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Solution Manual for Auditing Cases: An Interactive Learning Approach, 7th Edition

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    S E V E N T H E D I T I O N Resource Manual Mark S. Beasley Frank A. Buckless Steven M. Glover Douglas F. Prawitt Auditing Cases

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    v Table of Contents Overview Section / Audit Topic Primary Cases Cross-referenced Cases Bonus Online Cases* 1 Client Acceptance 1 2 Understanding the Client’s Business and Assessing Risks 3 1 3 Professional and Ethical Issues 6 4 Accounting Fraud and Auditor Legal Liability 8 1 5 Internal Control Over Financial Reporting 8 2 6 The Impact of Information Technology 1 5 2 7 Planning Materiality 1 4 8 Analytical Procedures 3 1 9 Auditing Cash, Fair Value, and Revenues 7 3 10 Planning and Performing Audit Procedures in the Revenue and Expenditure Cycles 5 11 Developing and Evaluating Audit Documentation 1 2 12 Completing the Audit, Reporting to Management, and External Reporting 6 Total Cases 50 18 3 *In addition to the 50 cases included in the book, three additional cases from prior editions can be accessed via the casebook website (www.pearsonhighered.com/Beasley). Thus, there are 53 different case options available for use! Reprinted from the KPMG Professional Judgment Framework: Elevating Professional Judgment in Auditing with permission from KPMG LLP. © 2013 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. For additional news and information, please access KPMG's global Web site on the Internet at www.kpmguniversityconnection.com. Module on Professional Judgment The casebook includes a Learning Module on Professional Judgment that exposes students to a professional judgment framework and outlines a framework of good judgment as well as a number of judgment tendencies and traps that can introduce bias into the judgment process. Because professional judgments are required throughout the entire audit process, from client acceptance to report issuance, we include an Introduction to Professional Judgment as an upfront learning module rather than as an individual case. We encourage students to complete this learning module early in their auditing course to expose them to the fundamentals of professional judgment, which they can use as they complete the required professional judgment questions in many of the cases to this edition. The professional judgment questions are separately highlighted in gray- shaded sections of the Requirements section. ENVIRONMENT ENVIRONMENT Mindset Coaching Reflect on Previous Experience Coaching Reflect on Lessons Learned Influences/Biases Strategies for Avoiding Traps and Mitigating Bias Knowledge/Professional Standards 1 Clarify issues & Objectives 4 Reach Conclusion 5 articulate & Document Rationale 3 Gather & Evaluate information 2 Consider alternatives C o n s u l t a t i o n

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    vi In-Class and Out-of-Class Assignments While all of the cases can be assigned for completion as an outside- of-class assignment , several of the cases are designed so that they can be easily used as an in-class learning opportunity . The Instructor’s Resource Manual provides several ideas of how many of the cases can be easily incorporated as an in-class activity, which should be especially helpful for instructors who have “flipped” their classes. Real-World Application Each case presents a number of audit related issues and decisions that help students apply their audit knowledge and skills to real-world scenarios . A number of the cases are based on actual situations involving real companies. Others are hypothetical cases that disguise the innocent. FLIPPED CLASSROOM DEVELOPING SKILLS FOR THE PROFESSION For students to succeed in a rapidly changing accounting and auditing profession, they need to be skilled at thinking critically and analytically, while remaining open and flexible to life-long learning and development. Auditing Cases: An Interactive Learning Approach provides an effective platform to help students build a strong toolkit of skills that will increase their career success. Here are some of the ways this casebook helps strengthen their abilities for careers in the accounting and auditing profession. Communication Skills A number of the cases require students to prepare written responses in memorandum or report format . The Instructor’s Resource Manual contains a number of different ideas for structuring assignments to have students develop their written communication skills. Team-Based and Individual Assignments All of the cases are designed so that students can complete them either in teams or individually . The Instructor’s Resource Manual contains a number of different suggestions for assigning the cases as group or individual assignments. Photo Credit: Creative Stall/Shutterstock Critical Thinking All of the cases present realistic issues and challenges that auditors face every day in the engagements they perform. Because of that, each case presents scenarios that require students to think critically about identifying the issue at hand and then determining how to respond in a way that would be appropriate in an audit engagement setting. Many of the cases present dilemmas that highlight the realities of the complexities students will face when in their professional careers. Completion of these cases will help students develop and mature their critical thinking and analytical skills . Hands-on Application All cases engage students in applying their knowledge and skills in a hands-on learning environment. For some cases, students review client generated documentation , complete actual audit program procedures , and prepare and evaluate audit working papers . Other cases require students to conduct Internet based research similar to what might be required in an audit to locate guidance in professional standards or to access relevant financial statement filings with the U.S. Securities and Exchange Commission.

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    ix Client Acceptance 1.1 Ocean Manufacturing, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 The New Client Acceptance Decision Understanding the Client’s Business and Assessing Risk 2.1 Your1040Return.com . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 Evaluating eBusiness Revenue Recognition, Information Privacy, and Electronic Evidence Issues 2.2 Apple Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 Evaluation of Client Business Risk 2.3 Asher Farms, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 Understanding of Client’s Business Environment 3.1 A Day in the Life of Brent Dorsey . . . . . . . . . . . . . . . . . . . . . . 65 Staff Auditor Professional Pressures 3.2 Nathan Johnson’s Rental Car Reimbursement . . . . . . . . . . . . . . 69 Should He Pocket the Cash? 3.3 The Anonymous Caller . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 Recognizing It’s a Fraud and Evaluating What to Do 3.4 WorldCom . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81 The Story of a Whistleblower 3.5 Hollinger International . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89 Realities of Audit-Related Litigation 3.6 Wells Fargo . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97 Assessing the Impact of Ethical Culture Professional Judgment . . . . . . . . 1 T A B L E O F C O N T E N T S 1 S E C T I O N 2 S E C T I O N I N T R O D U C T I O N Professional and Ethical Issues 3 S E C T I O N ADDITIONAL ONLINE CASE Flash Technologies, Inc. . . . . . . . . . . . . . . . . . . . . . . . 49 Risk Analysis

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    x 4.1 Enron Corporation and Andersen, LLP . . . . . . . . . . . . . . . . . . 113 Analyzing the Fall of Two Giants 4.2 Comptronix Corporation . . . . . . . . . . . . . . . . . . . . . . . . . . 121 Identifying Inherent Risk and Control Risk Factors 4.3 Cendant Corporation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133 Assessing the Control Environment and Evaluating Risk of Financial Statement Fraud 4.4 Waste Management, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . 141 Manipulating Accounting Estimates 4.5 Xerox Corporation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151 Evaluating Risk of Financial Statement Fraud 4.6 Phar-Mor, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 Accounting Fraud, Litigation, and Auditor Liability 4.7 Satyam Computer Services Limited . . . . . . . . . . . . . . . . . . . . 181 Controlling the Confirmation Process 4.8 Koss, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189 The Sounds of a High-Fidelity Fraud 5.1 Simply Steam, Co. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209 Evaluation of Internal Control Environment 5.2 Easy Clean, Co. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209 Evaluation of Internal Control Environment 5.3 Red Bluff Inn & Café . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219 Establishing Effective Internal Control in a Small Business 5.4 St. James Clothiers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223 Evaluation of Manual and IT-Based Sales Accounting System Risks 5.5 Collins Harp Enterprises . . . . . . . . . . . . . . . . . . . . . . . . . . 233 Recommending IT Systems Development Controls 5.6 Sarbox Scooter, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243 Scoping and Evaluation Judgments in the Audit of Internal Control over Financial Reporting 5.7 Société Générale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253 How a Low-Risk Trading Area Caused a $7.2 Billion Loss 5.8 Oilfields-R-Us, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263 Evaluation of Management Review Controls Accounting Fraud and Auditor Legal Liability 4 S E C T I O N Internal Control over Financial Reporting 5 S E C T I O N

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    xi 7.1 Anne Aylor, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297 Determination of Planning Materiality and Performance Materiality The Impact of Information Technology 6.1 Town and Country Hardware . . . . . . . . . . . . . . . . . . . . . . . . 271 Evaluation of Tests of Controls with Automated Component for the Expenditure Cycle (Purchases) 6 S E C T I O N ADDITIONAL ONLINE CASES Harley-Davidson, Inc. . . . . . . . . . . . . . . . . . . . . . . . . 277 Identifying eBusiness Risks and Related Assurance Services for the eBusiness Marketplace Jacksonville Jaguars . . . . . . . . . . . . . . . . . . . . . . . . 285 Evaluating IT Benefits and Risks and Identifying Trust Services Opportunities CASES RELATED TO THIS SECTION 2.1 Your1040Return.com . . . . . . . . . . . . . . . . . . . . . . . . . 19 Evaluating eBusiness Revenue Recognition, Information Privacy, and Electronic Evidence Issues 5.4 St. James Clothiers . . . . . . . . . . . . . . . . . . . . . . . . . 223 Evaluation of Manual and IT-Based Sales Accounting System Risks 5.5 Collins Harp Enterprises . . . . . . . . . . . . . . . . . . . . . . 233 Recommending IT Systems Development Controls 5.8 Oilfields-R-Us, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . 263 Evaluation of Management Review Controls 9.2 Henrico Retail, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . 351 Understanding the IT Accounting System and Identifying Audit Evidence for Retail Sales Planning Materiality 7 S E C T I O N CASES RELATED TO THIS SECTION 3.6 Wells Fargo . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97 Assessing the Impact of Ethical Culture 5.6 Sarbox Scooter, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . 243 Scoping and Evaluation Judgments in the Audit of Internal Control over Financial Reporting 12.1 EyeMax Corporation . . . . . . . . . . . . . . . . . . . . . . . . 471 Evaluation of Audit Differences 12.2 Auto Parts, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . 481 Considering Materiality When Evaluating Accounting Policies and Footnote Disclosures

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    xii 8.1 Laramie Wire Manufacturing . . . . . . . . . . . . . . . . . . . . . . . 307 Using Analytical Procedures in Audit Planning 8.2 Northwest Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313 Developing Expectations for Analytical Procedures 8.3 Burlingham Bees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321 Using Analytical Procedures as Substantive Tests 9.1 Wally’s Billboard & Sign Supply . . . . . . . . . . . . . . . . . . . . . . 331 The Audit of Cash 9.2 Henrico Retail, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351 Understanding the IT Accounting System and Identifying Audit Evidence for Retail Sales 9.3 Longeta Corporation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359 Auditing Revenue Contracts 9.4 Bud's Big Blue Manufacturing . . . . . . . . . . . . . . . . . . . . . . 367 Accounts Receivable Confirmations 9.5 Morris Mining Corporation . . . . . . . . . . . . . . . . . . . . . . . . 373 Auditing Fair Value 9.6 Hooplah, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 381 Applying Audit Sampling Concepts to Tests of Controls and Substantive Testing in the Revenue Cycle 9.7 RedPack Beer Company . . . . . . . . . . . . . . . . . . . . . . . . . . 393 Estimating the Allowance for Bad Debts 8 S E C T I O N Analytical Procedures CASES RELATED TO THIS SECTION 1.1 Ocean Manufacturing, Inc. . . . . . . . . . . . . . . . . . . . . . . 9 The New Client Acceptance Decision Auditing Cash, Fair Value, and Revenues 9 S E C T I O N CASES RELATED TO THIS SECTION 4.7 Satyam Computer Services Limited . . . . . . . . . . . . . . . . . 181 Controlling the Confirmation Process 8.2 Northwest Bank . . . . . . . . . . . . . . . . . . . . . . . . . . 313 Developing Expectations for Analytical Procedures 8.3 Burlingham Bees . . . . . . . . . . . . . . . . . . . . . . . . . . 321 Using Analytical Procedures as Substantive Tests

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    xiii 10.1 Southeast Shoe Distributor, Inc. . . . . . . . . . . . . . . . . . . . . . 401 Identification of Tests of Controls for the Revenue Cycle (Sales and Cash Receipts) 10.2 Southeast Shoe Distributor, Inc. . . . . . . . . . . . . . . . . . . . . . 415 Identification of Substantive Tests for the Revenue Cycle (Sales and Cash Receipts) 10.3 Southeast Shoe Distributor, Inc. . . . . . . . . . . . . . . . . . . . . . 423 Selection of Audit Tests and Risk Assessment for the Revenue Cycle (Sales and Cash Receipts) 10.4 Southeast Shoe Distributor, Inc. . . . . . . . . . . . . . . . . . . . . . 433 Performance of Tests of Transactions for the Expenditure Cycle (Acquisitions and Cash Disbursements) 10.5 Southeast Shoe Distributor, Inc. . . . . . . . . . . . . . . . . . . . . . 449 Performance of Tests of Balances for the Expenditure Cycle (Acquisitions and Cash Disbursements) 11.1 The Runners Shop . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 461 Litigation Support Review of Audit Documentation for Notes Payable 11 S E C T I O N CASES RELATED TO THIS SECTION 9.1-6 Section 9: Auditing Cash, Fair Value, and Revenues . . . . . . . . 331 Various Cases 10.1-5 Section 10: Southeast Shoe Distributor, Inc. . . . . . . . . . . . . 401 An Audit Simulation Developing and Evaluating Audit Documentation Planning and Performing Audit Procedures in the Revenue and Expenditure Cycles 10 S E C T I O N An Audit Simulation

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    xiv 12.1 EyeMax Corporation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 471 Evaluation of Audit Differences 12.2 Auto Parts, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 481 Considering Materiality When Evaluating Accounting Policies and Footnote Disclosures 12.3 K&K, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 487 Leveraging Audit Findings to Provide Value-Added Insights in a Manufacturing Environment 12.4 Surfer Dude Duds, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . 493 Considering the Going-Concern Assumption 12.5 Murchison Technologies, Inc. . . . . . . . . . . . . . . . . . . . . . . . 497 Evaluating an Attorney’s Response and Identifying the Proper Audit Report 12.6 Going Green . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509 Sustainability and External Reporting Completing the Audit, Reporting to Management, and External Reporting 12 S E C T I O N

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    xv 7.1 Anne Aylor, Inc. . . . . . . . . . . . . . . . . . 297 3.3 Anonymous Caller, The . . . . . . . . . . . . . . 73 2.2 Apple Inc. . . . . . . . . . . . . . . . . . . . . . . 31 2.3 Asher Farms, Inc. . . . . . . . . . . . . . . . . . . 41 12.2 Auto Parts, Inc. . . . . . . . . . . . . . . . . . . 481 9.4 Bud's Big Blue Manufacturing . . . . . . . . . 367 8.3 Burlingham Bees . . . . . . . . . . . . . . . . 321 4.3 Cendant Corporation . . . . . . . . . . . . . . 133 5.5 Collins Harp Enterprises . . . . . . . . . . . . 233 4.2 Comptronix Corporation . . . . . . . . . . . . 121 3.1 Day in the Life of Brent Dorsey, A . . . . . . . . 65 5.2 Easy Clean, Co. . . . . . . . . . . . . . . . . . . 209 4.1 Enron Corporation and Andersen, LLP . . . . . 113 12.1 EyeMax Corporation . . . . . . . . . . . . . . . 471 ONLINE Flash Technologies, Inc. . . . . . . . . . . . . . . 49 12.6 Going Green . . . . . . . . . . . . . . . . . . . 509 ONLINE Harley-Davidson, Inc. . . . . . . . . . . . . . . 277 9.2 Henrico Retail, Inc. . . . . . . . . . . . . . . . . 351 3.5 Hollinger International . . . . . . . . . . . . . . 89 9.6 Hooplah, Inc. . . . . . . . . . . . . . . . . . . . 381 ONLINE Jacksonville Jaguars . . . . . . . . . . . . . . 285 12.3 K&K, Inc. . . . . . . . . . . . . . . . . . . . . . . 487 4.8 Koss, Inc. . . . . . . . . . . . . . . . . . . . . . . 189 8.1 Laramie Wire Manufacturing . . . . . . . . . . 307 9.3 Longeta Corporation . . . . . . . . . . . . . . . 359 9.5 Morris Mining Corporation . . . . . . . . . . . 373 12.5 Murchison Technologies, Inc. . . . . . . . . . 497 3.2 Nathan Johnson’s Rental Car Reimbursement . . . . . . . . . . . . 69 8.2 Northwest Bank . . . . . . . . . . . . . . . . . 313 A L P H A B E T I C C A S E I N D E X 5.8 Oilfields-R-Us, Inc. . . . . . . . . . . 263 1.1 Ocean Manufacturing, Inc. . . . . . . . 9 4.6 Phar-Mor, Inc. . . . . . . . . . . . . 165 5.3 Red Bluff Inn & Café . . . . . . . . . 219 9.7 RedPack Beer Company . . . . . . . 393 11.1 Runners Shop, The . . . . . . . . . . 461 5.6 Sarbox Scooter, Inc. . . . . . . . . . 243 4.7 Satyam Computer Services Limited 181 5.1 Simply Steam, Co. . . . . . . . . . . 209 5.7 Société Générale . . . . . . . . . . . 253 10.1 Southeast Shoe Distributor, Inc.: Tests of Controls for the Revenue Cycle . . . . . . . . 401 10.2 Southeast Shoe Distributor, Inc.: Substantive Tests for the Revenue Cycle . . . . . . . . 415 10.3 Southeast Shoe Distributor, Inc.: Audit Tests and Risk Assessment for the Revenue Cycle . . . . . . . 423 10.4 Southeast Shoe Distributor, Inc.: Tests of Transactions for the Expenditure Cycle . . . . . . . . 433 10.5 Southeast Shoe Distributor, Inc.: Tests of Balances for the Expenditure Cycle . . . . . 449 5.4 St. James Clothiers . . . . . . . . . 223 12.4 Surfer Dude Duds, Inc. . . . . . . . 493 6.1 Town and Country Hardware . . . . 271 9.1 Wally’s Billboard & Sign Supply . . 331 4.4 Waste Management, Inc. . . . . . . 141 3.6 Wells Fargo . . . . . . . . . . . . . . . 97 3.4 WorldCom . . . . . . . . . . . . . . . . 81 4.5 Xerox Corporation . . . . . . . . . . 151 2.1 Your1040Return.com . . . . . . . . . 19

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    1 The 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. and Douglas F. Prawitt, Ph.D. of Brigham Young University, as a basis for class discussion. It is not intended to illustrate either effective or ineffective handling of an administrative situation. [1] To help students understand that the changing nature of the accounting profession increasingly requires professionals to use professional judgment (e.g., fair value measurements and principles-based standards). [2] To help students gain an understanding of a good judgment process and practice using it in an accounting context. [3] To help students identify, recognize and mitigate common judgment traps and tendencies. [4] To help students gain an understanding of professional skepticism by exploring judgment frames. INSTRUCTIONAL OBJECTIVES BACKGROUND KPMG LLP, one of the four largest international public accounting firms, launched an initiative in 2009 to enhance the professional judgment and professional skepticism of its people and teams. KPMG collaborated with two professors at BrighamYoung University, Professors Steve Glover and Doug Prawitt, to emphasize these skills in its training. The result of this effort is refreshed professional judgment content throughout KPMG's audit training curriculum for all levels of audit professionals. KPMG took the additional step of sharing and leveraging its professional judgment training content to create, again in collaboration with Brigham Young University Professors Glover and Prawitt, a monograph to help students accelerate the development of their professional judgment while still in college. The monograph is titled Elevating Professional Judgment in Auditing and Accounting: The KPMG Professional Judgment Framework. That monograph is available free of charge for college students and professors on KPMG’s University Connection site. (You can find the monograph at http://www.kpmguniversityconnection.com). It is only available in electronic form because it comes as a pdf, with live internet links and audio files embedded. In addition, there are video files and an instructor’s manual available separately to professors who register on KPMG University Connection. This Professional Judgment Module is adapted from the KPMG Elevating Professional Judgment in Auditing and Accounting monograph. It covers some of the topics that are discussed and illustrated in more depth in the monograph. This module can be used as an overview for the monograph and as a brief introduction to professional judgment for those who do not have space in the curriculum to assign the full monograph. The KPMG Professional Judgment Framework, from which this module is adapted with permission from KPMG, LLP, was awarded the 2013 American Accounting Association/Deloitte Wildman Award. The Wildman Professional Judgment Understanding and Developing Professional Judgment in Auditing and Accounting Mark S. Beasley · Frank A. Buckless · Steven M. Glover · Douglas F. Prawitt I N T R O D U C T I O N

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    2 Section 2 | Understanding the Client’s Business and Assessing Risk award, first presented in 1979, recognizes a work that the judges view as “the most significant contribution to the advancement of the practice of public accountancy” published within the most recent 5-years. USE OF CASE The Professional Judgment Introduction is a summary of the KPMG monograph titled, Elevating Professional Judgment in Auditing and Accounting: The KPMG Professional Judgment Framework. The full version of the monograph and accompanying instructor’s guide can be found at http://www.kpmguniversityconnection. com. Both the student version and the instructor’s guide contain additional links and resources that would be beneficial to students’ learning. This section of the casebook introduces students to the components of a good judgment process. The introduction also discusses traps and biases that can threaten good judgment and suggests common-sense ways to mitigate the effects of those threats. This section is recommended for use in undergraduate or graduate auditing and accounting courses to introduce students to fundamental judgment concepts. It can be utilized in a variety of ways, depending on the amount of in-class time that is available. For example, all of the reading and work could be assigned outside of class; or the cases found at the end of this section could be used for creating an in-class discussion. Additionally, as discussed in the preface, we have added various questions to many of the cases that involve exercising the skills discussed and developed in this section.These question questions will allow students to apply what they have learned in this section to a variety of circumstances similar to those that they will experience in their professional careers. Students will need to have read this introduction in order to fully benefit from those questions. PROFESSIONAL STANDARDS PCAOB standards are referenced by standard number. Relevant professional standards for this assignment are: PCAOB Standards: AU Section 230, “Due Professional Care in the Performance of Work” QUESTIONS AND SUGGESTED SOLUTIONS [1] Identify and describe two common judgment traps Rush to Solve and Judgment Triggers. Rush to solve occurs when professionals want to “get to a solution” quickly and as a result tend to skip the first step of the judgment process, which involves identifying the problem or issue to be solved and specifying the objectives to be achieved. Likewise, decision triggers, which are often alternatives masquerading as a problem definition, tend to push the decision maker to fail to consider the problem definition and problem objectives. Skipping this first step of the judgment process usually artificially limits the size of the set of potential alternatives. This is important because a decision can only be as good as the best alternative identified. [2] How can considering multiple judgment frames enhance an auditor’s professional skepticism? Explain and give an example. Evaluating issues and objectives from different frames can help auditors to understand a variety of different perspectives. Considering multiple frames can bring additional insights or ways to understand a situation. It can also open up a variety of additional alternatives that might not have been considered otherwise. For example, suppose that a client’s revenues have increased more than any other company in the industry and that the client attributes its success to a new marketing strategy. The auditor should understand the client’s explanation and then apply professional skepticism by considering other possibilities, such as an error in revenue recognition or even financial statement fraud. Considering financial results from that perspective will help the engagement team identify evidence that could help to either identify or rule out the possibility of error or fraud.

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    3 Professional Judgment | [3] What is the first step in avoiding traps or reducing bias? Briefly explain why this first step is so important. Awareness of potential traps and conditions that lead to bias is the most important factor—it is a necessary first step before any other efforts to mitigate bias can be implemented. [4] Identify and briefly describe three potential ways to mitigate the effects of biases. Actively questioning our assumptions, which might include considering potentially disconfirming evidence or seeking more complete information, is a key approach in mitigating all of the judgment biases. Consulting with others can go a long way toward mitigating the effects of the availability tendency. Getting an outside view on a going-concern uncertainty assessment can help keep the auditor’s judgment from being too optimistic, or pessimistic, given recent, salient experiences. In other judgment and decision tasks, a helpful approach is to ask others to gather and evaluate information without revealing our preference. (We do not want to reveal our preference because it may affect their judgment just like it may affect our own.) Finally, we can also take steps to objectively evaluate the pros and cons for each alternative. In mitigating bias related to the anchoring tendency, it can be helpful to seek out and explicitly consider alternative anchors. DISCUSSION CASES [5] An audit engagement team is planning for the upcoming audit of a client who recently underwent a significant restructuring of its debt. The restructuring was necessary as economic conditions hampered the client’s ability to make scheduled re-payments of its debt obligations. The restructured debt agreements included new debt covenants. In auditing the debt obligation in the prior year (before the restructuring), the team established materiality specific to the financial statement debt account (account level materiality) at a lower amount than overall financial statement materiality. In planning the audit for the current year, the team plans to use a similar materiality level. While such a conclusion might be appropriate, what judgment trap(s) might the team fall into and which step(s) in the judgment process are most likely affected? The team needs to understand the terms of the debt restructuring. If the covenants in the new debt agreements require the company to maintain certain financial ratios (for example, ratio of assets to liabilities greater than 1.5 to 1), the appropriate account level materiality threshold may be lower than the threshold used in the prior year when the debt agreement in place only required the client to meet certain non-financial debt covenants. The traps that the team may have fallen into include both a rush to solve and a judgment trigger in that they may have considered only the same approach or alternative as was used in the prior year, even though conditions have changed in important ways. The step in the judgment process most affected in this scenario is Step 2, “Consider Alternatives.” [6] A client is determining its accounting treatment for new types of long-term contracts. Consider the differences in outcome for the two scenarios below regarding the approach the client and auditor took. How does framing relate to the two different scenarios? Scenario A: The client entered into a large number of long-term sales contracts and recorded revenue using an approach they determined was the preferred approach, with no consultation or discussion with the audit engagement team. The engagement team conducted revenue recognition testing to ensure that the client correctly followed the chosen approach. The engagement team noted that the client consistently and accurately applied the approach and determined that the audit testing supported the amount of revenue reported by the client. Scenario B: Before entering into long-term contracts with customers, the client reached out to the audit engagement team to discuss the client’s preferred approach for recognizing revenue. The team researched authoritative accounting standards and considered the client’s preferred alternative. The team also considered other possible approaches and consulted with other

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    4 Section 2 | Understanding the Client’s Business and Assessing Risk engagement teams with experience in accounting for long-term contracts. Based on this process, the engagement team determined that although the client’s preferred approach had merit, another alternative was more consistent with accounting principles for revenue recognition. The client carefully reconsidered the situation and ultimately decided to use the alternative suggested by the engagement team to recognize revenue associated with the long-term contracts they entered into. In Scenario A, the auditor appears to have adopted the client’s frame without considering alternatives.While the client’s accounting treatment may have been correct, the auditor did not apply sufficient professional skepticism. In Scenario B, the auditor took time to understand the client’s frame and then also challenged that frame by researching and considering alternative perspectives. Considering more than one frame is the “stuff ” of professional skepticism. In Scenario B, rigorous application of professional skepticism led the engagement team to recommend a different revenue recognition accounting treatment. [7] For each of the two audit situations below, determine which judgment shortcut or tendency is most prevalent and briefly describe the likely consequences of using the shortcut. [a] A staff auditor is testing accounts payable balances. The auditor observes an unexpected fluctuation in the account balance compared to the prior year. The client happens to be walking by, so the auditor asks the client about the fluctuation. The client provides a plausible and reasonable explanation. In considering other possible causes for the fluctuation, the client’s explanation seems to be the most likely, so the staff auditor documents it as evidence supporting the fluctuation. Later, it is determined that other facts encountered during the audit do not support the client’s explanation. It appears the staff auditor was influenced by the availability tendency in considering the client’s available and plausible explanation as most likely. The staff auditor may also have been vulnerable to the confirmation tendency. In this scenario, the availability and confirmation tendencies led to shallow thinking, insufficient professional skepticism, lack of corroborating evidence, and weak documentation. Some of the ramifications for the audit could include weak documentation—no corroboration of the client’s explanation, and lack of evidence of professional skepticism. [a] A client has provided the audit engagement team an estimate of the inventory valuation reserve. The client used a method for calculating the reserve that had been used in prior years. To audit the reserve, the engagement team obtained and reviewed the client’s calculation. However, the team noted that the client’s calculation did not reflect a significant decline in customer demand for an older product line that was losing popularity relative to the newer products. The engagement team suggested that the client adjust the reserve upward. The client argued that the current reserve amount was adequate but indicated that a small increase in the reserve would be acceptable. The engagement team reviewed the client’s proposal, and ultimately accepted the inventory account as fairly stated in view of the increase to the reserve. However, within a few months after the financial statements and audit report were issued, it became apparent that the reserve was insufficient as significant inventory write- downs were recorded for obsolete inventory that was discarded at scrap value. While it appears that the team initially fell prey to the confirmation tendency in auditing to the client’s reported value, the team did recognize the need to increase the reserve for the drop in market demand. Thus, the tendency that ultimately led to biased judgment in this scenario likely is the anchoring tendency. The auditor accepted an insufficient adjustment to the reserve because the client’s initial estimate served as an anchor. The bias impacted Steps 3 and 4 of the judgment process, and led to a biased reserve estimate.

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