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.
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.
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.
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:
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.
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.
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:
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:
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.
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.”
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