Assume you are the audit manager for the 2015 audit of Fox Aeronautics,
Question # 00262514
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Updated on: 04/26/2016 12:04 PM Due on: 05/26/2016
Assume you are the audit manager for the 2015 audit of Fox Aeronautics, an SEC registrant. This
is your firm’s third year with Fox, a company that manufactures components used in airplane
assembly. Fox’s unaudited 2015 pretax earnings were $95 million. It is now mid-February 2016,
and your audit team is evaluating the following potential misstatements from the client’s yearend financial statements.
Income taxes. Fox’s tax attorney informed you that it is probable the client will have to
pay $7,500 in taxes regarding a tax dispute that began four years ago. The tax
professionals at your firm agree with the tax attorney’s assessment. Fox’s CEO told you
the company cannot estimate an amount, noting he is not aware of any similar cases that
would provide a good estimate. Therefore, the company did not record any contingent
liability for income taxes in the 12/31/15 financial statements. However, Fox did disclose
the situation in a financial statement footnote.
Inventory. The audit team conducted counts of Fox’s inventory on a sample basis. The
book value of the sample was 5% of the total inventory book value of $120,669,000. The
sample items were understated by $17,825.
Patent Infringement. In 2015, Fox was sued by a competitor for patent infringement. The
company recorded a contingent liability of $3,800,000 in its 12/31/15 financial
statements. Based on the legal letter and a follow-up discussion with the client’s attorney,
you are satisfied that it is unlikely at this point that the client will have to either pay a
settlement or lose the case in court.
Allowance for uncollectible accounts. Recently, Fox has had difficulty collecting credit
sales efficiently, and its days outstanding in accounts receivable has significantly
increased over the past two years. Consequently, Fox increased the percentage of credit
sales it uses for calculating the allowance for uncollectible accounts during 2015. Both
the board of directors and your firm agree with this change. Fox uses the allowance
method for accounting for bad debts, and despite the increase in the allowance account
itself, still required a bad debt replenishment of $7,489,800. Fox did not record this yearend adjusting entry.
Fixed Assets. An accounting error involving depreciation led to an overstatement of
depreciation expense by $1,950,000.
Questions:
1. (a) What is the aggregate misstatement? Show all calculations and explain why you
believe each potential misstatement is either a misstatement or is not a misstatement.
(b) Does the aggregate misstatement overstate or understate net income?
1
2. (a) How much of an overall adjustment would you require to issue an unqualified
opinion? Provide a specific amount (not a range) and explain your reasoning.
(b) How would you allocate your adjustment from 2(a) to the various accounts? Explain
your reasoning. If you did not make an adjustment in part 2(a), assume the partner asked
you to make a $1,000,000 adjustment and allocate it to the accounts in question.
2
Case 3-2: Audit Negotiations
Assume you are a partner and are wrapping up the 2015 audit of Houston Electric, an SEC
registrant with a 12/31 year-end. Houston works with builders and installs electrical systems in
new homes and businesses. Your firm has been auditing Houston for several years and has
always given standard unqualified opinions during this time. This year, Houston replaced its
CEO as part of a change in the company’s strategic vision. Houston has developed a five-year
plan to grow from a regional to national presence in the electronics installation market.
As part of your firm’s quality control procedures, each existing client is reviewed annually to
determine whether your firm will continue to audit the client (assuming the client wants to
engage your firm). Before this year’s audit, your firm decided to renew its contract with
Houston. However, as the lead partner, you did note concern in internal documentation regarding
the new CEO, Bob Davis. Specifically, Bob was very interested in accounting for fair value
adjustments for investments. Bob seems to believe that if GAAP doesn’t provide a precise
method of accounting, then the company can do whatever it wants as long as it abides by
relevant laws and regulations.
Your initial concerns about Bob led you to modify some of your risk assessments from prior
years, and change the audit plan accordingly. You initially established planning materiality for
Houston Technologies at $4.4 million, but you also know that a decrease in unaudited pretax
earnings by more than $4 million will cause Houston to miss the consensus analyst EPS forecast.
Following fieldwork for the 2015 audit, the audit team prepared the following list of items you
want to discuss with Bob Davis and the CFO (Joan Richards):
Depreciation Expense. In 2015 Bob Davis asked Joan Richards to evaluate the useful
lives of all depreciable assets. This change resulted in a reduction of depreciation expense
by $750,000. The audit team investigated this issue, and could not identify a reason to
change the useful lives of the assets involved.
Investments in available-for-sale (AFS) securities. Consistent with GAAP, Houston’s
accounting policy requires that the carrying value of AFS securities be regularly adjusted
to market value. Houston makes these adjustments monthly. Until this year, Houston used
a highly credible, well-known investment bank to provide market values for securities.
This year, Bob Davis changed the policy to use a local investment broker. Bob explained
that he went to college with the owners of the local firm, and they would go out of
business without the contract with Houston. According to diligent work performed by one
of your staff auditors, the year-end fair value of the AFS securities would have been
$1,275,000 lower if Houston had continued to use the national firm.
IT Equipment. The audit team identified an uncorrected accounting error involving the
acquisition of servers, computers, and other IT hardware purchased and installed on
1/2/2015. Houston did not book amortization expense for the portion allocated to 2015.
The amount involved is $3,800,000.
3
Your Discussion with Bob and Joan:
You: Thank you for meeting with me. I assume my staff forwarded you a summary of the issues
I’d like to discuss.
Joan: Yes, we received them, thank you.
Bob: So, let us know what you think. Do we need to book any adjustments?
You: I’m proposing the following adjustments: $3.8 million to correct the error involving IT
equipment, and a $1,275,000 decrease in the carrying value of your AFS securities portfolio. I
also need some more information about the change in depreciation policy.
At this point, Bob interrupts you.
Bob: I can accept the adjustment for the IT equipment. We made a mistake, that’s obvious. And
I’m ok with changing the AFS, that will go to other comprehensive income so we’ll still make
the basic EPS forecast. If we don’t meet that, I may be out of a job and the investors who hold on
to the stock will take a hit. But, come on, there is no problem with depreciation. What we did
was well within your accounting rules. Joan looked into it, and there’s nothing against
periodically evaluating the useful lives of depreciable assets. If you think about it, it’s really
more conservative this way since we’ll book more depreciation expense down the road than we
would have if we had not adjusted the useful lives. Plus, I doubt its material.
Questions:
1. How would you respond to Bob if you were in this situation? Your answer must include,
but not be limited to, whether you would propose an adjustment to depreciation and how
much of an adjustment you would propose ($0 if you do not propose an adjustment).
2. According to auditing standards, what information should you communicate to Houston’s
audit committee based on this case? Be sure to cite the appropriate standard(s). Do not
quote the standard(s); use your own words.
3. Assume you did propose an adjustment for depreciation. How much would you propose?
Why?
4. Assume you did not agree with the client’s change in depreciation method, and proposed
a $750,000 adjustment to depreciation expense/accumulated depreciation. Further
assume that the client did not book the adjustment. Which opinion would you offer?
Explain your answer.
5. Assume you agreed with the client’s change in depreciation method? Which opinion
would you issue?
4
Case 3-3: Opinions and Finishing the Audit
Assume you are a partner supervising the audit of Wildcat Grocers, a publicly-traded company
that supplies grocery stores with a 12/31 fiscal year-end. It is now mid-February 2016, and you
are considering which opinion to issue for the 2015 audit. You must sign the audit opinion no
later than February 25, and Wildcat must file its audited financial statements with the SEC by
March 5. All audit issues have been resolved to your satisfaction except two, which you must
decide how to address. Both of these issues are material.
Wildcat is losing market share to companies that offer products at lower prices. Sales
have been trending downward for several years, and operating cash flows have been
negative during this time. The CFO assured you that the company will make it through
this rough period. She described a plan that included issuing new stock and laying off
workers to maintain its long-term viability. The company’s stock price is now at an alltime low of $1.01 per share, and a report from an independent broker indicates that if
Wildcat issues new stock, it will provide the company sufficient capital to cover five
months of operations.
A significant portion of Wildcat’s inventory was destroyed in a fire on January 31, 2016.
The CFO included a footnote to the 2015 financial statements to disclose information
regarding the loss of inventory. She believes the company should receive an insurance
settlement for the full amount of inventory, minus a small deductible, no later than June
15, 2016. One of your audit staff independently reviewed the company’s insurance policy
and reached the same conclusion.
Questions:
1. According to auditing standards, what specific responsibilities does the auditor have in
evaluating the client as a going concern? Cite the appropriate standard(s) and describe
the auditor’s responsibilities in your own words.
2. Would you issue a going concern opinion to Wildcat? Why or why not?
3. Assume you decided to issue a going concern opinion and Wildcat was able to thrive in
2016, erasing any concern about its financial health. Does this mean that the going
concern modification was the wrong opinion? Why or why not?
4. According to auditing standards: (a) Describe the difference between Type I and Type II
subsequent events. (b) What procedures should an auditor perform to identify and
evaluate subsequent events? Cite the appropriate standard(s) and describe the audit
procedures in your own words.
5. Is Wildcat’s loss of inventory a Type I or Type II subsequent event? Explain your
reasoning.
5
is your firm’s third year with Fox, a company that manufactures components used in airplane
assembly. Fox’s unaudited 2015 pretax earnings were $95 million. It is now mid-February 2016,
and your audit team is evaluating the following potential misstatements from the client’s yearend financial statements.
Income taxes. Fox’s tax attorney informed you that it is probable the client will have to
pay $7,500 in taxes regarding a tax dispute that began four years ago. The tax
professionals at your firm agree with the tax attorney’s assessment. Fox’s CEO told you
the company cannot estimate an amount, noting he is not aware of any similar cases that
would provide a good estimate. Therefore, the company did not record any contingent
liability for income taxes in the 12/31/15 financial statements. However, Fox did disclose
the situation in a financial statement footnote.
Inventory. The audit team conducted counts of Fox’s inventory on a sample basis. The
book value of the sample was 5% of the total inventory book value of $120,669,000. The
sample items were understated by $17,825.
Patent Infringement. In 2015, Fox was sued by a competitor for patent infringement. The
company recorded a contingent liability of $3,800,000 in its 12/31/15 financial
statements. Based on the legal letter and a follow-up discussion with the client’s attorney,
you are satisfied that it is unlikely at this point that the client will have to either pay a
settlement or lose the case in court.
Allowance for uncollectible accounts. Recently, Fox has had difficulty collecting credit
sales efficiently, and its days outstanding in accounts receivable has significantly
increased over the past two years. Consequently, Fox increased the percentage of credit
sales it uses for calculating the allowance for uncollectible accounts during 2015. Both
the board of directors and your firm agree with this change. Fox uses the allowance
method for accounting for bad debts, and despite the increase in the allowance account
itself, still required a bad debt replenishment of $7,489,800. Fox did not record this yearend adjusting entry.
Fixed Assets. An accounting error involving depreciation led to an overstatement of
depreciation expense by $1,950,000.
Questions:
1. (a) What is the aggregate misstatement? Show all calculations and explain why you
believe each potential misstatement is either a misstatement or is not a misstatement.
(b) Does the aggregate misstatement overstate or understate net income?
1
2. (a) How much of an overall adjustment would you require to issue an unqualified
opinion? Provide a specific amount (not a range) and explain your reasoning.
(b) How would you allocate your adjustment from 2(a) to the various accounts? Explain
your reasoning. If you did not make an adjustment in part 2(a), assume the partner asked
you to make a $1,000,000 adjustment and allocate it to the accounts in question.
2
Case 3-2: Audit Negotiations
Assume you are a partner and are wrapping up the 2015 audit of Houston Electric, an SEC
registrant with a 12/31 year-end. Houston works with builders and installs electrical systems in
new homes and businesses. Your firm has been auditing Houston for several years and has
always given standard unqualified opinions during this time. This year, Houston replaced its
CEO as part of a change in the company’s strategic vision. Houston has developed a five-year
plan to grow from a regional to national presence in the electronics installation market.
As part of your firm’s quality control procedures, each existing client is reviewed annually to
determine whether your firm will continue to audit the client (assuming the client wants to
engage your firm). Before this year’s audit, your firm decided to renew its contract with
Houston. However, as the lead partner, you did note concern in internal documentation regarding
the new CEO, Bob Davis. Specifically, Bob was very interested in accounting for fair value
adjustments for investments. Bob seems to believe that if GAAP doesn’t provide a precise
method of accounting, then the company can do whatever it wants as long as it abides by
relevant laws and regulations.
Your initial concerns about Bob led you to modify some of your risk assessments from prior
years, and change the audit plan accordingly. You initially established planning materiality for
Houston Technologies at $4.4 million, but you also know that a decrease in unaudited pretax
earnings by more than $4 million will cause Houston to miss the consensus analyst EPS forecast.
Following fieldwork for the 2015 audit, the audit team prepared the following list of items you
want to discuss with Bob Davis and the CFO (Joan Richards):
Depreciation Expense. In 2015 Bob Davis asked Joan Richards to evaluate the useful
lives of all depreciable assets. This change resulted in a reduction of depreciation expense
by $750,000. The audit team investigated this issue, and could not identify a reason to
change the useful lives of the assets involved.
Investments in available-for-sale (AFS) securities. Consistent with GAAP, Houston’s
accounting policy requires that the carrying value of AFS securities be regularly adjusted
to market value. Houston makes these adjustments monthly. Until this year, Houston used
a highly credible, well-known investment bank to provide market values for securities.
This year, Bob Davis changed the policy to use a local investment broker. Bob explained
that he went to college with the owners of the local firm, and they would go out of
business without the contract with Houston. According to diligent work performed by one
of your staff auditors, the year-end fair value of the AFS securities would have been
$1,275,000 lower if Houston had continued to use the national firm.
IT Equipment. The audit team identified an uncorrected accounting error involving the
acquisition of servers, computers, and other IT hardware purchased and installed on
1/2/2015. Houston did not book amortization expense for the portion allocated to 2015.
The amount involved is $3,800,000.
3
Your Discussion with Bob and Joan:
You: Thank you for meeting with me. I assume my staff forwarded you a summary of the issues
I’d like to discuss.
Joan: Yes, we received them, thank you.
Bob: So, let us know what you think. Do we need to book any adjustments?
You: I’m proposing the following adjustments: $3.8 million to correct the error involving IT
equipment, and a $1,275,000 decrease in the carrying value of your AFS securities portfolio. I
also need some more information about the change in depreciation policy.
At this point, Bob interrupts you.
Bob: I can accept the adjustment for the IT equipment. We made a mistake, that’s obvious. And
I’m ok with changing the AFS, that will go to other comprehensive income so we’ll still make
the basic EPS forecast. If we don’t meet that, I may be out of a job and the investors who hold on
to the stock will take a hit. But, come on, there is no problem with depreciation. What we did
was well within your accounting rules. Joan looked into it, and there’s nothing against
periodically evaluating the useful lives of depreciable assets. If you think about it, it’s really
more conservative this way since we’ll book more depreciation expense down the road than we
would have if we had not adjusted the useful lives. Plus, I doubt its material.
Questions:
1. How would you respond to Bob if you were in this situation? Your answer must include,
but not be limited to, whether you would propose an adjustment to depreciation and how
much of an adjustment you would propose ($0 if you do not propose an adjustment).
2. According to auditing standards, what information should you communicate to Houston’s
audit committee based on this case? Be sure to cite the appropriate standard(s). Do not
quote the standard(s); use your own words.
3. Assume you did propose an adjustment for depreciation. How much would you propose?
Why?
4. Assume you did not agree with the client’s change in depreciation method, and proposed
a $750,000 adjustment to depreciation expense/accumulated depreciation. Further
assume that the client did not book the adjustment. Which opinion would you offer?
Explain your answer.
5. Assume you agreed with the client’s change in depreciation method? Which opinion
would you issue?
4
Case 3-3: Opinions and Finishing the Audit
Assume you are a partner supervising the audit of Wildcat Grocers, a publicly-traded company
that supplies grocery stores with a 12/31 fiscal year-end. It is now mid-February 2016, and you
are considering which opinion to issue for the 2015 audit. You must sign the audit opinion no
later than February 25, and Wildcat must file its audited financial statements with the SEC by
March 5. All audit issues have been resolved to your satisfaction except two, which you must
decide how to address. Both of these issues are material.
Wildcat is losing market share to companies that offer products at lower prices. Sales
have been trending downward for several years, and operating cash flows have been
negative during this time. The CFO assured you that the company will make it through
this rough period. She described a plan that included issuing new stock and laying off
workers to maintain its long-term viability. The company’s stock price is now at an alltime low of $1.01 per share, and a report from an independent broker indicates that if
Wildcat issues new stock, it will provide the company sufficient capital to cover five
months of operations.
A significant portion of Wildcat’s inventory was destroyed in a fire on January 31, 2016.
The CFO included a footnote to the 2015 financial statements to disclose information
regarding the loss of inventory. She believes the company should receive an insurance
settlement for the full amount of inventory, minus a small deductible, no later than June
15, 2016. One of your audit staff independently reviewed the company’s insurance policy
and reached the same conclusion.
Questions:
1. According to auditing standards, what specific responsibilities does the auditor have in
evaluating the client as a going concern? Cite the appropriate standard(s) and describe
the auditor’s responsibilities in your own words.
2. Would you issue a going concern opinion to Wildcat? Why or why not?
3. Assume you decided to issue a going concern opinion and Wildcat was able to thrive in
2016, erasing any concern about its financial health. Does this mean that the going
concern modification was the wrong opinion? Why or why not?
4. According to auditing standards: (a) Describe the difference between Type I and Type II
subsequent events. (b) What procedures should an auditor perform to identify and
evaluate subsequent events? Cite the appropriate standard(s) and describe the audit
procedures in your own words.
5. Is Wildcat’s loss of inventory a Type I or Type II subsequent event? Explain your
reasoning.
5
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Rating:
/5
Solution: Assume you are the audit manager for the 2015 audit of Fox Aeronautics,