RedPack Beer Company

1. CAS 540 listed the following requirements related to auditing accounting estimates: When performing risk assessment procedures and related activities to obtain an understanding of the client and its environment, the auditor shall obtain an understanding of the following: The requirements of the applicable financial reporting framework relevant to accounting estimates, including related disclosures How management identifies those transactions, events and conditions that may give rise to the need for accounting estimates to be recognized or disclosed in the financial statements. And the auditor shall make inquiries of management regarding changes in circumstances that may give risk or new or the need to revise existing, accounting estimates.

How management makes the accounting estimates, and an understanding of the data on which they are based, including the method, relevant controls, the use of an expert, the assumptions underlying, the change in the methods adopted and the reason for the change, plus how management has assessed the effect of estimation uncertainty. The auditor shall review the outcome of accounting estimates included in the prior period financial statements, or, where applicable, their subsequent re-estimation for the purpose of the current period. The nature and extent of the auditor’s review takes account of the nature of the accounting estimates, and whether the information obtained from the review would be relevant to identifying and assessing risks of material misstatement of accounting estimates made in the current period financial statements. However, the review is not intended to call into question the judgments made in the prior periods that were based on information available at the time.

In identifying and assessing the risks of material misstatement, the auditor shall evaluate the degree of estimation uncertainty associated with an accounting estimate. The auditor shall determine whether, in the auditor’s judgment, any of those accounting estimates that have been identified as having high estimation uncertainty give rise to significant risks. Based on the assessed risks of material misstatement, the auditor shall determine whether management has appropriately applied the requirements of the applicable financial reporting framework relevant to the accounting estimate and whether the methods for making the accounting estimates are appropriate and have been applied consistently, and whether changes, if any, in accounting estimates or in the method for making them from the prior period are appropriate in the circumstances. In responding to the assessed risks of material misstatement, the auditor shall undertake one or more of the following, taking account of the nature of the accounting estimate: Determine whether events occurring up to the date of the auditor’s report provide audit evidence regarding the accounting estimate.

Test how management made the accounting estimate and the data on which it is based. In doing so, the auditor shall evaluate whether: The method of measurement used is appropriate in the circumstances; and The assumptions used by management are reasonable in light of the measurement objectives of the applicable financial reporting framework. Test the operating effectiveness of the controls over how management made the accounting estimate, together with appropriate substantive procedures. Develop a point estimate or a range to evaluate management’s point estimate. For this purpose: If the auditor uses assumptions or methods that differ from management’s, the auditor shall obtain an understanding of management’s assumptions or methods sufficient to establish that the auditor’s point estimate or range takes into account relevant variables and to evaluate any significant differences from management’s point estimate. If the auditor concludes that it is appropriate to use a range, the auditor shall narrow the range, based on audit evidence available, until all outcomes within the range are considered reasonable.

Further Substantive Procedures to Respond to Significant Risks Estimation Uncertainty: the auditor shall evaluate the following: How management has considered alternative assumptions or outcomes, and why it has rejected them, or how management has otherwise addressed estimation uncertainty in making the accounting estimate. Whether the significant assumptions used by management are reasonable. Where relevant to the reasonableness of the significant assumptions used by management or the appropriate application of the applicable financial reporting framework, management’s intent to carry out specific courses of action and its ability to do so. If, in the auditor’s judgment, management has not adequately addressed the effects of estimation uncertainty on the accounting estimates that give rise to significant risks, the auditor shall, if considered necessary, develop a range with which to evaluate the reasonableness of the accounting estimate.

Recognition and Measurement Criteria: the auditor shall obtain sufficient appropriate audit evidence about whether management’s decision to recognize, or to not recognize, the accounting estimates in the financial statements; and the selected measurement basis for the accounting estimates, are in accordance with the requirements of the applicable financial reporting framework. Evaluating the Reasonableness of the Accounting Estimates, and Determining Misstatements: the auditor shall evaluate, based on the audit evidence, whether the accounting estimates in the financial statements are either reasonable in the context of the applicable financial reporting framework, or are misstated. Disclosures Related to Accounting Estimates

The auditor shall obtain sufficient appropriate audit evidence about whether the disclosures in the financial statements related to accounting estimates are in accordance with the requirements of the applicable financial reporting framework. For accounting estimates that give rise to significant risks, the auditor shall also evaluate the adequacy of the disclosure of their estimation uncertainty in the financial statements in the context of the applicable financial reporting framework. Indicators of Possible Management Bias: the auditor shall review the judgments and decisions made by management in the making of accounting estimates to identify whether there are indicators of possible management bias.

Indicators of possible management bias do not themselves constitute misstatements for the purposes of drawing conclusions on the reasonableness of individual accounting estimates. Written Representations: the auditor shall obtain written representations from management and, where appropriate, those charged with governance whether they believe significant assumptions used in making accounting estimates are reasonable. Documentation: the auditor shall include in the audit documentation (a) the basis for the auditor’s conclusions about the reasonableness of accounting estimates and their disclosure that give rise to significant risks; and (b) indicators of possible management bias, if any.

2. based on the interview with the Credit Manager:
a) Distinct Beer Distributor (DBD): 50% of the outstanding balance (totaling $2712.08) from DBD has been reserved. However, DBD is a small family owned distributor and has no business interruption insurance. Thus, the likelihood of collection is low. A reserve for the full amount should be considered. (range: 100% or less depends on conservativeness)

Eagle Beverage Group (EBG): 100% of the $1,449.40 from EBG has been reserved. Based on the conversation, it is reasonable to conclude that the invoice amount will not be collectible.

Golden Holdings (GH): none of the $2,706.54 balance that is between 91-120 days past due has been reserved even though RedPack has already realized that it will turn to a collection agency. In this case, RedPack should at least reserve no less than 50% as it could only receive fifty cents of the amount collected by the agency. In other words, a reserve of $1,353.27 should be established. (range: at least 50%, maybe half of the entire amount given that we are sending it to a collection agency)

b) The auditor only considered the 3 customers that have outstanding balances past due in more than 90 days. During the interview, the auditor ignored the balances that are past due in 90 days, except for the DBD. The auditor should be concerned about the collectability of other invoices, such as the outstanding balances from EBG and GH. The auditor should also ask if there is any other issue that might impact the collectability of other accounts, such as the balance of American Premium Beverages. (if RedPack is recognizing revenue too early.) (increase of substantial tests over those Golden accounts) (the sales manager may get commission from the sales, may be more biased than the credit manager) (bank covenants: incentive to overstate A/R) (shipment concern) (classification error)

The auditors should have the above concerns because there are some internal control problems with RedPack’s sales process. For example, the customer billing error and the last shipment problem suggests the control problems with its invoicing and shipping processes. And the policy of having the sales manager contact customers identified as having past due balances and the review of the adequacy of the allowance for bad debts is conducted on a quarterly basis by the credit manager suggest there are some problems about the estimation of the allowance for bad debts. c)

31-90 days old
$1,387.73
10% of the balance 31 to 90 days past due, i.e. ($16,652.61-$2,775.34) DBD
$ 5,424.16
100% of outstanding balance
EBG
$ 1,449.40
100% of balance in dispute
GH
$ 1,353.27
50% of balance from collection agency
Total
$ 9,614.56

The management’s estimate for bad debts is $5,549, which is $4,065.56 less than the above estimate. That difference is material as it is greater than the performance materiality of $2,500. ( going to the statement of unadjusted differences)

d) adjusting entry:
Bad Debt Expense$4,065.56
Allowance for Bad Debts$4,065.56

e) The auditor shall review the outcome of accounting estimates included in the prior period financial statements as it may provide relevant information for current year estimates. The auditor should understand management’s basis for the estimation policy, such as the basis of the assumptions that no reserve for balances not past due in 30 days is considered and the reasonableness of the reserve estimates (e.g. 10%, 25%).

Whether the percentages are still appropriate?
Why there is no reverse on balances past due in less than 30 days?