As part of your firm’s training program, newly hired PA recruits must audit a fictitious audit client, Merlon Intercom Inc. (MII).

Question 1 (18 marks)

As part of your firm’s training program, newly hired PA recruits must audit a fictitious audit client, Merlon Intercom Inc. (MII). The recruits complete various sections of the audit file for the year ended December 31, 2015.  The files are then reviewed by more experienced co-workers. 

The partner in charge of the training program asks you, an experienced public accountant, to review a file prepared by a recruit and comment on each section.  Below is a description of MII, followed by the work on the file completed by the recruit.

DESCRIPTION OF MII OPERATIONS

MII is a privately held, medium-sized company that is managed by the sole owner who is actively involved.  MII buys intercom equipment, telephone equipment, parts and related equipment and resells them at a mark-up to a loyal base of corporate customers (approximately 250 customers).  Approximately 60 of MII’s 250 customers make up 75% of MII’s total sales. Competition is growing, but the market is favourable, and MII offers excellent customer service, giving it a competitive advantage. The owner is very involved in most of the operating decisions.  His capable assistant steps in when necessary.  The owner wishes to implement a code of ethics at some point and also wishes to improve certain controls.

MII operates multiple (six in total) warehouses, each carrying a mix of inventory items - approximately 1,500 different products.  The first type of inventory, that can be quite costly, consists of specialized telecom equipment hardware, high end intercom equipment and parts.   The turnover rate of this inventory is high since new technology is always emerging.  Because the company orders months in advance, MII occasionally overestimates demand.  After three or four months, products are difficult to sell but they are kept because most cannot be returned to the supplier, and MII is reluctant to hold liquidation sales for fear they would negatively affect the sales of the regular products. 

The second type of inventory, parts and peripherals, generates a significant portion of MII’s sales.  This category includes items such as cables, headphones and replacement parts.

The third type of inventory includes batteries and chargers for cordless phones.  This inventory can be returned to suppliers if unsold after a certain period.

The sales mix has not changed significantly from previous years. Ten new accounts were opened during the year, with average monthly sales of $5,000 each. Sales also increased because a new sales representative was hired at the beginning of the fiscal year. Average monthly sales for the 10 experienced representatives are $500,000 each.   Rookie representatives normally perform at 50% of an experienced representative’s level in their first year.  MII also lost a customer, who had averaged $90,000 a year in sales, to the competition. Purchases of products increased in the current year and were distributed across the inventory types in amounts similar to the overall sales mix.

Sales representatives enter orders into the sales database, and can modify the information, including quantities and selling prices. Any changes are usually made to orders before

shipping. Problems result if representatives make changes after shipping, since they should issue credits instead. The timing differences create reconciliation problems for both customers and MII when settling invoices. Also, sometimes credits have been issued in error.

Sales representatives are compensated based on a combination of a basic salary and commissions on sales. 

The owner noted he just received a memo from a clerk at one of the warehouses. It says the amount of damaged inventory has been gradually increasing over the past eight months. The clerk suggests this is because the forklift is not operating properly and items are being dropped as they are loaded for shipment.  He wants the forklift replaced. He asks what he should do with the damaged inventory that has been piling up in a corner of the warehouse.  He suggests holding a liquidation sale to get rid of it, since it needs space.

The owner’s assistant has a vital role in the day to day operations of the business.  He is responsible for developing relationships with the various vendors and finding new vendors.  He adds new vendors in the system and also places orders when inventory items are low.  Lastly the assistant assumes all of the owner’s responsibilities when the owner is on vacation or on a business trip.

SECTIONS FROM THE RECRUIT’S AUDIT FILE

INVENTORY WORK PERFORMED

1.      Matched totals on inventory listing to sub-ledger and general ledger.

2.      Went to one of the six warehouse locations.  Traced quantities from MII’s inventory listing to the warehouse floor for a random sample of 10 cordless phones. My inventory count matched quantities on the inventory listing.

3.      Traced prices for the 10 cordless phones sampled in the previous test. Prices matched those on the price listing, except for two models. The owner explained that employees sometimes manually change inventory prices to adjust for errors made when recording purchases. He provided a second listing with handwritten corrections. However, no backup documents were available to substantiate the changes.

4.      Recalculated quantity and price extensions for the same 10 cordless phones and they were accurate.

5.      One customer placed an order of more than $800,000 for specialized telephone equipment.  Unfortunately, the customer went bankrupt and, 10 months later, the specialized telephone equipment was still in inventory. MII never posted the sale because the equipment was never shipped. The company is certain it can resell the equipment  to another customer, so no provision has been booked.

EXCERT FROM SALES WORK PERFORMED

Sales variance analysis:

2015

2014

Variance ($)

Variance %

Telephone Devices

$20,000,000

$22,000,000

$2,000,000

10%

Parts & peripherals

35,000,000

37,500,000

2,500,000

7%

Cordless Phones

5,000,000

5,500,000

500,000

10%

Total

$60,000,000

$65,000,000

$5,000,000

8%

Explanation for variance: Sales increased because a new sales representative was hired.

ACCOUNTS RECEIVABLE WORK PERFORMED

1.      Customers have 30 days to pay invoices, but most take advantage of the 2% discount offered for payment within 10 days. A sample of five year-end balances was tested, and all payments were received subsequent to year-end, so accounts receivable were reasonable at year-end.

2.      On January 2, 2016, goods related to a sale made on December 29, 2015 were destroyed in a transport accident.  The goods were sold FOB shipping point and the customer is refusing to pay for the goods.  The goods were valued at $200,000. 

3.      In order to save time, MII applied a blanket provision of 5% for uncollectible accounts.  Historically, the amount of uncollectible accounts ranges from 4% to 5%. Credit procedures were tightened two years ago, and since then, the rate has been at the lower end. Therefore, 5% is quite conservative, allowing for potential overstatement of receivables.

Required:

a) Identify six deficiencies with the sample selection process in the accounts receivable and inventory work performed by the recruit. Your response should describe any deficiencies in the samples selected and provide an appropriate recommendation to correct each deficiency. (12 marks)

Sampling – Description of Deficiencies

Recommendation

Sampling – Description of Deficiencies

Recommendation

Sampling – Description of Deficiencies

Recommendation

Sampling – Description of Deficiencies

Recommendation

Sampling – Description of Deficiencies

Recommendation

Sampling – Description of Deficiencies

Recommendation

Sampling – Description of Deficiencies

Recommendation

b)Explain three major deficiencies in the work performed in the inventory, and accounts receivable testing.  State what recommendation (action or further procedures to be performed) should be made by the recruit to address each deficiency  (1 mark for explanation of the deficiency, 1 mark for each valid point made in your recommendation).    (6 marks) 

NOTE:  NO MARKS WILL BE AWARDED FOR DEFICIENCIES STATED IN PART a)

Explanation of the nature of the deficiency

Recommendation

Auditor action or further procedure(s)  to be performed prior to the issuance of the unqualified audit report

1.

Explanation of the nature of the deficiency)

Recommendation

Auditor action or further procedure(s)  to be performed prior to the issuance of the unqualified audit report

2_

Explanation of the nature of the deficiency

Recommendation

Auditor action or further procedure(s)  to be performed prior to the issuance of the unqualified audit report

3.

Question 2 (10 marks)

Tinkerbell Toys Co (Tinkerbell) is a manufacturer of children’s building block toys; they have been trading for over 35 years and they sell to a wide variety of customers including large and small toy retailers across the country.

The company’s year end is May 31, 2015. The company has a large manufacturing plant, four large warehouses and a head office. Upon manufacture, the toys are stored in one of the warehouses until they are despatched to customers. The company does not have an internal audit department.  Your accounting firm is the auditor of Tinkerbell.  You have reviewed the internal controls over the sales ordering, goods despatched and invoicing and believe the controls are strong and would like to rely on the controls.  The following is how the sales system works: 

Sales ordering, goods despatched and invoicing. 

Each customer has a unique customer account number and this is used to enter sales orders when they are received in writing from customers. The orders are entered by an order clerk and the system automatically checks that the

goods are available and that the order will not take the customer over their credit limit. For new customers, a sales manager completes a credit application; this is checked through a credit agency and a credit limit entered into the system by the credit controller. The company has a price list, which is updated twice a year. Larger customers are entitled to a discount; this is agreed by the sales director and set up within the customer master file.

Once the order is entered an acceptance is automatically sent to the customer by mail/email confirming the goods ordered and a likely despatch date. The order is then sorted by address of customer. The warehouse closest to the customer receives the order electronically and a despatch list and sequentially numbered goods despatch notes.    (GDNs) are automatically generated. The warehouse team pack the goods from the despatch list and, before they are sent out, a second member of the team double checks the despatch list to the GDN, which accompanies the goods.

Once despatched, a copy of the GDN is sent to the accounts team at head office and a sequentially numbered sales  invoice is raised and checked to the GDN. Periodically a computer sequence check is performed for any missing sales invoice numbers.

Required:

Recommend five tests of controls the auditor would normally carry out on the sales system of Tinkerbell, and explain the objective for each test.

Question 3 (10 marks)

You are the in-charge auditor for Mitt-texts Inc., a publicly traded company that sells mittens specially designed for texting. The mittens have a specially designed thumb and index finger that with a quick flip allows the full use of thumb and finger.  Demand for the mittens was so high, Mitt-texts went public last year in order to fund its rapid expansion.

This is the second year that your firm has performed the audit of Mitt-texts. The company sells its product online via credit cards and to large retailers such as department stores and accessory shops.  There are approximately 800 online customers and 50 retail customers.

Last year, there were many errors and adjustments to the financial statements.  Management of the company is very focused on growing the company and has not had time to develop controls and procedures.  Management does not believe in wasting time and effort to put in controls that they perceive to be administrative and burdensome.  Due to significant turnover, the accounting department now has only 5 employees. As a result, duties are not segregated and employees perform most of the tasks without review or approval.  In addition, employees work significant overtime and have not performed tasks such as cash collections and reconciliations.

Management is struggling to maintain the cash flow necessary to continue it’s for growth and is now raising debt financing and needs to show good growth and strong financial ratios. Management has chosen aggressive accounting policies to optimize the company’s performance.  Over the last year, many other companies have entered the market with similar mittens and gloves.

You are responsible for auditing the accounts receivable, revenues and inventory for the company.     Details of select GL accounts are listed below:

     Year 2

       Year 1

Accounts Receivable

$3,500,000

$1,790,000

Allowance for Doubtful Accounts

(400,000)

    (400,000)

Inventory

     915,000

      310,000

Revenues – Retailers

$8,030,000

 $7,500,000

Revenues – Online

                950,000

   1,100,000

Required

Identify and compute five (5) analytical procedures that you might perform to identify unusual relationships in revenues, accounts receivable, allowance for doubtful accounts, and inventory.  What question would you inquire with management with respect to the relationship(s)?  Arrange your answer in the following format.  (10 marks)

Analytical Procedure

Computation

Question for Management

Analytical Procedure

Computation

Question for Management