LDP 2.1 Interpreting Reliability and Comparability of F/S

Question 1

What are some important important audit procedures?

Answer 1

• Tests of the underlying documentation to support account balances
• Observation of the physical inventory counts
• Outside confirmation of account receivable balances
• Assessment of the risk of fraud

Question 2

With each audit, the CPA presents an opinion letter on:

Answer 2

• The application of GAAP
• The fairness and consistency of the statements
• Any exceptions

Question 3

Types of opinion letters:

Answer 3

Qualified
Unqualified
Adverse
Disclaimer

Question 4

Opinion Letter:

Unqualified

Answer 4

The audit has been performed according to generally accepted auditing standards, and the financial statements are prepared in accordance with GAAP.

Question 5

Opinion Letter:

Qualified:

Answer 5

The financial statements present the entity’s financial position, results of operations, and cash flows in conformity with GAAP, with one or more identified exceptions.

Question 6

Opinion Letter:

Adverse

Answer 6

The financial statements do not present the entity’s financial position, results of operations, and cash flows in conformity with GAAP.

Question 7

Opinion Letter:

Disclaimer

Answer 7

The auditor is unable to form an opinion on an entity’s financial statements.

Question 8

Whether to require audited statements depends on:

Answer 8

• The degree of risk you find in the outstanding or proposed loan
• The length of time a loan is expected to be outstanding
• Where you find your margins of protection

Question 9

Alternate Accounting Methods (not in accordance with GAAP)

Answer 9

Cash-basis
Modified Cash Basis
Tax Basis

Question 10

Cash-Basis

Answer 10

• Revenues are recorded only when cash is collected.
• Expenses are recorded only when cash is paid to settle them.
• Understate revenues if the company sells on credit
• Understate expenses if the company buys on credit
• Distort expenses if the company uses long-lived assets such as trucks

Question 11

Modified cash basis

Answer 11

• Starts with the cash basis, but attempts to overcome some of the profit measurement distortions

Common modifications to cash transactions:

• Divide the cost of property, plant, and equipment over the years they will be in service.
• Show the property, plant, and equipment as assets on the balance sheet.
• Record each year’s portion of the cost as depreciation expense.
• Recognize borrowed funds as liabilities on the balance sheet. Some companies show accounts payable; most companies show bank loans.
• Recognize income taxes to be paid after year-end as a current obligation.

Question 12

Tax basis

Answer 12

Measures and records the dollar impact of transactions according to allowable income and expense recognition under tax laws (regardless of how the underlying transactions might be measured under either accrual or cash accounting)

Question 13

Other Factors that Affect Reliability of F/S

Answer 13

• Qualification and independence of the auditor
• Integrity of the issuer (management)
  NOTE: Financial statements are the responsibility of management and not the auditor!
• Relationship of the financial statement date to the company’s operating cycle
• Companies included in the financial statements relative to those obligated on your loan

Question 14

Types of Financial Statements

Answer 14

Consolidated
Consolidating
Separate or Parent only

Question 15

Consolidated

Answer 15

• Presents the condition and performance of two or more companies combined.
• Prepared by combining the individual statements of the entities, account-by-account, except for inter-company transactions

Question 16

Consolidating

Answer 16

• Displays the financial statements of two or more related companies, showing the inter-company amounts that have been eliminated to achieve the combined amount of each account on the consolidated financial statements

Question 17

Separate or Parent only

Answer 17

Reflects the condition and performance of only one company not combined with any other company

Question 18

Inventory valuation:

Answer 18

Specific identification
Average cost
First-In, First-Out (FIFO)
Last-In, First-Out (LIFO)

Question 19

Specific identification

Answer 19

A specific cost assigned to each individual item in inventory is matched to a specific sale

Question 20

Average cost

Answer 20

The average cost of all units available for sale for the period = The cost of each unit sold during the period

Question 21

First-In, First-Out (FIFO)

Answer 21

• The assumption that first items purchased were the first items sold
• Will report higher earnings and pay higher taxes during a period of rising inventory costs (higher inv)
• Will have a balance sheet that closely reflects probable current values of inventory

Question 22

Last-In, First-Out (LIFO)

Answer 22

• The assumption that the oldest inventory is still on hand, and that the period’s sales were fulfilled from the most recently purchased inventory
• Will report lower earnings and pay lower taxes during a period of rising inventory costs (lower inv)
• Are required by tax rules to maintain records that enable them to compute what inventory and cost of goods sold would have been under the FIFO method (the LIFO reserve)
• Can report lower profits and pay lower taxes
  
• May understate the probable current value of inventory on hand
• Are required by law to use the same method for financial reporting

Question 23

Expense vs. Capitalize

Answer 23

1) Capitalize: When costs are expected to provide benefits in the future, beyond the accounting period in which they are incurred
2) Expense: When costs do not provide benefits beyond the current period; done in the current period

Question 24

LIFO Reserve

Answer 24

• Tax rules require companies using LIFO to maintain records that enable them to compute what inventory and COGS would have been under the FIFO method.
• The LIFO reserve measures the cumulative amount by which the LIFO method understates inventory compared to FIFO, measured beginning on the day the company adopted LIFO.
• Each year that prices continue to rise, the LIFO reserve grows as well.

Question 25

Common examples valuation accounts

Answer 25

1) allowance for doubtful accounts, with its associated bad-debt expense
2) liability for future warranty payments, with its associated warranty expense
3) allowance for obsolete inventory, with its associated COGS expense.

Question 26

Common alternatives of reporting allowed by GAAP

Answer 26

1) Revenue recognition - Revenue can be recognized (1) before a sale is actually made or (2) during performance of a service (but before the service is complete).
2) Expense recognition choices:
3) Inventory valuation:
4) Expense vs. Capitalize
5) Leasing choices:

Question 27

My client would like to borrow $1,000,000, but the company’s owner will not guarantee the loan. If you were in my position, what would you require of the client?

Answer 27

In a situation where the client is asking for a loan that the company’s owner will not guarantee, audited financial statements will give me the most reliable description of a company’s financial circumstances,

Question 28

Which type of accounting method best describes my client’s accounting practices if revenues are recorded when cash is received, expenses are recorded when cash is paid out, the cost of equipment is divided over the years it will be in service, and borrowed funds are shown as liabilities on the balance sheet?

Answer 28

modified cash-basis accounting

Question 29

How will using FIFO in a time of rising prices affect inventory, profit, and taxes?

Answer 29

As prices rise inventory, profit, and taxes will increase