Question

7-38 (Objective 7-4) Grande Stores is a large discount catalog department store chain. The company has recently expanded from six to 43 stores by borrowing from several large financial institutions and from a public offering of common stock. A recent investigation has disclosed that Grande 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 Grande’s audit firm, Montgomery & Ross, 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. McClure Advertising Credits—Grande 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. Grande created a 114-page list of approximately 1,100 vendors, supporting advertising credits of $300,000. Grande’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 Grande debit memos charging the vendors for the promotional allowances.

2. Springbrook Credits—Grande created 28 fictitious credit memos totaling $257,000 from Springbrook Distributors, the main supplier of health and beauty aids to Grande. Grande’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 Grande would continue to use Springbrook as a supplier. One of the Montgomery & Ross staff auditors concluded that a $257,000 payment to retain Grande’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, Jon Steiner, the president of Grande Stores, placed a call to Mort Seagal, the president of Springbrook, and handed the phone to the staff auditor. In fact, the call had been placed to an officer of Grande. The Grande officer, posing as Seagal, orally confirmed the credits. Grande refused to allow Montgomery & Ross to obtain written confirmations supporting the credits. Although the staff auditor doubted the validity of the credits, the audit partner, Mark Franklin, accepted the credits based on the credit memoranda, telephone confirmation of the credits, and oral representations of Grande officers.

3. Ridolfi Credits—$130,000 in credits based on 35 credit memoranda from Ridolfi, Inc., were purportedly for the return of overstocked goods from several Grande stores. A Montgomery & Ross 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 Ridolfi 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 Ridolfi, treasurer of Ridolfi, Inc., and was informed that the $130,000 in goods had not been returned and the money was not owed to Grande by Ridolfi. Steiner advised Franklin, the audit partner, that he had talked to Harold Ridolfi, who claimed he had been misunderstood by the staff auditor. Steiner told Franklin not to have anyone call Ridolfi to verify the amount because of pending litigation between Grande and Ridolfi, Inc.

4. Accounts Payable Accrual—Montgomery & Ross assigned a senior with experience in the retail area to audit accounts payable. Although Grande had poor internal control, Montgomery & Ross selected a sample of 50 for confirmation of the several thousand vendors who did business with Grande. Twenty-seven responses were received, and 21 were reconciled to Grande’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 Grande’s president made telephone calls to some suppliers who had received confirmation requests from Montgomery & Ross and told them how to respond to the request.

   Montgomery & Ross 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 Grande eventually agreed on an adjustment to increase accounts payable by $260,000.

REQUIRED

1. Identify deficiencies in the sufficiency and appropriateness of the evidence gathered in the audit of accounts payable of Grande Stores.

Answer 1

Solution Grande Stores is a large discount department store. It is been observed that the Company expanded from six to 43 stores by overstating the net income The company has indulge in fraud by acquiring loan from bank on materially overstated profit. The company was able to overstate the profits by understating Accounts Payable. In this case the auditor needs to understand the internal controls that are relevant to financial statement, before the auditor plans detection risk and substantive tests. Deficiencies: The auditior needs obtain a document that explains the internal control in financial statements. The document can be obtained by using techniquies such as narrative, flow chart and internal control questionnaire. By going through these techniquies the auditor will understand the clients internal control and deficiencies in the internal control. The auditor will be able to conclude the scope of deficiencies that can arise due the deficiencies in the internal control. The deficiencies can be significant deficiencies or material deficiencies. Significance deficiencies will not lead to material misstatement in the financial statement. It can arise due to deficiencies due to over sight. Material deficiencies needs to be detected or will lead to material misstatement in the financial statement. Grande store acquired huge finance by loan from bank and by issuing common stock to public. The loan acquired from the bank is by material mistatement in the financial statement. The Public also invested in the common stock by being mislead by the material misstatement in the financial statement. By the investments received by Grande, it was able to expand from six store to 43 stores.

McClure Advertising Credit: Here Grande created 114-page list of 1100 vendors, supporting advertising credit of $300,000. Here the auditor opted for sampling audit and a 4 sample out of 1100 items were considered. When a sampling audit is done the auditor needs to do perform an extensive audit which involves in tracing them from the intiation through the entire accounting process. This helps the auditor to understand the internal control system in the company. Here it is observed that the auditor failed to perform the required procedure. The items were confirmed by telephone, one traced to cash receipt's, 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 Grande debit memos charging the vendors for the promotional allowances. Springbrook Credits Fictitious credit memos created for $ 257,000, so that Grande would continue to use Springbrook as a supplier. However, the credit memos indicated that the credits were for damaged merchandise. To verify this, a fake telephonic conversation was arranged between the auditor and the President of Springbrook Credit by the President of Grande. An oral confirmation was received and was refused to provide with a written confirmation. Here the validity of debt need to be further scrutanized by doing a substantive testing by the auditor. As there is a fraud involved in the financial misstatement. Ridolfi Credits: $130,000 in credits based on 35 credit memoranda from Ridolfi, Inc., were purportedly for the return of overstocked goods from several Grande stores. It was informed to the auditor not to call Ridolfi, Inc to verify the credit memo, as there is litigation between Ridolfi, Inc and Grande. In this case the auditor needs to do substantive inventory book audit and follow the required analytic procedure to verify the authenticity of the credit memorandam issue from Ridolfi,lnc. Accounts Payable Accrual Out of the 50 sample among several thousand vendors audited by the auditor. It's been observed that only 21 of them were reconciled to Grandes record. The auditor concluded that there is an unrecorded liability of $290,000. Further investigation by the auditor revealed the involvement of fraud by the President of Grande. When a substantive audit was done by Montgomery & Ross, it was concluded that there would be a potential unrecorded liability of $ 500,000. At the end the President of Grande, negotiated with the auditor to record liability for $ 260,000 The Auditors duty is communicate the above frauds to Securities and Exchange Commission. But in all the above cases auditor failed to inform..