“Audit Judgment” Please respond to the following:
Case Study
TLD CPAs is performing the audit of REDTOP Sports. You are on the external audit team for that engagement. Following is some information about the client and its internal audit function. After reviewing this information, you will be asked to assess the quality of the internal audit function and whether the external auditor should rely on work performed by the internal auditors.
General Background Information about REDTOP Sports
REDTOP Sports Company is a publicly held manufacturing company. The primary activities of REDTOP Sports Company include the design and manufacture of sporting and athletic goods. The major product lines are bicycle helmets for infants, youths, and adults and other bicycle accessories, including child bicycle seats, car bicycle carriers, and water-bottle cages. In the United States, a number of jurisdictions have passed mandatory helmet regulations and REDTOP Sports is currently a market leader in this growing market. Sales are made primarily on credit to independent bicycle dealers and sporting goods stores. The sales terms require that balances be paid within sixty days. This practice is consistent with the industry.
Company Objectives and Related Risks
For this company, there is a specific risk associated with potential errors in the valuation of receivables, the existence of receivables, and the cutoff of sales. This risk results from REDTOP Sports’ interest in expanding to a global market. Helmet sales in Europe are expected to increase significantly in the near future and REDTOP would like to be in a position to obtain a significant market share in Europe. REDTOP Sports would like to finance this growth through an additional stock offering during the next year. To assure that the stock offering is successful, some pressure has been exerted on management to meet slightly optimistic growth levels over the past two years. Bonuses for top management have been partially based on the achievement of these growth goals.
Summary Financial Information
Sales of REDTOP Sports continue to grow. Over the last five years, sales have climbed at an average annual rate of 27%. When compared to other firms in this industry, the growth in earnings per share (EPS) over the past two years has been at the same level as the growth for the industry: 39%. In comparing this firm to the S&P 500, the firm’s EPS has increased at 39% while the EPS of the S&P 500 has increased at 14% (about 2.8 times more).
The growth in accounts receivable has been primarily due to the increased sales demand. Current year recorded sales total $99,133,000. The accounts receivable balance for the current year consists of approximately 500 accounts, primarily from retail and sporting goods stores. The individual accounts range from approximately $300 to $65,000. The year-end balance in the accounts receivable account is $18,248,000 (net of the allowance of $796,000).
Internal Controls and the Internal Audit Function
The company has implemented a system of internal controls in the sales and accounts receivable area that is completely computerized and considered to be moderately complex.
The only significant recent change to the company’s internal controls in the sales, billing, and collection area is related to the internal audit function. The internal audit function is performed in-house at REDTOP Sports and is made up of four staff auditors, one manager, and a director. Each staff auditor had two to three years of public accounting experience prior to joining REDTOP’s internal audit function. The manager and director of the internal audit function each had at least five years of public accounting experience prior to joining REDTOP five years ago. Both the manager and director have professional certifications.
In previous years, the work of the internal audit function had been primarily operational. For the last 18 months, however, the focus has become much more financial in nature. Audits currently performed by in-house internal audit include operational audits (i.e., employee benefits plan review), compliance audits (i.e., compliance with laws and regulations), and audits of financial controls and financial statement accounts.
The current-year work of the internal auditors was such that some of their activities are related to the accounts receivable account. They have obtained two types of evidence for accounts receivable: (1) evidence about the adequacy of and adherence to internal control policies and (2) evidence related to the accounts receivable balance.
Information about REDTOP’s Internal Audit Function
Organizational Status and Communications with the Audit Committee and Management
The authority of the internal audit function has been granted to it by the CEO and the audit committee. In terms of organizational status, the director of internal audit reports directly to the CEO and has direct access to the audit committee. The appointment and termination of the internal audit director are the responsibilities of the CEO. The audit committee is advised of such decisions.
Procedures and Work Processes
Standardized audit programs are not typically used. Rather, the staff auditor responsible for an audit is to develop the audit program during the planning of the audit. Each audit program, therefore, is tailored to the specific objectives of the audit engagement. Modifications to the program are made as necessary during the course of the audit. The internal auditors rarely use computerassisted auditing techniques. The computers are primarily used for spreadsheet programs and word processing packages. The internal audit function currently does not use any type of generalized audit software.
Workpaper review is the responsibility of the internal audit manager, and staff work is reviewed by the manager periodically throughout each audit. Review notes are prepared and must be cleared before an internal audit report is issued. Supervisory review of workpapers is performed to determine that the workpapers adequately support findings, conclusions, and reports. The director of internal audit has decided not to be directly responsible for any workpaper review; however, the director reviews enough of the work to be comfortable with the conclusions reached in the internal audit report.
Quality Assurance
The internal audit director has established a quality assurance program that requires periodic internal quality reviews. The purpose of the quality assurance review is to provide senior management and the audit committee with an assessment of the internal audit function. These reviews are performed by members of the internal audit staff, but they do not review any of their own work. The results of the current year’s review indicated a number of areas where minor improvements could be made. The internal audit director is currently determining how to respond to the need for these improvements. No written action plan has yet been developed.
Accounts Receivable Work Performed by the Internal Audit Function
In testing the controls in the sales, billing, and collection cycle during the year, the internal auditors documented the system of internal controls and performed inquiries and observations of appropriate personnel once during the year. Tests of controls were also performed although the sample sizes for these detailed tests were much smaller than the sample sizes their external auditors would have used. Only minor exceptions in the operating effectiveness were noted.
In testing the existence assertion of accounts receivable during the course of the audit year, the internal auditors had sent out confirmations to customers with accounts receivable balances and accounts written off to justify their conclusions in the area. The number of confirmations sent was about the same as the number that the external auditors normally send out. The accounts receivables for confirmation were selected and evaluated using appropriate methods. The response rate was lower than that experienced on typical external audit engagements. Follow-up work for these no-replies was performed; however, on two of the five exceptions it appeared to be inadequate. While these two exceptions were explained as timing differences in the workpapers, the workpapers contained no documentation to support that explanation.
In testing the valuation of accounts receivable during the year, once each quarter, the internal audit function selected a sample of sales invoices to test the pricing by comparing the invoices with price lists and contracts. Sample sizes were more than adequate. Several pricing errors were noted in the workpapers. These differences were explained as resulting from the use of an outdated price list at the time of the sale. This explanation was documented in the workpapers. At year end, the internal audit function reviewed the analysis of the doubtful accounts and related documents and concluded that the allowance account was mathematically correct and that the method used to compute the allowance was the same as in the prior year.
In determining whether the accounts receivable balances are owned by the company (rights and obligations assertion), the internal audit function reviewed company minutes to determine if the board of directors had approved factoring of any receivables. Inquiry of the credit manager was also made. These activities were performed on a quarterly basis. Based on these procedures, the internal audit function concluded that all of the recorded receivables are owned by REDTOP Sports.
The internal audit function had not performed any tests of cutoff for sales or accounts receivable for either the current or previous audit year.
A review of a sample of the internal audit function’s workpaper files for audits of accounts receivable for the current audit year indicated the following. An audit program was included in all but one of these files. For the other file, the staff auditor had prepared a memo at the end of the audit indicating the various steps that were performed. This memo served as the audit program. Of the files reviewed, one file did not adequately document the audit objectives. Although the workpapers were all indexed, the differences across workpapers made it difficult to follow the indexing in some cases. In general, workpaper documentation, while acceptable, could be improved.
Of the files reviewed, it was noted that for two internal audits the workpapers were not reviewed until after the internal audit report was issued. Upon inquiry, the internal audit manager indicated that the primary purpose of workpaper review was to assure that the papers support the information included in the audit report. Given that this responsibility primarily rested with the internal auditor performing the engagement, the internal audit manager indicated that a review of workpapers after the issuance of the audit report was acceptable.
Conclusions are reasonably well documented in the corresponding workpapers. In fact, the documented conclusions appeared appropriate except for one set of workpapers related to the valuation assertion in which the conclusions did not appear to reflect the degree of negative evidence obtained during the audit. Specifically, the number of pricing errors documented seemed rather excessive. The conclusions in the workpapers, however, indicated that pricing errors did not represent a significant problem.
