Solution Manual for Auditing Cases: An Interactive Learning Approach, 5th Edition

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Auditing Casesf I f T he D I T I o nInstructor resource ManualMark S. BeasleyFrank A. BucklessSteven M. GloverDouglas F. Prawitt

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T a b l eo fc o nTe nTsiCases inCluded in thisseCtionclientacceptancese cT Io n11.1Ocean Manufacturing, Inc............................3The New Client Acceptance DecisionCases inCluded in thisseCtionUnderstanding the Client’s Businessandassessingriskse cT Io n22.1Your1040Return.com..............................13Evaluating eBusiness Revenue Recognition, Information Privacy,and Electronic Evidence Issues2.2Dell Inc.......................................25Evaluation of Client Business Risk2.3Flash Technologies, Inc.............................37Risk Analysis2.4Asher Farms Inc..................................49Understanding of Client’s Business EnvironmentCases inCluded in thisseCtionprofessional andethical Issuesse cT Io n33.1A Day in the Life of Brent Dorsey.......................59Staff Auditor Professional Pressures3.2Nathan Johnson’s Rental Car Reimbursement................63Should He Pocket the Cash?3.3The Anonymous Caller.............................65Recognizing It’s a Fraud and Evaluating What to Do3.4WorldCom.....................................71The Story of a Whistleblower3.5Hollinger International.............................79Realities of Audit-Related Litigation

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T a b l eo fc o nTe nTsiiCases inCluded in thisseCtionaccountingfraud andauditorlegalliabilityse cT Io n44.1Enron Corporation and Andersen, LLP...................89Analyzing the Fall of Two Giants4.2Comptronix Corporation............................99Identifying Inherent Risk and Control Risk Factors4.3Cendant Corporation.............................111Assessing the Control Environment and Evaluating Risk ofFinancial Statement Fraud4.4Waste Management, Inc............................119Manipulating Accounting Estimates4.5Xerox Corporation...............................127Evaluating Risk of Financial Statement Fraud4.6Phar-Mor, Inc..................................141Accounting Fraud, Litigation, and Auditor Liability4.7Satyam Computer Services Limited.....................157Controlling the Confirmation ProcessCases inCluded in thisseCtionInternalcontrol overfinancialreportingse cT Io n55.1Simply Steam, Co................................167Evaluation of Internal Control Environment5.2Easy Clean, Co..................................167Evaluation of Internal Control Environment5.3Red Bluff Inn & Café..............................177Establishing Effective Internal Control in a Small Business5.4St. James Clothiers...............................181Evaluation of Manual and IT-Based Sales Accounting System Risks5.5Collins Harp Enterprises...........................189Recommending IT Systems Development Controls5.6Sarbox Scooter, Inc...............................197Scoping and Evaluation Judgments in the Audit of InternalControl over Financial Reporting5.7Société Générale................................207How a Low-Risk Trading Area Caused a $7.2 Billion Loss

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T a b l eo fc o nTe nTsiiiCases inCluded in thisseCtion2.1Your1040Return.com...........................13Evaluating eBusiness Revenue Recognition, Information Privacy,and Electronic Evidence Issues5.4St. James Clothiers...........................181Evaluation of Manual and IT-Based Sales Accounting System Risks5.5Collins Harp Enterprises........................189Recommending IT Systems Development Controls9.2Henrico Retail, Inc............................291Understanding the IT Accounting System and Identifying AuditEvidence for Retail SalesotherCases that disCuss topiCs related to this seCtionThe Impact of Information Technologyse cT Io n66.1Harley-Davidson, Inc..............................219Identifying eBusiness Risks and Related Assurance Services forthe eBusiness Marketplace6.2Jacksonville Jaguars..............................227Evaluating IT Benefits and Risks and Identifying Trust ServicesOpportunitiesCases inCluded in thisseCtionotherCases that disCuss topiCs related to this seCtionplanning Materialityse cT Io n77.1Anne Aylor, Inc.................................241Determination of Planning Materiality and Tolerable Misstatement5.6Sarbox Scooter, Inc............................197Scoping and Evaluation Judgments in the Audit of InternalControl over Financial Reporting12.1EyeMax Corporation..........................399Evaluation of Audit Differences12.2Auto Parts, Inc..............................409Considering Materiality When Evaluating Accounting Policiesand Footnote Disclosures

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T a b l eo fc o nTe nTsivCases inCluded in thisseCtionotherCases that disCuss topiCs related to this seCtionanalyticalproceduresse cT Io n88.1Laramie Wire Manufacturing.........................251Using Analytical Procedures in Audit Planning8.2Northwest Bank.................................257Developing Expectations for Analytical Procedures8.3Burlingham Bees................................263Using Analytical Procedures as Substantive Tests1.1Ocean Manufacturing, Inc..........................3The New Client Acceptance Decision2.3Flash Technologies, Inc..........................37Risk AnalysisCases inCluded in thisseCtionauditingcash,fair Value, andrevenuesse cT Io n99.1Wally’s Billboard & Sign Supply.......................271The Audit of Cash9.2Henrico Retail, Inc...............................291Understanding the IT Accounting System and Identifying AuditEvidence for Retail Sales9.3Longeta Corporation.............................297Auditing Revenue Contracts9.4Bud's Big Blue Manufacturing........................303Accounts Receivable Confirmations9.5Morris Mining Corporation.........................309Auditing Fair Value9.6Hooplah, Inc...................................317Applying Audit Sampling Concepts to Tests of Controls andSubstantive Testing in the Revenue CycleotherCases that disCuss topiCs related to this seCtion4.7Satyam Computer Services Limited..................157Controlling the Confirmation Process8.2Northwest Bank.............................257Developing Expectations for Analytical Procedures8.3Burlingham Bees............................263Using Analytical Procedures as Substantive Tests

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T a b l eo fc o nTe nTsvCases inCluded in thisseCtionplanning andperformingauditproceduresin therevenue andexpenditurecyclesanauditsimulationse cT Io n1010.1Southeast Shoe Distributor, Inc.......................329Identification of Tests of Controls for the Revenue Cycle(Sales and Cash Receipts)10.2Southeast Shoe Distributor, Inc.......................339Identification of Substantive Tests for the Revenue Cycle(Sales and Cash Receipts)10.3Southeast Shoe Distributor, Inc.......................347Selection of Audit Tests and Risk Assessment for the Revenue Cycle(Sales and Cash Receipts)10.4Southeast Shoe Distributor, Inc.......................361Performance of Tests of Transactions for the Expenditure Cycle(Acquisitions and Cash Disbursements)10.5Southeast Shoe Distributor, Inc.......................377Performance of Tests of Balances for the Expenditure Cycle(Acquisitions and Cash Disbursements)Cases inCluded in thisseCtionotherCases that disCuss topiCs related to this seCtionDeveloping andevaluatingaudit Documentationse cT Io n1111.1The Runners Shop...............................389Litigation Support Review of Audit Documentationfor Notes Payable9.1-6Section 9: Auditing Cash, Fair Value, and Revenues.........271Various Cases10.1-5Southeast Shoe Distributor, Inc....................329An Audit Simulation

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T a b l eo fc o nTe nTsviCases inCluded in thisseCtioncompleting theaudit,reporting toManagement, andexternalreportingse cT Io n1212.1EyeMax Corporation..............................399Evaluation of Audit Differences12.2Auto Parts, Inc..................................409Considering Materiality When Evaluating Accounting Policiesand Footnote Disclosures12.3K&K Inc......................................415Leveraging Audit Findings to Provide Value-Added Insights in aManufacturing Environment12.4Surfer Dude Duds, Inc.............................421Considering the Going-Concern Assumption12.5Murchison Technologies, Inc.........................425Evaluating an Attorney’s Response and Identifying the ProperAudit Report12.6Going Green...................................435Sustainability and External Reporting

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viial p h a b eT Icca s eI nDe x7.1Anne Aylor, Inc................................................2413.3Anonymous Caller, The..........................................652.4Asher Farms Inc...............................................4912.2Auto Parts, Inc...............................................4099.4Bud's Big Blue Manufacturing.....................................3038.3Burlingham Bees.............................................2634.3Cendant Corporation..........................................1115.5Collins Harp Enterprises........................................1894.2Comptronix Corporation........................................993.1Day in the Life of Brent Dorsey, A...................................592.2Dell Computer Corporation.......................................255.2Easy Clean, Co...............................................1674.1Enron Corporation and Andersen, LLP...............................8912.1EyeMax Corporation...........................................3992.3Flash Technologies, Inc..........................................3712.6Going Green................................................4356.1Harley-Davidson, Inc...........................................2199.2Henrico Retail, Inc............................................2913.5Hollinger International..........................................799.6Hooplah, Inc.................................................3176.2Jacksonville Jaguars...........................................22712.3K&K Inc....................................................4158.1Laramie Wire Manufacturing.....................................2519.3Longeta Corporation..........................................2979.5Morris Mining Corporation......................................30912.5Murchison Technologies, Inc.....................................4253.2Nathan Johnson’s Rental Car Reimbursement..........................638.2Northwest Bank..............................................2571.1Ocean Manufacturing, Inc........................................34.6Phar-Mor, Inc................................................1415.3Red Bluff Inn & Café...........................................17711.1Runners Shop, The............................................3895.6Sarbox Scooter, Inc............................................1974.7Satyam Computer Services Limited................................1575.1Simply Steam, Co.............................................1675.7Société Générale.............................................20710.1Southeast Shoe Distributor, Inc.:Tests of Controls for the Revenue Cycle.............32910.2Southeast Shoe Distributor, Inc.:Substantive Tests for the Revenue Cycle............33910.3Southeast Shoe Distributor, Inc.:Audit Tests and Risk Assessment for the Revenue Cycle....34710.4Southeast Shoe Distributor, Inc.:Tests of Transactions for the Expenditure Cycle.........36110.5Southeast Shoe Distributor, Inc.:Tests of Balances for the Expenditure Cycle...........3775.4St. James Clothiers............................................18112.4Surfer Dude Duds, Inc..........................................4219.1Wally’s Billboard & Sign Supply...................................2714.4Waste Management, Inc.........................................1193.4WorldCom...................................................714.5Xerox Corporation............................................1272.1Your1040Return.com...........................................13

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viiiac k n o w l eDg eMe nTsWe would like to thank our families for their understanding and support while writing this case-book. We would also like to thank Jonathan Liljegren for his excellent work in the design and layoutof this casebook as well as Christina Rumbaugh and Stephanie Wall for their editorial support.We are grateful to the research assistants both past and present who have helped write,revise, and review the cases in this edition. We especially thank Jace Garrett and Aaron Jacob fortheir assistance with this latest edition.

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ixpr e f a c eAuditing educators continue to look for opportunities to increase their emphasis on the developmentof students’ critical thinking, communication, and interpersonal relationship skills.Developmentof these types of skills requires a shift from passive instruction to active involvement of students inthe learning process. Unfortunately, current course materials provided by many publishers are notreadily adaptable to this kind of active learning environment, or do not provide materials that addresseach major part of the audit process.The purpose of this casebook is to give students hands-onexposure to realistic auditing situations focusing specifically on each aspect of the audit process.This casebook contains a collection of 48 auditing cases that allow the instructor to focusand deepen students’ understanding in each of the major activities performed during the conductof an audit, from client acceptance to issuance of an audit report. The cases are designed to engagethe student’s interest through the use of lively narrative and the introduction of engaging issues. Insome cases, supporting material in the instructor notes allows the instructor to create a “surprise” or“aha!” experience for the student, creating vivid and memorable learning experiences. Many of thecases are based on actual companies, some involving financial reporting fraud. Several cases givestudents hands-on experience with realistic audit evidence and documentation.Each case contains a series of questions requiring student analysis, with numerous questionsrelated to the guidance contained in several new authoritative auditing standards, including thePCAOB’s recently issued Risk Assessment Auditing Standards (up through AS No. 15, AuditEvidence) and recent standards issued by the Auditing Standards Board (up through SAS No. 121,Revised Applicability of SAS No. 100, Interim Financial Information). The instructor’s resourcemanual also provides references in the solutions to many of the recently revised SASs that are partof the ASB’s Clarity Project. Several cases require students to gain a clearer understanding of thespecific requirements contained in the Sarbanes-Oxley Act of 2002. Other cases provide additionalexposure to the role of information technology in today’s environment, including a focus on TrustServices. One case incorporates actual excerpts from transcripts of testimony provided in courtrelated to a financial statement fraud to illustrate the importance of following audit principles andprocedures. Finally, cases new to this edition highlight the challenges of auditing fair value estimates,audit decisions related to the use of sampling when performing tests of controls and substantivetesting, audit deficiencies in the highly publicized Satyam fraud, and opportunities for providingassurance on sustainability reports.The cases included in this book are suitable for both undergraduate and graduate students.At the undergraduate level, the cases provide students with active learning experiences that reinforcekey audit concepts addressed by the instructor and textbook. At the graduate level, the cases providestudents with active learning experiences that expand the depth of their audit knowledge. Use of thecasebook will provide students with opportunities to develop a much richer understanding of theessential underlying issues involved in auditing, while at the same time developing critical thinking,communication, and interpersonal relationship skills.The casebook provides a wide variety of cases to facilitate different learning and teachingstyles.For example, several of the cases can be used either as in-class exercises or out-of-classassignments.This manual clearly illustrates the different instructional approaches available foreach case (e.g., examples of cooperative/active learning activities and/or out-of-class individual orgroup assignments) and efficiently prepares the instructor for leading interactive discussions.Please submit any corrections or suggestions to:auditingcases@byu.edu

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xf IfTheD I T Io nupdates to priorCasesCases from the prior edition have been updated to reflect changes in professional standards. Casesbased on events at real companies have been updated to reflect recent developments. Dates in thehypothetical cases have been set in calendar year 2012 with audit procedures performed on the 2011fiscal year information and/or interim procedures performed on the 2012 fiscal year information.When appropriate, we have changed underlying data in the hypothetical cases so that the casesdiffer from prior editions.new to the fifth editionThe following cases have been added to the fifth edition to expand coverage of audit topics andprovide timely coverage of recent high profile accounting-related events.4.7Satyam Computer Services Limited....................157Controlling the Confirmation ProcessThis case highlights the accounting fraud at the Satyam Computer ServicesCompany based in Hyderabad, India whereby senior management manipulatedthe company's IT-based accounting system to orchestrate a $1.1 billion fraud.Studentslearnabouttechniquesusedbyseniorexecutivestomanipulaterevenues and profitability and the importance of maintaining control of the entireconfirmation process.9.5Morris Mining Corporation.........................309Auditing Fair ValueIn this case students research standards on auditing fair value and then have theopportunity to consider the appropriateness of Morris Mining's fair value esti-mate for a patent obtained in an acquisition. Students get hands-on practice atconsidering sensitivity of the fair value estimate to changes in the model inputs.Morris Mining Corporation is a hypothetical company.9.6Hooplah, Inc...................................317Applying Audit Sampling Concepts to Tests of Controlsand Substantive Testing in the Revenue CycleThis case provides students the opportunity to apply audit sampling concepts indetermining the nature and extent of testing. Students evaluate and perform testsof controls and tests of details on selected samples in an accounts receivable setting.Students also consider the benefits of risk- and coverage-based substantive testingprior to applying audit sampling. Hooplah, Inc. is a hypothetical company.12.6Going Green..................................435Sustainability and External ReportingThis case presents students with the opportunity to explore the emerging area ofsustainability reporting. Students gain knowledge of the Global Reporting InitiativeFramework for sustainability reporting and use it to evaluate the sustainability reportof an actual company. Students also gain knowledge of the AICPA Attestation Stan-dards and International Standard on Assurance Engagements that would be used toprovide assurances on sustainability reports.

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1s e cT Io nclientacceptance1.1Ocean Manufacturing, Inc.......................3The New Client Acceptance DecisionCases inCluded in thisseCtion

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3copyright©2012 bypearsoneducation, Inc.,uppersaddleriver,nJ 07458The case was prepared by Mark S. Beasley, Ph.D. and Frank A. Buckless, Ph.D. of North Carolina State University and Steven M. Glover, Ph.D. andDouglas F. Prawitt, Ph.D. of Brigham Young University, as a basis for class discussion. Ocean Manufacturing is a fictitious company. All charactersand names represented are fictitious; any similarity to existing companies or persons is purely coincidental.ocean Manufacturing, Inc.Thenewclientacceptance DecisionMark S. Beasley · Frank A. Buckless · Steven M. Glover · Douglas F. PrawittTo help students understand the process of[1]considering a new prospective audit client andthe factors that auditors commonly consider inmaking the acceptance decision.To give students experience in computing and[2]interpreting preliminary analytical procedurescommonly used in obtaining an understandingof a prospective client during the clientacceptance decision process.To raise issues relating to auditor independence[3]in the context of client acceptance, both in termsof financial interests and the provision ofnon-audit services.To illustrate the subjective and sometimes[4]difficult nature of the judgments involved in theclient acceptance decision, and to give studentsthe opportunity to justify a recommendation onclient acceptance in the presence of bothsignificant positive and negative factors.To help students understand how information[5]gathered in the client acceptance process canhelp the auditor in planning the audit if theclient is accepted.instr uCtionalobjeCtivesKEY FACTSThe student takes on the role of a newly promoted audit manager recently given the task ofconsidering factors and making a recommendation with respect to the acceptance of a newprospective client.The request to consider the engagement was received two weeks past theclient’s fiscal year-end.The accounting firm, Barnes and Fischer, LLP, is a medium sized national firm with over 6,000professionals on the payroll. The firm mainly provides auditing and tax services, but has beentrying with some success to build the information systems consulting side of the business overthe past few years. Most of the clients in the local office that is considering the acceptance ofOcean Manufacturing, Inc. are in the healthcare services industry.The prospective client, Ocean Manufacturing, is a medium-sized manufacturer of small homeappliances, and is planning an initial public offering (IPO) in the next two years. The companyhas recently decided to terminate its relationship with its current auditor. The partner is intriguedwith the idea of having a client in the home appliance industry. She believes the engagementmay present an excellent opportunity for Barnes and Fischer to enter a new market.The case gives brief background information on the home appliances industry and Ocean’sbusiness environment, management team, selected financial statement accounts, and internalcontrols.Summary information is also provided on the predecessor auditor, independenceissues, and client background checks. Ocean’s financial statements are also included, togetherwith some industry ratios.Ocean’s management reluctantly gives Barnes and Fischer permission to contact the predecessor1.1ca s e

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4section 1:clientacceptanceauditor.The engagement partner at the predecessor firm indicates he had problems dealingwith Ocean’s new IT system and management’s tendency to become aggressive with financialreporting issues (year-end accruals and revenue recognition) to meet creditor requirements forrelatively favorable interest rates. He also indicates there had been some disagreement over theproposed audit fee.Two independence issues are raised for research or discussion. These involve consulting servicesand an immaterial indirect financial interest by a partner in another office.Ocean has recently implemented a new IT system, and the transition has not gone smoothly. Asa result, some audit trails have not been successfully maintained. Risk of material misstatementis high in 1) inventory tracking and cost accumulation, 2) receivables billing and aging, 3)payroll deductions, 4) payables balances, and 5) balance sheet account classifications.There has been significant management turnover in the past year. A client background checkreveals that the V.P. of finance was charged with illegal gambling five years ago, raising amanagement integrity issue.USE OF CASEThis case is designed to expose students to a client acceptance decision that includes considerationof both significant positive and negative client acceptance issues. The case has been designed topresent a non-trivial acceptance decision, making class discussion more rich and interesting. Thecase is intended to go beyond the standard textbook treatment of the client acceptance decision byillustrating the subjective nature of the process and stimulating discussion of the issues affecting thisimportant decision. The case can be used in either an introductory or an advanced financial statementauditing course.The case is short enough to be used as a stimulating in-class learning exercise,but involved enough to be used as an out-of-class written assignment, including computation ofpreliminary analytical procedures and preparation of recommendation and pre-planning memos.If the case is to be used for an in-class discussion, we recommend having students read thecase as an out-of-class reading assignment prior to the in-class discussion. A useful cooperativelearning technique to use for the in-class discussion is “Roundtable.” The basic process for theRoundtable activity is to have students meet in small groups to state aloud and write down on asingle sheet of paper ideas for each question. Once all students have had an opportunity to statetheir ideas and arrive at a group consensus, the instructor can randomly call on individual studentsto share their group’s answers with the class. The class time allocated to the group discussion canbe shortened by assigning groups responsibility for different case questions. Randomly calling onindividual students to share their group’s answers with the class helps to ensure that all students takeresponsibility for learning the material.If the case is going to be used as an out-of-class writing assignment, we recommenddiscussing the case requirements with the students prior to having them complete the assignment.A useful cooperative learning technique to use for the out-of-class writing assignment is “peerediting.” With this approach students first meet in pairs to develop an outline for each memo. Oncethe outlines are developed, one student individually drafts the recommendations memo while theother student drafts the pre-planning memo based on the outlines. When the drafts are completed,students exchange draft responses and prepare written suggestions on the grammar, organization,and accuracy of the composition. Students then meet to discuss revisions for each draft. Finally,students revise their responses based on the suggestions provided. To ensure the process is followed,students should attach their final drafts to the outlines and critiqued drafts. The out-of-class activitycan be reviewed by having student pairs compare their answers with another student pair. Studentscan then be selected to share their answers with the whole class. Again, randomly selecting studentsto share their answers with the class helps to maintain individual student accountability for thelearning task.

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5case 1.1:ocean Manufacturing, Inc.PROFESSIONAL STANDARDSReferences to AU sections have been updated to reflect the new codification of ASB clarity standards.PCAOB standards are referenced by standard number. Relevant professional standards for thisassignment are:AICPA ASB Standards:AU 210, “Terms of Engagement,” AU 300, “Planning an Audit,” AU 510,“Opening Balances --Initial Audit Engagements, Including Reaudit Engagements,” ET Section 101“Independence,” ET Section 301, “Confidential Client Information,” and QC Section 10, “A Firm'sSystem of Quality Control.”PCAOB Standards:AS9, "Audit Planning.”Questions andsuGGestedsolutionsNOTE:The underlying attendance, facts, numbers, and suggested solutions have changed in the5th edition to address the availability of solutions of prior editions for sale on the internet.The client acceptance process can be quite complex. Identify five procedures an auditor should[1]perform in determining whether to accept a client. Which of these five are required by auditingstandards?There are many activities that are reasonable for an auditor to perform in making the clientacceptance decision.Thus, students’ answers will vary greatly.Relevant standards (seeprior listing) require that the audit firm establish quality control procedures to determinewhether a client should be accepted. The audit firm also must determine its independencewith respect to the prospective client, evaluate its ability to adequately service theprospective client, evaluate the integrity of management, and attempt to communicate withthe predecessor auditor after obtaining permission from the prospective client to discussconfidential matters.Once these steps are taken the client and auditor must come to anagreement on various issues such as the nature and limitations of the specific services tobe rendered, the expected cooperation of client personnel, the anticipated audit start andend dates, and an estimated audit fee. Below are some of the more common and importantactivities (those activities that arespecificallyrequired by relevant standards begin with anasterisk):Obtain and review client financial information such as annual reports and income taxa)returns.*Evaluate the integrity of client management.b)*Communicate with the predecessor auditor after receiving permission from the client.c)Topics discussed should include management integrity and any disagreements aboutaccounting or auditing issues.*Determine the independence of your firm with respect to the client.d)Inquire of third parties about the client (banks, attorneys, credit agencies, etc.).e)*Take various steps to obtain an understanding of the client and its industry (e.g., on-sitef)tour, reviewing industry publications), and determine if your firm has or can reasonablyexpect to obtain the technical skills and industry knowledge needed to perform the auditproperly.Consider whether the client has any unusual or special circumstances that will requireg)special attention by your firm. Also consider whether issues such as litigation or going-concern problems exist for the client.Perform preliminary analytical procedures to obtain an understanding of the prospectiveh)client and its industry.

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6section 1:clientacceptanceEvaluate the opportunities and business risks posed by the client to your auditing firm.i)Obtain an agreement from management that it acknowledges and understands itsj)responsibility for selecting the appropriate financial reporting framework, establishingand maintaining internal control, and providing access and information to the auditor.Determine whether the client is using an acceptable accounting framework.k)Determine if management is going to impose a limitation on the scope of the auditor’sl)work.Using Ocean’s financial information, calculate relevant preliminary analytical procedures to[2]obtain a better understanding of the prospective client and to determine how Ocean is doingfinancially.Compare Ocean’s ratios to the industry ratios provided.Identify any majordifferences and briefly list any concerns that arise from this analysis.The following are various ratios computed from Ocean’s financial statements. This questionis intentionally vague so that students will have to refer to their auditing textbook forguidance on the types of analytical procedures useful for gaining an understanding of theclient.The instructor can make the assignment more specific by requiring specific ratiosto be computed.The instructor could also require preparation of horizontal and verticalanalyses on the financial statements.Several interesting trends should be noted in the ratios. Return ratios are improving,as is inventory turnover (which is poor relative to the industry), but accounts receivableturnover, while relatively good, is deteriorating.201120102009ROE8.94%7.11%6.28%ROA4.54%3.77%3.39%Asset to equity1.971.881.85Accounts Receivable Turnover11.6913.1114.02Average Collection Period31.2327.8526.03Inventory Turnover6.084.513.48Days in Inventory59.9880.89104.99Debt Ratio0.490.470.46Debt to Equity0.970.880.85Times interest earned4.704.246.23Current ratio1.851.921.69Profit Margin (on operating income)5.5%6.0%4.7%Industry Ratios for Comparison:20112010ROE20.33%26.22%ROA6.62%8.10%Asset to equity3.302.82Accounts Receivable Turnover7.496.96Average Collection Period41.2544.35Inventory Turnover8.096.90Days in Inventory38.1643.86Debt to Equity2.381.90Times interest earned1.622.37Current ratio1.291.44Profit Margin (on operating income)10.58%10.82%

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7case 1.1:ocean Manufacturing, Inc.Major Differences to be noted:Ocean has a low return on equity relative to the industry.a)Ocean has a low return on assets relative to the industry.b)Ocean’s accounts receivable turnover is high relative to the industry.c)Ocean’s inventory turnover is low relative to the industry.d)Ocean’s profit margin is low relative to the industry.e)What nonfinancial matters should be considered before accepting Ocean as a client?How[3]important are these issues to the client acceptance decision? Why?Relevant non-financial matters include the following:Recent management turnover. This matter may or may not pose a potential problem toa)the audit, but may be a sign of other problems that should be investigated. The controlleris very new and has little relevant experience, which may make audit work slower andmore difficult.High auditor turnover rate.This should be a red flag to the auditors.The auditorsb)should look into why Ocean has employed so many different auditors in so few years.Complicated new computer system. The complicated system poses a couple of problemsc)for the auditors.First, the auditors may have difficulty getting the information theyneed from the system, and a question arises regarding auditability. Second, inadequatecontrols over the new system may increase the amount of substantive testing required.Client hesitant to allow new auditor to speak with previous auditor. Anytime a client isd)hesitant or unwilling to allow new auditors to communicate with the previous auditor, ared flag should be raised in the mind of the successor auditor, and a careful examinationof the issue, including consideration of management integrity, should ensue.Illegal gambling incident. This is a matter of concern because it raises the managemente)integrity issue.What the V.P. of finance did was definitely wrong, but the impact onthe overall integrity of management is a matter of judgment. This issue can be debatedamong the students.Some will come down on one side saying that if a key memberof management is dishonest in one thing, he is likely to be dishonest in others. Otherstudents will argue that the incident has little to do with the business and its management,especially since there are no other known incidents. At a minimum, this incident createsan opportunity to raise and discuss the central role of management integrity in the clientacceptance decision.Initial public offering.Ocean has plans to go public and aggressively expand into thef)national market. If successful, these plans will make Ocean a more attractive client forBarnes and Fischer, but they also serve to increase the auditor’s business risk (increasedreliance on the statements, increased litigation risk, etc.) and should be considered.Management’s aggressiveness. There are some indications in the case that managementg)is willing to manipulate the financial statements via year-end accruals and revenuerecognition to achieve relatively low interest rates from creditors. This raises a potentialmanagement integrity issue, and should be heavily weighted in view of the fact that theupcoming IPO may give management even greater incentive to manipulate the financialstatements.Relationship with predecessor auditor.This issue is left intentionally debatable inh)the case, but is certainly a concern that should be raised.The relationship with thepredecessor auditor has been negative, and this is cause for concern. On the other hand,the poor relations may be present because the auditor did not have a sound understandingof Ocean’s business and was not competent in helping Ocean with its new IT system.Personality issues can also play a role. Further, the apparent differences over the currentyear’s audit fee should be a concern to Barnes and Fischer from a business perspective.Students should also raisei)positivenon-financial issues, such as the opportunity to expand

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8section 1:clientacceptanceinto a new industry and the opportunity to provide significant consulting servicesrelating to Ocean’s new IT system as well as to Ocean’s internal controls. The companyhas a relatively long and stable history in the small appliances industry. Further, Oceanis well positioned in the small appliances market.With its plans for going public andexpanding nationally, the company may become an even larger and more attractiveclient.Some students will think the case represents a clear non-acceptance situationdue to the negative factors listed above. The instructor can provide some perspectiveby pointing out that no prospective client comes without some concerns and problems.Ocean certainly presents some issues and concerns, but would likely be accepted by mostauditing firms. (Two different partners from major firms commented in presenting thiscase to graduate auditing courses that the level of risk presented by Ocean Mfg. was fairlytypical of many of the firm’s clients. In our experience, most students indicate that theywould not accept Ocean Mfg. as a client. This case provides an opportunity for studentsto better understand the subjective issues and risks that auditors face in practice.).[a][4]Ocean wants Barnes and Fischer to aid in developing and improving its IT system. Whatare the advantages and disadvantages of having the same CPA firm provide both auditing andconsulting services? Given current auditor independence rules, will Barnes and Fischer be ableto help Ocean with its IT system and still provide a financial statement audit? Support yourconclusion with appropriate citations to authoritative standards if your instructor indicatesthat you should do so.The issue of providing both systems consulting and auditing services to the same client hasbeen a topic of considerable debate in the profession.Some parties argue that providingboth consulting and auditing services to the same client may impair auditor objectivity. Onthe other hand, many in the profession argue that a great deal of efficiency is gained by thesame firm providing both kinds of services because the firm can leverage the auditor’s deepunderstanding of the client and its information system in providing additional services. Forpublic companies, which are subject to the Sarbanes-Oxley Act of 2002, the auditor is notpermitted to provide certain types of consulting services for clients. Financial informationsystems design and implementation is not an approved consulting service under Sarbanes-Oxley. Until it executes its planned initial public offering, Ocean is a privately-held companyand is thus subject to AICPA independence requirements. The AICPA Code of ProfessionalConduct indicates that systems implementation is an acceptable nonattest service toprovide to audit clients under certain conditions.For example, while a CPA firm mayassist an audit client in implementing a computer software package, it may not “design” thefinancial information system by creating or changing the computer source code underlyingthe system. Students typically have strong views on this issue. Some argue that objectivitywould likely be impaired, and others argue that the objectivity issue can be dealt with andthat the efficiencies gained outweigh the potential costs.[b]As indicated in the case, one of the partners in another office has invested in a venture capitalfund that owns shares of Ocean common stock. Would this situation constitute a violation ofindependence according to the AICPA Code of Professional Conduct? Why or why not?According to Rule 101 of the AICPACode of Professional Conduct, materiality is not to beconsidered in the case of a direct financial interest—no direct financial interests on the part ofthe auditor are tolerated. However, if the financial interest is indirect, as in the case of a mutualfund or venture capital fund investment, materiality is considered. It is fairly clear from thecase that the partner’s indirect financial interest is immaterial and thus does not constitute aviolation of Rule 101. The instructor may wish to point out that no individual who is on theengagement team, who is a partner or manager not on the attest engagement team but whoprovides nonattest services to that client, who is a partner who works in the same office as the

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9case 1.1:ocean Manufacturing, Inc.attest engagement’s lead partner, or who is a position to influence the engagement, can hold adirectfinancial interest in the client. However, even the partner in charge of the Ocean auditwouldbe permitted to hold an immaterialindirectfinancial interest in Ocean.[a][5]Prepare a memo to the partner making a recommendation as to whether Barnes and Fischershould or should not accept Ocean Manufacturing, Inc. as an audit client. Carefully justifyyour position in light of the information in the case. Include consideration of reasons both forand against acceptance and be sure to address both financial and nonfinancial issues to justifyyour recommendation.The memo should be professional in appearance and in substance, and should be well written.The memo should include the points brought out in the preceding questions, which aredesigned to help prepare the students to make reasoned and informed recommendations.The memo should also include a clear recommendation as to whether the client should beaccepted. There is no right or wrong recommendation as long as a student demonstrates s/he weighed the issues and made a reasonable decision based on the information provided.However, in our experience, students tend to be much more negative about the prospectof accepting Ocean as an audit client than are auditing professionals. Most of our studentstend to reject Ocean as a client; audit partners visiting our classrooms, especially thosepartners from non-big 4 firms, often indicate that Ocean is similar to many of their ownclients. Students tend to want an ideal client; audit professionals have to make a living inthe real world, which includes dealing with clients that have some issues and that presentsome risks. Emphasize that the client acceptance decision is a very subjective one that isultimately determined by professional judgment.[b]Prepare a separate memo to the partner briefly listing and discussing the five or six mostimportant factors or risk areas that will likely affect how the audit is conducted if the Oceanengagement is accepted. Be sure to indicate specific ways in which the audit firm should tailorits approach based on the factors you identify.This pre-planning memo should include many of the same issues considered in the acceptancedecision. However, this memo should then consider the implications of these issues for howthe audit will be conducted assuming the client is accepted. The case discusses many issuesthat would have potentially important implications for conducting the audit. Some of themore important implications are listed below.As a result of Ocean’s recent IT implementation, some audit trails have not beena)successfully maintained. The auditor will need to determine how to gain comfort on theitems for which traditional audit trails were not maintained. Depending on the natureof the items, the auditor may be able to gather evidence by backing in to the missingperiods using the data from before and after the breakdown of the trails. Additionally,analytical procedures to test for reasonableness may become more important due to theaudit trail breakdowns.Also as a result of Ocean’s recent IT implementation, risk of material misstatement isb)high in inventory tracking and cost accumulation, receivables billing and aging, payrolldeductions, payables balances, and balance sheet account classifications.Substantiveprocedures with relatively large sample sizes will likely play an important role in theseareas, with particular emphasis on tests of details of balances.Internal controls appear to be lacking. Thus, the auditor will likely have to rely heavilyc)on substantive procedures. This will in turn have implications for staffing budgets andthe cost of the audit.Accounts Receivable turnover, while good, is deteriorating.This suggests that thed)auditor may want to pay special attention to the valuation of receivables.Inventory turnover, while still poor relative to the industry, has improved rathere)

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10section 1:clientacceptancedramatically over the past three years.This could be due to more effective inventorymanagement, but may also be due to misstatements in the inventory account.Thissuggests the auditor may want to emphasize the completeness, valuation, and accuracyobjectives for inventory. Since the client is a manufacturer with relatively large inventorybalances, the audit of inventory will be a major focus of the audit.Ocean’s profit margin percentage and return on equity are low relative to the industry.f)The auditor should identify and corroborate a viable explanation.These factors arelikely related to Ocean’s cost structure or the competitiveness of Ocean’s region orproduct set. However, the issue is worth investigating as these ratios may be seen as redflags for fraud risk.The predecessor auditor indicated that Ocean’s management tended to become aggressiveg)in the treatment of accruals and revenue recognition toward the year-end. This is clearlyan area where the auditors will want to focus a great deal of attention, increasing theextent of cut-off tests, reasonableness of accruals, etc. Frequent material fourth-quarteradjustments are also considered a red flag for fraud, so the audit program should probablytake into account a heightened risk of fraud, in accordance with auditing standards.Since the successor auditor will take on the audit subsequent to year-end, some cut-off andh)inventory issues arise. For ending inventory in particular, the successor will either haveto rely on the work of the predecessor auditor (if the predecessor observed the client’sending inventory procedures) or gain comfort by “backing into” the ending inventorybalance via alternative procedures, such as roll-backs and tests of transactions.

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2s e cT Io nunderstandingthe Client’s Businessandassessingrisk2.1Your1040Return.com.........................13Evaluating eBusiness Revenue Recognition,Information Privacy, and Electronic Evidence Issues2.2Dell Inc....................................25Evaluation of Client Business Risk2.3Flash Technologies, Inc........................37Risk Analysis2.4Asher Farms Inc.............................49Understanding of Client’s Business EnvironmentCases inCluded in thisseCtion

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13copyright©2012 bypearsoneducation, Inc.,uppersaddleriver,nJ 07458The case was prepared by Mark S. Beasley, Ph.D. and Frank A. Buckless, Ph.D. of North Carolina State University and Steven M. Glover, Ph.D. andDouglas F. Prawitt, Ph.D. of Brigham Young University, as a basis for class discussion. Your1040Return.com is a fictitious company. All charactersand names represented are fictitious; any similarity to existing companies or persons is purely coincidental.your1040return.comevaluating ebusinessrevenuerecognition,Informationprivacy, andelectronicevidence IssuesMark S. Beasley · Frank A. Buckless · Steven M. Glover · Douglas F. PrawittTo illustrate business risks for Internet-only[1]business models.To help students develop skills related to[2]identifying internal control responses toeBusiness risks.To highlight revenue recognition issues related[3]to eBusiness transactions.To illustrate unique accounting issues associated[4]with Internet web site banner advertisements.To help students identify privacy issues[5]associated with Internet-based business models.To illustrate audit implications when transaction[6]audit trails are solely electronic.To help students recognize threats to eBusiness[7]strategies.instr uCtionalobjeCtivesKEY FACTSYour1040Return.com is a leading provider of online income tax preparation and filing servicesfor individual taxpayers.The company was founded two years ago by Steven Chicago who realized individuals may befrustrated with the need to purchase tax preparation software upgrades each year to ensure theirtax software reflects recent changes in the tax code.Your1040Return.com’s strategy is to provide up-to-date tax preparation software that can beaccessed through the Internet by individuals who pay membership fees for that access.In essence, Your1040Return.com’s customers “rent” access to tax preparation software packagesthat are continually kept up-to-date with the latest tax law changes.Customers can also useYour1040Return.com’s services to electronically file an already prepared paper-based tax return.Customers can use Your1040Return.com to file both state and federal tax returns.Your1040Return.com customers select from one of three service packages:Silver, Gold, orPlatinum.Silver package customers can access electronic copies of tax forms, schedules, and publicationsand can enter tax return information directly onto those forms and schedules. Your1040Return.com will also file the completed return electronically to the appropriate regulatory agency.In addition to the Silver package services, Gold package customers have one-year access to acommercially developed and continually maintained tax preparation software package thatassists customers in the preparation of their individual returns.Platinum package customers have access to the premium level of services, which allow customersto have multi-year access to the tax preparation software and personalized attention and real-time tax support from qualified income tax specialists.2.1ca s e

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14Section 2: Understanding the Client’s Business and Assessing RiskRevenue recognition differs for each product offered by Your1040Return.com.Your1040Return.com’s business is seasonal with its highest demand from early February throughApril 15theach year. The company experiences peaks in demand during periods surroundingextension deadlines.Tax payments and refunds are not funded by Your1040Return.com.Rather, tax refunds areremitted directly from the IRS or state agency to the individual. Tax payments are charged bythe IRS or state agency to the individual’s credit card account.Your1040Return.com also engages in ad swapping with a number of major Internet companies.In exchange for providing electronic advertisements on the Your1040Return.com web site, thecompany receives free banner ads on other web sites.Servers located at Your1040Return.com’s offices support the tax preparation software.Theservers are in facilities with physical access securities and are protected logically by firewallsand access passwords.The company hires several tax experts to monitor tax code changes and to help ensure theunderlying tax software is accurate.The company contracts with a software design firm todevelop the online tools. Two of Chicago's nephews oversee the operations of the IT platform;each has less than 5 years of relevant work experience.The company's CFO joined the company after three years of audit experience with a Big Fourinternational accounting firm.The company does not have an official customer privacy policy. The company has been approachedby marketing executives who are interested in purchasing Your1040Return.com’s customer lists.As part of a recent line of credit arrangement with the local bank, Your1040Return.com’s financialstatements must now be audited.USE OF CASEThis case assignment provides students the opportunity to recognize that while the Internet andrelated innovative uses of technology offer opportunities for new avenues for conducting business,there are unique risks and related accounting issues that must be considered.This case exposesstudents to issues associated with a relatively new eBusiness enterprise that provides tax-relatedservices via the Internet. This case explores several issues that arise with an Internet-based businessmodel.First, the case highlights how the Internet provides innovative ways for businesses to delivervalue added services to consumers. As a result, this case exposes students to issues different fromthose associated with traditional “brick and mortar” businesses.And, because the underlyingservice relates to tax preparation software for customers, accounting students can easily understandthe main components of Your1040Return.com’s service offering to consumers.Second, the structure of the three levels of product service offerings (Silver, Gold, andPlatinum) provides a nice opportunity to engage students in an analysis and class discussion ofthe accounting implications related to revenue recognition. This analysis helps students see howoperational decisions about product and service offerings create different accounting issues for eachoffering.In addition, the use of bartering for the ad banner transactions exposes students to aunique accounting issue for many Internet based businesses.Third, the case illustrates basic business decisions that start-up companies must make.For example, the case highlights the practical aspects and related implications of attracting andhiring affordable employees with the necessary job skills. It also highlights the difficult realities ofmaintaining basic business operations with limited resources and talents, such as Your1040Return.com’s limited IT system and lack of ideal data and system backups.Finally, the case illustratestradeoffs business owners must make by highlighting the ethical dilemmas associated with thepotential decision to sell private customer information to external marketing agencies.

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15case 2.1:your1040return.comThis case could be used in either an undergraduate or graduate auditing or accountinginformation systems course to highlight unique business risks, internal controls, and audit evidenceissues associated with Internet-based businesses. The questions related to revenue recognition maybe effective for use in an undergraduate intermediate accounting course.Students can complete the case individually or in groups as an in-class or out-of-classassignment. Because the case is relatively short, students can read the case during the class periodto prepare for an in-class discussion of several of the questions. Other questions, however, may bebetter suited as an out-of-class assignment (e.g., see question 1.e and 1.g) that students completebefore an in-class discussion is held.This assignment can be broken down into several sub-assignments that can be completed atvarious points during a quarter or semester. Students should particularly enjoy this case, given thatit exposes them to broader business issues associated with Internet-based businesses.PROFESSIONAL STANDARDSReferences to AU sections have been updated to reflect the new codification of ASB clarity standards.PCAOB standards are referenced by standard number. Relevant professional standards for thisassignment are:AICPA ASB Standards:Relevant professional standards for this assignment include AU Section 315“Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement,”AU Section 330, “Performing Audit Procedures in Response to Assessed Risks and Evaluating theAudit Evidence Obtained,” and AU Section 540, “Auditing Accounting Estimates, Including FairValue Accounting Estimates and Related Disclosures.”PCAOB Standards:AS5, “An Audit of Internal Control over Financial Reporting That is Integratedwith an Audit of Financial Statements,” AS 8, “Audit Risk,” and AS12, "Identifying and AssessingRisks of Material Misstatement.”(Note:PCAOB Standards are relevant from an informationalperspective, but are not required since Your1040Return.com is not a public company.)QuestionsandsuGGestedsolutionsYou are an audit senior with Gooch & Brown CPA, LLP, a local accounting firm specializing in[1]audits of information systems and financial statements. Your1040Return.com engaged yourfirm to perform its financial statement audit. You have been asked by the partner to performthe following tasks:Describe to Stephen Chicago why it is important for your firm to have an understanding of[a]Your1040Return.com’s business model.The second standard of fieldwork in generally accepted auditing standards requires that“The auditor must obtain a sufficient understanding of the entity and its environment, includingits internal control, to assess the risk of material misstatement of the financial statements whetherdue to error or fraud, and to design the nature, timing , and extent of further audit procedures.”A thorough understanding of the client’s business model is essential for doing an adequateaudit.The nature of the client’s business operations and industry directly affects clientbusiness risks and the risk of material misstatements in the financial statements. The auditoruses the knowledge about these risks to determine the appropriate extent of audit evidenceto be obtained through further audit procedures. Without an adequate understanding of theunderlying client business models, auditors may fail to adequately identify relevant businessrisks.That failure will likely result in audit procedures inadequately designed to detectmaterial misstatements in the financial statements.

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16Section 2: Understanding the Client’s Business and Assessing RiskThe auditor should understand factors such as major sources of revenue, key customersand suppliers, sources of financing, and competitors, among other matters, related to theclient’s core business operations. Through such an understanding, the auditor may be morelikely to identify business risks arising from unique incentives and pressures or deficienciesin internal controls created by that business model structure that increase opportunitiesfor misstatements in the financial statements. Additionally, knowledge about core businessmodels gives auditors a better understanding of the client’s business and industry to providevalue-added services to those clients.Identify Your1040Return.com’s major business risks and describe how those risks may[b]increase the likelihood of material misstatements in Your1040Return.com’s financialstatements.Because Your1040Return.com’s main business model involves the provision of softwareand other services accessed through the Internet, the company faces different issues fromtraditional “brick and mortar” businesses. Here is an overview of several business risks thatYour1040Return.com faces:Customer Demand.Because the business model is solely based on services deliveredthrough the Internet, there may be individuals who are uncomfortable using the Internetto use the online tax services. Certain customers may be reluctant to submit personaltax related financial information over the public Internet. As a result, the customer basein the online marketplace may be limited.That may put pressure on management togenerate future revenues to maintain profitability goals and targets. That pressure mayprovide incentives for management to aggressively account for revenue and expensetransactions to achieve those profitability goals. In some cases, management may selectoptions that are not in compliance with generally accepted accounting principles.Software Technical Accuracy.One of the main selling features for Your1040Return.com is access to an up-to-date popular tax software package.There is some risk thatthe tax preparation software contains errors in the interpretation and application ofthe complicated federal and state tax codes, which in turn may cause customers to fileincorrect returns. If that risk is realized, Your1040Return.com may create contingenciesrelated to potential liabilities associated with litigation claims from customers.Inaddition, as information about errors in the tax software packages becomes public,customers may be reluctant to continue subscribing to the online services offered, whichwill lead to decreased revenues. The revenue pressure may lead to incentives to engagein aggressive accounting to maintain profitability goals.Service Availability.Because Your1040Return.com’s core business is based on servicesdelivered via the Internet, the company faces the risk that customers may not be able toaccess the tax preparation software if there is a failure in the Internet link to the services.Any system failures with Your1040Return.com’s computer servers would prevent thecompany from providing services for its customers, unless reliable and quick backup accessis consistently maintained. If the service access is unavailable for a significant amount oftime, the company may lose customers, which would create pressures for management tomaintain its profitability. In addition, the lack of access to services may create revenuerecognition problems given that the company has not fulfilled its service obligations forcustomers who have already paid for unlimited access to the software services.Inadequate Staff.Currently, key staff positions related to system support and theaccounting functions have limited experience.As Your1040Return.com’s businesscontinues to grow, the size and complexities associated with company growth may present

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17case 2.1:your1040return.comissues that the current staff is unable to adequately handle. The lack of experience of thecurrent staff may result in errors in judgment that lead to misstatements in the financialstatements.ElectronicOnlyEvidence.Your1040Return.comengagesinalltransactionselectronically, with backups of that data performed daily. There is some risk that the datamay be lost or temporarily not accessible, which may increase the difficulty of managingthe business and creating (and auditing) accurate financial statements.Customer Privacy.Because customers access Your1040Return.com’s services tocomplete their individual tax returns, Your1040Return.com has access to highlysensitive personal financial and other demographic data. There is a risk that some of thatinformation might be inadvertently given to or accessed by external parties. If that occurs,Your1040Return.com may face contingencies associated with litigation and other claimsfiled by customers affected that would need to be disclosed in the financial statements.Indicate what Your1040Return.com should do to improve its internal control?[c]Below are suggestions designed to strengthen Your1040Return.com’s internal controls:Revenue Recognition Controls.Your1040Return.com should evaluate the adequacy ofinternal controls surrounding its revenue recognition. Currently, Your1040Return.comrecognizes revenue differently for the three levels of service. For the Platinum service,revenue for the first year of service is recognized completely at the point the customerrequests the service. Revenue recognition is not spread across the year of service andis not contingent on the filing of a return.However, revenue for the Gold service istreated differently. A portion of the revenue is recognized when service is activated withthe remainder not recognized until the customer files the return.Management needsto evaluate internal controls over revenue recognition to ensure that the treatment isconsistent with generally accepted accounting principles for all levels of service (Forfurther information regarding revenue recognition see solution to question 1.e).Backup and Contingency Controls.Your1040Return.com’sabilitytogeneraterevenues is dependent on the availability of customer access through the Internet toYour1040Return.com’s servers and databases.The company needs to evaluate theadequacy of the backup and contingency controls in the event there is a server failure.Backup files should be made frequently (at least daily) and stored off site in secureenvironments. Alternative servers fully loaded with software and necessary backup datafiles should be available so that service can be provided in the event of a system failure.These backup and contingency controls should be regularly tested.Privacy Controls.Because Your1040Return.com has access to highly sensitive customerfinancial and other demographic information, Your1040Return.com should developa formal customer privacy policy that identifies how private customer informationis maintained and protected.Without a formal policy, sensitive information may beinadvertently released, which may expose Your1040Return.com to significant liabilities.In addition, the company should ensure that policies related to security controls (i.e.,firewalls and passwords) are continually evaluated for adequacy.Controls Over Advertising Arrangements.Because contracts associated with banneradvertising can often contain complex revenue provisions (i.e., ad revenues can oftenbe a function of the number of hits to the banner ads and the extent of subsequent drilldowns on the advertiser’s web site), Your1040Return.com needs to develop controlsto ensure the company correctly understands and accounts for revenue transactionsgenerated from offering banner advertisements.

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18Section 2: Understanding the Client’s Business and Assessing RiskExplain what audit implications arise if you decide that the controls over electronic records[d]at Your1040Return.com are inadequate to ensure that records have not been altered?Given that all transactions are documented solely in electronic form, there is no alternativepaper trail to serve as evidence supporting financial statement transactions and accounts. Ifthe auditor is unable to determine that electronic records have not been altered, there maybe no reliable evidence for the auditor to examine when evaluating the fair presentationof account balances and transactions.In certain cases, the lack of reliable electronic orother alternative evidence may cause the auditor to conclude that the entity is un-auditable(see AU 500, “Evidential Matter”).In that case, the auditor may be unable to accept theaudit engagement or may have to withdraw at a later date.Thus, Your1040Return.com’smanagement needs to establish effective internal controls to ensure that adequate evidenceis maintained to support accounts and transactions in the financial statements.Authoritative literature provides guidelines for proper revenue recognition policies for[e]transactions such as those discussed in the case. Analyze Your1040Return.com’s revenuerecognition policies for the three package services.Provide appropriate citations toauthoritative literature.As summarized in the case materials, Your1040Return.com recognizes revenues differentlyfor each of the three service packages.Your1040Return.com’s Revenue Recognition PoliciesFor the Silver package, customers pay for access to tax forms, schedules, and publications.And, Silver package customers can submit tax forms electronically. Access is only allowedfor one year. Your 1040.com recognizes revenue on the Silver package when the customersubmits the tax return to the IRS or state agency.Gold package customers can access the tax preparation software to complete and submitthe return.Access is allowed for one year.Your1040Return.com recognizes a portionof the revenue when the customer accesses the tax software package for the first time.Your1040Return.com recognizes the remaining portion of the revenues when the customersubmits the return.Platinum package customers pay to access the tax software on a multi-year contract basis.Customers can access the tax software package year round to update their tax informationand they can receive personalized attention and real-time tax support from qualified incometax specialists.Your1040Return.com recognizes revenues for each year immediately afterthe customer selects the Platinum service.At a minimum, Your1040Return.com needs to evaluate their revenue recognition policiesto ensure they are applying revenue recognition criteria correctly and consistently across allthree products.In addition, Your1040Return.com needs to evaluate implications of theircancellation policy to determine whether they need to record an accrual for the cancellationexpense.

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