Problem 5-4, Page 181 (6 th . Edition)

1. Problem 5-4, Page 181 (6th. Edition) Predecessor and Successor Auditors. The president of Allpurpose Loan Company had a genuine dislike for external auditors. Almost any conflict generated a towering rage. Consequently, the company changed auditors often. Wells & Ratley (W&R), PAs, was recently hired to audit the 2013 financial statements, the firm succeeding the firm of Canby & Company which had obtained the audit after Albrecht & Hubbard (A&H) had been fired. A&H audited the 2012 financial statements and rendered a report that contained an additional paragraph explaining an uncertainty about Allpurpose Loan Company's loan loss reserve. Goodbye, A&H! Canby & Company then audited the 2013 financial statements, and Art Canby started the work. But, before the audit could be completed and an audit report issued, Canby was fired, and W&R was hired to complete the audit. Required: Does W&R need to initiate communications with Canby & Company? With A&H? with both? Explain your response in terms of the purposes of communications between predecessor and successor auditors.

2. Predecessor and Successor Auditors Wells & Ratley need to initiate communications with both predecessor auditors. The situation is unusual, but W&R need to obtain complete information from all the predecessors involved since the last audit (2012 financial statements). Both Canby & Co. and Albrecht & Hubbard are predecessors. (If Canby & Co. had completed the 2013 audit, and W&R had been hired to perform the 2014 audit, then Canby & Co. would be the only predecessor. A&H would be history.) Inquiry of only one of the predecessors would not result in complete information because the circumstances surrounding each auditor change may be different. The two predecessors, having served at different times and for different lengths of time, may have different knowledge about Allpurpose Loan Company and its president. If the company is public and subject to securities market reporting requirements, reports for both changes should have been filed with the regulator.

3. Problem 5-6, Page 233 Materiality Level Reduced Your firm has done the audit of Rhea Fashions Inc. for many years. You are in charge of the fieldwork for the current year’s audit. Rhea is a manufacturer of high-fashion clothing. Its shares are publically traded, but a majority of the common shares are held by members of the family that started the business during the 1950s. During the current year, Rhea’s business shrank substantially because of losing a major customer, a country-wide department store chain that went out of business. Rhea has not been able to replace the lost business. Since many of Rhea’s long-time employees were happy to take an early retirement offer, Rhea management’s strategy now is continue to operate only a few unique clothing brands that represented about 50% of its sales volume in prior years. The materiality level used in the prior years was $80,000. The audit partner has determined that the appropriate materiality for the current year financial statement audit is $40,000. Required: • Discuss the factors that the audit partner would have considered in deciding to reduce the materiality level. • What impact will the lower materiality level likely have on your audit procedures in the current year? • While reviewing the previous year’s audit file, you note that last years staff uncovered one error. Rhea failed to accrue approximately $50,000 of customer volume discounts because of a calculation error in computing the customer’s total sales. Since the error was less than materiality, no adjustments were made to the prior year’s financial statements. Explain the impact it will have on the current year’s financial statements when it reverses, and on your audit, given your new materiality level.

4. Materiality Level Reduced The case requires consideration of the factors that determine the materiality level for audit purposes, in particular a decision to reduce the materiality level. • The magnitude of net income, other financial statement items, the users and the potential impact of errors on their decisions, and other qualitative factors can be discussed. • Lower materiality will tend to require more audit procedures, e.g. higher sample extents when representative samples are tested, and this will apply whether extents are determined statistically or judgmentally - if a smaller error matters, more has to be looked at to get the same assurance that a material error is unlikely to have occurred. • In this case the auditors need to consider the impact of a lower materiality level on the unadjusted errors (and the potentially undetected errors) in the opening balances. It may be that at the lower materiality level these errors would have needed to be adjusted. Since they were not, and they affected a current asset, they will reverse in this year, and which in turn materially affects the current year-end balances. It will be important for the auditor to take the reversal of this prior period error into account.

5. A reversing entry is a journal entry made in an accounting period, which reverses selected entries made in the immediately preceding accounting period. The reversing entry typically occurs at the beginning of a reporting period. A reversing entry is commonly used in situations when either revenue or expenses were accrued in the preceding period, and you do not want the accruals to remain in the accounting system for another period. It is extremely easy to forget to manually reverse an entry in the following period, so it is customary to designate the original journal entry as a reversing entry in the accounting software when you create it. This is done by clicking on a "reversing entry" flag. Example of a Reversing Journal Entry To explain the concept, the following entry shows an expense accrual in January for an $18,000 expense item for which the supplier's invoice has not yet arrived: Expense 20,000 Accrued Expenses 20,000 The following reversing entry is now created at the beginning of the February accounting period. This leaves the original $18,000 expense in the income statement in January, but now creates a negative $18,000 expense in the income statement in February. Accrued Expenses 20,000 Expenses 20,000 But it is not done yet. The supplier's invoice arrives later in February, and we record it with the following entry, which offsets the negative $20,000 that would otherwise have appeared in the company's income statement in February: Expense 20,000 Accounts Payable 20,000

6. A sales discount is a reduction in the price of a product or service that is offered by the seller, in exchange for early payment by the buyer. A sales discount may be offered when the seller is short of cash, or if it wants to reduce the recorded amount of its receivables outstanding for other reasons. An example of a sales discount is for the buyer to take a 1% discount in exchange for paying within 10 days of the invoice date, rather than the normal 30 days (also noted on an invoice as "1% 10/ Net 30" terms). Another common sales discount is "2% 10/Net 30" terms, which allows a 2% discount for paying within 10 days of the invoice date, or paying in 30 days. If a customer takes advantage of these terms and pays less than the full amount of an invoice, the seller records the discount as a debit to the sales discounts account and a credit to the accounts receivable account. The sales discounts account appears in the income statement and is a contra revenue account, which means that it offsets gross sales, resulting in a smaller net sales figure. The presentation of a sales discount in the income statement is: A company may choose to simply present its net sales in its income statement, rather than breaking out the gross sales and sales discounts separately. This is most common when the sales discount amount is so small that separate presentation does not yield any material additional information for readers. For example, ABC International issues a $10,000 invoice to a customer that offers a 2% discount if the customer pays the invoice within 10 days. The customer does so, sending in a payment of $9,800.  ABC records the payment with this transaction:

7. If this billing were the only invoice issued by ABC during the reporting period, and if the customer paid within the reporting period, then the revenue section of ABC's income statement would look like this: If the number of discounts taken by customers are few and the impact of these discounts on reported sales results are minimal, then the accounting treatment just noted is acceptable. However, what if many discounts are taken? You could have a situation where a company issues most of its invoices at the end of a month (a common scenario) and then customers take discounts in the following month, which reduces sales in a different period from the one in which the invoices were originally generated. This scenario does not pass standard set by the matching principle, where all revenues and expenses associated with a transaction should be recognized within the same period. If there is a risk that a large proportion of sales discounts will be recognized in a later period, create a sales discounts allowance account, in which you record an estimate of what the sales discounts will actually be in a later period. By doing so, you can immediately reduce sales by the amount of estimated discounts taken, thereby complying with the matching principle. If ABC International were to use an allowance account to record the preceding transaction, the entry at the time when it issued the $10,000 would include the following: Then, when the customer later paid the invoice, the entry would be:

8. Thus, the net effect of the allowance technique is to recognize the estimated amount of the discount at once and park that amount in an allowance account on the balance sheet. Then, when the customer actually takes the discount, you charge it against the allowance, thereby avoiding any further impact on the income statement in the later accounting period.

9. Problem 5-5, Page 233 Quantitative and qualitative materiality criteria You are performing the audit of Pirouette Systems Inc. (PSI) financial statements for its year ended November 30, 20X0. PSI is a private company that sells and installs computer networks for businesses in the Toronto area. PSI has four shareholders who are all actively involved in the business. PSI’s audited financial statements are used mainly by its bank, which has made a large operating loan. The bank requires PSI to maintain a current ratio of at least 1.2 to 1, based on its year-end financial statements, otherwise the bank can require PSI to repay the loan in full immediately. PSI’s accounting policy for recognizing revenue is to recognize 50% of the sales contract amount when the customer signs a sales contract and the balance when the network installation is complete. All sales are on account. During 20X0, PSI hired a new sales manager who has focused on making sales to larger companies. On November 30, 20X0, the sales manager reported to the PSI’s accountant that $250,000 should be recorded as sales revenue. This amount is 50% of the revenue on a large sale to a new customer. This is the largest single sale in PSI’s history. In January 20X1, while doing the audit you have discovered that the sales manager had been premature in reporting this contract as a sale, since the customer did not actually give the final approval of the contract purchase of the network until December 15, 20X0. Before correcting this error, PSI’s draft financial statements show the following: • Net income before taxes of $6,200,000 • Accounts receivable, net of allowance foe bad debts, of $850,000 • Total current assets of $1,100,000 • Total current liabilities of $860,000 Required: • Explain how the accounts in the PSI financial statements will be affected by this error. In your explanation identify the assertion(s) violated by this error. • Calculate the impact of this error on PSI’s current ratio. (Note: Current ration = Current assets / Current liabilities) • Would you consider this error material? Justify your response.

10. Quantitative and qualitative materiality criteria • The following accounts will be overstated: Accounts receivable Current assets and total assets Sales revenue Income and retained earnings This cut-off error most clearly affects the EXISTENCE (or OCCURRENCE) assertion since it results in the year’s sales and year-end A/R balance being overstated. • Current ratio calculations: including error = 1,100,000/860,000 = 1.28 with error corrected = (1100000-250000) / (860,000) = 0.99 Impact is to lower the ratio from 1.28 to 0.99. This brings the ratio below the level required by the bank covenant. • Based on quantitative criteria only, an auditor might conclude it is not material since it is less than 5% of NIBT. However, another auditor might judge it to be close enough to quantitative thresholds for it to be considered material, since it is 4% of NIBT, 2.3% current assets, etc. In any case, since correcting the error will push ratio below the minimum level set in the bank covenant of 1.2 to 1, the error affects a key financial ratio that the bank/user is monitoring and will affect banks decision to continue loan or call it back. This is a qualitative factor that makes it a material misstatement. In conclusion, it should be considered material based on qualitative considerations.