Solution Manual For Auditing Cases: An Interactive Learning Approach, 6/E by Mark S. Beasley, North Carolina State University Frank A. Buckless Steven M. Glover Douglas F. Prawitt

Instant Download with all chapters and Answers

Sample Chapters

*you will get solution manuals in PDF in best viewable format after buy*

Understanding
the Client’s Business
and Assessing Risk
2.1 Your1040Return.com . . . . . . . . . . . . . . . . . . . . . . . . . 21
Evaluating eBusiness Revenue Recognition,
Information Privacy, and Electronic Evidence Issues
2.2 Dell Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Evaluation of Client Business Risk
2.3 Flash Technologies, Inc. . . . . . . . . . . . . . . . . . . . . . . . 43
Risk Analysis
2.4 Asher Farms Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
Understanding of Client’s Business Environment
CASES INCLUDED IN THIS SECTION

21
The case was prepared by Mark S. Beasley, Ph.D. and Frank A. Buckless, Ph.D. of North Carolina State University and Steven M. Glover, Ph.D. and
Douglas F. Prawitt, Ph.D. of Brigham Young University, as a basis for class discussion. Your1040Return.com is a fictitious company. All characters
and names represented are fictitious; any similarity to existing companies or persons is purely coincidental.
Your1040Return.com
Evaluating eBusiness Revenue Recognition,
Information Privacy, and Electronic Evidence Issues
Mark S. Beasley · Frank A. Buckless · Steven M. Glover · Douglas F. Prawitt
[1] To illustrate business risks for Internet-only
business models.
[2] To help students develop skills related to
identifying internal control responses to
eBusiness risks.
[3] To highlight revenue recognition issues related
to eBusiness transactions.
[4] To illustrate unique accounting issues associated
with Internet web site banner advertisements.
[5] To help students identify privacy issues
associated with Internet-based business models.
[6] To illustrate audit implications when transaction
audit trails are solely electronic.
[7] To expose students to the benefits of cloud
computing
[8] To help students recognize threats to eBusiness
strategies.
INSTRUCTIONAL OBJECTIVES
KEY FACTS
 Your1040Return.com is a leading provider of online income tax preparation and filing services
for individual taxpayers.
 The company was founded two years ago by Steven Chicago who realized individuals may be
frustrated with the need to purchase tax preparation software upgrades each year to ensure their
tax software reflects recent changes in the tax code.
 Your1040Return.com’s strategy is to provide up-to-date tax preparation software that can be
accessed through the Internet by individuals who pay membership fees for that access.
 In essence, Your1040Return.com’s customers “rent” access to tax preparation software packages
that are continually kept up-to-date with the latest tax law changes. Customers can also use
Your1040Return.com’s services to electronically file an already prepared paper-based tax return.
 Customers can use Your1040Return.com to file both state and federal tax returns.
 Your1040Return.com customers select from one of three service packages: Silver, Gold, or
Platinum.
 Silver package customers can access electronic copies of tax forms, schedules, and publications
and can enter tax return information directly onto those forms and schedules. Your1040Return.
com will also file the completed return electronically to the appropriate regulatory agency.
 In addition to the Silver package services, Gold package customers have one-year access to a
commercially developed and continually maintained tax preparation software package that
assists customers in the preparation of their individual returns.
 Platinum package customers have access to the premium level of services, which allow customers
to have multi-year access to the tax preparation software and personalized attention and realtime tax support from qualified income tax specialists.
C A S E 2.1
22
Section 2: Understanding the Client’s Business and Assessing Risk
 Revenue recognition differs for each product offered by Your1040Return.com.
 Your1040Return.com’s business is seasonal with its highest demand from early February through
April 15th each year. The company experiences peaks in demand during periods surrounding
extension deadlines.
 Tax payments and refunds are not funded by Your1040Return.com. Rather, tax refunds are
remitted directly from the IRS or state agency to the individual. Tax payments are charged by
the IRS or state agency to the individual’s credit card account.
 Your1040Return.com also engages in ad swapping with a number of major Internet companies.
In exchange for providing electronic advertisements on the Your1040Return.com web site, the
company receives free banner ads on other web sites.
 Servers located at Your1040Return.com’s offices support the tax preparation software. The
servers are in facilities with physical access securities and are protected logically by firewalls
and access passwords.
 The company hires several tax experts to monitor tax code changes and to help ensure the
underlying tax software is accurate. The company contracts with a software design firm to
develop the online tools. Two of Chicago’s nephews oversee the operations of the IT platform;
each has less than 5 years of relevant work experience.
 The company’s CFO joined the company after three years of audit experience with a Big Four
international accounting firm.
 The company does not have an official customer privacy policy. The company has been
approached by marketing executives who are interested in purchasing Your1040Return.com’s
customer lists.
 As part of a recent line of credit arrangement with the local bank, Your1040Return.com’s
financial statements must now be audited.
USE OF CASE
This case assignment provides students the opportunity to recognize that while the Internet and
related innovative uses of technology offer opportunities for new avenues for conducting business,
there are unique risks and related accounting issues that must be considered. This case exposes
students to issues associated with a relatively new eBusiness enterprise that provides tax-related
services via the Internet. This case explores several issues that arise with an Internet-based business
model.
First, the case highlights how the Internet provides innovative ways for businesses to deliver
value added services to consumers. As a result, this case exposes students to issues different from
those associated with traditional “brick and mortar” businesses. And, because the underlying
service relates to tax preparation software for customers, accounting students can easily understand
the main components of Your1040Return.com’s service offering to consumers.
Second, the structure of the three levels of product service offerings (Silver, Gold, and
Platinum) provides a nice opportunity to engage students in an analysis and class discussion of
the accounting implications related to revenue recognition. This analysis helps students see how
operational decisions about product and service offerings create different accounting issues for each
offering. In addition, the use of bartering for the ad banner transactions exposes students to a
unique accounting issue for many Internet based businesses.
Third, the case illustrates basic business decisions that start-up companies must make.
For example, the case highlights the practical aspects and related implications of attracting and
hiring affordable employees with the necessary job skills. It also highlights the difficult realities of
maintaining basic business operations with limited resources and talents, such as Your1040Return.
com’s limited IT system and lack of ideal data and system backups. Finally, the case illustrates
tradeoffs business owners must make by highlighting the ethical dilemmas associated with the
potential decision to sell private customer information to external marketing agencies.
23
Case 2.1: Your1040Return.com
This case could be used in either an undergraduate or graduate auditing or accounting
information systems course to highlight unique business risks, internal controls, and audit evidence
issues associated with Internet-based businesses. The questions related to revenue recognition may
be effective for use in an undergraduate intermediate accounting course.
Students can complete the case individually or in groups as an in-class or out-of-class
assignment. Because the case is relatively short, students can read the case during the class period
to prepare for an in-class discussion of several of the questions. Other questions, however, may be
better suited as an out-of-class assignment (e.g., see question 1.g and 1.i) that students complete
before an in-class discussion is held.
This assignment can be broken down into several sub-assignments that can be completed at
various points during a quarter or semester. Students should particularly enjoy this case, given that
it exposes them to broader business issues associated with Internet-based businesses.
PROFESSIONAL STANDARDS
References to AU-C sections have been updated to reflect the new codification of ASB clarity
standards. PCAOB standards are referenced by standard number. Relevant professional standards
for this assignment are:
AICPA ASB Standards: Relevant professional standards for this assignment include AU-C
Section 315 “Understanding the Entity and Its Environment and Assessing the Risks of Material
Misstatement,” AU-C Section 330, “Performing Audit Procedures in Response to Assessed Risks and
Evaluating the Audit Evidence Obtained,” and AU-C Section 540, “Auditing Accounting Estimates,
Including Fair Value Accounting Estimates and Related Disclosures.”
PCAOB Standards: AS5, “An Audit of Internal Control over Financial Reporting That is Integrated
with an Audit of Financial Statements,” AS 8, “Audit Risk,” and AS12, “Identifying and Assessing
Risks of Material Misstatement.” (Note: PCAOB Standards are relevant from an informational
perspective, but are not required since Your1040Return.com is not a public company.)
QUESTIONS AND SUGGESTED SOLUTIONS
[1] You are an audit senior with Gooch & Brown CPA, LLP, a local accounting firm specializing in
audits of information systems and financial statements. Your1040Return.com engaged your
firm to perform its financial statement audit. You have been asked by the partner to perform
the following tasks:
[a] Why does Your1040.com need to have its financial statements audited? How might
understanding the reasons for the audit of the financial statements inform the auditor
about potential audit risk?
The bank that has provided Your1040.com with a bank line of credit has requested that
Your1040.com submit audited financial statements annually as part of the financing
arrangement. Knowledge about the main reasons for Your1040.com to engage your firm to
conduct the audit provides important insight about potential users of the audited financial
statements and how they might be using the audited information to assess the creditworthiness
of Your1040.com. Awareness of the reasons for the audit are also informative to the auditor’s
assessment of the risks of material misstatements, including the risk of fraud. Management
of Your1040.com would have incentives to preserve the line of credit to help manage cash
flows of their business. That incentive, if excessive, may pressure management to present
financial information that portrays a favorable perception of Your1040.com’s financial
strength. Thus, remaining aware of that possible risk would be important to the audit of the
financial statements.
24
Section 2: Understanding the Client’s Business and Assessing Risk
[b] Describe to Stephen Chicago why it is important for your firm to have an understanding of
Your1040Return.com’s business model.
Auditing standards require that the auditor obtain a sufficient understanding of the entity
and its environment, including its internal control, to assess the risk of material misstatement
of the financial statements whether due to error or fraud, and to design the nature, timing,
and extent of further audit procedures. A thorough understanding of the client’s business
model is essential for doing an adequate audit. The nature of the client’s business operations
and industry directly affects client business risks and the risk of material misstatements in
the financial statements. The auditor uses the knowledge about these risks to determine
the appropriate extent of audit evidence to be obtained through further audit procedures.
Without an adequate understanding of the underlying client business models, auditors
may fail to adequately identify relevant business risks. That failure will likely result in
audit procedures inadequately designed to detect material misstatements in the financial
statements.
The auditor should understand factors such as major sources of revenue, key
customers and suppliers, sources of financing, and competitors, among other matters,
related to the client’s core business operations. Through such an understanding, the auditor
may be more likely to identify business risks arising from unique incentives and pressures
or deficiencies in internal controls created by that business model structure that increase
opportunities for misstatements in the financial statements. Additionally, knowledge about
core business models gives auditors a better understanding of the client’s business and
industry to provide value-added services to those clients.
[c] Identify Your1040Return.com’s major business risks and describe how those risks may
increase the likelihood of material misstatements in Your1040Return.com’s financial
statements.
Because Your1040Return.com’s main business model involves the provision of software
and other services accessed through the Internet, the company faces different issues from
traditional “brick and mortar” businesses. Here is an overview of several business risks that
Your1040Return.com faces:
 Customer Demand. Because the business model is solely based on services delivered
through the Internet, there may be individuals who are uncomfortable using the Internet
to use the online tax services. Certain customers may be reluctant to submit personal
tax related financial information over the public Internet. As a result, the customer base
in the online marketplace may be limited. That may put pressure on management to
generate future revenues to maintain profitability goals and targets. That pressure may
provide incentives for management to aggressively account for revenue and expense
transactions to achieve those profitability goals. In some cases, management may select
options that are not in compliance with generally accepted accounting principles.
 Software Technical Accuracy. One of the main selling features for Your1040Return.
com is access to an up-to-date popular tax software package. There is some risk that
the tax preparation software contains errors in the interpretation and application of
the complicated federal and state tax codes, which in turn may cause customers to file
incorrect returns. If that risk is realized, Your1040Return.com may create contingencies
related to potential liabilities associated with litigation claims from customers. In
addition, as information about errors in the tax software packages becomes public,
customers may be reluctant to continue subscribing to the online services offered, which
will lead to decreased revenues. The revenue pressure may lead to incentives to engage
in aggressive accounting to maintain profitability goals.
25
Case 2.1: Your1040Return.com
 Service Availability. Because Your1040Return.com’s core business is based on services
delivered via the Internet, the company faces the risk that customers may not be able to
access the tax preparation software if there is a failure in the Internet link to the services.
Any system failures with Your1040Return.com’s computer servers would prevent the
company from providing services for its customers, unless reliable and quick backup access
is consistently maintained. If the service access is unavailable for a significant amount of
time, the company may lose customers, which would create pressures for management to
maintain its profitability. In addition, the lack of access to services may create revenue
recognition problems given that the company has not fulfilled its service obligations for
customers who have already paid for unlimited access to the software services.
 Inadequate Staff. Currently, key staff positions related to system support and the
accounting functions have limited experience. As Your1040Return.com’s business
continues to grow, the size and complexities associated with company growth may present
issues that the current staff is unable to adequately handle. The lack of experience of the
current staff may result in errors in judgment that lead to misstatements in the financial
statements.
 Electronic Only Evidence. Your1040Return.com engages in all transactions
electronically, with backups of that data performed daily. There is some risk that the data
may be lost or temporarily not accessible, which may increase the difficulty of managing
the business and creating (and auditing) accurate financial statements.
 Customer Privacy. Because customers access Your1040Return.com’s services to
complete their individual tax returns, Your1040Return.com has access to highly
sensitive personal financial and other demographic data. There is a risk that some of that
information might be inadvertently given to or accessed by external parties. If that occurs,
Your1040Return.com may face contingencies associated with litigation and other claims
filed by customers affected that would need to be disclosed in the financial statements.
[d] Indicate what Your1040Return.com should do to improve its internal control?
Below are suggestions designed to strengthen Your1040Return.com’s internal controls:
 Revenue Recognition Controls. Your1040Return.com should evaluate the adequacy of
internal controls surrounding its revenue recognition. Currently, Your1040Return.com
recognizes revenue differently for the three levels of service. For the Platinum service,
revenue for the first year of service is recognized completely at the point the customer
requests the service. Revenue recognition is not spread across the year of service and
is not contingent on the filing of a return. However, revenue for the Gold service is
treated differently. A portion of the revenue is recognized when service is activated with
the remainder not recognized until the customer files the return. Management needs
to evaluate internal controls over revenue recognition to ensure that the treatment is
consistent with generally accepted accounting principles for all levels of service (For
further information regarding revenue recognition see solution to question 1.g).
 Backup and Contingency Controls. Your1040Return.com’s ability to generate
revenues is dependent on the availability of customer access through the Internet to
Your1040Return.com’s servers and databases. The company needs to evaluate the
adequacy of the backup and contingency controls in the event there is a server failure.
Backup files should be made frequently (at least daily) and stored off site in secure
environments. Alternative servers fully loaded with software and necessary backup data
files should be available so that service can be provided in the event of a system failure.
These backup and contingency controls should be regularly tested.
26
Section 2: Understanding the Client’s Business and Assessing Risk
 Privacy Controls. Because Your1040Return.com has access to highly sensitive customer
financial and other demographic information, Your1040Return.com should develop
a formal customer privacy policy that identifies how private customer information
is maintained and protected. Without a formal policy, sensitive information may be
inadvertently released, which may expose Your1040Return.com to significant liabilities.
In addition, the company should ensure that policies related to security controls (i.e.,
firewalls and passwords) are continually evaluated for adequacy.
 Controls Over Advertising Arrangements. Because contracts associated with banner
advertising can often contain complex revenue provisions (i.e., ad revenues can often
be a function of the number of hits to the banner ads and the extent of subsequent drill
downs on the advertiser’s web site), Your1040Return.com needs to develop controls
to ensure the company correctly understands and accounts for revenue transactions
generated from offering banner advertisements.
[e] Explain what audit implications arise if you decide that the controls over electronic records
at Your1040Return.com are inadequate to ensure that records have not been altered?
Given that all transactions are documented solely in electronic form, there is no alternative
paper trail to serve as evidence supporting financial statement transactions and accounts. If
the auditor is unable to determine that electronic records have not been altered, there may
be no reliable evidence for the auditor to examine when evaluating the fair presentation
of account balances and transactions. In certain cases, the lack of reliable electronic or
other alternative evidence may cause the auditor to conclude that the entity is un-auditable
(see AU-C 500, “Evidential Matter”). In that case, the auditor may be unable to accept the
audit engagement or may have to withdraw at a later date. Thus, Your1040Return.com’s
management needs to establish effective internal controls to ensure that adequate evidence
is maintained to support accounts and transactions in the financial statements.
[f] Steven Chicago has indicated that he is exploring upgrades to the company’s IT systems.
Your audit partner would like you to explore whether cloud computing is an option that
your firm might recommend for consideration by Steven, Perform research to explain what
cloud computing is and why it might offer benefits to Your1040.com.
COSO’s thought paper, Enterprise Risk Management for Cloud Computing, defines cloud
computing as “a computing resource deployment and procurement model that enables
an organization to obtain its computing resources and applications from any location via
an Internet connection.” Depending on a particular cloud solution, all or parts of the
organization’s hardware, software, and data might reside on servers in data centers managed
by the cloud service provider. One of the most signficant benefits of this cloud solution for
Your1040.com is the fact that the hardware supporting the tax return preparation software
and related data storage would be managed by a third-party IT service provider that is in
the business of maintaining and securing IT platforms. Thus, the level of infrastructure
support and security surrounding Your1040.com’s systems would most likely be signficantly
strengthened. Additionally, given Your1040.com’s business model is seasonal, the cloud
option most likely would provide Your1040.com the ability to scale up operations during
peak times and then scale down operations in off-peak times. The cloud option would also
be more likely to support any significant growth in Your1040.com’s business, given the
scalability options of cloud-based IT solutions.
[g] Authoritative literature provides guidelines for proper revenue recognition policies for
transactions such as those discussed in the case. Analyze Your1040Return.com’s revenue
recognition policies for the three package services. Provide appropriate citations to
authoritative literature.
27
Case 2.1: Your1040Return.com
As summarized in the case materials, Your1040Return.com recognizes revenues differently
for each of the three service packages.
Your1040Return.com’s Revenue Recognition Policies
For the Silver package, customers pay for access to tax forms, schedules, and publications.
And, Silver package customers can submit tax forms electronically. Access is only allowed
for one year. Your 1040.com recognizes revenue on the Silver package when the customer
submits the tax return to the IRS or state agency.
Gold package customers can access the tax preparation software to complete and submit
the return. Access is allowed for one year. Your1040Return.com recognizes a portion
of the revenue when the customer accesses the tax software package for the first time.
Your1040Return.com recognizes the remaining portion of the revenues when the customer
submits the return.
Platinum package customers pay to access the tax software on a multi-year contract basis.
Customers can access the tax software package year round to update their tax information
and they can receive personalized attention and real-time tax support from qualified income
tax specialists. Your1040Return.com recognizes revenues for each year immediately after
the customer selects the Platinum service.
At a minimum, Your1040Return.com needs to evaluate their revenue recognition policies
to ensure they are applying revenue recognition criteria correctly and consistently across all
three products. In addition, Your1040Return.com needs to evaluate implications of their
cancellation policy to determine whether they need to record an accrual for the cancellation
expense.
Guidance Relevant to Revenue Recognition
The Financial Accounting Standards Board (FASB) and the International Accounting
Standards Board (IASB) recently completed a joint project to develop a common revenue
standard for U.S. GAAP and IFRS to improve revenue recognition practices and to remove
inconsistencies and weaknesses in revenue requirements. The updated guidance is contained
in the Accounting Standards Codification as Topic 606, “Revenue from Contracts with
Customers.” In order to record revenue transactions, ASC 606, “Revenue from Contracts
with Customers,” describes the core principle for revenue recognition as follows: “…the
entity should recognize revenue to depict the transfer of promised goods or services to
customers in the amount that reflects the consideration to which the entity expects to be
entitled in exchange for those goods or services.” To achieve that core principle, ASC 606
notes that the entity should apply the following steps:
Step 1: Identify the contract(s) with a customer.
Step 2: Identify the performance obligations in the contract.
Step 3: Determine the transaction price.
Step 4: Allocate the transaction price to the performance obligations in the contract.
Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation.
For Your1040Return.com, all three packages (Silver, Gold, and Platinum) grant customers
access to the web site for a contracted period of time. For the Silver and Gold memberships,
28
Section 2: Understanding the Client’s Business and Assessing Risk
customers have access for a full year. For the Platinum service, customers contract for
multiple year service. Because the services allow customers access for a period of time,
one may argue that Your1040Return.com should recognize revenues for the Silver and Gold
services evenly over the 12-month contractual period. For the Platinum service, revenues
should be spread evenly over the number of months contracted in the multi-year package
selected.
While all of the revenues for the Silver package and a portion of the revenues for the Gold
package are not recognized until the customer files the tax return, one could argue that
Your1040Return.com is prematurely recording a portion of the revenue. Even though the
tax return has been filed by the customer, both the Silver and Gold packages allow customers
access to the web site information to file amendments to their already filed returns. Thus,
Your1040Return.com promises access to services beyond the tax return filing date. As a
result, Your1040Return.com has an obligation to its customers for the entire one-year
period. Thus, revenues are not fully realized until the 12 months expire.
Your1040Return.com’s revenue recognition policy appears most aggressive for the Platinum
package. Fees for each year’s service are recognized as revenue immediately after the
customer selects the Platinum option. Because the customer is paying for access to the
software and tax specialists for an entire year, revenues from the Platinum service should
be earned proportionately over the entire contract period. Thus, Your1040Return.com
should modify its revenue recognition policy for the Platinum service to ensure that it is not
prematurely recording revenues.
Your1040Return.com needs to evaluate the extent that customers have cancelled previously
paid for services during the contract period, as allowed by its cancellation policy. Management
needs to perform this evaluation to provide a basis for developing an estimate for the
cancellation expense and related liability that should be recorded to reflect this cancellation
expense in the financial statements. Your1040Return.com should also determine whether
the cancellation policy should be modified to clearly communicate cancellation options for
customers during the contract period.
[h] Explain how you can obtain evidence that ad swapping actually occurred between the
Your1040Return.com and Amazon.com? Describe accounting issues that arise when
Internet-based companies swap ad services and identify relevant authoritative literature.
Your1040Return.com and Amazon should have entered into formal contracts regarding the
exchange of advertising services on each company’s web sites. The auditor would want to
obtain copies of the contracts for the audit files to determine the terms of the arrangements
and obligations each company has to provide advertisements. Reviews of those contracts
would help the auditor determine whether there are underlying accounting issues related to
recognizing revenues for advertisements provided on the Your1040Return.com web site or
expenses related to Your1040Return.com advertisements at Amazon.com’s web site.
The web site systems can be designed to track the time and date advertisements
are programmed to appear on the respective web sites. Reports or logs from these systems
could be reconciled back to the ad contracts for compliance. Based on information obtained
from the review of the ad contracts, the auditor could also visit the respective web sites at
those scheduled times to determine if the ads actually appear as stipulated in the contracts.
Because neither Your1040Return.com nor Amazon.com actually pay each other for
the advertising services, both companies have actually entered into a non-monetary barter
transaction. While currently there is no formal pronouncement from the FASB specifically
addressing the accounting for web site advertising arranged on a barter basis, there is relevant
29
Case 2.1: Your1040Return.com
guidance for accounting for non-monetary transactions. Accounting Standards Codification
No. 845, Nonmonentary Transactions, states that “the accounting for nonmonetary transactions
should be based on the fair values of the assets (or services) involved, which is the same basis as
that used in monetary transactions. Thus, the cost of a nonmonetary asset acquired in exchange
for another nonmonetary asset is the fair value of the asset surrendered to obtain it, and a gain
or loss shall be recognized on the exchange. The fair value of the asset received shall be used to
measure the cost if it is more clearly evident than the fair value of the asset surrendered.” ASC No.
920, Entertainment – Broadcasters, contains guidance related to bartering of advertising in
the broadcast industry that may be analogous to Your1040Return.com’s use of bartering for
banner related advertising. Paragraph 30-1 of ASC No. 920 states that “All barter transactions
except those involving the exchange of advertising time for network programming shall be reported
at the estimated fair market value of the product or service received.”
As a result of these accounting provisions, Your1040Return.com needs to gather
information to determine the fair market value of the revenues related to advertising it
provides for Amazon.com on the Your1040Return.com web site. And, management needs to
gather information to determine the fair market value of the expenses related to advertising
Your1040Return.com incurs for advertisements on the Amazon.com web site. In addition,
information in the contract may provide useful information about the timing of the banner
advertisements to determine if there are related receivables and payables that should be
reflected in Your1040Return.com’s balance sheet.
[i] Address a memo to Steven Chicago detailing the appropriate contents for a customer
privacy policy. (You may want to visit other company web sites, such as www.amazon.
com, to see an example of a privacy policy.) Why is it important for Your1040Return.com
to have an explicit privacy policy? How might the lack of a policy affect Your1040Return.
com’s financial statements in the future?
Online privacy policies should focus on protecting the privacy of personal information
an organization may collect from its customers through its electronic commerce systems.
The AICPA/CICA’s Trust Services Principles and Criteria provide useful guidance about
the importance of online privacy protection for customers engaging in Internet-based
businesses that could be pointed out in a memo to Steven Chicago. You could note that
the following concepts are commonly used to facilitate the creation and implementation of
privacy policies and practices:
 Notice. An entity should inform customers about its privacy policies and practices at or
before the time information is collected or as soon as practicable thereafter. The notice
should describe the purpose for which personal information is collected and how it will
be used.
 Choice and Consent. The entity should describe the choices available to individuals and
obtain consent from them with respect to the collection, use, disclosure, and retention of
personal information.
 Collection. The entity should limit the collection of personal information to that which
is necessary for the purpose described in the notice.
 Use and Retention. The entity should limit the use of personal information to the
purposes described in the notice and for which the individual has provided either implicit
or explicit consent. The entity should retain personal information for only as long as
necessary for the fulfillment of the stated purposes, or as required by law or regulation.
 Access. Customers should have access to their own personal or sensitive information for
the purposes of correction, update and deletion.
30
Section 2: Understanding the Client’s Business and Assessing Risk
 Onward Transfer and Disclosure. The entity should only disclose personal information
to third parties for purposes described in the notice and for which the individual has
provided either implicit or explicit consent, or as permitted by law or regulations. The
entity should only disclose personal information to third parties who provide substantially
equivalent privacy protection as the entity.
 Security. The entity that gathers, maintains, or uses personal information must take
reasonable precautions to protect the information from loss, misuse, unauthorized
access, disclosure, alteration, and destruction.
 Integrity. The entity should take reasonable care that the information it collects, whether
personal or sensitive, be relevant for the purposes for which it is to be used.
 Management and Enforcement. The entity should provide procedures for assurance
of compliance with its own privacy policies and independent recourse procedures to
address any unresolved complaints and disputes. The entity should designate one or
more individuals who are accountable for the entity’s compliance with its privacy policies.
It is important for Your1040Return.com to consider developing an online privacy
policy because it is important for consumers to have confidence that an entity takes appropriate
steps to protect personal information, especially information as sensitive as that surrounding
income and taxation. Because many consumers consider the use of private information about
them to be an invasion of their privacy, it is important that entities inform their customers
about the kinds of information that are collected about them, the uses of that information,
customer options, and related matters. Additionally, some countries have implemented laws
and regulations covering the privacy of information obtained through e-commerce.
Failure to develop a formal online privacy policy may lead to future issues that may have
an impact on Your1040Return.com’s financial statements. First, the lack of a policy may cause
some customers to not purchase or renew tax preparation services from Your1040Return.
com. Given that customers are using Your1040Return.com’s services to prepare and submit
highly-sensitive personal tax information, the lack of an adequate privacy policy may be of
major concern to potential customers. That reluctance may put pressure on management to
generate adequate revenues to be profitable. Second, the lack of an adequately stated privacy
policy creates uncertainty as to how Your1040Return.com can use the information it collects
from customers ordering tax services online. That lack of uncertainty may lead to inconsistent
interpretations about the appropriate uses of the personal information. In some cases,
customers may be offended by Your1040Return.com’s decision to use the personal information
it collects (e.g., decision to sell the customer lists to marketing agencies). Those customers
may ultimately enter into litigation against Your1040Return.com to prevent further misuse.
Any contingencies that arise related to the litigation may warrant disclosure and recording in
the Your1040Return.com financial statements.
Delta Airlines’ opening web page at www.delta.com contains an online link to its privacy
& security policies. To examine the Delta privacy policy, visit this web site link:
http://www.delta.com/privacy_security/index.jsp
[2] Your1040Return.com’s main business strategy involves the delivery of services via the Internet.
What are some threats to the viability of Your1040Return.com’s business strategy?
Because Your1040Return.com’s core business strategy involves the delivery of services to
customers via the Internet, there are several issues that threaten the viability of successfully
continuing this service. Below are examples of some of those threats (note that the answers to
this question are similar to those for question 1-c):
31
Case 2.1: Your1040Return.com
 Customer Demand. Because the business model is based solely on services delivered
through the Internet, there may be individuals who are uncomfortable using the Internet
to use the online tax services. Certain customers may be reluctant to submit personal tax
related financial information over the public Internet. As a result, the customer base in the
online marketplace may be limited. One of Your1040Return.com’s comparative advantages
is that it provides customers access to the most up-to-date tax preparation software. If
providers of traditional tax preparation software purchased in retail stores make available
easy access to updated software, there may be less demand for Your1040Return.com’s online
access to up-to-date software.
 Software Technical Accuracy. One of the main selling features for Your1040Return.com
is access to an up-to-date popular tax software package. There is some risk that the tax
preparation software contains errors in the interpretation and application of the complicated
federal and state tax codes, which in turn may cause customers to file incorrect returns. If
that risk is realized, Your1040Return.com may lose its customer base.
 Service Availability. Because Your1040Return.com’s core business is based on services
delivered via the Internet, the company faces the risk that customers may not be able to
access the tax preparation software if there is a failure in the Internet link to the services.
Any system failures with Your1040Return.com’s computer servers would prevent the
company from providing services for its customers, unless reliable and quick backup access
is consistently maintained. If the service access is unavailable for a significant amount of
time, the company may lose its core customer base.
 Customer Privacy. Certain customers may be reluctant to submit personal tax related
financial information over the public Internet because of concerns about the privacy of their
highly sensitive tax information. As a result, the customer base in the online marketplace may
be limited. Any breaches in customer privacy may cause a deterioration of Your1040Return.
com’s customer base.
 Competitors. Given Your1040Return.com’s success of offering online tax preparation
software, other established tax preparers may decide to compete directly with
Your1040Return.com. Tax preparers, such as H&R Block and national CPA firms,
may decide to offer similar online tax preparation software services. To some extent,
the IRS already competes with the Silver service package, given that individuals can
access electronic copies of tax schedules, forms, and publication via the IRS web site
(http://www.irs.gov/).
[3] When customers register for the Platinum package, they have online access to tax professionals
who are paid on a contract basis. If you were in Steven Chicago’s shoes, how would you
compensate those professionals for their services? What controls could Your1040Return.com
implement to ensure that the company does not overpay for those professional services?
Currently, the tax professionals who provide online tax consulting to Platinum service
customers are compensated on a contract basis. Most likely, Steven Chicago would compensate
those individuals on an hourly basis for the work they perform. Perhaps a small set of those
professionals may be contracted on a retainer basis to perform a minimum number of hours of
service each month or quarter of the year for Your1040Return.com customers. Each month (or
quarter) the tax professionals could submit a detailed time analysis of the work performed to
determine if the minimum number of hours have been worked in accordance with the retainer
agreement. In the event the number of hours worked exceed the contracted amount, the tax
professionals would be paid for the additional work performed on an hourly rate basis.
Your1040Return.com should design adequate controls to ensure that the tax
professionals perform legitimate tax consulting services in exchange for their pay. Perhaps, the
32
Section 2: Understanding the Client’s Business and Assessing Risk
Your1040Return.com web site could be designed to capture information when the customer
clicks on a link to activate the instant messenger program that allows communication between
the Platinum customer and the tax professional service. The web site could be designed such
that pertinent information is captured (e.g., time, date, customer number, question asked)
automatically by Your1040Return.com’s server. The server could also be designed to capture
information about the tax professional (e.g., contractor id) who responds to the customer’s
inquiry. That information captured automatically could then be reconciled to the monthly
time analysis submitted by the tax professional that indicates the services performed for the
customer. The tax professional’s time analysis would be set up to “charge” hours worked to each
customer number serviced by that professional. Your1040Return.com could also require the
tax professional to retain electronic or paper copies of the responses provided to the customer
via the internet messenger program as backup of all services performed. Your1040Return.com
could selectively “audit” charges submitted by the tax professionals back to these files on a
periodic basis.
Thinking about the issues Your1040Return.com faces in paying its tax consultants is a
valuable exercise that will bring students face-to-face with the challenging issues brought about
by the unique e-business models made possible by the Internet. Thus, the specific content
of student answers to this question is less important than the depth of their thinking and the
quality of their insights.
[4] Auditing standards provide guidance for auditors when evaluating electronic evidence. What
are the implications for an auditor when a client’s accounting system produces and stores
transaction evidence only electronically?
Paragraph A134 of AU-C Section 315, “Understanding the Entity and Its Environment and
Assessing the Risk of Material Misstatement”, summarizes the implications as follows:
“When such routine business transactions are subject to highly automated processing with
little or no manual intervention, it may not be possible to perform only substantive procedures
in relation to the risk. For example, the auditor may consider this to be the case when a
significant amount of an entity’s information is initiated, authorized, recorded, processed, or
reported only in electronic form, such as in an integrated system. In such cases
– audit evidence may be available only in electronic form, and its sufficiency and
appropriateness usually depend on the effectiveness of controls over its accuracy and
completeness.
– the potential for improper initiation or alteration of information to occur and not be
detected may be greater if appropriate controls are not operating effectively.”
33
1 The background information about Dell Computer Corporation was taken from Dell Computer Corporation’s January 28, 2011 Form 10-K
filed with the Securities and Exchange Commission.
The case was prepared by Mark S. Beasley, Ph.D. and Frank A. Buckless, Ph.D. of North Carolina State University and Steven M. Glover, Ph.D. and
Douglas F. Prawitt, Ph.D. of Brigham Young University, as a basis for class discussion. It is not intended to illustrate either effective or ineffective
handling of an administrative situation.
Apple Inc.
Evaluation of Client Business Risk
Mark S. Beasley · Frank A. Buckless · Steven M. Glover · Douglas F. Prawitt
[1] To provide experience with obtaining and reading a form 10-K report.
[2] To provide experience with identifying information relevant for assessing a client’s business risks.
[3] To provide experience with linking business
risks to audit implications.
[4] To provide experience linking an audit client’s
business risks to risks of material financial misstatement.
[5] To provide experience with writing a formal
business memorandum.
INSTRUCTIONAL OBJECTIVES
KEY FACTS
 Apple Inc. (Apple) is a publicly traded company (NASDAQ) that had 899,738,000 shares of
common stock outstanding with a trading price of $508.89 as of October 18, 2013.
 Apple offers a broad range of products and services including iPhone®, iPad®, Mac®, iPod®,
Apple TV®, a portfolio of consumer and professional software applications, the iOS and OS
X® operating systems, iCloud®, and a variety of accessory, service and support offerings. The
Company also sells and delivers digital content and applications through the iTunes Store ®, App
StoreTM, iBooks StoreTM, and Mac App Store.
 Apple’s hardware products are manufactured primarily by outsourcing partners that are located
in Asia.
 Apple’s net revenue for fiscal 2013 was $170.9 billion while net income was $37.0 billion.
 Apple’s percentage sales by geographic mareket are: Americas 16.7%; Europe 22.2%; Greater
China 14.9%; Japan 7.9%; Rest of Asia Pacific 6.5%; and Retail 11.8%.
 Apple’s percentage sales by product are: iPhone 53.4%; iPad 18.7%; Mac 12.6%; iPod 2.6%;
iTunes, software and services 9.4%; and Accessories 3.3%.
 Apple is required to have an integrated audit of its consolidated financial statements and its
internal control over financial reporting in accordance with the standards of the Public Company
Accounting Oversight Board (United States).
 Apple’s fiscal year is the 52 or 53-week period that ends on the last Saturday of September.
USE OF CASE
Many students will be uncomfortable with this case assignment if they have had no previous
experience analyzing a company’s business risk. This case assignment will provide students with
a structure for evaluating an audit client’s business risk. The case assignment is best used in an
undergraduate and graduating auditing course when understanding a client’s business or audit risk
and materiality are discussed.
C A S E 2.2
34
Section 2: Understanding the Client’s Business and Assessing Risk
The approach we recommend for this assignment is to first ask students to review the case
assignment materials and conduct a preliminary “in-class” discussion of the business risks to be
included in the evaluation memorandum and case requirements. Specifically, it is useful to begin
with a discussion of emerging business forces and business strategies related to the electronics/
computer industry. A useful learning activity for the “in-class” assignment is “roundtable.” The
basic process for this activity is to have students meet in small groups to state aloud and write
down on a single sheet of paper their ideas for the external business forces (customers, competitors,
suppliers, labor, capital market, and regulations). For example, students could first discuss their
ideas concerning customers, then competitors, then suppliers, and so on. Once all students have
had an opportunity to state their ideas and arrive at a group consensus, the instructor can randomly
call on individual students to share their group’s answer with the class. Students normally do not
have a difficult time identifying that the primary business strategy used by Apple is differnetiation.
The selected financial information for Apple and Samsung (provided at the end of this document)
is a useful to share with students to discuss Apple’s strategy and highlight how the strategy can be
understood by looking at the financial information. Before discussing with the class you can ask
students to compare and contrast the financial information for the two companies in small groups
and then call on individuals to share what was discussed in their group.
For the “out-of-class” assignment, it is important to discuss the solution with students to
maximize their learning experience. Active learning activities can easily be adapted to the “outof-class” component of this assignment. The learning activity called “homework review” could be
used to discuss the students’ answers to this assignment. The basic process for this activity is to
have the students meet in pairs or small groups to compare and discuss their responses to questions
2a through 2j. The tasks of answering and checking the accuracy of each explanation should be
rotated among pairs or group members. After students have had the opportunity to review all their
responses the instructor can randomly call on individual students to share their responses with the
class. It is important for the instructor to randomly call on individual students to ensure that all
students take responsibility for learning the material. Note, if students complete their answers in
pairs or groups “out-of-class,” it is best to have students discuss their answers with different students
“in-class.”
If the case assignment is going to be used as an “out-of-class” writing assignment, we
recommend discussing the case requirements with the students prior to having them complete the
assignment. A useful learning technique to use for the “out-of-class” writing assignment is “peer
editing.” With this approach students first meet in pairs to develop an outline for their written
solutions. Once an outline is developed, students individually draft a written response based on
the outline. When the drafts are completed, students exchange draft responses and prepare written
suggestions on the grammar, organization, and accuracy of the composition. Students then meet
to discuss revisions for each draft. Finally, students revise their responses based on the suggestions
provided. To ensure the process is followed, students should attach their final draft to the outline
and critiqued drafts when given to the instructor.
When multiple writing projects are assigned during the semester, the above approach can
be modified to require students to complete a joint response in place of individual responses. The
basic difference is that one student is assigned responsibility to compose and re-write the written
response while the other student is assigned responsibility to critique the original draft. Students
should still meet to create an outline for the written solution. The responsibilities of writer and
reviewer should be alternated for each written assignment.
PROFESSIONAL STANDARDS
References to AU-C sections have been updated to reflect the codification of ASB clarity standards.
PCAOB standards are referenced by standard number. Relevant professional standards for this
assignment are:
35
Case 2.2: Apple Inc.
AICPA ASB Standards: AU-C Section 240 “Consideration of Fraud in a Financial Statement
Audit,” AU-C Section 300 “Planning an Audit,” and AU-C Section 315 “Understanding the Entity
and Its Environment and Assessing the Risks of Material Misstatement.”
PCAOB Standards: AS8, “Audit Risk,” AS9, “Audit Planning,” and AS12, “Identifying and Assessing
Risks of Material Misstatement”
QUESTIONS AND SUGGESTED SOLUTION
Solution for “In-Class” Discussion
As discussed earlier in the “Use of Case” section, we suggest that you introduce this case by first
having an “in-class” discussion of emerging business forces and Apple’s business strategy. Here are
some suggested points that could be made:
Emerging Business Forces
 Customers – Apple designs, manufactures and sells consumer electronics, computers, software
and related services to a wide sepctrum of customers from large organizations to individuals.
Apple’s products are distinctive using their own operating system to ensure full software and
hardware integration that enhances quality and usability.
 Competitors – Apple’s major competitors include Samsung, Amazon, Google, Microsoft, Dell,
Hewlett-Packard, IBM, and Lenovo. The markets for Apple’s products and services are highly
competitative. Apple’s future success is dependent on its ability to continue to develop and offer
new innovative products and services to its customers.
 Suppliers – Hardware components for Apple’s products are obtained primarily from contract
manufacturering partners. Many hardware components can be purchased in a highly competitive
global market served by many contract manufacturers. In contrast, some hardware components
are customized for Apple and may be available from only one manufacturering source. The cost of
switching suppliers, other than customized component suppliers, is relatively low as there are many
contract manufacturers available to provide components included in Apple’s products.
 Labor – Labor is less than two percent of the total cost of producing an iPhone. Labor costs for
other products are also a small proportion of the total cost of producing the products.
 Capital Markets – The market for mobile communicaton and media devices, personal computers,
portable music and media devices, and related software and services is highly competitive and
considered a high risk industry. There are several large and well financed companies participating
in this industry. Therefore, there is not an overabundance of long-term investors and creditors
available to finance new entrants into this market.
 Regulations – Apple must comply with various federal, state and international laws governing
product safety (for example, U.S. Consumer Product Safety), radio frequency emission (for
example, U.S. Federal Communications Commission), import/export activities (for example, U.S.
Department of Commerce), anti-trust activities (for example, U.S. Federal Trade Commission
and Department of Justice), environment activities (for example, U.S. Environmental Protection
Agency), and labor activities (for example, U.S. Department of Labor Occupational Safety
& Health Administration). There are no changes to the regulatory environment suggesting a
change to Apple’s competitive position.
Business Strategy
 Apple’s products are noted for their innovative design and ease of use suggesting that Apple’s
primary mode of competition is differentiation and not cost leadership.
 Financial information is provided for Apple and Samsung as a percentage of net revenues and
total assets. Apple generally has had a higher gross margin percent and lower asset turnover
36
Section 2: Understanding the Client’s Business and Assessing Risk
than Samsung. This information is consistent with Apple following a differentiation strategy.
Although the information suggests that Samsung’s gross margin has been improving.
 Other interesting insights that can be obtained from the information provided is that long-term
operating assets represent less than ten percent of total assets for Apple but are more than thirty
percent for Samsung. This information highlights that Apple relies on contract manugacturers
more than Samsung and that Samsung manugactures and sells a broader range of products as
compared to Apple. Both companies finance less than ten percent of their assests through longterm debt.
Solution for Case Assignment
[1] Go to Apple’s website (investor.apple.com) and explore the website. Click on the “SEC Filings”
link. Obtain the most recent SEC Form 10-K provided for Apple. Based on the information
obtained from the website and your knowledge of the industry, prepare a memo discussing the
following items:
[a] Apple’s information for fiscal year ended 9/28/2013:
Sales – $170.9 billion
Net income – $37.0 billion
Cash flow from operating activities – $53.7 billion
Total assets – $207.0 billion
Number of employees – Approximately 80,300 full-time employees
[b] What are Apple’s products?
Apple’s primary product offerings include the following items: iPhone®, iPad®, Mac®, iPod®,
Apple TV®, a portfolio of consumer and professional software applications, the iOS and OS
X® operating systems, iCloud®, and a variety of accessory, service and support offerings. The
Company also sells and delivers digital content and applications through the iTunes Store ®,
App StoreTM, iBooks StoreTM, and Mac App Store.
[c] Who are Apple’s competitors?
Major competitors for Apple include Samsung, Amazon, Google, Microsoft, Dell, HewlettPackard, IBM, and Lenovo. The markets for the Company’s products and services are highly
competitive. The market for the company’s products and services can be characterized by
frequent product introductions and rapid technological advances.
[d] Who are Apple’s customers?
Apple sells its products and services to consumers; small and mid-sized businesses; and
education, enterprise and government customers.
[e] Who are Apple’s suppliers?
Apple uses contract manufacturers for hardware components used in its products. Hardware
components are generally available from multiple sources. Some hardware components are
customized for Apple and may be available from only one manufacturering source. The final
assembly of products is performed in whole or in part by a few outsourcing partners located
primarily in Asia.
[f] How does Apple market and distribute its products?
Apple sells its products and resells third-party products in most of its major markets directly
to consumers and small and mid-sized businesses through its retail and online stores and
its direct sales force. The Company also employs a variety of indirect distribution channels,
such as third-party cellular network carriers, wholesalers, retailers, and value-added resellers.
During 2013, the Company’s net sales through its direct and indirect distribution channels
accounted for 30% and 70%, respectively, of total net sales.
37
Case 2.2: Apple Inc.
[g] What is Apple’s basic business strategy (cost leadership or differentiation)?
Apple’s basic business strategy is differentiation. Apple is noted for providing products
with innovative design and ease of use. The Company’s objective is to design and develop
operating systems, hardware, application software, and services that provide customers new
products and solutions with superior ease-of-use, seamless integration, and innovative design.
The Company believes continual investment in research and development, marketing and
advertising is critical to the development and sale of innovative products and technologies.
The Company does not try to sell its product and services at the lowest price, rather it wants its
customer to have a superior experience with its prodcuts and services.
What are critical business processes for Apple given its basic business strategy ( for example,
supply chain management)?
 Processes related to product development. The most critical business process for Apple is
its product and service development. The Company has experienced substantial growth
from the early 2000s with the introduction of the iPod, then iPhone and iPad. Recently
the company introduced the iWatch. The company has relied on the introduction of new
innovative products that have had a disruptive effect to the marketplace. Apple’s ability to
compete successfully depends heavily upon its ability to ensure a continual and timely flow
of competitive products, services and technologies to the marketplace.
 Processes related to customer relations. Demand for technology products is volatile. Good
communications between Apple and its customers can help it properly plan for changes in
demand. Additionally, good communications with customers can help ensure that Apple
introduces products and services with features most desirable to customers.
 Processes related to supplier relations. The manucfacturing and final assembly of Apple
products is handled by contract manufacturers. Many components are available from
multiple sources while some components and final assembly have few sources. Samsung,
a primary competitor, is the only provider of application processors and Foxconn is the
main assembler of Apple products. Apple must have good relations with its suppliers to
continuously introduce reliable products with new innovative technology.
[h] What accounting information is associated with the critical business processes and how
does Apple measure-up on that information?
 Accounting information associated with product and service development would include
sales and service revenues, gross margin, accounts receivable, inventory, and research
and development expense. Financial information for Apple Inc. is provided at the end
of this case. Apple’s revenues have grown by over 300 percent over the last five years
but the rate of growth has slowed in the most recent year. Apple’s gross margin percent
has ranged from 37.6 percent to 43.9 percent over the last five years with the lowest
margin in the most recent year. Accounts receivable turnover have ranged from 14.2 to
19.9 over the last five years with the lowest accounts receivable turnover in the most
recent year. Inventory turnover has ranged from 52.5 to 112.1over the last five years with
the inventory turnover for the most current year being 83.5. Reseach and development
expenditures as a percent of revenues have ranged from 2.2 percent to 3.1 percent over
the last five years with the most recent year being 2.6 percent. In total, research and
development expenses have been growing. The accounting information suggests that
Apple continues to be sucessful with prodcut and service development but there are
competitive forces putting downward pressure on Apple’s performance.
 Accounting information associated with customer relations would include sales
and service revenue, accounts receivable, and selling expense. Selling, general and
38
Section 2: Understanding the Client’s Business and Assessing Risk
administrative expense have been growing at a rate of over 30 percent per year until the
most recent year where the year over year growth was approximately 7 percent. Selling,
general, and adminsistrative expense as a percent of revenues has declined over the last
five years from 9.7 percent to 6.3 percent. The accounting information suggests that
Apple continues to be sucessful with customer relations but there are competitive forces
putting downward pressure on Apple’s performance.
 Accounting information associated with supplier relations would include cost of sales,
inventory, accounts payable, and warranty expense. Cost of goods sold as a percent of
revenues has ranged from 56.1 percent to 62.4 percent over the last five years with the
highest percentage in the most recent year. Inventory turnover has ranged from 52.5 to
112.1over the last five years with the most recent inventory turnover of 83.5. Accounts
payable turnover has ranged from 4.5 to 4.9 over the last five years with the most recent
accounts payable turnover of 4.9. Warranty expense was 0.4 million in 2009, 0.9 million
in 2010, $1.6 million in 2011, 2.2 million in 2012, and 5.0 million in 2013. As a percent
of revenues warranty expense has ranged from 1.0 percent to 2.9 percent with the highest
percent in 2013. The accounting information suggests that Apple has been sucessful
with supplier relations but there may be some issues going forward.
[i] What accounting method is Apple using to report the accounting information associated
with critical business processes and what is the risk of material misstatement?
 Revenue – recognized when persuasive evidence of an arrangement exists, delivery has
occurred, the sales price is fixed or determinable, and collection is probable. For most
of the Company’s sales, these criteria are met at the time the product is shipped. Service
revenues are recongnized over the service coverage period. The company reduces
revenues for esitmates related to returns and price reductions. There is extreme pressure
for Apple to show continuous revenue growth. Additionally, Apple has experienced
extreme competition in recent years with some of its key products like the iPhone. There
is some risk of misstatement given the competitive nature of the industry, Apple’s desire
to show continuous revenue growth, and Apple’s desire to be a market leader.
 Accounts receivable – allowance method for uncollectible accounts. The business
economies are slowly recovering for Apple’s primary markets reducing the likelihood of
misstatement.
 Cost of revenues (sales) – method not discussed in notes to financial statements. Cost
of revenues are required to be reported when the related sale is recorded. Some risk
of misstatement as Apple is strategically focused on differentiation and strong gross
margins are expected with this strategy.
 Inventory – The lower of cost or market. Cost is computed using FIFO. There is a low
risk of misstatement given that Apple does not manufacture components or handle final
assembly of its products and it has done an excellent job of minimizing its inventory
levels (limiting the risk of obsolescence).
 Accounts payable – method not discussed in notes to financial statements. Accounts
payable are required to be recorded when related goods or services are received. There
is a low risk of misstatement as the numbers are consistent with our understanding of the
current business environment.
 Warranty expense – estimated and recorded in year of sale. Warranty expense was
2.9 percent, 1.4 percent, and 1.5 percent of sales for the three most recent fiscal years.
Some risk of misstatement as Apple is strategically focused on differentiation and thus
is consistently introducing new product features creating uncertaining with the risk of
failure.
 Research and Development – expensed as incurred. Low risk of misstatement as these
costs are expensed immediately.
39
Case 2.2: Apple Inc.
