Henrico retail inc case solution

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Week 5 Individual Assignment

(I chose Case 9.2 & 9.3)

The cases in Section 9 each cover audit approaches for different balance sheet accounts and business processes. For this assignment, select two of these cases which appeals most to you and complete all required questions in brief answers, approximately 30 to 45 words. The cases and topics are listed below:

· Case 9.1 Wally's Billboards covers cash

· Case 9.2 Henrico Retail covers IT accounting systems and retail sales

· Case 9.3 Longeta Corporation covers auditing revenue contracts

· Case 9.4 Bud's Big Blue Manufacturing covers accounts receivable confirmations

· Case 9.5 Morris Mining Corporation covers auditing fair value

· Case 9.6 Hooplah, Inc. covers audit sampling techniques

· Case 9.7 RedPack Beer Company covers estimating allowance for bad debt

CASE 9.2 Henrico Retail, Inc. Understanding the IT Accounting System and Identifying Audit Evidence for Retail Sales

MARK S. BEASLEY • FRANK A. BUCKLESS • STEVEN M. GLOVER • DOUGLAS F. PRAWITT

LEARNING OBJECTIVES

After completing and discussing this case you should be able to

[1] Outline the audit trail for processing retail sales transactions

[2] Recognize when audit evidence must be gathered electronically if a traditional paper trail is absent

[3] Develop audit plans for gathering evidence to test the occurrence and accuracy assertions for retail sales transactions

INTRODUCTION

Henrico Retail, Inc. is a first year audit client. The audit partner obtained the following description of the sales system after recently meeting with client personnel at the corporate office.

DESCRIPTION OF THE SALES SYSTEM

Henrico’s sales system is IT-based with computerized cash registers on the floors of all of its stores. At the point of sale, Henrico’s sales clerks scan the bar code on the price tag of the product being sold to read the product number. If the quantity of a product being sold exceeds one, sales clerks can either enter the quantity being sold for that particular product code or scan the bar code for each individual item being purchased. At that point, the computerized cash register performs the following:

■ Identifies correct unit price for that product number from the online price master file stored on the store server

■ Notifies the clerk if product number is invalid

■ Calculates total price of purchase (price × quantity)

■ Extends totals, calculates sales taxes, and determines final transaction amount.

Before the sale can be completed, sales clerks must indicate whether this is a cash, debit, or credit sale. For credit sales, Henrico only accepts VISA or MasterCard credit cards. Customers swipe their credit card through a card reader directly linked to VISA and MasterCard to initiate the online credit card approval process. When the credit card agency’s electronic approval is transmitted back to the cash register system, the credit approval code is electronically recorded on the cash register hard drive before the charge slip is generated for customer signature. When credit is denied, customers must either pay by cash or the sales clerk voids the sale. The original signed copy of the credit charge slip is maintained in the cash drawer. Debit card transactions work virtually in the same manner as credit sales except that the online system seeks authorization from the customer’s bank.

The case was prepared by Mark S. Beasley, Ph.D. and Frank A. Buckless, Ph.D. of North Carolina State University and Steven M. Glover, Ph.D. and Douglas F. Prawitt, Ph.D. of Brigham Young University, as a basis for class discussion. Henrico is a fictitious company. All characters and names represented are fictitious; any similarity to existing companies or persons is purely coincidental.

For all types of sales, the cash register generates a customer paper-based receipt while a duplicate record of the transaction is stored on the cash register’s hard drive in an online file that is backed up hourly to the store’s computer server. This electronic transaction information documents on the register’s hard drive the product number, unit price, quantity sold, the extended transaction totals, and credit card agency or bank approval information.

Sales clerks have no access to the transaction electronic file. In addition, sales clerks can only read unit price information and have no access to change unit prices in the online price master file. Only the store manager’s staff has access to the price master file. Each week, the store manager’s staff approves price changes and new product listings to be added to the price list master files. And, only the store’s human resources manager is authorized to input changes to the employee master file of valid employee identification numbers.

Store clerks are allowed to operate any machine on the floor as long as the clerk has a valid employee identification number. If a cash register is not currently being used, all the sales clerk has to do is enter his or her employee identification number before scanning any product being sold. The system will not proceed without a valid employee identification number. Generally, operation of the cash register is self-explanatory although some problems have occurred previously. New sales clerks receive two hours of training on the operation of the cash register before serving customers on the sales floor. Henrico management believes “on the job experience” is most effective.

At the end of each day, sales clerks select the “register closing” option on the cash register. That process automatically updates both the transaction online file stored on the cash register’s hard drive and the backup file stored on the store’s server. The closing process generates a receipt printout at the register that summarizes the total amount of cash sales, debit and credit sales, sales returns, and any other miscellaneous transactions for the day. The sales clerks count the cash in the drawer and list the total cash count on a Daily Deposit Sheet (a preprinted blank form). In addition, sales clerks summarize total debit and credit sales on the Daily Deposit Sheet by listing total amounts from the debit and credit sales slips in the register. The sales clerks also record on the Daily Deposit Sheet the cash, debit, credit, and other transaction totals indicated on the cash register receipt generated by the register closing process. The sales clerks reconcile their cash, debit, and credit slip counts to these transaction totals and indicate any differences in amount. At that point, the sales clerks take the cash drawer, which includes debit and credit slips, to the store cashier who is located in the store cashier’s office. The store cashier verifies the Daily Deposit Sheet and initials the total cash and debit and credit sales columns listed on the Daily Deposit Sheet for each register closed indicating that the amounts in the drawer reconcile to the amounts on the Daily Deposit Sheet.

The cashier leaves $200 in each cash drawer to begin the following day. Cash drawers are stored overnight in the store’s vault. Each night, a local Brinks security service picks up the cash, debit transaction receipts, and credit charge slips collected during the day for delivery to the overnight depository at the store’s local bank. The next day, the bank immediately gives the store cash credits for all charge slips presented based on the bank’s arrangement with VISA and MasterCard and funds from debit transactions are electronically transmitted to Henrico’s bank account from the customers’ banks. And, the bank automatically credits the store’s bank account for all cash received. The store cashier can download confirmation of the deposit processed each day by logging into the bank’s online customer account access webpage.

An independent person in accounting for each store verifies that the sum of the cash, debit transactions, and credit card slip totals on all Daily Deposit Sheets for the prior day reconcile to the confirmation received from the bank of the deposit processed. After the reconciliation is performed, the bank’s email confirmation is printed and attached to the Daily Deposit Sheets, which are filed together by date.

Overnight, the store computer server processes all transactions downloaded from each cash register through the register closing process and summarizes that information in a Daily Sales Report, which is an electronic file stored on the store’s server. Each night, an electronic copy of the Daily Sales Report file from each store is transmitted automatically at midnight to the corporate office main server. The store server also automatically generates a paper copy of the Daily Sales Report for each store nightly. It summarizes total store sales, as well as subtotals of cash transactions, debit transactions, and credit sales, by store cash register. These reports are filed by date at each store.

Each night, the store computer server automatically updates perpetual inventory records, which are stored on the store’s computer server. Once the perpetual inventory records are updated, an electronic copy of the perpetual inventory record is transmitted to the corporate office main server. No paper reports of daily updates to the perpetual inventory record are generated by the computer.

At month end, the store computer server generates an Inventory Report from the perpetual inventory file. The Inventory Report provides inventory quantity information by product number. Also, the store computer server uses each day’s Daily Sales Report file to generate a Monthly Sales Report file for each store. This file contains daily sales totals for the store for each day of the month. This Monthly Sales Report information is electronically transmitted to the corporate office. Each store’s server generates a printout of the Monthly Sales Report at month end. The corporate office computer server uses this information to prepare and print a consolidated General Ledger, which summarizes the postings of monthly sales totals from each store to the consolidated sales account.

REQUIRED

You are the audit senior assigned to the audit of Henrico Retail Inc. The audit partner recently asked you to assist in planning the audit of the sales system based on your review of the client-prepared sales system narrative. The partner has asked you to address the following issues:

[1] Describe the sales transaction audit trail from the point of sale to the general ledger posting to the consolidated sales accounts at the corporate office. Be sure to emphasize which aspects of the audit trail are in paper or electronic form.

[2] Describe the difference between a preventative control and a detective control and give an example of each that are present in the sales system at Henrico.

[3] Develop a proposed strategy for auditing the occurrence assertion for sales transactions. Describe whether there is a sufficient paper-based audit trail to audit that assertion without relying on IT audit specialists to test electronic only processes.

[4] What evidence source would you use to select a sample of sales transactions to test the occurrence of sales transactions at one store? Why would you use this source? What evidence would you examine for each transaction selected?

[5] Develop a proposed strategy for auditing the accuracy assertion for sales transactions. Describe whether there is a sufficient paper-based audit trail to audit that assertion without relying on IT audit specialists to test electronic only processes.

[6] Describe whether you can use the same sample of transactions selected to test the occurrence assertion to also test the accuracy assertion.

[7] How would you select a sample to test the completeness assertion for sales? Explain whether the sample used to test the occurrence assertion would be effective for testing the completeness assertion.

[8] How do risks related to manual controls differ from risks related to automated controls? Give an example of each from the sales system at Henrico.

[9] What portion, if any, of the accounting system will likely require the assistance of an IT systems auditor, who evaluates evidence existing only in electronic form?

[10] What control deficiencies can you identify in the existing sales system?

CASE 9.3 Longeta Corporation Auditing Revenue Contracts

MARK S. BEASLEY • FRANK A. BUCKLESS • STEVEN M. GLOVER • DOUGLAS F. PRAWITT

LEARNING OBJECTIVES

After completing and discussing this case you should be able to

[1] Analyze complex revenue transactions for fair GAAP presentation

[2] Document final conclusions about the fair presentation of accounts

[3] Understand criteria for recording revenue

[4] Assess client accounting treatment when oral or written arrangements are made outside normal contract arrangements

BACKGROUND

You couldn’t be more excited about being on your first financial statement audit as you launch into your new professional accounting career. Having recently graduated with a Master of Accountancy degree, you are thrilled to be employing all the skills acquired in your rigorous accounting program.

The client engagement you’re now working on is Longeta Corporation, which is a Californiabased developer and marketer of software used to manage data storage functions for complex computer networks. Longeta particularly markets its products to other companies who serve as intermediaries for government purchasers. These intermediaries purchase Longeta’s products and then “resell” them to government purchasers and other organizations. The company’s stock is quoted on the NASDAQ National Market System.

The audit manager in charge of the engagement assigned you responsibility for auditing revenues for Longeta. You are excited to be in charge of this highly significant account and are enjoying the work you’ve done so far in the audit of some of the significant revenue transactions recorded during the year. The financial statements under audit are for the fiscal period ended September 30, 2015.

ASSESSING EVIDENCE OBTAINED

You have gathered quite a bit of information about several of the revenue transactions for the year. One of the transactions particularly caught your attention given its size. So, you’re in the process of assessing the evidence obtained to determine if the revenues from this transaction are fairly stated. You obtained this information from reviewing documentation related to the transaction and from inquiries you made of the vice president of sales and the controller. You made the following notes about what you’ve learned and are now preparing for a meeting with the audit manager to discuss issues related to the transaction. Here’s what you’ve noted so far:

The case was prepared by Mark S. Beasley, Ph.D. and Frank A. Buckless, Ph.D. of North Carolina State University and Steven M. Glover, Ph.D. and Douglas F. Prawitt, Ph.D. of Brigham Young University, as a basis for class discussion. It is not intended to illustrate either effective or ineffective handling of an administrative situation.

■ During July 2015, Longeta’s vice president of sales sent a proposal to Magicon Inc, to sell $7 million worth of Longeta software and services to the U.S. Air Force. Longeta approached Magicon because Magicon has a relationship with the U.S. Air Force while Longeta does not. Magicon is a necessary intermediary under the government’s procurement regulations.

■ Under terms of the proposal, Magicon would place a $7 million order for Longeta software and services by September 30, 2015, which is the last day of Longeta’s fiscal year. In exchange, Magicon would receive a sizeable commission and become an exclusive reseller of Longeta products for the Air Force.

■ Longeta normally must enter into “reseller agreements” with intermediaries such as Magicon in order to complete transactions. However, given the short timetable, Magicon was unable to obtain necessary corporate approvals from its legal department to sign a reseller agreement with Longeta before year end on September 30.

■ As a substitute for the reseller agreement, Magicon’s buyers agreed to place its order through an “order letter” that would later be followed by a purchase order and the reseller agreement.

■ Before the order letter was submitted, Magicon’s legal department requested that Longeta grant Magicon the right to cancel its obligation to pay Longeta the $7 million if Longeta and Magicon were unable to negotiate a mutually acceptable reseller agreement within 30 days.

■ In late September, Longeta’s vice president of sales emailed and faxed a letter on Longeta letterhead to Magicon legal specialists. Here is an excerpt from the letter:

“Per our discussion, the following is a clarification of the intent of the order letter dated September 30, 2015 between Longeta Corporation and Magicon Inc. The order letter meets GAAP requirement 97-4 for revenue recognition. The order letter allows Longeta to recognize revenue for our year ended September 30, 2015… The order letter gives us 30 days to reach mutually agreeable terms and conditions. In the unlikely event that we do not reach “mutually agreeable terms and conditions,” Magicon will have the right to terminate the order letter and all obligations. This contingency may not be expressly stated in the order letter. However, you have my assurance that in the event that we cannot reach terms we will not hold you to the commitment to pay referenced in the order letter.”

■ On September 30, 2015, the Magicon legal department approved the deal and Magicon’s purchasers signed and transmitted an order letter from Magicon to Longeta to buy $7 million worth of software and support services. The separate letter from the vice president of sales to Magicon, however, was not attached to the order letter and it was not referenced in the order letter.

■ The order letter was submitted to Longeta’s finance department. At that point, Longeta’s made an accounting entry to record $5.8 million as current revenue for the product Longeta had shipped. The remaining $1.2 million was to be separately invoiced for updates and technical support services and was therefore recorded as deferred revenue.

REQUIRED

You want to be thoroughly prepared for the meeting with the audit manager. Perform the following procedures to be certain you have all necessary information about the transaction’s treatment.

[1] The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) recently completed a joint project to develop a common revenue standard for U.S. GAAP and IFRS to improve revenue recognition practices and to remove inconsistencies and weaknesses in revenue requirements. The updated guidance is contained in the Accounting Standards Codification as Topic 606, “Revenue from Contracts with Customers.” Review that guidance to summarize the core principle for recognizing revenue and briefly describe the five steps needed to achieve the core principle. Also, describe how the core principle was not achieved in this situation.

[2] In your own words, explain the company’s reasoning for recording $5.8 million as current revenue while recording the remaining $1.2 million as deferred revenue. Also, document where on the financial statements the deferred revenue account would be presented.

[3] Assess the content of the separate letter issued by Longeta’s vice president of sales to Magicon. Document your conclusion about how the content of the letter affects or does not affect revenue recognition for Longeta for the year ended September 30, 2015.

[4] Given that the letter from the vice president of sales was not attached to or documented in the order letter submitted by Magicon to Longeta, document your conclusion as to the impact, if any, the vice president’s letter has on the accounting treatment for the transaction since it was not part of the order letter.

[5] Research PCAOB Auditing Standards on the PCAOB’s website (www.pcaob.org) to summarize the guidance for auditors in regards to their assessment of the risk of material misstatement related to revenue recognition. What do those standards require of auditors in regards to their assessment of risk related to revenue recognition?

[6] Auditing standards describe three conditions that are usually found to be present. What are those three conditions and what red flags, if any, might be present at Longeta?

[7] The separate letter from the vice president of sales was emailed and faxed to Magicon representatives. What would be the impact if Longeta’s vice president had only provided that information orally to Magicon representatives and not forwarded the information in written form?

[8] As of September 30, 2015, Magicon had only submitted the order letter. Document your conclusion about the impact on the accounting for the transaction if Longeta and Magicon (a) sign the reseller agreement within 30 days or (b) do not sign the reseller agreement within 30 days.

[9] Document your final conclusion about the accounting treatment of this transaction between Longeta and Magicon. Be sure to provide a basis for your conclusion.

PROFESSIONAL JUDGMENT QUESTION

It is recommended that you read the Professional Judgment Introduction found at the beginning of the book prior to responding to the following question.

[10] One of the environmental factors affecting judgment is the “rush to solve” judgment trap. Briefly describe the trap and how it applies to the situation affecting the recording of the sales transaction.