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Case 9-56: Judging the quality of a
client’s internal audit function and determining the effects of internal
audit’s work
Case study for advance auditing discussion |
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 companies 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 company to
the S&P 500, the company’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 computer-assisted
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.
CASE STUDY FOR INTERNATIONAL FINACE MANAGEMENT DISCUSSION
BLADES, INC. CASE
International
Cash Management
Recall from
Chapter 20 that the new Thailand subsidiary of Blades, Inc., received a
one-time order from a customer for 120,000 pairs of Speedos, Blades’ primary
product. There is a 6-month lag between the time when Blades needs funds to
purchase material for the production of the Speedos and the time when it will
be paid by the customer. Ben Holt, Blades’ chief
financial officer (CFO), has decided to finance the cost by borrowing Thai baht
at an interest rate of 6 percent over a 6-month period. Since the average cost
per pair of Speedos is approximately 3,500 baht, Blades will borrow 420 million
baht. The payment for the order will be used to repay the loan’s principal and
interest. Holt is currently planning to instruct the Thai subsidiary to remit
any remaining baht-denominated cash flows back to the United States. Just
before Blades receives payment for the large order, however, Holt notices that
interest rates in Thailand have increased substantially. Blades would be able
to invest funds in Thailand at a relatively high interest rate compared to the
U.S. rate. Specifically, Blades could invest the remaining baht-denominated
funds for 1 year in Thailand at an interest rate of 15 percent. If the funds
are remitted back to the U.S. parent, the excess dollar volume resulting from
the conversion of baht will either be used to support the U.S. production of
Speedos, if needed, or be invested in the United States. Specifically, the
funds will be used to cover cost of goods sold in the U.S. manufacturing plant,
located in Omaha, Nebraska. Since Blades used a significant amount of cash to
finance the initial investment to build the plant in Thailand and purchase the
necessary equipment, its U.S. operations are strapped for cash. Consequently,
if the subsidiary’s earnings are not remitted back to the United States, Blades
will have to borrow funds at an interest rate of 10 percent to support its U.S.
operations. Any funds remitted by the subsidiary that are not used to support
U.S. operations will be invested in the United States at an interest rate of 8
percent. Holt estimates that approximately 60 percent of the remitted funds
will be needed to support U.S. operations and that the remaining 40 percent
will be invested in the United States. Consequently, Holt must choose between
two alternative plans. First, he could instruct the Thai subsidiary to repay
the baht loan (with interest) and invest any remaining funds in Thailand at an
interest rate of 15 percent. Second, he could instruct the Thai subsidiary to
repay the baht loan and remit any remaining funds back to the United States,
where 60 percent of the funds would be used to support U.S. operations and 40
percent would be invested at an interest rate of 8 percent. Assume no income or
withholding taxes on the earnings generated in Thailand. Holt has contacted
you, a financial analyst at Blades, Inc., to help him analyze these two
options. He has informed you that the current spot rate of the Thai baht is
.0225 and that the baht is expected to depreciate by 5 percent over the coming
year.
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