Auditing a risk based approach to conducting a quality audit 9th edition johnstone solutions manual

Solution Manual for Auditing A Risk Based Approach to Conducting a Quality Audit 9th Edition Johnstone

Gramling Rittenberg 1133939155 9781133939153

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True-False Questions

Multiple-Choice Questions

Review and Short Case Questions

12-33

The existence and valuation assertions related to long-lived assets are usually the more relevant assertions. Organizations may have incentives to overstate their long-lived assets and may do so by including fictitious long-lived assets on the financial statements. Alternatively, organizations may capitalize costs, such as repairs and maintenance costs, which should be expensed. Concerns regarding valuation include whether the organization properly and completely recorded depreciation and properly recorded any asset impairments. The valuation issues typically involve management estimates that may be subject to management bias.

Identifying and focusing on the relevant assertions will allow the auditor to be more efficient in the performance of the audit (i.e., the auditor will not over-audit the lower risk assertions).

12-34

Depreciation expense relates to the expensing of a fixed asset over its life. For natural resources, the related expense account would be referred to as depletion expense (the expense associated with the extraction of natural resources). For intangible assets with a definite life, the related expense account would be referred to as amortization expense.

12-35

The five management assertions relevant to long-lived assets are as follows:

1. Existence or occurrence. The long-lived assets exist at the balance sheet date. The focus is typically on additions during the year.

2. Completeness. Long-lived asset account balances include all relevant transactions that have taken place during the period.

3. Rights and obligations. The organization has ownership rights for the long-lived assets as of the balance sheet date.

4. Valuation or allocation. The recorded balances reflect the balance that is in accordance with GAAP (includes appropriate cost allocations and impairments).

5. Presentation and disclosure. The long-lived asset balance is reflected on the balance sheet in the noncurrent section. The disclosures for depreciation methods and capital lease terms are adequate.

12-36

Asset impairment is a term used to describe management’s recognition that a significant portion of fixed assets is no longer as productive as had originally been expected. When assets are impaired, the assets should be written down to their expected economic value.

Much of the inherent risk associated with long-lived assets is due to the importance of management estimates, such as estimating useful lives and residual values and determining

whether asset impairment has occurred. Inherent risk related to asset impairment stems from the following factors:

• Normally, management is not interested in identifying and writing down assets.

• Sometimes, management wants to write down every potentially impaired asset to a minimum realizable value (although this will cause a one-time reduction to current earnings, it will lead to higher reported earnings in the future).

• Determining asset impairment, especially for intangible assets, requires a good information system, a systematic process, good controls, and professional judgment.

Other inherent risks associated with long-lived assets and related expenses include:

• Incomplete recording of asset disposals

• Obsolescence of assets

• Incorrect recording of assets, due to complex ownership structures

• Amortization or depreciation schedules that do not reflect economic impairment or use of the asset

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Natural resources present unique risks. First, it is often difficult to identify the costs associated with discovery of the natural resource. Second, once the natural resource has been discovered, it is often difficult to estimate the amount of commercially available resources to be used in determining a depletion rate. Third, the client may be responsible for restoring the property to its original condition (reclamation) after the resources are removed. Reclamation costs may be difficult to estimate.

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Intangible assets should be recorded at cost. However, the determination of cost for intangible assets is not as straightforward as it is for tangible assets, such as equipment. As with tangible long-lived assets, management needs to determine if the book values of patents and other intangible assets have been impaired. Thus, there is a great deal of estimation by management associated with intangible assets.

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a. Management’s motivation to overstate fixed assets is similar to other circumstances in which fraud is perpetrated:

 Increase reported earnings

 Boost stock price

 Improve ability of the company to acquire another company

 Avoid a violation of company debt covenants

b. The auditor should also consider the other two components of the fraud triangle–opportunity and rationalization–when assessing fraud risk associated with long-lived assets.

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A skeptical auditor will understand that management can manage earnings in a number of ways, including:

 Improperly recording repairs and maintenance costs that should be expensed as fixed assets.

 Lengthening the estimated useful lives and/or increasing estimated residual value of depreciable assets without economic justification as was done in the Waste Management fraud.

The auditor becomes aware of management’s potential by considering relevant fraud risk factors, including incorporating information related to internal control effectiveness–in particular the control environment.

12-41

Potential fraud schemes related to long-lived assets include:

 Sales of assets are not recorded and proceeds are misappropriated.

 Assets that have been sold are not removed from the books.

 Inappropriate residual values or lives are assigned to the assets, resulting in miscalculation of depreciation.

 Amortization of intangible assets is miscalculated.

 Costs that should have been expensed are improperly capitalized.

 Impairment losses on long-lived assets are not recognized.

 Fair value estimates are unreasonable or unsupportable.

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Typically, the more relevant assertions (areas of higher risk) for tangible long-lived assets (e.g., property, plant, and equipment) include existence and valuation. For these assertions, the appropriate internal controls could include:

 The use of a computerized property ledger. The property ledger should uniquely identify each asset. In addition the property ledger should provide detail on the cost of the property, the acquisition date, depreciation method used for both book and tax, estimated life, estimated scrap value (if any), and accumulated depreciation to date.

 Authorization procedures to acquire new assets. In particular, the use of a capital budgeting committee to analyze the potential return on investment is a strong control procedure.

 Periodic physical inventory of the assets and reconciliation with the recorded assets.

 Formal procedures to account for the disposal of assets.

 Periodic review of asset lives and adjustments of depreciation methods to reflect the changes in estimated useful lives.

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The more relevant assertions for intangible assets include valuation and presentation and disclosure. For intangible assets, controls should be designed to:

• Provide reasonable assurance that decisions are appropriately made as to when to capitalize or expense research and development expenditures (presentation and disclosure).

• Develop amortization schedules that reflect the remaining useful life of patents or copyrights associated with the asset (valuation).

• Identify and account for intangible-asset impairments (valuation).

Management should have a monitoring process in place to review valuation of intangible assets. For example, a pharmaceutical company should have fairly sophisticated models to predict the success of newly developed drugs and monitor actual performance against expected performance to determine whether a drug is likely to achieve expected revenue and profit goals. Similarly, a software company should have controls in place to determine whether capitalized software development costs will be realized.

Specific examples of controls include:

 Management authorizations are required for intangible asset transactions.

 Documentation regarding intangible assets should be maintained and such documentation should include:

o Manner of acquisition (e.g., purchased, developed internally)

o Basis for the capitalized amount

o Expected period of benefit

o Amortization method

 Amortization periods and calculations should be approved and periodically reviewed by appropriate personnel.

12-44

Analytical procedures that would be helpful in performing preliminary analytical procedures related to depreciation expense include analysis of the following relationships in the light the expectations developed by the auditor:

 Current depreciation expense as a percentage of the previous year's depreciation expense,

 Fixed assets (by class) as a percentage of previous year's assets. The relative increase in this percentage can be compared with the relative increase in depreciation expense as a test of overall reasonableness.

 Depreciation expense (by asset class) as a percentage of assets each year. This ratio can indicate changes in the age of equipment or changes in depreciation policy, or computation errors.

 Accumulated depreciation (by class) as a percentage of gross assets each year. This ratio provides information on the overall reasonableness of the account and may indicate problems of accounting for fully depreciated equipment.

 Average age of equipment (by class). This ratio provides additional insight on the age of assets and may be useful in modifying depreciation estimates.

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Ratios and expected relationships that auditors can use when performing preliminary analytical procedures include:

• Review and analyze gains/losses on disposals of equipment (gains indicate depreciation lives are too short, losses indicate the opposite).

• Perform an overall estimate of depreciation expense.

• Compare capital expenditures with the client’s capital budget, with an expectation that capital expenditures would be in line with the capital budget.

• Compare depreciable lives used by the client for various asset categories with that of the industry. Large differences may indicate earnings management.

• Compare the asset and related expense account balances in the current period to similar items in the prior audit and determine whether the amounts appear reasonable in relation to other information you know about the client, such as changes in operations

Ratios that the auditor should plan to review, after developing independent expectations, include:

 Ratio of depreciation expense to total depreciable long-lived tangible assets. This ratio should be predictable and comparable over time unless there is a change in depreciation method, basis, or lives. The auditor should plan to analyze any unexpected deviation and assess whether any changes are reasonable.

 Ratio of repairs and maintenance expense to total depreciable long-lived tangible assets. This ratio may fluctuate because of changes in management’s policies (for example, maintenance expenses can be postponed without immediate breakdowns or loss of productivity). The auditor should plan to analyze any unexpected deviation with this consideration in mind.

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Panel B of Exhibit 12.3 illustrates the different levels of assurance that the auditor could obtain from tests of controls and substantive procedures. The reason for the differing approaches is due to the different levels of risk of material misstatement associated with each of the clients. Panel B makes the point that because of the higher risk associated with the existence of equipment at Client B, the auditor will want to design the audit so that more of the assurance is coming from tests of details. In contrast, the risk associated with the existence of equipment at Client A is lower and therefore the auditor would be willing to obtain more assurance from tests of controls and substantive analytics, and less assurance from substantive tests of details. Note that the relative percentages are judgmental in nature; the examples are simply intended to give you a sense of how an auditor might select an appropriate mix of procedures.

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For many organizations, long-lived assets involve only a few assets of relatively high value. In these settings, the time and effort needed to perform tests of controls in order to reduce substantive testing may exceed the time required to simply perform the substantive tests. Thus, the most efficient approach would be to use a substantive approach, using test of details, for testing.

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Control Procedure

Purpose of Control Procedure (a)

1. Periodic physical inventory of assets. Provide reasonable assurance that records reflect equipment on-hand and in use. Relates to existence and completeness.

2. Policy to classify equipment and compute depreciation.

Provide reasonable assurance of consistent use of depreciation methods based on experience of client. Relates to valuation.

Impact on Substantive Audit Procedures (b)

Auditor should expand procedures either by taking a sample from the property ledger and verifying existence or take a tour of plant and identify idle equipment for future review (or both procedures.)

Auditor would have to review each equipment life for consistency and rationale for the life chosen.

3. Policy on minimum amounts that are to be capitalized.

Promote processing efficiency by expensing small dollar value items.

There is no particular effect on the audit except that the property, plant and equipment ledger would have substantially larger items as the smaller dollar items would have been expensed.

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Control Procedure

4. Method for designating scrap or idle equipment for disposal.

Purpose of Control Procedure (a)

Provide reasonable assurance that the records are updated for changes in productive life of assets. Relates to valuation.

Impact on Substantive Audit Procedures (b)

Auditor would expand production facilities tour with special emphasis on identifying obsolete or non-productive assets. The items identified would be discussed with management in order to determine if adjustments are needed.

5. Differentiate major renovations from repair and maintenance.

Provide reasonable assurance that the proper accounting since major renovations may extend the life of the asset and should be debited to accumulated depreciation.

Expand review of repairs and maintenance expense. Investigate all large expenditures to determine if they are more appropriately classified as renovations.

6. Self-construction of assets.

Provide reasonable assurance of proper accounting for selfconstructed assets.

Perform a detailed review of all self-constructed assets.

7. Systematic review for asset impairment.

Provide reasonable assurance of proper accounting for asset impairment (valuation issues). Company performing the review on a consistent basis is a strong control because it eliminates many of the "big bath" write-offs.

Auditor would have to review asset productivity each year and make inquiries of client of the accounting for impaired assets. Auditor would be more alert to declining productivity indicators or changes in product mix that might affect asset values.

8. Management periodically reviews disposals for potential impact on changing asset lives for depreciation purposes.

Provide reasonable assurance of asset valuation.

Auditor should review asset disposals for potential impact on choice of economic lives for assets.

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Test of controls over tangible long-lived assets could include:

 Examine documentation corroborating that a tangible long-lived asset budget is prepared and used.

 Examine relevant documentation for management's approval process of the tangible longlived asset budget.

 Examine a sample of tangible long-lived asset requisition forms for management's approval.

 Inspect copies of the vouchers used to document departmental request for sale, retirement, or scrapping of tangible long-lived assets for management's approval.

 Test depreciation shown in the general ledger to the amounts shown in the tangible longlived asset ledger. (This might be performed as a dual purpose test.)

 Review or recompute a sample of depreciation calculations.

 Agree the posting of depreciation expense to the general ledger.

 Inspect the tangible long-lived asset ledger for adequate detail to support the tangible longlived asset accounts.

 Verify that the tangible long-lived asset ledger is periodically balanced to the general ledger.

 Verify accuracy of calculations on a sample of tangible long-lived asset requisition forms.

 Check for the existence of a written policy which establishes whether a budget request is to be considered a capital expenditure or a routine maintenance expenditure.

 Confirm the existence of approved vouchers for entries which remove assets from the tangible long-lived asset ledger.

 Inspect documentation of tangible long-lived asset requisition forms for authenticity.

 Test a sample of maintenance expenditures to evaluate compliance with the written policy which establishes whether an item is to be considered a capital expenditure or a routine maintenance expenditure.

 Evaluate the effectiveness and appropriateness of the written policy used to distinguish capital expenditures from maintenance expenditures.

 Compare costs and prices on a sample of tangible long-lived asset requisition forms to established list prices to determine reasonableness.

 Compare sale or scrap prices on a sample of vouchers used to document departmental requests for sale, retirement, or scrapping of tangible long-lived assets to established list prices to determine reasonableness.

 Review tangible long-lived asset budget reports and note management's explanation of any significant variances.

 Scan the tangible long-lived asset ledger for unusually large or small items.

 Through review of relevant documentation and inquiry of appropriate personnel determine that tangible long-lived asset records are maintained by persons other than those who are responsible for custody and use of the assets.

 Agree the identification numbers of a sample of fixed assets to those shown in the tangible long-lived asset ledger.

 Through review of relevant documentation and inquiry of appropriate personnel, verify that periodic physical inventories of tangible long-lived assets are taken for purposes of

reconciliation to the tangible long-lived asset ledger as well as appraisal for insurance purposes.

 Through review of relevant documentation and inquiry of appropriate personnel, substantiate that periodic physical inventories of tangible long-lived assets are taken under the supervision of employees who are not responsible for the custody of record keeping for the tangible long-lived assets.

 Through review of relevant documentation and inquiry of appropriate personnel, investigate whether significant discrepancies between the tangible long-lived asset ledger and physical inventories are reported to management.

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CONTROL POSSIBLE TESTS OF CONTROLS

Management authorizations are required for intangible asset transactions.

Documentation regarding intangible assets should be maintained and such documentation should include:

o Manner of acquisition (e.g., purchased, developed internally),

o Basis for the capitalized amount,

o Expected period of benefit, and amortization method.

Amortization periods and calculations should be approved and periodically reviewed by appropriate personnel.

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For selected intangible asset transactions inquire of management as to the authorization process and review documentation of the appropriate authorizations.

For selected intangible assets, review documentation and assess reasonableness of management estimates

For selected items, inquire of management regarding this process, review documentation supporting the process, and recompute calculations.

To detect fictitious assets, the auditor should have traced recent acquisitions to the fixed-asset accounts and to original source documents; doing so would have enabled the auditor to realize that such documents did not exist. For improper depreciation, the auditor should have compared depreciation expense over a period of time, adjusted for the volume of business and the number of trucks used. The decrease in depreciation per truck should have led to more detailed investigation, including tests of depreciation on each truck. For the impairment issue, the auditor should have compared current earnings with future expected earnings that were predicted when the goodwill was initially recorded. A dramatic decrease in current earnings signals the need for an impairment adjustment. For the impaired assets, the auditor should have noted (a) the relative age of the assets (net book value has decreased), (b) idle equipment during a tour of the factory, and (c) should have traced apparently idle assets to the books. For the assets overvalued at acquisition, the auditor should have determined if the company had used a reputable and certified

12-11

independent appraiser. If the auditor had doubts, he or she should have hired an appraiser to form an independent opinion.

12-52

Compute the average balance: ($380,500 + $438,900) / 2 = $409,700

Adjust for the salvage value: $409,700 * .9 = $368,730

Compute the annual depreciation expense: $368,730 / 6 = $61,455.

Once the auditor has developed an expectation of the account balance, the auditor will compare that expectation with the amount recorded by the client. If the difference between the two amounts is less than the threshold (based on level of materiality) set by the auditor, the auditor would conclude that the recorded depreciation expense is reasonable. Although the problem did not provide details on the auditor’s threshold, it is reasonable to believe that the difference between the auditor’s expectation and the client’s recorded amount in this problem would be below that auditor’s threshold. Thus, the auditor would likely conclude that the recorded depreciation expense of $60,500 appears reasonable. Given the results of this substantive analytical procedure, the auditor will likely not need to perform any additional substantive tests of details.

12-53

The audit approaches applicable to identifying and determining the proper accounting of fully depreciated or idle facilities would include:

 The auditor should tour the client facilities and make inquiries concerning idle equipment. The auditor should note all idle equipment to be subsequently traced to the property ledger. Discussions with management about these issues will also be helpful.

 Generalized audit software could be used to develop a schedule of fully depreciated assets. A sample could be taken and the auditor could attempt to physically observe the asset and determine whether it is in production and whether a scrap value is appropriate.

12-54

The client has a policy that apparently has been used for a number of years. Assignment of assets to classes for depreciation purposes is common and represents an expedient method of dealing with depreciation issues. The auditor can determine the reasonableness of the classification schemes by:

 Reviewing previous data on the asset's productive life (within each category

 Reviewing IRS guidelines for classification and reasonableness in comparison with the company's categories and life guidelines

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 Noting significant gains/losses on disposal.

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The general concept of valuing impaired assets consists of two major approaches:

 Estimating the future economic benefits to be derived from the asset. The auditor would evaluate management’s assumptions and estimates for reasonableness.

 Obtaining an independent appraisal of current value. The auditor could either assess the competence and independence of the appraiser hired by management and the reasonableness of the assumptions used or the auditor could obtain an independent appraisal of the value of the asset.

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The auditor must make sure the appraisal is reasonable. The auditor should consider the qualifications and certification of the appraiser and appropriateness of the assumptions used by the appraiser. The auditor may also need to use a specialist/expert to assist with these audit procedures.

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General substantive procedures for leases include:

• Obtain copies of lease agreements, read the agreements, and develop a schedule of lease expenditures.

• Review the lease expense account, select entries to the account, and determine if there are entries that are not covered by the leases obtained from the client. Review to determine if the expenses are properly accounted for.

• Review the relevant criteria from FASB ASC to determine which leases meet the requirement of capital leases.

• For all capital leases, determine that the assets and lease obligations are recorded at their present value. Determine the economic life of the asset. Calculate amortization expense and interest expenses, and determine any adjustments to correct the financial statements.

• Develop a schedule of all future lease obligations or test the client’s schedule by reference to underlying lease agreements to determine that the schedule is correct.

• Review the client’s disclosure of lease obligations to determine that it is in accordance with GAAP.

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a. Items 1 through 6 would have been found in the following way:

1. The company's policies for depreciating equipment are available from several sources:

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 The prior-year's audit working papers and permanent file.

 Footnote disclosure in the annual report and SEC Form 10-K.

 Company procedures manual.

 Detailed fixed asset records.

 Inquiry of relevant client personnel.

2. The ten-year lease contract would be found when supporting data for current year's equipment additions were examined. Also, it may be found by a review of company lease and contract files.

3. The building wing addition would be apparent by the addition to buildings during the year. The use of the low construction bid amount would be found when support for the addition was examined. When it was determined that this inappropriate method was followed, the actual costs were determined by reference to construction work orders and supporting data. The wing was also physically observed by the auditor.

4. The paving and fencing was discovered when support was examined for the addition to land. These costs should be charged to Land Improvements and depreciated.

5. The details of the retirement transactions were determined by examining the sales agreement, cash receipts documentation, and related detailed fixed asset record. This examination would be instigated by the recording of the retirement in the machinery account or the review of cash receipts records.

6. The auditor would become aware of a new plant in several ways:

 Volume would increase.

 Account details such as cash, inventory, prepaid expenses, and payroll would be attributed to the new location.

 The transaction may be indicated in documents such as the minutes of the board, press releases, and reports to the stockholders.

 Property tax and insurance bills examined show the new plant.

 Inquiry of appropriate client personnel.

One or more of these factors would lead the auditor to investigate the reasons and circumstances involved. Documents from the city and appraisals would be examined to determine the details involved.

b. The appropriate adjusting journal entries are as follows:

1. No entry necessary.

2. This is an operating lease because it is cancelable with a 60 day notice and should not have been capitalized.

To correct initial recording of lease.

Dr. Equipment rent expense $ 3,750

Cr. Prepaid rent $3,750

To record nine months of rent:

9/12 x $5,000 = $3,750

3. The wing should have been recorded at its cost to the company.

Dr. (Accounts originally credited) $1,500

Cr. Buildings $1,500

To correct initial recording of a new wing at its cost rather than the outside bid.

Dr. Depreciation expense $ 290

Cr. Allowance for depreciation--buildings $ 290

To correct depreciation for excess cost.

Depreciation on beginning balance.

120,000/25 = 4,800

Depreciation recorded on addition

5,150 - 4,800 = 350

Correct depreciation for addition:

Remaining useful life of addition at the beginning of the year is 12 ½ years (60,000/120,000 x 25 = 12 ½ years; (25 – 12 ½ = 12 ½)

Depreciation = $16,000/12 ½ / 2 = $640

Correction = $640 - $350 = $290

4. The paving and fencing are land improvements and should be depreciated over their useful lives.

Dr. Land improvements $5,000

Cr. Land $5,000

To correct initial recording of paving and fencing.

Dr. Depreciation expense $ 250

Cr. Allowance for depreciation Land Improvements $250

To record first year's depreciation on paving and fencing.

$5,000/10 / 2 = $250

5. The cost and allowance for depreciation should have been removed from the accounts and a gain or loss on sale recorded separately into income.

Depreciation expense for 2014 should be $2,400 rather than the $3,500 that was recorded.

is:

6. Donated property should be capitalized at its fair market value. Dr. Land $10,000

Cr. Contributed capitalDonated Property $50,000

To record land and buildings for new plant donated by Crux City.

Dr. Depreciation expense $800

Cr. Allowance for depreciation-Buildings $ 800

To record depreciation on new plant.

$40,000/25 / 2 = $800

a. Impairment of assets refers to long-lived assets and certain identifiable intangibles to be held and used by an entity for which events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. In performing the review for recoverability, the entity should estimate the future cash flows expected to result from the use of the asset and its eventual disposition. If the sum of the expected future cash flows (undiscounted and without interest charges) is less than the carrying amount of the asset, an impairment loss is recognized. Otherwise, an impairment loss is not recognized. Measurement of an impairment loss for long-lived assets and identifiable intangibles that an entity expects to hold and use should be based on the fair value of the asset.

b. Management’s motivation will depend on the specific facts and circumstances. In some settings, management may follow the so-called big bath theory and take very large write-offs when any write-off occurs. The rationale for this approach is that the market seems to be forgiving, especially if there is a change in management and the new management can blame the problems on the previous management. If the write-off is large, then it decreases the amount of assets that might be charged against earnings in the future. In some settings, the investment public is skeptical of the large write-offs and has recognized such write-offs as a symbol of management failure. Thus, managers will resist taking any write-offs unless there is compelling evidence that there has been impairment in assets.

However, it is important to recognize that management will want to understate expenses, and thus overstate income, and so will want to understate the right. The auditor has to be aware of management’s incentives when assessing the nature and type of potential misstatements. c Step 1. Identify the ethical issue. The ethical issue is that the auditor believes that her estimate is correct, and knows that it is materially lower than management’s estimate of the impairment.

Step 2. Determine who are the affected parties and identify their rights. There are various affected parties:

 shareholders, who have a right to accurate financial information

 the audit committee and board, who have a right to know that the auditor and management are having a material disagreement

 management, who has a right to uphold their own valid, defensible professional opinions

 the auditor and audit firm, who have a right to exercise their own professional judgment and to minimize potential litigation against themselves

 tax authorities, who have a right to expect that management will make tax deductions that are reasonable and appropriate

Step 3. Determine the most important rights. The most important rights are likely those of shareholders, followed by the audit committee and board as major players in the corporate

governance of the company. The tax authorities represent society in general, so their rights are also quite important.

Step 4. Develop alternative courses of action. The auditor could pursue various courses of action:

a. Try again to convince management that the auditor’s estimates are superior.

b. Alert the audit committee of the disagreement and let them help to resolve it.

c. Threaten management with a qualified audit opinion if they refuse to acquiesce to the auditor’s preference.

d. Resign from the engagement.

Step 5. Determine the likely consequences of each proposed course of action.

a. Trying to convince management may or may not work. If it does work, then the situation is resolved. If it does not work, the relationship between the auditor and management will likely become even more strained.

b. Alerting the audit committee is required by professional standards. While it may annoy management, the auditor can fall back on the fact that they are required to discuss such issues with the audit committee.

c. Threatening management will obviously strain the relationship with the auditor, but it may be successful in getting management to see the auditor’s point of view.

d. Resigning is the last resort as it is a fairly extreme measure, and will result in public disclosure of the disagreement for the company, and loss of revenue for the audit firm.

Step 6. Assess the possible consequences, including an estimation of the greatest good for the greatest number. The auditor is required via professional standards to alert the audit committee, and doing so will likely enable the auditor to (a) re-think their estimate if the audit committee convincingly challenges their calculations, or (b) use the interaction to convince management to use the correct valuation in the impairment. Ultimately, the process of interacting with the audit committee and management will enable all parties to determine the most appropriate impairment calculation. The revelation of that amount to shareholders and tax authorities will result in the greatest good for the greatest number.

Step 7. Decide on the appropriate course of action. The auditor should first try to convince management to change the estimate, and even if they succeed in doing so the auditor must alert the audit committee to the situation.

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1. The main difficulty that the auditor faces in determining whether the charges are reasonable is to understand management’s estimation procedures and to decide if they are reasonable. The auditor will have to understand the following types of decisions:

 Which third party offers were used in the calculations? How did management choose which offers to use if there were multiple offers?

 What is the appropriate discount rate for the discounted future cash flow calculations?

 Is it appropriate to completely write off the Falkirk, Scotland assets? Or is management possibly setting up a cookie jar reserve by doing so?

2. The consequences of the auditor’s decisions are associated with providing reasonable assurance that no fixed assets are inappropriately over-valued on the balance sheet (with resulting under-expensing of impairment charges on the income statement) or under-valued on the balance sheet (with resulting over-expensing of impairment charges on the income statement).

3. The risks are those associated with inaccurate financial reporting, particularly if the impairment charges are material to the client’s financial statements. The uncertainties involve the estimates, for example, is a 7% discount rate correct, or should it be 5%?

4. The auditor can gather various types of evidence:

 Documentation of management’s estimation process and assumptions

 Documentation that includes third-party offers and negotiations

 Confirmations with third parties

 Comparisons of fixed asset values with competitors

 Understanding and documenting management’s potential motivations for under- or overexpensing the impairment charges

 Obtaining current market values of assets.

Contemporary and Historical Cases

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a. IRG’s lease accounts and fixed asset accounts (including related deprecation charges) were misstated.

b. While the textbook feature does not provide information specifically related to management motivation, students will likely note that the company recently went public and may have intentionally misstated the financial statements so that the public offering would be more successful. The motivation, coupled with opportunity due to weak internal controls, is often highlighted by students.

c. Typical controls that affect multiple assertions for long-lived assets include:

 Formal budgeting process with appropriate follow-up variance analysis

 Written policies for acquisition and disposals of long-lived assets, including required approvals

 Limited physical access to assets, where appropriate

 Periodic comparison of physical assets to subsidiary records

 Periodic reconciliations of subsidiary records with the general ledger

Further, controls should be in place to:

 Identify existing assets, inventory them, and reconcile the physical asset inventory with the property ledger on a periodic basis (existence).

 Provide reasonable assurance that all purchases are authorized and properly valued (valuation).

 Appropriately classify new equipment according to its expected use and estimate of useful life (valuation).

 Periodically reassess the appropriateness of depreciation categories (valuation).

 Identify obsolete or scrapped equipment and write the equipment down to scrap value (valuation).

 Review management strategy and systematically assess the impairment of assets (valuation).

With respect to the lease accounts, the company should have policies and procedures requiring review all of leases by a qualified lease accountant to provide reasonable assurance over proper recording of those transactions.

d. The auditors should have gained an understanding of the client’s internal controls over these long-lived assets. If the controls were not well designed (or determined not to be operating effectively), the auditors should have increased the assurance they needed regarding whether the asset accounts were materially misstated. For the lease audit, the auditors could perform the following:

• Obtain copies of lease agreements, read the agreements, and develop a schedule of lease expenditures.

• Review the lease expense account, select entries to the account, and determine if there are entries that are not covered by the leases obtained from the client. Review to determine if the expenses are properly accounted for.

• Review the relevant criteria from FASB ASC to determine which leases meet the requirement of capital leases.

• For all capital leases, determine that the assets and lease obligations are recorded at their present value. Determine the economic life of the asset. Calculate amortization expense and interest expenses, and determine any adjustments to correct the financial statements.

• Develop a schedule of all future lease obligations or test the client’s schedule by reference to underlying lease agreements to determine that the schedule is correct.

• Review the client’s disclosure of lease obligations to determine that it is in accordance with GAAP.

As for the tangible long-lived assets, a great deal of this chapter is focused on appropriate substantive procedures for both the asset and expense accounts. Further, Exhibit 12-4 outlines possible procedures that the auditor could have performed.

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a. Yes, it would be highly unusual for debits to fixed assets to come from journal entries. Most debits to fixed assets should come from purchases of the assets and should be evidenced by

invoices and contracts. The auditor should view significant amounts of debits to fixed asset as high risk and should investigate all of the entries if the aggregate amount could be significant or material.

b. No, entries to depreciation expense and accumulated depreciation should normally come from journal entries. However, the journal entries should come from an automated computer program. Thus, the auditor should trace the summary entries back to the detail computation for specific items.

c. An explanation of “Capitalization of line capacity per CFO, amounts were originally incorrectly recorded as an expense” is a highly unusual transaction. The auditor should be highly skeptical because it does not appear to be supported by outside, objective evidence. The client claims it is misclassified as an expense. The auditor should seek the following evidence:

 Ask the client to examine the original invoice, contract, and other information associated with the original payment for the goods, services, or fixed asset.

 The auditor should examine the invoice to determine the nature of the purchase.

 The auditor should determine that the document that is examined was not used to support other purchases, that is, the auditor should be suspicious of the information because it is all obtained internally. The auditor should be concerned that one invoice might serve as support for this journal entry and another purchase.

 The auditor should use GAS to prepare a list of all other purchases from the vendor. The auditor should trace the purchases to invoices and to proper recording in the accounts.

 The auditor should consider confirming the total amount of purchases with the outside vendor.

Significant differences should be recorded as misstatements and projected to the statements as a whole. If the auditor has suspicions that other such misstatements might exist in the accounts, the auditor should use GAS to schedule all entries to the account balance that comes from other than the purchase journal and should investigate all of the entries in a similar manner. 12-63

a. The statement of facts for this case reveals that company management had made promises (earnings expectations) to investors and Wall Street that were not going to materialize, thereby suggesting the motivation for management. Further, it is likely that the controls in place were not very effective. While Safety-Kleen had policies prohibiting the types of fraudulent entries that were being made, presumably there was no monitoring or review of adherence to these policies. And students can often see how management might provide rationalizations for the fraud (for example, not our fault the numbers are not being meant, we shouldn’t suffer because of something outside of our control, etc.).

b. It is important to note that this response has the benefit of hindsight. However, analytical procedures (either preliminary or substantive) should have noted the increases in quarter end adjustments, with rather significant adjustments occurring in the 3rd and 4th quarters of 1999

Further, the 2000 1st quarter adjustment was quite a bit larger than the previous 1st quarter adjustment. The case states that these adjustments in 1999 were significantly higher than the adjustments in previous. We assume that these balances in 1999 and 2000 were different than what an auditor, knowledgeable of the industry, would expect. Therefore, the auditor should have followed up on these unexpected account balances to determine if there was supporting documentation to validate the balances. The statement of facts for the case indicates that for the $7.3 million of fraudulent adjustments to capitalize the tires on the company's trucks and the fuel in the tanks, a company executive sketched these adjustments on graph paper, without any analysis or documentation to support them.

The problem states that one of the adjusting entries was recorded twice. The use of GAS or other procedures should have identified this duplicate recording.

Further, the auditor should likely have selected capitalized items and reviewed documentation to determine whether the capitalization was appropriate or whether the items (such as salary expense) should have been expensed.

Students might also expect that audit work in the area of payroll expenses might have identified an unexpected decrease in payroll expenses and that follow-up of this unexpected result might have identified the inappropriate capitalization.

Application Activities

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The point of this exercise is to get students to access online financial reports, to see the relationship to conceptual auditing topics involving impairments, and to read and interpret financial statement disclosures. Further, discussing each student’s findings in a small group or even as an entire class may prove beneficial in stimulating conversation about the nature of impairment charges, their causes, their magnitudes, and implications for the external auditor in terms of assessing reasonableness of the estimates made by management.

There are many recent examples that students might find including:

 Best Buy, for the fiscal year ended March 3, 2012

 Sears Holding Corporation, for the fiscal year ended January 28, 2012

 AT&T Inc., for the fiscal year ended December 31, 2011

For a less recent example, consider that Starbuck’s recorded a $224 million impairment charge in 2009, and that was following a $325 million impairment charge in 2008. These impairment charges were associated with a significant slowdown in the Company’s expansion, with fewer store openings attributed to reduced demand and a steep decline in discretionary consumer spending related to the recession. Note 2 of Starbuck’s Annual Report provides a nice summary of the Company’s restructuring plan.

While the judgments that management made may vary across the selected companies, typical judgments that management makes concern expected useful lives of long-lived assets, undiscounted cash flows, and anticipated changes in economic conditions and operating performance. Necessarily, these types of estimates are by definition uncertain. Thus, the job of the auditor is to assess their reasonableness and to be professionally skeptical of the numbers produced by management based upon these estimates.

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DRG Audits- Excerpts from PCAOB Order

DRG reported in the notes to its 2008 financial statements that it had incurred advertising expenses during 2008 and that it had capitalized approximately $840,000 of those expenses as "direct response advertising" pursuant to AICPA Statement of Position ("SOP") 93-7, Reporting on Advertising Costs (December 29, 1993). DRG's capitalized direct response advertising balance for 2008 represented an increase of over 350% from the prior year and constituted 21% of DRG's total reported assets.

SOP 93-7 provides that a company may only capitalize advertising expenses as direct response advertising if (1) the primary purpose of the advertising "is to elicit sales to customers who could be shown to have responded specifically to the advertising;" and (2) the advertising "results in probable future benefits." In addition, SOP 93-7 states that direct response advertising costs reported as assets are to be "amortized on a cost-pool-by-cost-pool basis over the period during which the future benefits are expected to be received.”

During the 2008 audit, JSW failed to exercise due professional care and failed to obtain sufficient audit evidence to conclude that DRG was appropriately capitalizing, as opposed to expensing, the costs it reported as direct response advertising. Specifically, JSW failed to obtain audit evidence indicating that sales were to customers responding specifically to the advertising. Nor did JSW obtain sufficient competent audit evidence indicating that the advertising would result in probable future benefits to DRG. In addition, JSW failed to perform any procedures to evaluate whether DRG was appropriately amortizing the amounts it capitalized as direct response advertising. Indeed, JSW's work papers include a schedule, provided by DRG, indicating that the company was not amortizing those amounts.

DDM Audits- Excerpts from PCAOB Order

As of year-end 2008, more than 75% of DDM's total reported assets were classified as intangible assets and consisted mostly of website and platform development costs for an unlaunched product. During the 2008 audit, JSW failed to ensure that the engagement team appropriately tested DDM's intangible asset balance for impairment. The work papers reflect that management's basis for not recognizing an impairment on its intangible assets in 2008 was a cash flow projection. JSW, however, performed no procedures to assess the reasonableness of the cash flow projection, including the relevance, sufficiency, and reliability of the data supporting the projection and the assumptions management made in formulating the projection. In addition,

the untested cash flow projection was inconsistent with JSW's conclusion that there was substantial doubt as to DDM's ability to continue operating as a going concern.

Sanctions

Accordingly, it is hereby ORDERED that: A. Pursuant to Section 105(c)(4)(E) of the Act and PCAOB Rule 5300(a)(5), Jewett, Schwartz, Wolfe & Associates, P.L. is hereby censured.

Pursuant to Section 105(c)(4)(A) of the Act and PCAOB Rule 5300(a)(1), the registration of Jewett, Schwartz, Wolfe & Associates, P.L. is revoked.

After five (5) years from the date of this Order, Jewett, Schwartz, Wolfe & Associates, P.L. may reapply for registration by filing an application pursuant to PCAOB Rule 2101.

Student discussion as to the severity and appropriateness of the sanctions can be quite lively.

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The following excerpts from the speech provide useful points of discussion including the difficulty of measuring intangible assets, the potential for abuse, and the constraints imposed by the accounting standards.

One of the biggest measurement dilemmas relates to intangible assets. We know that they are there. While the value of Facebook’s tangible assets is relatively limited, its business concept is immensely valuable (although 25% less immense than a month ago).

Likewise, the money-making potential of pharmaceutical patents is often quite substantial. However, both types of intangible assets go unrecorded (or under-recorded) on the balance sheet. Under strict conditions, IAS 38 Intangible Assets allows for limited capitalisation of Development expenditures, but we know the standard is rudimentary because it is based on historical cost, which may not reflect the true value of the intangible asset.

The fact is that it is simply very difficult to identify or measure intangible assets. High market-to-book ratios may provide indications of their existence and value. However, after the excesses of the dot.com bubble, there is understandable reluctance to record them on the balance sheet.

Pragmatism also means we need to look very carefully at any possible undesirable use of our standards. Whenever we are confronted with a high degree of uncertainty, we should act with great caution. I just gave the example of intangible assets. We know they are there, but measurement is a big problem. If our standards were to provide too much room for recognition of intangible assets, the potential for mistakes or abuse would be immense.

In such circumstances, it is better for our standards to require more qualitative reporting than pseudo-exact quantitative reporting.

By the way, people always tell us we should not set our standards from an anti-abuse perspective. I think that is nonsense. If we see ample scope for abuse in a standard, we had better do something about it. There are sufficient temptations and incentives for creative accounting as it is.

These excerpts highlight the difficulty of auditing intangible assets if the asset is difficult to measure, it will be difficult to audit. Estimation and uncertainty make audits of intangibles extremely challenging and highlight the importance of professional skepticism.

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a. From late 2004 to mid-2006 more than 250 U.S. firms uncovered and corrected accounting errors related to operating leases. The underlying issue was that the accounting method used was in violation of generally accepted accounting principles (GAAP). Many of these companies filed restated financial statements with the SEC, while many other companies elected to use a less visible current-period catch-up adjustment. GAAP allows companies to avoid formal restatements when the error is deemed immaterial by management and the independent auditor. This setting is one where materiality considerations are likely to be the dominant influence on whether the correct the error through a restatement or through a catch-up adjustments. Accordingly, this setting allows for the authors to test the role of various materiality related factors (quantitative and qualitative) in explaining which correction method a company used. (The authors also consider whether the method previously used by other companies in the same industry influences the materiality decisions, and hence the correction method used.) Regulatory bodies provide general guidance on assessing materiality however, they are vague at best. That leaves the question of materiality to the judgment of company management and the auditor.

b. The results of the research indicate that the materiality judgment (and hence the judgment regarding the correction method) is based on more than a purely quantitative approach (for example, 5 percent of net income). Qualitative factors such as scaled magnitude of the error, presence of other identified errors, and the importance of leasing activities to firm operations play an important role in the determination of materiality. Firms’ materiality assessments are also heavily associated with the prior actions of other firms.

c. In settings where a decision has to made as how to correct an error, there is likely a fair amount of negotiation between the auditor and the client (preparer). Auditors and their clients will find it useful to understand the determinants of this decision and whether their own decisions seem reasonable given the evidence in this paper. It may be that auditors provide some recommendations to clients on this issue; evidence in this paper could be used to support the auditor’s recommendation and potentially help avoid placing the auditor in a legal liability situation.

At least in the setting examined in the paper, it appears that materiality assessments are pretty consistent across firms. However, the auditing standard setters might consider providing more specific materiality guidelines for auditors to follow. This would reduce the amount of judgment required on behalf of the auditor and management, and may be useful in other settings requiring materiality assessments. The financial statements of companies would be more consistent and provide more meaningful information to the investors who are comparing company financials thereby increasing the value of audited financial statement.

d. The initial sample of companies to use for this research was gathered from the investment newsletter “Analysts’ Accounting Observer” supplemented by companies found in wire service press releases and SEC filings. The final sample consisted of 244 firms which included 150 firms

that used restatements to correct lease accounting errors and 91 that used current-period adjustments. To gain insights in to the factors that affected a company’s decision regarding its lease correction method, the authors use a logistic regression model of the likelihood that restatement is used to correct the discovered lease accounting errors. Explanatory variables in the model included quantitative factors, qualitative factors, and contextual variables.

e. The archival research method used for this paper is subject to certain limitations. For example, some disclosures regarding correction of the error were not specific as to the dollar amount of the error and thus were not included in the analysis. Further, there may be variables other than the ones examined that influenced companies’ corrections methods and if these variables were included, the results might be different. Further, data limitations do not allow for the authors to provide evidence on whether auditors differ in the determinants (and weights placed on those determinants) of error correction decisions and materiality assessments.

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a. This paper addresses the issue of client negotiation in an asset write-down setting. Asset write-downs can be highly judgmental audit areas, and the amounts reported in financial statement for such highly judgmental audit areas are a product of auditor-client negotiation. This paper specifically addresses how an auditor characteristic (negotiation experience) and a client characteristic (negotiation style) can impact the outcomes of negotiation and thus impact the amounts reported in the financial statements. The authors examine how these characteristics influence auditors’ perceptions of negotiation outcomes at the beginning of negotiations. Namely, the authors ask the participants to predict the ultimate outcome of a negotiation prior to engaging in dialogue with the client. This study examines the impact of the aforementioned characteristics on the level of this prediction

b. The authors find that auditor negotiation experience effects auditors’ predictions of the ultimate outcome of negotiations, but only in situations where the client uses a contentious negotiating style. Specifically, higher auditor negotiation experience leads auditors to predict a higher ultimate write-down when a client uses a contentious negotiating style. However, when a client uses a collaborative negotiating style, auditor negotiation experience does not affect auditors’ predictions of the ultimate write-down. The authors note these results suggest that auditor negotiation experience reaps benefits when it is needed most (i.e. when the client is difficult to deal with). Similarly, the authors show that the effect of client negotiation style on auditors’ perceived outcomes is contingent on auditor negotiation experience. Specifically, they note that inexperienced auditors perceive a lower ultimate negotiated write-down when dealing with a contentious client, rather than a collaborative client. However, experienced auditors perceived negotiated write-downs are not affected by clients’ negotiation styles.

c. This paper shows that a client’s negotiation style can affect the amounts reported in the financial statements. This finding indicates that auditors may benefit from considering clients’ negotiation styles in their decision-making. For example, auditors may benefit from considering client negotiation style in resource management decisions. The authors note that audit firms could benefit from assigning auditors with greater negotiation experience to negotiate with clients who are known to be contentious during client-auditor negotiations. Further, the results

suggest that audit firms could implement policies that encourage inexperienced auditors to seek assistance in negotiating with contentious clients.

Additionally, auditors can consider client negotiation style in the client acceptance and the evidence evaluation (completion) stages of the audit. With respect to client acceptance, audit firms may increase efficiency and profitability by considering the risks and potential resource demands on engagements for clients that are known to be contentious in negotiation. Further, audit firms can enhance their risk management procedures through enhanced reviews of final audited financial statements for clients with contentious financial statements. For example, firms may consider enhanced concurring review for such clients.

d. The authors perform an experiment using 20 partners (12.1 years of experience) and 76 managers (7.2 years of experience) from a Big 4 CPA firm in China during a regular training session. The authors randomly assigned each auditor to one of two groups: 1) contentious client negotiating style and 2) collaborative negotiating style. The authors distributed materials indicating the audit team identified an audit adjustment for an additional asset write-down of $1.8 million, where the materiality level for the overall financial statements was $1.9 million. Participants in the contentious group were told that the CFO had previously adopted a tough stand, was typically reluctant to record audit adjustments, and had expressed reservations in recording the current adjustment. Participants in the collaborative group were told that the CFO had previously been reasonable, was generally open to discussions of audit adjustments, and had expressed willingness to consider the current audit adjustment. The authors then asked the participants in both groups the following question: “Suppose that you have had a few rounds of discussions with the client’s manager. Indicate the amount of the proposed audit adjustment that you believe will ultimately be recorded in the client’s audited financial statements.” As part of the experiment, the authors measured auditor negotiation experience by asking each participant to indicate the number of auditor-client interactions they had completed in the past three years to resolve 1) a complex and material financial reporting issue and 2) a complex financial reporting issue that approached materiality. The authors averaged the responses to these two questions to calculate a measure of negotiating experience.

Using the data collected, the authors measured the effects of auditor negotiation experience and client negotiation style on the perceived amount of the ultimate audit adjustment. The authors find that when the client negotiating style is contentious, auditor negotiation experience has a significant effect on the perceived amount. However, auditor negotiation experience has no such effect when the negotiating style is collaborative. Similarly, the authors find that when auditor negotiation experience is low, client negotiating style has a significant effect on the perceived amount. However, client negotiating style has no such effect when auditor negotiation experience is high.

e. The authors self-identify four limitations of this study:

 The authors use a self-reported measure of negotiation experience to measure auditor expertise. Self-reported measures are susceptible to bias, and experience does not necessarily constitute expertise.

 The audit adjustment used in the study was not quantitatively material. The results may have been different if this adjustment was quantitatively material

 This study does not consider several key considerations that can affect auditor-client negotiations: concern over losing the client, auditors’ preferred write-downs and goals, auditors’ strategies.

 The authors do not measure an actual outcome of an actual negotiation; rather, they only measure auditors’ perceived outcome. This measure does not consider the iterative, rich, and complex nature of negotiation.

Additional weaknesses to consider may include:

 This experiment was performed in China. Cultural differences could limit the generalizability of these results.

 The authors do not appear to control for the position of the participants (i.e. manager vs. partner)

 The authors do not explain why auditor negotiation experience might even matter in negotiations with a collaborative client. For example, if a client is collaborative, then there may be no reason to believe negotiation will matter. Without this tension, the contribution of this research is limited.

 The results indicate that while an auditor’s negotiation experience and a client’s negotiating style may effect auditor-client negotiations, the results do not indicate that auditors allow material misstatements to go uncorrected. Thus, while the results are interesting, there is no evidence that the characteristics examined in this study have a meaningful effect on the outcomes of audits.

Ford and Toyota

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Note to instructor: This answer is based upon the FYE 2009 annual reports for Ford and Toyota as they appeared in the 8th edition. An updated solution as of FYE 2012 will be posted to the Cengage website as soon as the applicable annual reports become available.

1a.

Net property, Assets of discontinued /held for sale operations, depreciation, impairment charges.

1b.

The following are excerpted from Ford’s public filing.

Depreciation and Amortization

Property and equipment are stated at cost and depreciated primarily using the straight-line method over the estimated useful life of the asset. Useful lives range from 3 years to 36 years. The estimated useful lives generally are 14.5 years for machinery and equipment, and 30 years for buildings and land improvements. Maintenance, repairs, and rearrangement costs are expensed as incurred. Beginning January 1, 2006, we changed our method of amortization for special tools from an activity-based method (units-of-production) to a time-based method. The

time-based method amortizes the cost of special tools over their expected useful lives using a straight-line method or, if the production volumes for major product programs associated with the tools are expected to materially decline over the life of the tool, an accelerated method reflecting the rate of decline. For 2006, this change in method decreased Automotive cost of sales by $135 million.

Asset Impairments

Held-for-Sale and Discontinued Operations. We perform an impairment test on an asset group to be discontinued, held for sale, or otherwise disposed of when management has committed to the action and the action is expected to be completed within one year. We estimate fair value to approximate the expected proceeds to be received, less transaction costs, and compare it to the carrying value of the asset group. An impairment charge is recognized when the carrying value exceeds the estimated fair value.

Held-and-Used Long-Lived Assets. We monitor the carrying value of long-lived asset groups held and used for potential impairment when certain triggering events have occurred. These events include current period losses combined with a history of losses or a projection of continuing losses. When a triggering event occurs, a test for recoverability is performed, comparing projected undiscounted future cash flows (utilizing current cash flow information and expected growth rates) to the carrying value of the asset group. If the test for recoverability identifies a possible impairment, the asset group's fair value is measured relying primarily on the discounted cash flow methodology. Additionally, we consider various market multiples (e.g., revenue and earnings before interest, taxes, and depreciation and amortization ("EBITDA")) and consult with external valuation experts. An impairment charge is recognized for the amount by which the carrying value of the asset group exceeds its estimated fair value. 1c.

Students may determine a variety of ratios that are useful, and the process of having students identify their own ratios should help them understand that auditors need to tailor standard analytics to individual clients. Below we present several ratios that we developed:

expense of auto sector/total auto sales

These ratios show that:

o Ford has fewer physical assets to total assets compared to Toyota.

o Ford has less depreciated assets to total assets compared to Toyota.

o Ford has lower depreciation expense to total product sales compared to Toyota.

It may be helpful to point out to students that in the actual audits of Ford and Toyota, the auditors will have the above financial information by segment and geographic region, so disaggregating the above ratios in those ways will be helpful in understanding where potential problems may lie in reported numbers. Further, comparing ratios over a longer time horizon would be helpful in understanding and predicting trends in relevant accounts. Finally, the auditors may want to compare the client’s ratios to relevant industry averages.

2a.

Monetary value of impairment: $5.3 billion

Cause of the impairment and key assumptions/estimates: According to Footnote 15, the reasons for the impairment and the key assumptions/estimates were as follows:

“During the second quarter of 2008, higher fuel prices and the weak economic climate in the United States and Canada resulted in a more pronounced and accelerated shift in consumer preferences away from full-size trucks and traditional sport utility vehicles ("SUVs") to smaller, more fuel-efficient vehicles. This shift in consumer preferences combined with lower-thananticipated U.S. industry demand and greater-than-anticipated escalation of commodity costs resulted in impairment charges related to Ford North America's long-lived assets and Ford Credit's operating lease portfolio.” “Based upon the financial impact of rapidly-changing U.S. market conditions during the second quarter of 2008, we projected a decline in net cash flows for the Ford North America segment. As a result, in the second quarter of 2008 we tested the longlived assets for impairment and recorded in Automotive cost of sales a pretax charge of $5.3 billion, representing the amount by which the carrying value of the assets exceeded the estimated fair value. See Note 4 for further discussion of the fair value used in the impairment.”

In general, key assumptions and estimates of this nature generally involve business projections (particularly in terms of assumptions about the level of product acceptance in the marketplace), the growth rate (the expected rate at which a business unit’s earnings stream is projected to grow beyond the planning period), economic projections (assumptions regarding industry sales, pricing estimates, industry volumes, inflation, interest rates, and prices of raw materials), and discount rates (the rate at which expected future cash flows are brought to present value).

2b.

The audit firm is obligated to assess whether the key assumptions that management employs in determining fair value and impairments are reasonable, despite their obvious subjectivity. The

audit firm is obligated to conduct some independent estimation procedure of its own to determine the extent to which they agree with management’s estimates, and any potential write down. These estimates pose risk to the audit firm to the extent that, if the estimates are materially incorrect, and the audit firm issues an unqualified opinion, then the audit firm has inappropriately assured third party users of the appropriateness of the estimates when in fact they are not appropriate. In some circumstances, the auditor may want to use the services of a specialist within the firm (or an expert outside of the firm) to help the auditor perform these procedures.