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Auditing 2
SECTION 12
Completing the Audit, Reporting to Management, and External
Reporting
Arranged by :
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
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?
[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
Litigation expense
Accounts Receivables/Sales
Total
Total $310,000
Case 12.2
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.
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
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.
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.
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.
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.
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.
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
Messier, William F. 2008. Jasa Audit dan Assurance Pendekatan Sistematis Auditing and
Assurance Services: A Systematic Approach Edisi 6 Buku 1. Salemba Empat : Jakarta
Website:
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.