Solutions for Chapter 18 Advanced Topics Concerning Complex Auditing Judgments

Review Questions: 18-1. Yes, and in fact, it is the auditors obligation to question the acceptability of the clients judgments. To evaluate the clients judgments, the auditor should determine whether the client has a systematic process in place to evaluate the (a) the reasonable of the assumptions made in developing the estimate, (b) the quality of the data used in making the estimate, (c) the calculation of the estimate, and (d) the consistency of the estimate with prior year estimates and current economic conditions. The audit process should examine the four factors identified above, i.e. the assumptions, the quality of the data going into the estimation model, the nature of the calculations, and the consistency of the estimate. 18-2. The investors make some very important points, including the following: many of the estimates made in the past have not been very reliable, problems usually culminate over a period of time, so advance warning and some information on the development of problems would be very useful, companies ought to disclose contingencies that have the potential of a severe impact, regardless of the likelihood of outcome (auditors and managers do not seem to be very good at estimating likelihood of outcomes).

The letters do a good job of reaffirming the need to understand materiality from an investor (user) perspective. 18-3. Yes, inventory, accounts receivable, and property, plant, & equipment are all subject to fair value estimates because all of these accounts are either subject to lower of cost or market considerations or impairment considerations. The lower of cost or market is used for both inventory and accounts receivable and requires management and the auditor to estimate the realizable (market) value of the assets. When plant and equipment are no longer being used, or are not being used productively, the auditor has to assess the potential decline in the value of the asset due to impairment and that impairment is assessed through a market estimate of its value. 18-4. The Net Investment in Operating Leases represents the improvements and the investments made in property that the company leases, e.g. improvements to a building, or modifications made to equipment. Many textbooks refer to this account as leasehold

improvements. Like all other assets, this account is also subject to impairment tests. If the company will no longer be using the assets under lease, then the net investment in the operating leases should be written down to its fair value. 18-5. Materiality decisions are complex and judgmental because they are a matter of professional judgment, depend on the needs of a reasonable person, which is obviously an ambiguous concept, and involve both quantitative and qualitative considerations. Further, they differ from one audit client to another and may change for the same client from one period to another. In addition, there are a variety of users with differing concepts as to what is material to their decision-making. 18-6. The rollover method focuses on the materiality of current year misstatements and the reversing effect of prior year misstatements on the income statement. This method may allow misstatements to accumulate on the balance sheet. The iron curtain method focuses on ensuring that the year end balance sheet is correct and does not consider the impact of prior year uncorrected misstatements reversing in later years. 18-7. The purpose of materiality judgments is to ensure that the auditor gathers sufficient evidential matter to provide reasonable assurance about whether the financial statements are free of material misstatement. 18-8. The auditor should evaluate each misstatement individually, and the auditor should consider the aggregate effect of all misstatements. 18-9. A quantitatively small misstatement might be considered material under the following circumstances:

If the misstatement arises from an item capable of precise measurement or whether it arises from an estimate and, if so, the degree of imprecision inherent in the estimate if the misstatement masks a change in earnings or other trends if the misstatement hides a failure to meet analysts' consensus expectations for the enterprise if the misstatement changes a loss into income or vice versa if the misstatement concerns a segment or other portion of the registrant's business that has been identified as playing a significant role in the registrant's operations or profitability if the misstatement affects the registrant's compliance with regulatory requirements if the misstatement affects the registrant's compliance with loan covenants or other contractual requirements

if the misstatement has the effect of increasing management's compensation for example, by satisfying requirements for the award of bonuses or other forms of incentive compensation if the misstatement involves concealment of an unlawful transaction.

18-10. Because of the importance of cash flows to investment decisions, the statement of cash flows has gained in visibility, use, and scrutiny. Thus, it is important that each of the classifications is correctly stated. For example, cash flows associated with operating activities are often an important measure for investors and investors would like to have confidence that the measure is materially correct. 18-11. It is important that the auditor project the amount of detected misstatements to the population (most likely misstatement) because that is the best estimate of the misstatements in the account balance that the auditor would most likely find if the auditor performed audit procedures on 100% of the population. The auditor would be underestimating errors if he or she only used the misstatements that were found in the sample. Thus, the auditor uses both the known misstatements and the projected most likely misstatements. The auditor should also consider the upper misstatement limit to allow for sampling error. 18-12. The factors the auditor should consider in determining the classification of a weakness in internal control include: Control Environment. Because weaknesses in the control environment are likely to affect all other components of internal control, such weaknesses are more likely to be material. Repeatability of Process. If a systematic weakness exists in a process that is repeated, e.g. heavily computerized, it is more likely to be either significant or material. Volume of Transactions. The higher the volume of transactions, the more likely that a weakness could result in misstatements that could be either significant or material. Complexity and Subjectivity of the Account Balance. The more complex and subjective a material account balance is, the more likely that a deficiency will be material. Effectiveness of Oversight and Governance. A lack of sufficient oversight would be considered a material weakness regardless of whether misstatements are actually detected in the financial statements. Existence of Complementary Controls. Often there are other controls in place that might complement a deficiency in a particular control, and that make the original weakness less likely to be judged material.

Remediation of a Control Deficiency. The auditors report addresses whether or not there are material weaknesses in internal control as of the companys year-end. If the control is remediated on a timely basis, it would move a material weakness to either a significant or immaterial deficiency.

18-13. Objectivity is achieved when the auditor makes a balanced assessment of all the relevant circumstances and is not influenced by their own interests or others in forming judgments. The external auditing standards (see SAS No. 65) indicate that objectivity should be assessed through consideration of the organizational status of the internal auditor responsible for the internal audit function and policies to maintain internal auditors' objectivity about the areas audited, 18-14. In making this determination the external auditor will consider three issues. The first is the materiality of the financial statement amounts that is, account balances or classes of transactions. The second is the risk (consisting of inherent risk and control risk) of material misstatement of the assertions related to these financial statement amounts. The third is the degree of subjectivity involved in the evaluation of the audit evidence gathered in support of the assertions. As the materiality of the financial statement amounts increases and either the risk of material misstatement or the degree of subjectivity increases, the external auditors will need to perform more of the work, and will be able to rely less on the work of the internal audit function. As these factors decrease, the need for the external auditors to perform their own tests decreases. Assertions where the external auditors may be able to rely on internal audits work to a great extent relate to less material financial statement amounts where the risk of material misstatement or the degree of subjectivity involved in the evaluation of the audit evidence is low. These include assertions about the existence of cash, prepaid assets, and fixed-asset additions. Assertions where the external auditor may not want to rely on the internal auditors work to a great extent, or even at all, are assertions that have a high risk of material misstatement or involve a high degree of subjectivity in the evaluation of audit evidence. These might include assertions about the valuation of assets and liabilities involving significant accounting estimates, or the existence and disclosure of related-party transactions, contingencies, uncertainties, and subsequent events. 18-15. SAS No. 65 provides a list of possible factors to include. This list is not an exhaustive list and other factors might be considered relevant. Factors that might be considered in evaluating competence include:

Educational level and professional experience of internal auditors. Professional certification and continuing education. Audit policies, programs, and procedures. Practices regarding assignment of internal auditors. Supervision and review of internal auditors' activities. Quality of working-paper documentation, reports, and recommendations.

Factors that might be considered when assessing the quality of the work include whether the internal auditors' scope of work is appropriate to meet the objectives, audit programs are adequate, working papers adequately document work performed, including evidence of supervision and review, conclusions are appropriate in the circumstances, and reports are consistent with the results of the work performed. 18-16. Fair value is defined as: the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value measurements are applied when they are dictated by underlying accounting principles. The most likely times that fair value measurements are applied occur when: there is a decrease in the value of an asset account that is supposed to be carried at the lower of cost or market, e.g. inventory, or at realizable value, e.g. with receivables. fair value is dictated by the underlying accounting principle such as carrying marketable securities at their fair market value.

18-17 The FASB has set a hierarchy of inputs to consider in assessing fair value:

Level 1 is quoted prices for identical items in active, liquid and visible markets such as stock exchanges. An example would be a recent trade on the NYSE of a stock or a bond. Level 2 is observable information for similar items in active or inactive markets, such as two similarly situated buildings in a downtown real estate market. Level 3 are unobservable inputs to be used in situations where markets dont exist or are illiquid such as the credit crisis of 2009. This is often referred to as mark to model since it is highly dependent on managements estimates of future cash flows associated with the asset or liability to be valued. Level 3 valuations are often highly subjective.

18-18. An asset is impaired when the realizability of the asset is less than its carrying value, or its value in use (as it is presently used). In order to estimate impairment, the auditor has

to consider projected future cash flows from the asset. One example includes property that may no longer be used because of managements decision to discontinue a product line in production. Perhaps the most common example is goodwill, which must be tested for impairment every year.

Multiple Choice Questions: 18-19. 18-20. 18-21. 18-22. 18-23. 18-24. 18-25. 18-26. 18-27. 18-28. 18-29. 18-30. 18-31. b d a d c d c d a c c d a

Discussion and Research Questions: 18-32. a. The quotes from the investors tell us three things about materiality: Investors are interested in knowing as much as possible about problems that may take a long time to develop. Investors are concerned that many estimates have historically been wildly inaccurate. Investors want more information about contingencies that could have a significant effect on the companys operations and/or financial condition even if the auditor and company management cannot estimate the likelihood of the outcome.

These results tell us something about economic information that the auditor and management are capable of communicating that is important to understanding financial results even if current GAAP does not lead to the quantification of the items in financial statements. b. (1) It is true that neither auditors, investors, nor managers can predict the future. However, there is appropriate evidence that the auditor can gather including: the reasonableness of the assumptions made in developing the estimate, the quality of the data used in making the estimate, the calculation of the estimate, and

the consistency of the estimate with prior year estimates and current economic conditions.

The audit process should examine the four factors identified above, i.e. the assumptions, the quality of the data going into the estimation model, the nature of the calculations, and the consistency of the estimate. (2) The quality of the note disclosure affects materiality the same as any line item in the financial statements affects materiality. If the notes do not contain adequate disclosures that can be reasonably expected by investors, there is a material problem. c. This is an item for class discussion. The intent is to get students to think about issues from an investors perspective. The requests from the investors are simply to list all contingencies that could have a significant effect even if the amount or the likelihood cannot be evaluated with any specific level of precision. On the positive side, it can be argued that such contingencies are something the company knows about and can easily communicate. On the negative side, there are potential issues that the accounting profession has to consider including, but not limited to: the use of 20-20 hindsight bias, in other words, there might be something that no one saw that came to light and investors want to hold managers and auditors liable, the disclosures may give away competitive information. For example, if the company were to list all claims against the firm, then it might provide information that would be useful to plaintiffs (the other view is that such information would allow investors to make more informed judgments), investors may request disclosure of items that are not normally covered in financial statements or notes resulting in an increased burden on management and the auditors.

18-33. a. The Net Investment in Operating Leases represents the improvements and the investments made in property that the company leases, e.g. improvements to a building, or modifications made to equipment. Many textbooks refer to this account as leasehold improvements. Like all other assets, this account is also subject to impairment tests. If the company will no longer be using the assets under lease, then the net investment in the operating leases should be written down to its fair value. Information that Ford should gather on a regular basis to determine if there is an impairment of the asset include:

b.

 c.

Management strategic plans about operations, including closing plants or expanding plants, Expansion or contraction of car and/or truck sales, Alternative use of the net assets associated with the leasehold improvements, Alternative uses for the leased assets Profitability of products produced utilizing the assets including expected cash flow in the future, and Potential market value of the assets.

Yes, lack of information collection in this regard would represent a material weakness in internal control over financial reporting. Companies need to expand their accounting systems beyond that of transactions processing to gather systematic information that can be used in making accounting estimates or identifying and analyzing impairments. Yes, the definition of materiality applies to impairments and estimates. Although the auditor cannot precisely estimate the dollar amount, the audit work should be performed using statistical based models, e.g. regression analysis, or other analytical or computational models, that provides for a high degree of precision and confidence in the estimate. Yes, the same concepts of risk also apply. The auditor should perform tests of the account balances at a level of risk that is consistent with the overall auditor risk model and setting of Audit Risk for the client. The auditor cannot be 100% of any account balance that represents subjectivity including, for example, the allowance for uncollectible accounts. However, the auditor is testing a model and the computations. The auditor should be highly confident that the tests performed of the input data, the assumptions, and the computation of the model are highly accurate.

d.

e.

18-34. a. Under the rollover method, the current-year effect would be the amount by which the current year income statement is misstated (i.e., $20). Under the iron curtain method, the current year effect would be the amount by which the year-end balance sheet is misstated (i.e., $100). However, both of these would be moderated by the amount of materiality for each year as is discussed in part B. There are two thoughts on the proper adjustment for this year. An adjustment of $100 would correct the liability account and there would be no carry-overs for the next year to consider. However, such an adjustment would lead to a $50 misstatement in the income statement an amount that would be considered

b.

material. The auditor would most likely recommend an adjustment of around $75 (give or take a little) such that the amount by which the liability and income misstatement would be misstated by less than a material amount. The preference would be to adjust the liability in the following year so there would be no carryovers to the next year. An important thing to remember is that conservative accounting in one year leads to the opportunity for aggressive accounting in the future years. Thus, the preference is to get to a clean balance sheet such that there are not uncorrected misstatements carrying forward. 18-35. a. When auditors detect an intentional misstatement, they should do the following: (1) re-consider the level of audit risk for the client, (2) consider revising the nature, timing, and extent of audit procedures, and (3) evaluate whether to resign from the audit engagement. The detection of an intentional misstatement likely signals the existence of an internal control material weakness and certainly speaks to control environment problems involving the tone at the top of the organization. The auditor must discuss the matter with the audit committee. If the client corrects the misstatement, there is no need to report the misstatement to outside parties. The financial statements are fairly presented and the auditors task is to provide an opinion on the fairness of the financial statements. However, the auditor has an obligation to report the intentional misstatement to the audit committee and to determine whether or not the audit committee has taken proper action with regard to the intentional misstatement. If the audit committee takes no action, the auditor would usually seek legal counsel to determine potential expansion to report outside of the normal auditor report. If the client is a public company, then the intentional misstatement is clearly a material weakness in internal control. The misstatement was corrected only because the auditor had found it during the audit. The auditor should fully describe the nature of the material weakness in internal control. It is up to the board and management to communicate how they have dealt if at all with the cause of the internal control weakness. c. The implication is that, in finding a material misstatement, the auditor has to evaluate the cause of the misstatement. There is prima facie evidence that there is a material weakness in internal control. Further, intentional misstatements reflect directly on the tone at the top and the control environment. Such material weaknesses should be reported in the auditors report on internal control. No, the auditor cannot assume the financial statements are free of material misstatements. The auditor must consider all aspects of the factors leading to the

b.

18-36. a.

percentages. This question comes directly from the SECs SAB No. 99. The entirety of SAB 99 is meant to address this question. The following excerpt from SAB No. 99 highlights the key points with respect to this scenario and suggests that the auditor should not just make a quantitative assessment but should also consider qualitative factors. The [SEC] staff is aware that certain registrants, over time, have developed quantitative thresholds as "rules of thumb" to assist in the preparation of their financial statements, and that auditors also have used these thresholds in their evaluation of whether items might be considered material to users of a registrant's financial statements. One rule of thumb in particular suggests that the misstatement or omission of an item that falls under a 5% threshold is not material in the absence of particularly egregious circumstances, such as self-dealing or misappropriation by senior management. The [SEC] staff reminds registrants and the auditors of their financial statements that exclusive reliance on this or any percentage or numerical threshold has no basis in the accounting literature or the law. The use of a percentage as a numerical threshold, such as 5%, may provide the basis for a preliminary assumption that without considering all relevant circumstances a deviation of less than the specified percentage with respect to a particular item on the registrant's financial statements is unlikely to be material. The [SEC] staff has no objection to such a "rule of thumb" as an initial step in assessing materiality. But quantifying, in percentage terms, the magnitude of a misstatement is only the beginning of an analysis of materiality; it cannot appropriately be used as a substitute for a full analysis of all relevant considerations. Materiality concerns the significance of an item to users of a registrant's financial statements. A matter is "material" if there is a substantial likelihood that a reasonable person would consider it important. In its Statement of Financial Accounting Concepts No. 2, the FASB stated the essence of the concept of materiality as follows: The omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item. b. Additional factors the auditor should consider in evaluating materiality include: Trends in earnings both at the segment level and the consolidated level, The extent management was involved in the misstatement, The amounts and effects on the financial statements before they were netted, The relationship to internal controls, particularly those that might be reflected in the tone at the top, or control environment.

18-37. a. No, we do not agree with the statement. The range of materiality should not vary with the subjectivity of the account balance. While there is uncertainty whenever subjective estimates are made, the auditor should apply a systematic process that should lead to a conclusion on whether or not a material misstatement in the account balance may be likely. An important point is that the estimate may turn out to be correct or incorrect, but the auditors estimate (as well as managements estimate) ought to be based on the best information available at the time of the preparation of the financial statements and the assumptions of the underlying model ought to be evaluated by the client and the auditor. Materiality is a contemporaneous evaluation, not one that is made with the advantage of 20/20 hindsight made from a perspective of a few years after the estimate was made. The question is whether management and the auditor had gathered the best available evidence, including assumptions, valid input data, and computations to make a good estimate. The auditors comment: the preciseness of the estimate is dependent on the soundness of the underlying prediction model. If the auditor determines that the inputs are correct and agrees on the model, there is no need for audit judgment merits thoughtful consideration. Students may agree or disagree with the statement the quality of their argument is important. Regarding each point, the authors opinions are as follows: No Need for Auditor Judgment. We disagree as there is always a need for some auditor judgment because not every factor can be precisely measured or modeled. There is an expectation that an audit partner will consider all other factors, e.g. changes in the economy, industry competitiveness, management policies, changes in management, and so forth to determine if the estimate while computationally correct makes sense in light of all of the surrounding circumstances. Verifying the Soundness of the Model. The auditor should consider: o o o o Accuracy of predictions in the past, The statistical precision of the model, Consistency over time, Changes in the economy or in company business.

b.

Overruling the Computational Model. The auditor is responsible for applying the accumulation of knowledge gained over time on all audits, as well as a detailed knowledge of gained from auditing the particular client. However, if the auditor chooses to overrule the knowledge, the audit or should write a detailed explanation of all the factors that have led to the conclusion. The memo describing the rationale for the changes should be challenged by the outside reviewing auditor (the concurring partner).

18-38. a. Reporting requirements regarding internal control deficiencies are as follows: Non-material, non significant should be summarized and communicated to management and the audit committee (not mandatory, but improves communication so that audit committee understands scope and nature of the auditors work). Significant deficiency must be communicated to management and the audit committee. Material Weakness must be communicated to management and the audit committee, and must be addressed in the auditors report on internal control over financial reporting.

b. Explain how the following factors influence how a control deficiency is classified: Weakness is in the control environment. Because weaknesses in the control environment are generally pervasive, it is likely that such weaknesses will be considered material weaknesses. Repeatability of the process. If the volume is high, it is likely that the systematic failure could lead to a material misstatement, or certainly a significant deficiency. Based on the nature of the deficiency, the auditor would report either a significant deficiency or a material weakness. Volume of transactions affected by the control deficiency. When applied to transactions processing, the volume directly affects the materiality of the weakness. Complexity and subjectivity of the area in which the control was supposed to be working. The concept captures the problem often associated with audit engagements where there may not be a large number of transactions, but the complexity and subjectivity of the area often leads to material misstatements. As was covered in the text, there is a need for the company to have sufficient controls to gather data, test assumptions, and make estimates. Most often these deficiencies will be either significant or material. Existence of complementary controls. It is important to recognize that complementary controls may address the risk of misstatement. Therefore, it is possible to have deficiencies in important controls but have the risk of misstatement addressed by complementary controls. In such cases, the existence of complementary controls would most likely lead the auditor to conclude there were no deficiencies in internal controls over financial reporting.

Remediation of control deficiency before year-end. If a weakness is identified and remediated and this is important it is both remediated and the auditor has sufficient time to test to see that the control is working sufficiently, then there is no weakness in internal control. The answer also depends on who found the original deficiency. If it were found and corrected by the company, then it is not likely to constitute a significant deficiency. However, if the control deficiency were detected by the auditor then it means the company does not have sufficient methodologies in place to monitor the effectiveness of their controls and that would constitute at least a significant deficiency if the control area was one that addressed material account balances. Weaknesses in the oversight function of the board. Since oversight by the board and those in the governing processes are pervasive, such weaknesses would most often constitute material weaknesses in internal control.

18-39. a. The primary factors the auditor should consider in evaluating the effectiveness of the audit committee are: Demonstration that the audit committee is effectively exercising its oversight responsibilities, Financial competence and expertise of the audit committee members, Quality of support mechanisms for the audit committee, e.g. the existence of an effective internal audit activity, the quality and timeliness of financial information received by the audit committee, and the willingness of the committee to hold meetings as necessary to address important issues.

b. Elements of an audit program to evaluate the effectiveness of an audit committee would include the following: Assess financial competence of the audit committee members: o Examine background of each member, o Evaluate knowledge based on auditor observation of audit committee members, o Evaluate knowledge based on quality of questions addressed during the audit committee meeting. Assess the time spent in audit committee meetings and whether the time is sufficient to address information on their agenda. Assess the quality of internal audit oversight and the quality of internal audit work.

Review the agenda for audit committee meetings and determine whether they address all important issues. It also provides an opportunity to assess the quality of information provided to the audit committee to assist it in carrying out its functions. Determine if the audit committee has a continuing education plan that addresses important accounting and audit issues that will be affecting the company. Determine if the audit committee performs a self-evaluation each year and review the results of that self evaluation. This helps assess whether or not the audit committee is committed to continuous improvement.

c.These items constitute a material weakness in internal control because of: Lack of financial competence. It is difficult for most if not all audit committees to provide proper oversight (especially of a publicly-traded company) if it only meets an hour each quarter. This was one of the problems with audit committees associated with many of the frauds that have been discovered in the recent past. The audit committee should always hold executive meetings with both its internal and external auditors. It is these sessions that open communication to address significant issues without management being present. The overall attitude of the audit committee in this scenario is not of one committed to effective oversight.

18-40.

a. A material restatement constitutes prima facie evidence that there was a weakness in internal controls over financial reporting. The weakness in this case was in the commitment to financial competency and therefore was a weakness in the companys control environment. KPMG issued an adverse report on internal control in this reallife example. b. In this scenario, the substance of the issue is that the client is relying on the external auditor to prepare the tax estimate. Yes, this would constitute a material weakness in internal controls because the client does not have the competence to perform their own estimate. c. No, there is not sufficient evidence that the client has remediated the weakness in sufficient time to avoid an adverse report on internal control. There are two reasons for this conclusion: First, the problem was discovered by the auditor, not the client. Second, it takes time to bring new people into the organization and have them

demonstrate a level of competence that was previously lacking. This takes more than a week or two and most likely takes a year to demonstrate. Regarding whether the misstatement was intentional, the auditor has limited ability to make such a determination. However, the auditor should do the following: review the clients approach to making the tax accrual, review managements statements to the press regarding expected earnings, interview the personnel responsible for the tax estimate to assess whether they were under pressure from management, analyze the errors made in the estimate to determine if they were conceptual or were simply a blatant disregard for the tax laws.

If the auditor were to determine that the misstatement was intentional, the auditor would: 18-41. a. The external auditing standards (see SAS No. 65) indicate that objectivity should be assessed through consideration of the organizational status of the internal auditor responsible for the internal audit function and policies to maintain internal auditors' objectivity about the areas audited, The students may have different perspectives on this issue. On the one hand, some may indicate that the internal auditor can achieve the same level of objectivity on a given audit as does the external auditor. Objectivity is a state of mind an unbiased approach to gathering, evaluating, and analyzing evidence. It is extremely important that both audit functions strive for the highest level of objectivity on each audit engagement. ISA 610 makes the following observation: Internal auditing is part of the entity. Irrespective of the degree of autonomy and objectivity of internal auditing, it cannot achieve the same degree of independence as required of the external auditor when expressing an opinion on the financial statements. communicate the matter to the audit committee discuss the matter, where appropriate, with the full board determine what corrective action the board took particularly action that might have involved senior management review correspondence with the IRS to determine that the misstatement had been communicated to them determine whether to remain on the audit or to resign depending on the actions taken by the board and whether senior management was involved in the misstatement

b.

The observation in ISA 610 takes the perspective that independence is achieved when the auditor's judgments are not influenced by any relationships. Independence is most closely related to the auditors reporting relationship and the ability of management to influence either areas to be audited or audit findings. The internal audit department achieves its greatest independence when the audit committee is intimately involved in determining the budget for the audit department as well as audit coverage. Some students may note that the description of objectivity in the text, which is based on SAS 65, uses the term objectivity but the way that it is used in the standard is more closely related to independence than objectivity. c. Arguments for using the work performed by the internal audit function are: Documented performance at the highest level of standards in the profession. A quality review that indicates a highly competent and objective audit function. Policies in place to attract and retain highly qualified auditors especially those with computer skills, Auditors in place throughout the year to implement concurrent audit techniques and to monitor the quality of controls and system performance.

n terms of arguments against using the work performed by the internal audit function, all of the brief information about the internal audit function is positive. However, there is additional information that the external auditor would want to know before making a decision to rely on the internal auditors work. The first issue is whether the internal auditors work is relevant to the financial statement audit or the audit of internal controls. If that work is relevant, then the external auditor would want to obtain information about the objectivity of the internal audit function. For example, does the head of the internal audit function have an independent reporting relationship with the audit committee? Are there policies in place to help maintain an internal auditors' objectivity in the areas where audits are conducted? Finally, the external auditors would want to assess the quality of the worked performed by the internal audit function. 18-42. a. The FASB has set a hierarchy of inputs to consider in assessing fair value:

Level 1 is quoted prices for identical items in active, liquid and visible markets such as stock exchanges. An example would be a recent trade on the NYSE of a stock or a bond.

Level 2 is observable information for similar items in active or inactive markets, such as two similarly situated buildings in a downtown real estate market. Level 3 are unobservable inputs to be used in situations where markets dont exist or are illiquid such as the credit crisis of 2009. This is often referred to as mark to model since it is highly dependent on managements estimates of future cash flows associated with the asset or liability to be valued. Level 3 valuations are often highly subjective.

b. Ford Motor Co. has decided to close a major factory in St. Paul, MN: Classification: The building is either a level 2 or a level 3 fair value classification. The rationale for level 2 is that the factory now becomes a commercial building and there may be comparable values for one-story commercial buildings that could be used to estimate value. (Interestingly, the building was eventually sold to the post office). Managements Responsibility. It is managements responsibility to determine the fair value estimate of the building and the associated equipment with the building. Management should use the services of real estate professionals and others to develop a fair value estimate of the building and equipment. Relationship to Internal Control. Management should have an accounting system sufficient to make important estimates including those of fair value estimates for impairment of assets. If management does not have a process in place, or put a process in place when it decides to close the factories, then it has a material weakness in internal control over financial reporting. Audit Approach. The auditor can be comfortable in testing the clients estimate assuming the auditor (1) can assess the competence and independence of the appraiser, (2) evaluates the quality of the inputs to the appraisers model, and (3) can independently test the computation based on the appraisals inputs. If the auditor were not satisfied on these three dimensions, the auditor would consider getting an independent appraisal. However, as noted above, if the auditor needs to hire an independent appraiser, then there may be questions about the quality of the internal control process of the client with possible ramifications of the auditors report on internal control over financial reporting.

18-43. a. A reporting entity is an internal division of a company with which the goodwill is associated. It is normally defined as the same unit that the company had acquired when goodwill was added to the books. For example, if it were a software company that was acquired and that software unit remained as a separate reporting unit within the company, then it would meet the definition of a reporting entity.

b.

The first step in determining whether there is a need for a goodwill impairment to be recorded is for the auditor to compare the total market value of the firm with the book value of the company. As of December 31, 2008, there was a gap between market value and book value that was in excess of $1 trillion. Therefore, it is expected that there will be significant write-downs of goodwill at the end of 2008. An outline of an audit program for the storage solutions reporting unit follows. Please note that management always seems to be optimistic that future prospects are good. Compare market value of the company with book value to determine the extent that goodwill might be impaired. Determine whether other account balances that are subject to fair value estimates have been properly accounted for (if other assets are not written down prior to making the goodwill impairment estimate, it will result in an understatement of the amount that goodwill should be impaired). Review the valuation model and estimates used by Sun when they acquired the storage solutions reporting unit. Compare actual results with the assumptions made in the acquisition of the reporting unit. Review the assumptions made by management regarding new product introductions, profit margins, and industry position. Compare those assumptions with external and internal information available regarding new product introductions and competitor actions. Test client computations based on the assumptions made by the client. Compare with same valuation model using any changes in assumptions that might be dictated by current economic trends. Perform a sensitivity analysis of the assumptions, i.e. what would happen if the assumptions were 20% less favorable, 30% less favorable, or 10% more favorable. Perform an analysis of your best estimate with that of the client. Determine the amount of goodwill that should be written down. Determine if management writes goodwill down to a point that is within materiality bounds as dictated by planning materiality for the audit. Document the reasoning process and evidence considered in a separate memo to be included in the working papers.

c.

18-44. a. Reasoning process regarding materiality: Planning Materiality. The reasoning process should first document the factors that influenced the reasoning process. We would expect that the auditor would consider the following: CPA firm guidance on materiality judgments. Materiality used in past audits for the client. An analysis of investor guidance regarding the company, including expectations regarding earnings per share, earnings trend, and whether the investor community is paying particular attention to segments or to earnings trends. Discussion with management regarding their view of materiality and how they have set materiality regarding both the overall financial statements and individual line items. Review of important debt covenants and how close the company might be to violating some of those covenants. Review SEC guidance on materiality particularly the guidance on netting or offsetting potentially material amounts and analyzing the carry-over aspects of potential adjustments from previous years that were not made.

After considering these factors as well as others that may be pertinent to the client the auditor should document the factors that led to planning materiality. The reasoning should be rigorous such that the auditor would not necessarily want to change if something was found that was just borderline material to the financial statements. Misstatements that were not adjusted. The auditor should be primarily influenced by planning materiality in determining whether misstatements should be booked. The factors that need to be considered include: the effect on each individual account balance. the effect on current year and previous year estimates, i.e. whether the amounts might be material to reported net income even if not material to the related asset or liability account.

the importance of the adjustment to individual segments that may be of special interest to the investing community. the effect on debt covenants or other contracts that could have an adverse effect on the company. the potential effect on next years financial results considering the rollover or iron curtain approaches identified by the SEC. Keep in mind that conservatism in one year presents opportunities for aggressive growth in future years.

b. The adequacy of the clients estimate of warranty reserves. Similar to part A, the auditor should first start with an identification of important information that would affect the estimate. These include, but might not be limited to: c. the number of units sold and under warranty. past experience on warranty repairs, by model, by year. number of products still on warranty. new production techniques that might affect warranty reserves. trend in warranty costs. the clients information system and methodology in estimating the warranty reserve. consistency of the reserve with that of previous years. Adequacy of the allowance for uncollectible accounts. Similar to part A, the auditor should first start with an identification of important information that would affect the estimate. These include, but might not be limited to: changes in credit policies. changes in the economy and the likely effect on customers. disputes regarding quality of client products that could lead to the customer not paying for the goods received. past results comparison of estimates with experience. Note, however, that too much attention can be paid to past results when economic conditions have changed. auditor testing of the aged accounts receivable trial balance. current cash position and pressure on client to raise cash, including the possibility of selling the receivables.

Cases: 18-45. a. Using the maximum thresholds for net income, net sales, and total assets, and the 10% posting threshold yields the following amounts: Common Benchmarks % of Net Income % of Net Sales % of Total Assets Maximum Overall Materiality Threshold 5%=$2,872,800 1%=$10,666,910 1%=$6,987,520 Posting Threshold (10%) 10% X (2,872,800) = $287,280 10% X (10,666,910) = $1,066,691 10% X (6,987,520) = $698,752

b. The difficulty that the different materiality amounts poses for the auditor is that it is hard to choose among the alternatives. In practice, consistency with past decisions is important, so the auditor will likely use the prior years benchmark, i.e., if % of net income was used last year it makes sense to use that benchmark again unless conditions have changed. The qualitative factors that the auditor should consider in this case are: o There have been misstatements in the past in accounts receivable, so it is possible that the posting threshold should be even lower than 10% for this account. o The company is under considerable pressure from analysts to make their earnings forecasts. o Margins have declined for the company, as has earnings per share. So, the company looks worse to Wall Street than last year regardless of the outcome of the issue concerning the write down of accounts receivable. Thus, management is under considerable pressure to improve the financial results of the company. c. Because the problem provides no information on the benchmark used in the past, any of the three benchmarks is a reasonable answer to the question. Students may decide on total assets as the benchmark because the misstatement is on the balance sheet. Or students may decide on net income as the benchmark because of the focus on analyst expectations noted in the problem. Regardless of the benchmark chose, the 10% posting threshold is calculated in part (a) to the answer above.

d. The fact that errors have occurred in this account in the past suggests that a posting threshold even lower than 10% might be appropriate. So, for example, students might decide on a 5% posting threshold to reflect the qualitative risks noted in the problem. In that case, the posting thresholds would be: Common Benchmarks Maximum Overall Materiality Threshold 5%=$2,872,800 1%=$10,666,910 1%=$6,987,520 Posting Threshold (5%) 5% X (2,872,800) = $143,640 5% X (10,666,910) = $533,346 5% X (6,987,520) = $349,376

% of Net Income % of Net Sales % of Total Assets e.

Step 1. Structure the problem. The problem is that the auditor has discovered a misstatement of $345,000 in the accounts receivable balance totaling $25,152,000, an account in which the auditor has discovered misstatements in the past. The auditor recommends that management correct the problem, but management refuses. Step 2. Assess consequences. The consequences are that (1) the financial statements may be materially misstated, (2) investors could be misled, (3) if management prevails, the auditor loses some power in the long-term relationship in the sense that management may use this instance of the auditor backing down to gain leverage in other contentious issues. Step 3. Assess risks and uncertainties. The major risk is that given the negative earnings and margin trend at the company, the financial results for this year are particularly important to the investment community, i.e., accuracy and transparency are critical. Thus, there will be significant scrutiny of the financial statements, so the auditors put themselves at risk by not requiring a correction of a material misstatement. The uncertainty is whether or not the misstatement is actually material. Step 4. Evaluate information/audit evidence gathering alternatives. The auditor can use various materiality measures and thresholds, which we have outlined in the answer to the problem above. Step 5. Conduct sensitivity analyses. The difficulty is that the alternative materiality measures yield differing conclusions. If the auditor uses % of net income as the benchmark under either the 10% posting threshold (assuming a high risk client, but not considering the fact that there have been errors in accounts receivable in past years) or the 5% posting threshold (assuming a high risk client, but considering the fact that there have been errors in accounts receivable in past years), the $345,000 misstatement is clearly material and the auditor should require management to correct the misstatement. If the auditor uses the % of sales threshold, the misstatement is clearly immaterial regardless of whether the 10% or 5% posting threshold is used. If the auditor uses the %

of assets threshold, the misstatement is clearly immaterial using the 10% posting threshold, but it is marginally material using the 5% posting threshold. If the auditor uses either the % of sales or the % of assets thresholds, the auditor should note the situation in the management representation letter and alert the audit committee, but they do not have to necessarily require correction of the misstatement. However, consideration should be given to the fact that the SEC objects to management waiving supposedly immaterial adjustments, and the fact that there is strong analyst pressure for management to achieve earnings targets this year, which is an important qualitative factor. Step 6. Gather information/audit evidence. The auditor may decide to gather additional audit evidence to be certain that the misstatement of accounts receivable that they have calculated is precise and not subject to debate. If the auditor has clear evidence that the accounts receivable are definitively overstated, they will have more leverage to convince management of the need for a write-down. Step 7. Make decision. Different student groups will reach alternative conclusions depending on the assumptions that they make. 18-46. a. Materiality concerns the significance of an item to users of a registrant's financial statements. A matter is "material" if there is a substantial likelihood that a reasonable person would consider it important. In its Statement of Financial Accounting Concepts No. 2, the FASB stated the essence of the concept of materiality as follows: The omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item. While the question (or the AAER) does not provide much detail on the materiality assessment made by the audit partners, it is difficult to believe that the partners considered relevant factors, or even the above definition of materiality. For example, the auditors should have included qualitative factors in their assessment, such as the riskiness of the client. In fact, AAER 904 notes that the engagement partners were aware of red flags that should have caused a heightened level of professional skepticism. For example, the partners were aware that: (1) certain revenue was recorded by SDRC based on purchase orders containing conditional language and (2) material amounts of receivables were outstanding for long periods of time and then ultimately written off when the related revenue was reversed by SDRC. The engagement partner failed to demonstrate an appropriate level of professional skepticism with respect to the conditional purchase orders, the significant write-offs of accounts receivable and the material audit difference. Further, the engagement partner failed to consider adequately whether these factors were an indication that the financial statements were materially misstated.

b.

The AAER notes that the audit partners placed undue reliance on management's representations and failed to exercise due care in connection with assessing the materiality of the passed audit difference. Relying on management representation alone would not be sufficient. Further, as noted in (a) above, the assessment should have included other qualitative factors. The auditor should evaluate each misstatement individually, and the auditor should consider the aggregate effect of all misstatements. Further, if an individual misstatement causes the financial statements as a whole to be materially misstated, that effect cannot be eliminated by other misstatements that have a different directional effect on the financial statements.

c.

18-47. a. There are obviously no correct solutions to this question. The description of the internal audit function includes many of the factors that are indicated in SAS No. 65. The intention when designing the description was that the internal audit function would be assessed to be of a moderate level of quality, at best. The internal auditors appear to have a reasonable level of experience and the top two people have professional certifications. The level of objectivity of the internal audit function might be in question. While the internal audit function does have access to the audit committee, they report to the CEO. This arrangement is not uncommon, although not a best practice. The quality of work appears to be mixed. For example, appropriate follow-up work (on confirmations) was not performed for all items. However, the work related to the ownership of the receivable appears to be adequate. In some cases sample sizes were appropriate (accounts receivable testing related to pricing, accounts receivable confirmations) while in other cases the sample size was smaller than the external auditor would have used (testing controls). The auditing standards do not provide any guidance to suggest that the evaluation of an internal audit function would differ if that function were staffed in-house or outsourced. However, some students might suggest that the objectivity of an outsourced internal audit function would likely be higher than that of an in-house internal audit function. That conclusion is not unreasonable and is supported by a research studying using basically the same case as the one presented in this problem. In that study, external auditors assessed the objectivity of the outsourced internal audit function to be higher than the objectivity of the internal audit function when it was described as being staffed in-house. (See Gramling, A. A. and S. D. Vandervelde. 2006. Assessing Internal Audit Quality. Internal Auditing (May/June): 26-33.) The answer to this question should incorporate the issues of materiality, risk (inherent and control) and subjectivity of evidence evaluation. Although there is not enough information to conclude whether the accounts receivable balance is material, such a conclusion would seem reasonable. There is some risk associated with this account given the growth goals for management and the future stock offering. Based

b.

c.

on the work that the internal auditors have performed, the control risk in this area does not seem particularly high. Some of the assertions will require a higher level of subjectivity in evaluating the evidence (valuation) than other assertions (existence, rights and obligations). The external auditors will definitely want to do more work related to the valuation assertion. However, they may be willing to rely quite a bit on the work that the internal auditors did related to the rights and obligation assertion. As f or the existence assertion, the external auditors will most likely want to send their own confirmations, but they may be willing to reduce the number of confirmations they would normally send by relying on the work already performed by the internal auditors. Finally, the internal auditors have performed some control testing and the external auditors may be willing to reduce their extent of control testing by relying on the work performed by the internal auditors. d. In addition to, or in place of, relying on the work already performed by REDTOPs internal audit function, the external auditors may choose to have REDTOPs internal auditors provide assistance during the performance of the audit. In this capacity, the internal auditors would perform some of the audit procedures that might typically be performed by the staff auditors on the external audit team.

Ford Motor Company and Toyota Motor Corporation: Materiality Judgments 1. Locate and read the SECs guidance on materiality judgments, Staff Accounting Bulletin No. 99. Hint: you may find it helpful to use the search term SAB No. 99 on Google. No solution necessary. 2a. Calculate these numerical thresholds for Ford and Toyota. 5% of net income 1% of assets Ford 0.05 X (-2,723,000,000) = 0 0.01 X (279,264,000,000) = 2,792,640,000 Toyota 0.05 X (13,927,000,000) = 696,350,000 0.01 X (275,941,000,000) = 2,759,410,000

2b. Obviously, the numerical thresholds differ across the two companies. Why does that present a problem for the auditor? Third party users? For auditors, different numerical thresholds at different clients mean that they must adjust their assessments of materiality for the variation at clients, which is an inherently subjective and difficult task. PricewaterhouseCoopers LLP audits both Ford and Toyota, and their size in terms of total assets (and the associated materiality threshold) is quite similar. Yet, the numerical materiality thresholds for misstatements as a percentage of net income, for example, are vastly different. That threshold is inapplicable for Ford because it is a negative number (essentially zero), while it is almost $700 million for Toyota. Thus, there are a variety of different thresholds that may apply, and the numerical amounts may differ by companies. This lack of standardization is what presents a problem/challenge for auditors. For third party users, the different thresholds across companies means that a misstatement that is material at one company could be immaterial at another company, thus causing difficulties in comparability across companies. 2c. What is the SECs position on the use of numerical thresholds? The SECs position is that auditors may use numerical thresholds as a starting point, but they must use their professional judgment and consider qualitative factors in addition to the quantitative thresholds. 2d. What other characteristics of potential misstatements should auditors consider when evaluating their materiality? Among the considerations that may cause quantitatively small misstatement of a financial statement item to become material are

whether the misstatement arises from an item capable of precise measurement or whether it arises from an estimate and, if so, the degree of imprecision inherent in the estimate whether the misstatement masks a change in earnings or other trends whether the misstatement hides a failure to meet analysts' consensus expectations for the enterprise whether the misstatement changes a loss into income or vice versa whether the misstatement concerns a segment or other portion of the registrant's business that has been identified as playing a significant role in the registrant's operations or profitability whether the misstatement affects the registrant's compliance with regulatory requirements whether the misstatement affects the registrant's compliance with loan covenants or other contractual requirements whether the misstatement has the effect of increasing management's compensation for example, by satisfying requirements for the award of bonuses or other forms of incentive compensation whether the misstatement involves concealment of an unlawful transaction.

3a. What does the term netting mean in the context of materiality judgments? Netting means that a material misstatement in one financial statement direction, e.g., increasing revenue is used to offset a material misstatement in the opposite financial statement direction, e.g., increasing expenses. 3b. What is the SECs guidance concerning netting? In determining whether multiple misstatements cause the financial statements to be materially misstated, registrants and the auditors of their financial statements should consider each misstatement separately and the aggregate effect of all misstatements. A registrant and its auditor should evaluate misstatements in light of quantitative and qualitative factors and "consider whether, in relation to individual line item amounts, subtotals, or totals in the financial statements, they materially misstate the financial statements taken as a whole." This requires consideration of the significance of an item to a particular entity (for example, inventories to a manufacturing company), the pervasiveness of the misstatement (such as whether it affects the presentation of numerous financial statement items), and the effect of the misstatement on the financial statements taken as a whole .... Registrants and their auditors first should consider whether each misstatement is material, irrespective of its effect when combined with other misstatements. The literature notes that the

analysis should consider whether the misstatement of "individual amounts" causes a material misstatement of the financial statements taken as a whole. As with materiality generally, this analysis requires consideration of both quantitative and qualitative factors. If the misstatement of an individual amount causes the financial statements as a whole to be materially misstated, that effect cannot be eliminated by other misstatements whose effect may be to diminish the impact of the misstatement on other financial statement items. To take an obvious example, if a registrant's revenues are a material financial statement item and if they are materially overstated, the financial statements taken as a whole will be materially misleading even if the effect on earnings is completely offset by an equivalent overstatement of expenses. Even though a misstatement of an individual amount may not cause the financial statements taken as a whole to be materially misstated, it may nonetheless, when aggregated with other misstatements, render the financial statements taken as a whole to be materially misleading. Registrants and the auditors of their financial statements accordingly should consider the effect of the misstatement on subtotals or totals. The auditor should aggregate all misstatements that affect each subtotal or total and consider whether the misstatements in the aggregate affect the subtotal or total in a way that causes the registrant's financial statements taken as a whole to be materially misleading. The staff believes that, in considering the aggregate effect of multiple misstatements on a subtotal or total, registrants and the auditors of their financial statements should exercise particular care when considering whether to offset (or the appropriateness of offsetting) a misstatement of an estimated amount with a misstatement of an item capable of precise measurement. As noted above, assessments of materiality should never be purely mechanical; given the imprecision inherent in estimates, there is by definition a corresponding imprecision in the aggregation of misstatements involving estimates with those that do not involve an estimate. 3c. Why is it helpful to financial statement users to have companies avoid netting? By avoiding netting, financial statement users get the full picture of a company, particularly in terms of understanding the factors that affect net income calculations, which are the focus of many analyst estimates and shareholder concern. While management may argue that the total effect on net income is unchanged if, for example, two misstatements net each other in equal and opposing amounts, the shareholder never learns the true effect on total net revenues and total net expenses. 4.a As you read the balance sheet of Ford, what are the accounts that you consider complex? What is it about the accounts that lead you to the conclusion that they are complex, or that the audit of the accounts are complex? There are a number of accounts that might be viewed as complex. They include: Marketable Securities Goodwill Finance Receivables

Deferred Income Taxes Pensions Other Post-Retirement Obligations Liabilities related to restructuring

There are a number of factors that might influence the auditors judgment of complexity. Some of the issues involved in the above accounts include: Needed adjustments to market value, Financial instruments may be complex because it is often difficult to understand the relationship to all of the counter-parties, the financial health of the counter-parties, and the obligations. The nature of assumptions involved in valuing the accounts. Estimates needed to determine the impairment of assets, including that of goodwill. Estimates needed for the amount of liabilities associated with restructurings or discontinuance of operations.

4b. In 2006, an account titled Deferred Income Taxes is listed as an asset of $9.268 Billion and a Liability of $0.783 Billion. What is the nature of the asset account and what valuation issues are important for the auditor to investigate? Normally, deferred income taxes is primarily a liability account because the company takes deductions for income taxes earlier than it recognizes the expenses on the income statements therefore leading to an income tax liability (deferred income tax liability). On the other hand, a deferred income tax asset means that the company is recognizing a reduction in taxes in the income statement that it cannot yet recognize for tax purposes. Generally, the deferred income tax asset relates to net operating loss carryforwards, i.e. there is a loss that is carried forward for income taxes that can be used to offset future reported profit (generally limited to five years). The reason this is often complex is that the company must generate sufficient operating profits to offset the previous losses. However, when a company is historically generating losses, it is difficult to project that it will turn around and be profitable during a period of time needed to obtain the tax advantage. In the case of Ford, both the company and the auditors are confident that they will generate sufficient operating profits to attain the tax benefits. 4c. Accrued Liabilities and Deferred Revenue (see Note 16) are very large amounts. Regarding that account: How large is pension and OPEB costs for Ford in comparison with Toyota? What might be the composition of the deferred revenue account? How should an analyst interpret that account? Both of these accounts are considerably larger for Ford because Ford has traditionally had a history of granting very large pension grants for its employees (a phenomenon that is primarily U.S.) as well as generous post-retirement benefits for both its salaried and hourly employees. They often did so to reduce demands for current wages as well as to encourage a long-time committed work force.

The deferred revenue account is a somewhat unusual account for most companies. Essentially it would imply that the company has received cash from dealers or other parties, but have not delivered the cars to the dealers. The deferred revenue account recognizes that (a) revenue is not recognized until the car is delivered, and (b) the company has a legal obligation to deliver the vehicles to the dealer. The auditor would want to determine that the company has strong internal controls to identify the deferred revenue and the companys obligation to deliver the vehicles, and to record the delivery of vehicles as a reduction in the liability and the proper recognition of revenue. 4d. Read footnote 18. What is the cost to Ford for Separation Actions and Disposals. How do these costs relate to the future profitability of Ford and to the overall Pension and OPEB costs? What are the valuation problems that auditor must address in Footnote 18? The cost to Ford is significant. Most of the actions started in 2006 and were accrued at that time. It is also interesting that the full amount of the costs are not disclosed in one place, nor summarized in one place. For example, you must read footnote 24 (which footnote 18 refers to) in order to fully understand the magnitude of the segregation costs. However, what is disclosed for 2006 is as follows: Job Banks Increase Separation Costs Salaried separation Total $2.583 billion 3.240 0.364 $6.187 billion

When reading further on footnote 24, the students will discover a total of future expected payments for Medicare Prescription drug benefits exceed $35 billion. Further, we find that Ford has committed to the UAW funding for part of the pension benefits that will be administered by the UAW. Part of that funding will come in the form of share appreciation rights for 8.75 million shares of stock whereby the union will gain value for an increase in the share price of the companys stock over $8.15. In other words, the union will share any increase in the value of the companys stock, but will be paid that amount in stock appreciation rights. Valuation Issues Assumptions: Return on Assets Invested: It is interesting to note that Ford has projected a return on assets invested in pension or post-retirement funds to generate between 7.75% and 8.5% on an annual basis for the length of the obligation. That assumption could be questioned and any significant changes in that assumption would also dramatically affect the valuation of the liability. Employees Accepting Retirement: Part of the estimate depends on the number of employees who accept the companys offer of early retirement.

Increase in the Cost of Medical Care: The company, as most U.S. companies, is experiencing an environment in which medical costs keep rising at a rate that seems out of control. Since the nature of the obligation has generally been in the form of specific medical coverage, rather than specific dollar amounts, the assumption about the rate of increase in medical costs can affect the valuation of this liability. Life and Health Expectancy: Both of these are important to pension obligations, as well as predicting future costs related to OPEB.