Compute key ratios for period 1984-1987 1984 1985 1986 1987 Current . 93 1. 56 1. 40 2. 41 A/R turnover 52. 7 49. 8 116. 8 32. 5 Inventory turnover 4. 58 3. 9 3. 25 2. 5 Debt-to-equity 4. 9 1. 75 1. 98 2. 16 Efficiency 3. 75 2. 08 2. 07 1. 2 GM% . 22 . 24 . 26 . 23 Return on assets . 21 . 19 . 2 . 06 Red Flags The Inventory turnover rate steadily declines from 1984-87, which could indicate, lost sales. Misstatements of inventory or cost of goods sold could be possible. It also indicates employee strikes or, in Crazy Eddies’ case, employees leaving their jobs.
In 1986 the A/R turnover rate was extremely high which is unusual because in that year the consumer electronics industry boom days had ended. Competition in the New York area was high. Inventory turnover rates had been decreasing. How was Crazy Eddie receiving all this money if sales were down? Extremely high A/R turnover rates are and indicator of credit and collection policies that are too restrictive. 2. a) Falsification of inventory count sheets (reperformance) A corrective internal control measure to establish existence includes tracing backward items in the inventory to vendor’s invoices to the receiving reports and paid checks. ) Bogus debit memos for accounts payable (confirmation) Confirm notes payable with banks and creditors, then trace information in the confirmation replies to the general ledger.
c) Recording of transshipping transactions as retail sales (Observation) View recorded sales from authorized shipping and approve customer orders and send monthly statements to customers. Segregate duties between handling cash and record keeping and independent reconciliation of bank accounts. This provides separate, independent verification of the cash receipts and enhances proper application of such receipts to the appropriate accounts ) Inclusion of consigned merchandise in year-end inventory (documentation) Use of an adequate chart of accounts and internal verification of classification will assist in proper classification. Also tracing backwards from items in the inventory to vendor’s invoices to the recording reports and paid checks. 3. Understanding the client’s industry is very important. An auditor has to know the unique accounting requirements associated with that industry. Understanding changes in the industry can help the auditor identify risks that can affect the acceptable audit risk, as well as, identify common inherent risk of the industry.
During the late 80s the consumer electronics industry was undergoing rapid and dramatic changing. Competition was fierce and Crazy Eddie was having a hard time competing. This could have been one factor that made acceptable audit risk high. Another factor was the disintegration of Antar’s principal advisors, as well as, the poor operating results in 1987. All of these examples increase acceptable audit risk, which is why it is important for the auditor to have an understanding of what and how the industries’ changes affect the audit planning decision. 4.
Lowballing means soliciting services far below generally accepted market price too stave off competitor’s bid for the same services to perspective clients. The scope of the audit would not be reflective and narrow in this situation. The audit might also be understaffed because due to the inability to charge over stated rate in engagement. Also there might not be enough money to do thorough and proper procedures in the audit. 5. Inventory is the largest account on the balance sheet. Accumulating evidence for this account is important. Scope restrictions apply in this situation because one third of the evidence is missing.
The auditor can not say that inventory is fairly stated on the balance sheet. I would disclaim because of high materiality of potential misstatements in inventory. 6. I think that companies should be allowed to hire individuals who formerly served as independent auditors because it can be an asset to the company. PROS Has an understanding of internal controls of management Knows the prior ways to present the F/S to auditors Has an understanding of what an auditor wants Knows how to make it a successful audit CONS They can cover up information Know the loopholes that could lead to fraudulent acts
Lack of Independence user might not want to rely on information 7. Preliminary judgement of materiality: $3,785,400 Using my judgement 20% of Earnings from operation is a fair amount because this amount allows for the accumulation of lots of evidence. This is a new client so I would like to set the judgement amount low. I am not familiar with their internal controls. First I computed total earnings from operations which came to be $18,927,00. I felt that 20% of this amount would be considered material $18,927,000*20%= $3,785,400 Tolerable misstatement for each account can not exceed: 60%* $3,785,400 = $2,271,240
Sum of tolerable misstatement: 2 * $3,785,400 = $7,570,800 Allocation: Current Assets Cash $110,000 Short term investments 0 Receivables 2,271,240 Merchandise inventories 2,271,240 Prepaid Expenses 0 PP;amp;E 110,000 Other Assets 110,000 Current Liabilities Accounts Payable 1,000,000 Short-term debt 388,320 Unearned Revenue 0 Accrued Expenses 0 Long Term Liabilities Long-term debt 1,200,000 Unearned Revenue 110,000 Equity Common Stock 0 Additional paid in capital 0 Retained Earnings 0 Total misstatement $7,570,800