Chapter 8 Homework

8-29 (Objective 8-3) In your audit of Canyon Outdoor Provision Company’s financial
statements, the following transactions came to your attention.
1. Canyon Outdoor's operating lease for its main store is with York Properties, which is a real
estate investment firm owned by Travis Smedes. Mr. Smedes is a member of Canyon Outdoor's
board of directors.
2. One of Canyon Outdoor's main suppliers for kayaks is Hessel Boating Company.
Canyon Outdoor has purchased kayaks and canoes from Hessel for the last 25 years, under a
long-term contract arrangement.
3. Short-term financing lines of credit are provided by Cameron Bank and Trust.
Suzanne Strayhorn is the lending officer assigned to the Canyon Outdoor account.
Suzanne is the wife of the largest investor of Canyon Outdoor.
4. Hillsborough Travel partners with Canyon Outdoor to provide hiking and rafting adventure
vacations. The owner of Hillsborough Travel lives in the same neighborhood as the CEO of
Canyon Outdoor. They are acquaintances, but not close friends.
5. The board of directors consists of several individuals who own stock in Canyon Outdoor. As
a recent board meeting, the board approved its annual dividend payable to shareholders effective
June 1.

Required
a. Define what constitutes a “related party.”

A related party transaction occurs when one party to a transaction has the ability to
impose3 contract terms that would not have occurred if the parties had been unrelated.
Accounting standards conclude that related that related parties consist of all affiliates of an
enterprise, including its management and their immediate families, its principal owners
and their immediate families, investments accounted for by the equity method, beneficial
employee trusts that are managed by the management of the enterprise, and any party that
may, or does, deal with the enterprise and has ownership, control, or significant influence
over the management or operating policies or another party to the extent that an arm’s-
length transaction may not be achieved.
b. Which of the preceding transactions would most likely be considered to be a related party
transaction?
1. Related party transaction. Canyon Outdoor has entered into an operating lease with a
company owned by one of the directors on Canyon’s board. Because the board has control
and significant influence over management of Canyon, the lease transaction may not be at
arm’s length.
2. Not a related party transaction. The fact that Canyon Outdoor has purchased inventory
items for many years from Hessel Boating Company is a normal business transaction
between two independent parties. Neither party has an ownership interest in the other
party, and neither has an ability to exercise control or significance influence over the other.
3. Related party transaction. The financing provided by Cameron Bank and Trust through
the assistance of Suzanne may not be at arm’s length given Suzanne’s husband has control
and significant influence over Canyon Outdoors and may have be able to influence the
transaction through his wife’s employment at the bank or through his influence over
Canyon’s management.
4. Not a related party transaction. Just because the two owners are neighbors does not
mean that either has significant influence or control over the other. Mere acquaintance
does not suggest the transactions would not be at arm’s length.
5. Not a related party transaction. The declaration and approval of dividends payable to
shareholders is a normal board function.
c. What financial statement implications, if any, would each of the above transactions have for
Canyon Outdoor?
When related party transactions or balances are material, the following disclosures are
required: the nature of the relationship or relationships, a description of the transaction
for the period reported on, including amounts if any, and such other information deemed
necessary to obtain an understanding of the effect on the financial statements, the dollar
volume of transactions and the effects of any change in the method of establishing terms
from those used in the preceding period, and amounts due from or to related parties, and if
not otherwise apparent, the terms and manner of settlement.
d. What procedures might auditors consider to help them identify potential related party
transactions for clients like Canyon Outdoor?

Obtain background information about the client, perform analytical procedures of nature,
review and understand the client’s legal obligations, review the information available in the
audit files, discuss the possibility of fraudulent financial reporting with personnel assigned
to the client their knowledge of management involvement in material transactions, discuss
the possibility of fraudulent financial reporting, investigate whether material transactions
occur close to year-end, and whenever there are material non-arm’s-length transactions,
each one should be evaluated to determine its nature and the possibility of its being
recorded at the improper amount, inspect entries in public records concerning proper
recording of real property transactions and personal property liens, and inspect the
records of the related party to a material transaction.
8-32 (Objective 8-5, 8-7, 8-8) You are auditing payroll for the Morehead Technologies company
for the year ended October 31, 2013. Included next are amounts from the client’s trial balance,
along with comparative audited information for the prior year.
Audited Balance Preliminary Balance
10/31/2012 10/30/2013
$ $
Sales 51,316,234 57,474,182

Executive salaries 546,940 615,970

Factory hourly payroll
 10,038,877 11,476,319

Factory supervisors' salaries 785,825 810,588

Office salaries 1,990,296 2,055,302

Sales commission 2,018,149 2,367,962

You have obtained the following information to help you perform preliminary analytical
procedures for the payroll account balances.
1. There has been a significant increase in the demand for Morehead’s products. The increase in
sales was due to both an increase in the average selling price of 4 percent and an increase in units
sold that resulted from the increased demand and an increased marketing effort.
2. Even though sales volume increased there was no addition of executives, factory supervisors,
or office personnel.
3. All employees including executives, but excluding commission salespeople, received a 3
percent salary increase starting November 1, 2012. Commission salespeople receive their
increased compensation through the increase in sales.
4. The increased number of factory hourly employees was accomplished by recalling employees
that had been laid off. They receive the same wage rate as existing employees, Morehead does
not permit overtime.
5. Commission salespeople receive a 5 percent commission on all sales on which a commission
is given. Approximately 75 percent of sales earn sales commission. The other 25 percent are
“call-ins” for which no commission is given. Commissions are paid in the month following the
month they are earned.
a. Use the final balances for the prior year included above and the information in items 1 through
5 to develop an expected value for each account, except sales.
b. Calculate the difference between your expectation and the clients’ recorded amount as a
percentage using the formula (expected value – recorded amount)/expected value.
 Difference in Expected
Account Expected Value and Recorded Reasoning to Support Expected Value
All executives received a 3 percent increase in salaries
Executive effective November 1, 2012. There were no additions
Salaries $563,348 -9.34% to the number of executives in the current year.
=546940*1.03 =(563348-615970)/563348
Factory Hourly Increase due to
Payroll $301,166 payrate increase
=10038877*0.03
The increase in factory hourly payroll is attributed to two
primary factors. First, payroll expense would be
expected to increase 3% over the prior year to account
for the 3% wage increase for all employees (except
Increase due to executives). Second payroll expense should increase
Factory Hourly increased 8% to account for the 8% increase in the number of
Payroll $11,167,246 production -2.77% units produced and sold.
=(10038877+301166)*1.08

Factory All factory supervisors' salaries received a 3% increase

Supervisors' effective November 1, 2012. There were no additions
Salaries $809,400 -0.15% to the number of office personnel in the current year.
=785825*1.03
All office personnel received a 3% increase in salaries
effective Novembr 1, 2012. There were no additions to
Office Salaries $2,050,005 -0.26% the number of office personnel in the current year.
=1990296*1.03
Increase in
Sales commissions due
Commissions $230,923 to increased sales
=0.05*4618461
Sales increased by $6,157,948. Commissions are only
earned on about 75% of the increase ($4,618,461)
would be considered in the calculation of commission
expense. The fact that commissions are paid one month
after they are earned does not affect commission
expense for the year since management would have to
Sales accrue the expense for commissions earned but not paid
Commissions $2,249,072 -5.29% as of October 31, 2013.
=2018149+230923