Question

Worthington Department Stores

Auditing standards require the auditor to obtain sufficient appropriate audit evidence (AS 1105.04: Audit Evidence). The audit firm of Hepple & Ramsey was investigated for the audit of Worthington. Worthington is a large discount catalog department store chain. The company recently expanded from 6 to 43 stores by borrowing from several large financial institutions and from a public offering of common stock. A recent investigation has disclosed that Worthington materially overstated net income. This was accomplished by understating accounts payable and recording fictitious supplier credits that further reduced accounts payable. An SEC investigation was critical of the evidence gathered by Worthington’s audit firm, Hepple & Ramsey, in testing accounts payable and the supplier credits. The following is a description of some of the fictitious supplier credits and unrecorded amounts in accounts payable, as well as the audit procedures.

1. Manning Advertising Credits—Worthington had arrangements with some vendors to share the cost of advertising the vendor’s product. The arrangements were usually agreed to in advance by the vendor and supported by evidence of the placing of the ad. Worthington created a 114-page list of approximately 1,100 vendors, supporting advertising credits of $300,000. Worthington’s auditors selected a sample of 4 of the 1,100 items for direct confirmation. One item was confirmed by telephone, one traced to cash receipts, one to a vendor credit memo for part of the amount and cash receipts for the rest, and one to a vendor credit memo. Two of the amounts confirmed differed from the amount on the list, but the auditors did not seek an explanation for the differences because the amounts were not material. The rest of the credits were tested by selecting 20 items (one or two from each page of the list). Twelve of the items were supported by examining the ads placed, and eight were supported by Worthington debit memos charging the vendors for the promotional allowances.
2. HealthLock Credits—Worthington created 28 fictitious credit memos totaling $257,000 from HealthLock Distributors, the main supplier of health and beauty aids to Worthington. Worthington’s controller initially told the auditor that the credits were for returned goods, then said they were a volume discount, and finally stated they were a payment so that Worthington would continue to use HealthLock as a supplier. One of the Hepple & Ramsey staff auditors concluded that a $257,000 payment to retain Worthington’s business was too large to make economic sense. The credit memos indicated that the credits were for damaged merchandise, volume rebates, and advertising allowances. The audit firm requested a confirmation of the credits. In response, Tom Seymore, the president of Worthington Stores, placed a call to Martin Leary, the president of HealthLock, and handed the phone to the staff auditor. In fact, the call had been placed to an officer of Worthington. The Worthington officer, posing as Leary, orally confirmed the credits. Worthington refused to allow Hepple & Ramsey to obtain written confirmations supporting the credits. Although the staff auditor doubted the validity of the credits, the audit partner, Michael Jennings, accepted the credits based on the credit memoranda, telephone confirmation of the credits, and oral representations of Worthington officers.
3. Ringet Credits—$130,000 in credits based on 35 credit memoranda from Ringet, Inc., were purportedly for the return of overstocked goods from several Worthington stores. A Hepple & Ramsey staff auditor noted the size of the credit and that the credit memos were dated subsequent to year-end. He further noticed that a sentence on the credit memos from Ringet had been obliterated by a felt-tip marker. When held to the light, the accountant could read that the marked-out sentence read, “Do not post until merchandise received.” The staff auditor thereafter called Harold Ringet, treasurer of Ringet, Inc., and was informed that the $130,000 in goods had not been returned and the money was not owed to Worthington by Ringet. Seymore advised Jennings, the audit partner, that he had talked to Harold Ringet, who claimed he had been misunderstood by the staff auditor. Seymore told Jennings not to have anyone call Ringet to verify the amount because of pending litigation between Worthington and Ringet, Inc.
4. Accounts Payable Accrual—Hepple & Ramsey assigned a senior with experience in the retail area to audit accounts payable. Although Worthington had poor internal controls, Hepple & Ramsey selected a sample of 50 for confirmation of the several thousand vendors who did business with Worthington. Twenty-seven responses were received, and 21 were reconciled to Worthington’s records. These tests indicated an unrecorded liability of approximately $290,000 when projected to the population of accounts payable. However, the investigation disclosed that Worthington’s president made telephone calls to some suppliers who had received confirmation requests from Hepple & Ramsey and told them how to respond to the request.
5. Cut-Off —Hepple & Ramsey also performed a purchases cutoff test by vouching accounts payable invoices received for nine weeks after year-end. The purpose of this test was to identify invoices received after year-end that should have been recorded in accounts payable. Thirty percent of the sample ($160,000) was found to relate to the prior year, indicating a potential unrecorded liability of approximately $500,000. The audit firm and Worthington eventually agreed on an adjustment to increase accounts payable by $260,000.

For each of the five instances above, identify deficiencies in the sufficiency and appropriateness of the evidence gathered in the audit of accounts payable of Worthington Stores.

Answer 1

This International Standard on Auditing (ISA) explains what constitutes audit evidence in an audit of financial statements, and deals with the auditor's responsibility to design and perform audit procedures to obtain sufficient appropriate audit evidence to be able to draw reasonable conclusions on which to base.

A recent investigation has disclosed that Worthington materially overstated net income so SA 315 identifying and assesing the risk of material mistatement should be taken care of.

SA 315 deals with the responsibility of auditor in identifying and assessing the risk of material misstatement through understanding the entity and its environment.

SA 530, “Audit Sampling” does not contain any material modifications vis à vis ISA 530. In considering the characteristics of the population from which the sample will be drawn, the auditor may determine that stratification or value-weighted selection is appropriate.

SA 320, materiality on planning and performing auditing, in these case auditor's responsibility to apply the concept of materiality in planning and performing an audit of financial statements.

The materiality concept refers to a situation where the financial information of a company is considered to be material from the point of view of the preparation of the financial statements if it has the potential to alter the view or opinion of a reasonable person.

The auditor may identify deficiencies in internal control not only during this risk assessment process but also at any other stage of the audit. SA 265.

A deficiency in internal control over financial reporting exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely basis.Here in these case deficiency is found in the internal control hence all the SA guidlines as mentioned above should be followed properly.