sales in inventory.
Looking at only those two accounts, identify 3 – 5 key financial indicators that you would
want to examine in developing an audit program for Ford and/or Toyota. Be prepared to
explain to your classmates why you identified the specific statistic you identified. You may
assume that you are auditing in a period of either no or slow growth in the economy.

This question is designed to encourage students to think about operating data and the importance
of operating data for the audit. The following list is not necessarily all inclusive, but represents a
start for a good class discussion:

Receivables:

% of receivables due from dealers vs. % due from consumers (finance receivables)
Overall financial health of dealers.

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Aging of receivables (partitioned by type of receivables)
Changes in interest rates in the economy (may affect valuation)
Changes in economic conditions, e.g. increases in bankruptcies, or poor financial health due to
the sub-prime crisis.
Changes in the composition of consumer receivables, e.g. amounts for car loans vs. mortgages,
etc.

Inventories:

No. of Days Sales in Receivables

No. of Days sales on hand
Composition of inventory, e.g. trucks, SUV’s, cars, economy cars, etc.
Backorders from dealers
Overall car sales in the industry and the company’s share of car sales
Quality of cars, e.g. the annual report from J. D. Power & Associates

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