Kpmg urgent medical device case answers

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1

Urgent Medical Device, Inc. A Teaching Case Designed to Integrate Data and Analytics in the

Financial Statement Auditing Classroom

By

Allen D. Blay – Florida State University

Jay C. Thibodeau – Bentley University

Background

Urgent Medical Device, Inc. (the Company) is a medical device company founded in 2013 in Provo,

Utah that specializes in the development and manufacturing of cutting-edge medical devices designed

for all types of joint replacement surgeries. In January 2015, the FDA approved Urgent’s premier

product, a hinged titanium axle designed to provide physicians with more precise placement of joints

during joint replacement surgery.

In early 2016, approximately one year after the new product’s approval, the Company hired a new

senior vice president (SVP) of sales to oversee sales, physician training, product delivery, and customer

service. The broad set of responsibilities allowed the charismatic SVP to significantly influence the

Company’s revenue generation. The hiring of the new SVP was also done in large part to help guide

the company’s development of an important new sales channel: third-party distributors that are each

strategically located in close proximity to key hospitals in regions around the country.

The move to hire the SVP was in direct response to overwhelming disappointment about the first

year’s sales volume for the new surgical implant, which was lagging significantly behind expectations.

Reports from the field led management to recommend the new sales channel to the board of directors

that overwhelmingly approved the new strategy, the execution of which was being led by the new

SVP.

Execution of strategy

To help execute the new strategy, the SVP hired five regional sales managers who would become his

trusted cohorts. Together, they set aggressive sales targets for the Company’s surgical implants. The

sales targets focused on achieving a growth pattern that was characterized by a record high sales

volume for each successive quarter in each region. In fact, it is fair to say that the sales targets were

intentionally created at almost unreachable levels to remove any question about possible weakness in

demand for the Company’s new product.

The strategy focused on the development of a new sales channel with third-party distributors. Each of

the distributors had already established close relationships with the physicians that were actually using

the product during surgical procedures. To help pay for the launch of their new product, along with the

execution of the new strategy, the Company was also working hard to raise a significant amount of

new investment capital to fund the resulting increased operating costs. In order to be successful in

attracting the new investment capital, top management made it clear to the SVP how important it was

to report strong sales for its premier product, the surgical implant for titanium joints. The SVP, in turn,

passed along the same message to the regional sales managers.

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Management control philosophy

The upper management team of Urgent can be described as being aggressive in business practices

and often emphasizes speed and efficiency when implementing their decisions. Management rarely

hires external consultants because they are of the opinion that consultants are too expensive and often

follow a conservative approach. The upper management team meets regularly with its key managers.

In general, the upper management team has cooperated with the audit team in order to provide fair

and adequate financial reporting, but there have been disagreements in the past. The Company has a

strict policy for following all established internal control procedures.

Incentive compensation

Top management focuses significant attention on achieving short-term performance measures based

on the audited financial statements when determining compensation and making promotion decisions.

Revenue earned is the most important criterion in performance assessment throughout the

organization. As part of the launch of its new surgical implant, a new bonus plan was established to

provide additional incentives for the entire organization to focus on this new opportunity, with revenue

earned as the key criterion used to determine incentive compensation.

Preliminary results

Despite the SVP’s optimism about sales in 2017, internal reports have indicated that the actual sales

volume of the surgical implant was well below budget each quarter. The SVP responded to these

reports by repeatedly communicating his disappointment to the regional sales managers. Furthermore,

he consistently warned that if the team could not boost sales, the Company would likely not be able to

raise additional investment capital and would then be forced to significantly downsize its headcount.

Unfortunately, boosting revenue of the new surgical implants was not as simple as merely shipping the

product to distributors. The distributors were hesitant to purchase product until the sale to the final

customer was finalized as the distributors did not want to be stuck with the inventory on their own

balance sheets. Further, the terms of the sales do not include any refund or rebate conditions. In

addition, the Company has no intention of changing those terms and accepting any return. Therefore,

any sale to distributors are final.

By the end of 2017, the Company had signed on a total of 73 distributors to sell its surgical implants in

more than 20 different states throughout the United States. Each distributor was independently owned

and operated but the company routinely shared best practices among its network. The SVP monitored

sales closely from the distributor network through his regional sales managers. In fact, he even

maintained a monthly sales report from each of the 73 distributors.

The Company invoices customers when the goods are shipped, and invoicing triggers the recording of

revenue. The Company does not include freight costs in sales revenue but does offset shipping costs

with any freight charged to customers.

The following relevant financial data is taken from the Company’s unaudited trial balance, which was

used to produce the unaudited financial statements:

Sales revenue, year ended 12/31/2017 $84,867,855

Gross accounts receivable, 12/31/2017 $11,988,886

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Audit approach

Your audit team is currently in the midst of year-end testing in the revenue and accounts receivable

cycle for the audit of the calendar year 2017 financial statements. Your testing will focus on the

existence/occurrence, cutoff, and accuracy assertions for sales revenue, as well as the existence and

valuation assertions for accounts receivable. As relationships with third-party distributors generally

require significant contract analysis to ensure the appropriateness of when revenue is recognized, the

audit team expects more hours to be spent this year testing revenue and accounts receivable as

compared to the prior year. In addition to the procedures you will perform, the audit team will also

confirm accounts receivable and perform other procedures according to the audit plan. The audit team

has assessed the risk of material misstatement (RMM) for each relevant assertion in order to

determine the nature, timing, and extent of the procedures to be performed at Urgent.

Other members of the audit team have already completed a walk-through of the revenue and accounts

receivable processes, identified “what could go wrongs” within the process, and identified the

controls that have been placed in operation to mitigate the risks. Based on the work performed, the

team decided to test the operating effectiveness of certain key controls during interim testing. The

results are found below.

Tests of controls – Revenue and accounts receivable cycle –

Interim

There are four key application controls tested at interim. Prior to testing the application controls, the

information technology (IT) auditors tested the general controls (GITCs) over program changes, access

to programs, and computer operations that are relevant to the revenue and accounts receivable cycle.

The GITCs were found to be effective and can be relied upon to support the effective operation of

application controls. In addition, the IT auditors tested the system to make sure that proper segregation

of duties occurred throughout the period and that controls over data input, data integrity, and the

completion and accuracy of data used in the four application controls were operating effectively. No

exceptions were noted in the testing performed by the IT auditors, and the team decided to test the

four key application controls.

The first control is an automated three-way sales match. The control matches the details from 1) an

approved sales order; 2) relevant shipping documents; and 3) the sales invoice before revenue is

recorded. The control has been designed to support the existence/occurrence assertion for revenue. A

test of the control’s operating effectiveness was conducted at the interim. No exceptions were noted.

The second control requires the credit department at Urgent to conduct a detailed credit check for all

new customers, including the new distributors. To do so, the credit department obtains information

from the customer that allows for a comprehensive review of the financial condition of the new

customer and an assessment of the customer’s capacity to pay outstanding invoices. The control

culminates with an approval of the new customer and the establishment of a credit limit by the credit

department manager based on the information reviewed. A test of the control’s operating

effectiveness was conducted at interim. No exceptions were noted.

The third control is an automated sales authorization control. When a sales order is entered into the

system, the amount of the sale is added to the existing accounts receivable balance for that customer.

The sum is then compared to the customer’s credit limit. If the sum is greater than the credit limit, the

sale is not approved. If the sum is less than the credit limit, the sale is approved. A credit manager

notes the approval and authorizes shipment by electronically entering their initials into the system,

which gets posted into the sales order database. A test of the control’s operating effectiveness was

conducted at interim. No exceptions were noted.

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The fourth control is a monthly review of the adequacy of the allowance for doubtful accounts,

completed by the controller. On a monthly basis, the controller reviews the aging of accounts

receivable report produced by the company’s information system. During the review, the controller

identifies for follow-up all balances greater than 90 days past due for consideration in the allowance

calculation. A test of the control’s operating effectiveness was conducted at interim. No exceptions

were noted.

Roll-forward period

By the end of the third quarter of 2017, sales revenue for the company’s premier surgical implant was

still lagging far behind expectations. To help ensure that Urgent delivered impressive fourth quarter

revenue numbers, the entire sales team, led by the SVP and the regional sales managers, began to

exert pressure on a number of distributors in an attempt to improve sales in 2017. This effort seemed

to be paying off as the sales team successfully persuaded more than a dozen distributors to purchase

product in advance of final customer demand.

These circumstances presented a problem for the Company, because the distributors began to ask for

concessions from Urgent Medical. For example, in order to persuade the distributors, the Company

agreed to hold the inventory in their own warehouse.

The SVP’s actions led to a dramatic increase in revenue for the fourth quarter of 2017. In fact, sales

increased year-over-year by 214 percent for the fourth quarter alone. The upward trajectory of sales

revenue helped the Company raise the much-needed investment capital as Urgent issued more than

10 million shares of common stock for $40 million in early 2018.

Most importantly, roll-forward testing procedures were completed for each of the four key application

controls. No exceptions were noted in the roll-forward procedures. Thus, the audit team concluded that

the controls were operating effectively throughout the year.

Substantive testing – Revenue and accounts receivable

cycle – Final

As a result of the tests of controls, the audit team assessed the control risk as low for the

existence/occurrence, cutoff, and the accuracy assertions for revenue and the valuation assertion for

accounts receivable. Since the recognition of revenue is a presumed fraud risk, along with the

significant risk of sales cutoff related to the launch of the new surgical implant, the audit team

concluded that fraud risk related to the timing of revenue recognition over period-end is high. Overall,

based on the control risk assessment as low and the inherent risk assessment of high, the overall

assessment of RMM is moderate for each of the assertions. In response to the RMM assessment, the

audit team has asked that you complete a number of substantive testing procedures. In addition, since

your manager is trying to improve the efficiency and effectiveness of substantive testing, you have

been asked to use two technological tools, IDEA and Tableau, to facilitate identification of potential

concerns related to the substantive testing for the revenue and accounts receivable cycle. Urgent has

provide you with the following databases to facilitate your testing.

Database definitions for data provided

1. SalesOrders – Urgent has provided the SalesOrders database, which includes a master listing of

all customer orders placed during the year. The client has informed you that the database also

includes sales orders from the prior year that were not completed until the current year, as well as

orders taken this year that were not delivered to customers as of 12/31. This database is also the

client’s primary database for the three-way match control. When an order is shipped or invoiced,

the system automatically posts the ShipID or InvoiceID to the SalesOrders database.

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Column name Column description Field type

SalesOrderID Customer order number – Primary Key Numeric (int)

OrderDate Date the customer order was created Date

MM/DD/YYYY

ProdID Product Number. Foreign Key to

Products.ProdID

Character

CustID Distributor Number. Foreign Key to

CustomerMaster.CustID

Numeric (int)

TerritoryID Territory in which the sale was made.

Foreign key to SalesTerritory.TerritoryID

Numeric (int)

Quantity Quantity Ordered Numeric (int)

UnitPrice Price per unit Numeric (dollars)

SubTotal Sales subtotal, amount included in Sales

Revenue

Numeric (dollars)

TaxAmt Tax amount Numeric (dollars)

Freight Shipping Cost Numeric (dollars)

TotalDue Total due from customer, amount posted

to Accounts Receivable

Numeric (dollars)

CredApr Credit Approval – Initials of CM Character

ShipID Shipping ID number – Foreign key to

Shipments.ShipID

Numeric

InvoiceID Invoice ID number – Foreign key to

Invoice.InvoiceID

Numeric

ModifiedDate Date the row was last updated Date

MM/DD/YYYY

ModifiedTime Time the row was last updated Time (24-hour)

2. Shipments – Urgent has provided you with the Shipments database, which includes a listing of all

shipments made during fiscal 2017, as well as shipments of products ordered during 2017 and not

shipped until 2018.

Column name Column description Field type

ShipID Shipping ID Number – Primary Key Numeric (sequential int)

SalesOrderID Sales order number – Foreign key to

SalesOrders.SalesOrderID

Numeric (int)

ShipDate Date of shipment Date

MM/DD/YYYY

ShipWeight Total Weight of Shipment Numeric (int)

Carrier Shipping Carrier Character

ModifiedDate Date the row was last updated Date

MM/DD/YYYY

ModifiedTime Time the row was last updated Time (24-hour)

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3. CustomerInvoices – Urgent has provided you with the CustomerInvoices database, which

includes a listing of all invoices issued during 2017, as well as invoices for sales orders taken

during 2017 but not delivered to customers until 2018.

Column name Column description Field type

InvoiceID Invoice number – Primary Key Numeric (sequential int)

CustID Distributor ID number - Foreign key to

CustomerMaster.CustID

Numeric (int)

InvoiceDate Date of sales invoice Date

MM/DD/YYYY

SalesOrderID Sales Order ID – Foreign key to

SalesOrders

Character

PaidDate Date invoice paid, 9/9/9999 is unpaid Date

MM/DD/YYYY

ModifiedDate Date the row was last updated Date

MM/DD/YYYY

ModifiedTime Time the row was last updated Time (24-hour)

4. SalesTerritory – Urgent has provided you with this database listing the sales territories, as well as

the sales goals for the fourth quarter of 2017 for all territories.

Column name Column description Field type

TerritoryID Territory Identification Number –

Primary Key

Numeric (int)

TerritoryName Name of Sales Territory Character

SalesVP Name of Sales VP for Territory Character

SalesGoalQTR Quarterly Territory Sales Goal Numeric (dollars)

ModifiedDate Date the row was last updated Date

MM/DD/YYYY

ModifiedTime Time the row was last updated Time (24-hour)

5. CustomerMaster – Urgent has provided you with the CustomerMaster database, which is a listing

of all distributors. It classifies distributors by territory and also includes the most current credit limit

for the customer. This credit limit is used for the automated credit limit check control.

Column name Column description Field type

CustID Distributor ID number – Primary Key Numeric (int)

TerritoryID Territory in which the customer is

located. Foreign key to

SalesTerritory.TerritoryID

Numeric (int)

CustName Distributor Name Character

ShipAddr Distributor Shipping Address Character

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Column name Column description Field type

BillAddr Distributor Billing Address Character

CredLimit Credit Approval Limit Numeric (dollars)

ModifiedDate Date the row was last updated Date

MM/DD/YYYY

ModifiedTime Time the row was last updated Time (24-hour)

6. Products – Urgent provided the Products database, which includes a listing of all products

currently manufactured and sold by the company. The UnitPrice is the current verified selling price

and is automatically populated in SalesOrders when a customer places an order. Similarly, the

weight determines the freight charged to customers.

Column name Column description Field type

ProdID Product ID number – Primary Key Numeric (int)

ProdName Product Name Character

SafetyStockLevel Minimum inventory quantity Numeric (int)

ReManPoint Inventory level that triggers

manufacturing additional product

Numeric (int)

StandardCost Standard manufacturing cost of product Numeric (dollars)

UnitPrice Selling price Numeric (dollars)

Weight Shipping Weight of Product Decimal (8,2)

DaysToMan Number of days required to manufacture

the product

Numeric (int)

SellStartDate Date the product was available for sale Date

MM/DD/YYYY

ModifiedDate Date the row was last updated Date

MM/DD/YYYY

ModifiedTime Time the row was last updated Time (24-hour)

Your firm’s Data and Analytics center has already converted the files, as provided by the client, into

Excel format. As such, the contents and format of the databases you have been provided are exactly

the same as they were provided by the client.

Requirements

1. According to the professional auditing standards, an audit team should ordinarily presume that

revenue recognition is a fraud risk. Complete the following steps.

a. Based on your understanding of fraud risk assessment and the case information, identify at

least three specific fraud risk factors related to Urgent. Classify these risks in terms of What

Can Go Wrong (WCGW) with each of the significant accounts and relevant assertions identified

for Urgent’s revenue and accounts receivable cycle.

b. What do you believe is the most significant risk related to the revenue account for Urgent?

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c. What special audit considerations would you propose in response to the significant risk you

identified above? In your response, consider how you would change your approach to the

nature, timing, and extent of evidence in response to the identified risk.

2. Based on the tests of controls and other Information Technology General Controls (ITGC) testing,

your firm has concluded that the data files supplied to you for your procedures are complete and

accurate. The conclusion was based on tests of controls over data input risks, including all relevant

data elements (e.g., invoice date), data integrity risks, and the relevant automated application

controls. However, it is also important to confirm that the data, once imported into IDEA or

Tableau, was transferred into the technology tool in a complete and accurate manner prior to

working with the data within the technology tool. Import all supplied data into IDEA and then

reconcile the data with the supplied trial balance and check figures from the case. Simply stated,

you must check that the data has been transferred in a complete and accurate manner at each step

in the process. Thus, to ensure that you are working with the set of transactions and balances that

the client used to calculate Sales Revenue and Accounts Receivable, answer the following

questions:

a. What are the total number of valid sales that comprise the $84,867,855 sales revenue shown

on the trial balance as of 12/31/2017?

b. What are the total number of unpaid invoices that comprise the $11,988,886 gross accounts

receivable balance shown on the trial balance as of 12/31/2017? Assume that Urgent has no

outstanding accounts receivable from 2016.

3. Data visualization tools such as Tableau can be used to help audit teams identify items or specific

areas of higher risk within an entire population. Your data and analytics center has provided you

with a set of Tableau visualizations to consider during your substantive testing procedures:

i. Three-way match of SalesOrderID, InvoiceID, and ShipID based solely on

SalesOrders database

ii. Sales by territory

iii. Sales by distributor

iv. Sales by quarter

v. Sales by territory by quarter

vi. Product sales by territory

vii. Fourth quarter sales by territory

viii. Sales vs. sales goals for fourth quarter by territory

ix. Sales by quarter by territory vs fourth quarter sales goals

a. Using the data visualizations provided in Tableau, compose a memo to be included in the audit

documentation file that identifies any pattern in the data that you believe may be indicative of

specific audit risks. In your memo, be sure to link the identified risks to the appropriate

significant account and relevant assertions.

b. Based on the analysis completed above, what further testing, if any, needs to be performed

over the identified risks and the remaining population? Stated differently, do any further tests

need to be performed or does the three-way match visualization, combined with your tests of

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controls and additional visualizations, provide you with sufficient appropriate evidence to

conclude about the occurrence of revenue at Urgent?

4. Technology tools like IDEA can also be used to help audit teams identify items with potentially

higher risks within an entire population of items in an efficient and effective manner. With this in

mind, complete the following steps.

a. The SalesOrder database was used to produce a Tableau visualization of three-way match in

the revenue cycle as described in the previous requirement. Using IDEA, verify the accuracy of

the SalesOrder database by creating a three-way match on your own using the SalesOrder,

Shipments, and CustomerInvoices databases. Are your conclusions the same? If so, how does

this increase your assurance about the accuracy of the SalesOrder database? If not, why not?

Did you identify any specific transaction that you believe should be considered higher risk for

the audit?

b. Analyze the sales revenue file using IDEA to determine whether any sales were made to

distributors without an established credit limit. Are there any exceptions? If there are

exceptions, what further testing would you perform on these exceptions?

c. Analyze the accounts receivable and related credit authorization limits using IDEA to determine

whether any customers have account balances as of 12/31/17 that exceed their existing credit

limit. Are there any exceptions to the credit limit control as of 12/31/17? Do you notice any

pattern in the exceptions? What further testing would you perform on these exceptions?

d. For some time, Urgent has based its allowance for doubtful accounts on an aging analysis and

the results have been historically accurate. Below, you have been provided with the client’s list

of customer balances in excess of 90 days. These are the accounts that the client will consider

when calculating the allowance for doubtful accounts as of 12/31/2017. Perform an aging

analysis using IDEA to assess the completeness and accuracy of Urgent’s list of customer

balances in excess of 90 days.

Urgent Medical Devices

Analysis of >90-Day Delinquent Accounts Receivable

As of December 31, 2017

SalesOrderID InvoiceDate TotalDue

3236 7/4/2017 56,251.34

3241 7/9/2017 73,450.67

3422 9/5/2017 73,450.67

3466 9/21/2017 59,932.09

3490 9/27/2017 54,851.15

317,935.92

i. Based on your analysis, does the client’s listing agree to your analysis completed in

IDEA?

ii. Do you have any concern with the client’s process for identifying the total amount of

significantly delinquent accounts? You may think broadly, beyond mechanical accuracy, in

considering the sufficiency of their process for identification of delinquent accounts.

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iii. According to Urgent’s unaudited trial balance, the balance for Allowance for Doubtful

Accounts is $310,000. Does the test performed above provide sufficient appropriate

evidence to support a conclusion on the valuation of accounts receivable? If not, what

additional testing would you recommend to reach an audit conclusion for this relevant

assertion?

5. Based on your risk analysis and findings in requirements 1) through 4), perform additional analyses

using IDEA to identify specific transactions, territories, or distributors that may require additional

substantive testing. Be creative when doing so. For example, consider patterns in the data

provided that might indicate management override of a control activity. Focus your additional

analytics on those areas. Prepare a listing of specific findings from your additional analytics that you

believe warrant additional testing.

6. In order to conclude on whether the risk of material misstatement has been reduced to an

acceptably low level for the relevant assertions identified, you need to consider, on an overall

basis, whether the results of your procedures provide sufficient appropriate evidence. Based on

the evidence that you have considered, can you reach a conclusion for the relevant assertions

identified? Why or why not?

Learning objectives of case

1. To understand the fraud risks associated with revenue recognition and its impact on the testing of

the revenue and accounts receivable cycle (demonstrated when students complete

requirement 1 of the case).

2. To understand the importance of determining that a population of data is complete and accurate

prior to its use in audit testing, including understanding how to reconcile the population to the

underlying books and records of the audit client (demonstrated when students complete

requirement 2 of the case).

3. To learn how to interpret commonly used data visualizations and reach audit conclusions based on

the issues, objectives and alternatives that surface given the observed facts and circumstances

(demonstrated when students complete requirement 3 of the case).

4. To understand how to utilize commonly used data and analytics software tools (i.e., IDEA and

Tableau) within a realistic audit context (demonstrated when students complete requirements

3, 4, and 5 of the case).

5. To develop critical thinking skills around the identification of exceptions and risk factors in client

provided data (demonstrated when students complete requirements 3, 4, and 5 of the case).

6. To recognize the importance of reaching an overall conclusion for each relevant assertion in

accordance with applicable professional standards based on the evidential matter considered

(demonstrated when students complete requirement 6 of the case).

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provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in

the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.

This simulation is a work of fiction. Any names of persons, companies, events or incidents, are fictitious. Any resemblance to actual persons, living or dead, companies or

actual events is purely coincidental.

The views and opinions expressed herein are those of the authors and do not necessarily represent the views and opinions of KPMG LLP.