Case 3-2: Audit Negotiations

Assume you are a partner and are wrapping up the 2015 audit of Houston Electric, an SEC registrant with a 12/31 year-end. Houston works with builders and installs electrical systems in new homes and businesses. Your firm has been auditing Houston for several years and has always given standard unqualified opinions during this time. This year, Houston replaced its CEO as part of a change in the company?s strategic vision. Houston has developed a five-year plan to grow from a regional to national presence in the electronics installation market.

As part of your firm?s quality control procedures, each existing client is reviewed annually to determine whether your firm will continue to audit the client (assuming the client wants to engage your firm). Before this year?s audit, your firm decided to renew its contract with Houston. However, as the lead partner, you did note concern in internal documentation regarding the new CEO, Bob Davis. Specifically, Bob was very interested in accounting for fair value adjustments for investments. Bob seems to believe that if GAAP doesn?t provide a precise method of accounting, then the company can do whatever it wants as long as it abides by relevant laws and regulations.

Your initial concerns about Bob led you to modify some of your risk assessments from prior years, and change the audit plan accordingly. You initially established planning materiality for Houston Technologies at $4.4 million, but you also know that a decrease in unaudited pretax earnings by more than $4 million will cause Houston to miss the consensus analyst EPS forecast. Following fieldwork for the 2015 audit, the audit team prepared the following list of items you want to discuss with Bob Davis and the CFO (Joan Richards):

• Depreciation Expense. In 2015 Bob Davis asked Joan Richards to evaluate the useful lives of all depreciable assets. This change resulted in a reduction of depreciation expense by $750,000. The audit team investigated this issue, and could not identify a reason to change the useful lives of the assets involved.

• Investments in available-for-sale (AFS) securities. Consistent with GAAP, Houston?s accounting policy requires that the carrying value of AFS securities be regularly adjusted to market value. Houston makes these adjustments monthly. Until this year, Houston used a highly credible, well-known investment bank to provide market values for securities. This year, Bob Davis changed the policy to use a local investment broker. Bob explained that he went to college with the owners of the local firm, and they would go out of business without the contract with Houston. According to diligent work performed by one of your staff auditors, the year-end fair value of the AFS securities would have been $1,275,000 lower if Houston had continued to use the national firm.

• IT Equipment. The audit team identified an uncorrected accounting error involving the acquisition of servers, computers, and other IT hardware purchased and installed on 1/2/2015. Houston did not book amortization expense for the portion allocated to 2015. The amount involved is $3,800,000.

Your Discussion with Bob and Joan:

You: Thank you for meeting with me. I assume my staff forwarded you a summary of the issues I?d like to discuss.

Joan: Yes, we received them, thank you.

Bob: So, let us know what you think. Do we need to book any adjustments?

You: I?m proposing the following adjustments: $3.8 million to correct the error involving IT equipment, and a $1,275,000 decrease in the carrying value of your AFS securities portfolio. I also need some more information about the change in depreciation policy.

At this point, Bob interrupts you.

Bob: I can accept the adjustment for the IT equipment. We made a mistake, that?s obvious. And I?m ok with changing the AFS, that will go to other comprehensive income so we?ll still make the basic EPS forecast. If we don?t meet that, I may be out of a job and the investors who hold on to the stock will take a hit. But, come on, there is no problem with depreciation. What we did was well within your accounting rules. Joan looked into it, and there?s nothing against periodically evaluating the useful lives of depreciable assets. If you think about it, it?s really more conservative this way since we?ll book more depreciation expense down the road than we would have if we had not adjusted the useful lives. Plus, I doubt its material.

Questions:

1. How would you respond to Bob if you were in this situation? Your answer must include, but not be limited to, whether you would propose an adjustment to depreciation and how much of an adjustment you would propose ($0 if you do not propose an adjustment).

1. According to auditing standards, what information should you communicate to Houston?s audit committee based on this case? Be sure to cite the appropriate standard(s). Do not quote the standard(s); use your own words.

1. Assume you did propose an adjustment for depreciation. How much would you propose? Why?

1. Assume you did not agree with the client?s change in depreciation method, and proposed a $750,000 adjustment to depreciation expense/accumulated depreciation. Further assume that the client did not book the adjustment. Which opinion would you offer? Explain your answer.

1. Assume you agreed with the client?s change in depreciation method? Which opinion would you issue?

Case 3-3: Opinions and Finishing the Audit

Assume you are a partner supervising the audit of Wildcat Grocers, a publicly-traded company that supplies grocery stores with a 12/31 fiscal year-end. It is now mid-February 2016, and you are considering which opinion to issue for the 2015 audit. You must sign the audit opinion no later than February 25, and Wildcat must file its audited financial statements with the SEC by March 5. All audit issues have been resolved to your satisfaction except two, which you must decide how to address. Both of these issues are material.

• Wildcat is losing market share to companies that offer products at lower prices. Sales have been trending downward for several years, and operating cash flows have been negative during this time. The CFO assured you that the company will make it through this rough period. She described a plan that included issuing new stock and laying off workers to maintain its long-term viability. The company?s stock price is now at an all-time low of $1.01 per share, and a report from an independent broker indicates that if Wildcat issues new stock, it will provide the company sufficient capital to cover five months of operations.

• A significant portion of Wildcat?s inventory was destroyed in a fire on January 31, 2016. The CFO included a footnote to the 2015 financial statements to disclose information regarding the loss of inventory. She believes the company should receive an insurance settlement for the full amount of inventory, minus a small deductible, no later than June 15, 2016. One of your audit staff independently reviewed the company?s insurance policy and reached the same conclusion.

Questions:

1. According to auditing standards, what specific responsibilities does the auditor have in evaluating the client as a going concern? Cite the appropriate standard(s) and describe the auditor?s responsibilities in your own words.

1. Would you issue a going concern opinion to Wildcat? Why or why not?

1. Assume you decided to issue a going concern opinion and Wildcat was able to thrive in 2016, erasing any concern about its financial health. Does this mean that the going concern modification was the wrong opinion? Why or why not?

1. According to auditing standards: (a) Describe the difference between Type I and Type II subsequent events. (b) What procedures should an auditor perform to identify and evaluate subsequent events? Cite the appropriate standard(s) and describe the audit procedures in your own words.

1. Is Wildcat?s loss of inventory a Type I or Type II subsequent event? Explain your reasoning.

ACCT 4400 Dr. Robertson Case Set 3 Spring 2016 Case Set 3 covers issues related to finalizing the audit, and consists of the following cases: Case 3-1: Misstatements Case 3-2: Audit Negotiations Case 3-3: Opinions and Finishing the Audit Case 3-1: Misstatements Assume you are the audit manager for the 2015 audit of Fox Aeronautics, an SEC registrant. This is your firm's third year with Fox, a company that manufactures components used in airplane assembly. Fox's unaudited 2015 pretax earnings were $95 million. It is now mid-February 2016, and your audit team is evaluating the following potential misstatements from the client's yearend financial statements. Income taxes. Fox's tax attorney informed you that it is probable the client will have to pay $7,500 in taxes regarding a tax dispute that began four years ago. The tax professionals at your firm agree with the tax attorney's assessment. Fox's CEO told you the company cannot estimate an amount, noting he is not aware of any similar cases that would provide a good estimate. Therefore, the company did not record any contingent liability for income taxes in the 12/31/15 financial statements. However, Fox did disclose the situation in a financial statement footnote. Inventory. The audit team conducted counts of Fox's inventory on a sample basis. The book value of the sample was 5% of the total inventory book value of $120,669,000. The sample items were understated by $17,825. Patent Infringement. In 2015, Fox was sued by a competitor for patent infringement. The company recorded a contingent liability of $3,800,000 in its 12/31/15 financial statements. Based on the legal letter and a follow-up discussion with the client's attorney, you are satisfied that it is unlikely at this point that the client will have to either pay a settlement or lose the case in court. Allowance for uncollectible accounts. Recently, Fox has had difficulty collecting credit sales efficiently, and its days outstanding in accounts receivable has significantly increased over the past two years. Consequently, Fox increased the percentage of credit sales it uses for calculating the allowance for uncollectible accounts during 2015. Both the board of directors and your firm agree with this change. Fox uses the allowance method for accounting for bad debts, and despite the increase in the allowance account itself, still required a bad debt replenishment of $7,489,800. Fox did not record this yearend adjusting entry. 1 Fixed Assets. An accounting error involving depreciation led to an overstatement of depreciation expense by $1,950,000. Questions: 1. (a) What is the aggregate misstatement? Show all calculations and explain why you believe each potential misstatement is either a misstatement or is not a misstatement. (b) Does the aggregate misstatement overstate or understate net income? 2. (a) How much of an overall adjustment would you require to issue an unqualified opinion? Provide a specific amount (not a range) and explain your reasoning. (b) How would you allocate your adjustment from 2(a) to the various accounts? Explain your reasoning. If you did not make an adjustment in part 2(a), assume the partner asked you to make a $1,000,000 adjustment and allocate it to the accounts in question. 2 Case 3-2: Audit Negotiations Assume you are a partner and are wrapping up the 2015 audit of Houston Electric, an SEC registrant with a 12/31 year-end. Houston works with builders and installs electrical systems in new homes and businesses. Your firm has been auditing Houston for several years and has always given standard unqualified opinions during this time. This year, Houston replaced its CEO as part of a change in the company's strategic vision. Houston has developed a five-year plan to grow from a regional to national presence in the electronics installation market. As part of your firm's quality control procedures, each existing client is reviewed annually to determine whether your firm will continue to audit the client (assuming the client wants to engage your firm). Before this year's audit, your firm decided to renew its contract with Houston. However, as the lead partner, you did note concern in internal documentation regarding the new CEO, Bob Davis. Specifically, Bob was very interested in accounting for fair value adjustments for investments. Bob seems to believe that if GAAP doesn't provide a precise method of accounting, then the company can do whatever it wants as long as it abides by relevant laws and regulations. Your initial concerns about Bob led you to modify some of your risk assessments from prior years, and change the audit plan accordingly. You initially established planning materiality for Houston Technologies at $4.4 million, but you also know that a decrease in unaudited pretax earnings by more than $4 million will cause Houston to miss the consensus analyst EPS forecast. Following fieldwork for the 2015 audit, the audit team prepared the following list of items you want to discuss with Bob Davis and the CFO (Joan Richards): Depreciation Expense. In 2015 Bob Davis asked Joan Richards to evaluate the useful lives of all depreciable assets. This change resulted in a reduction of depreciation expense by $750,000. The audit team investigated this issue, and could not identify a reason to change the useful lives of the assets involved. Investments in available-for-sale (AFS) securities. Consistent with GAAP, Houston's accounting policy requires that the carrying value of AFS securities be regularly adjusted to market value. Houston makes these adjustments monthly. Until this year, Houston used a highly credible, well-known investment bank to provide market values for securities. This year, Bob Davis changed the policy to use a local investment broker. Bob explained that he went to college with the owners of the local firm, and they would go out of business without the contract with Houston. According to diligent work performed by one of your staff auditors, the year-end fair value of the AFS securities would have been $1,275,000 lower if Houston had continued to use the national firm. IT Equipment. The audit team identified an uncorrected accounting error involving the acquisition of servers, computers, and other IT hardware purchased and installed on 1/2/2015. Houston did not book amortization expense for the portion allocated to 2015. The amount involved is $3,800,000. 3 Your Discussion with Bob and Joan: You: Thank you for meeting with me. I assume my staff forwarded you a summary of the issues I'd like to discuss. Joan: Yes, we received them, thank you. Bob: So, let us know what you think. Do we need to book any adjustments? You: I'm proposing the following adjustments: $3.8 million to correct the error involving IT equipment, and a $1,275,000 decrease in the carrying value of your AFS securities portfolio. I also need some more information about the change in depreciation policy. At this point, Bob interrupts you. Bob: I can accept the adjustment for the IT equipment. We made a mistake, that's obvious. And I'm ok with changing the AFS, that will go to other comprehensive income so we'll still make the basic EPS forecast. If we don't meet that, I may be out of a job and the investors who hold on to the stock will take a hit. But, come on, there is no problem with depreciation. What we did was well within your accounting rules. Joan looked into it, and there's nothing against periodically evaluating the useful lives of depreciable assets. If you think about it, it's really more conservative this way since we'll book more depreciation expense down the road than we would have if we had not adjusted the useful lives. Plus, I doubt its material. Questions: 1. How would you respond to Bob if you were in this situation? Your answer must include, but not be limited to, whether you would propose an adjustment to depreciation and how much of an adjustment you would propose ($0 if you do not propose an adjustment). 2. According to auditing standards, what information should you communicate to Houston's audit committee based on this case? Be sure to cite the appropriate standard(s). Do not quote the standard(s); use your own words. 3. Assume you did propose an adjustment for depreciation. How much would you propose? Why? 4. Assume you did not agree with the client's change in depreciation method, and proposed a $750,000 adjustment to depreciation expense/accumulated depreciation. Further assume that the client did not book the adjustment. Which opinion would you offer? Explain your answer. 5. Assume you agreed with the client's change in depreciation method? Which opinion would you issue? 4 Case 3-3: Opinions and Finishing the Audit Assume you are a partner supervising the audit of Wildcat Grocers, a publicly-traded company that supplies grocery stores with a 12/31 fiscal year-end. It is now mid-February 2016, and you are considering which opinion to issue for the 2015 audit. You must sign the audit opinion no later than February 25, and Wildcat must file its audited financial statements with the SEC by March 5. All audit issues have been resolved to your satisfaction except two, which you must decide how to address. Both of these issues are material. Wildcat is losing market share to companies that offer products at lower prices. Sales have been trending downward for several years, and operating cash flows have been negative during this time. The CFO assured you that the company will make it through this rough period. She described a plan that included issuing new stock and laying off workers to maintain its long-term viability. The company's stock price is now at an alltime low of $1.01 per share, and a report from an independent broker indicates that if Wildcat issues new stock, it will provide the company sufficient capital to cover five months of operations. A significant portion of Wildcat's inventory was destroyed in a fire on January 31, 2016. The CFO included a footnote to the 2015 financial statements to disclose information regarding the loss of inventory. She believes the company should receive an insurance settlement for the full amount of inventory, minus a small deductible, no later than June 15, 2016. One of your audit staff independently reviewed the company's insurance policy and reached the same conclusion. Questions: 1. According to auditing standards, what specific responsibilities does the auditor have in evaluating the client as a going concern? Cite the appropriate standard(s) and describe the auditor's responsibilities in your own words. 2. Would you issue a going concern opinion to Wildcat? Why or why not? 3. Assume you decided to issue a going concern opinion and Wildcat was able to thrive in 2016, erasing any concern about its financial health. Does this mean that the going concern modification was the wrong opinion? Why or why not? 4. According to auditing standards: (a) Describe the difference between Type I and Type II subsequent events. (b) What procedures should an auditor perform to identify and evaluate subsequent events? Cite the appropriate standard(s) and describe the audit procedures in your own words. 5. Is Wildcat's loss of inventory a Type I or Type II subsequent event? Explain your reasoning. 5