This simulation presents an Analytical Procedures/Risk Assessment Analysis document prepared by two members of your audit team relating to the Keystone Computers & Networks Incorporated (Keystone), audit. Background financial and other information on Keystone is included in Appendix 6C of Chapter 6. Parts 810 require information about accounting obtained in previous accounting and other courses. These topics are also addressed in subsequent chapters of this text (particularly Chapters 13 and 15). You are working on the audit of Keystone Computers & Networks Incorporated (Keystone), a calendar year-end nonissuer. The two associates assigned to the engagement provided a document with a number of observations relating to analytical procedures/risk assessment for the audit of year 5. Required: Your job as senior on the engagement is to review the various points made by the assistant, including consideration of the exhibits. For each of the sentences called out in the points on the document, determine if the current language is appropriate as is, should be removed altogether, or replaced with any of the provided alternatives. Links to each of the exhibits are provided in the document, but are available in the list below for convenience. Exhibit 1 - Working Trial Balance Exhibit 2 - Ratios Exhibit 3 - CPA Firm Summary of Several key Keystone accounting policies Exhibit 4 - Email to CFO from Controller Exhibit 5 - Memo from Audit Partner to Audit Files Document TO: Audit Senior FROM: Audit Associates RE: Analytical Procedures/Risk Assessment Analysis DATE: January 7, year 6 We downloaded the year 4 audited and year 5 unaudited Keystone working trial balances into our macro (Exhibit 1). The program also calculated various ratios (Exhibit 2). Note that Exhibit 3 summarizes several of Keystone Companys key accounting policies. Following are areas we believe include significant changes between years and our tentative conclusions: Overall, Keystone reports income decreasing from $989,275 to $229,877. The allowance for doubtful accounts increased by 8,000 from year 4 to year 5. The company currently has $104,000 in the allowance for doubtful accounts, and per the controller has $31,701.54 in uncollectible accounts in receivables (Exhibit 4). The total of $31,701.54 indicates that the allowance for doubtful accounts seems adequate as of year-end and that no adjusting entry is necessary. (Callout #1) See also the third bullet under suggested audit procedures. The current ratio decreased a bit, from 1.2 to 1.1. The input with the largest effect decreasing the current ratio is CashFirst National Bank. (Callout #2) The inventories, valued using the LIFO method, increased. To test proper use of the lower of cost or market rule relating to the LIFO method, we should perform tests to determine that inventory recorded values exceed current market values of the items. (Callout #3) In addition, we suggest the following specific audit procedures: Relating to inventories, we should be aware of possible obsolete items; we should determine that all slow-moving items are valued at zero. (Callout #4) The president indicates that no inventory items (or proceeds upon sale) have been pledged (Exhibit 5). We should carefully inspect items for pledging status during the count of inventory. (Callout #5) Relating to doubtful accounts receivable (see second bullet above), we should be aware of potential other accounts that might need to be written off as of year-end and should test and analyze the clients aging of receivables. (Callout #6) Examine Board of Director approval of increased receivables from officers. Also, vouch the cash disbursement. (Callout #7) Although there were increases in fixed assets, the accumulated depreciation went up by a much larger percentage. It would seem that the client has a policy of making no depreciation entries related to acquisitions or disposals during the year and we should consider the propriety of this policy. (Callout #8) Vouch invoices in support of the change in leasehold improvements. (Callout #9) The capital stock and paid-in capital accounts did not change during the year. We should obtain evidence that no changes in shareholders occurred during the year. (Callout #10)

Explanation

Callout #1: c. should be written off as of year-end with a debit to the allowance for doubtful accounts and a credit to accounts receivable and we should perform further procedures on the adequacy of the allowance for doubtful accounts. As indicated in Exhibit 3, the client uses an allowance method for bad debt expense. This is the needed entry and additional procedures are necessary.

Callout #2: e. Line of credit. The large dollar increase in the Line of Credit, which is in the denominator of the current ratio (given it is a current liability) decreases the ratio. Software development cost and long-term debt are non-current and not considered in the ratio. The increases in both Cash-First National Bank and Accounts Receivable-Trade are in the numerator and therefore, by themselves, increase the ratio.

Callout #3: c. equal or are less than current market prices of the items. The lower of cost or market rule requires that market prices exceed cost. This may be calculated in a variety of manners (e.g., individual items, similar types of items).

Callout #4: d. we should calculate turnover ratios of inventory items. Low turnover rates will indicate that demand for the item may be low and that the related inventory item may either be obsolete or may be becoming obsolete. Slow moving items need not all be written down to zero. While testing some (or all) inventory extensions is desirable it more directly addresses the clerical accuracy of inventory. The statements on leasehold improvements and software development cost are no directly related to obsolete inventory.

Callout #5: d. We should examine cash confirmations and debt agreements. An examination of cash confirmations and debt agreements will provide information on whether inventory items have been pledged. Inspecting items will not ordinarily provide evidence on pledging (unless items are separated from other items). The president already has indicated that no items are pledged. Subsequent events procedures may reveal such pledging but ordinarily is less effective at this than the proper reply.

Callout #6: a. [Original text] analyze the clients aging of receivables. An aging of receivables will reveal those past due, and particularly prone to non-payment. Information on inventory turnover rates is unlikely to assist in the audit of the allowance for doubtful accounts. Confirming not overdue accounts is likely to provide only very limited information relating to the allowance account. Vouching sales before or after year-end is likewise unlikely to assist the auditors in arriving at a judgment.

Callout #7: a. [Original text] vouch the cash disbursement. Since Keystone disbursed another $27,027 relating to the receivables from officers, vouching the disbursement is an appropriate procedure. No representation relating to a guarantee of repayment will be obtained. The shareholders will not ordinarily approve such a loan, particularly all shareholders. The loan rate may or may not relate to a prime rate. No company cash receipt is involved.

Callout #8: e. We should inquire of the client as to details of this years depreciation calculation and entry. The Keystone Company CEO spoke of the controller having some difficulties with the job (Exhibit 4). This might be one result and inquiry provides a starting point. Exhibit 3 outlines Keystones depreciation policy, and it does involve entries for acquisitions and disposals. There is no indication of extended lives, and the likelihood of arriving at exactly the same total as the previous year seems remote. GAAP provides no such guidelines, and the difference involved may or may not be immaterial and inconsequential.

Callout #9: d. Consider the reasonableness of amortization of leasehold improvements during the year. A total of $7,670 was amortized during the period. While this amount is low, one may question whether amortizing at this rate is adequate as compared to the expected lifetime of the improvements. There is no change in leasehold improvements other than the amortization entry, so vouching is not appropriate. Comparing the amortization period of leasehold improvements with accounts receivable seems an ambiguous procedure with no clear meaning.

Callout #10: c. no stock was issued or repurchased by Keystone during the year. The absence of recorded changes in these equity accounts suggests that neither stock was issued nor retired during the year. When one shareholder sold stock to another the entry is not recorded in these accounts. Dividends are not subtracted from the accounts. There is no indication of preferred stock issuance and, if there was, it should not be included within the line of credit. Disbursements to shareholders properly may exist.