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• •
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An Interactive Learning Approach
SEVENTH
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•
EDITION
Mark S. Beasley
Frank A. Buckless
Steven M. Glover
Douglas F. Prawitt
Pearson
'e,vYo ..k, r,.ry
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Library o f Con gress Cataloging-in -Pu b licati on Data
Names: Beasley, Mark S.
Ti tle: Auditing cases : an interactive learning approach I Mark S. Beasley
[and three others).
Descr ip tion: Seventh edition. I Ne,v York : Pearson Education, (2019)
Identifiers: LCCN 20 17042450 I ISBN 978013442 1827 I ISBN 0 134421825
Subjects: LCSH: Auditing--Case studies. I Forensic accounting--Case studies.
Classification: LCC HF5667 .A83 18 20 19 I DOC 657 I .45--dc23
LC record available at https:// lccn.loc.gov / 2017 042450
l
18
Pearson
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ISBN 10:
0-1 3-442 182-5
ISBN 13: 978-0-13-442182-7
TA B L E O F CONTENTS
Professional Judgment ...... .. 1
Client Acceptance
1.1
Ocean Manufacturing, Inc . .. . . . . . . . . . . . .
. . 13
The New Client Acceptance Decision
Understanding the Client's
Business and Assessing Risk
2.1
Your1040Return.com . . . . . . . . . . . . . . . .
. 23
Evaluating eBusiness Revenue Recognition, Information Privacy,
and Electronic Evidence Issues
2.2
27
Apple Inc. . . . . . . . . . .
Evaluation of Client Business Risk
2.3
Asher Farms, Inc. . ....
31
Understanding of Client's Business Environment
ADDITIONAL ONLINE CASE
Flash Technologies, Inc.
. . . . . . . www.pearsonhighered.com/beasley
Risk Analysis
Professional and Ethical Issues
3.1
A Day in the Life of Brent Dorsey . . . . . . . .
. 37
Staff Auditor Professional Pressures
3.2
Nathan Johnson's Rental Car Reimbursement
. 41
Should He Pocket the Cash?
3.3
The Anonymous Caller . . . . . . . . . .
. 43
Recognizing It's a Fraud and Evaluating What to Do
3.4
WorldCom . . . . . . . .
. 47
The Story of a Whistleblower
3.5
Hollinger International .
53
Realities of Audit-Related Litigation
3.6
Wells Fargo . . . . . . . . . .
65
Assessing the Impact of Ethical Culture
© 2019 Pearson Education, Inc.
...Ill
Accounting Fraud and
Auditor Legal Liability
4.1
Enron Corporation and Andersen, LLP .... . ... . .... . ... . . 75
Analyzing the Fall of Two Giants
4.2
Comptronix Corporation . . . . . . . . . . . . . ... . .... . ... . . 87
Identifying Inherent Risk and Control Risk Factors
4.3
Cendant Corporation . . . . . . . .
. . . . . . . . . . . . . . . . . . . 95
Assessing the Control Environment and
Evaluating Risk of Financial Statement Fraud
4.4 Waste Management, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . 101
Manipulating Accounting Estimates
4.5 Xerox Corporation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
Evaluating Risk of Financial Statement Fraud
4.6
Phar-Mor, Inc. . . . . . . . . . . . .
117
Accounting Fraud, Litigation, and Auditor Liability
4.7
Satyam Computer Services Limited .
129
Controlling the Confirmation Process
4.8
Koss, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
The Sounds of a High-Fidelity Fraud
Internal Control over
Financial Reporting
5.1
Simply Steam, Co . ...... .
147
Evaluation of Internal Control Environment
5.2
Easy Clean, Co. . . . . . . . . . . .
155
Evaluation of Internal Control Environment
5.3
Red Bluff Inn &Cafe ....... .
163
Establishing Effective Internal Control in a Small Business
5.4 St. James Clothiers . . . . . . . . . . . . ..
165
Evaluation of Manual and IT-Based Sales Accounting System Risks
5.5 Collins Harp Enterprises . . . . . . . . . . . . . ... . .... . ... . 173
Recommending IT Systems Development Controls
5.6 Sarbox Scooter, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
Scoping and Evaluation Judgments in the Audit of Internal
Control over Financial Reporting
5.7
Societe Generale . . . . . . . . . . . . . . .
191
How a Low-Risk Trading Area Caused a $7.2 Billion Loss
5.8 Oilfields-R-Us, Inc . . . . . . . . . . . . .. .
.IV
199
Evaluation of Management Review Controls
© 2019 Pearson Education, Inc.
The Impact of
Information Technology
6.1
Town and Country Hardware ..... .
. . . . 209
Evaluation of Tests of Controls with Automated
Component for the Expenditure Cycle (Purchases)
ADDITIONAL ONLINE CASES
Harley-Davidson, Inc. . . . . . . . . . www.pearsonhighered.com/beasley
Identifying eBusiness Risks and Related Assurance Services for the eBusiness Marketplace
Jacksonville Jaguars . . . . . . . . . www.pearsonhighered.com/beasley
Evaluating IT Benefits and Risks and Identifying Trust Services Opportunities
CASES RELATED TO THIS SECTION
Z.1 Your1040Return.com . . . . . . . . . . . . . . . . . . . . . . . . . 23
Evaluating eBusiness Revenue Recognition, Information Privacy,
and Electronic Evidence Issues
5.4 St. James Clothiers . . . . . . . . . . . . . .
165
Evaluation of Manual and IT-Based Sales Accounting System Risks
5.5 Collins Harp Enterprises . . . . . . . . . . . .
173
Recommending IT Systems Development Controls
5.8 Oilfields-R-Us, Inc. . . . . . . .
199
Evaluation of Management Review Controls
9.Z Henrico Retail, Inc. . . . . . . . . . . . . . . . . .
269
Understanding the ITAccounting System and Identifying Audit Evidence
for Retail Sales
Planning Materiality
7.1
AnneAylor,lnc . .. .. ... . ... .. ....... .
. . . . . . . . 223
Determination of Planning Materiality and Performance Materiality
CASES RELATED TO THIS SECTION
3.6 Wells Fargo . . . . . . . .
. 65
Assessing the Impact of Ethical Culture
5.6 Sarbox Scooter, Inc. . .. . . . . . . . . .
177
Scoping and Evaluation Judgments in the Audit of Internal
Control over Financial Reporting
1Z.1 Eye Max Corporation . .
399
Evaluation of Audit Differences
12.Z Auto Parts, Inc . . .. . . . . . . . . . . . . .
405
Considering Materiality When Evaluating Accounting Policies
and Footnote Disclosures
© 2019 P<!arson Education, Inc.
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Analytical Procedures
8.1
Laramie Wire Manufacturing ..
237
Using Analytical Procedures in Audit Planning
8.2
Northwest Bank . . . . . . . . . . .
241
Developing Expectations for Analytical Procedures
8.3
Burlingham Bees . . . . . . . . . . .
247
Using Analytical Procedures as Substantive Tests
CASES RELATED TO THIS SECTION
1.1
Ocean Manufacturing, Inc. . . . . .. . . . . . . . .. . . .. . .. 13
The New Client Acceptance Decision
Auditing Cash, Fair Value,
and Revenues
9.1
Wally's Billboard &Sign Supply .. . ..... . .. . . .. . . . .. . . 253
The Audit of Cash
9.2
Henrico Retail, Inc. . ...... .
269
Understanding the IT Accounting System and
Identifying Audit Evidence for Retail Sales
9.3
Longeta Corporation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
Auditing Revenue Contracts
9.4
277
Bud's Big Blue Manufacturing
Accounts Receivable Confirmations
9.5
Morris Mining Corporation . . . . . . . . . . . . . . . . . . . . . . . . 289
Auditing Fair Value
9.6
Hooplah, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295
Applying Audit Sampling Concepts to Tests of Controls
and Substantive Testing in the Revenue Cycle
9.7
Red Pack Beer Company . . . . . . . . . . . . . . . . . . . . . . . . . . 305
Estimating the Allowance for Bad Debts
CASES RELATED TO THIS SECTION
4.7 Satyam Computer Services Limited .
129
Controlling the Confirmation Process
8.2 Northwest Bank . . . . . . . . . .
241
Developing Expectations for Analytical Procedures
8.3 Burlingham Bees . . . . . . . . . .
247
Using Analytical Procedures as Substantive Tests
.
VI
© 2019 Pearson Education, Inc.
An Audit Simulation
Planning and Performing Audit
Procedures in the Revenue and
Expenditure Cycles
10.1 Southeast Shoe Distributor, Inc. . . . . . . . . . . . . . . . . . . . . . 315
Identification of Tests of Controls for the Revenue Cycle
(Sales and Cash Receipts)
10.2 Southeast Shoe Distributor, Inc. . . . . .
. . . . . . . . . . . . . . . 333
Identification of Substantive Tests for the Revenue Cycle
(Sales and Cash Receipts)
10.3 Southeast Shoe Distributor, Inc. . . . . . . . . . . . . . . . . . . . . . 343
Selection of Audit Tests and Risk Assessment for the Revenue Cycle
(Sales and Cash Receipts)
10.4 Southeast Shoe Distributor, Inc. . . . . . . . .
. . . . . . . . . . . 351
Performance of Tests of Transactions for the Expenditure Cycle
(Acquisitions and Cash Disbursements)
10.5 Southeast Shoe Distributor, Inc. . . . . . . .
. . . . . . . . . . . . . 371
Performance of Tests of Balances for the Expenditure Cycle
(Acquisitions and Cash Disbursements)
Developing and Evaluating
Audit Documentation
11.1 The Runners Shop . . . . . . . . . . . . . . . . . . . .
. . . . . . . 383
Litigation Support Review of Audit Documentation for Notes Payable
CASES RELATED TO THIS SECTION
9.1·6 Section 9: Auditing Cash, Fair Value, and Revenues
253
Various Cases
10.1·5 Section 10: Southeast Shoe Distributor, Inc . .
315
An Audit Simulation
© 2019 P<!arson Education, Inc.
..
VII
Completing the Audit,
Reporting to Management,
and External Reporting
12.1 EyeMax Corporation ..
399
Evaluation of Audit Differences
12.2 Auto Parts, Inc. . . . . .
405
Considering Materiality When Evaluating Accounting Policies
and Footnote Disclosures
12.3 K&K, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 407
Leveraging Audit Findings to Provide Value-Added Insights
in a Manufacturing Environment
12.4 Surfer Dude Duds, Inc. . . . . . . . . . . . . .
413
Considering the Going-Concern Assumption
12.5 Murchison Technologies, Inc.
417
Evaluating an Attorney's Response and
Identifying the Proper Audit Report
12.6 Going Green . . . . . . . . .
Sustainability and External Reporting
...
VIII
. . . . . . . . . . . . . . . . . . . . . . . 42 3
© 2019 Pearson Education, Inc.
ALPHABETIC
CA S E I N D EX
7.1 Anne Aylor, Inc. . . . . . . . . . . . . . . . . . 223
5.8 Oilfields·R·Us, Inc. . . . . . . . . . . 199
3.3 Anonymous Caller, The . . . . . . . . . . . . . . 43
1.1 Ocean Manufacturing, Inc. . . . . . . 13
2.2 Apple Inc. . . . . . . . . . . . . . . . . .
. . 27
4.6 Phar-Mor, Inc. . . . . .
117
2.3 Asher Farms, Inc. . . . . . . . . . . . . .
. . 31
5.3 Red Bluff Inn &Cafe . .
163
12.2 Auto Parts, Inc. . . . . . . . . . . . . . . . . . . 405
9.7 RedPack Beer Company . . . . . . . 305
9.4 Bud's Big Blue Manufacturing . . . . . . . . . 277
11.1 Runners Shop, The . . .
383
8.3 Burlingham Bees . . . . . . . . . ..... . . 247
5.6 Sarbox Scooter, Inc. . .
177
4.3 Cendant Corporation . . . . . . . . . . . . . . . 95
4.7 Satyam Computer Services Limited 129
5.5 Collins Harp Enterprises
5.1 Simply Steam, Co... ...... . . 147
. 173
4.2 Comptronix Corporation . . . . . . . . . . . . . 87
3.1 Day in the Life of Brent Dorsey, A
. . 37
5.2 Easy Clean, Co. . . . . . . . . . . .
. 155
4.1 Enron Corporation and Andersen, LLP . . . . . . 75
12.1 EyeMax Corporation . . . . . . . . . . . . . . . 399
Flash Technologies, Inc. . www.pearsonhighered.com/Beasley
12.6 Going Green . . . . . . . . . . . . . . . . . . . 423
Harley-Davidson, Inc. . . www.pearsonhighered.com/Beasley
9.2 Henrico Retail, Inc. . . . . . . . . . . . . . . . . 269
3.5 Hollinger International . . . . . . . . . . . . . . 53
9.6 Hooplah, Inc. . . . . . . . . . . . . . . . . . . . 295
5.7 Societe Generale .
191
10.1 Southeast Shoe Distributor, Inc.:
Tests of Controls for
the Revenue Cycle . . . . . . . . 315
10.2 Southeast Shoe Distributor, Inc.:
Substantive Tests for
the Revenue Cycle . . . . . . . . 333
10.3 Southeast Shoe Distributor, Inc.:
Audit Tests and Risk Assessment
for the Revenue Cycle . . . . . . . 343
10.4 Southeast Shoe Distributor, Inc.:
Tests of Transactions for the
Expenditure Cycle . . . . . . . . 351
10.5 Southeast Shoe Distributor, Inc.:
Jacksonville Jaguars . . www.pearsonhighered.com/Beasley
Tests of Balances
for the Expenditure Cycle . . • .
371
12.3 K&K, Inc.. . . . . . . . . . . . . . . . . . . . . . 407
5.4 St. James Clothiers . . . . . . . .
165
4.8 Koss, Inc.. . . . . . . . . . . . . . . . . .
. 135
12.4 Surfer Dude Duds, Inc. . . . . . . . 413
8.1 Laramie Wire Manufacturing . . . . . .
. 237
6.1 Town and Country Hardware . . . . 209
9.3 Longeta Corporation . . . . . . . . . . . . . . . 273
9.1 Wally's Billboard &Sign Supply . . 253
9.5 Morris Mining Corporation . . . . . . .
. 289
4.4 Waste Management, Inc. . . . . . . 101
. 417
3.6 Wells Fargo . . . . . . . . . . . . . . . 65
12.5 Murchison Technologies, Inc.
. .
..
.
3.2 Nathan Johnson's
Rental Car Reimbursement . . . . . . . . . . . . 41
8.2 Northwest Bank
© 2019 Pearson Education, Inc.
. . . .
..
. . . .
..
. . . .
. 241
3.4 WorldCom . . . . .
. . 47
4.5 Xerox Corporation
. . . . . . . 109
2.1 Your1040Return.com . . . . . . . . . 23
.
IX
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PR EF AC E
Auditing Cases: An Interactive Learning Approach provides exposure to real-",orld aud it techniques
a nd hands-on lea rning fo r studen ts in both underg raduate a nd g raduate auditing courses. This Seven th
Edit ion continues our t radition of provid ing a rich learning e xperience for studen ts that c hallenges the111
to apply kno,vledge learned in the classroom and fro m traditional aud iting textbooks so they ca n develop
skills to co111plete tasks they " 'ill b e asked to do once they en ter th e accounti ng and a uditing p rofession.
NEW CASES TO THE SEVENTH EDITION
The Seventh Edition continues to feature a variety of cases that address differen t aspects of the audit. So111e are
based on real companies, " 'Jule others are disguised as "hypoth etical co111panies" in ord er to provide a "surprise
element" once they are completed. Additional cases include examples of client syste111 documentation and audit
" 'Orkpapers that students prepare and evaluate as if they are on a curre nt audit team.
CA S E
J.6
Wells Fargo
Assessing the Impact of Ethical Culture
This case features the alleged inappropriate sales culture at \¥ells Fargo Bank that
ultimately led to the CEOs 20 16 testimony in front of the U.S. Senate Banking
Committee and his subsequent resignation. T he banks audit finn " 'as challenged to
d efend its ,vork by fow· U.S. Senators, one of ,vhom included Bernie Sanders, a recent
candidate for ll.S. President.
CA S E
4.8
Koss, Inc.
The Sounds of a High-Fidelity Fraud
This case gives students a "bi rd's-eye" vie,v of the 9th-largest e111bezzlemen t fraud in
U.S. lustory, ,vhich took place at the Koss Corporation, headquarte red in Wisconsin.The
case viviclly illustrates ,vhat can happen ,vhen internal conb·ol over financial reporting
(ICFR) is lax at a public company. The case ,viii be particularly interesting for students
because n1uch of th e story of tlus massive defalcation fraud is introduced through the
" 'ords of the co111panys CEO and the individual " 'ho stole S 34 million from the co111pany,
adapted from d eposition state111ents. The case brings to life the impo rtance of effective
ICFR, " 'ith an emphasis on the Control Environ111ent, and introduces students to the
role that accountants can play as expert ,vitnesses in court cases.
CA S E
5.8
Oilfields-R-Us, Inc.
Evaluation of Management Review Controls
This case introduces students to manage111ent revie,v controls (MRCs), an increasingly
i111portant topic in practice for both manage111ent and auditors. In a MRC, members
of management revie"' key infonnation and evaluate reasonablen ess by con1paring it
to expected value, such as budget-to-actual con1parisons and revie,v of accounting
esti mates. This case helps students appreciate the importance of the e ffective design
and e xecution of MRCs, and it highlights son1e of the challenges of evaluating their
effectiveness in audits of inte rnal con trol over financial reporting.
© 2019 Pearson Education, Inc.
.
XI
Town and Country Hardware
Evaluation of Tests of Controls with Automated
Component for the Expenditure Cycle (Purchases)
6.1
CA S E
T his case introduces students to in ternal con trols ,vith an automated component that
are an increasingly impor tant topic in the practice for both 111anagemen t and audito rs.
This case helps stu dents appreciate the challenges of evaluating the effectiveness of
internal controls over financial repor ting " 'ith an automated componen t.
ADDITIONAL NEW FEATURES OF THE SEVENTH EDITION
Reflects Recent Auditing Standards
T his edition includes upd ates that reflect ne"' auditing standards issued by the AICPA's Auditing Stan dards
Board (up thro ugh SAS No. 132, The Auditor's Consideration ef an Enti9''.f Abili9' to Continue as a Goin9 Concern)
and the PCAOB'sAuditing Standards (up through AS 310 1, The Auditor's Report on an Audit ,jFinancial Statements
When the Auditor Expresses an Unqualified Opinion) . vVhen relevant , questions expose students to ne"' g uidance
con tained in recently issued auditing standards.
Updated and Re-ordered Materials and Questions
Many of the case questions have been restructured to change the nature of the topics addressed and to e xpose
students to d ifferen t issues fro111 those e xa111ined in prior editions. Many cases also have reordered questions.
Dates in hyp othetical cases have been set in calendar year 20 18 " 'ith aud it p rocedures perfon ned on the 20 17
fiscal year information and/or in terim p rocedures performed on th e 20 18 fiscal year infor mation. vVhen
appropr iate, " 'e have changed underlying data in so111e of the hypothetical cases so that the cases differ fro111
p rior editions. All of these changes reduce th e poten tial benefit of students seeking our solutions from p rior
editions of th e casebook. Fur ther, studen ts ,vho inapp ropriately access and use solutions to p rior editions are
more likely to be detected by the instr uctor.
i
SOLVING TEACHING AND LEARNING CHALLENGES
Auditing educators con tinue to look for oppor tunities to increase their e111phasis on the develop111ent of students'
p rofessional judgment, critical thinking , communication, and interpersonal relationships skills. Developmen t of
th ese skills requires a shift from passive insb·uction to active involvemen t of students in the learning process.
l lnfor tunately, curren t course materials provided by many p ublishe rs are not readily adap table to this kind of
active learning e nvironmen t, or they do not provide 111aterials that address each 111ajor part of the audit process.
T he purp ose of this casebook is to give students hands-on exposure to realistic auditing situations focusing
specifically on each aspect of the audit process.
Over 50 Cases Spanning the Audit Processes
T his casebook contains a collection of 50 aud iting cases plus a separate learning module about p rofessional
judg111ent that allo,vs the instructor to focus and deepen students' understanding in each of the 111ajor activities
performed d uring th e conduct of an audit. T hese cases expose students to aspects of the audit spanning from
clien t acceptance to issuance of an audit rep ort, " 'ith a particular focus on ho"' p rofessional judg111ent is applied
throughout the audit . Each case is primarily assigned to one of 12 iden tified aspects of an audit; ho"'ever, a
number of cases address more than one top ic. As a result, cases are cross-referenced in the Table of Conten ts so
that insb·uctors can easily p inpoint ho,v a par ticular case might be useful to address differen t audit topics. The
follo,vi ng Table of Con tents Ove1·vie,v p rovides the number of cases for each of the 12 topics.
XII
© 2019 Pearson Education, Inc.
Table of Contents Overview
•
Section
/ A d•tT •
u I op1c
1 Client Acceptance
2 Understanding the Client's Business and
Assessing Risks
3 Professional and Ethical Issues
4 Accounting Fraud and Auditor Legal Liability
5 Internal Control Over Financial Reporting
6 The Impact of Information Technology
1 Planning Materiality
8 Analytical Procedures
9 Auditing Cash, Fair Value, and Revenues
10 Planning and Performing Audit Procedures in
the Revenue and Expenditure Cycles
11 Developing and Evaluating Audit
Documentation
12 Completing the Audit, Reporting to
Management, and External Reporting
Total Cases
Primary
Cases
1
Cross-referenced Bonus Online
Cases
Cases*
1
3
6
8
8
1
1
1
2
5
4
2
1
3
3
7
5
2
1
6
50
18
3
*In addition to the SO cases included in the book, three additional cases from pr ior editions can be accessed ,ia the casebook website
(""' ""pearsonhighered.com/ Beasley).Thus, there are 53 different case options available fo r use!
Module on Professional Judgment
The casebook includes a Lear ning Module on
Professional Judgmen t that exposes students
to a professional judgmen t frame,vork and
o utlines a frame,vork of good judg111ent as
" 'ell as a nu111ber of judg111ent te ndencies
and traps that can inb·oduce bias into the
judg111ent process. Because professional
judg111ents are required throughout the enti re
audit process, from clien t acceptance to
report issuance, " 'e include an Int roduction
to Professional Judgment as an upfront
learning module rather than as an individual
case. \Ive encourage students to co111plete
this learning 111odule early in their auditing
cow·se to expose the111 to the funda111entals
of professional judgment, ,vhich they can use
as they complete the required professional
judg111ent questions in 111any of the cases
to th is edition. The professional judg111ent
questions are separately highlighted in g rayshaded sections of the Requirements section.
© 2019 Pearson Education, Inc.
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:
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ENVIRONMENT
Influences/ Biases
----:=======:=::;;;;:::-- 1
Co.ch1ng
Knowledge/ Professional Standards
Rcpnn1cd from W KPMG Profc ~ (udgm,:,n1 Fr.:imcy;nrt, Elc\·.v:mg l~lon.:il }114tll'll':m in Au.:bdng with
pcrmb.oon from KPMG LJ.P. 0 101l KPMG LLP, .:i Do:bw.m: limited li..:ibdity puu)er:thlp uid the U.S. me~
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KPMG'i; glnb.:il \\\"b i1tc <>n the !mertlo¢t .:it '"'"°'""'·lcprngun-NlryrolltlCC:UIWl.oorn.
XIII
In-Class and Out-of-Class Assignments
FLIPPED
While all of the cases can be assigned for completion as an outsid eof-c lass a ssignmen t , several of the cases are designed so that they
can be easily used as an in-class learning opp o r tunity. The
Instructor's Resource Manual p rovides several ideas of ho\v many of
the cases can be easily incorporated as an in-class activity, \vhich should
be especially helpful for instructors ,vho have "flipped" their classes.
Real-World Application
Each case p resents a number of audit related issues and decisions that help studen ts apply their audit kno,vledge
and skills to r ea l-"\vorld scenarios. A nu mber of the cases are based on actual situations involving real
companies. Others are hypothetical cases that disguise the innocen t.
DEVELOPING SKILLS FOR THE PROFESSION
For stu dents to succeed in a rapidly changing accounting and auditing profession, they need to be skilled at
th inking critically and analytically, \vhile re111aining open and flexible to life-long learning and developmen t.
Auditin9 Cases: An lnteraciire Learnin9 Approach provides an effective platfon n to help studen ts build a strong
toolkit of skills that \viii increase their career success. Here are so111e of the ,vays this casebook helps strengthen
th eir abilities for careers in the accounting and auditing p rofession.
Critical Thinking
:
-0 --ili1l ---
All of the cases p resen t realistic issues and challenges that auditors face eve1·y day in the
engage111ents they perfon n . Because of that, each case presents scenarios that require
stu dents to think critically about identifying the issue at hand and then deten n ining ho"'
to respond in a \vay that \vould be appropriate in an audit engage111ent setting Many of
the cases p resent dilemmas that highlight the realities of th e complexities students " 'ill
face " 'hen in their professional careers. Co111pletion of these cases " 'ill help students
develop and 111ature their critical thinking and analytical skills.
Hands-on Application
All cases engage studen ts in applyi ng their kno,vledge and skills in a hands-on learning
envi ron111ent. For some cases, studen ts revie\v client generated documentation ,
co111plete actual audit program procedures, and p repare and evaluate audit working
papers. Other cases require students to conduct lnte1·net based research si111ilar to ,vhat
might be required in an audit to locate guid ance in professional stan dards or to access
relevant financial statemen t filings ,vith the U.S. Securities and Exchange Commission.
Communication Skills
•
..
0
Team-Based and Individual Assignments
•
•
•
.,. 1'
:
A number of the cases require studen ts to p repare ,vritten responses in memorandum
o r report format. The Instructor's Resource Manual con tains a number of differen t ideas
for structw·ing assignments to have students develop their " 'r itten communication skills.
:
~
·.
888
XIV
All of the cases are designed so that students can complete the111 either in teams or
individually.T he lnsb·uctors Resource Manual con tains a number ofdifferent suggestions
for assigning the cases as g ro up or individual assignments.
Photo Credit: Crcati\'c StaU/Shuncrstock
© 2019 Pearson Education, Inc.
INSTRUCTOR TEACHING RESOURCES
The accompanying Instructor Resource Manual c learly illustrates the different instructional approaches available
for each case (e.g., exa111ples of cooperative/active learning activities and/or o ut-of-class individual or g ro up
assign111ents) and efficiently prepares the instructor for leading interactive discussions. The Instructor Resource
Manual contains rich solutions to help instructors pinpoint th e relevan t issues that are the focus of each of the
cases. To access this 111anual, log on to:
www.pearsonhighered.com/Beasley
We are p leased to provide this updated Seventh Edition and hope that the professional skills of your studen ts
,vill be e nhanced through co111pletion of cases con tained " 'ithin this edition.
ACKNOWLEDGEMENTS
The authors appreciate th e assistance of Bran t Christensen and Jacob Smith in assembling materials for so111e
of the cases. We also ,van t to express our sincere g ratitude to Jonathan Liljegren for his incredible ,vork in the
d esign and assembly of th e entire casebook and instructor resources. We are g rateful for his professionalism
and eye for detail. Finally, ,ve thank our fanulies " 'ho are al"'ays supportive of our effor ts and ,vho allo,v us to
pw·sue these kinds of c reative oppo rtunities.
ABOUT THE AUTHORS
Mark S. Beasley, PhD, CPA
Mark Beasley is the Deloitte Professor of Enterp rise Risk Manage111ent
and Professor of Accounting in the Poole College of Manage111ent at Nor th
Carolina State University. He has taug ht underg raduate and g raduate audit ing
cow·ses and has received several teaching a,vards including membership in NC
States Acade111y of O utstanding Teachers. He has extensive p rofessional audit
exp erience ,vith the predecessor firm to EY and has extensive standards-setting
exp erience ,vith " 'orking ,vi th the Auditing Standards Board as a Technical
Manager in the Audit and Attest Division of the AI CPA. He served over seven
years as a me111ber of the COSO Board, represen ting the AAA. He has coautho red over 90 articles, books, and research monographs.
Frank A. Buckless, PhD
Frank Buckless is the KPMG Professor and Department Head of Account ing
in the Poole College of Management at North Carolina State l lruversity. He
has taug ht underg raduate and g raduate auditing and cur rently trains audit
p rofessionals " 'itl1 KPMG. He also has been a co-instructor for the Audit
Sections Audit Educator's Bootcamp. Frank ,vorked professionally as an
auditor ,vith Arthur Andersen & Co. He has authored nu111erous articles and
books and ,vas the 2016 recipien t of the Amer ican Accounting Association's
Innovation in Accounting Education A,vard.
© 2019 Pearson Education, Inc.
xv
Steven M. Glover, PhD, CPA
Steve Glove r is the K. Fred Skousen Professor and Associate Dean of the
Marriott School of Manage ment at Brigham Young University. He has taught
undergraduate and graduate auditing courses and g raduate courses on a
judg111ent and decision-n1aking. Steve has significant audit experience ,vith
KPMG and P,vC and he continues to consult ,vith public accounting firms
and as a subject matte r exper t in litigation and restatements. Steve is on the
Auditing Standards Board of the A!CPA and is past President of the Auditing
Section of the Amer ican Accounting Association (AAA). Steve has published
numerous articles and books and is a co-author on leading monographs,
including Eleratin9 Pr,jessional Jud9ment in Auditin9 and Accountin9: The KPMG
Prefessional Jud9ment Framell'ork, " 'h.ic h received the AAA Deloitte/vVildman
Medal a,vard recognizing the published " 'Ork making the most significant
con tribution to the advancement of the practice of p ublic accountancy over a
period of 5 years.
Douglas F. Prawitt, PhD, CPA
Doug Pra,vitt is the McAllister / Deloitte Professor of Accountancy at BYU.
His research and teaching in BYUs graduate accounting and MBA programs
focus on financial statement auditing and professional judgment. Doug has
published a,vard-,vinrung articles in top p ractice journals and has co-autho red
t,vo leading auditing textbooks. His research has been published in pre mie r
acadenuc journals, including TheAccountin9 Review,Journal ,jAccountin9 Research,
and Contemporary Accountin9 Research. Doug has " 'On several research, teaching,
and "best researc h paper " a,vards , including the 2013 AAA/Deloitte Wildman
Medal A"'ard recognizing the publication over a five-year ti111e span most likely
to positively impact the public accounting p rofession, the 20 16 BYU Marriott
School Outstanding Faculty A",ard, and the American Accounting Associations
2016 Outstanding Accounting Educator A,vard. Doug is active in the p rofession,
having served a three-year term as a 111e111ber of theA!CPAsAuditing Standards
Board, and cw-rently serves as a member of the COSO Board. He also serves as
an expe r t ,vitness in high-profile auditing cases and consults ,vith a variety of
p rofessional services firms , large and s111all .
.
XVI
© 2019 Pearson Education, Inc.
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I NTRODUCT I ON
Professional Judgment
Understanding and Developing Professional Judgment
in Auditing and Accounting
Mark S. Beasley , Frank A. Buckless , Steven M. Glover , Douglas F. Prawitt
THE IMPORTANCE OF PROFESSIONAL JUDGMENT IN AUDITING AND
ACCOUNTING 1
As you p repare for a professional career, have you ever " 'ondered ,vhat character istics distinguish an exceptional
p rofessional from one ,vho is just average? One key distinguishing feature is the ability to consistently make
high-quality professional judgments. Professional judg111ent, ,vhich is the bedrock of the accounting and auditing
professions, is referenced throughout the professional literature. In so111e of your accounting or auditing classes,
you 111ay have had an instructor respond to a question ,vith the classic ans"'er, "That depends; it is a 111atter of
professional judgment."This is often true in auditing, but it is not overly satisfying to a student " 'ho ,vonders
exactly " 'hat good professional judg111ent looks like, or ho"' he or she can develop the ability to make good
p rofessional judg111ents. The purpose of this module is to provide a very br ief ove1-vie,v and introduction to
help you understand ,vhat a good professional judg111ent process looks like, make you a,vare of con1n1on ilireats
to exercising good judgment, and give you a head start in developing and i111proving your o,vn p ro fessional
judg111ent abilities.
A common question people have is, "Can you really teach good judgment?" Many believe that it is a
gift; eiilier you have it o r you do not. Others ,vould say you cannot teach good judgment; rather, it must be
d eveloped through tile "school of hard knocks" after 111any years of experience. There is no question that talent
and exper ience are i111por tant components of effective p rofessional judg111ent, but it is p ossible to enhance your
professional judg111ent skills through learning and applying some key concepts. As ,vith other important skills,
the sooner you start learning ho,v to make good professional judg111ents, the better- ,vhich is " 'hy KPMG
made a very significant investment of time and resources to p roduce tile monograph from ,vhich this 111odule
is adapted to help tile next generation of professionals get a head start on developing p rofessional judgment.
Research in the areas of judgment and decision making over tile last fe,v decades indicates iliat
additional kno",ledge about common threats to good judgment, together ,villi tools and processes for 111aking
good judg111ents, can i111prove the professional judgment abilities of boili ne,v and seasoned professionals.W iili
the movement in financial repor ting tO"'ard more principles-based standards and more fair value measurements,
e xerc ising good professional judg111ent is increasingly i111por tant for auditors. While this 111odule contains a
brief overvie, v of some of the 111ost important topics, KPMG's full 111onograph contains considerably more ind epth infon nation about professional judgment in auditing, including additional coverage of judg111ent traps
and biases, judgment in g roups, and other topics. That n1onograph is titled Elerating Prefessional Judgment in
Auditing and Accounting: The KPJ11G Prefessional Judgment Framework; it is available ,vithout c harge at http: I /w,nv.
kpmguniversi9,conneaion. com .
l This Profc:s...,ion.al Judgment Introduction is adapted from Th~ KP.IIG l'r'!fessJonal Jud9menc FrammY>rk: Elerat1n9 fr'![eJSlMal Jud9men1 Jn Audltln9 and is indudcd with
this c-.tscbook with pcrmiss:ion from KPMC, Ll.P. Cl 20 13 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMC network of
independent member 6rms affiliated. with KPMG International Cooperative ("KPMC lntcmational"), a Swiss entity.AUrights rcscn-cd.
AU informatio n prm·idcd is of a general nature and is not intended to address the circumstances of any particular individual o r entity. Although we e ndeamr to
proi.-ide accurate and time~· information, there can be no guarantee that such information is accurate as of the date it is received o r that it will continue to be
accurate in the future. No one should act upon such information w itho ut appropriate professional advice after a thorough examination of the facts of a part icular
situation. For additional news and information, please access KPMG's global Web site on the Internet at www.kpmguniversityconncction.com.
© 2019 Pearson Education, Inc.
1
lntrocludlon I Professional Judgment
A MODEL OF A GOOD JUDGMENT PROCESS
Let's star t "'ith a con1mon definition of judg111ent: Jud9ment is the process <?f reachin9 a decision or drawing a
conclusion where chere are a number efpossible a/cernatil'e solutions.2 Judg111ent occurs in a setting of uncertainty and
risk. In the areas of auditing and accounting, judg111ent is typically exercised in tlu·ee broad areas:
• Evaluation of evidence
•
•
(e.g., does the evidence obtained fro111 confirmations, co111bined ,vith
othe r audit evidence, p rovid e sufficien t appropriate audit evidence to determine ,vhether accounts
receivable is fairly stated)
Estimating probabilities (e.g., deten n jning "'hether the p robability-,veighted cash Ao,vs used by a
company to d etermine the recoverab ility of long-lived assets are reasonable)
Deciding between options (e.g. , audit p rocedure choices, such as inquiry of manage111ent ,
inspection, or confin nation)
O f course, ,ve d o not need to invest signi ficant ti me or effor t ,vhen 111aking easy o r trivial judgments.
Ho,vever, as the judgments beco111e more impo rtant and n1ore difficult, it is helpful to have a reliable, tested
frame,"ork to help gwde our judgmen t p rocess. KPMGs Professional Judg111ent Fra111e,vork is an exa111ple of
such a frame,vork. Follo"'ing a good p rocess , viii not make hard judg111ents easy o r ahvays g uaran tee a good
o utco111e, but a ,veil -grounded process can improve the quali ty of judgmen ts and help auditing p rofessionals
more e ffectively navigate tlu·ough co111plexity and uncer tainty.
In th e figure belo"', you ,viii see the KPMG Professional Judgmen t Frame"'ork.The Frame,vork includes
a nu111ber of con1ponents, such as mindset, consultation, kno,vledge and p rofessional standards, influences and
biases, reflection, and coaching. At the core of the Frame,vork, you " 'ill see a five-step judgmen t process.
ENVIRONMENT
--;;;::::::::::::::::::=:=:=:::::==::=~=----l~n~fluences/Biases
Coaching
Clarty
Issues &
Gather &
Evaluate
Knowledge/Professional Standards
R.t:pr1t1Lt:d from the KPMG Profo-.n:il Ju.:lpn1 Ft.:imt'Y.'Ort: E~\~tmg Prof~ (llllg:mt,:lt it! Auditmg "'itb pennl~ from KPMG LLP. 0 2013 KPMG LI.P,.:i [)('bw~t lunited lubllny p,u-iotrdlip
.11)(1 the US.. member hrm oft.he Kl'MG l)e:'l\\'t•rk flfit1d.:pcnd,:n1 memhcr 6mu .:ilnb..ucd wM KPMG ln1ern:m.:,n.:il Cooper.ul\'t rKPMG lntenul.ic,n:il), .:i s..iu entity.All tighu - ~
For 11ddition.:iJ nc...~ .:ind mform,uMWI, p!uiae 11cct:H KPMG'$ glolMJWd, inc (IU the ln1cmc1 .u www.kpmgunfrcrinyooancctfon..com.
2 Making judgments can be distinguished from making decisions. Decision making im·ol\'cs the act o f choosing among options or altcrnati\'cs, while
judgment, according to \Vcbstcr's l l th, in\'oh-cs ..the proccs.<.: of form ing an opinion or c\'aluat ion by discerning and comparing."Thus, judg ment is a subset
of the process of decision making - man\' judg ments arc typically made in coming to a decision. Howe.Yer, for simplicity in t his module, we often refer to
the combined. processes of judgment and decision making as "judgment;' .,profess ional judgment," o r ..making judg ments."
2
© 2019 Pearson Education, Inc.
Professional Judgment I Introduction
Take a n10111ent to examine the steps in the process at the cen ter of the frame,vork. These steps are
rathe r si111ple and intuitive. Ho"'ever, " 'hile the KPMG Professional Judg111ent Frame"'Ork provides a good
representation of the process ,ve should follo,v ,vhen applying professional judgment, but it is not necessar ily
an accw·ate representation of the processes people follo,v consistently. The reality is that in a " 'orld of pressure,
time consb·aints, and linuted capacity, there are a nu111ber of judg111ent traps ,ve can fall into. In addition, " 'e can
be subject to biases caused by self-interest o r by unkno,vingly applying men tal shortcuts.
The Professional Judg111ent Fra111e,vork d epicts constraints, inAuences, and biases that threaten good
judg111ent ,vith the box on the outer rim of the Frame,vork labeled "Environmen t" and th e triangle at the top
labeled "InAuences/Biases." At th e bottom of the Professional Judgment Frame,vork, you ,viii see Kno,vledge
and Professional Standards, as these factors are foW1dational to quality judg111ents. These are e nvironmental
inAuences that can affect professional judg111ent. Th e "ribbon" of coaching and reAection runni ng through the
Fra111e"'Ork is of g reat importance to the developmen t of p rofessional judgmen t in young professionals. In the
next section of this module, ,ve ,viii highlight common judgmen t tendencies and th e associated biases that can
inAuence auditor judgmen t.
At the very center of the KPMG frame,vork is "mindset." It is i111portant that aud itors approach matters
objectively and independently, " 'ith inquiring and incisive minds. Professional skepticism, ,vhich is required by
p rofessional auditing standards, is an objective attitude that includes a questioning nund and a c ritical assessment
of aud it evidence. Professional skepticism is not synonymous " 'ith p rofessional judgmen t, but rather, it is an
important componen t o r subset of professional judg111ent. Professional skepticism helps to frame our "nundset."
Finally, ,vTapping aro und "nundset" in the Frame"'ork is "consultation." At professional services firms
like KPMG, consultation ,vith others, including engagemen t tea111 members, specialists, o r other professionals,
is a vital part of 111aintaining consistently high judgmen t quality and enhancing the exercise of appropriate
p rofessional skepticism.
TRAPS THAT CATCH US IN THE EARLY STEPS
OF THE JUDGMENT PROCESS
As ,ve mentioned earlier, in reality peop le often do not folio"' a good process due to con1n1on judg111ent traps
and tendencies that can lead to bias. These traps and tendencies are systematic- in other " 'ords, th ey are
common to 111ost p eople, and they are p redictable. Some of these tendencies are judgmen t "shortcuts" that help
simplify a complex ,vorld and facilitate more efficient judgmen ts. These sho rtcuts are usually quite effective, but
because they are sho rtcuts, they can lead to systematically biased judg111ents. As a simple illustration of ho"' our
mental p rocesses that no rmally serve us ve1·y ,veil can sometimes lead to bias, consider "optical illusions" you
may have seen on the internet. 3 Our eyes and related perceptual skills ordinarily are quite good at perceiving
and helping us to accurately judge shape similar ity. Ho,vever, optical illusions can p redictably and syste111atically
fool our eyes. Just as " 'ith perceptual biases, there are times ,vhen our intuitive judg111ent falls prey to systematic
traps and biases. Research provides convincing evidence that even the smar test and most experienced people
similarly fall in to predictable judgmen t b·aps and biases.
The "Rush to Solve." One of the most common judg111ent traps is the tendency to ,vant to immediately
solve a problem by making a quick judg111ent. As a result, ,ve W1der-invest in the i111por tant early steps in the
judg111ent process and often go ,vith tl1e first ,vorkable alternative that co111es to mind o r that is presented. As a
result of the rush-to-solve trap, ,ve so111etimes end up solving the " 'rong problem, o r ,ve settle for a suboptimal
o utcome because " 'e did not consider a full set of alternatives.
Judgment Triggers: Solving the Wrong Problem. Consider the follo,ving example. T,vo snack food
companies are competi ng for 111arket share-let's call the m Ax Snack Company and Bobb Goodies Inc. Bobbs
e xecutives " 'ere convinced that Ax's competitive advantage ,vas attributable to the companys distinctive, highly
recognizable individual snack packaging design. T he individual snack pac kages seemed to dra,v custo111ers to
the products. So, Bobbs executives determined that to gain market share, they ,vould need to d evelop individual
3 KPMC's Professional Judgment student monograph contains illustr.itions. audio files, and links to internet files that ,·ividly iUustr.ttc many of the
concepts introduced in this module .
© 2019 Pearson Education, Inc.
3
lntrodudlon I Professional Judgment
package d esigns that ,ve re equally d istinctive. They spent millions on improved packaging appearance for their
snack foods to co111pete against Axs distinctive packaging. When increased 111arket share did not follo,v, Bobbs
e xecutive team realized that they kne,v relatively little about ,vhat customers really " 'anted and ,vhat drove the
consumption of their snack foods. Bobb's executives d ecid ed to conduct 111arket research, and along the ,vay, they
discovered an important and some,vhat unexpected aspect of consu111er behavior: regardless of the quantity of
product they p laced in a ho111e, it " 'ould be consu111ed in relatively short order. Thus, Bobb's executives clarified
the d ecision p roblem as "ho,v to get larger quantities of snack p roducts into consumers' homes." Accordingly,
they focused less on the appearance of individual snack packages and instead introduced bulk packaging that
made it easier and n1ore convenient to get n1ore snacks into consumers' ho111es. The resulting gain in 111arket
share ,vas dra111atic.
This exa111ple illustrates one of the biggest traps ,ve run into dw·ing the first couple of steps of the
judg111ent process, ,vhich is under -investing in defining the funda111ental issue. In the example above, Ax Snack
Company's distinctive packaging functioned as ,vhat could be called a judg111ent trigger, or an assu111ed or
inherited issue that can lead the decision 111aker to skip the c rucial early steps in the judgment process. It caused
Bobb Goodies' executives to focus, at first, on the ,vrong issue or problem. Judgment triggers can often be
recognized " 'hen a particular alternative is used to d efine the p roblem in place of a ,veil thought-out proble111
d efinition. Often, the b·igger comes fro111 the ,vay oth ers have defined the issue, ,vhich is often fonnulated in
terms of one potential solution. Alte1·natively, ,ve may create triggers ourselves because ,ve are in such a hurry to
"solve" or to be decisive. Judgment triggers often lead to judg111ents made on incomplete facts or W1derstandings.
Ho,v nught you overco111e the ve1·y common trap of skipping the first couple of elements in the judg111ent
process that comes about tlu·ough the r ush to solve or tlu·ough judg111ent triggers?The ans"'er is to ask '\vhat"
and '\vhy" questions. For exa111ple, you might initially ans,ver a '\vhat" question regarding retirement goals " 'ith,
"I " 'ant to have a certain a111ount of n1oney in a retire ment fund." That certainly is a ,vorthy objective, but as
" 'ith many initial objectives, it is only a means to an end. Follo,ving up by asking ,vhy you ,vant a certain amount
of n1oney can help you uncover the mo re fundamental objective, ,vhich nught be sometlung like, "to 111aintain
a high quality of life in retirement." Note that by clarifying the objective in this ,vay, a number of additional
approaches to achieving a high quality of life co111e to nund (such as good health, no d ebt, cost of living, location,
availability of outdoor recreation, etc.). Carefully clarifying W1derly;ng objectives by asking '\vhy" is a key step
in making important judgments.
It often does not take a lot of ti111e to consider the first step in the judg111ent process, but the mo re
important the judgment, the mo re i111por tant it is to invest in clarifying tl1e fW1damental issues and objectives.
A little extra investment in clarifying the issue and objectives " 'ill almost al,vays pay off, someti111es in a big ,vay.
One very po"'erful ,vay to improve your professional judgment is to 111ake sure you are not accepting a judgment
trigger in place of a solid problem definition, but rather that you are taking time to ensure your proble111
definition is complete and cor rect.
PROFESSIONAL SKEPTICISM AND "JUDGMENT FRAMING"
As noted previously, at the center of the Frame"'ork is "mindset." Professional skepticis111 helps to appropriately
frame an auditor's mindset. Essential to an auditor's ability to effectively question a client's aCCOWlting choices
is a funda111ental but po,verful concept called "judgment framing."This concept relates to the early steps in the
judg111ent process. The definition of franung follo,vs: Frames are mental srruciures char we use, usuallj• subconscious!J,
co simplify•, or9anize, and 9uide our underscandin9 efa situation. They shape our perspectives and determine the ieformacion
char we will see as rele,,anc or irrele,,anc, important or unimportant. Fra111es are a necessary aspect of judgment, but
it is important to realize that our judg111ent fra111es p rovide only one particular perspective. This is similar to
looking out one , vindo,v of your ho me -it provides one vie,v that might be quite different fro111 the vie,v
through another " 'indo"' facing a diffe rent direction.
Fra111es are necessary and helpful, but the proble111 is that ,ve often are not a,vare of the perspective
or fra111e " 'e are using. Also, our frame can blind us to the fact that there are other valid perspectives. In other
" 'Ords, frames help us make sense of tlungs but they also 111ake it difficult for us to see oth er vie,vs. By being
proactive in our use of judg111ent fra111es, ,ve can improve ho,v ,vell ,ve do ,vith the initial steps in the judgment
4
© 2019 Pearson Education, Inc.
Professional Judgment I lntrocludlon
p rocess: clarifying issues and objectives and considering alternatives. This is important because a disting uishing
character istic of professionals "'ho consistently exercise sound judg111ent is that they recognize the judg111ent
frame th ey are using, and they are able to consider the situation through different fra111es, o r " 'hat KPMG
p rofessionals re fer to as a "fresh lens." Sounds si mple enough, but it is not ahvays easy to do! The concept of
judg111ent framing is impo rtant because appropriately questioning manage111ent's pe rspective by vie,ving the
situation through o ther fra111es is fundamental to professional skepticis111.
For exa111ple, suppose the results of a substan tive analytical procedure suggest that a clien t's allo,vance
for doubtful accounts is underst ated.The auditors approach to gathering fur ther audit evidence ,vill be different
if th e results are framed in the conte xt of a change in business condition o r a c hange in the clients credit policy
as compared to an indicato r o f a likely e1-ro r.Tlus is not to say one frame is necessarily better than the othe r, but
the auditor can boost his o r her professional skepticis111 by considering both fra111es.
A key characteristic of those ,vho make high-quality judgments is that they are fra111e-a"'are.They kno,v
ho"' to seek and consider d ifferent fram es to get a fuller p icture of the situation. Seasoned, e xperienced auditors
d evelop tlus ability and apply it in situations ,vhere they need to help client management see an alte1-native
vie"'pOint on an i111por tant accounting issue. For example, an alternative frame tl1at auditors nught use could be
an investor o r analyst perspective, o r a regulator p erspective. O r it nught be a "hi ndsigh t" perspective-in o ther
" 'ords, ho,v " 'ill management's judgmen t look if a regulator later questions it, o r if it is repor ted in the p ress in
six months?Wlu le exper ienced auditors are typically quite skilled at challenging frames and considering issues
from different perspectives, this is an area " 'here audito rs enter ing th e profession typically need i111provemen t.
JUDGMENT TENDENCIES THAT CAN RESULT IN BIAS
Peoples' judg111ents can be unin tentionally biased due to un derlying self-interest or because they unkno,vingly
use men tal shortcu ts. For the most part, the shortc uts ,ve use are efficien t and often effective, but in certain
situations, they can result in systematic, predictable b ias. Keep in nund that the tendencies o r shortc uts ,ve " 'ill
discuss are si111plif)'ing judg111ent strategies or rules of thumb that ,ve have unkno"'ingly developed over ti111e
to help us cope " 'ith the co111plex environments in , vhich ,ve operate. T hey are efficien t and often effective, but
because they are shortcu ts, tl1ey can lead to lo,ver quality judgmen t in some situations. Heres a quick example
of a simplifying shortcut.Wllen c rossing a city street, say in Ne",York City, so111e people d on't ,va.it until they get
a ""'alk" sign; rathe r, th ey move throug h intersections by quickly looking to the left for onconung traffic. If the
coast is c lear, they , vill take a step ou t into th e street and then look to the rig ht for traffic conung the other ,vay.
Tlus is a very efficient and often effective shor tcut st rategy. Over ti me, it can beco111e an unconscious, automatic
par t of ho,v people cross the street in a busy c ity. Ho,vever, if ,ve ,vere to use this shortcut strategy in London,
" 'here they drive on tl1e oth er side of the street, it could result in a very bad ou tcome. Even in Ne,v York City,
the shortcut can lead to a bad outcome if applied to all streets, since there are one-, vay streets that come from
the othe r direction.
Similarly, the judg111ent shor tcuts ,ve commonly use are efficien t and generally effective. Hov,ever, the re
are situ ations " 'here the use of a shortcut can predictably result in a lo,ver quality o r b iased judgment. The
good ne,vs is that once " 'e understand the implications of a sho rtcut , " 'e can d evise ,vays to nutigate potential
bias resulting from the shor tcut .vVhen it comes to crossing the street in London, transpor tation officials have
d evised rather ingenious ,vays to reduce the p otentially serious consequences of using the "American" shor tcut
to start across the street looking first only to the left. Th ey have placed signs on the sid e,valk, on signposts, and
even on the street, reminding visiting p edestrians of the direction of t raffic Ao"'·The signs are an attempt to get
visitors out of th e subconscious shor tcut mode and apply mo re formal thinking, " 'hich is pretty importan t for
the ,veil -being of American to urists in London.
vVe " 'ill briefly in troduce four con1n1on judgmen t tendencies that are n1ost applicable and i111por tant
for audit p rofessionals: the availability tendency, the confin nation tendency, th e overconfidence tendency, and
the anchoring tendency.
The
availability tendency is defined
as: The tendency far decision makers to consider ieformation chat is
easi[y retrie,,ablefrom memo,y as being more likelj11 more re/e,,ant, and more important far a jud9ment.
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lntrodudlon I Professional Judgment
In other ,vords, the information that is most "available" to our me111ory 111ay unduly inAuence esti111ates,
p robability assessmen ts, and oth er professional judgments. Like other men tal shortcuts, the availability tendency
often se1-ves us ,veU, but it has been sho"'n to introduce bias into business and audit judgments. For example,
an auditor 111ay be inclined to folio"' the app roach used in a pr ior period or on a recent engagement even if
th e approach is not the best for the c urrent engage111ent . Th is tendency is esp ecially po"'erful if the app roach
" 'orked ,veU o n the p rior engagemen t.
The confirmation tendency is defined as: The tendencyfor decision makers to seekfor and put more wei9ht
on ieformation that is consistent with their initial beliefs or preferences.
You may have heard the old joke, "My nund is made up; don't confuse me " 'ith the facts!" Hundred s
of years ago, leading philosophers recognized that once people have adop ted a p reference or an op inion, they
tend to consider and gather inforn1ation that supports and agrees ,vith their p reference. Research in psychology
backs this up: p eople tend to seek confin natory evidence, rather than looking for something inconsisten t ,vith
th eir opinions o r p references. After receiving this confin natory evidence, decision make rs often are confident
that they have adequate evidence to suppor t their belief. The mo re confi rmatory evidence they are able to
accumulate, the more confident they become. Ho"'ever, in many instances, " 'e cannot kno,v so111ething to
be b-ue unless " 'e explicitly consider ho"' and ,vhy it may be false. As an example of the confin nation bias in
auditi ng , research and revie"'S of " 'orking papers find that auditors 111ay be p rone to over rely on manage111ent's
explanation for a significant difference bet,veen th e auditor's expectation and manage111ent's recorded value,
even ,vhen the cl ients explanation is inadequate.
The
overconfidence tendency is defined as: The tendency for
decision makers to overestimate cheir own
abilities to peiform tasks or co make accurate dia9noses or other jud9ments and decisions.
When g roups of people are asked to assess their o,vn abilities, ,vhether in auditing o r in driving a car,
a majority of the participan ts assess themselves as above average relative to the g roup being surveyed. But, of
course, it is not possible for all par ticipants to be above average. This is a simple illustration of the fact that
many of us are overconfident in our abili ties an d, as a result, ,ve often tend not to ackno",ledge the actual
uncer tainty that exists. Overconfidence is a subconscious te ndency that results from personal motivations
o r self-interest. Importantly, this tendency to be mo re confiden t than is justified is likely to affect us even
" 'hen ,ve are d oing our best to be objective. Researc h indicates that many people, including very experienced
p rofessionals, are consisten tly overconfiden t " 'hen atte111pting to estimate o utcomes or likelihoods. Stud ies
involving p racticing auditors de111onstrate that aud itors may be overconfident in thei r technical kno,vledge and
th eir competence in auditing risky areas. In addition, par tners and 111anagers may be overly confident in the
abili ty of less experienced people in completing complex tasks. Conversely, associates and senior associates may
be overconfiden t in the competency of mo re experienced auditors to complete lo,ver -level tasks that they aren't
accustomed to pe1-fornung on a regular basis. Such overconfidence can lead to a variety of subopti111al outcomes
in auditing , including neglecting to ask for needed help or g uidance, failing to acquire needed kno",ledge, poor
task performance, budget overruns, assignmen t of audit tasks to underqualified subordinates, and un derrevie,v
of subordinates' ,vorking pap ers.
The anchoring tendency is defined as: The tendency efdecision makers to make assessments by starcin9jrom
an initial numerical value and then to adjust in.n1Jiciently awayjrom chat initial value in formin9 a final jud9ment.
To illustrate the anch oring tendency, managers often make salary d ecisions by adjusting fro m the starting
poin t of an employee's previous salary. A p rospective e mployer might quickly realize the unreasonableness of the
anchor (e.g., her p revious e mployer only paid her S48,000 before she earned an MBA degree), but p roposes a
sta rting salary irrationally close to the star ting po int, o r anchor. So, in this example, the job applicant is likely to
receive a lo,ver salary offer if the prospective employer kno,vs her salary before she earned her MBA. There a re
t,vo componen ts of anchor ing and adjust111ent- the tendency to anchor o n an initial value and the tendency
to make adjust111ents a,vay from that initial value that are smaller than " 'hat is actually justified by the situation.
The anchoring tendency clearly has direct relevance to auditing in many settings. For example, manage111ent's
estimate or unaudited account balance can serve as an anc hor.The auditor is c harged " 'ith o bjectively assessing
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Professional Judgment I lntrocludlon
the fairness of an account balance. But if his or her judg111ents are influenced by th e a111ount asser ted by
manage111ent in an unaudited account balance, that objectivity might be comp ro mised. In o ther " 'Ords, the
auditor might beco111e an chored to manage111ent's estimate.
MITIGATING THE EFFECTS OF JUDGMENT BIASES
The most i111por tant step in avoiding judgment traps and reducing bias caused by subconscious men tal shortcuts
o r self-interest is "a,vareness." By better understanding traps and biases, and recognizing con1n1on situations
" 'here they are likely to p resent themselves, ,ve can identify potential p roble111s and often formulate logical
steps to improve o ur judgmen t. If ,ve don't have any idea ,vhere the con1n1on judgment traps are, o r ,vhere " 'e
are likely to be systematically biased, ,ve do not even have a starting poin t. As ,ve said earlier, son1e of the most
serious judg111ent traps have to do ,vith the failure to folio"' a judgment process. In othe r ,vords, ,ve might be
influenced by a judgment trigger, solve the ,vrong p roblem, fail to clarify our objectives, o r push too quickly
through the initial steps in the judgmen t process because ,ve ,vant to quickly arrive at a solution or conclusion.
In terms of mitigating bias, the first step is to recognize si tuations " 'here " 'e might be vuln erable. A,vare ness,
coup led " 'ith the ten n ino logy to identify and label the potential traps and biases, is key to i111proving judgment.
In fact, research e xploring nutigation techniques suggests that si111ply p roviding instructions to decision 111akers
about the seriousness of a bias can reduce the e ffect of th ese biases.
vVlu le a tho rough discussion of poten tial ",ays to mitigate b iases is beyond the scope of this p ro fessional
judg111ent introduction, here are a fe,v examples. Actively questioning our assumptions, ,vhich nught include
considering p otentially disconfirming evidence o r seeking more co111plete infon nation, is a key approach in
mitigating all of the judgment b iases. Consulting " 'ith others can go a long ,vay to,vard nutigating the e ffects
of the availability tendency. Getting an ou tside vie,v on a going-concern uncer tainty assess111ent can help keep
the auditor's judgment fro111 being too opti mistic, or pessinustic, given recent, salien t e xperiences. In other
judg111ent and decision tasks, a help ful approach is to ask othe rs to gather and evaluate information ,vithout
revealing our preference.We " 'Ould not ,vant to reveal o ur p reference to others before getting their perspectives
because o ur p reference may affect th eir judgmen t just like it may affect our O"'n. Vl/'e can also take steps to
o bjectively evaluate th e p ros and cons for each alternative. In nutigating bias related to the an cho ring tendency,
it can be helpful to seek out and explicitly consider alternative anchors.
The bottom line is that ,ve need to realize " 'here and ho,v ,ve 111ay be biased in order to develop simple
approaches for mitigating the effects of those biases. And the good ne,vs is that once you are a"'are of traps
and biases, the 111itigation approach often is a matter of applying logic and common sense. Bias-n1itigation
techniques are impor tan t, but just as impo rtant in avoiding traps and mitigating b ias is to bake the steps of good
judg111ent , such as those p rovided in the KPMG Pro fessional Judgment Frame"'Ork, into your judgment-n1aking
p rocess.Thoughtfully applying the steps of a judgment process can in itself mitigate b ias.And, finally, in auditing,
the requiremen t to conclude and document provides the auditor the opportunity to carefully reconsider the
p receding steps of good judgment and th e possibility that judgmen t traps o r b iases may have influenced the final
conclusion.
CONCLUSION
Professional judgmen t is an increasingly i111por tant subject in accounting and auditing. As accounting st andards
beco111e more subjective and fair value 111easure111ent increasingly takes cen ter stage, p rofessionals ,viii be
required to apply 111ore and better p rofessional judgment on a consistent basis. In reality, none of us " 'ill ever
make perfect judg111ents o r be co111pletely free from bias or fro m judg111ent traps. But by becoming a",are of
" 'here ,ve can fall prey to such influences and by practicing common sense mitigation techniques, including the
steps in a judgment process, ,ve can improve the quality of o ur professional judgment. And this, n1ore than just
about anything else you can do, ,viii set you apar t as an outstanding professional.
For more in-dep th info rmation abou t p rofessional judgment in auditing, including additional coverage
of judgment traps and biases, judgmen t in g roups, and other topics, see the a,vard-,vinrung monograph, Elevating
PrefessionalJudgment in Auditing and Accountin9:The KPMG PrefessionalJudgment Framell'ork, available ,vithout charge
at http: I !1V1V1v.kpmgunil'ersicyconnection. com.
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lntrocludlon I Professional Judgment
REQUIRED
[1] Identify and d escribe hvo co111mon judg111ent traps.
[Z] Ho,v can considering multiple judgment frames enhance an auditors professional skepticis111? Explain and
give an e xa111ple.
[3] vVhat is the first step in avoiding traps o r reducing bias? BrieAy explain ,vhy this fi rst step is so important.
[ 4] Identify and brie Ay describe three potential " 'ays to mitigate the effects of biases.
DISCUSSION CASES
The follo,ving discussion cases provide oppor tunity to apply the principles p resented in this Professional
Judg111ent Introduction.
[SJ An audit engagement tea111 is planning for the upcoming aud it of a clien t " 'ho recently unden,,en t a
significan t restructuring of its debt.The restructuring ,vas necessary as econo mic conditions hampe red the
clien t's ability to make scheduled re -pay111ents of its debt obligations. The restructured d ebt agreements
included ne"' debt covenants. In auditing the d ebt obligation in the p rior year (before the restructuring),
th e team established materiality specific to the financial state111ent debt account (account level materiality)
at a lo"'er a111ount than overall financial statemen t mate riality. In planning the audit for the current year, the
team plans to use a sinular materiality level. While such a conclusion might be appropr iate, " 'hat judg111ent
trap(s) might the team fall into and " 'hich step(s) in the judg111ent process are 111ost likely affected?
[6] A c lient
is determining its accounting treat111ent for ne,v types of long-ten n con tracts. Consider the
diffe rences in outcome for the n,,o scenar ios that folio"' regarding the approach the clien t and auditor
took. Ho,v does franung relate to the t,vo differen t scenar ios?
• Scenario A: The client ente red into a large numbe r of long-term sales conb·acts and recorded
revenue using an approach they d eten nined ,vas the p referred approach, " 'ith no consultation or
discussion " 'ith the audit engagement team. T he engagement team conducted revenue recognition
testing to ensure that the clien t correctly follo",ed the ch osen approach.The engagemen t team noted
that the clien t consistently and accurately applied the approach and determined that the audit testing
suppor ted the a111ount of revenue reported by the client.
• Scenario B: Before en ter ing into long-term contracts ,yjth custo111ers, the client reached out to
the audit engagemen t tea111 to discuss the c lien t's preferred approach for recognizing revenue. The
team researc hed authoritative accoun ting standards and considered the c lient's prefen·ed alte1-native.
The tea111 also considered other possible approaches and consulted ,vith other engagemen t teams
" 'ith experience in accounting for long-term contracts. Based on this process, the engagemen t tea111
d etermined that although the client's preferred approach had merit, another alternative " 'as more
consistent " 'itl1 accounting principles for revenue recognition. T he clien t carefully reconsidered
the situation and ulti111ately decided to use the alternative suggested by the engage111ent team to
recognize revenue associated ,vith the long-tenn conb·acts they en tered into.
[7] For
each of the hvo audit situations belo,v, deternune ,vhich judgmen t shor tcut o r tendency is most
p revalent and brie Ay describe the likely consequences of using the shortcut.
[a] A staff auditor is testing accounts payable balances. Th e auditor observes an unexpected Auctuation in
the accoun t balance compared to the prior year. The clien t happens to be ,valking by, so the auditor
asks the clien t about the Auctuation. T he c lien t proyjdes a p lausible and reasonable explanation. In
considering otl1er possible causes for the fluctuation, the c lient's explanation seems to be the most
likely, so the staff auditor documen ts it as evidence suppor ting the Auctuation. Later, it is determined
that other facts encountered dur ing the audit do not support th e clien ts explanation.
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Professional Judgment I Introduction
[b) A client has provided the audit engagement tea111 an esti111ate of the inventory valuation reserve. The
client used a 111ethod for calculating the reserve that had been used in prior years.To audit the reserve,
the engagement tea111 obtained and revie",ed the client's calculation. Ho,vever, the tea111 noted that the
client's calculation did not reflect a significant decline in cust omer de111and for an older product line
that ,vas losing popularity relative to the ne"'er products. The engage111ent team suggested that the
client adjust the reserve up,vard. The client argued that the current reserve amount " 'as adequate but
indicated that a small increase in the reserve ,vould be acceptable. The engagement team revie,ved the
client's proposal, and ulti111ately accepted the inventory account as fairly stated in vie"' of the increase
to the reserve. Ho",ever, ,vithin a fe,v months after the financial statements and audit repor t ,vere
issued, it became apparent that the reserve ,vas insufficient as significant inventory "'l·ite-do,vns ,vere
recorded for obsolete inventory that ,vas discarded at scrap value.
[8) For each of the n,,o audit situations that follo,v, determine ,vluc h judg111ent tendency (or tendencies) is (or
are) most prevalent and ,vhat the auditor could d o to reduce bias.
[a) A client contacts the audit partner regarding the likely fee for the upcoming audit.The engagement tea111
is in the early stages of planning interim and final field,vork including making personnel assignments
and estimating required audit hours. In the prior year the total hours for the audit ,vere 900 hours.
The engagement partner tells the c lient's CFO that, because the engagement team is returning and is
ve1-y familiar " 'ith the client , the level of audit effort should be only slightly g reater than that of the
prior year, even though the client has acquired a ne,v subsidiary and has begun manufactur ing a ne"'
product line.
[b) An audit manager is tasked " 'ith approaching the client to discuss the possible need for ,vrite-do"'nS
on assets recorded at fair value (they are "level 2" in the FASB hierarchy).To her surprise, the client has
already prepared a d etailed schedule exanuning the assets in question and has modeled fai r value using
three different valuation approaches. Based on these analyses, the client has proposed a relatively s111all
"'l·ite-do,vn. The analysis appears to be " 'ell thought-out and carefully p erfor med. The audjt manager
checks the numbe rs in each valuation model and finds that there are no mathematical errors. The
manager concludes that the clients proposed ,vrite-do,vn is adequate.
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S E CT I O N
Client Acee tance
1.1 OceanManufaduring,lnc. .... . . . . . . . . .... . . . . . 13
The New Client Acceptance Decision
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Ocean Manufacturing, Inc.
The New Client Acceptance Decision
Mark S. Beasley , Frank A. Buckless , Steven M. Glover , Douglas F. Prawitt
LEARNING OBJECTIVES
After co,npleting and discussing this case you should be able to
(1 ) Understand the types of information relevant to
evaluating a prospective audit client
(2) List some of the steps an auditor should take in
deciding ,vhether to accept a prospective client
(3) Identify and evaluate factors important to the client
acceptance decision
(4) Understand the process of making and justifying a
recommendation regarding client acceptance
INTRODUCTION
The accounting firm of Barnes and Fische r, LLP, is a mediu111-sized, national CPA fi rm.The par tnership, fonned
in 1954, no,v has over 4,000 p rofessionals on the payroll.The fi rm 111ainly provides auditing and tax services, but
it has recently had success building the information systems consulting side of the business for non-audit clients
and for audit clients that are not publicly traded.
It is nud-January 2019, and you are a ne,vly pro111oted audit manager in an office of Barnes and Fischer,
located in the Pacific North,vest.You have been a senior auditor for the past three of your five years ,vith Barnes
and Fische r.Your first assignment as audit 111anager is to assist an audit partner on a client acceptance d ecision.
The partner explains to you tl1at the prospective client, Ocean Manufactw·ing, is a 111edium-sized manufacturer
of small home appliances. The par tner recently 111et the company's p residen t at a local chamber of commerce
meeting Th e president indicated that, after some difficult negotiations, the company has decided to ter nunate
its relat ionship ,vith its cw-ren t auditor. T he p residen t e xplained that the 111ain reason for the s,vitch is to build
a relationship ,vith a n1ore nationally established CPA finn because the company plans to make an initial public
offering (!PO) of its con1n1on stock ,vi thin th e next fe"' years. Oceans annual financial statemen ts have been
audited each of tl1e past 12 years in order to co111ply ,vith debt cove nants and to receive favorable interest rates
on the companys existi ng line of credit. Because the company's December 31 fiscal year-end has already passed,
ti me is of the essence for the company to con tract " 'ith a ne,v auditor to get the audit W1der " 'ay.
The par tner, Jane HW1te r, is in tr igued ,vith the idea of having a clien t in the ho111e appliance indusb-y,
especially one ,vith the favorable market position and g ro,vth potential of Ocean Manufacturing. Although
the re are several manufacturers of small ho111e appliances in the area, your office has never had a clien t in the
industry. Most of your office's curren t audit clien ts are in the healthcare se1-vices industry.Thus, th e parmer feels
the e ngage men t presents an excellent opportunity for Barnes and Fisch er to e nter a ne"' market. On tl1e other
hand, kno,ving the risks involved, the partner " 'ants to make sure the client acceptance decision is carefully
considered.
The case was prepared by Mark S. Beasley, Ph.D. and Frank A. Buckless, Ph.D. of North Caro lina St.itc Unfrcrs ity and Stc,·cn M. Clover, Ph.D. and
D ouglas F. Prawitt, Ph.D. of Brigham Young Unfrcrsity, as a basis for cl.ass discussion. Ocean Manufacturing is a fictitious company. All char.ictcrs and
names represented arc fictitious; any similarity to existing companies or persons is purely coincident.ii.
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Sedlon 11Client Acceptance
BACKGROUND
Ocean Manufacturing, Inc. 111anufactures small- to medium -sized ho me applian ces. The companys products
include items like toasters, blenders, and trash con1pactors.Althoug h Ocean's common stock and oth er securi ties
are not publicly traded , the company is planning an !PO in the nex t fe,v years in hop es that it ,vill be able to
trade Ocean's common st ock o n th e NASDAQ.You have been assigned to gath er infon nation in o rder to make a
recom111endation on ,vhether your firm should accep t Ocean Manufacturing as a client.
Ocean ,vants to hire your fi rm to issue an opinion o n its December 31 , 2018 financial statements and
has e xp ressed in terest in obtaining help to get its recently installed infon nation technology (IT) system in
better shap e. Ocean also ,vants your fin ns advice and guidan ce on getting everything in o rder for th e upconung
!PO. D uring the initial 111eeting " 'ith Ocean's management, th e follo,ving infon nation " 'as obtained about the
industry and the company.
The Home Appliances Industry
Over the past several years, the do111estic home appliances industry has been g ro"'ing at a steady pace. The
industry consists of a " 'ide variety of manufacture rs (do111estic and foreign) ,vho sell to a large number of
" 'holesale and retail o utlets. T hough resp onsive to technological improvements, pro duct 111arketability is linked
to g ro,vth in the housing 111arket. Retail outlets are served by both ,vho lesale and 111anufacture r representatives.
Ocean Manufacturing, Inc
Ocean's unaudited December 31, 2018 financial state111ents repor t total assets of S76 milljon, sales
revenues of $156 m illion, and n et p rofit of S3.9 mill io n. In the past , the co mpany has not atte mpted to
e xpand agg ressively o r develop ne"' p ro duct lines. Rathe r, it has con centrated on ma intaining a steady
g ro,vth rate by providing reliable products ,vithin a moderate to lo, v p rice ra nge. Ho,vever, Ocean hopes
to use the capital fro m the up co ming !PO to aggressively expa nd fro m a regio nal to a n ationa l 111arke t .
Ocean p ri111ar ily sells its p ro ducts in small q uantities to individ ually o,vned app lia nce stores. Over the last
fe,v years th e compa ny has begun to supply larger q uantities to three n ational retail chains. T,vo of these
la rger retailer s star ted buying Ocean's p roducts abou t t"'O years ago. In o rder to ha ndle the increased
sales, Ocean sig nificantly ex pand ed its manufactur ing capacity.
Though shake n by recen t 111anagemen t turnover and ongoing difficulties " 'ith the companys ne"'
account ing syste111, management feels that Ocean is in a position to g ro,v considerably. Manage111ent notes that
earnings have increased substan tially each year over the past tlu·ee years and that Oceans products have received
increasjng acceptance in the small applian ce marketplace. Three years ago, the company received a qualified
audit opinion relating to revenues and receivables. Ocean has c hanged audjtors tlu·ee ti111es in the past 12 years.
Management
In October 20 18, the co111p any e xpe rienced sig nifica nt ma nage111ent tu rnover ,vhen both th e vicep res ident of op e rat ions and the controller res igned to take jobs in other cities. T he reason fo r thei r leaving
" 'as disclosed by 111anagemen t as being re lated to "personal issues." A n e"' vice-president, Jessica \IVood,
" 'as hired in November, and the n e"' con t ro lle r joined early last month. Jess ica is an MBA ,vith al most 12
years of e xper ience in th e ind ustry. Theodo re Jones, the n e"' controlle r, has li ttle relevan t experie nce and
see111s frustrated " ' ith the company's n e"' IT system. The company's presid ent, An d re, v Cole, has a BBA
a nd , as th e found e r, has ,vorked at a ll levels of th e business. Mr. Zach ery, " 'ho is p rincipally in c ha rge of the
co111p any's p rocu rement a nd manufacturing functions, meets " 'eek ly ,vith Mr. Cole, as d oes Fra nk Stevens,
" 'ho has served as vice president over fi na nce for the past e ig ht yea rs.
Accounting & Control Systems
T he company s,vitc hed to a ne,v, integrated central accounting system in early 20 18.This ne,v syste111 111ain tains
integrated inven tory, accounts receivable, accounts payable, payroll, and general ledger sofn vare modules. The
transition to the ne,v system throughout last year ,vas handled mainly by the former contro ller. Unfor tunately,
th e transition to this ne"' system " 'as not ,veil 111anaged. The company is sti ll " 'Orking to 111odify it to better
meet company needs, to retrain the accounting staff, and to adapt th e company's accounting controls to better
complement tl1e system.
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Ocean Manufacturing, Inc. I case 1.1
Proble1ns still exist in inventory tracking and cost accumulation, receivables billing and aging, payroll
tax deductions, payables, and balance sheet account classifications.The company stopped parallel processing the
old accounting system in April 20 18. During several brief periods throughout 20 18, conventional audit trails
" 'ere not kept intact due to system failures and e rrors 1nade by untrained personnel.
The con1panys accounting staff and management are both frustrated ,vith the situation because, among
other p roblems, internal manage1nent budget repor ts, inventory status repor ts, and receivables billings are often
late and inaccurate, and several shipping deadlines have been missed.
Your office has never audited a company ,vith the specific IT system in place at Ocean. Ho"'ever, your
local office's IT tea1n is fairly confident they ,viii be able to diagnose Oceans control ,veaknesses and help Ocean
overcome current difficulties.
Accounts Receivable, Cash, and Inventories
The sales/receivables system handles a volume ranging fro1n 3,100 to 4,400 transactions per month, including
sales and payments on account for about 1,300 active credit customers. The seven largest customers currently
account for about 18% of accounts receivable, " 'hereas the remainder of the accounts range from $2,000 to
S36,000, " 'ith an average balance around S9,400.
Finished goods inventor ies are organized and ,veil protected, but in-process inventor ies appear so1ne,vhat
less organized. T he company uses a complicated hybr id form of process-costing to accu1nulate inventory costs
and to account for interd epartmental in-process inventory transfers for its four major product lines.
Predecessor Auditor
vVhen you approached Frank Stevens, Ocean's vice-president of finance, to request per mission to speak ,vith
the previous auditor, he seemed hesitant to discuss 1n uch about the p r ior audit firm. He explained that, in
his opinion, the previous auditor did not understand Oceans business e nvironment very " 'ell and ,vas not
technically competent to help the company ,vith its ne"' IT system. He further indicated that the predecessor
auditor and Ocean's 1nanagement had disagreed on minor accounting issues dur ing the prior years audit. In
Mr. Stevens' opinion, the disagreement " 'as primarily due to the auditor's lack of understanding of Oceans
business and industry environn1ent. According to Mr. Stevens, the audit partner indicated that because of the
accounting issues, he " 'Ould be unable to issue a clean opinion on the financial statements. In order to receive an
unquaufied opinion, Ocean had to record certain adjustments to revenues and receivables. Mr. Stevens believed
the adjustments ,vere unnecessary but felt forced to make them to receive a clean audit opinion.
Mr. Stevens noted that Ocean's 1nanagement feels confident that your firms personnel possess better
business judg1nent skills and have the kno,vledge and ability to understand and help improve Oceans IT system.
Mr. Stevens also indicated that Ocean ,vants to S"'itch auditors at this ti1ne to p repare for the upcoming IPO,
noting that con1panies often s,vitch to larger accounting finns ,vith national reputations in preparation for
going pubuc. Your firm has been highly recommended to rum by a friend ,vho is an administrator of a hospital
audited by Barnes and Fischer. After some discussion ben,,een Mr. Stevens and Mr. Cole, Ocean's p resident, they
granted you permission to contact the p revious auditor.
Dur ing your visit ,vith the p revious auditor, he indicated that the problems his fi rm had ,vith Ocean
p rimar ily related to ( l ) the complexities and p roblems ,vith Ocean's ne,v IT syste1n and (2) manage1nents
tendency to aggressively adjust year-end accruals in ord er to meet creditors' requirements. The auditor also
disclosed that the dissolution of the relationship " 'ith Ocean " 'as a n1utual agree1nent benveen the hvo parties,
and that his fir ms relationship ,vith 1nanagement had been so1ne,vhat difficult almost from the beginning
Apparently, the final stra,v that broke the relationship involved a disagree1nent over the fee for the upconung
audit.
Client Background Check
A background ch eck on Oceans 1nanagement revealed that five years ago Ocean's vice president of finance " 'as
charged "'ith a nusdemeanor involving illegal gambung on local college football games. Accord ing to th e ne,vs
reports, charges " 'ere later dropped in retw·n for Mr. Stevens' agreeing to pay a fine of S500 and to perfonn
100 hours of community service. T he background c heck revealed no other legal or ethical proble1ns " 'ith any
other Ocean executives.
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15
Sedlon 11Client Acceptance
Independence Review
As part of Barnes and Fischers quality control p rogra111, each employee of Barnes and Fischer is required to
file ,vith the finn an updated disclosure of their personal stock investmen ts every three n1onths.You ask a staff
auditor to revie"' the disclosures as part of the process of considering Ocean as a potential clien t. She reports
to you that there appears to be no stock o,vnership issue except that a partner in Barnes and Fischers Salt
Lake City office o,vns shares in a venture capital fund ,vhich in turn holds a p rivate equity invest111ent in Ocean
common stock. The venture capital fund holds 50,000 shares of Ocean stock, cw-rently valued at approxi111ately
S 18 a share. The stock is not p ublicly traded, so this value is esti mated. This investment represents just over a
half of one percent of the value of the funds total holdings.The partners total invest111ent in the mutual fund is
currently valued at about $56,000. No other independence issues " 'ere noted.
Financial Statements
You acquired the past three years' financial statemen ts fro111 Ocean, including the unaudited statemen ts for the
most recent year e nded December 31, 2018.This financial information is provided on the pages that follo,v.The
partner " 'ho " 'ill be in charge of the Ocean engage ment, Jane Hunte r, " 'ants you to look them over to see ,vhat
information you can dra,v from the111, paying par ticular atten tion to ite111s that might be helpful in determining
" 'hether or not to accept Ocean as a ne"' audit client.
16
© 2019 Pearson Education, Inc.
Ocean Manufacturing, Inc. I case 1.1
REQUIRED
[1] The client acceptance process can be quite complex. Identify five procedures an auditor should per fon n
in
d eter mining ,vhether to accept a client .Which of these five are required by auditing standards?
[Z] vVhat nonfinancial matte rs should be consid ered be fore accepting Ocean as a client? Ho,v important are
these issues to the client acceptance decision? Why?
[3] llsing Ocean's financial
information, belo,v, calculate relevant p reliminary analytical procedures to obtain a
better understanding of th e prospective client and to determine ho,v Ocean is doing financially. Co111pare
Ocean's ratios to the industry ratios provided. Ident ify any major diffe rences and briefly list any concerns
that arise fro111 this analysis in tenns of ho,v each might affect the client acceptance decision.
[4] [a]
Ocean ,vants Barnes and Fischer to aid in developing and improving its IT syste111. What are the
advantages and disadvantages of having the same CPA fin n p rovid e both auditing and consulting
services? Given current auditor independence r ules, ,vill Barnes and Fischer be able to help Ocean ,vith
its IT syste111 and still provide a financial statement audit? Suppor t your conclusion ,vith appropriate
citations to author itative standards if your instructor indicates that you should do so.
[b] As indicated in the case, one of the par tners in another office has invested in a venture capital fund
that o,vns shares of Ocean common stock. Would this situation constitute a violation of independence
according to the AI CPA Code ef Prefessional Conduci?\.Vhy o r " 'hy not?
[SJ [a] Prepare a me1110 to the par tner making a recommendation as to " 'hether Bar nes and Fischer should or
should not accept Ocean Manufacturing, Inc. as an audit client. Carefully justify yow· position in light
of th e infon nation in the case. Include consideration of reasons both for and against acceptance and be
sure to address both financial and nonfinancial issues to justify your reco111111endation.
[b] Prepare a separate memo to th e par tner briefly listing and discussing the five or six most i111por tant
factors or risk areas that ,viii likely affect ho"' the audit is conducted if the Ocean engagement is
accepted. Be sure to indicate specific ,vays in ,vluch the audit fin n should tailor its approach based on
the factors you identify.
PROFESSIONAL JUDGMENT QUESTIONS
It is recommended that you read the Professional J udgment Introduction found at the beginning of this book
p rior to resPonding to the follo,ving questions.
[6] [a] Ho"'
might the confi rmation tendency affect the auditor's client acceptance decision ?
[b] Ho,v nught the overconfidence tendency come into play in the auditor's client acceptance decision?
[C] Ho,v might an auditor mitigate the Possible effects of the confir mation and overconfidence tendencies
in a c lien t acceptance situation?
© 2019 Pearson Education, Inc.
17
Sedlon 11Client Acceptance
Ocean Manufacturing, Inc.
Balance Sheets as of December 31 , 2016-2018
(In Thousands)
(Unaudited)
2018
2017
2016
$ 3,008
12,434
11,907
3,853
1,286
32,488
$ 2, 171
7,936
10,487
4,843
1 627
27,064
$ 1,692
6,621
10,684
7,687
1,235
27 919
53,173
11,199
41,974
46,664
9,009
37,655
39, 170
7,050
32, 120
714
1 216
1,930
547
1 555
2, 102
339
735
1 074
$76,392
$66,821
$61,1 13
$12,285
3,535
865
872
17,557
$ 9,652
3,054
565
847
14, 118
$12,309
2,899
295
988
16,491
LONG-TERM DEBT
20,000
17 234
11 674
TOTAL LIABILITIES
37,557
31,352
28, 165
SHAREHOLDERS' EQUITY
Common stock (10,000,000 shares auth.)
Additional paid-in capital
Retained earnings
Total Shareholders' Equity
10,67 5
5,388
22,772
38,835
10,67 5
5,388
19 406
35,469
10,675
5,388
16,885
32,948
$76,392
$66,821
$61,1 13
ASSETS
CURRENT ASSETS
Cash
Accounts receivable(net of allowance)
Raw & in-process inventories
Finished goods inventories
Other current assets
Total Current Assets
PROPERTY, PLANT, & EQUIPMENT
Less accumulated depreciation
Net PP&E
OTHER ASSETS
Deferred income taxes
Other noncu rrent assets
Total Other Assets
TOTAL ASSETS
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES
Accounts payable and accrued expenses
Current portion of long-term debt
Income tax payable
Other current liabilities
Total Current Liabilities
TOTAL LIABILITIES AND EQUITY
18
© 2019 Pearson Education, Inc.
Ocean Manufacturing, Inc. I case 1.1
Ocean Manufacturing, Inc.
Statement of Earnings for Years Ended December 31, 201 6-2018
(In Thousands)
(Unaudited)
Sales
Cost of sales
Gross profit
Operating expenses
Operating income
Interest expense
Provision for income taxes
Net Earnings
2018
2017
2016
$155,621
102,487
53, 134
44,414
8720
1,750
3,078
$104,026
69, 177
34,849
28,607
6,242
1,473
2,246
$92,835
63,870
28,965
24,601
4,364
699
1,592
$3,892
$2,521
$2,073
Ocean Manufacturing, Inc.
Statement of Retained Earningsasof December 31, 2016-2018
(In Thousands)
(Unaudited)
2018
2017
2016
Balance, beginning of year
Cash dividends paid
Net earnings for year
$19,406
(526)
3,892
$16,885
0
2,521
$14,812
0
2,073
Balance, end of year
$22,772
$19,406
$16,885
Average Industry Ratios for Comparison
Return on Equity (ROE)
Return on Assets (ROA)
Assets to Equity
Accounts Receivable Turnover
Average Collection Period
Inventory Turn over
Days in Inventory
Debt to Equity
Ti mes Interest Earned
Current Ratio
Profit Margin
© 2019 Pearson Education, Inc.
2018
2017
20.17%
6.59°/o
3.28
7.55
41.39
8.13
37.16
2.38
1.62
1.27
10.54%
25.31o/o
8.09o/o
2.77
6.99
44.44
6.88
42.81
1.90
2.37
1.34
12.82%
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