What information would you want to gather regarding the integrity of management, and what are probable sources of that information?

Audit assignment

Management Integrity

Background

Your firm has been approached by a company desiring to change from their current Big-4 CPA firm to a regional firm to save over $100,000 in annual audit fees. The potential client is a privately owned producer of private label garments in the highly competitive sector, which sells primarily to major retailers such as Wal-Mart, Kmart, Sears and JC Penney. The company has experienced some financial difficulties in the past year, which could lead to its major line of credit being pulled if it does not make a profit.

In performing some preliminary analytical procedures, you noted some of the following changes in accounts related to accounts receivable:

Current Year

(000 omitted)

Previous Year

(000 omitted)

Industry

(000 omitted)

Sales $40,000 $39,000
Accounts Receivable $8,000 $6,300
% of accounts receivable current 72% 65%
No. of days’ sales in accounts receivable 63 41 43
Gross margin 18.70% 15.90% 16.30%
Days’ sales in inventory 72 45 47
Times interest earned 1.40 5.70 6.50

You also noticed the addition of a large account called “other assets” on the balance sheet.

When you inquire about the balances, the president has explanations for the changes. The other assets are old equipment that the company was previously depreciating, but they purchased new computerized production equipment during the year. They have not discarded the old equipment yet because they might use it if demand increases beyond the capacity of their current equipment. They merely wanted to move the equipment out of fixed assets for the current period since the equipment is not being depreciated.

The new computer equipment is also the explanation for the improved margins. By automating production beyond previous automation levels, they have been able to reduce labor costs and increase margins. This increased production capacity has also allowed them to increase inventory over levels in previous years.

The changes in accounts receivable are also tied to the new computerized manufacturing equipment. Since they now have ability to produce more garments more quickly than in the past, they can offer their customers a wider selection of products. Some of the customers returned some goods in exchange for the new products, so they were rebilled for the new deliveries. Having more time to pay for the goods since they were rebilled makes it appear that there are more days in accounts receivable.

There are many risks associated with accepting new clients, especially if the clients could be in financial distress. The reason behind planning analytical procedures is to identify areas of heightened risk of misstatement and then plan the audit to determine whether potential explanations satisfy all the unexpected changes that are observed in the account balances. Further, it is important to be skeptical of management-provided explanations.

Instructions:

  • What information would you want to gather regarding the integrity of management, and what are probable sources of that information?
  • What other critical background information might you want to get before accepting this client, and what are probable sources of that information?
  • What other factors, if any, might suggest a high degree of risk in taking on this client?
  • Based on the cursory preliminary analytical analysis, what accounts appear to have a high risk of material misstatement, and why?
  • What effect would the risk analysis have on your planning this audit if you decide to take the engagement?

Your paper should meet the following requirements:

Include at least two or three outside sources. The CSU-Global Library is a great place to start.

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