ACCT 4400
Dr. Robertson
Case Set 2
Spring 2016

Case Set 2 covers issues related to risk assessment, planning, and substantive tests, and consists of the following cases:

Case 2-1: Risk Assessment
Case 2-2: Planning Phase Analytical Procedures
Case 2-3: Substantive Tests and Documentation

Case 2-1: Risk Assessment

Today is April 8, 2016, and your firm is currently in negotiations to renew the contract to audit Smith Corp. for the 2015 fiscal year (Smith uses a 12/31 year-end). Smith manufactures electronic components and sells these products to manufacturers of cell phones, e-readers, and tablets. The Smith family founded the company, which originally manufactured components for radios, in the 1930s. The grandchildren of the founder had no interest in active management of the company, and it went public in the 1990s under different management. Your firm has audited Smith for ten years, and has always issued standard, unqualified opinions for both the financial statements and internal controls during this time.

New federal regulations concerning the disposal of manufacturing byproducts will impact Smith’s manufacturing process this year by limiting Smith’s ability to sell these byproducts to other companies. Furthermore, the company will have to incur costs to implement new methods of waste disposal. In combination, these issues related to the new regulations are material.

To keep up with the rapid advancement of technological developments in its industry, Smith has invested heavily in R&D over the last few years. The R&D has led to several new products that are ready to be included in the manufacturing process this year. The company believes these products will allow it to be competitive for at least three years. To fund its R&D, the company used most of its available credit lines and issued common stock last year. The CFO, Sam Austin, informed you that if the company needs additional capital over the next two years, it will be forced to accept above-market interest rates.

To reduce costs, the company implemented a just-in-time (JIT) inventory management model that launched this year. Analytical procedures for finished goods indicate the company has a lower inventory on hand and a higher inventory turnover compared to this time last year.

A review of documentation from Smith’s customer relationship module of its ERP system revealed an increase in customer complaints compared to this time last year. Most of the complaints centered on Smith not having sufficient products on hand to meet customer demand.

Stephen F. Lamar has been CEO for several years, and recently implemented a new policy for assembly line workers’ compensation. Under the new policy, workers are no longer allowed to work beyond the 8-hour shift each weekday. Mr. Lamar instructed the manufacturing supervisors to develop ideas to provide incentives for the workers in the absence of overtime pay. The stated reason for this change in policy is to reduce costs.

Smith’s internal audit department consists of three individuals. Jane Mills, the chief internal auditor, has a bachelor’s degree in communications and no certifications. Mrs. Mills has been in her position for the last seven years. The two staff internal auditors have high school diplomas, and one of them has an associate’s degree in nursing. Mrs. Mills reports to the audit committee.

The audit committee includes a local financial planner who is a certified financial analyst, a CPA who is also the CFO of a local bank, and an accounting professor from a nearby state university. The other members of the board of directors are Mr. Lamar (chair of the board), two members of the Smith family, and the CEO of a large hospital located a few miles away from Smith’s headquarters.

Questions:

1. Read AS 1001. (a) What are management’s responsibilities pertaining to the independent audit? (b) What are the auditor’s responsibilities pertaining to the independent audit? Be sure to cite paragraph numbers as appropriate, and do not simply copy and paste from the standard. Explain the responsibilities in your own words.

2. Assume you have a meeting tomorrow with Stephen F. Lamar. List the top three issues, in order of importance, that you will discuss with him, and briefly describe why you believe each issue is important.

3. What is your assessment of inherent risk at Smith (low, moderate, or high)? Why?

4. What is your assessment of control risk at Smith (low, moderate, or high)? Why?

5. To what extent will you rely on internal audit at Smith? Explain your answer.

Case 2-2: Planning Phase Analytical Procedures

Obtain the most recent annual reports for Barnes & Noble (BKS) Office Depot (ODP), OfficeMax (OMX), and Staples (SPLS). In your write-up, note the fiscal year you are using, the financial statement audit opinion, and the internal controls audit opinion for each company.

Calculate the following ratios for each company using the financial data in the most recent annual report for each company. Calculate an “industry average” consisting of the average ratio for the four companies in the Department Stores Industry.

You must use Excel to create and document the following ratios (print your Excel spreadsheet, once showing answers and once showing formulas):

* Current Ratio * Operating Cash Flow Ratio * Days Outstanding in A/R* * Days of Inventory on Hand * Gross Profit Percentage * Net Profit Margin * ROA * ROE * Debt to Equity * Times Interest Earned

* Use net sales if credit sales are not reported separately

Pick one of the four companies as your client, and discuss:

1. How your client compares to the industry averages you calculated using the four companies.

2. Your evaluation of the risk of material misstatement at your client relative to the industry. Include specific accounts you believe are most likely to be materially misstated, and explain your reasoning.

3. Design an audit plan for one of the accounts you identified in question 2 above. Your audit plan must include specific audit procedures to test the following assertions: * Existence/occurrence * Completeness * Cutoff * Accuracy or valuation, whichever is appropriate for the account you identified.

1.

Case 2-3: Substantive Tests and Documentation

Assume you have just taken a job with a prestigious accounting firm and are attending a training session on revenue recognition. The instructor for the session is Claire Rogers, a partner in the local office.

Ms. Rogers walks to the front of the room, welcomes the firm’s newest employees, allows the employees to introduce themselves, and jumps right into training mode. ‘‘I want to see how much you learned in college,’’ she says. ‘‘You will start by auditing reported revenue at College of Business Computers (CBC) for the year ended December 31, 2008. In our training simulation, CBC is a private company. We first train you to audit private companies. For these companies, we must comply with the auditing standards of the American Institute of Certified Public Accountants (AICPA). In subsequent training sessions, we will focus on public companies that are regulated by the Public Company Accounting Oversight Board (PCAOB). Here is a printout of the CBC sales journal.”

Vouch and Trace Auditing Project
College of Business Computers
Sales Journal

Date | Invoice no. | Customer name | Customer no. | Amount | Balance | 1/02/08 | 6521 | Sports Clothing | 109 | 12,376.00 | 12,376.00 | 1/28/08 | 6522 | Burger Queen | 106 | 14,314.00 | 26,690.00 | 1/31/08 | 6523 | Steel Tank | 119 | 9,182.00 | 35,872.00 | 2/10/08 | 6524 | Foothill Cyclery | 105 | 1,344.00 | 37,216.00 | 2/19/08 | 6525 | Dance Studio | 107 | 10,020.00 | 47,236.00 | 2/28/08 | 6526 | Ready Mix Concrete | 115 | 22,546.00 | 69,782.00 | 3/9/08 | 6527 | Edward's Sports | 111 | 32,807.00 | 102,589.00 | 3/18/08 | 6528 | Modern Inn | 101 | 7,688.00 | 110,277.00 | 3/25/08 | 6529 | Steel Tank | 119 | 8,076.00 | 118,353.00 | 4/1/08 | 6530 | Burger Queen | 106 | 6,482.00 | 124,835.00 | 4/11/08 | 6531 | Old Farm Inn | 108 | 11,020.00 | 135,855.00 | 4/20/08 | 6532 | Edward's Sports | 111 | 4,188.00 | 140,043.00 | 4/30/08 | 6533 | Johnson & Jones | 116 | 10,426.00 | 150,469.00 | 5/5/08 | 6534 | Flora Design Studio | 104 | 4,476.00 | 154,945.00 | 5/15/08 | 6535 | First Presyberian | 103 | 1,344.00 | 156,289.00 | 5/25/08 | 6536 | S&K Chevrolet | 102 | 4,188.00 | 160,477.00 | 6/1/08 | 6537 | Standard Motor Co. | 114 | 4,538.00 | 165,015.00 | 6/12/08 | 6538 | Dance Studio | 107 | 4,834.00 | 169,849.00 | 6/19/08 | 6539 | Atlantic | 118 | 2,594.00 | 172,443.00 | 6/27/08 | 6540 | Johnson & Jones | 116 | 1,344.00 | 173,787.00 | 7/4/08 | 6541 | Sports Clothing | 109 | 4,188.00 | 177,975.00 | 7/15/08 | 6542 | Airport Auto Center | 113 | 12,664.00 | 190,639.00 | 7/20/08 | 6543 | Burger Queen | 106 | 9,182.00 | 199,821.00 | 7/31/08 | 6544 | Modern Inn | 101 | 15,976.00 | 215,797.00 | 8/3/08 | 6545 | Flora Design Studio | 104 | 3,432.00 | 219,229.00 | 8/10/08 | 6546 | Edward's Sports | 111 | 1,344.00 | 220,573.00 | 8/18/08 | 6547 | Old Farm Inn | 108 | 39,340.00 | 259,913.00 | 8/26/08 | 6548 | Johnson & Jones | 116 | 12,314.00 | 272,227.00 | 8/30/08 | 6549 | Dance Studio | 107 | 19,970.00 | 292,197.00 | 9/3/08 | 6550 | Johnson & Jones | 116 | 5,214.00 | 297,411.00 | 9/12/08 | 6551 | Neal-Truesdale | 112 | 19,970.00 | 317,381.00 | 9/17/08 | 6552 | Steak House | 110 | 18,908.00 | 336,289.00 | 9/28/08 | 6553 | Ready Mix Concrete | 115 | 8,376.00 | 344,665.00 | 10/7/08 | 6554 | Old Farm Inn | 108 | 18,102.00 | 362,767.00 | 10/15/08 | 6555 | Standard Motor Co. | 114 | 5,832.00 | 368,599.00 | 10/25/08 | 6556 | Sanders and Smith - PC | 117 | 1,990.00 | 370,589.00 | 11/2/08 | 6557 | Airport Auto Center | 113 | 28,628.00 | 399,217.00 | 11/13/08 | 6558 | Steel Tank | 119 | 3,432.00 | 402,649.00 | 11/23/08 | 6559 | Ready Mix Concrete | 115 | 19,970.00 | 422,619.00 | 12/01/08 | 6560 | Foothill Cyclery | 105 | 12,446.00 | 435,065.00 | 12/11/08 | 6561 | Johnson & Jones | 116 | 1,344.00 | 436,409.00 | 12/21/08 | 6562 | Sanders and Smith - PC | 117 | 11,982.00 | 448,391.00 | 12/31/08 | 6563 | Emergency Medical | 120 | 19,370.00 | 467,761.00 | 12/31/08 | 6564 | S&K Chevrolet | 102 | 4,692.00 | 472,453.00 | 12/31/08 | 6565 | Sports Clothing | 109 | 16,576.00 | 489,029.00 |

“I will now tell you about the client’s sales process.’’ Ms. Rogers says.

‘‘This is what I know,’’ she continues. ‘‘CBC creates a sales order when a customer places an order by telephone. The sales department forwards one copy of the sales order to the warehouse and a second copy to the accounts receivable department. When the goods are shipped to the customer, the warehouse creates a shipping document and forwards one copy of the shipping document to the accounts receivable department. All goods are shipped F.O.B. shipping point. Although CBC’s policy and procedures manual states that the accounts receivable department is to prepare the invoice only after receiving both the sales order and the shipping document, there is no control in place to ensure that employees follow this procedure to prevent someone from preparing an invoice prior to receiving the shipping document. After preparing the invoice, the receivables department forwards a copy to the accounting department, where the invoice is posted to the sales journal. Sales orders are filed in the sales office, shipping documents are filed in the warehouse, and invoices are filed in the accounting department.’

‘‘You are to design an audit procedure that will detect revenue misstatements by testing the following assertions: occurrence, accuracy, and cutoff. For this training session, you need to select a sample of ten transactions from one of the following: (1) Sales Journal, (2) Sales Orders (filed in the sales department), (3) Shipping Documents (filed in the warehouse), or (4) Invoices (filed in the accounting department). Bear in mind that, for a real audit, you will be using statistical and nonstatistical sampling techniques to determine the correct sample size. That topic is out of scope for this training session. We’ll be covering statistical sampling and the related software program that our firm uses in a subsequent training session.

‘‘Once you select your sample of ten transactions, you need to obtain supporting evidence by tracing or vouching the ten transactions to related source documents. For instance, if you select a sample of ten entries from the sales journal, you might vouch from the sales journal to the related invoice, shipping documents, and sales order. If you select a sample of ten sales orders, you might trace the sales orders to the related shipping documents and invoices and finally into the sales journal. Or you might select your sample from the shipping documents or the invoices. Only one of these approaches is correct. You must determine which approach will provide evidence supporting the audit objective. Your goal is to obtain the most persuasive evidence that sales are not misstated. It should be helpful to know that the shipping document numbers are cross-referenced on the invoices and that the sales order numbers are cross-referenced on the shipping documents. ‘‘Finally, I want to emphasize that your deliverable to me should include two work papers. The first is a memorandum, which must include the audit client’s name; the account or system being audited; the name of the auditor who performed the procedure; the date; whether it is an analytical procedure, test of controls, test of account balance, or test of transactions; the objective of the procedure; the assertions to which the procedure relates; the tolerable error; a detailed description of the procedure; and your conclusion.

‘‘For ‘Description of the Procedure,’ you need to include a detailed description so that another auditor could replicate the procedure you use. The conclusion should be stated in terms of the objective. For this project, the conclusion should state that sales are fairly presented, materially misstated, or that additional evidence is needed to provide a reasonable basis for a conclusion. For planning purposes, assume that 1 percent of sales is material. The issue of materiality will be comprehensively covered in a subsequent training session. If you find misstatements on an actual audit engagement, you may request that the client make an audit adjustment based on materiality considerations. The second work paper is a spreadsheet indicating the items in the sample. Be sure to use tick marks to explain any exceptions that you found while performing the procedure.’’

Ms. Rogers hands out two documents to each trainee and says, ‘‘Here are examples for you to follow. The memorandum is labeled Appendix A and the example of the spreadsheet is labeled Appendix B.’’ She continues, ‘‘Use the following words carefully: invoice, shipping document, sales order, invoice file, shipping document file, order file, sales journal, vouching, and tracing. Although you might believe you have a better name for a document or file, it is best to use the standardized name so everyone understands which document or file you are referencing.’’
The sales journal, sales orders, shipping documents, invoices, and price list are available online at http://clubs.cob.calpoly.edu/~cmiller/ACTG%20425%20page.html * Look under Project heading in the middle of the page * You might have to click the Vouch and Trace link on the left * If your browser asks to save a file when you open the link, click cancel * We have been given access for use at UNT only by the case creator

Instructions

1. As you may recall from auditing class, it is very important for you to understand the internal controls over the sales process at CBC. From the information provided by Ms. Rogers, identify any control deficiencies for this company that might impact your assessment of control risk. Recommend internal control procedures that could be implemented to address any deficiencies you noted. You can find the definitions of control deficiencies, significant deficiencies and material weaknesses in the PCAOB’s AS 2201.

2. In general, how does the assessment of control risk impact the extent of an auditor’s substantive tests of transactions?

3. Conduct the planned substantive tests required to test occurrence, accuracy, and cutoff. Prepare two work papers to document your work, one patterned after Appendix A, and the second patterned after Appendix B.

Use an Excel spreadsheet to calculate the sample mean and project a value for a proposed audit adjustment (see Appendix A for an example of an audit adjustment and Appendix B for the related calculation). It is possible that you will not need to propose an adjustment, but at minimum, calculate the sample mean and mean difference between the audit and book values.

Do not select any of the 10 transactions presented in Appendix B for use in your sample of ten transactions; your sample must be completely different from the one in Appendix B.

Please remember that this project has as its focus revenue recognition audit procedures rather than statistical sampling, and your sample was not randomly selected. Consequently, you cannot statistically evaluate your results as you would on an actual audit engagement.

Appendix A | Sample Memorandum (Work Paper 1) | College of Business Computers | Performed by: Manuel Quijano | Sales and Collection Cycle | Date: 04/25/08 | | | Nature of Test: | Tests of transactions. | Objective: | The objective of this procedure is to determine if the sales account is misstated. | Assertion(s): | Occurrence, Accuracy, and Cutoff. | Tolerable error: | For the sales account we have determined tolerable error to be 1 percent of sales. | Procedure: | The sample includes ten entries from the sales journal for the year ended Dec. 31, 2007. Each entry was vouched to the related invoice. The date, customer name, and amount from the sales journal were agreed to the invoice. The invoice was vouched to the related shipping document. The customer information, items sold, and quantities on the invoice were agreed to the shipping document. The shipping document and invoice were vouched to the related sales order. The customer information, items sold, and quantities on the shipping document were agreed to the sales order. The customer information, items sold, quantities, and prices on the invoice were agreed to the sales order. For example, invoice 6478 was selected from the sales journal. The date, customer name, and sales total from the sales journal were agreed to the corresponding information on invoice 6478. Invoice 6478 indicated the goods were shipped on shipping document 4927. From invoice 6478, the customer information, items sold, and quantities were agreed to the shipping document. The shipping document indicated the order was placed on sales order 10107. The customer information, items sold, and quantities on shipping document 4927 were agreed to the corresponding information on sales order 10107. The customer information, items sold, quantities, and prices on invoice 6478 were agreed to sales order 10107. | Conclusion: | Three exceptions were found in the sample (see Appendix B, Work Paper 2). The sample results indicate that sales are materially overstated. We propose the following audit adjustment to reduce the recorded value to our projected value: | | Sales 75,069 Accounts Receivable $75,069 |

Appendix B | | Sample of Work Paper 2 | | College of Business Computers | Performed by: Manuel Quijano | | Sales and Collection Cycle | Date: 04/25/08 | | | | | Nature of Test: | Tests of transactions. | Objective: | The objective of this procedure is to determine if the sales account is misstated. | Assertion(s): | Occurrence, Accuracy, and Cutoff. | Tolerable error: | For the sales account we have determined tolerable error to be 1 percent of sales. | Procedure: | Please See Appendix A, Work Paper 1, for a description of the procedures performed in this work paper. | Invoice | Ship Doc | Sales Order | Customer | Revenue Recognized | Audited Amount | Difference | | 6478 | 4927 | 10107 | Steel Tank | 9,182.00 | 9,182.00 | 0.00 | | 6481 | 4929 | 10109 | Ready Mix Concrete | 22,546.00 | 22,546.00 | 0.00 | | 6487 | 4935 | 10115 | Edward's Sports | 4,188.00 | 4,188.00 | 0.00 | | 6492 | 4939 | 10119 | Standard Motor Co. | 4,538.00 | 4,538.00 | 0.00 | | 6498 | 4945 | 10125 | Burger Queen | 9,182.00 | 9,182.00 | 0.00 | | 6500 | | | Flora Design Studio | 3,432.00 | 0.00 | (3,432.00) | #1 | 6507 | 4953 | 10133 | Steak House | 18,908.00 | 18,908.00 | 0.00 | | 6515 | 4961 | 10141 | Foothill Cyclery | 12,446.00 | 11,572.00 | (874.00) | #2 | 6517 | 4963 | 10143 | Sanders and Smith-PC | 11,982.00 | 11,982.00 | 0.00 | | 6521 | 4971 | 10151 | Sports Clothing | 12,376.00 | 0.00 | (12,376.00) | #3 | | | | Sample Mean (AVE) | 9,209.80 | (1,668.20) | | | | | Projected Value (PV) | | 75,069.00 | | AVE | = | The sample mean of the audited values. | PV | = | Projected value—sample mean of the errors multiplied by the number of items in the population. | #1 | = | Occurrence—no shipping document or sales order to support this sale. | #2 | = | Accuracy—the prices on the invoice were greater than the prices quoted on the sales order. | #3 | = | Cutoff—the shipping document indicates this order was not shipped until January 2008. |

Case 2-3 Notes

Case 2-3 is from Miller and Savage (2009):

Miller, C.R., and A. Savage. 2009. Vouch and trace: A revenue recognition audit simulation. Issues in Accounting Education 24(1): 93-103.