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CASE SOLUTION

Auditing 2

SECTION 12
Completing the Audit, Reporting to Management, and External
Reporting

Arranged by :

Alan Budi Kusuma (01031181419259)


Annisa Kurnia Sari (01031281419105)
Sindi Selvia Oktariani (01031281419123)
Yurika Haspia (01031181419037)

ACCOUNTING DEPARTEMENT

ECONOMY FACULTY

SRIWIJAYA UNIVERSITY

2017
Case 12.1
EyeMax Corporation
Evaluation of Audit Differences

INTRODUCTION

- Eyemax Has debt agreement associated with publicly traded bonds that require audited
financial Statement
- The Management having financial statement prepared in accoordance with GAAP
- Audit fieldwork has been completed but several items has been posted to summary of
unadjusted Misstatement.
- An auditor should carefully consider materiality because auditor do not require their
client to book immaterial adjustment.

BACKGROUND

Nature Of Clients Business


- Eye max is engaged reaearch and development, manufacture, and sale of medical
devices for eyes surgeries.
- Wayne Carruth as a founder keep make eyemax grown.
- Eyemax is currently the third largest supplier of optical equipment, with a 25
percent market share, and employs 425 people.
- 30 % stock of eyemax is owned by the founder and family, 40 % is owned by
company employees, the rest stock owned by venture capitalist and investor.
Accounting Environmnet, Risk Assessment and Audit Apporach
- The company employs eight people with various background The Controller a
CPA, Accounting Supervisor and payroll supervisor have college degree in
business, and the five clerk have limited training and experience.
- The Accounting departement has not kept pace with the demand created by growth
in production and sales.
- In audit planning the inherent risk and control risk were assessed at less than the
maximum but audit still using substantive test.

Managements Position Regarding audit adjustment


- Eyemax has been an audit client for five years
- There was misstatement in prior year but there are no turn around effrct from it.
- The audit report always dated before the end february but this year fieldwork at
eyemax was not completed
- with no prior notification to the auditor, the company provided shareholders and
creditors with preliminary earning information in the last week of february.
- In the middle of march the president tend to minimize the adjusment of financial
statement
- The managing partener of auditing office that had been notified, she agree that the
team should not do the adjustment but the firm should practice the audit standard.
Materiality
- Total materiality was set at $626.000, this amount is equal to approximately 5% of
earning before taxes.
- Performance materiality for eyemax is set to 75% of overall materiality
- According to firm policy, tolerable misstatement for any one financial statement
account cannot exceed performance materiality

MISSTATEMENT POSTED TO THE SUMMARY OF UNADJUSTED MISSTATEMENT

All the item posted to the summary of undjusted misstatement have been discussed with
the client and the client agrees with auditor, the client prefer not to book any of the
items in the fiscal year under audit
1. Warranty Expense = Understated by $130.000, because of the change in warranty in
warranty policy, analysis of warranty repair and replacement data support a $130.000
addition to the waranty expense estimate for the current year.
2. Repair and Maintance expense = Understated by $200.000
3.Litigation Expense = Overstated by $50.000
4. Account receivable = Receivable from 1.545 customers with the book value of
approximately $12.600.000, Customer reported differences and alternative audit
procedure applied to noreplies revealed in four account
REQUIRED ;
Assume that you are the auditor responsible for the EyeMax audit. It is now
March 30, and all planned fieldwork has been completed. Recall that total overall
financial statement materiality has been set at $625,000 and tolerable mistatement
is set equal to performance materiality, which is 75% of overall materiality. Taking
into account the information provided, please answer the following question.

[1] Which of the following three alternatives best describes the conditions under
which you would issue a clean opinion for EyeMax?

a) I would not be willing to issue a clean opinion even if EyeMax is willing to


make adjustments for items on the Summary of Unadjusted
Misstatements.
b) I would be willing to issue a clean opinion without any adjustments.
c) I would be willing to issue a clean opinion only if EyeMax is willing to
make some adjustments to their financial statements for items on the
Summary of Unadjusted Misstatement

Briefly explain your choice ;


As an auditor, I will choose the c option, because based on International audit standard
auditors reponsibilites is to express an opinion on these financial statement based on audit in
accoordance with international Standard on Auditing. Those standards requiare that the comply
with the ethical requirements and plan and perform the audit obtain reasonable assurance
about the whether the financial statement are free from material misstatement. In this case, the
firm didnt apply the adjustment. To release the clean opinion, the auditor should perform the
reasonable assurance about the financial statement such as ; The audit evidence is complete,
fulfill three general audit standard and no material uncertainties. Meanwhile the materiality
happened in four account without any adjustment. This is will caused the integrity and
independency and reponsibilites of auditor ( based on international audit standard) are
questionable if they still releasing the clean opinion. From the firm perspective , the financial
statement will shown the incorrect information by still using about overstated and undestated
account, the firm wouldnt know how much their expense should be paid and how much the
receiveble that they should recieve because of the misstatement , So thats why the firm should
make adjustment then the auditor and team could make clean opinion without collide the
standard and ethic.

[2] If you selected options a or b in question 1, assume now that the client has
decided that they will make an adjustment of up to $250,000 to their financial statements.
Please decompose the total adjustment you would recommend into the individual account
classifications included on the Summary of Unadjusted Misstatements in the space
provided below (e.g., what adjustment would you require for warranty expense, repair
and maintenance expense, etc? The dollar values of your individual account adjustments
should sum to no more than $250,000).

If you selected item c in question 1, what is the minimum total adjustment that
you would require before issuing a clean opinion? $ _______________. Please decompose
this total adjustment into the individual account classifications included on the Summary
of Unadjusted Misstatements in the space provided below (e.g., what adjustment, if any,
would you require for warranty expense, repair and maintenance expense, etc? The dollar
values of your individual account adjustments should sum to your required minimum
adjustment).

Warranty expense

Repair and maintenance expense

Litigation expense
Accounts Receivables/Sales

Total

Please briefly explain your decisions:

The aggregation of known non-sampling misstatement and projected sampling


misstatement is less than 2% below matriality. Thus an adjustment of around $310,000 can be
justified. Assuming the auditor chooses not to increase their acceptable audit risk or materiality,
and assuming the auditor chooses to not conduct any additional tests, then the total adjustment
to the financial statements might be comprised of the following components:

Repair and maintenance expense 200,000

Warranty expense 70,000

Accounts receivables/sales 40,000 +

Total $310,000

Case 12.2

Auto Parts, Inc.


Considering Materiality When Evaluating Accounting Policies and Footnote
Disclosures

BACKGROUND
- Auto Parts, Inc. (The Company) manufactures automobile subassemblies marketed
primarily to the big three US automakers.

The unaudited financial statements for The unaudited financial statements for
the ended December 31, 2014 the ended December 31, 2013
Total Assets $56 million Total Assets $47 million
Total Revenue $73 million Total Revenue $60 million
Pre Tax Income $6 million Pre Tax Income $5 million

- Earnings per share have increased steadily over past five years, with cumulative return
of 140% over the period.
- During 2014 the Company significantly expanded its plant and fixed asset. The
Company purchased $1.330.000 of tooling supplies.
- In 2013, the Company expensed tooling supplies. However, at the beginning of 2014
the controller and CFO determined the capitalization of tooling supplies would be the
preferable accounting method. The Company changed its accounting policy
accordingly and began to include the tooling supplies in other current assets
until the supplies are placed into service, at which time the Company enters a
journal entry to remove the assets and record the costs of the used supplies as the
expense.
- During 2013, tooling expense is $650.000 and held approximately $35.000 of tooling
supplies on hand at year-end. The on-hand supplies were not included in assets on Auto
Parts balance sheet at 31 December, 2013. In 2014, the Company used $1.000.000 of
tooling supplies (in addition to the approximately $35.000 on hand at the beginning of
the year).
- The unaudited financial statements for the year ended December 31, 2014 reflect
$1.000.000 of tooling expense on the income statement and $330.000 of tooling
supplies as current assets on the balance sheet. The approximately $35.000 of tooling
supplies on hand at the end of last year were not included in the $1.000.000 tooling
expense recorded in 2014 because those costs were expensed in 2013 under the old
accounting policy.

QUESTION AND ANSWER:

1. Describe whether you agree that capitalization of the tooling supplies is the
preferable method of accounting for Auto Parts, Inc.
We agree with the management choice to change the accounting policy caused its still
appropriate changing. Based on IAS 8 Accounting Policies, Changes in Accounting
Estimates and Errors, an entity is permitted to change an accounting policy if the
change:
- Is required by a standard or interpretation; or
- Results in the financial statements providing reliable and more relevant information
about the effects of transaction, other events or conditions on the entitys financial
position, financial performance or cash flow.

Then we assume that our client, Auto Parts, Inc. change accounting policy caused it
will provide more relevant and more reliable information about the transaction. The
definition of asset itself is

An asset is an item of economic value that is expected to yield a benefit to the


owning entity in future periods.

Auto Parts, Inc. purchased big amount of tooling supplies and it can remain it in
inventory for weeks or months creating a future economic benefit. The preferred
accounting method for tooling supplies is to capitalize them on-hand tooling supply in
other assets and then expense supplies as they are placed in service.

2. In general, how do auditors develop an estimate of financial statement materiality?


For Auto Parts, Inc., what is your estimate of financial statement materiality? Are
the qualitative factors that might impact your decision about materiality of the
accounting treatment and the related disclosure?
- Materiality is omissions or misstatements of items are material if they could by
their size or nature, individually or collectively, influence the economic decisions
of users taken on the basis of the financial statements. How do auditors develop an
estimates materiality? Auditor needs professional judgment for that. Auditors will
follow the policies and procedure to assess the materiality. Consider to Messier the
rate of materiality is 3-5 percent of pre tax income. However the assessment of
materiality different from one client to other client.
- For Auto Parts, Inc. Assume if we used 5% of materiality rate, the amount of
materiality is
5% x pre tax income
5% x $ 6 million = $ 300.000
So, the estimation of financial statement materiality is $ 300.000.
- Yes, there are qualitative factor impact the materiality decision. Based on Auditing
Standard No. 14. The auditor should evaluate whether uncorrected misstatements
are material, individually or in combination with other misstatements. In making
this evaluation, the auditor should evaluate the misstatements in relation to the
specific accounts and disclosures involved and to the financial statements as a
whole, taking into account relevant quantitative and qualitative factors. Qualitative
factors to consider in the auditor's evaluation of the materiality of uncorrected
misstatements, if relevant, include the following:
a. The potential effect of the misstatement on trends, especially trends in
profitability.
b. The effects of misclassifications, for example, misclassification between
operating and non-operating income or recurring and non-recurring income
items.
c. The likelihood that a misstatement that is currently immaterial may have a
material effect in future periods because of a cumulative effect.
d. The motivation of management with respect to the misstatement.
e. The existence of statutory or regulatory reporting requirements that affect
materiality thresholds.

3. Assuming the policy change is considered material, how should it be reported and
disclosed in the 2014 financial statements and what would be the effect, if any, of
the accounting change on the auditors report?

The policy change is considered to be material in the following three ways, such as
when there is a change in the accounting principles, a change in the accounting
estimation, and a change due to accounting error.

- A Change in Accounting Principle


A change in accounting principle may be a voluntary change from one generally
accepted principle to another or a mandatory change because FASB has adopted a new
principle. A change in accounting principle also includes a change in the procedures
used to apply the accounting principles. Common changes in accounting principles
include changes in inventory cost flow assumptions or revenue recognition methods.
Once a company adopts an accounting principle, the principle should not be changed
unless a preferable principle is adopted. The justification for the change should be
clearly disclosed in the notes to the company's financial statements. A company
accounts for a change in accounting principle by the retrospective application of the
new accounting principle to all prior periods. The cumulative effect of changing to the
new accounting principle (net of income taxes) is shown as an adjustment to the
beginning balance of retained earnings (with corresponding adjustments to the carrying
values of assets and liabilities that are affected by the change).
The company then uses the new accounting principle in its current financial statements.
The financial statements of prior periods are restated as if the new accounting principle
had been applied in that period. The companys disclosures include the nature and
reason for the change, a description of the prior-period financial statement information
that was retrospectively adjusted, the effect of the change on income, earnings per share
and any other financial statement line item that was retrospectively adjusted, and the
cumulative effect of the change on retained earnings at the beginning of the earliest
period presented. If it is not practicable to retrospectively apply the new accounting
principle to a prior period, a company should apply the new accounting principle as if
the change was made prospectively as of the earliest date practicable.
When a change in accounting principle has both direct and indirect effects on the
companys income, only the direct effect of the change in accounting principle is
included in the retrospective adjustment. Any indirect effects are included in the year in
which the accounting change is made. The retrospective adjustment method enhances
comparability because the financial statements are prepared using consistent accounting
principles. Major disadvantages of this method include: confusion caused by changing
the prior years financial statements, inconsistency with the all-inclusive concept of
income (because adjustments are made directly to retained earnings and bypass the
income statement), adverse impacts on a companys contractual arrangements, and the
possibility that a companys management may attempt to manipulate income by
excluding items from the current years income statement. A company accounts for a
change in accounting principle at the beginning of the first interim period, regardless of
the interim period in which it makes the change.

- A Change in Accounting Estimation


A change in accounting estimate normally results when uncertainties are resolved as
new events occur, more experience is acquired, or as new information is obtained.
Changes in estimates are given prospective accounting treatment. That is, the company
adjusts the current (and future) financial statements to reflect the new estimate. Prior
years' financial statements are not adjusted for changes in accounting estimates. The
prospective treatment reduces comparability because results reported in the years before
the change are based on different estimates than the years after the change. If a change
in accounting estimate cannot be distinguished from a change in accounting principle
(e.g., a change in depreciation method), it is considered a change in estimate affected by
a change in accounting principle and is accounted for prospectively.
- Accounting for a Correction of an Error
Errors include mathematical mistakes, mistakes in the application of accounting
principles, oversights, or intentional misstatements of accounting records. FASB
Statement No. 154 requires that a company account for the correction of material error
made in previous periods as a prior period restatement (adjustment). The correction of
an error (net of the related income tax effects) is reflected as an adjustment to the
beginning balance of a company's retained earnings for each period presented (with
corresponding adjustments to the carrying values of assets and liabilities that are
affected by the error). This method is similar to the retrospective application of a new
accounting principle discussed earlier.
Errors may affect only a company's income statement or only its balance sheet, or both
financial statements. Errors affecting only the classification of either income statement
or balance sheet items can be corrected without a journal entry because the particular
financial statement item only needs to be reclassified. Errors affecting both the income

4. Do you concur with managements assessment that the accounting change is


immaterial and therefore, requires no disclosure? Why or why not?

We dont concur with managements assessment that the accounting changes requires
no disclosure. Because disclosures are a fundamental part of financial statements, seen
as an increasingly important way for preparers to communicate deeper insights about
the entitys financial position and financial performance than is possible through the
primary financial statements alone. If there accounting policy change like in this case,
managements should disclose it. It also to give information for user that the accounting
change is immaterial. Most likely any disclosure for this accounting policy change
would appear in the footnote discussing other assets.
Case 12.3

K&K, Inc.

Leveraging Audit Findings to Provide Value-Added Insights in a Manufacturing


Environment

INTRODUCTION
Spencer and Loveland, LLP is a medium-sized, regional accounting firm based in the
western of the US. Spencer will audit its new client, K&K, a manufacturing company that
creates a variey of picture frames. Spencer will audit the financial statements for 2014. K&K is
a privately owned company. Spencer and loveland has a reputation for providing value to its
client above and beyond the high quality auditing services the firm provides. Tus, this audit
engagement team has been instructed to generate suggestions that might help improve the
growth and profitability of K&K, which have taken a turn for the worse during the past year.

K&Ks original, labor-intensive custom-frame line appears to be struggling. K&Ks


production manager has long believed that it was only a matter of time before the companys
older custom-frame line would begin to lose the long-term profitability because the rising of
cost for skilled labor over the past several years. So that, he decide to expand the company to
the new area, which is mass produce plastic frame that is quiet profitable. To produce this
frame, K&K invested in the RX 1000 system

You are a second-year audit senior at Spencer and Loveland. You and your audit staff
are currently auditing the inventory and production costing systems at K&K. You and the junior
staff auditor on the team have performed most of the audit procedures outlined on the audit
program and have documented your findings in the audit papers.

As audit senior, you are responsible for reviewing the audit schedules and reporting to
the audit engagement manager any areas of concern with respect to the audit. In addition, the
manager asked you to analyze the clients inventory and production situation to indicate any
areas where you believe the firm can provide value-added constructive suggestions to the client.

BACKGROUND
K&K, Inc. Was founded 25 years ago brothers Kent and Kevin Shaw, started
manufacturing custom made picture frames for local artists. They soon realized there was profit
to be made in building large frames for use by painting and portrait studios. Because they sell
high quality frames, the name rose up as the best frame manufacturer in the western part of the
United States. Due to the nature of the frames produced, the production process for custom
frames is labor intensive which required specialization in using carving and shaping tools. There
are three basic sizes (small, medium and large) that use variety of designs and materials.

Because K&K genrating reasonable profit along the way, it started to penetrate the
market for small, mass produced inexpensive metal frame. For this, they two machines to
produce frames with large quantity in short time. But, this effort failed.thus, the machines
remained idle throght the second half of last year and company doesnt plan to produce any
more of this type of frame.

K&K currently produces 4.000 custom handwood frames in a month, or 48.000 a year.
After their failure in the metal frames, they started to plastic frames through investing RX-1000
system. Using his system, they can produce 6.000 frames with little variation of quality. Even
the machine is expensive, the plastic frame is much less labor intensive than the custom
handwood frame. This machine is able to hit the break even point in two or three years
according to the past years cost data.

Even the price of the plastic frame is lower tha the custom handwood frame, but the
management expect a reasonable profit through high volume production and higher percentage
profit margins. So far, K&Ks internal data indicates that the new line is far more profitable
than had been hoped even at current production volumes, with gross margins just under 50%.
By contrast, the gross margin percentage for the custom frame line dropped from its usual
average between 9% and 10% to an even more anemic 4.9% over the past year
The RX-1000 system consists of thee machines integrated into a single system . each
machines has their own specialization. Initially, this system cost $400.000 and each of the
machines will have six years useful life. K&K use straight line method. These machines do not
require as much direct labor as the custom frame line. Other than a specially trained employee
to operate and monitor the system, the only manual labor required is to place the promotional
photo and package the frames. The system is costly, incurred cost approximately $2.300 a
month for labor and parts that must be replaced regularly.

RX-1000 was so effective at mass-producing defect-free frames that management rented


out an additional storage facility to hold the finished inventory produced by the new machinery.
Later in the year, production rates had to be scaled back, and the system periodically sat idle
until plastic frame inventories shrank to more reasonable levels. Management wants to be in a
position to fill orders on a timely basis and avoid stock-outs, and thus is content to have a
considerable amount of both finished goods and raw materials inventories on hand. Inventory
costs consist of direct materials, direct labor, and overhead. Overhead continues to be allocated
to both product lines (i.e., the custom frames and the plastic frames) from a common, company-
wide cost pool using direct labor hours as the activity base.

QUESTIONS AND ANSWER

a. Briefly list and explain the primary audit risks in the production and inventory area of
the K7K audit
According to the description of the case, there are some primary problems that K&K
will face. The first problem that K7K will face related with its inventory is coming from the
difference in the amount expected to be sold and the amount which is sold. K&K produce
custom handwood frames for 48.000 units per year and start to produce plastic picture frames
which able to produce 60.000 frames per month (720.000 units per year) after the failed
experiments with mass produced metal frames. The custom handwood frames sales will not
become a problem since this product is sold well by K&K. But, the problems will be coming
from the plastic picture frames. K&K which produced 720.000 frames per year might not meet
its expected selling. In other words, the frames which are sold are not as many as the
management expect. K7K inventory is consist of these frames that may or may not be able to be
sold. Because the price of the frame is based on the market value, the unsold frames value
might be differ with the realized market value, resulted in the higher value of the frames on
hand compared to realizeable market value.
Another thing to concern is the valuation and the depreciation of machinery. The
production cycle of the frames must be defined. The production cycle will affect the valuation
and the depreciation of the machines because the production cycle will affect the method of
depreciation that the company use. In here, the auditor need to make sure the logic reason of
why a depreciation method is employed and the appropriate useful life of machine for
depreciation. And then, the auditor also need to concern about the accuracy of the machinery
value and its depreciation value.
Because the management rent the new storage facility for the product, the problems that
will come up is related with the value of the inventory. The management stores the frames in
more than one storage facility will increase the likelihood of inventorys value misstatement
because there might be some unexpected events. For example, when the frames is moved to a
storage, there might be some frames which are missed to be included in the total inventorys
value.
The next problem is related with the labor cost. The auditor need to make sure if the
labor cost for the maintenance of the machinery is classified in the factory overhead cost. If this
cost is classifed wrongly, it will cause the mistatement that might be material (since the cost is
high).

b. Identify any accounting or auditing issues in the way K&K handles its product costs,
including allocation, that need to be adressed in the current audit
Because K&K produce homogenous and labor intensive product line, it probaly
appropriate for K&K to define the overhead cost based on the direct labor cost driver. But,
because the plastic picture frame is produced by machine (machine intensive), the overhead cost
for this product should not be calculated based on direct labor cost driver from the common
overhead pool. So that, a new costing system is required, including different cost pool and cost
driver for each product.

Then, the overhead allocation in custom handwood frame is higher than the overhead
allocation in the plastic picture frame. Because of this condition, the cost of good sold probably
doent correctly stated. The amount of plastic picture frame which is high, added with high
quantitiy (inventory) of the frame will make the value of plastic picture frame inventory lower,
while the cost of good will be higher.

To overcome this issue, the auditor can give suggestions after a throughout analysis
toward the issue is done. By dong this, the auditor do not only solve the clients issue, but he
also elevate the service that he provide to K&K
REFERENCES

Book and E-book:

IAASB.2015. Handbook of International Quality Control, Auditing, Review, Other Assurance,


and related service pronouncement, Volume 1 (Pdf), Accesd on April, 26th 2017.

Messier, William F. 2008. Jasa Audit dan Assurance Pendekatan Sistematis Auditing and
Assurance Services: A Systematic Approach Edisi 6 Buku 1. Salemba Empat : Jakarta

Riadi, Muchlisin..Pengertian dan Jenis-Jenis Opini Audit.2007


http://www.kajianpustaka.com/2013/10/pengertian-dan-jenis-jenis-opini-audit.html,
Accesed on April, 26th 2017

Website:

https://www.iasplus.com/en/projects/major/ias-8. Diakses pada Rabu, 26 April 2017.

https://www.ifac.org/system/files/publications/files/IAASB-Disclosures-Exposure-Draft.pdf.
Diakses pada Rabu, 26 April 2017.

https://pcaobus.org/Standards/Auditing/Pages/Auditing_Standard_14_Appendix_B.aspx.
Diakses pada Rabu, 26 April 2017.

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