Module XII: Estimated Liability for Product Warranty All Brony’s Bikes products are sold under a one-year warranty covering all parts and labor. Repairs are performed locally, either by the dealer who sold the bicycle or by local entities licensed as official Brony’s Bikes bicycle repair shops. Brony’s Bikes reimburses the dealers and shops for labor and parts. Reimbursement is based on work orders submitted by the repairing agency. The customer signs the work orders, and the serial number of the product repaired also appears on each work order. Defective parts or products replaced must be returned to Brony’s Bikes with the accompanying work order. The parts and products are received and logged in on color-coded receiving reports designed for returns. Ignore the current deferred income tax liability arising from the difference between book warranty expense and warranty expense for income tax purpose. In this case, the deferred income tax liability account will not be adjusted. At the end of each month, the following standard journal entry is posted as an adjustment to estimated product warranty. Debit 8330 Product Warranty Expense Credit 2070 Estimated Product Warranty Liability For 20X9, the company applied 0.5% to cost of goods sold in determining the amount of the monthly adjustment. Debits to account 2070 are for reimbursements and for product and parts replacements. Defective parts and products are “zero valued” and placed in the rework department. Derick has asked you to analyze product warranty and determine the appropriate balance in the 20X9 liability account. He has already provided you with partially completed WP 20 contained in file named 20X9 warranty.xlxs (LINK) and a client-prepared analysis of returns over the past four years. In order to perform the analysis Derick has requested you must complete the calculations in WP 20 to determine whether an audit adjustment should be made. There are several formula errors in WP 20. If you correctly complete WP 20 those errors and the correct adjusted cost of goods sold account will be replaced by the computed values you need to determine whether the Estimated Warranty Liability and related Warranty Expense require adjustments. See file MUS (LINK) for Audit Adjustment #1 and file cutoff for Audit Adjustment #3. Requirements 1. Using Excel download the file labeled “20X9 Warranty.xlxs.” Examine the document carefully and comment on its adequacy and completeness. (Note that the 12/31/X8 audited balances appear to be unreasonable because you have not yet selected an appropriate provision percentage based on the “data from client-prepared analysis of warranty claims.”) 2. Scroll to the bottom of WP 20 and enter audit adjustments already made in previous modules that affect cost of goods sold for 20X9. You should identify the following adjustments. AJE No. 1 (Module IV correction of repairs expense capitalized as factory equipment); and AJE No. 3 (20X9 purchase recorded in 20Y0, detected in completing Module VI). 3. Enter equations in cells C44, D44, and E44 that will calculate the percentage of warranty claims to cost of goods sold for each of the three years 20X6–20X8. 4. Note the percentage that now appears in cell B46 and the resulting adjustment to product warranty expense. 5. What comprises the documentation examined by the auditor (audit legend E) supporting the debits to account 2070? 6. How would you audit the client-prepared analysis of warranty claims? (See “Year of Claim/Year of Sale” analysis in the middle of WP 20.) 7. Draft AJE No. 12 on the document. 8. Shelly Ross, the other assistant auditor on the engagement, asks why you didn’t adjust the prior years under provision through beginning retained earnings. What is your response? Module XIII: Mortgage Note Payable and Note Payable to Bank Two Brony’s Bikes’ long-term liabilities consist of the following: 10% mortgage note payable to Dallas Dollar Bank - $60 million; and 12% note payable to Bank Two - $45 million. Ignore the long-term deferred income tax liability arising from the difference between book depreciation and depreciation for income tax purposes. In this case, the deferred income tax liability account will not be adjusted. In 20X4, Brony’s Bikes upgraded its manufacturing facilities at a cost of $150 million. The project was financed by issuing 2 million shares of common stock at $25 per share, and by issuing a $100 million 10% mortgage note payable to Dallas Dollar Bank. The mortgage agreement requires repayment in ten annual installments of $10 million each. Interest on the unpaid principal is payable on the first day of each month. The principal installments are due on January 1. The next payment is due on 1/1/Y0. The 12% note payable to Bank Two was issued to alleviate the effects of the liquidity problems encountered in 20X9. This note is unsecured and requires repayment in ten equal annual installments. Unlike the Dollar Bank mortgage loan, interest on the Bank Two loan is payable annually. The first principal installment, together with interest, is due on 3/1/10. This note contains restrictive covenants, as described earlier, relating to a $10 million compensating balance requirement and restrictions regarding further borrowing and dividend payments. Derick has asked that you analyze the long-term notes payable, being particularly alert to any violations of the restrictive covenants contained in the Bank Two loan agreement. Requirements 1. Using Excel download the file labeled “20X9 Notes.xlxs.”(LINK) Locate the following documentation in this file: WP 14 - Notes payable and accrued interest - lead schedule; and WP 14.3 - Notes payable—long-term. Scroll to WP 14.3, “Notes Payable - Long-Term.” What are the audit objectives in the examination of long-term notes payable? What would the auditor consider to be the most relevant assertions? Has the evidence provided in the document addressed the audit objectives and the most relevant assertions? 2. Record Reclassification Journal Entry C for the current portion of both notes as of 12/31/07, and enter the amounts in WP 14.3. Now scroll up to WP 14, the lead schedule for notes payable and interest. Post your reclassifications to the lead schedule. 3. What is the probable nature of the adjustment to “notes payable - trade” and to “interest payable” appearing in the adjustments column of the lead schedule? Brony’s Bikes Module XIV: Working Trial Balance Upon completion of substantive audit testing, the auditor should post all audit adjustments and reclassification entries to the working trial balance and extend the audited balances. The extended balances then form the nucleus for the audited financial statements. (See AU 500.02.) Selected analytical procedures also should be applied at the conclusion of the audit. (See AU 520.03.) The results may be compared with those developed during the audit planning phase. This approach provides added support for audit conclusions contained in the documentation. Derick has asked you to post the adjustments and reclassifications and to perform the review phase analytical procedures. Requirements 1. Excel file labeled “20X9AJE sol.xlxs” (LINK) (adjusting journal entries). Review the adjustments, which will be presented to the client as proposed audit adjustments. Remember that the auditor can only propose that adjustments and reclassifications be recorded on Brony’s Bikes’ books. That is because Brony’s Bikes’ management is responsible for the financial statements. The auditor is responsible for obtaining sufficient appropriate evidence that the financial statements are presented fairly and then to render a report on those financial statements, including the auditor’s opinion or, if necessary, the auditor’s disclaimer of issuing an opinion. Derick has set the following materiality thresholds. These figures are not rounded to the nearest thousand dollars as are the financial statement amounts: Income statement $ 435,000 Balance sheet $1,542,270 Given these thresholds and referring to the proposed audit adjustments and reclassifications, determine whether the potential adjustments equal or exceed the income statement or balance sheet materiality threshold in the aggregate. Do not net understatements against overstatements. That is, if aggregate overstatements are $600,000 and aggregate understatements are $500,000, the adjustments should be proposed to Brony’s Bikes’ management, inasmuch as both exceed the income statement materiality threshold. 2. Retrieve the Excel file labeled “20X9 WTB.xlxs.” (LINK) Post the adjustments and reclassifications to the working trial balance. Observe the following rules in making your postings: a. Post account increases as positive amounts, and post account decreases as negative amounts; b. Postings are in “thousands of dollars,” whereas the adjustments and reclassifications are rounded to the nearest dollar. Therefore, in posting the adjustments and reclassifications, round to the nearest $1,000. c. Enter AJE numbers as text by typing a single quote before the number “1” so that Excel does not include the AJE numbers in the final balances. d. Your worksheet includes formulas to determine the sum of each column. 3. Retrieve the Excel file labeled “20X9 AUDBS.xlxs.” (LINK) Enter the amounts from the audited column in the 20X9 balance sheet. Calculate the percentages of individual balance sheet items and components relative to totals for 20X9. 4. Calculate the new ratios for 20X9 based on the audited financial statements. What is the purpose of applying analytical procedures in the evaluation and review phase of the audit? Why is it important to develop expectations as part of performing final analytical procedures? 5. Compare audited balance sheets together with the related ratios with the balance sheets and ratios that you developed in Module I. What conclusions can you draw regarding the comparison? 6. The Excel file 20X9 analytic procedures WP A.1 to 7 data.xlxs (LINK) that you used in Module I contains 7 separate working papers. Select WP A.5 Budgeted Versus Actual Income Statements. You may recall that the purpose for the Module I review was to identify significant budget variances that could be the result of under or over-budgeting, misstatements in recording data, or intentional misstatements. The auditor, of course, is most concerned with the latter two possibilities. Now you need to re-perform these procedures with the budgeted balances compared with audited balances. a. Create a new Excel file and copy/paste WP A.5 into the new file. Label the new file 20X9 Audited Versus Budgeted Amounts.xlxs. In the new file, substitute the audited amounts from your adjusted working trial balance for the unaudited figures in the “Actual 12/31/X9” column. Save your revised file. You now have two files with the same budgeted amounts but with audited versus unaudited actual amounts. b. Do significant variances still exist? If so, are you satisfied that the audit has resolved the causes of the significant variances? (Compare the variances resulting from this analysis with those calculated in Module I.) c. If you continue to have concerns about certain variances, what additional evidencegathering and evaluation procedures do you suggest? Brony’s Bikes Module XV: Audit Report The Vaughan audit team completed its audit field work on February 15, 2010. A conference was held on that date involving members of the audit firm and Brony’s Bikes management. Participants in the conference were Denise Vaughan, partner in charge of the Brony’s Bikes engagement; Carolyn Volmar, audit manager; Richard Derick, in-charge auditor; Trevor Lawton, Brony’s Bikes’ CEO; Gerald Groth, Brony’s Bikes’ controller; and Marlene McAfee, Brony’s Bikes’ treasurer. The Brony’s Bikes representatives agreed to all of the audit adjustments and reclassifications proposed by the audit team, and they agreed to reflect them in the December 31, 20X9, financial statements. They also agreed to modify and/or add footnote disclosures as recommended by the audit team. At the conclusion of the conference, the audit team obtained a client representation letter from Brony’s Bikes management and presented management with a copy of the “significant deficiencies” letter outlining discovered internal control deficiencies. The original of this letter was sent to Brony’s Bikes’ audit committee. The legal action initiated against Brony’s Bikes by Rollfast, a competitor, for alleged patent infringement, was not yet settled as of February 15. Because the letter obtained by Derick from Brony’s Bikes’ outside legal counsel was inconclusive as to the probable outcome of this action, Derick requested an informal conference with the attorney handling Brony’s Bikes’ case. This conference was convened on February 12, and the participants were Joel Haskins, the attorney, Gerald Groth, Denise Vaughan, and Richard Derick. Haskins exhibited a degree of pessimism that produced considerable uncertainty as to the probable outcome of the litigation. Inasmuch as the amount of loss could be quite substantial, and the probability of an unfavorable outcome was more than remote but less than likely, Groth agreed to disclose the matter in a footnote to the 20X9 financial statements. Notwithstanding the liquidity problems and loan default, Brony’s Bikes has been assured by Bank Two management that the bank plans no foreclosure action, provided Brony’s Bikes can restore the minimum required bank balance and continues to earn profits. Moreover, management’s expressed plans for dealing with the crisis and continued sales growth during January 20Y0 have convinced Vaughan that an explanatory paragraph expressing substantial doubt as to continued existence is not necessary. No scope restrictions were encountered during the audit, either imposed or otherwise. Also assume that Brony’s Bikes did not change accounting principles in either 20X8 or 20X9. Requirements 1. Draft the audit report as appropriate to conform to the Brony’s Bikes audit results. 
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