The auditors of STA, Inc., a calendar-year corporation, obtained the selected information for years 1 and 2 located in the exhibit below.

Selected information		Year 2			Year 1
Gross revenue	$	63,000,000		$	60,000,000
Net income before taxes		11,650,000			11,000,000
Salary expense		12,500,000			8,000,000
Rent expense		1,920,000			1,200,000
Utilities expense		155,000			120,000
Depreciation expense		705,000			675,000
Repairs and maintenance		375,000			300,000
Interest expense		523,000			338,100
Miscellaneous		151,000			135,000
Tax expense		4,325,150			3,850,000

Additionally, the auditors noted the following information:

• STA rents space in an office building:
  • Space in Building 1: 25,000 sq. ft.
• On January 1, year 2, the company added a second space:
  • Space in Building 2: 11,000 sq. ft.
• The balance of interest-bearing debt outstanding:
  • January 1, year 2: $4,830,000
  • December 31, year 2: $10,262,000
  • The company issued additional debt on July 1, year 2

The auditors are performing analytical procedures relative to the expectations of expenses for year 2 and have established a materiality threshold of 5% of the auditor's expected year 2 amount. For each of the expenses in column A below, consider the additional notes in column B, and complete the following:

1. In "Auditor's expectation" column, enter the auditor's expectation of year 2 expense. (Round all amounts to the nearest dollar.)
2. In "Auditor's decision" column, select the auditor's decision as to whether further testing is needed. (Consider each account independently - an option may be used once, more than once, or not at all.)

ANSWER ! CORRECT!!

Explanation

Salary Auditor's Expectation: $12,240,000 Given the 150% (300/200 = 150%) increase in the number of employees, current salaries should be about 150% times the previous year's salaries even without any raises. Given that average salaries increased 2% from the last year, current salaries should be about 102% of the previous year's salaries without any additional headcount. The higher headcount and salary increase combine, rather than offset, to increase the expense. Further, the increased salaries presumably apply to all employees. $8,000,000 150% 102% = $12,240,000 Auditor Decision: Within threshold, no further testing needed Since the actual salary expense of $12,500,000 is $260,000 more than the auditor's estimate of $12,240,000, the variance is +2% ($260,000/12,240,000). With a materiality threshold of 5%, this variance is within the threshold; no further testing would be needed. Rent Auditor's Expectation: $1,770,000 Given the additional space rented (i.e., building 2), current rent for the new space should be 12 times the monthly rent of $45,000. Given that rent on the previously rented space (i.e., building 1) increased 5% from the last year, halfway through the year on July 1, current rent for that space should be higher by 5% , which is equal to 102.5% of the previous year's rent. The additional space and rent increase combine to increase the expense, leaving the auditor with an expectation of $1,770,000. (102.5% $1,200,000) + (12 $45,000) = $1,770,000. Auditor Decision: Above acceptable amount, further testing needed Since the actual rent expense of $1,920,000 is $150,000 more than the auditor's estimate of $1,770,000, the variance is +8% ($150,000/$1,770,000). With a materiality threshold of 5%, this variance is above the acceptable amount by 3%; further testing would be needed. Utilities Auditor's Expectation: $172,800 Utilities are based on the space occupied. The new space was rented starting at the beginning of the year. Total space for the entire year was 25,000 + 11,000 = 36,000 square feet. Given that the space occupied increased about 144% (36,000/25,000) from the last year, current utilities should be about 144% of the previous year's utilities. 144% $120,000 = $172,800 Auditor Decision: Below acceptable amount, further testing needed Since the actual utilities expense of $155,000 is $17,800 less than the auditor's estimate of $172,800, the variance is 10% ($17,800/172,800). With a materiality threshold of 5%, this variance is below the acceptable amount by 5%; further testing would be needed. Miscellaneous Auditor's Expectation: $157,500 Miscellaneous expense is estimated based on 0.25% of gross revenue. 0.25% $63,000,000 = $157,500. Auditor Decision: Within threshold, no further testing needed Since the actual miscellaneous expense of $151,000 is $6,500 less than the auditor's estimate of $157,500, the variance is 4% ($6,500/$157,500). With a materiality threshold of 5%, this variance is within the threshold; no further testing would be needed. Repairs & Maintenance Auditor's Expectation: $350,000 Repairs and maintenance expense is estimated based on the average gross cost of assets. Year 1 average gross cost of assets = ($2,700,000 + $3,300,000) / 2 = $3,000,000. Year 1 repairs and maintenance expense was $300,000, so repairs and maintenance expense was 10% ($300,000 / $3,000,000) of year 1's average gross cost. Year 2 average gross cost of assets = ($3,300,000 + $3,700,000) / 2 = $3,500,000; thus, year 2 repairs and maintenance expense should be about $3,500,000 10% = $350,000. Auditor Decision: Above acceptable amount, further testing needed Since the actual repairs and maintenance expense of $375,000 is $25,000 more than the auditor's estimate of $350,000, the variance is +7% ($25,000/$350,000). With a materiality threshold of 5%, this variance is above the acceptable amount by 2%; further testing would be needed. Interest Expense Auditor's Expectation: $528,220 Interest expense is estimated based on outstanding debt and the average interest rate. STA had $4,830,000 of debt outstanding for the first six months and issued another $5,432,000 mid-year, so a total of $10,262,000 was outstanding for the second half of the year. (7% $4,830,000 6/12) + (7% $10,262,000 6/12) = $528,220. Auditor Decision: Within threshold, no further testing needed Since the actual interest expense of $523,000 is $5,220 less than the auditor's estimate of $528,220, the variance is 1% ($5,220 / $528,220). With a materiality threshold of 5%, this variance is within the threshold; no further testing would be needed.

Expense Additional Notes Auditor's Auditor's decision expectation $ 12,240,000 Within threshold. No further testing needed Salary Rent 1,770,000 Above acceptable amount. Further testing needed. Utilities Average salaries increased 2% effective January 1, year 2. Average headcount was 200 in year 1 and 300 in year 2. Building 1: On July 1, year 2, the company entered into a new lease agreement. Monthly rent expense was 5% higher than that of the prior lease. Building 2: The company began renting another facility on January 1, year 2, for 545,000 a month, on a month-to-month basis. The utilities expense is based on square footage of each facility; the rate did not change from year 1 to year 2. Calculation is based on 0.25% of gross revenue. Repairs and maintenance expense is based on the average gross value of assets at cost: January 1, year 1: $2,700,000 - January 1, year 2: $3,300,000 January 1, year 3: 53,700,000 172,800 Below acceptable amount. Further testing needed 157,500 Within threshold. No further testing needed Miscellaneous Repairs and maintenance 350,000 Above acceptable amount. Further testing needed. Interest expense The average interest rate of STA's debt is 7% 528,220 Within threshold. No further testing needed