00 3320 efficiency ratio 262 264 profit margin ratio

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Unformatted text preview: Item 1 in the planning issues raises a concern about the viability of the Solar-Electro division, but not necessarily the entire company. The conclusion in Part I of the case was that the likelihood of financial failure is low, even considering the issue with SolarElectro. Item 7 in the planning phase indicates there is a debt covenant requiring a current ratio above 2.0 and a debt-to-equity ratio below 1.0. The current ratio has fallen below 2.0. This could result in the loan being called unless a waiver of the loan covenant is granted. Management integrity: No major issue exists that would cause the auditor to question management integrity, but the auditor should have done extensive client acceptance procedures before accepting the client. It is possible that Item 6 in the planning phase, turnover of internal audit personnel, could be intentional and increases the risk of fraudulent financial reporting. b. Acceptable audit risk is likely to be medium to low because of the factors listed previously, especially the planned increase in financing and the potential violation of the debt covenant agreement. Some might prefer an even lower acceptable risk because it is a first year audit. 9-77 9-37 (continued) c. Inherent risks are addressed by examining each of the 11 items in the planning phase. 1. Inherent Risk: No effect on inherent risk 2. Inherent Risk: The primary concern is the possibility of obsolete inventory, which affects the valuation of inventory at the lower of cost or market. Accounts Affected: Inventory, cost of good sold 3. Inherent Risk: There is a potential related party transaction, which could affect the valuation of the transaction and may require disclosure as a related party transaction. Accounts Affected: Manufacturing equipment, footnote 4. Inherent Risk: No effect on inherent risk 5. Inherent Risk: There is a potential related party transaction, which could affect the valuation of the transaction and may require disclosure as a related party transaction. Accounts Affected: Repairs and maintenance expense and accounts payable. 6. Inherent Risk: Although this does not directly affect inherent risk, it is possible that turnover of internal audit personnel could be intentional and increases the risk of fraudulent financial reporting. The turnover may also affect the auditor’s assessment of control risk. Accounts Affected: All accounts 7. Inherent Risk: In addition to affecting acceptable audit risk, the auditor should be concerned about the risk of fraudulent financial reporting due to the incentive to make certain that all debt covenants have been met. Accounts Affected: All accounts 8. Inherent Risk: A receivable outstanding for several months from a customer making up 15% of the company’s outstanding accounts receivable balance may indicate a major collection problem, which could result in an understatement of the allowance for uncollectible accounts. Accounts Affected: Accounts receivable, bad debt expense, allowance for uncollectible accounts 9-78 9-37 (continued) 9. Inherent Risk: An ongoing dispute with the Internal Revenue Service may require an adjustment to income tax liability or a disclosure in footnotes for a contingency, depending on the status of the dispute. Accounts Affected: Income tax expense and income taxes payable 10. Inherent Risk: This situation involves a related party transaction (Solar-Electro borrowed money from the Welburn division). Because this transaction was not conducted with an outside party, it is possible that the related receivable and payable might not have been properly eliminated on Pinnacle’s consolidated financial statements. Accounts Affected: Notes payable, notes receivable, interest expense and interest income. 11. Inherent Risk: This situation involves a nonroutine transaction where there is a risk that materials, labor and/or overhead are incorrectly applied to the property accounts. Accounts Affected: Property accounts, inventory and cost of sales. ■ Internet Problem Solution: Materiality and Tolerable Misstatement 9-1 Establishing materiality for the audit of a client’s financial statement requires considerable judgment. The allocation of the auditor’s preliminary judgment about materiality to the client’s accounts requires substantial judgment as well. For this reason, decisions about materiality are made by more experienced auditors. The following problem affords you an opportunity to apply the concept of materiality to an actual set of financial statements. 1. Imagine that you are employed as an auditor in a CPA firm that performs the audit of Microsoft. Your firm’s materiality guidelines indicate that overall engagement materiality should be set at an amount between five and ten percent of income before taxes. a. Apply your firm’s guidelines to Microsoft’s 2008 financial statements. What percentage of income before taxes do you believe is appropriate? Why? What do you believe overall engagement materiality should have been for 2008? 9-79 Internet Problem 9-1 (continued)...
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