2COMPANY BACKGROUNDCTS, was founded by Jack C. Williamson in 1991 to provide engineering services, temporary personal and personnel training.Miller and Starr CPA was the auditing firm. Company was approved for a loan of 600,000 with the local bank and then banking relation transferred to second union bank with a credit line of $ 1M, based on the companies receivables (as collateral)CTS sales declined (loss) in April 1999 and Second union threatened to review CTS’s line of credit.
3COMPANY BACKGROUND (Contd.) Two months after reporting the loss, the CTS unaudited financial statements showed improved results, therefore the bank approves for a credit line up to 1.3 M upon CTS managements request.Due to ever increasing level of accounts receivable, amounts outstanding on the line of credit and accounts payable, the bank becomes concerned over the collateral and decides to meet with the management.On May 2001, CTS terminates its operations and surrenders all assets to the second union bank.
4Revenue should be recognized when earned. Accounting Issues 1. Per Generally Accepted Accounting Principles, when should revenue be recognized? Also how are accounts receivable to be valued and reported?Revenue should be recognized when earned.An entity's revenue-earning activities involve delivering or producing goods, rendering services, or other activities that constitute its ongoing major or central operations and revenues are considered to have been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues.Accounts Receivable are to be valued at Net realizable value
52. Are the stated revenue recognition policies of CTS on engineering services, as stated in the footnotes, appropriate and in accordance with the GAAP?CTS policy for recognizing revenue for recognizing revenue service is‘Revenue for engineering services are recognized upon completion of projects, which are generally of short duration. Direct costs associated with customer engineering projects in process are included in inventory at the lower of cost or realizable value.’YES
63. For the accounts receivable balances specifically discussed above, what is your opinion as to amount, if any, of the overstatement of accounts receivableAccount Receivable OverstatementCompany As of December 31, 1999Record shd be overstate/underPenns Engineering 75, ,000 (eng services)Tempo, Inc 0 77, ,340McDonald Douglas 58, , ,803Nexus Software 119,432 3, ,470Boeing Defense 75, , (eng services)128,933 (overstatement)Company As of December 31, 2000Nexus 187, ,210CMI K/P 197, ,697JLO 77, , ,283DCS, Inc. 57, , ,128Vortex 174, ,135639,453 (overstatement)*As of December 31, 1999 account receivable was overstated by $128,933.*As of December 31, 2000 account receivable was overstated by $639,453.
74. With the exception of accounts receivable, is there any other balance sheet accounts that you believe should be appropriately adjusted based on your findings?Assets2000 adjustment adjustedCash 1, ,700Accounts Receivables 1,744, ,453 1,105,354Inventory 229, ,023Prepaid expenses 31, ,958Total current asset 2,007, ,368,0351999 adjustment adjustedCash 1, ,898Accounts Receivables 1,023, , ,690Inventory 125, ,452Prepaid expenses 17, ,401Total current asset 1,168, ,047,441As of December 31, 1999 engineering services in process (Inventory) was understated by $8,340. This same transaction overstates cost of operations. CTS accounting policies states that direct cost associated with customer engineering projects in process are included in inventory and based on the Work Order Log for Penns, the inventory balance was 0.On 2000, CTS record billing for engineering services for Vortex, but no P.O. documentation was found as well as services performed.
85. What would have been the impact of the adjustment you have proposed on the pre-tax income of CTS Cal temp Services, IncIncome Statement2000adjustment after adjustsales 5,962, ,453 5,323,157cost of operations 4,368, ,368,487gross profit 1,594, ,670general & administrative expenses 1,309, ,309,985Income from operations 284, (355,315)Interest expenses, net (135,040) (135,040)Net income before provision of income taxes 149, (490,355)1,999sales 5,139, ,933 5,010,862cost of operations 3,761, ,340 3,752,889gross profit 1,378, ,257,973general & administrative expenses 1,255, ,255,802Income from operations 122, ,171Interest expenses, net (79,328) (79,328)Net income before provision of income taxes 43, (77,157)*As of December 31, 1999 Sales revenue was overstated by $128,933. Cost of operation was overstated by $8,340 because these services were expended instead of being recorded to inventory.*As of December 31, 2000 Sales Revenue was overstated by $639,453.
9Evidence that indicate fraudulent reporting on part of Williamson: Litigation Consulting Engagement Issues (1) What, if any, evidence have you identified that would indicate knowledge of any financial statement and collateral reporting fraud on the part of Williamson and Roberts?Evidence that indicate fraudulent reporting on part of Williamson:Penns Engineering, revenues were recognized and placed in accounts receivable as of December 1999, but work order log indicate work completed in mid Thus, the $75,000 that Mr. Williamson claimed belongs with the ‘1-30 Days’ Aged Accounts Receivables was inaccurate.The invoice prepared for McDonald Douglas, Inc was actually dated January 2000; ir was, however, recognized in November of Moreover, services were nor completed until mid January. The total amount of $58,995 should not have been recognized in the year 1999.
10Evidence that indicate fraudulent reporting on part of James Roberts: What, if any, evidence have you identified that would indicate knowledge of any financial statement and collateral reporting fraud on the part of Williamson and Roberts? ContinuedEvidence that indicate fraudulent reporting on part of James Roberts:For Nexus Software, CTS seemed to have been recording revenues for non-existent services rendered. The $187,210 ($118, ,000) was eventually reversed in early 2000; this occurred prior to payment of only $15,000 in April of 2001.The total amount of $77,200 was recorded for JLO Contracting Services as of December However, the remittance advice received with payment indicated invoice dated early The work order log also confirmed that services were rendered in 2001, not 2000.Secondly, total amount of $197,697 recorded in 2000 was (mysteriously) reversed in early Payments that management claimed to have received was, in actuality, draws from the bank (the line of credit); moreover, it was not indicated that subsequent invoices were prepared (after the credits were issued) to account for the payments
11(2) What were the apparent motives of management to commit a fraud in this situation? There was a need for drastic measures to increase revenues within a relatively short period of time. If management did not provide exemplary data, CTS would have been terminated.
123) Compute your best estimate of the damages that Second Union incurred as a result of delaying termination of the loan agreement with CTS until May 12, 2001, versus the result if they had terminated the agreement on December & 2000.ACCOUNTS RECEIVABLECTS recorded Should have recordedPenn Services 75,TempCo ,340McDonald 58, ,192Nexus , ,962Boeing 75, ,411Sum 328, ,905Difference (adj. to A/R) (128,933)ACCOUNTS RECEIVABLENexus 187,CMI K/P 197,JLO 77, ,917DCS 57, ,211Vortex 174,Sum 693,Difference (adj. to A/R) (639,453)
133) Compute your best estimate of the damages that Second Union incurred as a result of delaying termination of the loan agreement with CTS until May 12, 2001, versus the result if they had terminated the agreement on December & ContinuedDAMAGESCASH 1, ,700ADJ. ACCOUNTS RECEIVABLE 894, ,105,354896, ,107,054AMOUNT OWED TO 'SECOND UNION' 1,000, ,300,000DAMAGES (amount not recovered) (103,412) (192,946)In 1999 CTS recorded $1,023,623 as accounts receivable. The actual amount should have been $797,683 ($1,023,623 – 225,940). If termination had occurred at December 31, 1999, Second Union would have suffered over $100,000 in damages.In 2000 CTS recorded $1,744,807 as accounts receivable. The actual amount should have been $1,105,354 ($1,744,807 – 639,453). If termination had occurred in December 31, 2000, Second Union would have suffered almost $200,000 in damages.
14Auditing Issues1. Distinguish between an error and fraud. Would management’s actions in this case be considered an error or fraud?The factor that distinguishes fraud from error is described as being “whether the underlying action that results in the misstatement of the financial statements is intentional or unintentional.” If the misleading act is intentional, then it’s fraud.Management was fully aware of the fraudulent financial reporting taking place at CTS and there is enough evidence of the clear intention they had in reporting misstated financial statements. James Roberts, CTS’s VP of Finance even admitted that many of the 1.8 million in Accounts Receivable would be uncollectible.
151. What is the auditor’s responsibility for discovering errors and/or fraud? The Statement on Auditing Standards (SAS) No. 99, Consideration of Fraud in a Financial Statement Audit provides auditors with additional guidance for detecting material fraud.The standard reminds auditors that they must approach every audit with professional skepticism and not assume that management is honest. It puts fraud at the forefront of the auditor's mindAuditors will enter a much expanded arena of procedures to detect fraud as they implement SAS no. 99. Under SAS no. 99, auditors will gather and consider much more information to assess fraud risks than they have in the past.
162. What are some of the risk factors (red flags) that are apparent in this case? Understanding symptoms of fraud is the key to detecting fraud. A symptom of fraud may be defined as a condition which is directly attributable to dishonest fraudulent activity.The following are representative examples of symptoms or red flags of fraud in the Accounts Receivable process:Frequent undocumented and/or unapproved adjustments, credits, and write- offs to accounts receivable sub ledger.Low turnover or slow collection cycle for accounts receivable.Dramatic increase in allowance for doubtful accounts in view of positive economic events and stringent credit policies.Insufficient supervisory review of accounts receivable activity as well as customer account aging schedule.
173. Do you believe that the audit approaches employed by M&S were in accordance with GAAS? Why or why not?Auditors are responsible for carrying out their audits of financial statements prepared by management in accordance with GAAS, which state that auditors are responsible for planning and performing their audits to obtain reasonable, though not absolute, assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud. The purpose of independent audits therefore is not to produce financial statements but rather to enhance their reliability.M&S did perform their audit in accordance with GAAS since in the procedures they performed in the first four years were carried out based on an audit risk model. Confirmations were sent out, but due to the difficultness in getting confirmations returned, they performed “alternative procedures” from the fifth year on. These procedures included verification of payment soon after year-end and prior to the end of the audit, questioning to management about the uncollectibility of unpaid accounts, and review of unpaid invoices and respective files.
184. What additional evidential matter could have been acquired by M&S (based on your knowledge of CTS’s customers and accounting records)?One of the general quality criteria for conducting an audit set forth by GAAS Field Work Standards relates to the collection of “Sufficient Competent Evidential Matter” which includes the collection and validation of sufficient competent evidence to afford a reasonable and logical basis for audit decisions. Evidence includes the underlying accounting data and all available corroborating information. Competent evidence refers to what is valid and relevant for an audit decision. Sufficient recognizes that auditors will not audit all transactions and events but will rely on data samples.In this case, M&S working papers provided competent but not sufficient evidential matter would have enabled them to form an opinion. Confirmations and alternative procedures performed were both valid and relevant, therefore satisfying the competent quality, but in our opinion, the sample size should have been larger so it could have satisfied the sufficient quality that any evidential matter should have.
195. Based only on your analytical review of the CTS financial statements and accounts receivable trial balances as of December 31, 1999 and 2000, was information available which should have alerted the auditors to the potential of fraud and financial statement misstatement?Performing analytical review of Accounts Receivable Aged Summary trial balances alone would not have adequately alerted auditors of the financial misstatement since the percentages across the different A/R account types balances did not vary significantly from one year to the other. The “over 90 days” class was a minimal portion of the Total Balance on both years, and actually improved from one year to the other (11 to 3%), but the analytical review of the financial statements should have brought up to the auditor’s attention that the Total Balance of Accounts Receivable did significantly increased from 1999 to 2000, perhaps providing auditors of a red flag if the allowance for doubtful accounts was not properly adjusted.The big upward change in Accounts Receivable would have been an indication that the company had changed the way it recognized revenue and was padding its earnings with sales that were due for delivery in the future in order to increase current earnings.
206. Was it appropriate for M&S to accept a fax confirmation from Nexus Software as audit evidence in the confirmation process? What special concerns are there for the auditor in accepting faxes as audit evidence?In some cases, the respondent to a confirmation request may use a nontraditional medium to respond, such as telephone, telex, or facsimile. Use of these media can increase the possibility that confirmation results will be biased because of interception and alteration of the confirmation requests or responses. Recent litigation and enforcement actions indicate that auditors have indeed been duped by telephone, telex, and facsimile responses.The auditor should consider any special risks that may be associated with such media as electronic inquiries, facsimile responses, or oral confirmations when they are used in the confirmation process. The auditor is advised to take precautions to ensure that the response is coming to the auditor directly from the purported sender. CPAs should be on the lookout for confirmations that are faxed or have similar signatures and/or for a pattern of post-office-box addresses for accounts receivable.There was no wrongdoing from M&S in accepting a fax confirmation from Nexus Software since it’s a type of confirmation allowed under GAAS, as long as the confirmations are properly verified that they come directly from the customer and the receipt process is under control of the auditors and not the client.
217. Was M&S justified in their reliance on management representations 7. Was M&S justified in their reliance on management representations? Why or why not?Too often the auditors accept management representations about the collectibility of a particular receivable or class of receivables without adequately examining past collection experience or the reasonableness of management representations in light of market and industry conditions.In some instances clever CFOs outsmart experienced auditors with schemes intended to inflate the value of accounts receivable. The schemes sometimes involve third parties who intercept and forge confirmations to help friends and family members in the client company.In our opinion, M&S’s reliance on management representations were justified since they performed their audit in accordance with GAAS and alternative procedures performed in Accounts Receivables were adequate as well. CTS Management even certified that all accounts receivable amounts were according to the “agreements”, therefore they should carry the most weigh in the fraud scheme and be prosecuted accordingly.