Question :
At 31st December, 2011, EarthWear has $5,890,000 in a liability account labeled "Reserve for returns." The footnotes to the financial statements contain the subsequent policy: "At the time of sale, the company gives a reserve equal to the gross profit on projected merchandise returns, based on prior returns experience." The client has shown that returns for sales that are six months old are negligible, and gross profit percentage for the year is 42.5%. The client has also provided the subsequent information on sales for the last six months of the year:
Month Monthly Historical
Sales (in 000s) Return Rate
July $ 73,300 0.004
August 82,800 0.006
September 93,500 0.010
October 110,200 0.015
November 158,200 0.025
December 202,500 0.032
Required:
a. Using the information provided, prepare an expectation for the reserve for returns account. Because the rate of return varies based on the time that has passed since the date of sale, do not use an average historical return rate.
Month Estimated Returns
July $
August $
September $
October $
November $
December $
Total $
Gross Margin $
EarthWear's total income before taxes is $36 million (rounded). Consider that the auditors have decided that 5% of this benchmark is appropriate for planning materiality and allocate 50 % of it as tolerable misstatement.
b. Evaluate a tolerable difference for your analytical procedure.
Tolerable difference $________________
c. Compare your expectation to the book value and evaluate if it is greater than tolerable difference
Difference between book value and expectation is (less than/greater than) tolerable difference of $_____________
d. Independent of your answer in part (c), what procedures could the auditor performs if the difference between the expectation and the book value is greater than tolerable misstatement?