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for Solutions Chapter 14 Audit of Long-Term Liabilities, Equity, Acquisitions, and Related Entity Transactions Review Questions: 14-1. Audits of acquisitions and mergers are considered risky for the following reasons: it is often difficult to obtain objective evidence on the proper valuation of physical assets and liabilities acquired in the audit; for example appraisals of plant and equipment, or current value of liabilities, a number of accounts are valued based on subjective judgments especially longer term liabilities such as warranties or pensions, many companies do not perform adequate due diligence in takeovers a common form of merger and often overpay for the company acquired, it is difficult to measure and quantify many of the intangible assets, goodwill must be valued and subsequently tested for impairment. Recent research shows that a high number of mergers have not been successful, although many have been. Some of the success stories include the mergers of public accounting firms, and of Exxon and Mobil. Major failures include the mergers that led to the formation of WorldCom. 14-2. Costs associated with a merger and the valuation issues are as follows: assets valued are current market value. This is usually determined by an appraisal for fixed assets. Current assets are usually determined through normal audit-type procedures, e.g. estimating current market value of inventory, collectibility of receivables, etc. current liabilities valued at market value. These are short-term liabilities. Typical audit procedures can be used to identify amounts eventually paid, or to discover unrecorded assets. The acquiring company can use these same procedures. longer-term liabilities should be adjusted for changes in interest rate and credit rating of the company. Usually a ready market value is available. other liabilities (subjective) The auditor must be aware of significant changes that might be made to pension plans or other benefit plans. If there are changes, the auditor should engage an actuary to assist in making the judgment. restructuring reserves this has been a difficult area and one that has been subject to a great deal of manipulation by CFOs. Often, companies have overestimated the reserves for restructuring with intent to subsequently take the items into income. Newer accounting rules make it more difficult to manipulate these accounts. 14.3. Goodwill is a residual that represents the excess of purchase price paid for an entity above the net fair market value of all other identifiable tangible and intangible assets. Goodwill may represent a number of things such as a superior marketing force, unique technology, or superior management associated with the acquired entity. The auditor should look at factors such as the time over which a competitive advantage is obtained because of the superior marketing distribution, advanced technology, or the skills of existing management. Goodwill should be analyzed for impairment every year. 14.4. The auditor must determine that the appraiser engaged by the client is independent and competent for the task. If the auditor is satisfied that the appraiser meets the criteria, the appraisal values can be used for adjusting the assets. The auditor would still want to review the appraisal from a business sense to determine if the appraiser's recommendations make sense and are consistent with the operations of the entity. If the auditor has serious reservations about the independence or the competence of the appraiser, consideration would be given to engaging a second appraiser. The second appraiser would likely be asked to appraise only a sample of the assets as a basis to estimate the reliability of the results of the first appraiser. 14-5 The auditor does not normally need to hire an independent appraiser to test the computations and conclusions of the appraiser hired by the company if: the appraiser is indeed independent, the appraiser has credentials and a reputation for quality, the auditor can observe the nature of the appraisers work and processes, the auditor can test the appraisers processes as a basis for reaching a conclusion about the appraisal results. If the above factors are not present, the auditor should consider engaging his or her own appraiser to perform random tests and compare with the results of the client engaged appraiser. Differences should be projected to the population as a whole. 14-6. There are many ways to test for the impairment of goodwill. In the U.S., the FASB has suggested a two-stage approach that includes: Comparing the fair value (FV) of the reporting unit with the units carrying amount (CV) including goodwill. Compare the implied fair value of the reporting units goodwill with the carrying amount of the reporting goodwill. If the carrying amount of the reporting units goodwill is greater than the implied fair value of its goodwill, an impairment loss must be recognized for the excess. The difficult judgment is determining the fair value of the reporting entity, i.e. the acquired company that led to the creation of the goodwill. That entity may change over time as other companies are acquired and integrated into operations. The auditors task is to determine whether or not the entity is operating profitably and the likelihood the entity will continue to generate cash flows in excess of cash outflows. Sometimes there may be a market value for the entity, but in most cases, the auditor must evaluate operations to make the impairment test. As a first step, if the entity is not operating profitably, there is persuasive evidence that the goodwill has been impaired, depending, of course, on the plans for future profitability. In other cases, the auditor must make an independent judgment about the future operating prospects in order to judge goodwill. Stated in another way, the auditor has to first estimate the value of the reporting entity and then backs into the amount that should currently be on the books as goodwill. If there has been a decline in the value of the reporting entity, then presumably, there is a similar decline in the value of goodwill; there is impairment. 14-7. Factors that might signal the potential impairment of goodwill include: declining operating results in the division or company acquired, product obsolescence because of technological changes, management changes in the division because of poor results, management budgets that project a slower rate of growth or profitability for the division, management plans to sell the division, significant decrease in market capitalization of the firm, significant decline in key financial ratios of the division. The auditor would be aware of these factors by understanding the business and the industry, review of the budgets and unaudited financial statements, review of board of director minutes, inquiry of management, and analytical procedures. 14-8. Determining fair value of goodwill: reporting entity is full company and is publicly traded determine the total market capitalization of the company. Subtract the net sum of total tangible and intangible assets (less goodwill) less liabilities and invested capital from the market capitalization. Compare the computed amount with goodwill. If the goodwill is less than the amount, there is no impairment. If goodwill is greater than the amount so computed, there is goodwill impairment. reported entity is the full company, not publicly-traded. If there is an estimate of market value, e.g. from an investment banker, the approach is the same as described above for a public-traded company. If such information does not exist, the auditor will most likely look at the factors in 14-7 and make a judgment about potential impairment. reported entity is an operating segment. The auditor will primarily look at the factors described in 14-7 and make a judgment about the decline in operations. The auditor will also look at managements plan for the acquisition, i.e. if management had made projections of financial results and synergies to be obtained the auditor can compare actual results with projected results to see if the company is falling short. If the company is falling short of projected results, the auditor might take the net present value of the newly projected results and discount them back to the current term and compare with recorded goodwill. The difference would be recorded as an impairment. 14-9. Once goodwill is impaired, it is not written up to a greater value. Thus, if the decline in the market value is temporary, the goodwill account is written down, but is not subsequently written up. The difficulty is that neither the auditor nor management has information that a decline in market value is simply a temporary decline. Thus, the FASB has dictated that auditors and managers use the most current market value at the end of the period to test goodwill for impairment. 14-10. Many companies have transactions with other companies or people that may be related to it. These are often referred to as related party transactions. However, the term party often refers to individuals. Therefore, we use the term related entity to convey the broader sense that entities, as well as parties, may be related. Thus related entity transactions occur between parents and subsidiaries; between an entity and its owners; between an entity and other organizations in which it has part ownership, such as joint ventures; and between an entity and an assortment of special purpose entities, such as those designed to keep debt off the balance sheet. The accounting for related-entity transactions is straightforward: Since related-entity transactions are not arms-length transactions with outside parties, they need to be either (a) eliminated upon the development of consolidated financial statements, where applicable, or (b) fully disclosed. 14-11. The FASBs definition of variable interest entities recognizes the economics of many situations where companies take a position in another company, form joint ventures, or enter into other relationships with the other company. The FASB has been working on the consolidation framework for well over a decade and has struggled with the concept of control that it wants to better incorporate into the accounting standards. Failing the issuance of the new standard, the accounting concepts are implemented as follows: majority ownership, i.e. more than 50%, the controlled entitys operations and financial condition should be incorporated with that of the parent (controlling entity), significant control - between 20% and 50%, the entitys operations are accounted for on the equity basis, i.e. the entity owning the 20 50 % recognizes pro rata its share of the controlled entitys income. The income is also used to increase the companys investment in the entity. Dividends reduce the recorded investment in the entity. little control the asset is carried at historical cost. Dividends are recorded as income. In each case, the investment is periodically tested for impairment and if the investment is impaired, it is written down to its impaired value. 14-12. Special Purpose Entities (SPEs) can take many forms. Some are legitimate and are designed to accomplish specific tasks, e.g. perform research and development sufficient to bring a new product to market. Usually the SPEs are not owned by a company although the company may have controlling interest. SPEs attained notoriety because of their misuse by Enron. The CFO of Enron set up SPEs specifically to (a) keep debt off the books of Enron, and (b) facilitate the recognition of income by Enron by transferring impaired assets to the SPE and recognizing gains on the sale of the assets. 14-13. There are two broad approaches to recognizing transactions with related entities. They are: Review unusual transactions and investigate to determine if they are with related entities. Obtain a list of related entities and review all transactions with the entities. The major risks with related-entity transactions are that they are not independent, arms-length transactions. They are controlled by the entity. Historical accounting is designed to portray the companys results of entering into transactions with outside parties where each party makes an independent decision in their best interest. The major risk is that related-entity transactions if not discovered and separately disclosed will be portrayed as legitimate arms length transactions and can be used to manipulate financial reports and thus mislead the public. 14-14. Significant relationships other than full ownership with other entities include: joint ventures, cross-organizational supplier vendor relationships, Special Purpose Entities as described in the chapter and in the response to Review Question 14-12. tax shelters, financial engineering shelters. The last three have come under increased scrutiny by the media, the public, and by Congress. Full disclosure requires a description of: nature of the relationship of the related entities, dollar amount and nature of transactions, purpose of the transactions, future contractual obligations, and terms of the transactions, manner of settlement, and amounts due to or from the related parties. 14-15. This question describes the relationships that existed at Tyco. There are two subtle factors that need to be considered in answering this question: Were all of the reimbursements properly approved by the board of directors? Are these transactions a form of compensation? In addition, would owners have a genuine interest in the stewardship over these funds? The disclosure should occur under the compensation heading and should fully describe the nature of the compensation. The potential problem is that some of these transactions may push the limits on legality, as well as violating company by-laws. 14-16. Estimates that must be made: restructuring reserves plans to restructure, cost of displaced workers, estimates to dispose of plants or other equipment, the time period in which the restructuring will take place, the tax benefits associated with the restructuring. warranty reserves must understand the nature of the warranty, previous results on similar product or same product, estimated cost of each repair, the frequency of failure, and the time limit of the warranty. pension obligations the nature of the plan, i.e., defined benefit or defined contribution, the nature of the coverage, the estimated life of retirees, the current interest rate, and the rate of return on invested assets. other post-retirement liabilities. These have all the problems of pension obligations, but with the added uncertainty and lack of control over the basis for payments, e.g. with medical payments. Interesting, Alan Greenspan, in his confirmation hearings in June 2004, noted that Medicare payments were a bigger problem than were social security because social security was a defined benefit plan that could be estimated whereas there was no way in which future medical costs could be adequately estimated. 14-17. Outside specialists are used in estimating pension obligations in performing the following: estimating lives of retirees, determining net present value of actuarially defined future payments, determining the amounts that have to be invested to meet future payment requirements (at an assumed earnings rate), determining changes in value of the net pension assets or liabilities based on any changes made to the pension plan. 14-18. General Motors believed they had a better control over their warranty liability because by assuming the liability, they: obtained all data on claims and losses, thus allowing them to do pattern analysis to identify any significant problems with the automobiles sold and whether the problems applied to purchase parts, administered the claims and passed the costs on to their suppliers again maintaining control over the nature of the claims and all important data about product or component failures. 14-19. The bond indenture specifies important conditions governing the loan. If a company violates any of the indenture agreements, the bond may be considered in default and is payable on demand of the bondholders. Typical information that might be included in a bond indenture that an auditor would review includes restrictions on: the payment of dividends. minimal amount of stockholder's equity that must be maintained. minimal working capital ratios. the ability to issue any other debt that may be superior to it in claims on assets in times of default. minimum retained earnings before the debt is considered in default. The information is helpful to the auditor in determining if there is a default that would cause the debt to become current. It may affect tolerable misstatement if, for example, the working capital ratios are close to the limit. Tolerable misstatement for current assets and current liabilities may be much smaller than it would be otherwise. 14-20. The distinction made in this question is that the stock is used to acquire the assets, rather than the complete company. The assets should be valued at the cost incurred in acquisition. The potential problem is determining cost. If it is a publicly held company, then a ready market for the securities exists and the current market value of the stock could be used to measure the cost of the overall acquisition. The cost must then be allocated to individual assets. If the amounts are significant, the most reliable way to allocate the cost to the assets would be to base it on an independent appraisal of the assets. 14-21. A 5% stock dividend should be accounted for as a debit to retained earnings for the fair market value of the dividend and credited to capital stock and capital in excess of par. The auditor should be sure the board of directors authorized the dividend and should examine the Wall St. Journal or another financial reporting service to determine the fair market value of the dividend at the time of declaration. The auditor could then trace the amounts to their recording in the general ledger to determine if they were properly accounted for. 14-22. A spreadsheet could be developed to project the amortization of a bond discount or premium over the life of the bond and could also identify the corresponding entries to interest expense. The spreadsheet data could be used to compare with recorded interest expense and amortization. If the amounts agree, the auditor would not need to perform detailed review of the individual interest transactions. Multiple Choice Questions: 14-23. 14-24. 14-25. 14-26. 14-27. 14-28. 14-29. 14-30. 14-31. 14-32. b. d. c. a. d. c. c. a. b. b. Discussion and Research Questions: 14-33. a. An acquiring organization should do the following in evaluating the economics of a proposed acquisition: perform a detailed review of competitors, demographics, and likely growth in product line, analyze the expected synergies related to the combination, analyze projected cash flows for the combined entity, prepare a schedule of projected cash savings due to the merger, prepare a capital budget that analyzes the payment in terms of net present value or internal rate of return. b. If the processes described above are not in place, it is going to be more difficult to test goodwill for impairment. If the company has not made a systematic analysis of the projected cash flows, then the auditor and management do not have a base on which to compare actual results with projected results. If the procedures are not performed, both the auditor and management will have to perform similar analysis to determine if an impairment of goodwill exists. c. Mergers are difficult for the following reasons: incompatible systems must be blended into one system, different business cultures must be integrated into one culture, operations must come together, research efforts must be combined, personnel problems always exist and must be resolved. for large mergers, there are often constraints added by the justice department or some other regulatory agency to protect competition and thereby inhibit the merged entity from accomplishing all the synergies hoped for. The auditor would look to see how well operations have come together and that efficiencies are being gained. These efficiencies should be reflected in the financial statements with better operating results. 14-34. a. There is a number of unique valuation problems associated with the acquisition of Teasedale. These include: Determining the value of the purchase. The market value of a diluted common stock and any unissued preferred stock must be determined. Determining the fair market value of the identifiable tangible and intangible assets (and liabilities) of the acquired company. Determining the value of goodwill. Implementing the accounting for the consolidated assets and goodwill. b. A specialist would be used in appraising the fair market value of the net assets acquired. The specialist has to identify both the tangible and intangible assets controlled by Teasedale. c. The goodwill on Teasedale's books is eliminated upon consolidation. The only goodwill remaining on the books will be the new consolidated goodwill. d. The intangible assets (other than goodwill) should be separately identified and valued by the appraiser. The other intangible assets will be valued at their estimated fair market value at the time of acquisition and should be amortized over their remaining legal or estimated useful life. e. Assuming Teasedale remains a separate entity for tax purposes, the deferred tax liability will remain on the books. If, however, the company is totally absorbed in the operations of Romenesko, the deferred liability would be consolidated with the corporate deferred tax liability. f. The amount of goodwill to be recorded would be computed as follows: Acquisition Cost: Cash Paid $ 20.0 million ($10 * 2 mil shares) Common Stock 30.0 million ($30 * .5 * 2 mil shares) Preferred Stock 20.0 million (plugged to equal $35 / share Total Acquisition Cost $ 70.0 million Purchased Assets: Net Current Assets Plant & Equipment Other Intangibles Long-term Debt Pension Obligation Deferred Taxes Net Value of Assets Purchased Goodwill: Purchase price: $ (0.7) million 30.0 million 5.0 million (5.0) million (1.5) million (0.8) million $ 27.0 million $ 43.0 million $ 70.0 million 14-35. a. The inherent risks in this write-down include: A minor change in the discount rate can have a significant affect on the fair-value calculation. Estimating future cash flows is very subjective. b. Audit evidence would include: Support for the assumptions management used to estimate future cash flows. Information about the independence and competence of the professional appraisers such as their relationship with the client and professional certifications. Evidence supporting the appraisers determination of fair market value such as comparisons with recent sales of comparable assets. c. The auditor could hire the services of an independent appraiser to test the fair values of the original appraisers, perhaps on a sampling basis. 14-36. a. An operating segment is defined as a unit that has a distinct business plan, facilities, or market place and is treated by management as a separate unit for planning and control purposes. Criteria that an auditor might utilize to determine an operating unit include: separate physical operations, separate management, distinct product line and operations, separate markets, separate reporting and evaluation by management. Normally the decision to classify a purchase as part of an operating segment will take place at the time of acquisition. This is a natural time because management should have an explicitly developed strategic plan for the operation of the unit and how the unit fits in with other operations of the company. However, that decision may be revisited over time as the organization may develop new strategies or restructure its operations. b. Assuming that (a) the decision was made to integrate the operations of the two previously separated entities into one operating entity at the time that the two purchases were made, and (b) management has continued to operate and evaluate the two entities as if they were one operating unit, then it would be appropriate to look at the overall operations of the combined entity to determine whether or not there has been an impairment of goodwill. If the scenario, as described, holds true, then the auditor would compare the fair value of the operating unit with the carrying value of the operating unit, and assuming that fair value is greater, there would be no impairment of goodwill. However, if the company has continued to operate and evaluate the two units separately, as it sounds in this case (the company measures the profitability of each unit), then it would be appropriate to evaluate the two units separately. In such a case, the auditor would be considering a write-down or a write-off of the CCD goodwill of $8 million. It is important that the auditor establish, very early after the purchase, the operating entity so that the auditor has a defined base on which to make the impairment decision. c. The potential problems with measuring the impairment of the goodwill for the food product and design segment include: consistently defining and measuring the operating unit, evaluating managements strategic plans for the unit; for example, are the losses for the CCD operations due to heavy investments in new marketplace development that are expected to yield increased returns in the future, determining fair value of the reporting entity, especially when a separate marketplace for the reporting entity might not exist, projecting future net cash flows from operations as a basis for determining the fair value of the entity, determining a discount rate in developing an estimate of fair value, evaluating the likelihood that management will be able to achieve its plans, measuring profitability of each segment and determining if management has changed its own definition of reporting entity, determining if management has attempted to sell any part of the operations and gathering information on potential sales price. determining whether there is sufficient question of an impairment that the auditor should seek the counsel of an independent appraiser in obtaining an estimate of the potential impairment of goodwill. d. In most situations, if the profitability and the cash flows from the acquired entity exceed the budget utilized in determining the purchase price for the entity, there would not be an impairment of goodwill. The auditor, however, would need to be alert to changes in market conditions or changes in managements strategic plans as a basis to determine if more detailed work needs to be performed in determining whether or not an impairment of the asset has taken place. 14-37. a. Most companies anticipate some restructuring of operations following a merger. Some of the typical activities include: decrease in staff and operating personnel, shut down of plants, changes in benefit plans, e.g. pension plans, combining operations combining computer systems consolidation of research and development. The advantages in consolidating activities generally are: significant decrease in overall back-office costs, increased operating efficiency, greater market power. b. This is a description of a typical restructuring reserve. However, it is also typical of a reserve that can be manipulated and used to smooth income in the future. Thus, the FASB has required the company to have specifics identified before the reserve for potential loss can be recognized, i.e. the company must have identified specific individuals that will be terminated, specific plants that are going to be shut down, and so forth before the loss and accrued reserve for restructuring is to be recognized. Information that should be gathered includes analyses of benefit calculations and severance packages, appraisals of property and equipment, planned write-offs of assets and associated gains and losses, and estimates of purchases that will be needed to accomplish the restructuring and potential physical movement of assets. c. WorldCom used restructuring reserves extensively to smooth and enhance reported earnings. WorldCom engaged in a number of acquisitions. At the end of each acquisition, they would announce that they would restructure activities and set up a large reserve for the restructuring costs. They viewed the restructuring costs as part of the acquisition and often debited goodwill for the asset. They would almost always overestimate the reserve, i.e. estimate far greater expenses that they thought they would incur. Then, at some time later, they would release these reserves, i.e. they would decrease the liability and credit an expense account at the same time. Thus, the released reserve amounts were used to enhance net income in subsequent periods. It was a pure abuse of an accounting principle. d. If the company has a specific plan with specifically identified individuals or plants to be closed, then the company should recognize any expected costs associated with the restructuring as a current restructuring charge and accrue a restructuring liability. Then, as actual costs are incurred, the company should charge the restructuring reserve for the costs. If the estimate is accurate, at the end of the day, the costs charged against the reserve would be equal to the amount that was estimated as a liability. e. Management should have a definitive plan for restructuring and that plan should define the completion stage. Otherwise companies would always be involved in restructuring activities. If a company incurs restructuring charges that were substantially less than accrued, the proper journal entry should be as follows: Restructuring Reserve Liability Prior Period adjustment yyyy zzzzz 14-38. a. If a company incurs restructuring charges that were substantially less than accrued, the proper journal entry should be as follows: Restructuring Reserve Liability Prior Period adjustment yyyy zzzzz b. WorldCom took the excess reserve and released it into earnings, i.e. it credited other expense accounts to increase net income. It was used effectively by WorldCom (at least for some time) to smooth reported earnings. c. Management would overstate the estimated restructuring cost in order to have a credit on the liability side of the balance sheet that they could subsequently use to smooth earnings. They debit entry either went into a restructuring cost that was viewed as a one-time expense, or increased the reported amount of goodwill. d. Evidence the auditor should look at in evaluating the reasonableness of a restructuring reserve would include: specific plans to shut down a plant, appraisals for the plant, specific plans for terminating employees, including severance pay, benefits, and any other factors that would include a cost, estimated warranty or other expenses associated with products produced at the plant that may be phased out, review of contracts that may be terminated because of the shut-down and the economic implications associated with breaking any of the contracts. 14-39. a. Related entity refers to the broader sense that entities, as well as individuals, may be related. Thus, related entity transactions occur between parents and subsidiaries; between an entity and its owners; between an entity and other organizations in which it has part ownership, such as joint ventures; and between an entity and an assortment of special purpose entities, such as those designed to keep debt off the balance sheet. It includes related parties, e.g., an entity dealing with management and it also includes other relationships in which the entity exercises significant control and can influence the other partys actions. b. The audit approach is divided into two complementary sets of procedures: 1. Obtain a list of all related parties; then develop a list of all transactions with those parties during the year. 2. Carefully examine all unusual transactions, especially those near the end of the quarter or the end of the year, to determine whether the transactions occurred with related parties. Once all related parties are identified, the auditor can utilize generalized audit software to read the client files and list all transactions that occurred with the parties. The auditor then investigates the transactions to determine if they had been properly recorded. Finally, the auditor determines the appropriate disclosure. The other approach focuses on transactions that appear to be unusual. An example might be a large sale of goods near the end of the year at a price that is higher than normal, or that has extended terms. The auditor might investigate and find that the transaction has occurred with a brother-in-law or an entity controlled by a related party. c. (i) Audit procedures that would have identified the Tyco CEO and other personal expenses include: review all expense reimbursements claimed by CEO, CFO, and similar situated officers, make inquiries of management and board as to whether such transactions exist and if they have been approved by the board, use audit software to search the files for unusual transactions, or payments to non-authorized vendors (for example, the birthday party), list all the transactions and investigate, use audit software to prepare a list of all transactions with CEO, CFO, and similar situated officers and any other individual with a common last name and investigate to determine if they represent related-entity transactions, (ii) It is reasonable to expect the auditor detect to these unusual expenditures in a company with $36 billion in sales. The answer is yes because the auditor has a special obligation to search for related-entity transactions and needs to investigate all transactions with management. The related-entity transactions need to be reported as part of the stewardship function of management. (iii) The auditor should investigate these kinds of transactions every year because such transactions are material to the owners of the organization and are required as part of good governance. (iv)Controls that a company like Tyco should have include: a clear code of conduct that expressly prohibits such activities, a requirement that all expense reimbursements, outside of normal travel, be reviewed by a subcommittee of the board of directors, loans that are made solely on the discretion of the CEO should be prohibited (most likely, all loans should be prohibited, but if loans exist, there should be clear guidelines and independent review), internal audit should be asked to review all related entity transactions and expense reimbursements on a timely basis. 14.40. a. The sale should be recorded including any gain or loss. All elements of the sale should be disclosed as a related entity transaction including: amount of the sale, gain/loss recognized by Eisenhower, the terms of the sale, the relationship of the parties. b. Constructional Rental is a related entity. The amount of equipment, the lease expense, the purposes for which the equipment is used, etc. should be fully disclosed as a related-entity transaction. c. Procedures that might have uncovered the other related party transaction: inquire of management as to the existence of any other related party transactions, develop an understanding of the key players in the construction industry, including ownership of major leasing companies, review all major lease expense during the year (because this is more likely to be a related party transaction). Use GAS to schedule all lease expense from common companies. Investigate and determine ownership of lessor. take a sample of lease expense during the year and trace the expense back to invoice noting the nature of the transaction. obtain a list from management of all related parties, sons, daughters, common ownership, and so forth. Use GAS to identify any transactions with the related parties of companies that they control. 14.41. a. A related-entity transaction is one in which there is common control between both parties. The control does not need to be 100% control, it can occur in the form of significant influence. The accounting literature has made an historical distinction between related entity transactions and licensing or joint venture transactions in which two entities cooperate rather than compete with each other. The Merck and P&G relationship is a contractual relationship designed to improve the profitability of both organizations. b. The auditor would usually find out about licensing, joint venture, and SPE transactions by utilizing a combination of the following procedures: c. inquire of management as to the existence of such relationships, inquire of legal counsel as to the existence of such relationships, review of the financial press for reports of joint ventures or other cooperative arrangements with the client and another firm, review all unusual transactions during the year (schedule by using GAS) and inquire as to the nature of the transactions, review major new contracts signed during the year, review board of director minutes for approval of joint ventures, the development of SPEs or similar transactions, The SPEs entered into by Enron did not follow GAAP because: there was not separate ownership (in many cases) of the SPEs, the SPEs were controlled by the CFO of Enron, the transactions with the SPEs were not disclosed as related party transactions, the economics of the transactions were not considered in the recording process. In many situations, Enron retained responsibility for the debt or the other assets. The economics should have dictated that the liability remain on the books of Enron. 14.42. a. An information system that would be used to develop a warranty estimate would include: a tracking system of all trucks produced and sold during specific time periods. a tracking system that identifies the length and nature of the warranty provided on each truck, b. a tracking system that identifies all warranty claims and matches the claims to the vehicle, the product that failed, and the time that the vehicle was assembled. a claims analysis that identifies patterns of claims and costs to repair, a statistical projection model to project estimated warranty expenses on all products that are still under warranty. An audit program would include the following steps: Develop an understanding of the information system used by the client, and consider the need to test the controls that are part of this system. Take a sample of warranty claims and determine (a) the proper accounting for the claim, including the reduction of the warranty, and (b) the capture of pertinent claim information entered into the warranty liability information system. Review the clients process for analyzing product component failures and whether the company has a process in place to fix the product failures, Review the statistical projection model to determine if the estimate is updated for new information. Review the estimate for reasonableness and consistency with past warranty claims. c. The warranty is shorter, but more importantly, the company does not have as much data regarding military vehicles used in deserts. The auditor needs to determine the procedures used by the company to update the estimates for these trucks. The company should define component parts that have a record of failing more often and should identify the estimated cost of repairs. The rate of failure should then be used to project a failure rate for all warranted items and the warranty liability should be adjusted accordingly. d. i. The liability has grown. The auditor would look for the following to determine if the liability is likely overstated: evidence of any changes in warranty claims, changes in product failure rates, changes in warranty. If there are no significant changes, the clients statistical projection should show the need for a lower warranty liability. ii. If the account is materially overstated, the liability should be reduced to the best estimate of the actual liability. It could be argued that the estimate occurred because too much expense had been charged to previous years and therefore the adjustment should be recorded as a prior period adjustment. Some companies argue that the warranty reserve had been built up over a period of time and have a higher than needed amount is smart business and does not mislead investors. These individuals would argue that if the liability is going to be reduced, it should be reduced over a period of time by accruing less expense each period. Practice shows that the latter approach is used more often than the former approach. 14.43. a. The process for recognizing the liability for post-retirement drug benefits is similar to that used for pensions, as well as that used for other post-retirement medical care. These processes include: identifying all employees that are eligible for the benefit, actuarially estimating the average life expectancy of each retiree beyond retirement, reviewing governmental data on drug costs, project changes in drug cost to the future, and come up with an estimate of the increase in drug costs over the period of time covered by the benefits, developing an estimate of the drug benefit liability based on the above analysis. The auditor would audit the data by testing the individual data included in the system. b. The auditor would audit the $500 million reduction of the liability by: reviewing the medical guidelines issued by Congress to determine that the client had correctly interpreted them. testing the clients information system to determine that the number of employees is correct and that each employee has a promise of the drug benefit. calculating potential savings over a period of time. discounting the potential savings back to the current time using a net present value with a risk adjusted interest rate. comparing the amount with the amount recorded by the client. determining if any adjustments are required to the clients estimate. 14-44. a. Information that could be obtained from reading a bond indenture would include: Face value of bond, Stated interest rate, Maturity date, Conversion privileges and terms, Bond trustee, Sinking fund provisions, Callable provisions Underwriter and Underwriter responsibilities, Specific Financial Operating Constraints (restrictive covenants): o o o o maintenance of capital, dividend restrictions, working capital ratio, other financial statistics required Default definition, Standing in event of default by company or bankruptcy, Asset claims, Bondholder's standing regarding asset claims. b. It is usually not necessary for auditors to confirm the existence of the liability with individual bondholders: 1. Most bond transactions are handled by an independent bond trustee. The confirmation could go to the bond trustee. 2. The auditor can verify that the organization received proper proceeds from the borrower - thus establishing the existence of the liability. Any decrease in the liability (other than amortization of bond premium) would have to be accompanied by either a payment to the bondholders or conversion of the bond into other securities. The auditor would verify both of these transactions. c. A bond discount arises when a bond is sold to the public at less than its face value (effective interest rate is greater than the stated interest rate.) The amount of the discount is established by comparing the net proceeds available from the bond offering with the stated interest rate. The net proceeds can be used to compute the effective interest rate. The auditor can use a microcomputer spreadsheet package to compute the amortization of bond discount for each period and then can compare the amount recorded with the amount independently computed. d. The auditor could vouch the payments made to the bond trustee. e. The bond is due next period and therefore the initial persuasive evidence is that the bond ought to be recorded as a current liability. The auditor would examine legal documentation, e.g. a prospectus filed with the SEC, a letter or agreement with an underwriter, approval of a new offering in the board of directors minutes. In addition, the auditor would evaluate changes in the bond market to gather some assurance that it is highly likely that the refinancing is likely to take place according to the terms in the preliminary prospectus. 14-45. Any failure, or likely failure, of the organization to comply with the covenants should be reported in a note to the financial statements. a. The balance sheets should be reviewed for each applicable period to determine compliance with the covenant. If the company is below the stated ratio, the auditor should review officer compensation to determine if it is in compliance with the covenant. b. Examine client copies of insurance policies or certificates of insurance to determine compliance with the covenant. The auditor should prepare a summary of all the scheduled information contained in the policies. In addition, the auditor should confirm the existence of the policies with the trustee. c. Examine vouchers supporting tax payments on all property covered by the indenture. If vouchers are questionable, confirm tax payments with the trustee who holds the tax receipts. d. Vouch the payments to the sinking fund. Confirm bond purchases and the sinking fund balance with trustee. Confirm any cancellation of bonds with the trustee or observe the canceled bond. 14-46. a. Audit Program for Stockholder's Equity 1. Examine articles of incorporation, the bylaws, and minutes of the board of directors from inception to determine the provisions or decisions relating to the capital accounts. (Necessary only for the first year of the audit. Subsequent years will update the information.) Determine that the accounting records are in accordance with the provisions and that appropriate footnote disclosure is made. Extract pertinent date for the permanent file. 2. Examine stock certificate stub book and determine if it agrees with the capital stock account. Alternatively, if the stock is listed with an independent agent, confirm the stock transactions and current outstanding stock with the independent stock agent. 3. Schedule all entries to the accounts since inception. Vouch (examine documentation) supporting all entries into the accounts. Recompute major transactions to determine that the accounts have been properly classified and amounts credited to capital in excess are properly computed. 4. Examine retained earnings from inception: Examine support for all entries into retained earnings to determine if classification is correct. b. Schedule all entries into the account noting all that come from other than the annual closing of income and expense summaries. All stock dividends, or cash dividends, should be examined to determine appropriate valuation to retained earnings. The retained earnings account should be verified in connection with the audit of other accounts because such verification helps to: ensure that no important items were overlooked in the examination of the account, ensure that the account is handled in accordance with GAAP, e.g. only prior period correcting entries are taken to retained earnings directly; extraordinary items are recorded through the income statement. ensure that stock dividends are recorded correctly. 14-47. The document contains the following deficiencies: 1. The subject matter of the working paper and client name are not properly indicated in the title. 2. There is no indication of any follow-up on the identified error in the accrued interest payable computation. 3. There is no indication whether the confirmation exception was resolved. 4. The loan with the violation of a provision of the debt agreement is misclassified as long-term. 5. The liability activities of Lender's Capital Corp. and the working paper totals do not cross foot. 6. There is no indication of cross-referencing of the stockholder loan to the related party transactions working papers. 7. There is no investigation of the payment on the stockholder loan that was reborrowed soon after year end. 8. There is no consideration of the need to impute interest expense on the 0% stockholder loan. 9. There is no indication that the dates under "interest paid to" were audited. 10. There is no indication that the unusually high average interest rate ($281,333/$1,406,667= 20%) was noted and investigated. 11. The working paper does not support the overall conclusions expressed. 12. The tickmark "R" is used but not explained in the tickmark legend. 13. There is no indication that the working paper was prepared by client personnel. Cases: 14.48. a. The ethical difficulty arises because the senior manager is pushing to have the engagement team inappropriately use materiality as an argument for not capitalizing leases. This puts the engagement team in an awkward position. They know that the engagement manager does not want to report bad news to either the partner or the client, and yet the engagement team is convinced that the issue is material and incorrect. b. One option would be to discuss the matter with the partner without the senior manager present. However, the most preferred option would be to tell the senior manager that the engagement team is scheduling a meeting with the partner to discuss the issue, and to invite the senior manager to attend. This option would enable the senior manager to work with the engagement team in finding a way to handle the situation in the most constructive way possible. c. Several options seem available. First, one could appeal to the concern that the inappropriate accounting might be discovered by a user of the financial statements, leading to potential regulatory attention and litigation. Second, one could appeal to the audit firms internal guidance and need to treat different clients consistently. Third, the engagement team could appeal to the notion that client resistance on this issue may reflect a larger concern about their financial reporting transparency, and the associated risk, on other issues. If this client is pushing for inappropriate accounting treatments on this issue, it may be the case that there is a pattern of such behavior, which makes this client riskier in a general sense that should be considered in terms of engagement conduct and client retention decisions. Fourth, if the partner refuses to entertain the engagement teams recommendations, the engagement team could pursue the issue further with higher-level individuals in the audit quality group of the audit firm, an option that the partner clearly knows is a possibility for the engagement team. Note: We acknowledge the insights of Ira Chaleff, author of The Courageous Follower, for his help in generating ideas for the above case, which was used during an ethics symposium at the University of Wisconsin Madison. 14.49. (1) Identify the ethical issue(s). There are multiple compensation issues that the Board should address. First, what should be the compensation package for the new CEO, Kent Hussey? On one hand, he is being paid very well and is even receiving a bonus. On the other hand, he did not create the problems; he is trying to solve them. Second, there is a larger issue of executive compensation that is high in relation to other workers at the company, particularly in terms of the bonuses that the executives are receiving. (2) Determine who are the affected parties and identify their rights. The affected parties include lower-level employees (and their disproportionately low pay and high risk of losing their jobs with a potential bankruptcy), higher-level employees (who are receiving bonuses even though the company is doing terribly), and shareholders. Since this is a public company, the shareholders will be provided with disclosures of the executive compensation through the companys Compensation and Disclosure Analysis (CDA) which will be included in the materials the company files with the SEC. (3) Determine the most important rights. The shareholders rights are most important, particularly considering the greatest good for the greatest number idea. (4) Develop alternative courses of action. The question really is: should the existing executives be receiving bonuses at a time like this? So, the courses of action include (a) allowing the bonuses, or (b) not allowing the bonuses. (5) Determine the likely consequences of each proposed course of action. If the company continues to follow alternative (a), the current executives will at least stay with the company. If the company pursues alternative (b), the executives may leave the company during this time of peril, and the shareholders may be even worse off. Commenting on this issue in the Wisconsin State Journal on November 14, 2008, a UW-Madison School of Business professor said it's not unusual for a company to pay incentives to key officials, even when the business is financially ailing. In times of crisis, you need to think about whether you want to change leadership or not," said Barry Gerhart, human resources professor. "You can make the argument that continuity is important during a crisis to help the organization get out of it ... as long as you don't think the CEO is responsible for taking them into the crisis." And in this particular instance, the existing CEO was not directly responsible for the acquisition strategy (although he was a high level employee under Dave Jones, so he is at least partially responsible). (6) Assess the possible consequences, including an estimation of the greatest good for the greatest number. The greatest good for the greatest number in this case may very well be to have the executives stay on and to give them enough of a bonus to entice them to stay and help the company out of its difficult times. (7) Determine whether the rights framework would cause any course of action to be eliminated. This step is not particularly applicable to this situation. (8) Decide on the appropriate course of action. Students will vary on the resolution to this case. Some students will oppose the executive bonuses regardless of whether or not it may ultimately lead to greater losses for shareholders. 14-50. 1. The main difficulty that the auditor faces in determining whether managements analysis is reasonable is to understand managements procedures and to decide if they have merit. The auditor will have to understand the following types of issues: o What was the underlying data used in determining the award allocation amount? Was the calculation of the award allocation amount reasonable? o Was incorporation of the award allocation in the impairment analysis appropriate? Or is management possibly trying to avoid an impairment write-down? Should management and the auditors have performed the second step of the goodwill impairment test to determine if there was impairment? 2. The consequences of the auditors decisions are associated with assuring that the goodwill is not inappropriately over-valued on the balance sheet (with resulting under-expensing of impairment charges on the income statement) or under-valued on the balance sheet (with resulting overexpensing of impairment charges on the income statement). In this case, the greater concern would be with whether the goodwill in over-valued. Further, if management is intentionally attempting to engage in inaccurate financial reporting, the auditors decisions related to evidence gathering in other areas where there are subjective management judgments may need to be reassessed by the auditor. 3. The risks are those associated with inaccurate financial reporting, particularly if the impairment charges are material to the clients financial statements. 4. The auditor can gather various types of evidence: o Documentation of managements process and assumptions o Documentation of the sales on which the award allocation is based o Understanding and documenting managements potential motivations for under- or overexpensing the impairment charges o Accounting guidance that provides support for whether it is appropriate to incorporate the award allocation into the analysis Ford Motor Company and Toyota Motor Corporation: Pension Liabilities, Goodwill Impairment, Warranty Liabilities, and Long-Term Debt 1. One of Fords most significant liabilities concerns pensions and other post-retirement benefits. What is the nature of estimates required to value these liabilities? What risks do these estimates pose for the audit firm? Nature of estimates required: Pensions Nature of Estimates Required. The estimation of our pension obligations, costs and liabilities requires that we make use of estimates of the present value of the projected future payments to all participants, taking into consideration the likelihood of potential future events such as salary increases and demographic experience. These assumptions may have an effect on the amount and timing of future contributions. Assumptions and Approach Used. The assumptions used in developing the required estimates include the following key factors: Discount rates. We base the discount rate assumption primarily on the results of a cash flow matching analysis, which matches the future cash outflows for each major plan to a yield curve comprised of high quality bonds specific to the country of the plan. Benefit payments are discounted at the rates on the curve and a single discount rate specific to the plan is determined. Expected return on plan assets. The expected return on plan assets assumption reflects historical returns and long-run inputs from a range of advisors for capital market returns, inflation, bond yields, and other variables, adjusted for specific aspects of our investment strategy. The assumption is based on consideration of all inputs, with a focus on long-term trends to avoid short-term market influences. Assumptions are not changed unless structural trends in the underlying economy are identified, our asset strategy changes, or there are significant changes in other inputs. Salary growth. The salary growth assumption reflects our long-term actual experience, outlook and assumed inflation. Inflation. Our inflation assumption is based on an evaluation of external market indicators. Expected contributions. The expected amount and timing of contributions is based on an assessment of minimum requirements, and additional amounts based on cash availability and other considerations (e.g., funded status, avoidance of Pension Benefit Guaranty Corporation ("PBGC") penalty premiums, U.K. Pension Protection Fund levies, and tax efficiency). Retirement rates. Retirement rates are developed to reflect actual and projected plan experience. Mortality rates. Mortality rates are developed to reflect actual and projected plan experience. Plan obligations and costs are based on existing retirement plan provisions. No assumption is made regarding any potential future changes to benefit provisions beyond those to which we are presently committed (e.g., in existing labor contracts). Other Postretirement Employee Benefits Nature of Estimates Required. The estimation of our obligations, costs and liabilities associated with OPEB, primarily retiree health care and life insurance, requires that we make use of estimates of the present value of the projected future payments to all participants, taking into consideration the likelihood of potential future events such as health care cost increases, salary increases and demographic experience, which may have an effect on the amount and timing of future payments. Assumptions and Approach Used. The assumptions used in developing the required estimates include the following key factors: Discount rates. We base the discount rate assumption primarily on the results of a cash flow matching analysis, which matches the future cash outflows for each plan to a yield curve comprised of high quality bonds specific to the country of the plan. Benefit payments are discounted at the rates on the curve and a single discount rate specific to the plan is determined. Health care cost trends. Our health care cost trend assumptions are developed based on historical cost data, the near-term outlook, anticipated efficiencies and other cost-mitigation actions (including eligibility management, employee education and wellness, competitive sourcing and appropriate employee cost sharing) and an assessment of likely long-term trends. Expected return on short-duration plan assets. The expected return on short-duration plan assets assumption reflects external investment managers' expectations of likely returns on shortduration VEBA assets over the next several years. Expected return on long-duration plan assets. The expected return on long-duration plan assets assumption reflects historical returns and long-run inputs from a range of advisors for capital market returns, inflation, bond yields, and other variables, adjusted for specific aspects of our investment strategy. The assumption is based on consideration of all inputs, with a focus on long-term trends to avoid short-term market influences. Assumptions are not changed unless structural trends in the underlying economy are identified, our asset strategy changes, or there are significant changes in other inputs. Salary growth. The salary growth assumptions reflect our long-term actual experience, outlook and assumed inflation. Expected VEBA drawdowns. The expected amount and timing of VEBA drawdowns is based on an assessment of hourly retiree benefit payments to be reimbursed, tax efficiency, cash availability, and our previously-discussed MOU with the UAW. Retirement rates. Retirement rates are developed to reflect actual and projected plan experience. Mortality rates. Mortality rates are developed to reflect actual and projected plan experience. Plan obligations and costs are based on existing retirement plan provisions. No assumption is made regarding any potential future changes to benefit provisions beyond those to which we are presently committed (e.g., in existing labor contracts). Risks Posed to Audit Firm as a Result of these Estimates: These estimates pose risk to the audit firm to the extent that, if the estimates are materially incorrect, and the audit firm issues an unqualified opinion, then the audit firm has inappropriately assured third party users of the appropriateness of the estimates when in fact they are not appropriate. 2. Read Fords disclosures concerning goodwill impairments, and focus on the goodwill impairment associated with Volvo. How would Fords auditors gain assurance that the impairment charge is properly valued? Ford notes that goodwill associated with the acquisition of Volvo declined due to three factors: (1) weakening of the U.S. dollar, (2) consumer shifts towards more fuel efficient cars as a result of higher gas prices, and (3) higher than anticipated marketing incentives on Volvo vehicles. As a result of these considerations, Ford recorded an impairment charge of $2.4 billion. To obtain assurance that the impairment charge is properly valued, the auditors may develop their own independent estimate of the impairment charge by considering negotiations to sell the unit, comparing projected cash flows with cash flow projections made at the time of acquisition, and evaluating managements strategic plans for using the assets. Further, the auditors should evaluate managements methodology for assessing impairment and should evaluate whether objective evidence supports the clients conclusion. 3a. Warranty liabilities are a significant concern for manufacturers like Ford and Toyota. What is the nature of estimates required for warranty liabilities? Ford describes the estimates and assumptions as follows: Nature of Estimates Required. The estimated warranty and additional service action costs are accrued for each vehicle at the time of sale. Estimates are principally based on assumptions regarding the lifetime warranty costs of each vehicle line and each model year of that vehicle line, where little or no claims experience may exist. In addition, the number and magnitude of additional service actions expected to be approved, and policies related to additional service actions, are taken into consideration. Due to the uncertainty and potential volatility of these estimated factors, changes in our assumptions could materially affect net income. Assumptions and Approach Used. Our estimate of warranty and additional service action obligations is re-evaluated on a quarterly basis. Experience has shown that initial data for any given model year can be volatile; therefore, our process relies upon long-term historical averages until sufficient data are available. As actual experience becomes available, it is used to modify the historical averages to ensure that the forecast is within the range of likely outcomes. Resulting accruals are then compared with present spending rates to ensure that the balances are adequate to meet expected future obligations. 3b. What are the warranty liabilities for Ford? Toyota? What analytical procedures can you develop to help you understand the relative size of the warranty accounts for both companies? What inferences do you draw from the comparison of these analytics? Ford: Included in the warranty cost accruals are costs for basic warranty coverage on vehicles sold. Additional service actions, such as product recalls and other customer service actions, are not included in the warranty reconciliation below, but are also accrued for at the time of sale. Estimates for warranty costs are made based primarily on historical warranty claim experience. The following is a tabular reconciliation of the product warranty accruals (in millions): Beginning balance Payments made during the period Changes in accrual related to warranties issued during the period Changes in accrual related to pre-existing warranties Foreign currency translation and other Ending balance 2007 $ 5,235 (3,287) 2,894 (232) 252 $ 4,862 2006 $ 5,849 (3,508) 3,005 (280) 169 $ 5,235 Warranty expense as a percentage of automotive sales:2894/154379=0.019 Warranty accrual as a percentage of total liabilities: 4862/272215=0.018 Toyota: Liabilities for product warranties at beginning of year Payments made during year Provision for warranties Charges related to pre-existing warranties Other Liabilities for product warranties at end of year $3,201 (2,368) 2,851 (250) 60 3,494 Warranty expense as a percentage of automotive sales: 2851/192038=0.014 Warranty accrual as a percentage of total liabilities: 3494/(99680+70676)=0.020 Inferences: Ford and Toyota accrue and expense a similar amount for warranties, with Toyotas accruals running at a slightly higher percentage of total liabilities compared to Ford. Auditors will likely compare warranty liabilities at their client with other companies in the industry as a way to determine if managements estimates are reasonable. In addition, the auditor will want to consider the companys warranty accrual and expensing history over time to be sure that new accruals are reflective of new warranty outlays as they become known for new vehicle models and changing conditions, etc. ... View Full Document

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