1. Problem 21-17, Page 709 In an examination of Marco Corporation as of December 31, 2009, the following situations exist. No related entries have been made in the accounting records. 1.Marco Corporation has guaranteed the payment of interest on the 10-year, first mortgage bonds of Chen Corp., an affiliate. Outstanding bonds of Chen Corp. amount to $150,000 with interest payable at 8 percent per annum, due June 1 and December1 each year. The bonds were issued by Chen on December 31, 2007, and all interest payments have been met by that company with the exception of the payment due December 1, 2009. Marco Corporation states that it will pay the defaulted interest to the bondholder on January 15, 2010. 2.During the year 2009, Marco Corporation was named as a defendant in a suit by Dalton Inc. for damages for breach of contract. A decision adverse to Marco Corporation was rendered, and Dalton Inc. was awarded $40,000 in damages. At the time of the audit, the case was under appeal to higher court. 3.On December 23, 2009, Marco Corporation declared a common share dividend of 1,000 shares with a stated value of $100,000, payable February 2, 2010, to the common shareholders of record on December 30, 2009. REQUIRED: a)Describe the audit procedures that you would use to learn about each of the above situations. b)Describe the nature of the adjusting entries or disclosure, if any, that you would require for each of these situations. (Adapted from AICPA)

2. Problem 21-17 a.Audit procedures to learn about these items would be as follows: Apply to all three items: Discuss existence and nature of possible contingent liabilities with management. In this connection obtain appropriate written representations. Review the minutes of directors’ and shareholders’ meetings for indication of lawsuits or other contingencies. Analyze legal expense for period under audit and review invoices and statements of legal counsel for indications of contingent liabilities. Obtain confirmation from all major law firms performing legal services for the client as to the status of pending litigation or other contingent liabilities. Additional procedures for individual items: 1.Guarantee of interest payments Discuss, specifically, any related party transactions with management. Include in representations. Review financial statements of affiliate, and where related party transactions are apparent, make direct inquiries of affiliate management, and perhaps even examine records of affiliate if necessary. 2.Lawsuit Inquiry of management Review of all legal invoices paid or payable during the year Legal letter sent to all law firms used by the company 3.Stock dividend Confirm details of stock transactions with registrar and transfer agent. Review records for unusual journal entries subsequent to year end.

3. b.Nature of adjusting entries or disclosure, if any, would be as follows: 1.Guarantee of interest payments If payment by Chen is uncertain, the $6,000 interest liability for the period June 2 through December 1, 2004, could be reflected in the Marco Corporation’s accounting records by the following entry: ($1500,000 x 8% x 50% = $6,000) Interest Payments for Chen Corp.$6,000 Accrued Interest Payable: Chen Bonds$6,000 The debit entry should be included as other assets. Collection is uncertain and the Marco Corporation may not have a right against the Chen Corp. until all interest payments have been met and the bonds retired. If this treatment is followed, the balance sheet should be footnoted to the effect that the Marco Corporation is contingently liable for future interest payments on Chen Corp. bonds in the amount of $96,000. If the interest has been paid by the time the audit is completed, or if for other reasons it seems certain that the payment will be made by Chen on January 15, no entry should be made by Marco. In this circumstance a footnote disclosing the contingent liability of $102,000 and the facts as to the $6,000 should be included with the statements. 2.Lawsuit The lawsuit should be described in a footnote to the balance sheet. In view of the court decision, retained earnings may be restricted for $40,000, the amount of the first court decision. Also, in view of the court decision any reasonable estimate of the amount the company expects to pay as a result of the suit might be used in lieu of the $40,000. A current liability will be set up as soon as a final decision is rendered or if an agreement as to damages is reached. If liability is admitted to by Marco, and only the amount is in dispute, a liability can be set up for the amount admitted to by the company with a corresponding charge to expense or shown as an extraordinary item if the amount is material. 3.Stock dividend The declaration of such a dividend does not create a liability that affects the aggregate net worth in any way. The distribution of the dividend will cause a reduction in retained earnings and an increase in capital stock. No entry is necessary, but an indication of the action taken, and that such a transfer will subsequently be made, should be shown as a footnote or as a memorandum to Retained Earnings and Common Stock in the balance sheet.

4. Problem 21-18, Page 709 Melanie Adams is a public accountant in a medium sized public accounting firm and takes an active part in the conduct of every audit she supervises. She follows the practice of reviewing all working papers of subordinates as soon as it is convenient, rather than waiting until the end of the audit. When the audit is nearly finished, Melanie reviews the working papers again to make sure that she has not missed anything significant. Since she makes most of the major decisions on the audit, there is rarely anything that requires further investigation. When she completes the review, she prepares a draft of the financial statements, gets them approved by management, and has them assembled in her firm’s office. No other public accountant reviews the working papers because Melanie is responsible for signing the auditor’s report. REQUIRED: a)Evaluate the practice of reviewing the working papers of subordinates on a continuing basis rather than when the audit is completed. b)Is it acceptable for Melanie to prepare the financial statements rather than have the client assume that responsibility? c)Evaluate the practice of not having a review of the working papers by another public accountant in the firm.

5. Problem 21-18 a.The practice of reviewing the working papers of subordinates on a continuing basis rather than when the audit is completed, is a good one because it enables Adams to refine her audit based on the information provided from the working papers that are reviewed. In addition, since many areas of the audit relate to each other, reviewing the working papers on a continuing basis gives the auditor a more integrated picture of the company’s operations. It is also an excellent practice from a supervision point of view. b.It is acceptable for Adams to prepare the financial statements provided she has assured herself that she has obtained sufficient audit evidence to warrant their fair presentation. This is a common practice on many audits because the public accountant has greater expertise in financial statement presentation than the client. c.By not having a review of the working papers by another partner in the firm there is no check against any bias and unintentional error that may exist on the part of the auditor. Except for some degree of independence and technical competence, Adams is in much the same position of the typical controller. An independent review is essential in this case.

6. Problem 21-19, Page 709 Ruben Chavez, a public accountant, has prepared a management representation letter for the president and controller to sign. It contains references to the following items: 1.Inventory is fairly stated at the lower of cost or market and includes no obsolete items. 2.All actual and contingent liabilities are properly included in the statements. 3.All subsequent events of relevance to the financial statements have been disclosed. REQUIRED: a)Why is it desirable to have a letter of representation from the client concerning the above matters when the audit evidence accumulated during the course of the engagement is meant to verify the same information? b)To what extent is the letter of representation useful as audit evidence? c)List several other types of information commonly included in a letter of representation.

7. Problem 21-19 a.It is desirable to have a letter of representation in spite of the accumulated audit evidence to impress upon management its responsibility for the representations in the financial statements and to formally document the responses from the client to inquiries about various aspects of the audit. b.The letter of representation is not very useful as audit evidence since it is a written statement from a non-independent source. In effect, the client who is being audited makes certain representations related to the audit of himself or herself. c.Several other types of information commonly included in a letter of representation are: The company has proper title to all of its assets. All outstanding loans to officers of the company have been identified. All transactions for the year have been conducted at arm’s length. That financial statements are presented in accordance with GAAP. All related party transactions are disclosed. Completeness and availability of financial records, minutes of board meetings, and other pertinent documents.

8. Problem 21-22, Page 710 In analyzing legal expense for Boastman Bottle Company, Bart Little, a public accountant, observes that the company has paid legal fees to three different law firms during the current year. In accordance with his accounting firm’s normal operating practice, Bart requires standard confirmation letters as od the balance sheet date from each of the three law firms. On the last day of fieldwork, Bart notes that one of the confirmations has not yet been received. The confirmation from the second law firm contains a statement to the effect that the law firm deals exclusively in registering patents and refuses to comment on any lawsuits or other legal affairs of the client. The confirmation letter from the third law firm states that there is an outstanding bill due from the client and recognizes the existence of a potentially material lawsuit against the client but refuses to comment further to protect the legal rights of the client REQUIRED: a)Evaluate Bart’s approach to requesting the confirmations and his follow-up on the responses. b)What should Bart do about each of the confirmations?

9. Problem 21-22 a.In this situation, Little need only send confirmation requests to those law firms who are involved with legal matters directly affecting the financial statements. The confirmations should be sent reasonably near to the completion of the field work, but the follow-up on non-responses and unsatisfactory responses should not be deferred until the last day of field work. He should have examined the letter when it was returned and performed follow-up work at that time. Furthermore, the standard legal letter would have asked about the lawsuit if the client had informed the auditor of its existence. b.Regarding the third confirmation, it is necessary to have a conference with the law firm, client, and auditor to determine the nature and significance of the lawsuit. It would be a serious violation of due care to ignore the information in the law firm’s letter. In rare circumstances, a denial of opinion is necessary if the information cannot be obtained. The auditor would also be required to follow up on the first confirmation. Since the second confirmation is from a law firm that only does patent registration (i.e., they do not handle lawsuits), no further follow up is required.