5.6 Case Instructional Notes Sarbox Scooter, Inc.: Scoping and Evaluation Judgments in the Audit of Internal Control over Financial Reporting Mark S. Beasley, Frank A. Buckless, Steven M. Glover, Douglas F. Prawitt INSTRUCTIONAL OBJECTIVES To help students gain an understanding of the steps involved in the scoping process for the audit of internal control over financial reporting. To provide an opportunity for students to determine the significance of accounts and locations based on both quantitative and qualitative metrics in order to plan the nature and extent of the testing of controls. To help students understand the role of testing coverage in terms of significant accounts and locations and also in regards to the overall financial statement picture.
To allow students to understand and apply an evaluation methodology to determine the likelihood and magnitude of control deficiencies. To help students appreciate the judgment involved in evaluating internal control deficiencies. KEY FACTS Sarbox Scooter, Inc. is a publicly traded manufacturing firm specializing in motorized scooters and G.P. (Grand Prix) pocket bikes. The company was founded in 1997 and is headquartered in Basking Bridge, New Jersey. Sarbox Scooters business units are segmented by geographical region into the U.S., Mexico, and Europe. The U.S. region is further sub-divided into five business units: Northeast, Southeast, Central, Southwest, and Northwest. Sarbox Scooters management is striving to increase brand share, by 1% each year for the next five years, to 30% of the market. However, increases in brand share will be not be easy as competition in the industry is very intense. The Finance Director of the companys Mexican division recently resigned following deep scrutiny from Sarbox Scooters internal audit team of his control, monitoring, and reporting practices. a 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. Sarbox is a fictitious company.
All characters and names represented are fictitious; any similarity to existing companies or persons is purely coincidental. Copyright 2006 by Prentice-Hall, Inc. Beasley / Buckless / Glover / Prawitt Sarbox Scooters customer base consists primarily of dealerships both domestically and internationally. Sales to the dealerships account for approximately 90% of Sarbox Scooters annual sales. The Company also sells bulk orders directly to rental agencies and vacation resorts, which account for the remaining 10% of sales. The company has continued to progress in the areas of corporate governance and social responsibility by strengthening its Board of Directors and its internal audit function. USE OF CASE This case is designed primarily to expose students to the basic scoping and evaluation judgments that are involved in the planning stage of the audit of internal control over financial reporting and in the evaluation of internal control deficiencies. It contains two parts that can be assigned independently according the to the instructors discretion. Specifically, in Part A students are introduced to the quantitative and qualitative factors that must be addressed when deciding which locations and accounts will be tested and also when determining the extent, nature, and timing of the testing. In addition, students are required to consider the coverage of accounts and locations necessary to achieve a high level of assurance. In Part B, students are introduced to the considerations and steps used by auditing firms to evaluate the likelihood and magnitude of possible misstatement for the various levels of internal control deficiency.
The firm policy provided in the case is designed to present the major issues involved in the scoping and evaluation judgments and does not necessarily address every possible factor that might be considered. When this case was published, the PCAOB and the auditing profession were continuing to refine the professional guidance regarding the audit of internal control over financial reporting and certain changes may take place in the future to alter the emphasis of certain aspects of this case. If this case is used for an in-class discussion, we recommend that students read the case as an out-ofclass reading assignment prior to the in-class discussion. Roundtable activities are a useful cooperative learning technique for in-class discussion. To implement the Roundtable activity, divide students into small groups. Have each group discuss and record their answers, important ideas, and issues for each question assigned. Once all students have had an opportunity to state their ideas and arrive at a group consensus, the instructor can randomly call on individual students to share their groups answers with the class. The class time allocated to the group discussion can be shortened by assigning groups responsibility for different case questions.
Randomly calling on individual students to share their groups answers with the class helps to ensure that all students take responsibility for learning the material. If the case is used as an out-of-class assignment, we recommend discussing the case requirements with students prior to their completing the assignment. While most of the material needed to complete the case is included in the firm policy, students should have the necessary background in basic auditing concepts and theory in order to fully understand the process that is being demonstrated. Instructors may also want to include information regarding the events leading up to the new auditing standards and any changes or guidance that may have been given to the profession that is not included in this case. PROFESSIONAL STANDARDS Relevant professional standards for this assignment include the Sarbanes Oxley Act of 2002 Section 404, PCAOB Auditing Standard No. 2, An Audit of Internal Control over Financial Reporting Performed in Conjunction with an Audit of Financial Statements (AS2), PCAOB Policy Statement Regarding Implementation of Auditing Standard No. 2 (PCAOB Release No. 2005-009), and PCAOB Staff Questions and Answers: Auditing Internal Control Over Financial Reporting (May 16, 2005). 2 Case 5.6 Sarbox Scooter, Inc.: Scoping and Evaluation Judgments in the Audit of Internal Control over Financial Reporting SUGGESTED SOLUTION PART A 1. Section 404 of the SarbanesOxley Act of 2002 requires management to assess and evaluate the effectiveness of their internal controls. Management of Sarbox has decided to consider all accounts reported in the financial statements as significant. The PCAOBs AS2 requires the auditor to arrive at their own conclusion about which accounts are significant as part of evaluating managements assessment.
Referring to the following case materials describing Delmoss Watergrants policy on identifying significant accounts and Sarbox Scooter Inc.s consolidated balance sheet and income statement information, identify Sarboxs significant accounts. In your response, include the planning materiality threshold you applied (to determine materiality you may refer to your textbook or footnote 1 in Delmoss Watergrants policy on identifying significant accounts). If an account is considered significant for qualitative, but not quantitative reasons, please include the qualitative factors you considered. Similarly, if an account is not considered significant, even though it is quantitatively over the planning materiality threshold, please include the qualitative factors you considered. STEP 1: DETERMINE PLANNING MATERIALTY The first step students should take to identify significant accounts is to determine a threshold of planning materiality. The case provides guidance on materiality (see footnote 1), but also suggests that students may use guidance from their auditing textbook. If the footnote metrics are used students planning materiality will vary depending on the level of risk and the metric chosen. The ranges are provided below. Planning materiality (in thousands) Sales High Risk Moderate Risk Low Risk Pre-tax Earnings High Risk Moderate Risk Low Risk 1.00% 1.50% 2.00% 3.0% 4.0% 5.0% $1,987,174 $1,987,174 $1,987,174 $ 589,602 $ 589,602 $ 589,602 $19,872 $29,808 $39,744 $17,688 $23,584 $29,480 For purposes of this solution, we will use pre-tax earnings with a moderate level of risk to determine a planning materiality threshold of about $23.5 million. This seems reasonable given both positive pre-tax earnings and the information provided regarding Sarboxs relative risk. STEP 2: IDENTIFY QUANTITATIVELY SIGNIFICANT ACCOUNTS Students should compare the amount of planning materiality they have chosen with the various line items on the consolidated income statement and balance sheet to determine whether or not they are quantitatively significant. The case indicates that the client 3 Beasley / Buckless / Glover / Prawitt considered all accounts significant. This approach by clients was relatively common in the early application of section 404. On the income statement and balance sheet the majority of accounts will be identified as significant.
Using our estimate of planning materiality, all of the accounts would be determined to be significant with the exception of Severance Charges, Interest Income (net), Other (net), Suspense, Miscellaneous Receivables, Notes Receivable, and Work in Progress Inventory. Depending on the students evaluation of planning materiality, other accounts may or may not be selected. STEP 3: IDENTIFY QUALITATIVELY SIGNIFICANT ACCOUNTS While all accounts that exceed the planning materiality threshold will be considered significant from a quantitative standpoint, auditing standards also require the auditor to consider qualitative factors. While answers may vary somewhat depending on individual student opinion, it is likely the following accounts would be considered significant for qualitative reasons: Severance Charges: These charges typically relate to restructuring initiatives, which involves relatively complex accounting rules. Because of potential misstatement as well as insights that can be gained regarding potential issues with operations and with employees the account should be considered significant.
While the consolidated balance is zero, balances in the divisional suspense accounts can be an indicator that controls and processes are not operating effectively at those locations. Suspense account balances also are potential misstatement
indicators due to increased risk of error or fraud. Sometimes a suspense account balances represent transactions that the client accounting staff does not know how to resolve or properly account for. Suspense Account: Cash: Cash is typically considered significant because of the volume of transactions and the fact that controls and processes related to the receipt and disposition of cash relate to so many other accounts. The balance in cash is also often related contractually to debt covenants and is an important input in liquidity ratios. The auditor should also consider qualitative factors to determine if there are qualitatively low risk accounts that present a remote likelihood of material misstatement even if the account is larger than the quantitative hurdle of planning materiality. For example, fixed assets at a service corporation may be just over the quantitatively significant level, but if the account typically has little to no activity during the year the auditor may decide not to test controls over this account because the account poses a qualitatively remote risk of material misstatement.
1 For the purposes of this case, the student is only given the information presented in the introduction and in the consolidated financial statements. Given the information provided, there do not appear to be qualitatively low risk accounts 1 Evaluating qualitatively low risk accounts as not significant may not actually bring much testing relief because the controls around the account are typically not hard to evaluate and test. 4 Case 5.6 Sarbox Scooter, Inc.: Scoping and Evaluation Judgments in the Audit of Internal Control over Financial Reporting and thus all of the accounts that have been selected for quantitative reasons would require testing. Student answers may very, but for an account to not require testing, a specific reason should be given based on size, risk factors, the complexity of the transactions, and the nature of the account.
2. Section 404 of the Sarbanes-Oxley Act of 2002 requires management to assess and evaluate the effectiveness of their internal controls. Sarboxs management has decided to consider every location as a significant location. The auditor must arrive his at or her own assessment as to which locations should be tested. Referring to Delmoss Watergrants policy on identifying significant locations and Sarbox Scooter Inc.s financial information by location, identify Sarboxs individually significant locations. If a location is considered significant for qualitative, but not quantitative reasons, please include the qualitative factors you considered. Delmoss Watergrants policy for identifying significant locations requires the student to identify the following types of business units/locations: A. B. C. Individually important locations. Locations that contain specific risks that by themselves could create a material misstatement in the consolidated financial statements. Locations that when aggregated could represent a level of financial significance that could create a material misstatement in the consolidated financial statements. A. INDIVIDUALLY IMPORTANT BUSINESS UNITS/LOCATIONS The table below lists the specific metrics identified by Delmoss Watergrant to determine individually significant locations. If either condition is met, the business unit/location must be considered significant. Individually Important Business Units/Locations (in thousands) Metric 1 Units/Locations > $121,136 (5% of Total Revenue $2,422,722) Metric 2 Units/Locations > $171,103 (5% of Total Assets of $3,422,067) Under these conditions, students should have selected all of the locations except U.S. Northeast and Mexico as individually significant. B. IDENTIFY BUSINESS UNITS/LOCATIONS WITH SPECIFIC RISKS A location or business unit might present specific risks that, by themselves, could create a material misstatement in the companys financial statements, even though the unit might not be individually financially significant.
Students should consider the two remaining business units for inherent and fraud risks that could lead to material misstatement. As noted in the introduction about Sarbox Scooter, Inc., the Mexico Finance Director recently resigned following deep scrutiny from Sarbox Scooters internal audit team regarding his control, monitoring, and reporting practices. This scenario constitutes a specific control and fraud risk in regards to the control environment and therefore Mexico should be identified as a specific risk and considered significant for testing purposes. From the details given the in the case, there appears to be no reason to include the U.S. Northeast location. 5 Beasley / Buckless / Glover / Prawitt C. IDENTIFY BUSINESS UNITS/LOCATIONS THAT ARE SIGNIFICANT WHEN AGGREGATED As noted in the Delmoss Watergrants policy, this category contains all locations that are not individually significant, but are material when aggregated. In practice, firms typically leave this category as the catch all. In other words, once the individually significant units/locations are identified, then the firm would remove all units/locations that in aggregate are less than 5% of total assets and revenues and the units/locations left over are considered significant when aggregated. In the case of Sarbox Scooter, Inc., the only location not deemed individually significant is the U.S. Northeast unit so there are no aggregation issues and in this case there are no units/locations considered significant when aggregated.
3. Referring to Delmoss Watergrants policy on coverage by account and location, determine if adequate coverage of all significant accounts is achieved by testing at the significant locations. If not, what additional testing do you recommend? Assuming we have concluded that all locations, except the U.S. Northeast have been selected for testing, we should now examine the percentage of coverage for each significant account. With the exception of Prepaid expenses & other current assets, all significant accounts achieve a minimum of 50% of the consolidated account balances. As we have only covered approximately 46% of Prepaid expenses & other current assets, we will need to conduct additional testing specifically at the U.S. Northeast location, but only for this account. In other words, at the U.S. Northeast location, the auditor would only be required to test controls related to the Prepaid expenses & other assets account. Obviously for large, complex organizations this coverage test may result in a number of situations where the auditor must supplement the initial testing plan in order to obtain sufficient coverage.
4. Auditing standards require the identification of significant processes. What is the definition of a significant process? What processes will always be considered significant? A significant process is made up of business processes, sub-processes, and transactions that are of major importance to the operations of a company. Business processes include traditional cycles (e.g., sales and collections, inventory management, purchasing, human resource management, and financing) and are comprised of multiple sub-processes for which specific accounting procedures and controls are established by a company; for example, process sales orders, maintain customer data, maintain pricing, process invoices, process returns, and apply cash may be distinct sub-processes making up the sales and collections process. Each sub-process may be further comprised of classes of transactions. In addition to the traditional accounting cycles, there are other important processes such as period-end financial reporting. The period-end financial reporting process is always a significant process because of its importance to financial reporting in general and to the auditors opinion on the effectiveness of internal control over financial reporting and the financial statements as a whole (AS2 78). 6 Case 5.6 Sarbox Scooter, Inc.: Scoping and Evaluation Judgments in the Audit of Internal Control over Financial Reporting Required – Part B (CAN BE COMPLETED INDEPENDENTLY OF PART A) 1. What are the definitions of a control deficiency, significant deficiency, and material weakness? Which, if any, of these deficiency categories must the external auditor include in the audit report? A control deficiency 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.
A deficiency in design exists when (a) a control necessary to meet the control objective is missing or (b) an existing control is not properly designed so that, even if the control operates as designed, the control objective is not always met. A deficiency in operation exists when a properly designed control does not operate as designed, or when the person performing the control does not possess the necessary authority or qualifications to perform the control effectively (AS2, 8). A significant deficiency is a control deficiency, or combination of control deficiencies, that adversely affects the companys ability to initiate, authorize, record, process, or report external financial data reliably in accordance with generally accepted accounting principles such that there is more than a remote likelihood that a misstatement of the companys annual or interim financial statements that is more than inconsequential will not be prevented or detected (AS2, 9). A material weakness is a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected (AS2, 10). A material weakness must be included in the auditors report of the effectiveness of internal control over financial reporting. 2. Referring to Delmoss Watergrants policy for evaluating control deficiencies, determine if the following three deficiencies represent a control deficiency, significant deficiency, or a material weakness. Please consider each case separately and justify your answers. a. While examining Sarboxs period-end financial reporting process, you discover that revenue has been recognized on orders that were received and completed, but not yet shipped to the customer. No specific goods were set aside for these orders; however, there is sufficient inventory on hand to fill them. Also, you observe that some orders were shipped before being recorded as sales, so that your best estimate of total revenue cutoff error at year-end was approximately $2.3 million. Significant Deficiency: The scenario
appears to represent only a control deficiency as $2.3 million is below the $2.35 million consequential threshold 7 Beasley / Buckless / Glover / Prawitt (10% of planning materialty) required by Delmoss Watergrants firm policy for the magnitude to be more than inconsequential. However, students should notice that there is also another issue to consider. This form of revenue recognition does not meet specific factors set out in SAB 101 and is considered a violation of GAAP. AS 2 requires that deficiencies involving the controls over the selection and application of accounting policies that are in conformity with generally accepted accounting principles be considered at least a significant deficiency (AS2, 139). b. Sarboxs revenue recognition policy requires that all nonroutine sales (i.e. sales to clients other than dealerships) receive authorization from management in order to verify proper pricing and terms of sale. However, after examining a sample of nonroutine sales records you find that this control is not closely adhered to and that sales representatives offered discounts or altered sales terms that were not properly recorded in Sarboxs records.
As a result, in instances when the control is not followed the recorded sales prices tend to be too high and/or terms are not correctly reflected in the sales invoice and the customers complain. In some situations, customers have cancelled orders due to the over-billing or changed sales terms. Nonroutine sales represent about 10% of Sarboxs sales revenue. From your sample testing of the authorization control, you find that the control doesnt operate 4% of the time, with an upper bound of 9% (i.e., based on your sample, you can be 95% confident that the exception rate does not exceed 9%). Significant Deficiency: This scenario allows students the opportunity to examine gross and adjusted exposure. The gross exposure would be the full amount of possible misstatement if the nonrountine sales were 100% misstated. This amount is calculated by multiplying the total sales revenue by the 10%, because nonrountine sales constitute 10% of sales. Therefore gross exposure equals $198,717,400 ($1,987,174,000 x 10%). Adjusted exposure is calculated by multiplying gross exposure by the upper bound of the control deviation confidence interval. Adjusted exposure is $17,884,530 ($198,717,000 x .09) which is less than materiality but more than inconsequential; therefore it is a significant deficiency. c. Sarbox Scooter requires that all credit sales to new customers or to customers with a current balance over their pre-approved credit limit be approved by the credit manager prior to shipment However, during peak seasons this policy is not strictly followed in order to accommodate the need of both the company and its customers to have orders processed rapidly.
Because of these findings, you estimate that the allowance for doubtful accounts is materially understated. While the client does not dispute that the authorization control was not operating effectively during peak seasons, the client has pointed out compensating controls that it feels should reduce the magnitude of the deficiency below a material weakness. The first compensating control is that an accounts receivable aging schedule is reviewed each quarter by management and accounts that are older than 180 days are written-off. Also, management distributes a list of companies that default or fail to pay on time to all sales staff on a monthly basis to prohibit such companies from making additional purchases on credit. 8 Case 5.6 Sarbox Scooter, Inc.: Scoping and Evaluation Judgments in the Audit of Internal Control over Financial Reporting Material Weakness: The question indicates that the deficiency would be considered material unless there are compensating or redundant controls that reduce the likelihood and/or the potential exposure below a material amount. In the case of Sarbox Scooter, the compensating controls described would not be considered effective in reducing the potential magnitude of the deficiency below a material level because (1) the controls are not timely (only performed on a quarterly basis) and (2) the controls do not appear to be sufficiently detailed to reduce the levels of magnitude and likelihood below that of a material weakness. 9 Find millions of documents on Course Hero – Study Guides, Lecture Notes, Reference Materials, Practice Exams and more. Course Hero has millions of course specific materials providing students with the best way to expand their education.