EP 7-1 Give Examples of Errors and Frauds. LO1 This is an exercise concerning financial reporting misstatements, not employee theft. Required: Give an example of an error or fraud that would misstate financial statements to affect the accounts as follows, taken one case at a time. (Note: "Overstate" means the account has a higher value than would be appropriate under GAAP, and "understate" means it has a lower value.) a. Overstate an asset; understate another asset. b. Overstate an asset; overstate shareholder equity. c. Overstate an asset; overstate revenue. d. Overstate an asset; understate an expense. e. Overstate a liability; overstate an expense. f. Understate an asset; overstate an expense. g. Understate a liability; understate an expense. EP 7-2 Overall Analysis of Accounting Estimates. LO1, LO5 Oak Industries, a manufacturer of cable TV equipment and an operator of subscription TV systems, had a multitude of problems. Subscription services in a market area, for which $12 million cost had been deferred, were being terminated, and the customers were not paying on time ($4 million receivables in doubt). The chances are 50-50 that the business will survive another two years. An electronic part turned out to have defects that needed correction. Warranty expenses are estimated to range from $2 million to $6 million. The inventory of the part ($10 million) is obsolete, but $1 million can be recovered as salvage or the parts in inventory can be rebuilt at a cost of $2 million (selling price of the inventory on hand would then be $8 million, with 20% of selling price required to market and ship the products, and the normal profit expected would be 5% of the selling price). If the inventory were scrapped, the company would manufacture a replacement inventory at a cost of $6 million, excluding marketing and shipping costs and normal profit. The company has defaulted on completion of a military contract, and the government is claiming a $2 million refund. Company lawyers think the dispute might be settled for as little as $1 million. Page 276 The auditors had previously determined that an overstatement of income before taxes of $7 million would be material to the financial statements. These items were the only ones left for audit decisions about possible adjustment. Management has presented the analysis below for the determination of loss recognition: Required: Provide for expected warranty expense 2,000,000 Lower of cost and market inventory write-down 2,000,000 Loss on government contract refund Total write-offs and losses $11,000,000 Required: Prepare your own analysis of the amount of adjustment to the financial statements. Assume that none of these estimates have been recorded yet, and give the adjusting entry you would recommend. Give any supplementary explanations you believe necessary to support your recommendation. EP 7-3 Select Effective Procedures Responding to Fraud Risk. LO3, LO4, LO6 Below are some suspicions. You have been requested to select some effective extended procedures designed to confirm or deny the suspicions. Required: Write out the procedure you would suggest for each case so that another person would know what to do. a. The custodian of the petty cash fund may be removing cash on Friday afternoon to pay for his weekend activities. b. A manager has noticed that nine new vendors have been added to the purchasing department approved list since the assistant purchasing agent was promoted to chief agent three weeks ago. She suspects that all or some of them may be phony companies set up by the new chief purchasing agent. c. The payroll supervisor may be stealing unclaimed paycheques of people who quit work and don't pick up the last cheque. d. Although no customers have complained, cash collections on accounts receivable are down, and the counter clerks may have stolen customers' payments. e. The cashier may have "borrowed" money, covering it by holding each day's deposit until there is enough cash from the daily collection to make up the shortage, before sending the deposit to the bank. DC 7-5 Required: Management Controls, Impact on Audit. LO1, LO2 Jabiru Inc.'s senior management recently obtained a new decision-support database system that allows the managers to generate standard reports and also customize inquiries that use data from all functional areas of their company. Before this system was in place, reports to senior managers were generated manually by the operations managers in the various departments, such as purchasing, marketing, inventory control, production, human resources, and administration. The senior managers are much happier with the new system because now they can generate reports as soon as the period ends, they can draw the data directly from the company's computer databases, they can control the content and format of the reports, and the operating managers have less opportunity to manipulate the information in the reports. For example, in the first two months of the new system, senior managers identified a discrepancy in the production department that was resulting in significant shrinkage and quickly corrected the control weakness. The previous report, which had been designed and produced by the production manager, did not include the data needed to identify the shrinkage problem. a. Discuss how the new decision-support database system affects Jabiru's internal control and its risk of material misstatement. b. Comment on the potential audit planning implications of the new decision-support database system