Assume you are an audit manager

, today is April 15, 2015, and your public accounting firm is currently planning the 2015 financial statement audit of Gamma Industries, a public company using a 12/31 year-end (for this assignment, focus only on the financial statement audit). Gamma is a new client for your firm. Gamma manufactures medical equipment, and sells these machines to hospitals, out-patient surgery centers, and medical offices. The audit partner has asked you to help plan the audit for this new client using the following information obtained and summarized by the engagement team:

  • Ross Parker has been Gamma’s CEO for five years, and previously served as an executive vice president at Gamma for seven years. Before joining Gamma, Mr. Parker worked as an account manager at an advertising agency. A routine background check revealed one legal issue for Mr. Parker: he was arrested in 1998 for driving while intoxicated, but the case was dismissed on a technicality.
  • Emily Fielder, CPA, is Gamma’s CFO and a former auditor. Mrs. Fielder has worked at Gamma in various positions for nearly two decades, and has been CFO for six years.
  • While Mr. Parker and Mrs. Fielder have provided consistency in the CEO and CFO positions, respectively, Gamma has experienced significant turnover among its accounting personnel. The majority of the current accounting staff do not have accounting degrees, although both the controller and chief accounting officer have master’s degrees in accounting.
  • Gamma received a qualified financial statement opinion for its 2014 financial statements from the predecessor audit firm. Mr. Parker explained that this opinion was due to disagreements over a subjective accounting estimate, the allowance for doubtful accounts. Communications with the predecessor audit firm, which are required by standards, were consistent with his explanation. These disagreements led the predecessor audit firm to resign after completing the 2014 audit.
  • The company’s executives receive a base salary and incentive-based compensation such as stock options and bonuses. For accounting and financial services personnel, Gamma implemented a policy last year that combines years of service and corporate performance to encourage stability and limit turnover. Due to this policy, Mrs. Fielder will receive a very large bonus if the company meets its 2015 Basic EPS forecast because she will pass twenty years of service late in 2015.

This morning, the audit senior for the Gamma audit, Eric Wall, disclosed to you that his aunt owns a material (to her) amount of Gamma’s common stock. Eric told you he does not believe his independence is impaired and wishes to stay on the Gamma audit.

Please see the accompanying Excel file for Gamma’s 2014 financial statements.

Questions to Submit to the Professor

These questions address issues related to audit planning such as analytical procedures, inherent risk assessment, and audit engagement staffing. Per the syllabus, you must submit two versions: hard-copy in class on the due date and an electronic version through Turnitin via Blackboard. You must also record the multiple choice questions on the scantron provided by your instructor.

Questions

Part 1: Analytical Procedures using the 2014 Financial Statements

  1. An auditor calculating Gamma’s quick ratio should exclude which of the following item(s) from current assets?
    1. Cash and equivalents
    2. Inventory
    3. Prepaid Expenses
    4. B & C only
  1. The numerator of Gamma’s receivables turnover is equal to
    1. Eighty percent of Gamma’s net sales
    2. Gamma’s cost of sales
    3. Gamma’s net sales
  1. An auditor calculating Gamma’s gross profit percentage should calculate gross profit as a percentage of
    1. Eighty percent of Gamma’s net sales
    2. Gamma’s cost of sales
    3. Gamma’s net sales
  1. An auditor calculating Gamma’s times interest earned ratio should include which financial statement item in both the numerator and denominator?
    1. Interest expense
    2. Net income
    3. Notes payable
  1. Assuming a 360 day year, Gamma’s days outstanding in accounts receivables is __ days.
    1. 66.94
    2. 67.87
    3. 73.89
  1. Gamma’s net profit margin is __ %.
    1. 3.49
    2. 5.68
    3. 8.45
  1. Gamma’s return on equity (ROE) is __ %.
    1. 0.81
    2. 3.02
    3. 4.57
  1. Gamma’s quick ratio is
    1. 0.30
    2. 2.72
    3. 4.62
  1. Assume Gamma’s usual credit terms are 2/10, net 30. Gamma’s days outstanding in accounts receivables suggests bad debts are likely __ to accounts receivable.
    1. Immaterial
    2. Material
    3. Neither A nor B: Bad debts have no relationship with accounts receivable
  1. Gamma’s profit margin, relative to the industry of average of 17.43%, suggests a __ level of detection risk.
    1. Low
    2. High
    3. Neither A nor B: profit margin is irrelevant to assessing detection risk
  1. Gamma’s ROA, relative to the industry average of 13.3%, suggests a __ level of inherent risk.
    1. Low
    2. High
    3. Neither A nor B: ROA is irrelevant to assessing inherent risk
  1. Gamma’s current ratio may be distorted because the company
    1. Has not fully depreciated and amortized all of its fixed assets
    2. Did not present diluted EPS in its financial statements
    3. Likely has a high level of bad debts

Part 2: Inherent Risk (IR) Assessment

  1. Listfourissues from the summary information on p. 2 that could impact IR at Gamma
  1. Consider Gamma’s accounting and financial services personnel, including the controller, chief accounting officer, and CFO. What is your assessment of the collective competence of these employees? How does this assessment impact IR?
  1. What impact, if any, does the CEO’s (Mr. Parker) driving while intoxicated arrest in 1998 impact IR? Explain your answer.
  1. What is your IR assessment? Support your conclusion using both the summary information in this document and the 2014 financial statements, including the analytical procedures you performed in Part 1.

Part 3: Audit Engagement Staffing

  1. Describe your responsibility to the public interest in considering Eric’s issue? How does this responsibility impact your consideration of whether to remove him from the Gamma audit?
  1. Will you allow Eric to serve on the Gamma audit? Explain your reasoning, including how investors and regulators might view his participation on the audit.
  1. If the average auditor in practice was in Eric’s position and was allowed to stay on the Gamma audit, could this person be objective (be sure to explain your answer)? What specific advice would you give this person on how to maintain her/his objectivity?
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