CH-12-16 Auditing the Human Resource Management Process – Auditing and Assurance Services: A Systematic Approach : Book Guide

This Document Contains Chapters 12 to 16 Chapter 12 Auditing the Human Resource Management Process Answers to Review Questions 12-1 In addition to policies and processes around payroll transactions, the human resource management process requires sound policies and processes for hiring, training, evaluating, counseling, promoting, compensating, terminating, and taking remedial actions for employees. 12-2 There are two major types of transactions that are processed through the human resource management process: (1) payments to employees for services rendered and (2) accrual and payment of payroll-related liabilities arising from employees' services. The financial statements accounts that are generally affected by the two types of payroll- related transactions are: Payroll transaction: • Cash • Inventory • Direct and indirect labor expense • Various payroll-related liability and expense accounts Accrued payroll liability transactions: • Cash • Various accruals (e.g., payroll taxes, and pension costs) 12-3 The payroll register, which is also referred to as the payroll journal, is a summary of all payroll checks issued to employees. The payroll master file is the computer file that maintains all the entity's records related to payroll, including information on each employee such as name, Social Security number, pay rate, and authorized deductions. The payroll master file changes report contains a record of the changes made to the payroll master file. 12-4 The following duties are performed in the human resources, timekeeping, and payroll- processing functions: Human Resources: Authorization of hiring, firing, wage rates and salary adjustments, salaries, and payroll deductions. Timekeeping: Processing of employees' attendance and time information and coding of account distribution. Payroll processing: Computation of gross pay, deductions, and net pay; recording and summarizing of payments; and verification of account distribution. 12-5 The following table contains the key segregation of duties in the human resource management process and possible errors and fraud that can occur if such segregation of duties is not present. This Document Contains Chapters 12 to 16 Segregation of Duties Possible Errors or Fraud as a Result of Conflicts in Duties The supervision function should be segregated from the personnel records and payroll-processing functions. Unauthorized payments to existing employees or payments to fictitious employees. The disbursement function should be segregated from the personnel records, supervision, and payroll-processing functions. Unauthorized payroll checks may be issued. The payroll-processing function should be segregated from the general ledger function. Concealment of a defalcation/theft that would normally be detected by independent review of accounting entries made to the general ledger. 12-6 Except for executive and share-based compensation, there are generally few inherent risk factors that affect the human resource management process and its related accounts. Some factors the auditor might consider include the effect of economic conditions on payroll costs, the supply of skilled workers, the frequency of employee turnover, the presence of labor contracts, and legislation such as the Occupational Safety and Health Act. Because officers may have motive and opportunity to take advantage of their high- positions in the form of excessive compensation, inherent risk is frequently not set at low. Key risk factors to consider are the level of performance-based compensation and the closeness of key performance measures to compensation/bonus thresholds. Share-based compensation also has a higher inherent risk because of the required assumptions and financial disclosures. 12-7 Two control environment factors that have a pervasive effect on the human resource management process must be considered. First, the entity's organizational structure, its personnel practices, and its methods used to assign authority and responsibility must be examined. Second, the entity should have sound policies for hiring, training, promoting, and compensating employees. These policies should include specific authority and responsibility for hiring and firing of employees, for setting wage rates and making salary changes, and for establishing benefits. 12-8 The key authorization points within the human resource management process include authorization procedures for hiring and terminating employees, setting pay rates, making withholdings, awarding benefits, and issuing payroll checks. 12-9 Control activities must exist over the classification of payroll transactions to ensure that the appropriate payroll accounts are charged. If payroll is not properly classified between direct and indirect labor, inventory and cost of goods sold may not be properly valued. 12-10 Examples of audit procedures that can be performed using CAATs or Audit Data Analytics are: (1) testing the computer logic used to calculate payroll amounts, (2) recomputing the calculation of gross pay, deductions, and net pay, (3) identifying unusual employee expense reimbursements, and (4) foot payroll reports and reconcile to general ledger. 12-11 Substantive analytical procedures that can be used to test payroll accounts and payroll- related accrual accounts are: Payroll expense accounts: 1. Use a reasonableness test to develop an expectation based on number of employees and prior year average compensation per employee category after considering pay rate changes. Compare the expectation to current-year balance and investigate the difference if it is greater than the threshold. 2. Compare payroll costs as a percentage of sales with prior years’ and industry data. 3. Compare labor utilization rates and statistics with industry data. 4. Compare budgeted payroll expenses with actual payroll expenses. 5. Estimate sales commissions by application of commission formulas to recorded sales totals. Payroll-related accrual accounts: 1. Compare current-period balances in payroll-related accruals with the prior periods' balances after adjusting for changes in conditions. 2. Test reasonableness on accrual balances. 12-12 For the accrued payroll tax account, the auditor obtains a detailed account analysis schedule. The credits to the account represent the recognition of payroll tax expense at the end of each pay period. These amounts can be traced to the various payroll tax returns or other documentation filed by the entity and should agree to the amount of payroll tax expense included in the income statement. The debits to the account represent payments made to the relevant government agencies. These payments can be verified by tracing the amounts to the cash disbursements journal. 12-13 Disclosure items for the human resource management process and related accounts include: • Pension benefits • Postretirement benefits • Share-based compensation • Profit-sharing plans • Deferred-compensation arrangements Answers to Multiple-Choice Questions 12-14 b 12-19 c 12-15 c 12-20 b 12-16 a 12-21 c 12-17 b 12-22 b 12-18 c 12-23 c Solutions to Problems 12-24 To best prevent errors and fraud, one person should be assigned to each of the following functions: human resources, supervision, timekeeping, payroll processing, disbursement, and the general ledger. However, fewer could be hired, as long as certain segregations are in place. The supervision function should be separated from the human resources and payroll-processing functions; the disbursement function should be separate from human resources, supervision, and payroll-processing; and the payroll-processing function should be separate from the general ledger function. These separations would help prevent fictitious employees from appearing on the payroll, unauthorized payments from being made, and alteration of the accounting records from happening. 12-25 a. Weaknesses in the internal control system are the following: • Lack of approval of the foreman's time sheet by an appropriate supervisor is an unsound practice. Employees should not be permitted to maintain their own time records and submit them without approval. • The computation of regular and overtime hours prepared by payroll clerk no. 2 that is used in the preparation of the payroll register is not compared with the summary of regular and overtime hours prepared by the foreman. • Arithmetic computations and rates of pay used in the preparation of the payroll register are not checked by a person who is independent of their preparation, and payroll register columns are not verified (re-added) by a person other than the preparer of the payroll register. • Payroll checks are not reconciled to the payroll register in order to prevent improper disbursements. • A signature-stamp machine should not be in the custody of any payroll clerk who has access to unsigned checks. • An officer of the company does not approve payroll. • Since the paymaster should be independent of the payroll process, signed payroll checks should not be distributed by the foreman. • Unclaimed payroll checks should be in the custody of an employee who is independent of the payroll process. • The comparison of regular and overtime hours indicated on payroll checks with regular and overtime hours indicated on time sheets should not be performed by the clerk who is responsible for the original computation of regular and overtime hours indicated on time sheets. • The clerk who is responsible for preparing the payroll register should not perform the comparison of gross and net payroll indicated on payroll check with gross and net payroll indicated in the payroll register. b. One should inquire whether: • Payroll clerk no. 2 checks time sheets for the foreman's written approval. • Approved overtime is indicated on time sheets. • Employment, wage, and related data in payroll files are periodically crosschecked with personnel files for agreement. • The timekeeper system is proprietary or an “off-the-shelf” third party software. • How time entered through smart phone app is verified as being performed on company grounds. • Other mitigating internal control measures (e.g., bonding, required vacations, and so forth) are in existence. 12-26 McCarthy should consider performing the following procedures in the audit of Kent Company's payroll transactions: 1. Select a sample of payments to employees from the payroll register and compare each selected transaction to the related documents and records, and examine • Evidence in support of authorization of pay rate. • Evidence in support of time on which compensation was based, such as approved time cards or attendance records. • Evidence in support of proper authorization of payroll withholdings. • Evidence in support of account distribution. • The clerical accuracy of the transaction. • The entry to the employee's records used to summarize employee compensation for payroll reporting purposes. . 2. Obtain the payroll register for a selected period and • Test the arithmetic accuracy of the payroll register. • Determine whether payroll was approved in accordance with management's prescribed procedures. • Trace totals per the register to postings in the general ledger. 3. Observe the distribution of payroll checks. 4. Review the accounting for unclaimed wages. 5. Observe a sample of employees in the performance of their duties. 6. Perform analytical procedures. 12-27 a. In order to verify the information in the input form, James should: • Compare the names, Social Security numbers, and withholding data on the input form with W-4 forms. • Compare names with employment authorizations. • Compare pay rates with wage authorizations and union contracts. • Compare numbers of hours worked (regular and overtime) with approved time sheets or other supportive records; recompute regular and overtime hours. • Inspect employee authorization forms for "special deductions." b. James should perform the following procedures in the examination of the November payroll register: • Compare information on the input form with information in the payroll register and information on issued payroll checks (e.g., spelling of names, correctness of Social Security numbers, hours, rates, and deductions). • Test payroll deductions by using withholding tax tables to recompute Social Security and withholding taxes. • Manually compute gross and net pay and compare with computer printed figures. • Compare payroll summary totals with other pay periods and investigate any unusual variations among periods. • Check footings and cross footings in the payroll register. • Perform other related basic auditing procedures that may be deemed necessary in accordance with the circumstances. Solutions to Discussion Cases 12-28 a. The following edit checks might be used to detect errors during the typing of answers to the input cues: • Password: Ensures that the operator is authorized to access computer programs and files. • Field check to ensure that • numbers are entered into and accepted by the system where only numbers are required to be entered (e.g., numbers 0-9 in Social Security number). • letters are entered into and accepted by the system where only letters are required to be entered (e.g., letters A-Z in employee name). • only specific special characters are entered into and accepted by the system where only those special characters are required to be entered (e.g., hyphens between numbers in Social Security number). • Sign check: Ensures that positive or negative signs are entered into and accepted by the system where only such signs are required to be entered or that the absence of a positive or negative sign appears where such an absence is required (e.g., hours worked). • Arithmetic check: Ensures the validity of the result of a mathematical computation (e.g., total employees for period equal number of employee numbers in system). • Validity check: Ensures that only authorized data codes will be entered into and accepted by the system where only such authorized data codes are required (e.g., authorized employee account numbers). • Limit (reasonableness) check: Ensures that only data within predetermined limits will be entered into and accepted by the system (e.g., rate per hour cannot be lower than the minimum set by law or higher than the maximum set by management). • Self-checking digit: Ensures that only specific code numbers prepared by using a specific arithmetic operation will be entered into and accepted by the system (e.g., employee numbers generated by the modulus 11 method with prime-number weighting). • Size check: Ensures that only data using fixed or defined field lengths will be entered into and accepted by the system (e.g., number of dependents requires exactly two digits). • Missing-data check: Ensures that no blanks will be entered into and accepted into the system when data should be present (e.g., an "S" or "M" is entered in response to "single or married?"). • Overflow check: Ensures that no digits are dropped if a number becomes too large for a variable during processing (e.g., hourly rates "on size errors" are detected). • Control-total check: Ensures that no unauthorized changes are made to specified data or data fields and all data have been entered. • Logic check: Ensures that spurious data are rejected (e.g., no negative regular hours). b. The assurances provided by each validation check are provided within "a." above. Solution to Internet Assignment 12-29 a. A rough estimate of the average employee’s salary can be computed by dividing the estimated employee compensation expense by the estimated total number of employees. The salaries of the executive officers can be found on a number of websites (e.g., www.aflcio.org/paywatch) and are usually found in the company’s proxy statement or annual report. The salary for one officer divided by the average salary equals the proportion of executive salary to average employee salary. In 2016, for large companies, the average overall CEO Compensation was over $13.1 million whereas the median pay for all rank-and-file workers was $37,632. The following examples are from some of the highest-paid CEO’s listed at http://www.aflcio.org In 2015, Sundar Pichai, CEO of Google received $100.6 million in total compensation. Meaning Mr. Pichai made 2,674 times the average rank-and-file worker’s pay. Howard Schultz, CEO of Starbucks received almost $22 million in salary and bonus in 2016 for a ratio of 579 to 1 compared to rank-and-file workers. C. Douglas McMillon, CEO of Wal-Mart Stores received over $22 million in 2017 for a ratio of 593 to 1 compared to rank-and-file workers. In 2016, Satya Nadella, the CEO of Microsoft received $17.6 million in total compensation for a ratio of 470 to 1 compared to rank-and-file workers. In 2016, Warren E. Buffett, the CEO of Berkshire Hathaway received $487,881in total compensation for a ratio of 12 to 1 compared to rank-and-file workers. It is argued that this proportion is high because of the value of the executive’s strategic influence on the company. Whether or not this is true depends entirely on the circumstances of the company. In recent years, there has been increased public outrage at the large disparity between top executive salary and that of the average employee. b. It is argued that if executive compensation is tied to the value of the stock price then executives will perform better, because their interests will be aligned with those of the company’s stockholders. Also by using stock based compensation, companies are free to use the cash that would have been used as compensation to fund other areas of the company; this strategy is frequently employed by technology companies seeking rapid growth. The FASB did not always require companies to directly expense the value of stock option compensation to the income statement. However, under ASC 718 companies are now required to recognize the value of the options granted to employees over the vesting period as compensation expense. The biggest disadvantage is the potential greed associated with high levels of stock- option compensation. When the executive stands to gain tens or hundreds of millions of dollars by achieving earnings targets, the executive’s self-interests provide incentives for earnings management or fraud in order to meet or beat earnings forecasts. c. Potential audit procedures may include: • Analytical procedures can be used to benchmark compensation levels to other companies in the industry and to examine trends over time. • Evaluate whether there is proper objectivity in establishing compensation (i.e., is there a compensation committee independent of management). Examine minutes of board of directors and compensation committee for approval of executive compensation and information on other cash transfers (e.g., loans, expense reimbursement). • Use CAATs or audit data analytics to search for payments to executives or parties related to executives. • If fraud or embezzlement is suspected, hire a private investigator to evaluate if the executive is seemingly living beyond his or her compensation level. Chapter 13 Auditing the Inventory Management Process Answers to Review Questions 13-1 Inventory represents one of the most complex parts of the audit because the assignment of values to inventory quantities is difficult. There are also issues such as obsolescence and “lower of cost or market” that affect the valuation of inventory. The complexity of auditing inventory may also be affected by the degree of processing required to manufacture products. 13-2 The inventory process is affected by control activities in the revenue, purchasing, and human resource management processes. The purchasing process controls the acquisition and payment of raw materials and overhead costs. The cost of direct and indirect labor assigned to inventory is controlled through the human resource management process. Last, finished goods are sold and accounted for as part of the revenue process. 13-3 A production schedule is used to determine the quantity of goods needed and the time at which they are required to meet the production scheduling. The materials requisition is the document that authorizes the release of raw materials from the raw materials department. The inventory master file contains all the important information related to the entity's inventory, including the perpetual inventory records for raw material, work in process, and finished goods. Production data information is reported about the transfer of goods and related cost accumulation at each stage of production. This information is used to update the entity's perpetual inventory system and as input to generate the cost accumulation and variance reports produced by the inventory system. The cost accumulation and variance report summarizes the various costs charged to departments and products and presents the results of inventory processing in terms of actual costs versus standard or budgeted costs. 13-4 The following duties are performed within the inventory management, raw materials stores, and cost accounting functions: Inventory management: Maintenance of inventory at appropriate levels; issuance of purchase requisitions to the purchasing department; managing inventory through planning and scheduling manufacturing activities. Raw materials stores: Custody of raw materials and issuance of raw materials to manufacturing departments. Cost accounting: Responsible for ensuring that costs are properly attached to inventory as goods are processed through the manufacturing function. Cost accounting reviews the cost accumulation and variance reports after such data are processed into the accounting records. 13-5 The key segregation of duties in the inventory process and the errors or fraud that they can prevent are: Segregation of Duties Possible Errors or Fraud as a Result of Conflicts in Duties The inventory management function should be segregated from the cost- accounting function. Production and inventory costs can be manipulated, leading to an over- or understatement of inventory and net income. The inventory stores function should be segregated from the cost-accounting function. Unauthorized shipments can be made or the theft of goods can be covered up. The cost-accounting function should be segregated from the general ledger function. Unauthorized shipments resulting in theft of goods, leading to an overstatement of inventory. The responsibility for supervising the taking of physical inventory should be separated from the inventory management and inventory stores functions. Inventory shortages can be covered up through the adjustment of the inventory records to the physical inventory resulting in an overstatement of inventory. 13-6 Industry-related factors and operating and engagement inherent risk factors affect the inventory process. Industry factors include industry competition and changes in technology. Operating and engagement characteristics are (1) the susceptibility of the products sold by the entity to theft, (2) the difficulty in auditing and valuing inventory, and (3) possible related-party transactions for the acquisition of raw materials and sale of the finished product. 13-7 The three major steps in assessing control risk in the inventory process are: 1. Understand and document the inventory internal control system based on the planned level of control risk. 2. Plan and perform tests of controls on inventory process transactions. 3. Assess and document control risk for the inventory process. 13-8 The following control activities can be used by the entity to prevent unauthorized inventory production: • Preparation and review of an authorized production schedule. • Use of material requirements planning and/or just-in-time inventory systems. • Review of inventory levels by the inventory management department. 13-9 Substantive analytical procedures that can be used to test inventory and related account balances include: • Compare raw material, finished goods, and total inventory turnover to previous periods’ and industry averages. • Compare days outstanding in inventory to previous periods and industry data. • Compare gross profit percentage by product line with previous periods' and industry data. • Compare actual cost of goods sold to budgeted amounts. • Compare current-year standard costs with prior periods' after considering current conditions. • Compare actual manufacturing overhead costs with budgeted or standard manufacturing overhead costs. 13-10 To audit standard costs, the auditor should first review the entity's policies and procedures for constructing standard costs. Once the policies and procedures are understood, the auditor normally tests the component cost buildup for materials, labor, and overhead for a representative sample of standard product costs. The material component requires testing of the quantity and type of materials included in the product and the price of the materials. The quantity and type of materials are tested by reviewing the engineering specifications for the product. Labor costs require evidence about the type and amount of labor needed for production and the labor rate. The amount of labor necessary to assemble a product can be tested by reviewing engineering estimates, which may be based on time- and-motion studies or historical information. The labor rates for each type of labor necessary to assemble a product can be tested by examining a schedule of authorized wages. Overhead costs are tested by reviewing the entity's method of overhead allocation for reasonableness, compliance with GAAP, and consistency. The auditor examines the costs included in overhead to ensure that such costs are appropriate costs assignable to the product and that the inclusion or exclusion of such costs is consistent from one period to the next. 13-11 During the observation of the physical inventory count, the auditor should perform the following procedures: • Ensure that no production is scheduled. Or, if production is scheduled, ensure that proper controls are established for movement between departments in order to prevent double counting. • Ensure that there is no movement of goods during the inventory count. If movement is necessary, the auditor and entity personnel must ensure that the goods are not double counted and that all goods are counted. • Ensure that the entity's count teams are following the inventory count instructions. • Ensure that inventory tags are issued sequentially to individual departments. If the entity uses another method of counting inventory, such as detailed inventory listings, the auditor should obtain copies of the listings prior to the start of the inventory count. • Perform test counts and record a sample of counts in the working papers. • Obtain tag control information for testing the entity’s inventory compilation. Tag control information includes documentation of the numerical sequence of all inventory tags and accounting for all used and unused inventory tags. • Obtain cutoff information, including the number of the last shipping and receiving documents issued on the date of the physical inventory count. • Observe the condition of the inventory for items that may be obsolete, slow moving, or carried in excess quantities. • Inquire about goods held on consignment for others or held on a "bill-and-hold" basis. The auditor must also inquire about goods held on consignment for the entity. 13-12 Possible causes of book-to-physical inventory differences include: • Inventory cutoff errors. • Unreported scrap or spoilage. • Theft. 13-13 Example disclosure items for inventory and related accounts include: • Cost method (e.g. FIFO, LIFO, retail method). • Components of inventory. • Long-term purchase contracts. • Consigned inventory. • Purchases from related parties. • LIFO liquidations. • Pledged or assigned inventory. • Disclosure of unusual losses from write-downs of inventory or losses on long-term purchase commitments. • Warranty obligations. Answers to Multiple-Choice Questions 13-14 d 13-21 b 13-15 a 13-22 d 13-16 c 13-23 d 13-17 b 13-24 b 13-18 d 13-25 a 13-19 c 13-26 d 13-20 d Solutions to Problems 13-27 The identification and explanation of the systems and control weaknesses are as follows: • The purchase requisition is not approved. A responsible person in the stores department should approve the purchase requisition. The approval should be indicated on the purchase requisition after the approver is satisfied that it was properly prepared based on a need to replace stores or the proper request from a user department. • Purchase requisition number 2 is not required. Purchase requisitions are unnecessarily sent from the stores department to the receiving room. The receiving room does not make any use of the purchase requisitions, and no purpose seems to exist for the receiving room to obtain a copy. A copy of the requisition might be sent from the stores department directly to the accounts payable department, where it can be compared to the purchase order to verify that merchandise requisitioned by an authorized employee has been properly ordered. • Purchase requisitions and purchase orders are not compared in the stores department. Although purchase orders are attached to purchase requisitions in the stores department, there is no indication that any comparison is made of the two documents. Prior to attaching the purchase order to the purchase requisition, the requisitioner’s functions should include a check that (1) prices are reasonable, (2) the quality of the materials ordered is acceptable, (3) delivery dates are in accordance with company needs, and (4) all pertinent data on the purchase order and purchase requisition (e.g., quantities, specifications, delivery dates, etc.) are in agreement. Since the requisitioner will be charged for the materials ordered, the requisitioner is the logical person to perform these steps. • Purchase orders and purchase requisitions should not be combined and filed with the unmatched purchase requisitions in the stores department. A separate file should be maintained for the combined and matched documents. The unmatched purchase requisitions file can serve as a control over merchandise requisitioned but not yet ordered. • Preliminary review should be made before preparing purchase orders. Prior to preparation of the purchase order, the purchase office should review the company's need for the specific materials requisitioned and approve the request. • The purchase office should attempt to obtain the highest-quality merchandise at the lowest possible price, and the procedures that are followed to achieve this should be included on the flowchart. There is no indication that the purchase office submits purchase orders to competitive bidding when appropriate. That office should be directly involved with vendors in determining the cost of materials ordered and should be primarily responsible for deciding at what price materials should be ordered and which vendors should be used. • The purchase office does not review the invoice prior to processing invoice approval. The purchase office should review the vendor's invoice for overall accuracy and completeness, verifying quantity, prices, specifications, terms, dates, etc., and if the invoice is in agreement with the purchase order, receiving report, and purchase requisition, the purchase office should clearly indicate on the invoice that it is approved for payment processing. The approved invoice should be sent to the accounts payable department. • The copy of the purchase order sent to the receiving room generally should not show quantities ordered, thus forcing the department to count goods received. In addition to counting the merchandise received from the vendor, receiving department personnel should examine the condition and quality of the merchandise upon receipt. • There is no indication of the procedures in effect when the quantity of merchandise received differs from what was ordered. Procedures for handling over shipments should be clearly outlined and included on the flowchart. • The receiving report is not sent to the stores department. A copy of the receiving report should be sent from the receiving room directly to the stores department with the materials received. The stores department, after verifying the accuracy of the receiving report, should indicate approval on that copy and send it to the accounts payable department. The copy sent to the accounts payable department will serve as proof that the company received the materials ordered and are in the user department. • There is no indication of control over vouchers in the accounts payable department. In the accounts payable department, a record of all vouchers submitted to the cashier should be maintained, and a copy of the vouchers should be filed in an alphabetical vendor reference file. • There is no indication of control over dollar amounts on vouchers. Accounts payable personnel should prepare and maintain control sheets on the dollar amounts of vouchers. Such sheets should be sent to departments posting transactions to general and subsidiary ledgers. • There is no examination of documents prior to voucher preparation. In addition to the matching procedure, the mathematical accuracy of all documents should be verified prior to preparation of vouchers. • The controller should not be responsible for cash disbursements. The cash disbursement function should be the responsibility of the treasurer, not the controller, so as to provide proper segregation of duties between the custody of assets and the recording of transactions. • There is no indication of the company's procedures for handling purchase returns. Although separate return procedures may be in effect and included on a separate flowchart, some indications of this should be included as part of the purchases flowchart. • Discrepancy procedures are not indicated. The flowchart should indicate what procedures are followed whenever matching reveals a difference between the information on the documents compared. • There is no indication of any control over prenumbered forms. All prenumbered documents should be accounted for. 13-28 1. Evidence found in the working papers to support the fact that the audit was adequately planned and assistants were properly supervised would be: • Documentation indicating discussions with entity personnel concerning developments affecting the entity that require recognition in the audit plan. • Documentation of a pre-audit planning conference among audit firm personnel to develop an audit strategy by reviewing and considering matters noted in prior years' working papers, changes in accounting and auditing standards, etc. • An internal control write-up documenting that the internal control system had been reviewed. • Audit programs tailored to the strengths and weaknesses of the internal control system (i.e., tested the relevant assertions). • Audit programs indicating steps that were assigned to and completed by individual assistants. • A budget indicating the time to be spent in each audit area. • Individual working papers signed by reviewers to document review, approval, and responsibility. • Confirmations that all questions raised by assistants were answered. 2. Substantive tests that would document management’s completeness assertion as it relates to inventory quantities would be: • Observation of physical inventory counts. • Analytical procedures for the relationship of inventory balances to purchase, production, and sales activities. • Inspection of shipping and receiving documentation for proper amounts and dates to verify proper cutoff procedures. • Obtaining of confirmation of inventories at locations outside the entity. • Tracing of test counts recorded during the physical inventory observation to the inventory listing. • Accounting for all inventory tags and count sheets used in recording the physical inventory counts. • Re-computation of the inventory calculations for clerical accuracy. • Reconciliation of physical counts to perpetual records and general ledger balances and investigation of significant differences. 13-29 a. When an entity uses statistical sampling to estimate inventories, the auditor should perform procedures similar to the following: • The auditor should review the entity's procedures and methods for determining inventories to ascertain if they are sufficiently reliable to produce results substantially the same as those that would be obtained by a 100 percent inventory count. • The auditor should be satisfied that the statistical sampling plan to be used by the entity has statistical validity, that it will be properly applied, and that the planned tolerable and expected misstatement and risk of incorrect acceptance will be reasonable in the circumstances. • The auditor should ascertain that proper steps have been taken to ensure that all • parts and supplies in the warehouse are included in the perpetual inventory records. This would normally be checked in advance of the physical count. • The auditor should be present when the sample is drawn to make sure that the requirements for random selection are properly observed and that all items in the inventory have an equal or determinable probability of selection. • The auditor must be present to observe counts and must be satisfied with the entity's counting procedures. The inventory observation can be made either during or after the year-end of the period under audit if well-kept perpetual records are maintained and the entity makes periodic comparisons of physical counts with such records. • The auditor should review the statistical evaluation and be satisfied that the estimated value of the precision at a given level of reliability meets the materiality requirements set for the audit. b. In addition to the above, the following standard audit procedures for verification of physical quantities should be performed whether the entity conducts a periodic physical count for all or part of its inventory: • Review and be satisfied with the entity's physical inventory-taking procedures. • Observe the physical count. • Make test counts where appropriate. • Trace selected count data to the inventory compilation. • Select items from compilation and trace them to original count data. • Select items from the warehouse at random and trace these items to the perpetual inventory records. • Verify footings. • Compare inventory compilation amounts to the subsidiary ledger control and investigate significant differences. • Ascertain that there was a proper purchases and sales cutoff. • Review the treatment of merchandise in transit and consigned merchandise. • Confirm merchandise in warehouses. • Perform analytical procedures for inventories. • Account for all entity inventory count sheets. • Be sure inventory items are properly classified, in good condition, and of proper quality. 13-30 The substantive auditing procedures Kachelmeier may consider performing include: (a) Using the perpetual inventory file • Recalculate the beginning and ending balances (prices x quantities), foot, and create a report to be used to reconcile the totals with the general ledger or agree beginning balance with the prior year's working papers. • Calculate the quantity balances as of the physical inventory date for comparison to the physical inventory file. Alternatively, update the physical inventory file for purchases and sales from January 6 to January 31, 2018, for comparison to the perpetual inventory at January 31, 2018. • Select and print out a sample of items received and shipped for the periods (1) before and after January 5 and 31, 2018, for cutoff testing, (2) between January 5 and January 31, 2018, for vouching or analytical procedures, and (3) prior to January 5, 2018, for tests of details or analytical procedures. • Compare quantities sold during the year to quantities on hand at year-end. Print out a report of items for which turnover is less than expected. Alternatively, calculate the number of days' sales in inventory for selected items. • Select items noted as possibly unsalable or obsolete during the physical inventory observation and print out information about purchases and sales for further consideration. • Recalculate the prices used to value the year-end FIFO inventory by matching prices and quantities to the most recent purchases. • Select a sample of items for comparison to current sales prices. • Identify and print out unusual transactions. These are transactions other than purchases or sales for the year, or physical inventory adjustments as of January 5, 2018. • Recalculate the ending inventory by taking the beginning balances plus purchases, less sales, and print out the differences. • Recalculate the cost of sales for selected items sold during the year. (b) Using the physical inventory and test count files • Account for all inventory tag numbers used and print out a report of missing or duplicate numbers for follow-up. • Search for tag numbers noted during the physical inventory observation as being voided or not used. • Compare the physical inventory file to the file of test counts and print out a report of differences for auditor follow-up. • Combine the quantities for each item appearing on more than one inventory tag number for comparison to the perpetual file. • Compare the quantities on the file to the calculated quantity balances on the perpetual inventory file as of January 5, 2018. Alternatively, compare the physical inventory file updated to year end to the perpetual inventory file. • Calculate the quantities and dollar amounts of the book-to-physical adjustments for each item and the total adjustment. Print out a report to reconcile the total adjustment to the adjustment recorded in the general ledger before year-end. • Using the calculated book-to-physical adjustments for each item, compare the quantities and dollar amounts of each adjustment to the perpetual inventory file as of January 5, 2018, and print out a report of differences for follow-up. 13-31 Basic Inventory-Auditing Procedures How a Generalized Audit Software Package and the Inventory File Data Might Be Helpful 1. Observation of the physical count, making and recording test counts where applicable. 1. By determining which items are to be test counted by selecting a random sample of a representative number of items from the inventory file as of the date of the physical count. 2. Testing of the mathematical accuracy of the inventory compilation. 2. By mathematically computing the dollar value of each inventory item counted by multiplying the quantity on hand by the cost per unit and verifying the addition of the extended dollar values. 3. Comparison of the auditor's test counts to the inventory records. 3. By arranging test counts in an electronic file format identical to the inventory file and matching the data files. 4. Comparison of physical count data to inventory records. 4. By comparing the total extended values of all inventory items counted and the extended values of each inventory item counted to the inventory records. 5. Testing of the inventory pricing by obtaining a list of costs per item from buyers, vendors, or other sources. 5. By preparing an electronic data file in a format identical to the inventory file and matching the data files. 6. Examination of purchases and sales cutoff. 6. By listing a sample of items on the inventory file for which the date of last purchase and date of last sale are on or immediately prior to the date of the physical count. 7. Ascertainment of the propriety of items of inventory located in public warehouses. 7. By listing items located in public warehouses. 8. Analysis of inventory for evidence of possible obsolescence. 8. By listing items on the inventory file for which the quantity on hand is excessive in relation to the quantity sold during the year. 9. Analysis of inventory for evidence of possible overstocking or slow- moving items. 9. By listing items on the inventory file for which the quantity on hand is excessive in relation to the quantity sold during the year. 10. Performance of an overall test for accuracy of inventory master file. 10. By listing items, if any, with negative quantities or costs. 13-32 a. 6 b. 3 c. 1 d. 4 e. 2 Solution to Discussion Case 13-33 a. The auditors did not follow several audit procedures in a satisfactory manner, including: • Control of count sheets during and after the inventory. There may not have been adequate supervision and instruction of the inventory observation teams by the auditors. There is no evidence that there was adequate preplanning of the inventory count. Even though it is difficult to spend continuous time in the upper decks, there must be a careful control over their contents and planned counting must still be observed. • Although the late addition of such sheets is highly irregular, the auditors did very little to satisfy themselves of their accuracy. The altering of count sheets after the auditors left could have been prevented by "lining out" unused portions of the count sheet prior to leaving the inventory observation. Test counts of lines on sheets could also have detected the changes. • Physically examining inventory represented on additional count sheets with specific assurances that the items did not represent duplications in the count. Tracing the items to purchase invoices does not prove existence at the inventory date, only that the items were at one time bona fide. • Questions about inventory turnover and similar comparisons should have been raised and addressed. • If the additional items listed on the four additional sheets, the changing of unit designations, or the fictitious amounts added to completed sheets created unusual balances in specific inventory items, a review of the inventory balances and comparison with previous years’ would have indicated unusual increases. Because of the weaknesses in inventory control, audit procedures should have been expanded. b. Failure to obtain adequate evidence to support management’s assertions can result in legal liability from injured third parties and in fines and sanctions by the PCAOB and the SEC. Possible PCAOB and SEC sanctions are discussed in Chapter 20. For example, SEC sanctions can involve prohibition of appearing before the commission, prohibition from accepting new SEC entities, and/or required peer reviews. c. The following auditing standards (AICPA Clarified Standards) require that the auditor communicate specific information to the audit committee. AU-C 265, "Communicating Internal Control Related Matters Identified in an Audit,” requires that the auditor report to the audit committee, or to a similar level of authority if the entity does not have an audit committee, matters which are referred to as reportable conditions. AU-C 240, “Consideration of Fraud in a Financial Statement Audit,” and AU-C 250, “Consideration of Laws and Regulations in an Audit of Financial Statements,” state that the auditor should inform the audit committee or board of directors of material fraud that is identified. AU-C 260, “The Auditor’s Communication With Those Charged With Governance,” and PCAOB AS 1301, “Communications with Audit Committees,” require that the auditor communicate certain matters related to the conduct of the audit to the audit committee and those individuals responsible for oversight of the financial reporting process. For AU-C 260 the communication should address the following matters: • The auditor's responsibility under GAAS. • Significant accounting policies. • Management judgments and accounting estimates. • Significant audit adjustments. • Disagreements with management. • Consultation with other accountants. • Major issues discussed with management prior to retention. • Difficulties encountered during the audit. AS 1301 requires the following communications: • Terms of the engagement (objectives and responsibilities) • Information from the audit committee relevant to the audit • An overview of the audit strategy, significant risks, and timing of the audit • Timely observations arising from the audit that are significant to the financial reporting process (e.g., quality of accounting policies and practices, unusual transactions, quality of accounting estimates, difficult or contentious matters, uncorrected or corrected misstatements, disagreements with management, difficulties in performing the audit) Solutions to Internet Assignment 13-34 A search of the SEC’s website should identify a recent company that has been cited by the SEC for financial reporting problems related to inventory. For example, SEC v. Thor Industries is a litigation case where the SEC alleges that a fraud at the company resulted in higher accounting profits being reported due to outdated inventory prices in the accounting system. Chapter 14 Auditing The Financing/Investing Process: Prepaid Expenses, Intangible Assets, And Property, Plant, And Equipment Answers to Review Questions 14-1 Prepaid expenses provide a legal right to services or an economic benefit for less than a year and typically involve routine recurring expenditure paid in advance. Intangible assets provide economic benefit for longer than a year, therefore misstatements can occur which affect multiple periods. Intangible assets often represent intellectual property. Examples of prepaid expenses include: • Prepaid insurance • Prepaid rent • Prepaid interest Examples of intangible assets include: • Copyrights • Trademarks • Trade names • Licenses • Patents • Franchises • Goodwill • Computer software development costs 14-2 Intangible assets often present serious inherent risks because there are possible judgment issues relating to the valuation and estimated lives of items such as patents, franchises, and goodwill. These issues can lead to disagreements between the auditor and the client. 14-3 The purchasing process affects prepaid insurance and property, plant, and equipment transactions because such transactions are subject to the control activities included in the purchasing process. For example, control activities in the purchasing process may provide assurance as to the proper authorization and recording of insurance policies. Similarly, the occurrence (validity) and authorization of property, plant, and equipment transactions are normally part of the purchasing process. 14-4 Examples of substantive analytical procedures that can be used to test prepaid insurance are: • Compare the current-period balance in prepaid insurance and insurance expense with the prior periods’ balances after considering any changes in operations. • Compute the ratio of insurance expense to assets or sales and compare it with the prior periods’ ratios. • Create an estimate of the year-end balance in prepaid insurance based on the premium and the amount of time remaining on the policy at the end of the period. 14-5 A confirmation from insurance brokers would include information on the policy number, coverage, expiration date, deductibles, and premiums. 14-6 The categories of intangible assets are (only four are required to be listed): • Marketing—trademark, brand name, and Internet domain names. • Customer—customer lists, order backlogs, and customer relationships. • Artistic—items protected by copyright. • Contract—licenses, franchises, and broadcast rights. • Technology—patented and unpatented technology. • Goodwill—the difference between the acquisition price for a company and the fair values of the identified tangible and intangible assets. Four types of property, plant, and equipment transactions are: • Acquisition of capital assets for cash or other nonmonetary considerations. • Disposition of capital assets through sale, exchange, retirement, or abandonment. • Depreciation of capital assets over their useful economic life. • Leasing of assets. 14-7 a) Inherent risk factors to be considered when assessing inherent risk for intangible assets are: 1. Nature of the judgments required to establish the assets value: Considerable judgment is involved in valuing intangible assets acquired in a transaction. Inherent risk may be reduced if a specialist was hired by the client to assist in the valuation of the intangible assets. 2. Complexity of the accounting rules: The complex rules with regards to acquisitions, tests for impairment, and amortization of intangible assets with definite lives also increase inherent risk because they require the entity to make assumptions regarding the assets estimated value, life, or future cash flows. 3. Past or present disagreements with the client regarding valuation of intangible assets: If there have been disagreements in the past with the client or there are current concerns with the client’s valuation methods the auditor will increase the inherent risk for the account so that any potentially material misstatements resulting from improper valuation will be detected through the audit procedures. b) Inherent risk factors that should be considered when assessing inherent risk for property, plant, and equipment are: 1. Complex accounting issues: Lease accounting, self-constructed assets, and capitalized interest are examples of transactions that involve complex accounting issues. 2. Difficult-to-audit transactions: The vast majority of property, plant, and equipment transactions are relatively easy to audit. However, transactions involving donated assets, nonmonetary exchanges, and self-constructed assets are more difficult to audit because it may be difficult to verify the value of such assets. 3. Misstatements detected in prior audits: If the auditor has detected misstatements in prior audits, the likelihood of misstatements in the current year is higher. 14-8 Most entities have some type of authorization table for approving capital asset transactions. Control activities should be present to ensure that the authorization to purchase capital assets is consistent with the authorization table. For example, the control activities should specify dollar limits at each managerial level to ensure that larger projects are brought to the attention of higher levels of management for approval before commitments are made. The entity also needs to have control activities for authorizing the sale or other disposition of capital assets. This should include a level of authorization above the department initiating the disposition. Control activities should also identify assets that are no longer used in operations, because they may require different accounting treatment. Finally, an appropriate level of management should properly authorize all major maintenance or improvement transactions. 14-9 Some of the key segregation of duties for property, plant, and equipment and possible errors or fraud that can occur if they are not present are: Segregation of Duties Possible Errors or Fraud as a Result of Conflicts in Duties The initiation function should be segregated from the final approval function. Fictitious or unauthorized purchases of assets could occur, resulting in purchases of unnecessary assets, assets that do not meet the company's quality control standards, or illegal payments to suppliers or contractors. The property, plant, and equipment records function should be segregated from the general ledger function. A defalcation that would normally be detected by reconciling the subsidiary records with the general ledger control account could be concealed. The property, plant, and equipment records function should be segregated from the custodial function. Tools and equipment could be stolen and the theft could be concealed by adjusting the accounting records. If a periodic physical inventory of property, plant, and equipment is taken, the individual responsible for the inventory should be independent of the custodial and record- keeping functions. Theft of the entity's capital assets could be concealed. 14-10 The following substantive analytical procedures can be used in the audit of property, plant, and equipment: • Compare prior-year balances in property, plant, and equipment and depreciation expense with current-year balances taking into account any changes in conditions or asset composition. • Compute the ratio of depreciation expense to the related property, plant, and equipment accounts and comparison to prior years' ratios. • Compute the ratio of repairs and maintenance expense to the related property, plant, and equipment accounts and compare to prior years' ratios. • Compute the ratio of insurance expense to the related property, plant, and equipment account and compare to prior years' ratios. • Review capital budgets and compare the amounts spent with the amounts budgeted. 14-11 The following audit procedures can be used to verify the completeness, rights and obligations, and accuracy and valuation assertions: Completeness: -Physically examine a sample of capital assets and trace them into the property, plant, and equipment subsidiary ledger. -Trace a sample of purchase requisitions to receiving reports and to the PP&E records -Obtain a lead schedule and agree total to the general ledger Rights and Examine or confirm deeds or title documents for proof of Obligations: ownership. Accuracy and Vouch additions and dispositions to vendor invoices or Valuation: other supporting documentation. -Test depreciation calculations for a sample of capital assets. -Evaluate fixed assets for significant write-offs or impairments by: identifying events or circumstances that may indicate the carrying value is not recoverable, examining the expected future cash flows, or examining supporting documentation for write-offs. -For assets written off, test amounts charged against income and accumulated depreciation. Answers to Multiple-Choice Questions 14-12 c 14-18 d 14-13 a 14-19 a 14-14 b 14-20 d 14-15 b 14-21 b 14-16 a 14-22 a 14-17 a Solutions to Problems 14-23 a. Two substantive analytical procedures that can be used to test prepaid insurance are (only two required): • Examine the trend in prepaid insurance over 3-5 years to develop an expectation for the current year balance after considering any changes in operations. Compare the expectation to the current-year balance and investigate the difference if it is greater than the threshold. • Compute the ratio of insurance expense to assets or sales and compare it with the prior years’ ratios. • Compute an estimate of the ending prepaid account balance using the current premium and the amount of time remaining on the policy at the end of the period. b. The following substantive tests should be performed on the schedule of prepaid insurance: • Foot the schedule and trace the ending balance to the prepaid insurance account in the general ledger. • Send confirmations to the entity's insurance brokers, requesting information on each policy's number, coverage, expiration date, and premiums; alternatively, examine supporting documents such as insurance bills and policies. • Compare the detailed policies in the current year's insurance register with the policies included in prior years' insurance register. • Recompute the unexpired portion of the prepaid insurance after considering the premium paid and the term of the policy. • Examine the insurance policy coverage and ensure that costs are properly allocated to the various insurance expense accounts. • Inquire of management or its insurance broker about the adequacy of the entity's insurance coverage. 14-24 a. Taylor should consider performing the following procedures in the audit of Palmer's goodwill and trademark accounts: • Obtain a copy of the entity’s detailed listing of intangible assets, which should agree with the total amount of intangible assets reported on the entity’s balance sheet. • Examine the entity’s impairment documentation to ensure that each asset is subject to the appropriate impairment testing in accordance with GAAS including the goodwill and trademark accounts. • If impairment tests have not been performed on the goodwill and trademark accounts, the auditor would establish the fair value of all assets and liabilities of the reporting unit using an appropriate valuation model consistent with GAAP. A qualified, objective specialist may be employed to assist in this process. • The excess fair value of the reporting unit’s assets over liabilities is the implied fair value of goodwill. Verify if goodwill is impaired, and if so, verify if the amount of impairment loss is material. • The result of the valuation of the trademark assets is compared with the current book values of the trademark assets to verify if the assets are impaired. • If the trademark assets are impaired, verify if the amount of the impairment exceeds materiality. b. When specialists are used, the auditor is required to evaluate the specialist’s qualifications and objectivity. The auditor also must determine if the valuation model used by the specialist is appropriate and consistent with GAAP and the auditor must understand and agree with the reasonableness of the underlying assumptions. 14-25 The key internal controls related to Grant's property, equipment, and related transactions that Nakamura may consider in assessing control risk include the following: • Advance approval in accordance with management's criteria is required for property and equipment transactions. • Approval authority for transactions above an established dollar value is required at a higher level, such as the board of directors. • Property and equipment transactions are adequately documented. • There are written policies covering capitalizing expenditures, classifying leases, and determining estimated useful lives, salvage values, and methods of depreciation and amortization. • There are written policies covering retirement procedures that include serially numbered retirement work orders, stating the reasons for retirement and bearing appropriate approvals. • There are adequate policies and procedures to determine whether property and equipment are received and properly recorded, such as a system that matches purchase orders, receiving reports, and vendors' invoices. • There are adequate procedures to determine whether dispositions of property and equipment are properly accounted for and any proceeds are received in accordance with management's authorization. • A property and equipment subsidiary ledger is maintained showing additions, retirements, and depreciation, and the ledger is periodically reconciled. • Property and equipment is physically inspected and reconciled at reasonable intervals with independently maintained property and equipment records. • An annual budget is prepared and monitored to forecast and control acquisitions and retirements of property and equipment. • Reporting procedures ensure prompt identification and analysis of variances between authorized expenditures and actual costs. • Adequate safeguards protect property and equipment. • Property and equipment are insured in accordance with management's authorization. • Documents evidencing title and property rights are periodically compared with the detailed property records. • The entity employs internal auditors to test whether the internal controls are operating effectively. 14-26 a. Property, plant, and equipment normally include only fixed tangible assets. Fixed tangible assets are capital assets with useful lives generally in excess of one year that are used in the operation of the business and that are not purchased for resale purposes. In connection with the examination of property, plant, and equipment (PP&E), the auditor must be satisfied that: • Internal controls over PP&E and PP&E acquisitions are adequate. • Assets included in PP&E exist and are being used in the normal operations of the business. • Assets included in PP&E are owned by the company whose financial statements are being examined. • Assets included in PP&E are not encumbered by liens or, if so, the facts are properly disclosed in the footnotes to the financial statements. • Depreciation and/or amortization methods are proper. • Amounts in the financial statements are in substantial agreement with the supporting records. • Accounting for additions, disposals, and retirements is proper. • Accounting for leases is proper. • Maintenance accounts do not include items that should be capitalized. • The valuation and the disclosure of the method of evaluation are acceptable. • Important information relating to the assets is properly disclosed. b. Item Number Is Audit Adjustment or Reclassification Required? Reasons Why Audit Adjustment or Reclassification Is Required or Not Required 1. Yes Commissions paid to real estate agents are costs directly related to the acquisition of the property and should be included in the land cost. The costs of removing, relocating, or reconstructing property of others to acquire possessions are costs that are directly attributable to conditioning the property for use and should be included in land costs. An adjustment is required for these items so that total land costs can properly be included in property, plant, and equipment. 2. No No adjustment is required because clearing costs are costs that are directly attributable to conditioning the property for use and should be included in land costs, which are part of property, plant, and equipment. 3. Yes Since clearing costs are costs of the land, amounts realized from the sale of materials recovered, such as timber and gravel, should be a reduction of the cost of the land and should not be recorded as other income. 4. Yes All costs relating to the purchase of machinery and equipment should be capitalized. For purchased items such costs would include invoice price, freight costs, and unloading charges. Royalty payments, however, should not be included in the cost of the machinery. Such payments should be charged to expenses as they accrue. Machinery costs, other than royalty payments, should be included in property, plant, and equipment. 14-27 a. 4 b. 7 c. 2 14-28 Substantive audit procedures that Pierce should use in examining Wong's mobile construction equipment and related depreciation would include the following: • Determine that the equipment account is properly footed. • Determine that the subsidiary accounts agree with controlling accounts. • Obtain, or prepare, an analysis of changes in the account during the year. • Determine that beginning-of-year balances agree with the prior year's ending balances. • Inspect documents in support of additions during the year. • Inspect documents in support of retirements during the year. • Analyze repairs and maintenance for possible reclassifications. • Determine the propriety of accounting for equipment not in current use. • Test the accuracy of equipment and accounting records by (1) selecting items from the accounting records and verifying their physical existence and (2) selecting items of equipment and locating them in the accounting records. • Evaluate the reasonableness of estimated lives and methods of depreciation used. • Test the calculation of depreciation expense and accumulated depreciation balance. • Perform analytical procedures such as comparing depreciation expense to balance sheet accounts for proper relationship and compare the current year's depreciation expense with prior year's depreciation expense. • Evaluate the financial statement presentation and disclosures for conformity with generally accepted accounting principles. • Review insurance coverage. Solution to Discussion Case 14-29 a. The relevant accounting standard for this is found in FASB ASC Topic 360-20, “Real Estate Sales.” Under the standard, full recognition of profit requires that (1) the profit is determinable and (2) the earnings process is virtually complete. The standard further requires that a sale is not consummated until (1) the parties are bound by the contract, (2) all consideration has been exchanged, (3) any permanent financing for which the seller is responsible has been arranged, and (4) all conditions precedent to the closing have been performed (paragraph 6). Because no closing has taken place, Leno's transaction should not be accounted for under the full accrual method. Thus, Leno must account for the transaction using another method. The accounting standards provide a number of alternative approaches for recognizing revenue, including (1) the deposit method and (2) the cost recovery method. Under the deposit method, no profit is recognized because the sale has not been consummated. The cost recovery method can be used if the receipt of the irrevocable letter of credit is treated as a separate transaction from the total sales transaction and profit is recognized on this portion of the transaction independently of the remainder of the transaction. It could be argued that the first transaction (the receipt of the letter of credit) meets the requirements of FASB ASC Topic 360-20 because (1) profit on the transaction is determinable and collectability is assured and (2) the seller has earned the profit as evidenced by the fact that Leno can keep the proceeds from the letter of credit as well as the property if the buyer does not consummate the transaction. It can also be argued that the criteria in paragraph 5 have been met for this portion of the transaction, since it meets the requirement of an adequate initial investment (greater than 15% for commercial and industrial property). Following the cost recovery method at March 31, 2018, a gain of $1,580,000 would be recognized on the difference between the book value of the property and the amount of the irrevocable letter of credit. The property would be removed from Leno's balance sheet, and the letter of credit would be presented as a “deposit received under contract of sale.” b. Prior to recognizing any gain on the transaction, the auditor should: • Examine the sales contract. • Examine the letter of credit. • Obtain a confirmation from the bank on the terms of the letter of credit. • Examine the subsidiary records containing the information on the land and building's book value. • Examine financial information on the buyer to determine its financial position. Solutions to Internet Assignments 14-30 It is difficult to get information directly on some of EarthWear’s competitors. While Lands’ End was formerly a stand-alone public company, it is now part of the Sears Holding Corporation. The Sears’ annual report indicates that it uses a straight-line method over the estimated useful lives of the respective assets for financial statement purposes and accelerated methods for tax purposes. For example, Sears’ uses 3 to 5 years for computer systems and equipment. VF Corporation has apparel brands such as Vans, Wrangler, Timberland, Lee Jeans, The North Face, JanSport, Nautica and Eastpak. VF Corporations 10-K states, “Depreciation of owned assets is computed using the straight-line method over the estimated useful lives of the assets, ranging from 3 to 10 years for machinery and equipment and up to 40 years for buildings. Leasehold improvements and assets under capital leases are amortized over the shorter of their estimated useful lives or the lease terms.” Eddie Bauer, L.L. Bean and Patagonia are privately held companies and there are no publicly available financial statements. 14-31 A search of the SEC’s website should identify a company that has been recently cited by the SEC for problems related to property, plant, and equipment. Chapter 15 Auditing The Financing/Investing Process: Long-Term Liabilities, Stockholders' Equity, And Income Statement Accounts Answers to Review Questions 15-1 A substantive audit strategy is normally followed when auditing the long-term debt and capital accounts because, although the number of transactions is smaller, each transaction is usually material. Thus, it is normally more cost-effective to conduct substantive tests of the transactions that compose the account balance. The auditor may follow a reliance strategy for entities that engage in frequent financing activities. 15-2 The most important assertions to the auditor for long-term debt are occurrence, authorization, completeness, valuation, and classification. The documents that normally contain the authorization to issue long-term debt include a properly signed lending agreement and the minutes of board of directors' meetings. 15-3 The auditor can estimate interest expense by multiplying the twelve-monthly balances for long-term debt by the average interest rate. The reasonableness of interest expense can then be assessed by comparing this estimate to the interest expense amount recorded in the general ledger. If the two amounts are not materially different, the auditor can conclude that interest expense is fairly stated. If the estimated amount of interest expense is materially higher than the recorded amount, the auditor might conclude that the entity has failed to record a portion of interest expense. On the other hand, if the recorded amount of interest expense was materially higher than the estimated amount, the entity may have failed to record debt. It is important to remember that the inputs (i.e., interest rates, monthly balances) must be audited in order to obtain assurance from the substantive analytical procedure. 15-4 Confirmation of long-term debt provides evidence for the existence, completeness, and accuracy and valuation assertions. 15-5 The registrar is responsible for ensuring that all stock issued is in compliance with the corporate charter and for maintaining control totals for total shares outstanding. The transfer agent is responsible for preparing stock certificates and maintaining adequate stockholders' records. The dividend-disbursing agent prepares and mails dividend checks to the stockholders of record. 15-6 When the entity does not use a registrar or transfer agent and a sufficient number of personnel are available, the following segregation of duties should be maintained: • The individuals responsible for issuing, transferring, and canceling stock certificates should not have any accounting responsibilities. • The individual responsible for maintaining the detailed stockholders' records should be independent of the maintenance of the general ledger control accounts. • The individual responsible for maintaining the detailed stockholders' records should not also process cash receipts or disbursements. • The preparation, recording, signing, and mailing of dividend checks should be appropriately segregated. 15-7 The two most common disclosures for stockholders' equity are (1) the number of shares authorized, issued, and outstanding for each class of stock and (2) restrictions on retained earnings and dividends. These disclosures are necessary so that stockholders can determine what share of the company they own and whether there are any restrictions on the declaration of dividends. Other disclosures for stockholders' equity include: • Call privileges, prices, and dates for preferred stock. • Preferred stock sinking funds. • Stock option or purchase plans. • Any completed or pending transactions (e.g., stock dividends or splits) that may affect stockholders' equity. 15-8 When the entity uses an independent dividend-disbursing agent, the auditor can confirm the amount disbursed to the agent by the entity. This amount is agreed with the amount authorized by the board of directors. The auditor can recompute the dividend amount by multiplying the number of shares outstanding on the record date by the amount of the per share dividend approved by the board of directors. This amount should agree to the amount disbursed to shareholders and accrued at year-end. The auditor begins the audit of retained earnings by obtaining a schedule of the activity in the account for the period. The beginning balance is agreed to the prior year's working papers and financial statements. Net income or loss can be traced to the income statement. The amounts for any cash or stock dividends can be verified as described in the previous paragraph. If there are any prior-period adjustments, the auditor must be certain that the transactions satisfy the requirements of the relevant accounting standards. Any new appropriations or changes in existing appropriations should be traced to the contractual agreement that required the appropriation. Last, the auditor must make sure that all necessary disclosures related to retained earnings are made in the footnotes. 15-9 Three substantive analytical procedures that the auditor might use in auditing the income statement include: • Use the prior years’ trends in quarterly dollar amounts for each significant revenue and expense account (e.g., disaggregate revenue by product or location) to develop an expectation for the current year. • Calculate the ratio of individual expense accounts to net sales and comparing these percentages across years. • Perform substantive analytical procedures of specific revenue or expense accounts (e.g., sales commissions can be tested by using the entity's commission schedule and multiplying the commission rates times eligible sales). 15-10 The auditor conducts a detailed analysis and vouches the transactions in legal expense, travel and entertainment, and other income/expense accounts because these are accounts that are not directly affected by an accounting process, accounts which contain sensitive information or unusual transactions, or accounts for which detailed information is needed for the tax return or other schedules included with the financial statements. Answers to Multiple-Choice Questions 15-11 d 15-16 d 15-12 b 15-17 d 15-13 b 15-18 d 15-14 b 15-19 b 15-15 b 15-20 c Solutions to Problems 15-21 a. The procedures that Maslovskaya should employ in examining the loans are as follows: • Obtain an understanding of the business purpose of the loans made by the president. • Confirm the loans, including terms, by direct communication. • Recompute (or verifying) interest expense and interest payable. • Recompute the long-term and short-term portions of the debt. • Review minutes of meetings of the board of directors for proper authorization. • Verify payments made during the year and transactions after year-end. • Read the financial statements, including footnotes and loan agreements, and evaluating the adequacy of disclosure and compliance with restrictions. • Consider any tax implications for the interest on the loan from the company’s president. • Obtain a management representation letter. b. Broadwall's financial statements should disclose the following information concerning the loans from its president: • The nature of the related-party relationship. • The dollar amounts of the loans. • Amounts due the president and, if not otherwise apparent, the terms and manner of settlement. Subject to certain limited exceptions, loans to or from executives are prohibited for public companies. 15-22 To test the reasonableness of the amount of reported interest expense, the auditor could multiply (6%/12) by each of the monthly balances for long-term debt and add them together to estimate interest expense for the year. This estimate equals $4,575, which is significantly higher than the reported amount of $2,000. The auditor should investigate further as it appears the interest expense is likely misstated. 15-23 The working paper contains the following deficiencies: • The subject of the working paper is not properly indicated in the title. • There is no indication of any follow-up on the identified error in the accrued interest payable computation. • There is no indication as to whether the confirmation exception was resolved. • The loan with the unwaived violation of a provision of the debt agreement is misclassified as long-term. • The liability activities of Lender's Capital Corporation and the working paper totals do not crossfoot. • There is no indication of cross-referencing of the stockholder loan to the related-party transactions working papers. • There is no investigation of the payment on the stockholder loan that was reborrowed soon after year-end. • There is no consideration of the need to impute interest expense on the 0 percent stockholder loan. • There is no indication that the dates under “Interest paid to” were audited. • There is no indication that the unusually high average interest rate ($281,333/$1,406,667 = 20%) was noted and investigated. • The working paper does not support the overall conclusions expressed. • The tick mark “R” is used but not explained in the tick mark legend. • There is no indication that the working paper was prepared by entity personnel. 15-24 The substantive audit procedures that Lee should apply in examining the common stock and treasury stock accounts of Wu, Inc., are as follows: • Review the corporate charter to verify details of the common stock such as authorized shares, par value, etc. • Obtain or prepare an analysis of changes in common stock and treasury stock accounts. • Compare opening balances with prior year’s working papers. • Foot the total shares outstanding in the stockholders' ledger and stock certificate book. • Determine authorization for common-stock issuances and treasury-stock transactions by inspecting the minutes of board of directors’ meetings. • Verify capital-stock issuances by examining supporting documentation and tracing entries into the records. • Verify treasury-stock transactions by examining supporting documentation and tracing entries into the records. • Examine all certificates canceled during the year. • Inspect all treasury-stock certificates owned by the entity. • Reconcile the details of the individual certificates in the stock certificate book with the individual shareholders’ accounts in the stockholders' ledger. • Compare the totals in the stockholders' ledger and the stock certificate book to the balance sheet presentation. • Recompute the weighted average number of shares outstanding. • Compare the financial statement presentation and disclosure with GAAP. • Determine the existence of and proper accounting for common-stock and treasury-stock transactions occurring since year-end. • Obtain written representations concerning common and treasury stock in the client representation letter. Solution to Discussion Case 15-25 a. There are a number of audit procedures that Johnson can conduct in order to determine if the entity is in violation of the debt agreement. Note that the possible violation of the debt covenants may have occurred during the subsequent events period. The entity's year-end was June 30, and the suspected violation occurred on August 31, the date the restrictions became effective. Possible audit procedures are as follows: • Test the covenant restrictions at August 31. However, since the entity does not have good period-end cutoffs for sales and purchases, Johnson should perform cutoff procedures at August 31. • Test the covenant procedures at June 30. This may provide some additional evidence on the reliability of the tests at August 31. • Obtain a representation letter from management that the covenant restrictions were being met. If Johnson determined that Mother Earth was in violation on August 31, she could (1) ask management if it intended to seek a waiver or modification of the loan restrictions and (2) inquire of the lenders as to whether Mother Earth Foods would be granted such a waiver or modification. b. FASB ASC Topic 470, “Debt” provides guidance for situations in which a violation of a debt covenant has occurred at the balance sheet date. This standard basically states that callable debt shall be classified as a current liability unless (1) the creditor has waived or subsequently lost the right to demand payment for more than a year or (2) the debt contains a grace period and it is probable that the debtor can cure the violation within the grace period. If either of these two conditions are met, the debt could continue to be classified as noncurrent. In this case, the most appropriate solution is for Johnson to determine if Mother Earth violated the covenants on August 31. If so, and if the entity can obtain a waiver, the debt should continue to be classified as noncurrent because no violation existed at the balance sheet date and the waiver after the balance sheet date cures the problem. If Johnson determined that a violation had occurred at August 31, at a minimum, the status of the debt should be disclosed in the footnotes. Solution to Internet Assignment 15-26 Student’s answer will vary. a. Students should provide justification for their overall opinion. Most students will agree with the FASB’s decision to move operating lease obligations to the balance sheet because it results in a more accurate presentation of how companies use the leased assets. If students are opposed to the new standard, some reasons why could include potential complications with debt covenants or that such changes were not necessary given that external users such as analysts and investors already made adjustments to financial statements to account for uncapitalized operating leases. b. Some analysts have estimated that the new standard could add $2 trillion to the balance sheets of companies in the U.S. c. This is a great question and one that is not yet fully determined. The FASB is suggesting that the new liabilities not be considered long-term debt, because that could trigger debt covenant violations (see footnote 2 in the chapter). Rather, the operating lease liability will be shown as a separate line item on the balance sheet. However, it remains to be seen how lenders will classify operating lease liabilities. Some would argue that it should not affect sophisticated users of financial statements who were already aware of these off-balance sheet leases and made their own adjustments when valuing companies. d. The shift in liabilities to the balance sheet will change ratios and trends relative to prior years. Before FASB Topic ASC 842, auditors were required to understand and verify the accuracy and completeness of the operating lease footnote and related schedule. Going forward, auditors will apply similar tests and procedures to an operating lease liability to what they perform for short and long-term debt. Chapter 16 Auditing the Financing/Investing Process: Cash and Investments Answers to Review Questions 16-1 The reliability of an entity's control activities over cash receipts and cash disbursements affects the nature and extent of the auditor's substantive tests of cash balances. The effective operation of these control activities provides strong evidence that the completeness assertion is being met. A major internal control activity that directly affects the audit of cash is the completion of a monthly bank reconciliation by entity personnel who are independent of the handling and recording of cash receipts and cash disbursements. Such bank reconciliations ensure that the entity's books reflect the same balance as the bank balance after considering reconciling items. Controls can be improved further if an independent party such as the internal auditor reviews the bank reconciliation. 16-2 A general cash account is the principal cash account for most entities. The major source of cash receipts for this account is the revenue process, and the major sources of cash disbursements are the purchasing and human resource management processes. Companies that have multiple locations are likely to have branch accounts. Such accounts provide the branch with the ability to pay local expenses and to maintain banking relations with the local community. An imprest bank account contains a stipulated amount of money, and the account is used for limited purposes. Imprest accounts are frequently used for disbursing payroll and dividend checks. An imprest account serves as a clearing account for similar types of checks. By separating similar types of checks, the entity facilitates the disbursement of cash while maintaining adequate control over cash. Use of imprest accounts also minimizes the time necessary to reconcile the general cash account. 16-3 Because of the residual nature of cash, it does not have a predictable relationship to other financial statement accounts. As a result, the auditor's use of analytical procedures for auditing cash is limited to comparisons with prior years' cash balances and to budgeted amounts. This limited use of analytical procedures is normally offset by (1) extensive tests of controls and/or substantive tests of transactions for cash receipts and cash disbursements or (2) extensive tests of the entity's bank reconciliations. 16-4 The standard bank confirmation form does not identify all information about an entity's bank deposits or loans because it does not require bank personnel to conduct a comprehensive, detailed search of the bank's records beyond the account information requested on the confirmation. 16-5 A cutoff bank statement is obtained to test the reconciling items included in the bank reconciliation. The outstanding checks or substitute checks returned with the cutoff bank statement are examined for proper payee, amount, and endorsement. 16-6 Three fraud-related audit procedures for cash are: • Extended bank reconciliation procedures. These procedures include examining the disposition of the reconciling items included in the prior months’ reconciliations and the reconciling items included in the current bank reconciliation. • Proof of cash. The four-column proof of cash (1) ensures that all cash receipts recorded in the entity’s cash receipts journal were deposited in the entity’s bank account, (2) ensures that all cash disbursements recorded in the entity’s cash disbursements journal have cleared the entity’s bank account, and (3) ensures that no bank transactions have been omitted from the entity’s accounting records. See Exhibit 16-5 for an example. • Tests for kiting. An interbank transfer schedule is used to test for kiting (see Exhibit 16-6). 16-7 An approach used by auditors to test for kiting is the preparation of an interbank transfer schedule. With an interbank transfer schedule, the auditor tests the dates of cash disbursements and the cash receipt for each transfer to assure that the transfer is properly recorded. 16-8 The main transaction-related assertions for investments are occurrence, authorization, completeness, accuracy, and classification. The key segregation of duties for investments and the errors or fraud that they can prevent are: Segregation of Duties Possible Errors or Fraud as a Result of Conflicts in Duties The initiation function should be segregated from the final approval function. Fictitious transactions can be made or securities can be stolen. The value-monitoring function should be segregated from the acquisition function. Securities values can be improperly recorded or not reported to management. Responsibility for maintaining the securities ledger should be separate from that of making entries in the general ledger. Concealment of a defalcation that would normally be detected by reconciliation of subsidiary records with general ledger control accounts. Responsibility for custody of securities should be separate from that of accounting for the securities. Theft of securities can be concealed. 16-9 FASB ASC Topic 320, “Investments – Debt Securities,” requires that debt investments be classified in three categories and accounted for as follows: • Debt securities that the entity has the positive intent and ability to hold to maturity are classified as held-to-maturity securities and reported at amortized cost. • Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings. • Debt or equity securities not classified as either held-to-maturity or trading securities are classified as available-for-sale and are reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders' equity. The auditor must also determine if there has been any permanent decline in the value of an investment security. Auditing standards provide guidance for determining whether a decline in value below amortized cost is other than temporary. FASB ASC Topic 321, “Investments – Equity Securities,” requires that equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. For equity investments that do not have readily determinable fair value, an entity may choose to measure at cost minus impairment, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer. 16-10 The two presentation classification issues that are important for the audit of debt investments are: • Marketable securities need to be properly classified between held-to-maturity, trading, and available-for-sale. • The financial statement classification requires that all trading securities be reported as current assets and held-to-maturity securities and individual available-for-sale securities be classified as current or noncurrent assets based on whether management expects to convert them to cash within the next twelve months. 16-11 Fair value audit evidence for Level 1 is objective and market-based so the auditor will obtain fair values from publicly available sources (e.g., finance website). Level 3 fair value evidence will involve examining management’s assumptions and subjective inputs to valuation models. Complicated financial instruments, such as credit default swaps, asset- backed securities, and collateralized debt obligations, among others, may not be traded on active markets, making accurate valuation of such instruments difficult. The auditor will likely need to involve a valuation specialist. Answers to Multiple-Choice Questions 16-12 b 16-18 d 16-13 a 16-19 b 16-14 d 16-20 b 16-15 a 16-21 b 16-16 b 16-22 c 16-17 b 16-23 b Solutions to Problems 16-24 The auditor's internal control questionnaire should include the following additional questions: • Does access to the bank safe-deposit vault require the signature or presence of two designated persons? • Are all individuals who have access to marketable securities bonded? • Are those who have access to the securities denied access to the accounting records? • Does the accounting department keep detailed records of • Purchases and sales? • Securities (including number of shares) owned? • Stock certificate numbers? • Dividend income? • Gains and losses? • Are all securities registered in the name of the company? • Are all securities periodically inspected? • Are the inspections performed on a surprise basis? • Is the physical inventory of securities reconciled with the accounting records? • Are all purchases and sales of securities executed by the treasurer within the directives of the investment committee? • Is the amount of dividends received on individual investments periodically reconciled to published public records? • Does the investment committee periodically review compliance with its established policy? 16-25 Typical audit program steps for auditing Sevcik's bank balance include the following steps: • Review answers to questions on confirmation requests to determine proper recognition in accounting records and the necessity for financial statement disclosure. • Make inquiries as to compensating balances and restrictions. • Obtain copies of the bank reconciliations as of the balance sheet date and • Trace the adjusted book balances to the general ledger balances; and • Compare the bank balances to the opening balances on the cutoff bank statements. • Compare the bank balances to the balances on the confirmations. • Trace amounts of deposits in transit to the cutoff bank statements and ascertain whether the time lags are reasonable. • Verify the clerical accuracy of the reconciliations. • Obtain explanation for unusual reconciling items, including checks drawn to "bearer," "cash," and related parties. • Trace checks dated prior to the end of the period that were returned with the cutoff statements to the list of outstanding checks. • Investigate outstanding checks that did not clear with the cutoff bank statements. • Examine a sample of checks for payee, amount, date, authorized signatures, and endorsements to determine any deviations from company policy or fraud in the accounting records. • Prepare a bank transfer schedule from a review of the cash receipts and disbursements journals, bank statements, and related paid checks for the last few days before and the first few days after year-end. Review the schedule to determine that the deposit and disbursement of each transfer is recorded in the proper period. • Trace incomplete transfers to the schedule of outstanding checks and deposits in transit. 16-26 a. 4, 7 b. 1, 5, 6, 7, 8 c. 2, 5, 6, 7, 8 d. 7 e. 3 16-27 a. The following information is missing: • The date of purchase of security “S”. • The date of purchase and sale of security “R”. • Data concerning the accrual and/or receipt of interest due on “R” to the date of sale. • Data concerning the accrual and/or payment of interest due on “S” to the date of purchase. • Justification for accrual of dividends. • Accounting treatment of bond discount. • Data concerning the December 31, 2018, revenue accruals. • Data required to evaluate the classification of securities. b. The following procedures were not noted as having been performed: • The securities were not physically inspected or confirmed. • The broker's advice (or other independent corroborating evidence) verifying the sale of “R” was not examined. • Dividend rates were not verified by reference to public records (e.g., Standard & Poor's) of dividend declarations. • The stated interest rates, maturity dates, and market values were not verified. • Computations of year-end accruals were not made. • Not all amounts (e.g., loss on sale of “R”) were traced to the general ledger. 16-28 a. Primary Assertion Objective 4. Existence or occurrence To determine that the custodian holds the securities as identified in the confirmation. 5. Completeness To determine that all income and related collections from the investments are properly recorded. 6. Accuracy, valuation and allocation To determine that the market or other value of the investments is fairly stated. 7. Authorization, Presentation and Classification To determine that transfers are properly authorized and that the financial statement presentation and disclosure of investments is in conformity with generally accepted accounting principles consistently applied. 8. Accuracy, valuation and allocation To determine that the market or other value of the investments is fairly stated and the loss is properly recognized and recorded. b. Phung should consider applying the following additional substantive auditing procedures in auditing Vernon's investments: • Inspect securities on hand in the presence of the custodian. • Examine supporting evidence (broker's advices, etc.) for transactions between the balance sheet date and the inspection date. • Obtain confirmation from the issuers or trustees of investments in nonpublic entities. • Examine contractual terms of debt securities and preferred stock. • Determine if the board of directors or its designee properly approved sales and purchases. • Examine broker's advices in support of transactions or confirm transactions with broker. • Determine if gains and losses on dispositions have been properly computed. • Trace payments for purchases to canceled checks and proceeds from sales to entries in the cash receipts journal. • Determine if the amortization of premium or discount on bonds has been properly computed. • Determine if trading securities and available-for-sale securities are properly valued and any unrealized gains and losses are properly accounted for. • Ascertain whether any investments are pledged as collateral or encumbered by liens and, if so, are properly disclosed. 16-29 a. 5 b. 6 c. 4 16-30 a. Stock portfolio inputs: Current Stock Prices Option Expense inputs: Current stock price; risk-free rate; dividend-yield; exercise price; time; standard deviation. b. Stock portfolio, FASB ASC Topic 820 Levels • Stock Price: Level 1 • Overall Portfolio: Level 1 • Stock Compensation Expense, FASB ASC Topic 820 Levels • Current Stock Price: Level 2 • Risk-free Rate: Could be Levels 2 or 3 depending on whether management claims a rate difference from that commonly used by the industry. • Dividend-Yield: Level 2 • Exercise Price: Level 2 • Time: Level 2 • Standard Deviation: Level 2 or Level 3 • Overall Account: Level 2 or Level 3 c. Audit Plan: Stock portfolio • Verify that stock prices listed by company are accurate according to NYSE ticker quotes as of period-end. Audit Plan: Stock Compensation Expense • Verify that risk-free rate as used by the entity is consistent with quoted Treasury bill prices as of 12/31. • Verify that standard deviation as used by the entity is consistent with market information about previous fluctuations in the stock price. • Perform sensitivity analysis to see how much small changes in these inputs would impact the overall stock compensation expense listed on the financial statements. • Tie out inputs to the model, verify model’s accuracy, trace model outcome to accounting records. • Consider qualifications and competence of person(s) computing the valuation for the entity. • Consider past history of input estimates, has the company’s process yielded reasonable results or have they tended to be aggressive or conservative? • Consider involving an option valuation specialist. • Develop independent estimate of fair value. • Review subsequent events. • Determine appropriateness of valuation techniques considering the current market environment. Solution to Internet Assignment 16-31 Information regarding Intel and Microsoft are below (Note: ASU 2016-1 was not effective until 2018, and as such, in 2017 and earlier equity investments could still be classified as trading or available-for-sale securities). Students’ answers will vary. Of interest is the large difference between the investment balances between Intel and Microsoft. Most of this difference is due to overseas earnings by Microsoft that have yet to be repatriated and have been re-invested in US Treasury bonds. INTEL As of 12/31/2017, Intel held $8.755 billion USD in trading assets and $4.192 billion in marketable equity securities. The footnotes state: Trading Assets Marketable debt instruments are generally designated as trading assets when a market risk is economically hedged at inception with a related derivative instrument, or when the marketable debt instrument itself is used to economically hedge currency exchange rate risk from remeasurement. Investments designated as trading assets are reported at fair value. The gains or losses on these investments arising from changes in fair value due to interest rate and currency market fluctuations and credit market volatility, largely offset by losses or gains on the related derivative instruments and balance sheet remeasurement, are recorded in interest and other, net. Available-for-Sale Investments Available-for-sale investments are classified within cash and cash equivalents, short-term investments, marketable equity securities, or long-term investments based on the remaining maturity of the investment. Investments designated as available-for-sale are reported at fair value, with unrealized gains or losses, net of tax, recorded in accumulated other comprehensive income (loss), except as noted in our other-than-temporary impairment policy. We determine the cost of the investment sold based on an average cost basis at the individual security level. Our available-for-sale investments include: • Marketable debt instruments when the interest rate and foreign currency risks are not hedged at the inception of the investment or when our criteria for designation as trading assets are not met. We record the interest income and realized gains or losses on the sale of these instruments in interest and other, net. • Marketable equity securities when there is no plan to sell or hedge the investment at the time of original classification. We acquire these equity securities to promote business and strategic objectives. We record the realized gains or losses on the sale or exchange of marketable equity securities in gains (losses) on equity investments, net. MICROSOFT As of 6/30/2017, Microsoft held $125.3 billion USD in short-term investments and $6.0 billion in equity and other investments. The footnotes state: Investments We consider all highly liquid interest-earning investments with a maturity of three months or less at the date of purchase to be cash equivalents. The fair values of these investments approximate their carrying values. In general, investments with original maturities of greater than three months and remaining maturities of less than one year are classified as short-term investments. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations. All cash equivalents and short-term investments are classified as available-for-sale and realized gains and losses are recorded using the specific identification method. Changes in market value, excluding other-than-temporary impairments, are reflected in OCI. Equity and other investments classified as long-term include both debt and equity instruments. Debt and publicly-traded equity securities are classified as available-for-sale and realized gains and losses are recorded using the specific identification method. Changes in the market value of available-for-sale securities, excluding other-than-temporary impairments, are reflected in OCI. Common and preferred stock and other investments that are restricted for more than one year or are not publicly traded are recorded at cost or using the equity method. Cash, Cash Equivalents, and Investments Cash, cash equivalents, and short-term investments totaled $133.0 billion as of June 30, 2017, compared with $113.2 billion as of June 30, 2016. Equity and other investments were $6.0 billion as of June 30, 2017, compared with $10.4 billion as of June 30, 2016. Our short-term investments are primarily intended to facilitate liquidity and for capital preservation. They consist predominantly of highly liquid investment-grade fixed-income securities, diversified among industries and individual issuers. The investments are predominantly U.S. dollar-denominated securities, but also include foreign currency-denominated securities to diversify risk. Our fixed- income investments are exposed to interest rate risk and credit risk. The credit risk and average maturity of our fixed-income portfolio are managed to achieve economic returns that correlate to certain fixed-income indices. The settlement risk related to these investments is insignificant given that the short-term investments held are primarily highly liquid investment-grade fixed-income securities. Of the cash, cash equivalents, and short-term investments as of June 30, 2017, $127.9 billion was held by our foreign subsidiaries and would be subject to material repatriation tax effects. The amount of cash, cash equivalents, and short-term investments held by foreign subsidiaries subject to other restrictions on the free flow of funds (primarily currency and other local regulatory) was $2.4 billion. As of June 30, 2017, approximately 87% of the cash equivalents and short-term investments held by our foreign subsidiaries were invested in U.S. government and agency securities, approximately 3% were invested in U.S. mortgage- and asset-backed securities, and approximately 2% were invested in corporate notes and bonds of U.S. companies, all of which are denominated in U.S. dollars. The remaining cash equivalents and short-term investments held by our foreign subsidiaries were primarily invested in foreign securities. Solution Manual for Auditing and Assurance Services: A Systematic Approach William F. Messier, Steven M. Glover, Douglas F. Prawitt 9781260687637, 9780077732509, 9780077732509, 9781259162312