ACCT 403 Saudi Electronic University Attestation and Assurance Services Questions

College of Administration and Finance SciencesAssignment Question(s):
(Marks 15)
Question 1: The correct and complete sequence of steps in conducting research is as follows:
1. Identify broad area,
2. Select topic,
3. Decide approach,
4. Formulate plan,
5. Collect information,
6. Analyze data,
7. Present findings.
Using our Saudi Digital library (SDL) you should find two papers in accounting field and determine
for each paper the steps described above.
[4 marks] My old homework
Paper 1
Paper 2
1.The broad area of the
paper
2.The topic
3.Approach used
4.Data source
5. Data analysis
6.Findings
Paper 1
1.The broad
area of the
paper
2.The topic
3.Approach
used
4.Data source
Financial burden attaining higher
education degree.
Paper 2
Intention of Vaccination among college
students.
College Costs and Credit Cards: How
COVID-19 Vaccination and Intention to
Student Credit Card Use Influences
Vaccinate Among a Sample of College
College Degree Attainment
Students in New Jersey
This study relied on historical research, This study relied on surveying a large
using archival information and secondary sample of students.
source.
Similarly, utilized descriptive statistics,
The researcher used descriptive statistics then analyzing the data to identify
and analyses to identify statistically
statistically significant results.
significant results.
Data was obtained through the
A simple random sample of 2341
Educational Longitudinal Study (ELS) of students, obtained through the
2002, the ELS study follows students who Institutional Effectiveness Office at a
were in 10th grade in 2002 for 10 years, as diverse, public university. Subjects were
they transition into the workforce to enroll digitally invited to participate in the
in university, drop-out, get married, work, study. An anonymous cross-sectional
or make any other life decisions.
online survey of student conducted
Sourced here (Hyperlink).
during three weeks in February – March
2021.
College of Administration and Finance Sciences
Students received anonymous link to
their email, with reminders. An
informed consent was also obtained
prior to the completion of they survey.
All data was self-reported. 457 students
completed the survey, a response rate of
19.5%.
5. Data analysis 1- Descriptive analyses to report rates of Data analyses shown in two tables:
credit card ownership and use across
1- First table shows demographic
different groups, to provide an overview samples. Median age, sex,
of credit card behavior among college
race/ethnicity, class level, study major,
student groups. With focus of credit card employment status.
ownership and carrying balance from
2- Second table presents descriptive
month to month with a bivariate look to statistics for indicators of Covid-19
link carrying balance and college degree history, vaccine knowledge, sources,
attainment by 2012. The purpose is
utilization of information related to
establishing a baseline for the
covid-19, attitude towards the vaccine,
investigation in the subsequent different and vaccination history.
analyses.
Statistical analyses were conducted with
2- Using logistic regression models to
SPSS, descriptive analysis examines the
investigate which credit card behaviors distribution (frequencies & means) for
are significantly related to a bachelor’s
all variables. The separate binary
degree attainment, having control for
logistic regression was computed to
variables. The difference between Binary examine how various independent
logistic regression and linear regression is variables related to each of the two main
calculating the probability that the
outcomes (vaccinates and intention to
dependent variable outcome will be equal receive the vaccine).
to 1, as opposed to calculating a
numerical outcome along a continuous
scale.
6.Findings
It is shown that that credit card ownership The study finds that 23% are vaccinated,
is more common among student from low 52.8% have intention to receive
socioeconomics, students who started a 4 vaccination.
year study, and students who work 20
Also shows that health care workers,
hours a week, in the descriptive analysis. those who have vaccinated family
Similarly, they are least likely to carry
members, and students who receive
balance.
seasonal flu vaccine, show great affinity
In the descriptive analyses, its shown that and positive outlook towards
students who carry balance are likely to vaccination.
obtain a bachelor’s degree. This finding is Among non-vaccinated students, those
shown in logistic regression models and who discuss the vaccine are more likely
Mahalanobis Distance Matching models. to receive vaccinations.
Though there was an overall positive
attitude towards the vaccine, the study
recommends further education and
College of Administration and Finance Sciences
promotion to increase uptake of the
vaccine among college students.
Studies used:
1. Andrews, B. D. (2021). College Costs and Credit Cards: How Student Credit Card
Use Influences College Degree Attainment. Research in Higher Education, 62(6), 885–
913. https://doi.org/10.1007/s11162-020-09622-8
2. Kecojevic, A., Basch, C. H., Sullivan, M., Chen, Y. T., & Davi, N. K. (2021).
COVID-19 Vaccination and Intention to Vaccinate Among a Sample of College Students
in New Jersey. Journal of Community Health, 46(6), 1059–1068.
https://doi.org/10.1007/s10900-021-00992-3
Question 2: Write a description of the research problem you propose to investigate and
explain why you chose this topic. [2 marks] My old homeowork
Research Topic – NEOM, Saudi Vision 2030 & Future prosperity of the Kingdom of Saudi Arabia.
Saudi Vision 2030 launched by The Custodian of the Two Holy Mosques and his Royal Highness
the Crown Prince. A roadmap was drawn to harness the strategic position, investing power and
geographical location of the Arab and Islamic world.
The Kingdom of Saudi Arabia is on a path to achieve extraordinary ambitions, by setting a
foundation, and unprecedented reforms to the public sector’s operating model, the economy and
society. These foundations of success will open the Kingdom to the world, building platform for
growth and increasing the citizen’s quality of life.
NEOM challenges the perception the world has over the Kingdom of Saudi Arabia. Many believe to
this day that Saudi Arabia is a giant desert that has nothing going for it but oil. Whilst NEOM is
positioned on the Red Sea, where 13% of world trade passes, center of the Middle East, Islamic &
Arabic world. A perfect link for the region and a hub for international trade.
I would like to study the impact economical impact NEOM will have on Saudi Arabia, Saudi youth,
and regional/international trade.
I chose this topic for having a large and important impact on our future. Currently, much of the
Public Investment Fund has been diverted to NEOM, many jobs were created, plans were drawn for
The Line, OXAGON and more to be announced. Finally, the technological impact would be a
revolution for the world as a whole, not Saudi Arabia alone.
Sources:
1. Homepage: The Progress & Achievements of Saudi Arabia. (n.d.). Vision 2030.
Retrieved February 25, 2022, from https://www.vision2030.gov.sa/
2. NEOM: Made to Change. (n.d.). NEOM. Retrieved February 25, 2022, from
https://www.neom.com/en-us
College of Administration and Finance Sciences
Question 3: What should be considered in developing a good research idea? [2 marks]
previous shared answer.
The most significant feature of any study subject is clarity. The topic should be clear enough for
others to comprehend the nature of your study. So that individuals are not distracted, the study
issue should have a single interpretation.
Question 4: What are the five categories of research methods? [2mark] SLIDES
• Scientific reasoning and/or model building.
• Historical research using archival data and/or secondary sources.
• Case studies requiring extensive exploration in the field.
• Surveys, often involving large-scale sampling.
• Experiments, either in the field or in laboratory-type conditions.
Question 5: Differentiate between Quantitative vs. Qualitative research. [2.5 mark] SLIDES &
AI
Quantitative analysis – expression relies on numbers and graphs, used to confirm theories and
assumptions. The usage of this analysis methodology is intended to generalize facts and extrapolate
to the population.
A common method for quantitative analysis is surveys, for this example, SEU sends a survey to
student to decide on the most suitable hours for lectures during Ramadan, limited options (e.g., 2PM
– 6PM | 9PM – 1AM | 11PM – 3AM). When the vast majority of responses answer with after 9PM,
SEU considers that the best time for lectures for students. A similar survey can be sent to
instructors.
Qualitative analysis – expression uses words, used to understand thoughts, concepts and/or
experience. This analysis allows to gather in-depth information about the research topic.
In qualitative analysis, open questions are posed to participants in an interview of a focus group. In
this example, SEU conducts a study for Post-grad students who completed their bachelors in other
universities, to gauge the strength and weakness of the university compared to others.
Question 6: Define ANOVA and Regression Analysis [2.5 mark]
ANOVA (analysis of variance) was introduced by Ashton (1974) as a model for measuring the
significance, and percentage variance. It is an analysis tool used in statistics that splits the aggregate
variability found inside a data set into two parts: systematic factors and random factors. The
systematic factors have a statistical influence on the given data set, but the random factors do not.
Analysts use the analysis of the variance test to determine the result that independent variables have
on the dependent variable amid a regression study.
– Widely adopted as a means of eliminating multicollinearity problems.
– Reduces the effects of measurement errors, but it may incur information loss.
Regression analysis is a statistical method that estimates the relationship between a dependent
variable and one or more independent variables.
● Alternative forms of regression analysis
College of Administration and Finance Sciences
o Ordinary least-squares regression (for standard causal relationships)
Discriminant analysis
o Ordinary least-squares regression with dummy variables (for simple conditional
relationships)
o Moderated regression (for moderating variables)
o Path analysis (partial regression for intervening variables)
le fin
ISSUES IN ACCOUNTING EDUCATION
Vol. 37, No. 2
May 2022
pp. 37–51
American Accounting Association
DOI: 10.2308/ISSUES-2020-037
Wealthy Watches Inc.: The Substantive Testing of Accounts
Receivable in the Evolving Audit Environment
Lindsay M. Andiola
Virginia Commonwealth University
Denise Hanes Downey
Villanova University
Christine E. Earley
Providence College
Devon Jefferson
Virginia Commonwealth University
ABSTRACT: Substantive testing of accounts receivable through confirmations is an established and required audit
procedure. However, the technology used to perform portions of this work is evolving. This case exposes students to the
testing of accounts receivable while introducing them to audit-related technologies (such as Interactive Data Extraction
and Analysis [IDEA] software and robotic process automation [RPA]) used in practice. In this case, students (1) evaluate
a client-provided data file, (2) select a sample of customer invoices using IDEA, (3) obtain audit evidence from their
firm’s RPA software and evaluate the evidence for the identification of exceptions, (4) project any misstatements from
the sample to the population, and (5) document their conclusions. This case helps students develop a greater
awareness of technologies used in audit practice. The case also allows students to practice skepticism, apply
professional judgment, and hone their business writing skills by documenting their results in a professional memo.
Keywords: sampling; IDEA; robotic process automation; confirmations; accounts receivable; audit evidence.
I. THE CASE
Background Information
You are a fairly new audit staff member at Cardone LLP, a large regional public accounting firm in Boston, MA. You are
assigned to the Wealthy Watches Inc. engagement for your first busy season audit. During your first week on the job, your audit
manager gives you the responsibility of completing the audit work related to accounts receivable confirmations to test the
existence assertion of the accounts receivable balance as of December 31, 2019. Your manager is confident that you are capable
of completing the entire process, including evaluating the data file, selecting the sample, assessing the returned confirmations,
projecting any misstatements from the sample to the population, and formalizing a memo with your conclusions and
recommendations for his review.
We thank the following individuals for their valuable input and assistance: Kara Dugas, Candice Hux, Matthew Keane, Ed Lynch, Gary Sullivan, and Jay
Thibodeau. We also thank Owen Clark, Katherine Whalen, and Anthony Williams for their research assistance. In addition, Lindsay M. Andiola
recognizes generous funding from the Virginia Commonwealth University Quest Programmatic Fund and Denise Hanes Downey recognizes support
provided by the Villanova Institute for Teaching and Learning.
Lindsay M. Andiola, Virginia Commonwealth University, School of Business, Department of Accounting, Richmond, VA, USA; Denise Hanes Downey,
Villanova University, School of Business, Department of Accounting & Information Systems, Villanova, PA, USA; Christine E. Earley, Providence
College, School of Business, Department of Accountancy, Providence, RI, USA; Devon Jefferson, Virginia Commonwealth University, School of
Business, Department of Accounting, Richmond, VA, USA.
Supplemental material can be accessed by clicking the link in Appendix B.
Editor’s note: Accepted by Elizabeth Dreike Almer.
Submitted: May 2020
Accepted: June 2021
Published Online: September 2021
37
38
Andiola, Downey, Earley, and Jefferson
You are eager to impress your manager, but also a bit nervous about this responsibility because you know that testing the
existence of accounts receivable through the confirmation process is a key component in determining whether revenue
transactions occurred. Specifically, you are aware that the Public Company Accounting Oversight Board (PCAOB) views the
audit of revenue as often involving ‘‘significant risks that warrant special audit consideration’’ and ‘‘require auditors to presume
that improper revenue recognition is a fraud risk’’ (PCAOB 2014, 4). To address this concern, ‘‘there is a presumption that the
auditor will request the confirmation of accounts receivable during an audit’’ (PCAOB 2016b, para. 34) as the use of third-party
confirmations for accounts receivable is considered a high-quality audit procedure to evaluate the existence and accuracy of
revenue.1 Despite the obvious importance of auditing revenue and, in turn, accounts receivable, PCAOB staff members
continue to observe frequent deficiencies related to the design and performance of audit procedures related to revenue (PCAOB
2019a), including improper selection and application of sampling procedures in testing revenue transactions, as well as
inappropriately evaluating the sample results (PCAOB 2014, 2017, 2019b). Knowing that testing accounts receivable plays a
significant role in the revenue process, you are determined to follow each step in the testing of accounts receivable closely to
ensure your audit work does not have the same types of deficiencies.
Given the high risks involved with testing revenue, your manager has stressed the importance of understanding the various
ways revenue recognition fraud can occur. Importantly, your manager notes that in cases when upper management perpetrates a
fraud using improper revenue recognition, the credit entry recorded in the revenue account is often balanced with a debit entry
in the accounts receivable account. As a result, the ‘‘recognition of fictitious revenue often results in complementary false and
uncollectible receivables’’ (PCAOB 2007, 12). Auditors typically use several audit procedures to attempt to identify improper
revenue recognition, including testing internal controls over the company’s revenue process, performing analytical procedures
to determine current period trends, and tracing and agreeing a sample of revenue transactions to source documents (e.g., sales
invoices). Your role in verifying the existence of accounts receivable through confirmations will help your team determine
whether any instances of improper revenue recognition exist at Wealthy Watches Inc.
Understanding the Company and Risk Assessment
During your first few days on your new audit engagement, you become familiar with the audit client and the work already
completed by your engagement team. You learn that Wealthy Watches Inc. is an American designer and distributor of fine
watches, founded in 1965, and listed on the NASDAQ stock exchange (ticker symbol: WWIN). Wealthy Watches Inc. is
known as a brand-builder that seeks to offer superiorly designed and sought-after watches. To achieve its mission of quality and
brand power, the company has grown extensively through strategic acquisitions and license agreements with other wellrespected watch brands. The company competes largely in the luxury, fashion, and fitness watch markets in North America,
Europe, and Asia, with growing sales in other international locations. Wealthy Watches Inc. primarily distributes its products
wholesale through major jewelry store chains and department stores. In addition, the company maintains 15 outlet stores in the
U.S. where discontinued or imperfect merchandise is sold directly to the consumer. Historically, the company sells a greater
volume of watches during the holiday season. As a result, Wealthy Watches Inc. is susceptible to economic conditions and
other external factors that influence consumer spending from November to February. Despite this susceptibility, the company
continues to exhibit strong consumer demand with a consistent backlog of confirmed orders.
To comply with Securities and Exchange Commission (SEC) requirements and give investors further comfort regarding
the company’s financial performance, Wealthy Watches Inc. has retained Cardone LLP for the past several years to audit their
annual financial statements. As of December 31, 2019, Wealthy Watches Inc. has reported an accounts receivable balance of
$11.9 million, which is just over 10 percent of their revenue balance of $114 million. Although the company’s year-over-year
receivable balance has remained fairly constant, with only a small increase in the overall balance as of December 31, 2019,
compared to December 31, 2018, receivables remain significant to the core of the company’s business operations. Thus, a
careful audit of the company’s receivables is important as it provides insight into the company’s incoming cash flows.
During the planning phase of the audit, your engagement team assessed the risk of material misstatement (RMM) for each
relevant assertion to determine the nature, timing, and extent of the procedures to be performed. Your team performed all
necessary risk assessment procedures for the existence assertion of the accounts receivable balance, assessing the inherent risk
as high and the control risk as low.2 Based on these assessments, the RMM is moderate for the existence assertion for accounts
1
This presumption is made ‘‘unless one of the following is true: accounts receivable are immaterial to the financial statements, the use of confirmations
would be ineffective, or the auditor’s combined assessed level of inherent and control risk is low, and the assessed level, in conjunction with the
evidence provided by analytical procedures or other substantive tests of details, is sufficient to reduce audit risk to an acceptably low level for the
financial statement assertions’’ (PCAOB 2016c, AS 2310, para. 34).
2
Given the high risk of fraud associated with revenue recognition and the launch of a new fitness watch that the company is relying on to help increase
their market share within the watch industry, your engagement team has assessed inherent risk for testing the existence of accounts receivable as high.
In addition, during planning and interim audit work, your team assessed and tested internal controls. Based on this audit work the team believes that the
controls are operating effectively and can be relied on. As such, control risk for the current year is assessed as low.
Issues in Accounting Education
Volume 37, Number 2, 2022
Wealthy Watches Inc.: The Substantive Testing of Accounts Receivable in the Evolving Audit Environment
39
receivable. To respond to this risk, several substantive procedures need to be performed, including the procedure assigned to
you: obtain direct confirmation of accounts receivable and perform alternative procedures for nonresponses.
Task Overview and Requirements
To help guide your audit work, this section discusses each step that must be completed to sufficiently perform your
assigned audit procedure: obtain direct confirmation of accounts receivable and perform alternative procedures for
nonresponses. Specifically, you will first define and understand the population (Step 1) and use monetary-unit sampling (MUS)
to select a sample using Interactive Data Extraction and Analysis (IDEA) software (Step 2). Then, you will rely on robotic
process automation (RPA) software to obtain the accounts receivable confirmations and other client-provided information and
evaluate this audit evidence (Step 3). Finally, you will use IDEA to project any misstatements from the sample to the entire
population, communicate your results, and make recommendations for possible next steps to your audit manager (Step 4).
Task Overview and Requirements
Step 1: Evaluate the data file to be used for audit work. When you obtain a client-provided data file, it is important for
you to first review the data file. This process often involves scanning the data file to ensure you have been given the data that
you need for the audit work you plan to perform, reviewing the file to gain an understanding of the population, and ensuring the
completeness and accuracy of the file you plan to select a sample from (PCAOB 2016d, para. 17; PCAOB 2016a, para. 10).
During this process, you should exercise professional judgment to identify any items in the population that may be viewed as
particularly risky or concerning. Such items may be more likely to be associated with error or fraud. Thus, the auditor could
consider specifically selecting these items for testing while subjecting the remaining population to a statistical sampling
approach (PCAOB 2016d, para. 21).
Before proceeding, you should be sure to agree the total balance of the detailed listing to the balance sheet and the balance
per the imported IDEA file back to the balance of the detailed listing. These steps are critical as they help to ensure the total
population (as disclosed in the financial statements) is used to assess the completeness and accuracy of the accounts receivable
balance. After determining the population is complete and accurate, you may proceed with selecting a sample of customer
invoices to be confirmed.
Step 2: Select a statistical sample. Two of the most common statistical sampling methods used by auditors when
completing substantive tests of details are classical variables sampling (CVS) and monetary-unit sampling (MUS).3 Your
manager has indicated that, consistent with last year’s audit, you will use MUS to select your sample. The use of MUS
minimizes sampling risk, as it relies on statistical laws of probability to estimate the amount of misstatement in the account
balance being tested. MUS is acceptable under professional standards and offers several advantages (Johnstone, Gramling, and
Rittenberg 2019; Whittington and Pany 2019). One key advantage of using MUS is that high-dollar items are weighted more
heavily during sample selection, which usually results in a smaller overall sample size.4 Auditors often see this as advantageous
because the larger balances, which are typically also viewed as riskier, are more likely to be included in the sample. Thus, the
audit may achieve increased efficiency without sacrificing effectiveness, when compared to other sampling options. Further,
audit-related technologies, like IDEA, have made it more efficient and easier to apply statistical sampling methods, thereby
allowing any misstatements from the sample to be quickly and accurately projected to the population.
All statistical sampling methods, including MUS, still require the auditor to apply professional judgment when making
sampling decisions. Specifically, the professional standards state that to ‘‘determine the number of items to be selected in a
sample for a particular substantive test of details, the auditor should consider tolerable misstatement for the population; the
allowable risk of incorrect acceptance; and the characteristics of the population, including the expected size and frequency of
misstatements’’ (PCAOB 2016d, para. 23). The input of each of these judgments will influence the sample size (PCAOB
2016d, Table 1). For instance, the lower (higher) the tolerable misstatement for a particular sampling procedure, the larger
(smaller) the sample size.5 As a result, an audit engagement team must be careful in setting an appropriate tolerable
misstatement and allowable risk to address the RMM assessed by the auditor. Your audit manager informs you that the
3
MUS is also referred to as cumulative monetary amount (CMA) sampling, probability proportionate to size (PPS) sampling, or dollar-unit (DUS)
sampling.
4
While the PCAOB has criticized auditors for sample sizes being too small, these comments often relate to non-statistical samples in which sampling
risk cannot be controlled (e.g., PCAOB 2019b). Statistical sampling approaches, including MUS, allow sampling risk to be measured and controlled.
Therefore, the smaller sample size from using MUS provides ‘‘sufficient evidential matter when applied properly’’ (PCAOB 2016d, para. 3).
5
The ‘‘tolerable misstatement’’ is one of three factors that can impact sample size, with the other two being sampling risk and the expected population
deviation rate. Unlike the inverse relationship between the tolerable misstatement and sample size, sampling risk and the expected population deviation
rate is directly related to sample size (i.e., the higher the sampling risk and expected population deviation rate, the larger the sample size) (see PCAOB
2016d, Table 1).
Issues in Accounting Education
Volume 37, Number 2, 2022
40
Andiola, Downey, Earley, and Jefferson
tolerable misstatement threshold for the accounts receivable balance is $750,000, the allowable risk of incorrect acceptance is
0.10, and the expected error based on prior experience is $357,000.
Step 3: Perform accounts receivable audit work on the sample. Confirmation of accounts receivable is one way that
auditors may become aware of a client’s improper revenue recognition practices (e.g., channel stuffing, early recognition of
review, fictitious sales), as the results of this testing indicate whether the customers agree with the accounts receivable as
recorded by the client. Although direct third-party confirmation of a selected customer invoice generally provides reliable
evidence, the confirmation process is subject to the risk of interception and alteration of confirmation responses (Hanes, Porco,
and Thibodeau 2014). In addition, customers sometimes do not respond to confirmations, and thus require auditors to perform
alternative procedures (PCAOB 2016c, paras. 31–32).6
Some public accounting firms are experimenting with RPA. RPA is ‘‘software that interacts with other application software
at the user interface level (i.e., in the same way as humans) and is used to automate processes that are structured, rule-based,
and repetitive’’ (Cohen, Rozario, and Zhang 2019, 49). While the use of RPA software is fairly new, some firms, including
Cardone LLP, are piloting the use of RPA software to assist with substantive audit procedures. The RPA software used by
Cardone LLP drafts confirmations, sends confirmations electronically to customers, and evaluates basic confirmation responses.
However, it is your job to evaluate the work of the RPA software and, most importantly, evaluate the exceptions in the
confirmation evidence for which the RPA software does not have the professional judgment capabilities to assess.
Step 4: Evaluate, project, and communicate the results. The final step required to conclude on the existence of the
accounts receivable balance is to evaluate the results using both qualitative and quantitative approaches. A qualitative
evaluation includes considering the reason or cause of each misstatement (e.g., an internal control failure), whether the
misstatements are all in the same direction (i.e., all overstatements), whether a misstatement could become material in the
future, and/or whether the nature of the misstatement suggests fraud. A quantitative evaluation involves projecting any
misstatements discovered during testing of the sample to the population from which the sample was drawn (PCAOB 2016d,
para. 26). This projection (also called extrapolation) process is performed in the same software used to select the sample and
allows you to determine a reasonable dollar value range of the possible misstatement present within the population. You can
use this projected range to form your judgment on the existence of the accounts receivable balance (see PCAOB 2016c, para.
33; PCAOB 2016d, para. 27–30). If the total estimated misstatement is greater than the tolerable misstatement, an auditor needs
to consider the next steps.
Depending on the nature of the misstatements found, the auditor may need to consider increasing the sample size, speaking
to the client about a possible adjustment to the financial statements, or (in the case of fraud) addressing the issue with the
company’s audit committee. Alternatively, if the total estimated misstatement is less than the tolerable misstatement, the auditor
may include the estimate on their summary of unadjusted audit differences to consider during the completion phase of the
audit.7 The auditor may also consider whether further direct inquiry, with those customers providing disconfirming information,
may be necessary. When all audit work is complete, you must document in sufficient detail the procedures you performed, the
evidence you obtained, and the conclusions you reached concerning the relevant financial statement assertions (PCAOB 2016b,
para. 4–6).
Task Requirements
To complete Steps 1 and 2 discussed above, you must first obtain PBC 1, the AR Journal Excel file from your audit
manager (instructor).8 In addition, Appendix A, entitled Deliverable Workpaper and Memo Guidance, provides a workpaper
template, including specific questions to guide you through the necessary audit work and should be filled out as you complete
the required steps. Cardone LLP uses IDEA to perform sampling procedures required on financial statement audit engagements.
As such, your manager (instructor) has provided you with IDEA technical guidance to assist you in navigating IDEA to
perform your audit work. Upon completion of Steps 1 and 2, you must obtain PBC 2 from your audit manager (instructor) to
verify that your selected sample is accurate.
6
Alternative procedures include vouching entries to sales invoices, shipping documents, and customer orders and/or verifying subsequent cash receipt.
Performing these procedures are beyond the scope of your duties in this case.
7
The summary of unadjusted audit differences (also referred to as the summary of possible adjustments, the summary of uncorrected misstatements, or
the summary of unadjusted misstatements) is a compilation of all uncorrected errors that are identified during the audit, including both known and
projected errors, as well as carryover effects of prior-year uncorrected misstatements (Johnstone et al. 2019; Whittington and Pany 2019). Individually,
these items may not be material, but could have a material impact on the financial statements when evaluated in the aggregate. If the aggregate effect of
all errors is below materiality, then the financial statements will not require an adjustment.
8
In audit practice, PBC indicates a ‘‘prepared by client’’ document. In this case, this term is used to describe all documentation you are to obtain from
your instructor.
Issues in Accounting Education
Volume 37, Number 2, 2022
Wealthy Watches Inc.: The Substantive Testing of Accounts Receivable in the Evolving Audit Environment
41
As noted above, Cardone LLP is using RPA on a trial basis to assist with the confirmation process. This software has a
direct link to IDEA and automatically downloads your sample to create and electronically send confirmations. The RPA
application maintains an electronic confirmation log that documents when confirmation responses are received, maintains
copies of the confirmations, performs a preliminary analysis to determine whether each confirmation indicates either ‘‘no
issues’’ or ‘‘requires examination,’’ and emails the designated client contact to obtain responses related to confirmations
identified as ‘‘requires examination.’’ The RPA application emails all files to your audit manager upon completion of this work
(PBC 3). To complete Steps 3 and 4, you must obtain PBC 3 from your audit manager (instructor) and evaluate the
confirmations received and the responses from the client contact, Lucas V. Henry, Accounts Receivable Manager.
The confirmations identified as ‘‘requires examination’’ require you to evaluate the information contained in the
confirmation, as well as the responses from the client to make a judgment on whether a misstatement may be present. In
addition, because your firm is still piloting the RPA software, you should also double-check the confirmations where ‘‘no
issues’’ were noted. After evaluating each confirmation, you will need to project any identified misstatements to the population
using IDEA, and subsequently document and conclude on the results of your audit work in a memo to your audit manager
(instructor). The firm’s IDEA technical guidance will assist you in correctly inputting and evaluating the results of your audit
work. Appendix A provides specific questions for you to consider related to Steps 3 and 4, as well as guidance from your
manager on the information that should be contained in your memo. When complete, you will submit your deliverable
workpaper and memo, and the MUS Projection Report (printed directly from IDEA) to your audit manager (instructor).
REFERENCES
Cohen, M., A. M. Rozario, and C. Zhang. 2019. Exploring the use of robotic process automation (RPA) in substantive audit procedures.
The CPA Journal 2019 (July). Available at: https://www.cpajournal.com/2019/08/14/exploring-the-use-of-robotic-processautomation-rpa-in-substantive-audit-procedures/
Hanes, D. R., B. M. Porco, and J. C. Thibodeau. 2014. Simply Soups Inc.: A teaching case designed to integrate the electronic cash
confirmation process into the auditing curriculum. Issues in Accounting Education 29 (2): 349–369. https://doi.org/10.2308/iace50693
Johnstone, K. M., A. A. Gramling, and L. E. Rittenberg. 2019. Auditing: A Risk-Based Approach to Conducting Quality Audits. 11th
edition. Boston, MA: Cengage Learning.
Public Company Accounting Oversight Board (PCAOB). 2007. Observations on auditors’ implementation of PCAOB standards relating
to auditors’ responsibilities with respect to fraud. Available at: https://pcaobus.org/Inspections/Documents/2007_01-22_Release_
2007-001.pdf
Public Company Accounting Oversight Board (PCAOB). 2014. Staff Audit Practice Alert No. 12: Matters Related to Auditing Revenue in
an Audit of Financial Statements. Available at: https://pcaobus.org/Standards/QandA/9-9-14_SAPA_12.pdf
Public Company Accounting Oversight Board (PCAOB). 2016a. Auditing Standard 1105: Audit Evidence. Washington, DC: PCAOB.
Public Company Accounting Oversight Board (PCAOB). 2016b. Auditing Standard 1215: Audit Documentation. Washington, DC:
PCAOB.
Public Company Accounting Oversight Board (PCAOB). 2016c. Auditing Standard 2310: The Confirmation Process. Washington, DC:
PCAOB.
Public Company Accounting Oversight Board (PCAOB). 2016d. Auditing Standard 2315: Audit Sampling. Washington, DC: PCAOB.
Public Company Accounting Oversight Board (PCAOB). 2017. Staff inspection brief. (November). Available at: https://pcaobus.org/
Inspections/Documents/inspection-brief-2017-4-issuer-results.pdf?utm_source¼PCAOBþPublicþAffairs&utm_
campaign¼51293d48e2-Press_Release_2017-SIB-2016-preview-outlook&utm_medium¼email&utm_term¼0_7e8f08cfb351293d48e2-12535799
Public Company Accounting Oversight Board (PCAOB). 2019a. Staff Preview of 2018 Inspection Observations. (May 6). Available at:
https://pcaobus.org/Inspections/Documents/Staff-Preview-2018-Inspection-Observations.pdf
Public Company Accounting Oversight Board (PCAOB). 2019b. PCAOB Release No. 104-2019-044: Inspection of PricewaterhouseCoopers LLP. (February 28). Available at: https://pcaobus.org/Inspections/Reports/Documents/104-2019-044PricewaterhouseCoopers-LLP.pdf
Whittington, O. R., and K. Pany. 2019. Principles of Auditing and Other Assurance Services. 21st edition. New York, NY: McGraw-Hill.
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APPENDIX A
Deliverable Workpaper and Memo Guidance
Purpose: To obtain direct confirmation of accounts receivable and perform alternative procedures for nonresponses.
Case Questions for Steps 1 and 2: Sample Selection Process
Factors Required for Completing Sample Selection
Tolerable misstatement (i.e., desired precision, tolerable error, materiality): $750,000.00
Allowable risk of incorrect acceptance: 0.10
Expected misstatement (i.e., expected error): $357,000.00
Random starting point: 15151.00
Note: Obtain the IDEA Technical Guidance from your instructor to assist you in importing the Excel file into IDEA, selecting a
sample, and projecting any misstatements to the population.
STEP 1: Evaluate the data file to be used for audit work.
1a. Examine the ‘‘AR Aging File’’ tab and the ‘‘Top Ten Customer Analytics’’ tab provided in the data file [PBC 1]. If
you were taking a risk-based approach, which items would you want to ensure you tested during substantive
testing? Why?
1b. Ensure the completeness and accuracy of the data file by identifying the balances listed below and ensuring they
agree.
Accounts receivable balance per ‘‘AR Detail File’’ tab (in EXCEL): _____
Accounts receivable balance per ‘‘Balance Sheet’’ tab (in EXCEL): _____
Accounts receivable balance per imported IDEA file (in IDEA): _____
NOTE: Use IDEA Technical Guidance Step 1 to import the file into IDEA. If you make any computations within the ‘‘AR
Detail File’’ tab, be sure to delete them before the import.
1c. Why is it important to perform the above comparisons before selecting a sample?
STEP 2: Select a statistical sample: Use IDEA to perform Monetary-Unit Sampling (MUS) of accounts receivable
invoices (Use IDEA Technical Guidance Step 2).
2a. Refer to PCAOB AS 2315, paras. 10 and 46. Define sampling risk. Explain how the use of MUS helps to minimize
this risk. Identify two reasons you think your manager chose to use MUS.
2b. What is the final sample size? High Values: ____ Monetary Sample: ____ Total Sample: ____
2c. How would your sample size change if you increased your tolerable misstatement to $1 million (all other
requirements the same as originally stated)? Why would this occur?
2d. How would your sample size change if you decreased your allowable risk of incorrect acceptance to 0.05 (all other
requirements the same as originally stated)? Why would this occur?
STOP: Obtain PBC 2 and PBC 3 from your instructor. Use PBC 2 to verify your sample selection from Step 2 is accurate.
Then, use PBC 3 to complete Steps 3 and 4.
Case Questions for Steps 3 and 4: AR Confirmation Process
STEP 3: Perform accounts receivable audit work on the sample: Evaluate the RPA reported AR confirmation log and
confirmation letters [PBC 3].
3a. How many confirmations have no issues noted by the RPA? ______
3b. How many confirmations have issues noted by the RPA that require examination? ______
3c. Are the conclusions provided in the RPA AR confirmation log consistent with the conclusions you draw from
reviewing the returned confirmation letters? If no, explain.
3d. Read the articles assigned by your instructor to gain an understanding about how RPA technology is transforming
financial statement audits. After reading these articles, provide a response to the following questions.
 Discuss at least three specific reasons why audit firms are adopting RPAs to perform audit work. What types of
tasks and procedures can and cannot be performed by RPAs?
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 How do you feel about relying on RPA software for portions of the task you have been assigned? Describe any
risks or concerns you have.
STEP 4: Evaluate, project, and communicate the results:
4a. Use IDEA to project any misstatements from your accounts receivable confirmation audit work to the population
(use IDEA Technical Guidance Step 4).
What is the:
1. Gross most likely error for the sample of 30: _____
2. Gross upper error limit for the sample of 30: _____
3. Value of errors for the high value items: _____
4. Gross most likely error for all items: _____
5. Gross upper error limit for all items: _____
NOTE: Be sure to provide the MUS Projection Report from IDEA to support your above responses.
4b. Write a professional memo that addresses the below request from your audit manager.
Please provide me an overview of the work you performed, including any issues or matters you think I should
communicate to the client, and a printout of your MUS Projection Report page.
I know you are new, so allow me to clarify my expectations of what should be in your professional memo. The first
portion of the memo should be a recap of the overall sampling process and your assessment of Wealthy Watches Inc.’s
accounts receivable population. You should then discuss your ultimate sampling procedure, the results of your testing/
projections, and finally next steps. Your discussion of the next steps should include recommendations as to what
action the client may need to take and/or possible adjustments to the audit plan. Since ultimately this test was designed
to support the existence of the accounts receivable balance, you should be certain to discuss whether you feel that
management’s assertion is supported. Remember, per the PCAOB ‘‘if you didn’t document it, you didn’t do it’’ so
please be complete in your write-up. Below are a few guiding questions that I would expect you to address:
 How did you ensure the completeness of the population?
 What were your concerns about the population before testing?
 How does your sampling method help to address any of those concerns (i.e., statistical sampling, MUS)?
 Did you have any concerns related to the work performed by the RPA software?
 What are the results of your testing after projecting any misstatements identified?
 What does this mean for your conclusions on the existence of the population?
 What are your outstanding concerns about any specific misstatements that you might want the engagement
team to follow up on and what are your recommendations for the next steps?
Appendix A is available for download, see the link in Appendix B.
APPENDIX B
ISSUES-2020–037_Deliverable Workpaper_Memo Guidance: https://dx.doi.org/10.2308/ISSUES-2020-037.s01
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II. CASE LEARNING OBJECTIVES AND IMPLEMENTATION GUIDANCE
Purpose of the Case
This case exposes students to current accounts receivable confirmation practices, including aspects of this substantive
audit work that are evolving due to greater reliance on technology (such as IDEA and RPA). By completing this case,
students will: evaluate a client-provided data file, select a sample of customer invoices using IDEA, obtain results of tests
from the audit firm’s RPA software, assess the returned accounts receivable confirmations and responses provided by the
client contact, project any findings from the confirmations to the population, and communicate their conclusions in a memo
documenting the audit work. Thus, this case provides students an opportunity to improve their understanding of audit-related
technologies used in audit practice, strengthen their technical knowledge of applicable standards, develop their professional
judgment skills necessary to appropriately evaluate audit evidence, and practice documenting their results in a professional
manner.
Despite the obvious importance of auditing revenue and accounts receivable, PCAOB staff members continue to observe
frequent deficiencies related to the design and performance of revenue-related audit procedures (PCAOB 2019), including the
improper application of sampling procedures (PCAOB 2014, 2017).9 Given the troubling PCAOB observations (PCAOB
2014, 2017, 2019), a key motivation for this case is to provide instructors with a tool to expose students to the audit of revenue
and accounts receivable, with a particular focus on sampling and the evaluation of sample results using technology employed in
practice.
While sampling is still the primary method for conducting substantive tests of details, in general, and specifically with
accounts receivable confirmation testing, public accounting firms are pursuing the use of other audit-related technologies (e.g.,
RPA) to help automate structured, rule-based, and repetitive tasks (Cohen, Rozario, and Zhang 2019; KPMG 2019). As firms
continue to develop RPA software to perform more basic audit tasks, auditors in the field are going to be tasked with evaluating
the RPA output without having performed all or portions of the audit work themselves. Audit practitioners indicate that
students must become familiar with their new expected role through practice in the classroom, specifically as it relates to RPA
(Cooper, Holderness, Sorensen, and Wood 2019). Therefore, this case aims to provide audit instructors with the opportunity to
help students hone their knowledge of recent changes in the audit environment, and address some of the skill gaps highlighted
by public accounting firms and practitioners (PwC 2015; Cooper et al. 2019).
Learning Objectives
There are six learning objectives (LOs) for the case study, which are accomplished through several pedagogical methods
integrated into the case materials. The LOs are specifically designed to initiate students’ higher-order thinking in accordance
with the levels of Bloom’s Taxonomy (Bloom 1956), as well as specifically connect to the applicable PCAOB auditing
standards. Table 1 presents the LOs and relates each to the Bloom’s Taxonomy levels, the applicable PCAOB standard, and the
specific case requirement.
Students who satisfactorily complete this case will be able to accomplish the following:
 Evaluate whether a data file received from a client (i.e., a detailed journal listing) is complete and accurate and to
describe the significance of this procedure.
 Apply the professional standard pertaining to audit sampling and describe how professional judgment can impact an
auditor’s sample selection.
 Utilize a sampling software tool to select a statistical monetary unit sample.
 Critically assess information gathered by RPA software and direct audit evidence in light of the known risks inherent to
the revenue cycle, including improper revenue recognition and fraud.
 Evaluate the results of an audit sample and conclude on the existence of the accounts receivable balance, including
projecting any misstatements from the sample to the population.
 Document and communicate audit results and conclusions, including audit judgments and decisions made while
performing substantive audit procedures.
9
PCAOB inspection staff observe instances in testing revenue where auditors used ‘‘samples that were too small to provide sufficient audit evidence,’’
failed ‘‘to select a representative sample of items for testing, which is necessary to be able to extend the auditor’s conclusions to the entire population,’’
and failed ‘‘to apply audit procedures to all of the sample items selected and inappropriately evaluated the sample results as if the untested sample items
were tested without exception’’ (PCAOB 2014, 19).
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TABLE 1
Learning Objectives
#
Learning Objective
LO1
To evaluate whether a data file received from a
client (i.e., a detailed journal listing) is complete
and accurate and to describe the significance of
this procedure.
To apply the professional standard pertaining to
audit sampling and describe how professional
judgment can impact an auditor’s sample
selection.
To utilize a sampling software tool to select a
statistical monetary unit sample.
To critically assess information from RPA software
and direct audit evidence in light of the risks
inherent to the revenue cycle, including improper
revenue recognition and fraud.
To evaluate the results of an audit sample and
conclude on the existence of the accounts
receivable balance, including projecting
misstatements from the sample to the population.
To document and communicate audit results and
conclusions, including audit judgments and
decisions made while performing substantive
audit procedures.
LO2
LO3
LO4
LO5
LO6
Bloom’s
Taxonomy Level
Related PCAOB
Standards
Level 6: Evaluation
PCAOB AS 1105,
par. 10
Step 1, Question 1a-1c
Level 4: Analysis
PCAOB AS 2315,
par. 10, 17, 21-24,
& 46
Step 2, Question 2a, 2c-2d
Level 3: Application
PCAOB AS 2315,
par. 21-24 & 46
PCAOB AS 2310,
par. 34
Step 2, Question 2b
Level 6: Evaluation
PCAOB AS 2315,
par. 26-30; PCAOB
AS 2310, par. 33
Step 4, Question 4a-4b
Level 5: Synthesis
PCAOB AS 1215,
par. 4-6
Step 4, Question 4b
Level 6: Evaluation
Related Case
Requirement
Step 3, Question 3a-3d;
Step 4 Question 4b
Literature Review
We conducted a search of the past 20 years of Issues in Accounting Education and the Journal of Accounting Education to
identify similar cases that focus on the application of sampling, substantive procedures, evaluation of audit evidence, audit
documentation, and concluding and communicating results. While we identify several relevant cases, a key differentiator of our
case is the ability of students to perform these steps in their entirety, while gaining exposure to advanced techniques such as
RPA, an important and timely topic for auditing students (Cooper et al. 2019). Of cases published in Issues in Accounting
Education, several focus specifically on the revenue and/or accounts receivable audit area (Hogan, Bierstaker, and Seltz 2001;
Miller and Savage 2009; D’Aquila and Capriotti 2011; Andiola, Lambert, and Lynch 2018; L. Blix, W. Blix, Edmonds, and
Keenan 2019) and one focuses on statistical sampling (Richardson and Louwers 2010). Similarly, a few cases in the Journal of
Accounting Education focus on the general audit procedures that we highlight. Some focus on auditing revenue and/or accounts
receivable (Grimm and Hoag 2011; Spires 2012) or sampling (Dickins, Fallatah, and Higgs 2013), and one incorporates both
accounts receivable and sampling (Edmonds, Miller, and Savage 2019). Our case complements Edmonds et al. (2019), who
cover accounts receivable substantive audit work and sampling using Excel. However, our work is importantly differentiated
from the collective body of prior cases in that it allows students to: (1) perform a specific substantive test from beginning (i.e.,
obtaining the data file) to end (i.e., projecting any misstatements from the sample to the population and concluding on the audit
area); (2) consider reliance on advanced techniques (RPA), while using sampling software (IDEA) currently employed in audit
practice; and (3) communicate their results in a professional memo.
Implementation Guidance
The case is designed for use in an undergraduate or graduate auditing class. We recommend that instructors assign or ask
undergraduate students to form teams of two to three to complete the case as a group assignment and require graduate students
to complete the case as an individual assignment. Auditors commonly work in teams and undergraduate students may feel more
comfortable learning the IDEA technology when working together, as teams provide students with a peer group to answer
questions. The case may be completed as an assignment outside of class, but we recommend a more ‘‘hands-on’’ approach in
the classroom. During class testing of the case, instructors used a hybrid approach, having students complete Steps 1 and 2 in
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Andiola, Downey, Earley, and Jefferson
class and then completing Steps 3 and 4 outside of class for homework. Appendix A, the Deliverable Workpaper and Memo
Guidance, of the case provides a deliverable workpaper with questions related to each step and guidance on the professional
memo that should be turned in at the completion of the case. The requirements and final deliverables are the same regardless of
the team size or approach used.
Sampling Software
Before introducing the case in class, the instructor should encourage students to become familiar with the software chosen
for the case. We chose IDEA software because it offers free academic licenses, plenty of free instructional resources, is often
covered in textbooks already used in the classroom, and is used by several public accounting firms and companies. Students
who own the IDEA workbook or have purchased an auditing textbook that includes the IDEA software can install and use the
version that comes with their text.10 Other students may access IDEA via campus computers or by downloading it through
instructor-provided access. Instructors can provide their class access by registering through the IDEA software provider’s (Case
Ware Analytics) academic portal: academicportal.casewareanalytics.com/en/. Following approval, instructors select ‘‘Generate
Student Invite’’ in the academic portal to generate an invite, delivered via email to faculty, that provides students with
registration and access instructions. If instructors have any questions before or after registration, they may send an email to
helpdesk@audimation.com, and request to be connected to the current Academic Partnership Coordinator. We recommend that
instructors register their class several weeks ahead of planned case use. In addition, we recommend instructors provide their
students the link at least one week before the use of the case to ensure they have sufficient time to download the program.
Providing sufficient time to conduct the download may also allow interested students to gain familiarity with IDEA by
completing Audimation’s free tutorials.
Overview of Case Delivery
The optimal delivery structure for the case involves one full in-class session (60 to 75 minutes) and two weeks for students
to complete the workpaper and memo. An outline of the implementation steps and associated documents are provided in Table
2. We recommend that the instructor provide students with the case (including Appendix A, the Deliverable Workpaper and
Memo Guidance), PBC 1: AR Journal, and the IDEA Technical Guidance, along with the IDEA registration and access
instructions described above (if required), at least one week before planned class use.11 Regardless of whether instructors plan
to complete Steps 1 and 2 in class, we recommend instructors ‘‘kick-off’’ the case by reviewing the case requirements with
students, as well as providing some background on audit sampling and confirmations. Following this, instructors may ask
students to complete Steps 1 and 2 of the case on their own outside of class. However, we recommend proceeding through these
steps in class. Specifically, students/groups work to complete the required procedures, following the IDEA technical guidance
to walk students through the exact steps required to select a sample using IDEA. The instructor may facilitate completion by
walking through the questions related to Steps 1 and 2, and the associated technical guidance, pausing to ask various students to
share their work with the broader group after each step. This approach provides the instructor an opportunity to ensure that all
groups are on track and also allows students to help one another with technical issues. Whether Steps 1 and 2 are completed inclass or independently, all students/groups should receive PBC 2 (which contains the MUS sample selection solution) from
their instructor to ensure the accuracy of the MUS sample selected before proceeding to Step 3.
At this point, instructors will also need to distribute PBC 3 (containing the AR Confirmation Log, Confirmation Letters and
Responses, and Responses from the Audit Client Contact regarding the confirmations identified as ‘‘Requires examination’’ by
the RPA software) to allow students to begin work related to Step 3. PBC 2 and PBC 3 may be distributed in-class or
electronically. During this distribution, instructors may choose to discuss the requirements associated with Steps 3 and 4.
Specifically, instructors may wish to briefly review the procedures required to evaluate the confirmation evidence and project
any misstatements from the sample, referring students to the IDEA Technical Guidance for step-by-step instructions. We find it
helpful to remind students that the firm’s RPA software facilitates the confirmation response process by pulling required
information directly from IDEA after the sample is selected and using it to populate and send the necessary confirmations, and
thus, students do not work with the RPA software directly. Therefore, students shift from selecting the sample to now reviewing
the output from the RPA software, the received confirmations, and the responses from the client contact. Ultimately, students
will use the responses from the client to decide whether an adjustment to the recorded balance is needed for each discrepancy.
10
IDEA runs on a Windows-based operating system, so students must: be able to access a Windows-based computer; have access to IDEA through the
university’s virtual desktop or campus computers; or have a Windows-emulating software, such as Parallels, on their Macintosh computer.
11
PBCs 1–3 and the IDEA Technical Guidance, as well as PowerPoint presentations to provide support for the ‘‘kick-off’’ and ‘‘wrap-up’’ discussions, are
available for download by instructors, see the Teaching Notes.
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TABLE 2
Suggested Sequence of Case Implementation and Associated Documents
Implementation Steps
Pre-case work
Provide all students with electronic versions of the necessary documents to complete Steps 1 and 2.
Instruct students to read the case document and download IDEA (if necessary) and PBC 1 to their
computers.
Case introduction and activity
Conduct kick-off discussion.
Instruct students to complete Steps 1 and 2 case requirements. (OPTIONAL: Allow students to work
on Steps 1 and 2 during class.)
One week later. . .
Provide required PBCs to complete Steps 3 and 4 by email or online learning platform.
Instruct students to complete Steps 3 and 4 case requirements.
One week later. . .
Students turn in the deliverable (Appendix A), including responses to all questions and professional
memo.
Conduct debrief discussion.
Documents Needed
1. Student Case
2. PBC 1
3. IDEA Technical Guidance
Use Kick-off PPT
1. Student Case
2. PBC 1
3. IDEA Technical Guidance
1. Student Case
2. PBC 2
3. PBC 3
4. IDEA Technical Guidance
Use Wrap-up PPT
These adjustments must be made in IDEA before projecting any misstatements from the sample to the population. While
students will complete Steps 3 and 4 of the case outside of class, instructors may remind students that in addition to the
projection of any misstatements from the sample, the case requires a memo that involves thoughtful reflection on what the
projected results mean (in terms of next steps and audit impact).
Upon completion of Steps 3 and 4, students turn in the deliverable workpaper (Appendix A, Items 1a to 4a), the
professional memo (Appendix A, Item 4b), and the MUS Extrapolation Report from IDEA. We recommend instructors host a
brief in-class ‘‘wrap-up’’ discussion with students following final submission. Instructors may wish to allow students to share
their findings and experiences, before reviewing the solution in detail.12 In particular, instructors may want to highlight key
components of a well-developed memo, appropriate next audit steps, and reinforce how the projection of any misstatements
affects the audit, both at the account level and overall.
Case-Specific Documents
There are several appendices and PBCs that accompany this case. The following is a list of documents and resources
students need to complete the case. We recommend discussing these documents with students as they are introduced and
identifying those that are required case deliverables.
1. Appendix A of the Student Case: The Workpaper Deliverable and Memo Guidance provides questions related to each
step required in this case, as well as additional guidance on what should be included in the professional memo. This
memo is a key part of the final deliverable, as it requires students to connect and reflect on the knowledge gained from
the case.
2. IDEA Technical Guidance: Provides a step-by-step guide to navigate the IDEA technology, including screenshots to
assist students (available for download, see the Teaching Notes).
3. PBC 1: The AR Journal is a prepared-by-client Excel file that includes the accounts receivable detail, an aging schedule,
an analytic of the top ten customers, and a balance sheet excerpt. The ‘‘AR Detail File’’ is the tab students will import
into IDEA to select a sample of accounts receivable invoices (available for download, see the Teaching Notes).
4. PBC 2: The MUS Sample Selection for Confirmations Solution ensures students obtain the correct sample in Step 2 in
advance of completing Steps 3 and 4 of the case (available for download, see the Teaching Notes).
12
The Teaching Notes include specific discussion points that instructors may highlight to students when discussing the solutions.
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5. PBC 3: The AR Confirmation Log, Confirmation Letters and Responses, and Responses from the Audit Client Contact
provide students the results of the confirmation testing performed by the RPA software and responses from the client on
items noted as ‘‘Requires examination’’ (available for download, see the Teaching Notes).
In addition, question 3d in Appendix A of the case asks students to read assigned articles and reflect on reasons why RPA
is being adopted by auditors and for which audit tasks, and to consider the possible benefits and risks associated with relying on
RPA. Since this area is rapidly changing, we purposely did not list specific articles for this requirement in the case. Instead, we
encourage instructors to select the most recent and relevant articles at the time of assigning the case. Recent academic and
practitioner articles that you may choose to assign include:
 Exploring the use of robotic process automation (RPA) in substantive audit procedures (Cohen et al. 2019)
 Robotic process automation in public accounting (Cooper et al. 2019)
 Applying robotic process automation (RPA) in auditing: A framework (Huang and Vasarhelyi 2019)
 Robotic process automation for auditing (Moffitt et al. 2018)
 How robotic process is transforming accounting and auditing (Rozario and Vasarhelyi 2018)
Full citations for the articles listed above are included in the reference list.
Evidence of Efficacy
One hundred twelve accounting students from three U.S. public and private universities completed the case as part of
course requirements. Eighty-seven students were enrolled in an undergraduate auditing course and 25 were in a graduate
advanced auditing course. As suggested above, we allowed the undergraduate students to form teams of two or three, while the
graduate students completed the case individually. Two authors and one independent instructor conducted the case in their
classes.13 A pre-test and post-test were Institutional Review Board approved and administered before and after the case was
taught. The questions were formatted similarly to those in Dow, Watson, and Shea (2013) and Hess and Andiola (2018), and
were administered using comparable procedures to avoid any potential demand effects. The pre-test survey was administered a
few days before assigning the case. Students were informed that the survey was to assess their knowledge and comfort level
with specific course-related topics, that it was entirely voluntary, and that all responses would remain anonymous. The post-test
survey was administered following the class debrief of the case.
The questions used in the survey, the pre-test and post-test means, and significance levels are presented in Table 3.14 To
assess the case’s effect on students’ knowledge, we asked students six questions before and after case completion that dealt
with their understanding of the key learning objectives of the case. Table 3 shows that the case significantly increased students’
knowledge of evaluating a client-provided data set and audit evidence related to the accounts receivable confirmation process,
as well as applying the professional standards related to sampling (p , 0.001, two-tailed for all). In addition, the results show
increased knowledge of how to evaluate the results of an audit sample and draw conclusions, as well as how to document
related judgments and decisions (p , 0.001, two-tailed for both). Finally, the results indicate significantly greater comfort with
using sampling software to select a statistical sample (p , 0.001, two-tailed).
Table 4 summarizes the post-case questionnaire responses of students about their attitudes regarding the use of the case.
The results indicate that students responded favorably to the case, including believing that the case provided valuable
knowledge and skills for their career, was interesting, and overall, was a good learning experience.
Responses to the qualitative section of the questionnaire indicate that the case assignment piqued student interest and it
enhanced student learning beyond the textbook or typical classroom exposition on the topics of sampling and the substantive
audit of the revenue process. Illustrative comments regarding the features that students liked most are reproduced below:
 I liked how this case took us through the sampling process from the earliest stages of deciding which sampling procedure
best fits the population, all the way through evaluating final results and constructing a written memo for approval. It
helped to see how the process works in a more real-world scenario and challenged me to think about how things would
go about in a real engagement.
 Seeing the actual software and how a sample is chosen was helpful in visualizing what it is actually like to do [it] in
practice. The case write-up was possibly more valuable as it made me actually think about why we performed certain
tasks and the greater application of the case.
13
14
Sixty-six students were enrolled in authors’ courses and 46 were enrolled in the independent instructor’s courses.
When student results are compared between undergraduate and graduate students, audit internship experience (Yes/No), and sampling software
experience (Yes/No), the direction and magnitude of students’ responses are comparable between groups. Thus, combined results are presented in
Tables 3 and 4.
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TABLE 3
Paired Sample Pre- and Post-Test Means and Standard Deviations (SD)
Related
LO
Survey Item
Rate your level of knowledge of evaluating whether a client-provided data set is complete
and accurate and the importance of this procedure.
Rate your level of knowledge of the professional standard describing audit sampling and
its application.
Rate your level of comfort utilizing sampling software to select a statistical sample.
LO1
LO2
LO3
Rate your level of knowledge of evaluating audit evidence related to the accounts
receivable confirmation process.
Rate your level of knowledge of how to evaluate the results of an audit sample and draw
conclusions on the existence of the accounts receivable balance.
LO4
Rate your level of knowledge of how to document and communicate audit judgments and
decisions.
LO6
LO5
Pre-Case Post-Case
Mean
Mean
(SD)
(SD)
3.24
(1.34)
3.46
(1.48)
3.11
(1.43)
3.21
(1.52)
3.15
5.03
(1.17)
4.87
(1.28)
4.57
(1.42)
4.93
(1.06)
4.87
(1.56)
3.39
(1.53)
(1.11)
4.89
(1.19)
t-value
10.532***
7.527***
7.557***
9.715***
9.416***
8.112***
***Signifies p , 0.001, two-tailed.
This table presents the results of a pre-test and post-test comparison of six questions that directly relate to the case learning objectives. Responses were
provided on seven-point scales with 1 labeled ‘‘low knowledge’’ or ‘‘highly uncomfortable’’ and 7 labeled ‘‘high knowledge’’ or ‘‘highly comfortable.’’ The
pre-test data include 107 students and the post-test data includes 112 students.
 I like how realistic this case was with representing the confirmation process. I also liked the RPA software being
included because that will likely be what we work with in the future.
 I thought this case was very helpful in explaining the importance of audit sampling and the use of professional
skepticism when it comes to accounts receivable testing. Through the use of IDEA software we were able to pick a
sample that accurately reflected the entire set of transactions, and used the provided confirmations to make a decision
about whether the receivables actually existed. I felt like this was a great simulation and preparation for a situation that
may occur on an actual audit.
To further validate the case materials, one non-author instructor who employed the case in his audit classes evaluated the
efficacy of the case materials. Specifically, this instructor considered the ease of implementation, usefulness of the case to apply
course material, and whether the case materials enabled students to achieve the stated learning objectives. The instructor felt the
TABLE 4
Student’s Attitudes about the Case
Survey Item
The case and related questions encouraged me to use critical
thinking skills.
The case encouraged me to apply professional skepticism.
I believe working on this case provided me with valuable
knowledge and skills for my career.
I found the case interesting.
Overall, the case was a good learning experience.
Strongly
Somewhat
Somewhat
Strongly
Disagree Disagree Disagree Neutral Agree Agree Agree Mean
1
2
3
4
5
6
7
(SD)
0.0%
(0)
0.0%
(0)
0.0%
(0)
0.0%
(0)
0.0%
(0)
2.7%
(3)
1.8%
(2)
0.0%
(0)
0.0%
(0)
0.0%
(0)
3.6%
(4)
1.8%
(2)
4.5%
(5)
7.2%
(8)
3.6%
(4)
3.6%
(4)
6.2%
(7)
10.7%
(12)
12.6%
(14)
3.6%
(4)
27.0%
(30)
26.8%
(30)
23.2%
(26)
19.8%
(22)
15.1%
(17)
41.4%
(46)
36.6%
(41)
29.5%
(33)
39.6%
(44)
37.5%
(42)
22.3%
(25)
26.8%
(30)
32.1%
(36)
20.8%
(23)
40.2%
(45)
5.65
(1.14)
5.75
(1.09)
5.74
(1.15)
5.54
(1.17)
6.07
(1.01)
This table presents the results of five additional post-case questions reflecting students’ attitudes toward the case. Responses were provided on seven-point
scales with 1 labeled ‘‘strongly disagree’’ and 7 labeled ‘‘strongly agree.’’ The data include 112 students.
Issues in Accounting Education
Volume 37, Number 2, 2022
Andiola, Downey, Earley, and Jefferson
50
case was easy to implement, useful to highlight how course material relates to practice, and agreed that the case requirements
provided the students with an opportunity to acquire and apply the relevant knowledge necessary to achieve the learning
objectives. The instructor elaborated that, ‘‘I think this is a great exercise for students to complete. It gives students experience
working with real-world audit software and really helps clarify the concepts discussed in class. I plan on sharing/suggesting my
fellow instructors start using it with their classes next semester.’’ Furthermore, both the non-author instructor and author
instructors indicate that student performance on the case indicated that the learning objectives were met.
The finalized version of the case was completed by two graduate assistants to ensure that no inconsistencies or problems
occurred when completing the case. Two non-author audit instructors also reviewed the case and the support materials to ensure
no questions or concerns arose related to how to implement the case.
TEACHING NOTES AND STUDENT VERSION OF THE CASE
Teaching Notes and the Student Version of the Case are available only to non-student-member subscribers to Issues in
Accounting Education through the American Accounting Association’s electronic publications system at https://meridian.
allenpress.com/aaa/. Non-student-member subscribers should use their usernames and passwords for entry into the system
where the Teaching Notes can be reviewed and printed. The ‘‘Student Version of the Case’’ is available as a supplemental file
that is posted with the Teaching Notes. Please do not make the Teaching Notes available to students or post them on websites.
If you are a non-student-member of AAA with a subscription to Issues in Accounting Education and have any trouble
accessing this material, please contact the AAA headquarters office at info@aaahq.org or (941) 921-7747.
REFERENCES
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notes in the audit of accounts receivable. Issues in Accounting Education 33 (2): 43–55. https://doi.org/10.2308/iace-52055
Blix, L. H., W. Blix, M. Edmonds, and E. S. Keenan. 2019. Southern Industries: A realistic simulation of substantive testing for accounts
receivable. Issues in Accounting Education 34 (4): 1–13. https://doi.org/10.2308/iace-52462
Bloom, B. S. 1956. Taxonomy of Educational Objectives: The Cognitive Domain. New York, NY: David McKay Co., Inc.
Cohen, M., A. M. Rozario, and C. Zhang. 2019. Exploring the use of robotic process automation (RPA) in substantive audit procedures.
The CPA Journal (July). https://www.cpajournal.com/2019/08/14/exploring-the-use-of-robotic-process-automation-rpa-insubstantive-audit-procedures/
Cooper, L. A., D. K. Holderness, Jr., T. L. Sorensen, and D. A. Wood. 2019. Robotic process automation in public accounting.
Accounting Horizons 33 (4): 15–35. https://doi.org/10.2308/acch-52466
D’Aquila, J. M., and K. Capriotti. 2011. The SEC’s case against California Micro Devices: A lesson in using professional skepticism and
obtaining sufficient appropriate evidence. Issues in Accounting Education 26 (1): 145–154. https://doi.org/10.2308/iace.2011.26.1.
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Hogan, T. J., J. L. Bierstaker, and W. E. Seltz. 2001. Laborers Local 829 health and welfare plan: Testing investments and receivables.
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Accounting Information Systems 35: 100433. https://doi.org/10.1016/j.accinf.2019.100433
KPMG. 2019. Robotic process automation (RPA) powering up the audit. (August 7). Available at: https://home.kpmg/au/en/home/
insights/2019/02/audit-technology-robotic-process-automation-powering-audit.html
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an Audit of Financial Statements. Available at: https://pcaobus.org/Standards/QandA/9-9-14_SAPA_12.pdf
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Issues in Accounting Education
Volume 37, Number 2, 2022
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Journal of Accounting Research
Vol. 39 No. 3 December 2001
Printed in U.S.A.
Tax and Regulatory Motivations for
Issuing Non-voting,
Non-convertible Preferred Stock
C A R O L Y N M . C A L L A H A N ,∗ W A Y N E H . S H A W , †
AND WILLIAM D. TERANDO‡
Received 2 March 1998; accepted 19 January 2001
ABSTRACT
This paper extends prior studies that attempt to explain the existence of
unique securities, particularly Engel, Erickson, and Maydew [1999], by investigating why firms issue non-voting, non-convertible preferred stock (PS)
instead of other securities. We find that the choice of PS is influenced by tax
and regulatory changes imposed by the Tax Reform Act of 1986 (TRA86) and
the 1989 Basle Banking Accord as well as various firm specific incentives. We
find that industrials issue PS to preserve tax attributes by avoiding an ownership change and to maximize foreign tax credit utilization. In addition, we
find that the regulatory requirements of the Basle Accord influence the choice
by banks to issue PS. Finally, we show that although firms could have issued
alternative securities that would have allowed them to achieve the same tax
or regulatory goals, firm specific factors limit their ability to do so. For example, firms can also avoid triggering an ownership change by issuing straight
debt, however, financial distress considerations may constrain their ability to
issue additional debt. Therefore, we demonstrate that the final choice of PS is
influenced by a combination of tax, regulatory, and firm specific incentives.
∗ University of Arkansas–Fayetteville; †Southern Methodist University; ‡ Iowa State Univer-
sity. We are indebted to Dan Dhaliwal, J. Richard Dietrich, Thomas J. Frecka, E. Ann Gabriel,
Lillian Mills, Michael Morris, Terry Warfield, and workshop participants at the 1997 American
Accounting Association Annual Meeting, the 1997 University of Illinois Tax Symposium, Case
Western Reserve University, Lehigh University, Michigan State University, The Ohio State University, Southern Illinois at Edwardsville, University of Illinois at Chicago, Iowa State University,
and the University of Wisconsin at Madison. This paper was funded by a grant from the Ernst
and Young Foundation. Carolyn M. Callahan is grateful for the research support provided by
the KPMG Foundation.
463
C , University of Chicago on behalf of the Institute of Professional Accounting, 2001
Copyright 
464
C . M . CALLAHAN , W . H . SHAW , AND W . D . TERANDO
1. Introduction
This study investigates why firms select non-voting, non-convertible preferred stock (PS) over other financing options, such as common stock, convertible preferred stock, or debt (straight and convertible). We examine
whether the firm’s decision to issue PS is explained by firm specific incentives (ease of access to the capital markets, tax status, financial risk, and
ownership control considerations) as well as incentives created by two targeted provisions of the Tax Reform Act of 1986 (TRA86) and regulatory
incentives created by the Basle Banking Accord of 1989 (Basle Accord). The
first tax provision is associated with the limitation on the deductibility of net
operating losses (NOLs) after a corporate ownership change is triggered
while the second tax provision provides an incentive for U.S. multinationals
with binding foreign tax credit (FTC) limitations to substitute PS for debt
and thereby increase the amount of FTCs that can be used against U.S. tax
liabilities (see Collins and Shackelford [1992] and Newberry [1998]). Finally, banks have a regulatory incentive to issue PS to either meet minimum
capital adequacy levels or increase their percentage of core to supplemental
capital. The incentive is created by the Basle Accord which designates PS a
higher status in the bank capital adequacy definitions (as core capital) than
convertible preferred stock or debt (as supplemental capital).
We extend previous research explaining the existence of unique securities, particularly Engel, Erickson, and Maydew [1999], by showing that
specific tax and regulatory incentives are important in the firm’s decision to
issue PS.1 We show that industrials issue PS instead of other forms of equity
(and convertible debt) to preserve NOL tax attributes by avoiding an ownership change. We show also that industrials issue PS rather than common
stock to maximize foreign tax credit utilization. In addition, our results indicate that banks issue PS to increase their relative core capital levels, not
to meet minimum capital adequacy requirements.
The ownership change and FTC incentives do not, however, completely
explain why firms choose PS instead of straight debt or convertible preferred
stock, nor does the regulatory incentive provide insight as to why banks issue
PS rather than common stock. We show that such financing decisions are
influenced also by firm specific incentives related to a firm’s business and
operating environment. For example, firms with high debt levels and low
marginal tax rates (MTRs) choose PS over straight debt. We find also that the
decision to issue PS instead of convertible preferred stock is influenced by
the firms’ ability to access the PS markets (as proxied by firm size). Finally, we
show that banks choose PS over common stock in periods when their access
to the common equity market is limited because of depressed common stock
prices.
1 Engel, Erickson, and Maydew [1999] examine the financial, regulatory and tax objectives
of MIPS (Monthly Income Preferred Securities), or tax deductible preferred stock.
TAX AND REGULATORY MOTIVATIONS FOR STOCK
465
2. Incentives for PS Issuance
2.1 CHANGES IN TAX INCENTIVES
2.1.1. Ownership Change Incentive. TRA86 changed the rules governing
the use and availability of NOL carry forwards by corporations that experience an ownership change.2 An ownership change is triggered when the
percentage of qualifying stock (by value) held by certain shareholders incrementally increases by more than fifty percentage points during a three-year
testing period. Qualifying stock is defined generally as common stock, convertible preferred stock and convertible debt. In the event an ownership
change is triggered, the amount of “pre-change” NOLs (NOLs that exist immediately prior to the ownership change date) that can be applied against
“post-change” taxable income is limited on an annual basis to the product of
the firm’s equity market capitalization and the applicable federal long-term
tax exempt rate (annual limitation).3
To the extent a corporation has relatively low equity market capitalization
and high NOLs, triggering an ownership change may result in a decrease
in firm value and a corresponding increase in explicit tax costs through the
restricted use or loss of the NOL tax attribute. Corporations may avoid triggering an ownership change by issuing PS rather than a qualifying security
since PS is classified as a non-qualifying security for this purpose.4 However,
the tax savings associated with PS issuance must be weighed against the marketability of these securities. Since low equity market capitalization/high
NOL firms are likely to be financially distressed (Donaldson [1962]; Moyer,
Marr, and Chatfield [1987]), PS has two disadvantages for investors. First,
it is subordinate to a debt issue upon liquidation or bankruptcy. Second,
it generally has no voting rights. Given these non-tax costs, we expect that
corporations will issue PS in total or at the margin only if they receive a
substantial tax benefit by avoiding an ownership change. We predict that
this group will be dominated by corporations who would incur restricted
use or loss of “pre-change” NOLs if an ownership change were triggered.
2.1.2 Foreign Tax Credit Incentive. TRA86 also changed the computation
of the interest allocation rules by increasing the portion of domestic interest
expense that is allocated against foreign sourced income. Collins and Shackelford [1992] suggest the rule change decreased the tax-favored status of
2 These rules attempt to restrict the relief provided to firms by carrying forward NOLs to a
specific time period and to a specific shareholder group (Rizzi [1987]).
3 To compute the annual limitation, equity market capitalization is defined as the market
value of corporate stock immediately prior to the ownership change less investment assets (if
they comprise more than one-third of total assets) and capital contributions made during the
preceding two years.
4 The ownership change rules do not apply to corporations undergoing bankruptcy reorganizations if existing shareholders and creditors own at least 50% of the value and voting
power of corporate stock immediately after the reorganization. However, bankruptcy subjects
a firm to significant administrative costs that can be avoided by simply issuing a non-qualifying
security, such as PS.
466
C . M . CALLAHAN , W . H . SHAW , AND W . D . TERANDO
debt for U.S. multinationals by constraining the ability of corporations to
credit foreign taxes against U.S. tax liabilities (see also Newberry [1998]).
They demonstrate that firms with binding foreign tax credit limitations have
an incentive to substitute preferred stock (including PS) for debt to limit
the decrease in foreign sourced income and increase the amount of foreign
tax credits that can be utilized against U.S. tax liabilities. In this instance,
PS is a more appropriate substitute for debt than common stock because it
can be structured to mimic debt.
2.2 BANK REGULATORY INCENTIVES
In July 1988, the central bankers of the twelve major industrialized countries endorsed new risk-based capital adequacy standards. Although the
Basle Accord applies only to international banks, it was made applicable
to all federally regulated and insured banks and thrifts by U.S. regulators
in 1989. The principal objectives of these new standards are to: (1) achieve
greater consistency in the evaluation of capital adequacy of banks throughout the world, (2) make regulatory capital requirements more sensitive to
differences in bank risk profiles, and (3) factor off-balance sheet risk exposures into the determination of a bank’s “weighted-risk” asset level. They
differ from previous capital standards by: (1) defining capital more restrictively, (2) being risk-based, and (3) incorporating off-balance sheet items
(Beaver and Parker [1995]).
To assess capital adequacy, banks must consider both the level of core and
qualifying capital as a percentage of weighted-risk assets. Qualifying capital
consists of two components: core and supplemental capital. Core capital
is generally defined as the sum of common equity and PS less goodwill.
Supplemental capital includes the sum of: (1) loan loss reserves, (2) most
debt, and (3) convertible preferred stock. In addition, supplemental capital
is limited in total to 100% of core capital. A bank’s weighted-risk asset level
is determined by assigning assets and off-balance sheet items to various
risk categories (0, 10, 20, 50, and 100 percent) and accounts for the risk
attributable to various investment choices.
Since these regulations classify PS as core capital, there is an incentive
to issue PS in one of three situations. First, a bank may issue PS to meet
minimum capital adequacy standards that consider both its core and qualifying capital ratios. This allows it to avoid incurring the cost of supervisory
regulation faced by banks that are undercapitalized. Second, a bank may
issue PS to maintain or increase its relative level of core to supplemental
capital.5 This allows a bank to increase both its core and qualifying capital
levels while maintaining the future flexibility to issue additional securities
5 A bank with excess capital may issue additional equity due to risk aversion among managers
and the increasing cost of obtaining funds through deposits (O’Hara [1983]). Trade-offs are
made between the tax advantage of deposit financing and the disadvantages due to reserve
requirements and diseconomies of scale in the production of deposits (Orgler and Taggert
[1983]).
TAX AND REGULATORY MOTIVATIONS FOR STOCK
467
that qualify as supplemental capital. Finally, both incentives are likely to be
strengthened if a bank has excess supplemental capital (supplemental capital in excess of 100 percent of core capital). In this instance, PS issuance
provides a “double shot” to qualifying capital by increasing both core and
supplemental capital levels.
2.3 FIRM-SPECIFIC INCENTIVES
In addition to the two targeted tax and regulatory incentives discussed
above, we consider the impact of a variety of firm specific incentives on the
decision to issue PS, as follows:
2.3.1. Capital Market Incentive. The decision to issue PS may depend on
the firm’s relative ability to access the capital markets, as proxied by firm
size and the relative price of common equity at PS issuance date. Firm size
may influence the choice of security issued if large firms have easier access
to the financial markets. In addition, Scott and Iwahara [1994] suggest that
firms avoid issuing common stock when share prices are depressed. Rather,
they issue alternative securities, such as PS, with the intention of redeeming
them in the future when the market is more favorable for common stock
issuance.
2.3.2. Tax Clientele Incentive. Scholes and Wolfson [1992] suggest that because interest is deductible for tax purposes the tax system encourages firms
with high marginal tax rates (MTRs) to issue debt and it encourages low tax
firms to issue equity securities, such as PS.
2.3.3. Debt Level Incentive. Moyer, Marr, and Chatfield [1987] argue that
firms with high debt levels will substitute PS for debt (see also Scholes and
Wolfson [1992]). This allows them to issue a “debt-like” security while decreasing bankruptcy risk since PS shareholders cannot force the firm into
bankruptcy for unpaid dividends. In short, PS remains a viable alternative for
the firm that needs more capital but wants to avoid additional debt (Miller
[1991]).
2.3.4. Control Incentive. Firms may also prefer to issue PS as a means of
retaining control over the firm because PS is similar to debt since its issuance
avoids dilution of current shareholder interests and limits the influence of
new equity holders.
3. Sample Selection
We use the NAARs database to obtain our primary sample of PS issuers.6
We consider all 164 corporations that issued preferred stock between 1987
6 We selected the NAARS database for two reasons. First, it contains a large set of publicly
traded companies including those traded on the New York, American and OTC stock exchanges. Second, NAARS includes firms involved in cash and exchange offerings as well as
public offerings and private placements.
468
C . M . CALLAHAN , W . H . SHAW , AND W . D . TERANDO
and 1994 and also had the necessary financial statement data (in the year of
and year prior to preferred stock issuance) available for our tests.7 We then
eliminated 88 firms that issued convertible preferred stock and, consistent
with prior studies, we eliminated 15 public utilities. Our final sample consists
of 61 PS issuers and includes 38 industrials and 23 banks.
We obtained comparison samples of common stock (CS), convertible preferred stock (CPS), convertible debt (CDEBT), and straight debt (SDEBT)
issuers from the NAARS database for the 1987–1994 time period. They consist of all issuers within the same two-digit SIC classifications as the PS issuer
group that had the required financial statement data.8 The comparison
samples consist of 271 CS issuers (245 industrials and 26 banks), the 88 CPS
issuers identified above in obtaining the PS sample (65 industrials and 23
banks), 46 CDEBT issuers (42 industrials and 4 banks), and 173 SDEBT issuers (154 industrials and 19 banks).9 We analyze the two debt sub-samples
separately since convertible debt is a qualifying security for the purpose of
determining whether an ownership change is triggered while straight debt
is not.
4. Methodology
4.1 TAX AND FIRM SPECIFIC INCENTIVES
We use a dichotomous response logit model to investigate the ability of
the tax and firm specific incentives discussed above to explain the firm’s
decision to issue PS rather than other securities (equity or debt). We define
the model as follows:
FINANCING CHOICEi = α0 + β 1 LIMITi + β2 FTCi + β3 MTRi
+ β 4 DEBTi + β 5 BVMVi + β6 SIZEi + e i
(1)
The dependent variable, FINANCING CHOICE, equals one for PS issuance and zero for all other security issuances. We estimate the model for
PS issuance compared separately with each type of issuer group (CS, CPS,
CDEBT, or SDEBT).
Signed predictions for the coefficients of the independent variables in the
logit model are presented in Table 1 and discussed below for each financing
comparison. The first two variables represent the targeted tax incentives
while the remaining variables account for the influence of firm specific
incentives.
The variable LIMIT measures the ownership change incentive. It is defined as the ratio of each firm’s estimated annual limitation divided by its
7 Our sample period extends only through 1994 as the incentives for triggering an ownership
in bankruptcy changed after 1994 with (1) the repeal of the “stock for debt” exception, and
(2) related changes in the ownership change rules for corporations in bankruptcy.
8 We eliminated firms that triggered ownership changes in the year of security issue. This
assures that all firms in the primary and comparison groups are non-ownership change firms.
9 Please contact the authors for a complete listing of the firms in each sample.
TAX AND REGULATORY MOTIVATIONS FOR STOCK
469
TABLE 1
Predictions of the Tax and Firm Specific Incentives to Issue PS by Financing Choice a
FINANCING CHOICEI = α0 + β1 LIMITi + β2 FTCi + β3 MTRi + β4 LEVi
+ β5 BVMVi + β6 SIZEi + e i
Financing Choicec
Incentive
Ownership Change
FTC
Tax Clientele
Debt Level
Capital Market:
Book-to-Market
Firm Size
Variableb
LIMIT
FTC
MTR
LEV
PS
vs.
CS
—
+
N/A
±
PS
vs.
CPS
—
N/A
N/A
±
PS
vs.
CDEBT
—
+
—
+
PS
vs.
SDEBT
N/A
+
—
+
BVMV
SIZE
+
+
N/A
+
N/A
+
N/A
+
a
Using the NAARS database, each sample includes firms that issued non-voting, non-convertible preferred
stock (PS), common stock (CS), convertible preferred stock (CPS), convertible debt (CDEBT), and straight
debt (SDEBT) between 1987 and 1994 (utilities excluded).
b
The variables are defined as follows. LIMIT = estimated annual limitation divided by pre-change NOLs.
FTC = foreign assets divided by total assets, year of issuance. MTR = simulated marginal tax rates developed
by Graham [1996]. LEV = total debt divided by total assets, year prior to issuance. BVMV = book value
divided by market value of equity, year prior to issuance. SIZE = natural log of total assets, year prior to
issuance (in millions).
c
Variables with a sign prediction (+ or −) are tested using one-tailed tests. Variables without a sign
prediction (+ / −) are tested using two-tailed tests. Variables designated with an “N/A” indicate this incentive
does not influence the firms’ particular PS financing choice decision. Consequently, this variable is exc…

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