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

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S E V E N T HE D I T I O NResource ManualMark S. BeasleyFrank A. BucklessSteven M. GloverDouglas F. PrawittAuditingCases

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vTable of Contents OverviewSection / Audit TopicPrimaryCasesCross-referencedCasesBonus OnlineCases*1Client Acceptance12Understanding the Client’s Business andAssessing Risks313Professional and Ethical Issues64Accounting Fraud and Auditor Legal Liability815Internal Control Over Financial Reporting826The Impact of Information Technology1527Planning Materiality148Analytical Procedures319Auditing Cash, Fair Value, and Revenues7310Planning and Performing Audit Procedures inthe Revenue and Expenditure Cycles511Developing and Evaluating AuditDocumentation1212Completing the Audit, Reporting toManagement, and External Reporting6Total Cases50183*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 withpermission from KPMG LLP. © 2013 KPMG LLP, a Delaware limited liability partnership and the U.S. memberfirm of the KPMG network of independent member firms affiliated with KPMG International Cooperative(“KPMG International”), a Swiss entity.For additional news and information, please accessKPMG's globalWeb site on the Internet at www.kpmguniversityconnection.com.Module on Professional JudgmentThe casebook includes a Learning Module onProfessional Judgment that exposes studentsto a professional judgment framework andoutlines a framework of good judgment aswell as a number of judgment tendenciesand traps that can introduce bias into thejudgmentprocess.Becauseprofessionaljudgments are required throughout the entireaudit process, from client acceptance toreport issuance, we include an IntroductiontoProfessionalJudgmentasanupfrontlearning module rather than as an individualcase.We encourage students to completethis learning module early in their auditingcourse to expose them to the fundamentalsof professional judgment, which they can useas they complete the required professionaljudgment questions in many of the casesto this edition. The professional judgmentquestions are separately highlighted in gray-shaded sections of the Requirements section.ENVIRONMENTENVIRONMENTMindsetCoachingReflect on PreviousExperienceCoachingReflect onLessons LearnedInfluences/BiasesStrategies for Avoiding Traps and Mitigating BiasKnowledge/Professional Standards1Clarifyissues &Objectives4ReachConclusion5articulate &DocumentRationale3Gather &Evaluateinformation2ConsideralternativesConsultation

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viIn-Class and Out-of-Class AssignmentsWhile all of the cases can be assigned for completion as anoutside-of-class assignment, several of the cases are designed so that theycan be easily used as anin-class learning opportunity.TheInstructor’s Resource Manual provides several ideas of how many ofthe cases can be easily incorporated as an in-class activity, which shouldbe especially helpful for instructors who have “flipped” their classes.Real-World ApplicationEach case presents a number of audit related issues and decisions that help students apply their audit knowledgeand skills toreal-world scenarios. A number of the cases are based on actual situations involving realcompanies. Others are hypothetical cases that disguise the innocent.FLIPPEDCLASSROOMDEVELOPING SKILLS FOR THE PROFESSIONFor students to succeed in a rapidly changing accounting and auditing profession, they need to be skilled atthinking critically and analytically, while remaining open and flexible to life-long learning and development.Auditing Cases: An Interactive Learning Approachprovides an effective platform to help students build a strongtoolkit of skills that will increase their career success. Here are some of the ways this casebook helps strengthentheir abilities for careers in the accounting and auditing profession.Communication SkillsA number of the cases require students to prepare written responses inmemorandumorreport format. The Instructor’s Resource Manual contains a number of different ideasfor structuring assignments to have students develop their written communication skills.Team-Based and Individual AssignmentsAll of the cases are designed so that students can complete them either inteams orindividually. The Instructor’s Resource Manual contains a number of different suggestionsfor assigning the cases as group or individual assignments.Photo Credit: Creative Stall/ShutterstockCritical ThinkingAll of the cases present realistic issues and challenges that auditors face every day in theengagements they perform. Because of that, each case presents scenarios that requirestudents tothink criticallyabout identifying the issue at hand and then determining howto respond in a way that would be appropriate in an audit engagement setting. Many ofthe cases present dilemmas that highlight the realities of the complexities students willface when in their professional careers. Completion of these cases will help studentsdevelop and mature theircritical thinking and analytical skills.Hands-on ApplicationAll cases engage students in applying their knowledge and skills in a hands-on learningenvironment.For some cases, students reviewclient generated documentation,completeactual audit program procedures, and prepare and evaluateaudit workingpapers. Other cases require students to conduct Internet based research similar to whatmight be required in an audit to locate guidance in professional standards or to accessrelevant financial statement filings with the U.S. Securities and Exchange Commission.

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ixClient Acceptance1.1Ocean Manufacturing, Inc............................9The New Client Acceptance DecisionUnderstanding the Client’sBusiness and Assessing Risk2.1Your1040Return.com.............................19Evaluating eBusiness Revenue Recognition, Information Privacy,and Electronic Evidence Issues2.2Apple Inc.....................................31Evaluation of Client Business Risk2.3Asher Farms, Inc................................41Understanding of Client’s Business Environment3.1A Day in the Life of Brent Dorsey......................65Staff Auditor Professional Pressures3.2Nathan Johnson’s Rental Car Reimbursement..............69Should He Pocket the Cash?3.3The Anonymous Caller............................73Recognizing It’s a Fraud and Evaluating What to Do3.4WorldCom...................................81The Story of a Whistleblower3.5Hollinger International............................89Realities of Audit-Related Litigation3.6Wells Fargo...................................97Assessing the Impact of Ethical CultureProfessional Judgment........1T A B L EO FC O N T E N T S1S E C T I O N2S E C T I O NI N T R O D U C T I O NProfessional and Ethical Issues3S E C T I O NADDITIONAL ONLINE CASEFlash Technologies, Inc........................49Risk Analysis

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x4.1Enron Corporation and Andersen, LLP..................113Analyzing the Fall of Two Giants4.2Comptronix Corporation..........................121Identifying Inherent Risk and Control Risk Factors4.3Cendant Corporation............................133Assessing the Control Environment andEvaluating Risk of Financial Statement Fraud4.4Waste Management, Inc...........................141Manipulating Accounting Estimates4.5Xerox Corporation..............................151Evaluating Risk of Financial Statement Fraud4.6Phar-Mor, Inc.................................165Accounting Fraud, Litigation, and Auditor Liability4.7Satyam Computer Services Limited....................181Controlling the Confirmation Process4.8Koss, Inc....................................189The Sounds of a High-Fidelity Fraud5.1Simply Steam, Co...............................209Evaluation of Internal Control Environment5.2Easy Clean, Co.................................209Evaluation of Internal Control Environment5.3Red Bluff Inn & Café.............................219Establishing Effective Internal Control in a Small Business5.4St. James Clothiers.............................223Evaluation of Manual and IT-Based Sales Accounting System Risks5.5Collins Harp Enterprises..........................233Recommending IT Systems Development Controls5.6Sarbox Scooter, Inc..............................243Scoping and Evaluation Judgments in the Audit of InternalControl over Financial Reporting5.7Société Générale...............................253How a Low-Risk Trading Area Caused a $7.2 Billion Loss5.8Oilfields-R-Us, Inc...............................263Evaluation of Management Review ControlsAccounting Fraud andAuditor Legal Liability4S E C T I O NInternal Control overFinancial Reporting5S E C T I O N

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xi7.1Anne Aylor, Inc................................297Determination of Planning Materiality and Performance MaterialityThe Impact ofInformation Technology6.1Town and Country Hardware........................271Evaluation of Tests of Controls with AutomatedComponent for the Expenditure Cycle (Purchases)6S E C T I O NADDITIONAL ONLINE CASESHarley-Davidson, Inc.........................277Identifying eBusiness Risks and Related Assurance Services for the eBusiness MarketplaceJacksonville Jaguars........................285Evaluating IT Benefits and Risks and Identifying Trust Services OpportunitiesCASES RELATED TO THIS SECTION2.1Your1040Return.com.........................19Evaluating eBusiness Revenue Recognition, Information Privacy,and Electronic Evidence Issues5.4St. James Clothiers.........................223Evaluation of Manual and IT-Based Sales Accounting System Risks5.5Collins Harp Enterprises......................233Recommending IT Systems Development Controls5.8Oilfields-R-Us, Inc..........................263Evaluation of Management Review Controls9.2Henrico Retail, Inc..........................351Understanding the IT Accounting System and Identifying Audit Evidencefor Retail SalesPlanning Materiality7S E C T I O NCASES RELATED TO THIS SECTION3.6Wells Fargo..............................97Assessing the Impact of Ethical Culture5.6Sarbox Scooter, Inc..........................243Scoping and Evaluation Judgments in the Audit of InternalControl over Financial Reporting12.1EyeMax Corporation........................471Evaluation of Audit Differences12.2Auto Parts, Inc............................481Considering Materiality When Evaluating Accounting Policiesand Footnote Disclosures

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xii8.1Laramie Wire Manufacturing.......................307Using Analytical Procedures in Audit Planning8.2Northwest Bank...............................313Developing Expectations for Analytical Procedures8.3Burlingham Bees..............................321Using Analytical Procedures as Substantive Tests9.1Wally’s Billboard & Sign Supply......................331The Audit of Cash9.2Henrico Retail, Inc..............................351Understanding the IT Accounting System andIdentifying Audit Evidence for Retail Sales9.3Longeta Corporation............................359Auditing Revenue Contracts9.4Bud's Big Blue Manufacturing......................367Accounts Receivable Confirmations9.5Morris Mining Corporation........................373Auditing Fair Value9.6Hooplah, Inc..................................381Applying Audit Sampling Concepts to Tests of Controlsand Substantive Testing in the Revenue Cycle9.7RedPack Beer Company..........................393Estimating the Allowance for Bad Debts8S E C T I O NAnalytical ProceduresCASES RELATED TO THIS SECTION1.1Ocean Manufacturing, Inc.......................9The New Client Acceptance DecisionAuditing Cash, Fair Value,and Revenues9S E C T I O NCASES RELATED TO THIS SECTION4.7Satyam Computer Services Limited.................181Controlling the Confirmation Process8.2Northwest Bank..........................313Developing Expectations for Analytical Procedures8.3Burlingham Bees..........................321Using Analytical Procedures as Substantive Tests

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xiii10.1Southeast Shoe Distributor, Inc......................401Identification of Tests of Controls for the Revenue Cycle(Sales and Cash Receipts)10.2Southeast Shoe Distributor, Inc......................415Identification of Substantive Tests for the Revenue Cycle(Sales and Cash Receipts)10.3Southeast Shoe Distributor, Inc......................423Selection of Audit Tests and Risk Assessment for the Revenue Cycle(Sales and Cash Receipts)10.4Southeast Shoe Distributor, Inc......................433Performance of Tests of Transactions for the Expenditure Cycle(Acquisitions and Cash Disbursements)10.5Southeast Shoe Distributor, Inc......................449Performance of Tests of Balances for the Expenditure Cycle(Acquisitions and Cash Disbursements)11.1The Runners Shop..............................461Litigation Support Review of Audit Documentation for Notes Payable11S E C T I O NCASES RELATED TO THIS SECTION9.1-6Section 9: Auditing Cash, Fair Value, and Revenues........331Various Cases10.1-5Section 10: Southeast Shoe Distributor, Inc.............401An Audit SimulationDeveloping and EvaluatingAudit DocumentationPlanning and Performing AuditProcedures in the Revenue andExpenditure Cycles10S E C T I O NAn Audit Simulation

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xiv12.1EyeMax Corporation.............................471Evaluation of Audit Differences12.2Auto Parts, Inc.................................481Considering Materiality When Evaluating Accounting Policiesand Footnote Disclosures12.3K&K, Inc....................................487Leveraging Audit Findings to Provide Value-Added Insightsin a Manufacturing Environment12.4Surfer Dude Duds, Inc............................493Considering the Going-Concern Assumption12.5Murchison Technologies, Inc........................497Evaluating an Attorney’s Response andIdentifying the Proper Audit Report12.6Going Green.................................509Sustainability and External ReportingCompleting the Audit,Reporting to Management,and External Reporting12S E C T I O N

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xv7.1Anne Aylor, Inc..................2973.3Anonymous Caller, The..............732.2Apple Inc.......................312.3Asher Farms, Inc...................4112.2Auto Parts, Inc...................4819.4Bud's Big Blue Manufacturing.........3678.3Burlingham Bees................3214.3Cendant Corporation..............1335.5Collins Harp Enterprises............2334.2Comptronix Corporation............1213.1Day in the Life of Brent Dorsey, A........655.2Easy Clean, Co...................2094.1Enron Corporation and Andersen, LLP.....11312.1EyeMax Corporation...............471ONLINEFlash Technologies, Inc...............4912.6Going Green...................509ONLINEHarley-Davidson, Inc...............2779.2Henrico Retail, Inc.................3513.5Hollinger International..............899.6Hooplah, Inc....................381ONLINEJacksonville Jaguars..............28512.3K&K, Inc.......................4874.8Koss, Inc.......................1898.1Laramie Wire Manufacturing..........3079.3Longeta Corporation...............3599.5Morris Mining Corporation...........37312.5Murchison Technologies, Inc..........4973.2Nathan Johnson’sRental Car Reimbursement............698.2Northwest Bank.................313A L P H A B E T I CC A S EI N D E X5.8Oilfields-R-Us, Inc...........2631.1Ocean Manufacturing, Inc........94.6Phar-Mor, Inc.............1655.3Red Bluff Inn & Café.........2199.7RedPack Beer Company.......39311.1Runners Shop, The..........4615.6Sarbox Scooter, Inc..........2434.7Satyam Computer Services Limited1815.1Simply Steam, Co...........2095.7Société Générale...........25310.1Southeast Shoe Distributor, Inc.:Tests of Controls forthe Revenue Cycle........40110.2Southeast Shoe Distributor, Inc.:Substantive Tests forthe Revenue Cycle........41510.3Southeast Shoe Distributor, Inc.:Audit Tests and Risk Assessmentfor the Revenue Cycle.......42310.4Southeast Shoe Distributor, Inc.:Tests of Transactions for theExpenditure Cycle........43310.5Southeast Shoe Distributor, Inc.:Tests of Balancesfor the Expenditure Cycle.....4495.4St. James Clothiers.........22312.4Surfer Dude Duds, Inc........4936.1Town and Country Hardware....2719.1Wally’s Billboard & Sign Supply..3314.4Waste Management, Inc.......1413.6Wells Fargo...............973.4WorldCom................814.5Xerox Corporation..........1512.1Your1040Return.com.........19

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1The 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. It is not intended to illustrate either effective or ineffectivehandling of an administrative situation.[1]To help students understand that the changing natureof the accounting profession increasingly requiresprofessionals to use professional judgment (e.g., fairvalue measurements and principles-based standards).[2]To help students gain an understanding of a goodjudgment process and practice using it in anaccounting context.[3]To help students identify, recognize and mitigatecommon judgment traps and tendencies.[4]To help students gain an understanding of professionalskepticism by exploring judgment frames.INSTRUCTIONAL OBJECTIVESBACKGROUNDKPMG LLP, one of the four largest international public accounting firms, launched an initiative in 2009 toenhance the professional judgment and professional skepticism of its people and teams. KPMG collaboratedwith two professors at BrighamYoung University, Professors Steve Glover and Doug Prawitt, to emphasize theseskills in its training. The result of this effort is refreshed professional judgment content throughout KPMG'saudit training curriculum for all levels of audit professionals.KPMG took the additional step of sharing and leveraging its professional judgment training content tocreate, again in collaboration with Brigham Young University Professors Glover and Prawitt, a monograph tohelp students accelerate the development of their professional judgment while still in college. The monographis titled Elevating Professional Judgment in Auditing and Accounting: The KPMG Professional JudgmentFramework. That monograph is available free of charge for college students and professors on KPMG’sUniversity Connection site. (You can find the monograph at http://www.kpmguniversityconnection.com). Itis 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 onKPMG University Connection.This Professional Judgment Module is adapted from the KPMG Elevating Professional Judgment inAuditing and Accounting monograph. It covers some of the topics that are discussed and illustrated in moredepth in the monograph.This module can be used as an overview for the monograph and as a brief introductionto 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 fromKPMG, LLP, was awarded the 2013 American Accounting Association/Deloitte Wildman Award.The WildmanProfessional JudgmentUnderstanding and Developing Professional Judgmentin Auditing and AccountingMark S. Beasley·Frank A. Buckless·Steven M. Glover·Douglas F. PrawittI N T R O D U C T I O N

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2Section 2|Understanding the Client’s Business and Assessing Riskaward, first presented in 1979, recognizes a work that the judges view as “the most significant contribution tothe advancement of the practice of public accountancy” published within the most recent 5-years.USE OF CASEThe Professional Judgment Introduction is a summary of the KPMG monograph titled, Elevating ProfessionalJudgment in Auditing and Accounting: The KPMG Professional Judgment Framework. The full version of themonograph 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 bebeneficial to students’ learning.This section of the casebook introduces students to the components of a good judgment process.Theintroduction also discusses traps and biases that can threaten good judgment and suggests common-sense waysto mitigate the effects of those threats.This section is recommended for use in undergraduate or graduate auditing and accounting courses tointroduce students to fundamental judgment concepts. It can be utilized in a variety of ways, depending on theamount of in-class time that is available. For example, all of the reading and work could be assigned outside ofclass; 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 thatinvolve exercising the skills discussed and developed in this section.These question questions will allow studentsto apply what they have learned in this section to a variety of circumstances similar to those that they willexperience in their professional careers. Students will need to have read this introduction in order to fullybenefit from those questions.PROFESSIONAL STANDARDSPCAOB standards are referenced by standard number. Relevant professional standards for this assignment are:PCAOB Standards:AU Section 230, “Due Professional Care in the Performance ofWork”QUESTIONS AND SUGGESTED SOLUTIONS[1]Identify and describe two common judgment trapsRush 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 theproblem 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 failto consider the problem definition and problem objectives. Skipping this first step of the judgment processusually artificially limits the size of the set of potential alternatives. This is important because a decision canonly 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 differentperspectives. 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. Forexample, suppose that a client’s revenues have increased more than any other company in the industry andthat the client attributes its success to a new marketing strategy.The auditor should understand the client’sexplanation and then apply professional skepticism by considering other possibilities, such as an error inrevenue recognition or even financial statement fraud. Considering financial results from that perspectivewill help the engagement team identify evidence that could help to either identify or rule out the possibilityof error or fraud.

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3Professional Judgment|[3]What is the first step in avoiding traps or reducing bias? Briefly explain why this first step is soimportant.Awareness of potential traps and conditions that lead to bias is the most important factor—it is a necessaryfirst 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 evidenceor seeking more complete information, is a key approach in mitigating all of the judgment biases. Consultingwith others can go a long way toward mitigating the effects of the availability tendency. Getting an outsideview on a going-concern uncertainty assessment can help keep the auditor’s judgment from being toooptimistic, or pessimistic, given recent, salient experiences. In other judgment and decision tasks, a helpfulapproach is to ask others to gather and evaluate information without revealing our preference. (We do notwant 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 biasrelated 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 underwenta significant restructuring of its debt. The restructuring was necessary as economic conditionshampered the client’s ability to make scheduled re-payments of its debt obligations. Therestructured debt agreements included new debt covenants. In auditing the debt obligation inthe prior year (before the restructuring), the team established materiality specific to the financialstatement debt account (account level materiality) at a lower amount than overall financialstatement materiality. In planning the audit for the current year, the team plans to use a similarmateriality level. While such a conclusion might be appropriate, what judgment trap(s) mightthe 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 debtagreements require the company to maintain certain financial ratios (for example, ratio of assets toliabilities greater than 1.5 to 1), the appropriate account level materiality threshold may be lower than thethreshold used in the prior year when the debt agreement in place only required the client to meet certainnon-financial debt covenants.The traps that the team may have fallen into include both a rush to solve and ajudgment trigger in that they may have considered only the same approach or alternative as was used in theprior year, even though conditions have changed in important ways.The step in the judgment process mostaffected in this scenario is Step 2, “Consider Alternatives.”[6]A client is determining its accounting treatment for new types of long-term contracts. Considerthe differences in outcome for the two scenarios below regarding the approach the client andauditor 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 recordedrevenue using an approach they determined was the preferred approach, with no consultationor discussion with the audit engagement team. The engagement team conducted revenuerecognition testing to ensure that the client correctly followed the chosen approach. Theengagement team noted that the client consistently and accurately applied the approach anddetermined 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 tothe audit engagement team to discuss the client’s preferred approach for recognizing revenue.The team researched authoritative accounting standards and considered the client’s preferredalternative. The team also considered other possible approaches and consulted with other

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4Section 2|Understanding the Client’s Business and Assessing Riskengagement 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 alternativesuggested by the engagement team to recognize revenue associated with the long-term contractsthey entered into.In Scenario A, the auditor appears to have adopted the client’s frame without considering alternatives.Whilethe client’s accounting treatment may have been correct, the auditor did not apply sufficient professionalskepticism. In Scenario B, the auditor took time to understand the client’s frame and then also challengedthat frame by researching and considering alternative perspectives. Considering more than one frame isthe “stuff ” of professional skepticism. In Scenario B, rigorous application of professional skepticism led theengagement team to recommend a different revenue recognition accounting treatment.[7]For each of the two audit situations below, determine which judgment shortcut or tendency ismost prevalent and briefly describe the likely consequences of using the shortcut.[a]A staff auditor is testing accounts payable balances. The auditor observes an unexpectedfluctuation in the account balance compared to the prior year. The client happens to bewalking by, so the auditor asks the client about the fluctuation.The client provides a plausibleand reasonable explanation. In considering other possible causes for the fluctuation, theclient’s explanation seems to be the most likely, so the staff auditor documents it as evidencesupporting the fluctuation. Later, it is determined that other facts encountered during theaudit do not support the client’s explanation.It appears the staff auditor was influenced by the availability tendency in considering the client’savailable and plausible explanation as most likely. The staff auditor may also have been vulnerable tothe confirmation tendency. In this scenario, the availability and confirmation tendencies led to shallowthinking, insufficient professional skepticism, lack of corroborating evidence, and weak documentation.Some of the ramifications for the audit could include weak documentation—no corroboration of theclient’s explanation, and lack of evidence of professional skepticism.[a]A client has provided the audit engagement team an estimate of the inventory valuationreserve.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 incustomer demand for an older product line that was losing popularity relative to the newerproducts. The engagement team suggested that the client adjust the reserve upward. Theclient argued that the current reserve amount was adequate but indicated that a small increasein 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 thereserve. However, within a few months after the financial statements and audit report wereissued, 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’sreported 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 anchoringtendency. The auditor accepted an insufficient adjustment to the reserve because the client’s initialestimate served as an anchor. The bias impacted Steps 3 and 4 of the judgment process, and led to abiased reserve estimate.

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