Review Questions and Problem

Arton Nugroho (008201500040)

Glen Reynaldi Santosa
(008201500050)
Ismi Talmidah Arba’i
(008201500055)
Selvy Gunawan (008201500092)
What are the purposes for using preliminary
analytical procedures?
Answer :
The purposes for using analytical procedures at the
planning stage of an audit are :
1. To enhance the auditor’s understanding of the
client’s business and the transactions and events
that have occurred since the last audit
2. To identify areas that may represent risks relevant
to the audit.
Significant differences between the
auditor’s expectation and the client’s book
value require explanation through
quantification, corroboration and
evaluation. Expalin each of these terms.
Answer:
 Quantification: Quantification involves determining whether
the explanation or error can explain the observed difference.
This may require the recalculation of the expectation after
considering the additional information. For example, a client
may offer the explanation that the inventory account increased
by a certain percentage as compared to the prior year due to a
12 percent increase in raw materials prices. The auditor should
compute the effects of the raw materials price increase and
determine the extent to which the price increase explains (or
does not explain) the increase in the inventory account.
 Corroboration: Auditors must corroborate explanations for
unexpected differences by obtaining sufficient appropriate
audit evidence linking the explanation to the difference and
substantiating that the information supporting the explanation
is reliable. This evidence should be of the same quality as the
evidence obtained to support tests of details. Common
corroborating procedures include examination of supporting
evidence, inquiries of independent persons, and evaluating
evidence obtained from other auditing procedures.
Evaluation: Evaluation involves the effective
use of professional scepticism, combined with
the desire to obtain sufficient appropriate
audit evidence, similar to other auditing
procedures. The auditor should evaluate the
results of the substantive analytical
procedures to conclude whether the desired
level of assurance has been achieved. If the
auditor obtains evidence that a misstatement
exists and can be sufficiently quantified, the
auditor makes note of his or her proposed
adjustment to the client’s financial statements.
Why does the “audit testing hierarchy”
begin with test of contorls and substantive
analytical procedures?

Answer :

The Audit Testing Hierarchy starts with tests of

controls and substantive analytical procedures
because they are generally both more
effective and more efficient than starting with
tests of details (i.e. substantive tests of
transactions and substantive tests of account
balances and disclosures).
List and discuss the four categories of financial
ratios that are presented in the chapter.
Answer:
There are four categories of financial ratios discussed in the
text: short-term liquidity ratios, activity ratios, profitability
ratios, and coverage ratios. Short-term liquidity ratios are
indicators of the entity’s ability to meet its current
obligations when they become due. Activity ratios indicate
how effectively the entity's assets are managed. Profitability
ratios are indicators of the entity’s success or failure for a
given period. Coverage ratios provide information on the
long-term solvency of the entity, including the ability of the
entity to continue as a going concern.
At 31 December 2009, EarthWear has €5.890.000 in
a liability account labelled “Reserve for returns”.
The nots to the financial statements contain the
following policy: “At the time of sale, the company
provides a reserve equal to the gross profit on
projected merchandise returns, based on prior
returns experience”. EarhtWear has indicated that
returns for sales that are six months old are
negligible, and gross profit precentage for the year
is 42.5 per cent. EarthWear has also provide the
following information on sales for the last six months
of the year.
 Month Monthly Historical
Sales (€000s) Return Rate
July 73,300 0.004
August 82,200 0.005
September 93,500 0.010
October 110,200 0.015
November 158,200 0.025
December 202,500 0.032

Required :
a. Using the information given, develop an expectation for the reserve for
returns account. Because the rate of return varies based on the time that
has passed since the date of sale, do not use an average historical return
rate.
b. Determine a tolerable difference for your analytical procedure.
c. Compare your expectation to the book value and determine if it greater
than tolerable difference.
d. Independent of your answer to part C, what procedures should the
auditor perform if the difference between the expectation and the book
value is greater than tolarable difference?
 Month Monthly Historical Estimated
Sales Return Rate Returns
(€000s)
$€
July 73,300,000 0.004 293,200
August 82,200,000 0.005 496,800
September 93,500,000 0.010 935,000
October 110,200,000 0.015 1653,000
November 158,200,000 0.025 3,955,000
December 202,500,000 0.032 6,480,000
13,813,000
Gross x 0.425
Margin %
Auditor $€5,870,525
expectation
B. We can establish a tolerable difference by applying a
percentage (50-75%) to the planning materiality set for
EarthWear of €1,769,000. This results in a tolerable difference
of €885,000.
C. The expectation of €5,870,525 is approximately €20,000 less
the book value of €5,890,000. Since this amount is less than the
tolerable difference of €885,000, the analytical procedure
supports the fair presentation of the reserve for returns
account.
D. If the difference between the auditor’s expectation and the
book value is greater than the tolerable misstatement, the
auditor should consider performing the following audit
procedures:
• Review the general journal and general ledger for any
unusual entries.
• Re-evaluate the historical return rates.
• Re-evaluate the gross profit margin.
• Ask the client to adjust the books.
Arthur, independet auditor, is auditing The Home
Improvement Store as of of 31 December 2010. as with
all audit engagements, Arthur’s initial procedures are
to analyse the client’s financial data by reviewing
trends in significant ratios and comparing the
company’s performance with the industry so that he
better understands the business and can determine
where to concentrate his audit efforts. As part of
Arthur’s audit of The Home Improvement Store, he
performed analytical procedures by calculating the
following ratios and obtaining related industry data.
 The Home Improvement Store Industry
2006 2007 2008 2009 2010 2006 2007 2008 2009 2010
Quick 0.67 0.73 1.38 0.45 0.29 0.79 0.81 0.87 0.91 1.08
Ratio
Days of 62.73 75.15 82.40 84.02 80.52 82.26 79.89 86.86 84.13 75.04
Inventory
on Hand
Inventory/ 53.48% 45.51% 48.42 62.28 80.81 58.04% 56.44% 60.19% 60.92% 50.33%
current % % %
asset
Return on 16.10% 9.75% 5.70% 2.16% 6.05% 6.98% 8.87% 7.05% 5.06% 11.73%
asset
Debt to 0.02 0.07 0.47 2.36 0.72 0.44 0.31 0.56 0.53 0.57
Equity
Require :
Comapre The Home Improvement Store’s ratios with those of its
industry. You may want to reference Advanced Module 1 in this
chapter for more information regarding the ratios used in the
analytical procedure. For each ratio provided in the table above :
a. Indicate the potential risks the ratio and/or historical patterns
may present
b. Indicate one or two plausible explanations for why The Home
Improvement Store’s ratios historical patterns differ from those
of the industry.
 Total The Home Industry
Improvement Store
Quick ratio 3.52 4.46
Days of Inventory on 384.82 408.18
Hand
Inventory/current asset 290.5 285.92
Return on asset 39.76 39.69
Debt to Equity 3.64 2.41

a. Quick ratio = home improvement store has higher risk than the
industry
days of inventory on hand = the industry has higher risk than
home improvement store
inventory/current asset = the home improvement store have
higher current asset than industry
return on asset = profitability in home improvement store is
higher than industry.
Debt Ratio = home improvement store have higher risk,
because they have higher debt pressure than industry.
Reasons :


Industry have higher quantity of liquid
asset

Industry have high production amount

Home improvement store need more loan
than industry, because industry can fulfill
their funding from investor.