Question:

Case 3-1: Misstatements

Assume you are the audit manager for the 2015 audit of Fox Aeronautics, an SEC registrant. This is your firm's third year with Fox, a company that manufactures components used in airplane assembly. Fox's unaudited 2015 pretax earnings were $95 million. It is now mid-February 2016, and your audit team is evaluating the following potential misstatements from the client's year-end financial statements.

• Income taxes. Fox's tax attorney informed you that it is probable the client will have to pay $7,500 in taxes regarding a tax dispute that began four years ago. The tax professionals at your firm agree with the tax attorney's assessment. Fox's CEO told you the company cannot estimate an amount, noting he is not aware of any similar cases that would provide a good estimate. Therefore, the company did not record any contingent liability for income taxes in the 12/31/15 financial statements. However, Fox did disclose the situation in a financial statement footnote.
• Inventory. The audit team conducted counts of Fox's inventory on a sample basis. The book value of the sample was 5% of the total inventory book value of $120,669,000. The sample items were understated by $17,825.
• Patent Infringement. In 2015, Fox was sued by a competitor for patent infringement. The company recorded a contingent liability of $3,800,000 in its 12/31/15 financial statements. Based on the legal letter and a follow-up discussion with the client's attorney, you are satisfied that it is unlikely at this point that the client will have to either pay a settlement or lose the case in court.
• Allowance for uncollectible accounts. Recently, Fox has had difficulty collecting credit sales efficiently, and its days outstanding in accounts receivable has significantly increased over the past two years. Consequently, Fox increased the percentage of credit sales it uses for calculating the allowance for uncollectible accounts during 2015. Both the board of directors and your firm agree with this change. Fox uses the allowance method for accounting for bad debts, and despite the increase in the allowance account itself, still required a bad debt replenishment of $7,489,800. Fox did not record this year-end adjusting entry.
• Fixed Assets. An accounting error involving depreciation led to an overstatement of depreciation expense by $1,950,000.

Questions:

1. (a) What is the aggregate misstatement? Show all calculations and explain why you believe each potential misstatement is either a misstatement or is not a misstatement.

(b) Does the aggregate misstatement overstate or understate net income?

1. (a) How much of an overall adjustment would you require to issue an unqualified opinion? Provide a specific amount (not a range) and explain your reasoning.

(b) How would you allocate your adjustment from 2(a) to the various accounts? Explain your reasoning. If you did not make an adjustment in part 2(a), assume the partner asked you to make a $1,000,000 adjustment and allocate it to the accounts in question.