Audit Case Studies

A) Kingsley Manufacturing Company

The Kingsley Manufacturing Company employs about 50 production workers and has the following payroll procedures.

The factory foreman interviews applicants and on the basis of the interview either hires or rejects them. When applicants are hired, they prepare a W-4 form (Employee’s Withholding Exemption Certificate) and give it to the foreman. The foreman writes the hourly rate of pay for the new employee in the corner of the W-4 form and then gives the form to a payroll clerk as notice that the worker has been employed. The foreman verbally advises the payroll department of rate adjustments.

A supply of blank time cards is kept in a box near the time clock at the entrance to the factory. Each worker takes a time card on Monday morning, fills in his or her name, and punches the time clock upon their daily arrival and departure. At the end of the week, the workers drop the time cards in a box near the door to the factory.

On Monday morning, the completed time cards are taken from the box by a payroll clerk. One of the payroll clerks then enters the payroll transactions into the computer, which records all information for the payroll journal that was calculated by the clerk and automatically updates the employees’ earnings records and general ledger. Employees are automatically removed from the payroll when they fail to turn in a time card.

The payroll checks that are not directly deposited into employees’ bank accounts are manually signed by the chief accountant and given to the foreman. The foreman distributes the checks to the workers in the factory and arranges for the delivery of the checks to the workers who are absent. The payroll bank account is reconciled by the chief accountant, who also prepares the various quarterly and annual payroll tax reports.

1. List the deficiencies in internal control and state the misstatements that are likely to result from the deficiency.
2. For each deficiency that increases the likelihood of fraud, identify whether the likely fraud is misappropriation of assets or fraudulent financial reporting.

B) Worthington Department Stores

Auditing standards require the auditor to obtain sufficient appropriate audit evidence (AS 1105.04: Audit Evidence).  The audit firm of Hepple & Ramsey was investigated for the audit of Worthington.  Worthington is a large discount catalog department store chain. The company recently expanded from 6 to 43 stores by borrowing from several large financial institutions and from a public offering of common stock. A recent investigation has disclosed that Worthington materially overstated net income. This was accomplished by understating accounts payable and recording fictitious supplier credits that further reduced accounts payable. An SEC investigation was critical of the evidence gathered by Worthington’s audit firm, Hepple & Ramsey, in testing accounts payable and the supplier credits.  The following is a description of some of the fictitious supplier credits and unrecorded amounts in accounts payable, as well as the audit procedures.

1. Manning Advertising Credits—Worthington had arrangements with some vendors to share the cost of advertising the vendor’s product. The arrangements were usually agreed to in advance by the vendor and supported by evidence of the placing of the ad. Worthington created a 114-page list of approximately 1,100 vendors, supporting advertising credits of $300,000. Worthington’s auditors selected a sample of 4 of the 1,100 items for direct confirmation. One item was confirmed by telephone, one traced to cash receipts, one to a vendor credit memo for part of the amount and cash receipts for the rest, and one to a vendor credit memo. Two of the amounts confirmed differed from the amount on the list, but the auditors did not seek an explanation for the differences because the amounts were not material.  The rest of the credits were tested by selecting 20 items (one or two from each page of the list). Twelve of the items were supported by examining the ads placed, and eight were supported by Worthington debit memos charging the vendors for the promotional allowances.
2. HealthLock Credits—Worthington created 28 fictitious credit memos totaling $257,000 from HealthLock Distributors, the main supplier of health and beauty aids to Worthington. Worthington’s controller initially told the auditor that the credits were for returned goods, then said they were a volume discount, and finally stated they were a payment so that Worthington would continue to use HealthLock as a supplier. One of the Hepple & Ramsey staff auditors concluded that a $257,000 payment to retain Worthington’s business was too large to make economic sense. The credit memos indicated that the credits were for damaged merchandise, volume rebates, and advertising allowances. The audit firm requested a confirmation of the credits. In response, Tom Seymore, the president of Worthington Stores, placed a call to Martin Leary, the president of HealthLock, and handed the phone to the staff auditor. In fact, the call had been placed to an officer of Worthington. The Worthington officer, posing as Leary, orally confirmed the credits. Worthington refused to allow Hepple & Ramsey to obtain written confirmations supporting the credits. Although the staff auditor doubted the validity of the credits, the audit partner, Michael Jennings, accepted the credits based on the credit memoranda, telephone confirmation of the credits, and oral representations of Worthington officers.
3. Ringet Credits—$130,000 in credits based on 35 credit memoranda from Ringet, Inc., were purportedly for the return of overstocked goods from several Worthington stores. A Hepple & Ramsey staff auditor noted the size of the credit and that the credit memos were dated subsequent to year-end. He further noticed that a sentence on the credit memos from Ringet had been obliterated by a felt-tip marker. When held to the light, the accountant could read that the marked-out sentence read, “Do not post until merchandise received.” The staff auditor thereafter called Harold Ringet, treasurer of Ringet, Inc., and was informed that the $130,000 in goods had not been returned and the money was not owed to Worthington by Ringet. Seymore advised Jennings, the audit partner, that he had talked to Harold Ringet, who claimed he had been misunderstood by the staff auditor. Seymore told Jennings not to have anyone call Ringet to verify the amount because of pending litigation between Worthington and Ringet, Inc.
4. Accounts Payable Accrual—Hepple & Ramsey assigned a senior with experience in the retail area to audit accounts payable. Although Worthington had poor internal controls, Hepple & Ramsey selected a sample of 50 for confirmation of the several thousand vendors who did business with Worthington. Twenty-seven responses were received, and 21 were reconciled to Worthington’s records. These tests indicated an unrecorded liability of approximately $290,000 when projected to the population of accounts payable. However, the investigation disclosed that Worthington’s president made telephone calls to some suppliers who had received confirmation requests from Hepple & Ramsey and told them how to respond to the request.
5. Cut-Off —Hepple & Ramsey also performed a purchases cutoff test by vouching accounts payable invoices received for nine weeks after year-end. The purpose of this test was to identify invoices received after year-end that should have been recorded in accounts payable. Thirty percent of the sample ($160,000) was found to relate to the prior year, indicating a potential unrecorded liability of approximately $500,000. The audit firm and Worthington eventually agreed on an adjustment to increase accounts payable by $260,000.

For each of the five instances above, identify deficiencies in the sufficiency and appropriateness of the evidence gathered in the audit of accounts payable of Worthington Stores.

 

C) AutoSmart Corp

AutoSmart is a public company founded in 2004 to manufacture and sell specialty auto products mainly relating to paint protection and rustproofing. By 2013, the AutoSmart board of directors felt that the company’s products had fully matured and that it needed to diversify. AutoSmart aggressively sought out new products, and in March 2014 it acquired the formula and patent for a specialized motor lubricant (Smooth-Run) from SIM, LLC. In addition, the company purchased 15 percent of SIM’s outstanding common stock. At the time of the stock purchase, Steve Matthews owned 100 percent of SIM; he retained ownership of 85 percent of SIM after AutoSmart’s 15 percent purchase. In December 2014, the board of directors appointed Mr. Matthews to be president of AutoSmart.

Smooth-Run is unlike conventional motor lubricants. Its innovative molecular structure accounts for what management believes is its superior performance. Although it is more expensive to produce and has a higher selling price than its conventional competitors, management believes that it will reduce maintenance costs and extend the life of equipment in which it is used.

AutoSmart’s main competitor is a very successful multinational conglomerate that has excellent customer recognition of its products and a large distribution network. To create a market niche for Smooth-Run, AutoSmart’s management is targeting commercial businesses in western states that service vehicle fleets and industrial equipment.

AutoSmart’s existing facilities were not adequate to produce Smooth-Run in commercial quantities. In June 2015 AutoSmart commenced construction of a new plant in Nevada. After lengthy negotiation, it received a $900,000 grant from the state government. The terms of the grant require AutoSmart to maintain certain employment levels in Nevada over the next three years or the grant must be repaid. The new facilities became operational on December 1, 2015. AutoSmart financed its recent expansion with a term bank loan. Management is considering issuing additional stock later in 2016 to address the company’s cash flow problems.

AutoSmart’s auditors resigned in February 2016, after which Steve Matthews contacted your firm. The previous auditors informed Mr. Matthews that they disagreed with AutoSmart’s valuation of deferred development costs for Smooth-Run.

It is now April 20, 2016, and you and a partner in your firm have just met with Steve Matthews to discuss the services your firm can provide to AutoSmart for the year ending March 31, 2016. During your meeting, you collected the following information:

• AutoSmart incurred substantial losses during each of the past three fiscal years.
• There have been no significant orders of Smooth-Run received to date.
• AutoSmart has commenced a lawsuit against a major competitor for patent infringement and industrial espionage. Management has evidence that it believes will result in a successful action and wishes to record the estimated gain on settlement of $4 million. Although no court date has been set, legal correspondence shows that the competitor intends “to fight this action to the highest court in the land.”
• Deferred development costs of $2 million represent material, labor, and subcontract costs incurred during 2014 and 2015 to evaluate the Smooth-Run product and prepare it for market. AutoSmart has not taken any amortization to date but thinks that a period of 20 years would be appropriate.
• Royalties of $0.25 per liter of Smooth-Run produced are to be paid annually to SIM.
• The $3.514 million term bank loan is secured by a floating charge over all corporate assets. The loan agreement requires AutoSmart to undergo an annual environmental assessment of its old and new blending facilities.

As you return to the office, the partner tells you that he is interested in having AutoSmart as an audit client.  She wants you to provide a detailed list covering the audit and business risks you foresee arising from this potential engagement. HINT:  To help find the audit and business risks, go line by line through the case.

 

 

D) EZ Furniture Wholesalers, Inc.

You are a staff auditor with BLB CPAs.  BLB CPAs has been retained to perform the audit of the fiscal year 2019 by EZ Furniture Wholesalers, Inc. EZ Furniture Wholesalers, Inc. has been a client of BLB CPAs for several years. You are auditing the allowance for doubtful accounts and have concerns about some contradictory evidence.

Background Information

EZ Furniture Wholesalers, Inc. reserves for its allowance for doubtful accounts based on standard reserve percentages supported by historical collection experience. Management uses the same process for estimating the allowance for doubtful accounts (the “reserve”), as it did in the prior year. As part of its risk assessment procedures, the engagement team identified the following risk of material misstatement related to the valuation assertion:

• The entity may not appropriately update its reserve policy (including updates to reserve percentages) for changes in circumstances.

Note that the engagement team may have identified additional risks of material misstatement related to the valuation assertion identified as part of its risk assessment procedures; however, you must focus on this specific risk of material misstatement.

In addition, this risk was not identified as a fraud risk. You obtained the following evidence from the audit procedures performed to address this risk:

• The current-year reserve as a percentage of gross receivables is consistent with prior years, although there was an increase in revenues, gross receivables, and the related reserve.
• Bad debt expense has remained consistent as a percentage of gross revenue over the past several years.
• Retrospective review of receivable collections indicates that management’s reserves have historically been accurate.
• Economic conditions have been fairly stable and are predicted to remain stable.
• Revenues increased substantially year over year as a result of the introduction of a new product line.
• The new product line is marketed toward customers in the restaurant industry, in which the entity does not currently have an established customer base.
• The restaurant industry generally has a higher rate of business failure than other customer segments.
• The entity’s collections experience has primarily been with customers in the retail and professional services industries; the entity has very little collections experience with the new product line, given the recent launch.
• Approved sales terms have not changed year to year (e.g., sales personnel may offer an extension of credit of up to 100 percent of the purchase price consistent with prior year, creditworthiness is determined in the same manner, payment terms are consistent with prior year).
• Sales of the new product line are more frequently 100 percent financed versus sales of the existing product lines, resulting in an increase in gross receivables.
• Competitors who manufacture similar restaurant furniture products have higher reserves as a percentage of their trade receivables.

Required:

Your manager has asked you to prepare a document (Titled EZ Furniture Wholesalers Summary of Contradictory Evidence) answering the following questions.  The format of the document should first state the question; second, provide the relevant PCAOB AS Standard(s), and AICPA AU Standard(s) (you may cut and past the applicable sections of the standard); and third, your interpretation of how the standards applies to the case.  Each question should follow this format.  Save the document as YourLastNameEZ.

1. Identify and summarize the corroborative and contradictory audit evidence.
2. Determine what additional information, if any, is needed to reach a conclusion regarding management’s assertion.
3. On the basis of the case facts, determine whether management’s assertion is supportable and how additional information obtained might change your conclusion.

E) Omni Optical Inc

Omni Optical, Inc. was created in 2015 and entered the optical equipment industry. Its made-to-order optical equipment requires large investments in research and development. To fund these needs, Omni made a public stock offering, which was completed in 2016. Although the offering was moderately successful, Omni’s ambitious management is convinced that it must report a good profit this year (2017) to maintain the current market price of the stock. Omni’s president recently stressed this point when she told her controller, Paula Apple, “If we don’t make $1.25 million pretax this year, our stock will tank.”

Elkin was pleased that even after adjustments for accrued vacation pay, 2017 pretax profit was $1.35 million. However, Omni’s auditors, Jackson & Johnson (J&J), proposed an additional adjustment for inventory valuation that would reduce this profit to $900,000. J&J’s proposed adjustment had been discussed during the 2016 audit.

An additional issue discussed in 2016 was Omni’s failure to accrue executive vacation pay. At that time J&J did not insist on the adjustment because the amount ($20,000) was not material to the 2016 results and because Omni agreed to begin accruing vacation pay in future years. The cumulative accrued executive vacation pay amounts to $300,000 and has been accrued at the end of 2017.

The inventory issue arose in 2015 when Omni purchased $450,000 of specialized computer components to be used with its optical scanners for a special order. The order was subsequently canceled, and J&J proposed to write down this inventory in 2016. Omni explained, however, that the components could easily be sold without a loss during 2017, and no adjustment was made. However, the equipment was not sold by the end of 2017, and prospects for future sales were considered nonexistent. J&J proposed a write-off of the entire $450,000 in 2017.

The audit partner, Johanna Schmidt, insisted that Elkin make the inventory adjustment. Elkin tried to convince her that there were other alternatives, but Schmidt was adamant. Elkin knew the inventory was worthless, but she reminded Schmidt of the importance of this year’s reported income. Elkin continued her argument, “You can’t take both the write-down and the vacation accrual in one year; it doesn’t fairly present our performance this year. If you insist on taking that write-down, I’m taking back the accrual. Actually, that’s a good idea because the executives are such workaholics, they don’t take their vacations anyway.”

As Elkin calmed down, she said, “Johanna, let’s be reasonable; we like you—and we want to continue our good working relationship with your firm into the future. But we won’t have a future unless we put off this accrual for another year.”

1. Discuss the issue with the inventory and why Schmidt believes an adjustment is required. Do you agree with Schmidt?
2. Irrespective of your decision regarding the inventory adjustment, what is your reaction to Elkin’s suggestion to release the vacation accrual? Should Schmidt insist on keeping the accrual of the executives’ vacation pay?
3. Consider the conflict between Elkin and Schmidt. Assuming that Schmidt believes the inventory adjustment and vacation pay accrual must be made and that she does not want to lose the audit fee from the Omni audit, what should she do?