Reference no: EM1314271

Explain Meaning of Substantive Audit and Comparison of Audit Procedures.

Maxall Company was incorporated 6 years ago and is a wholesale and close -out distributor of kitchen appliances and cookware products. The president, Mary Maxall, has been in sales over twenty years. Maxall is a growing company which is publicly traded. Recently, Sales have accelerated at a rapid pace due to the implementation of internet sales and an extensive advertising campaign. Selected financial statement information for 20x1 and 20x2 are attached.

Enter & Mullen, CPAs (EM) are the auditors for Maxall, EM has audited Maxall since January, 20x1. Internal controls were reviewed in early 20x1 and EM determined that lack of segregation of duties existed in many areas of the company. EM decided reliance on internal controls would

be impossible and decided to do a substantive audit. In 20x2, the segregation of duties problem continued and, in addition, Maxall made changes in its computer system during the year, Again, the auditors' decided it would be more efficient to perform a substantive audit than to rely on controls.

Accounts Receivable

EM Auditors set materiality levels in the planning process and documented these levels in their planning memoranda. In 20x1, materiality was set AT $35,000 in the sales/accounts receivable area. In 20x2,due to growth in the company , materiality was set at $50,000.

EM reviewed the adequacy of the allowance for doubtful accounts and inquired about selected balances which were over 90 days old. EM sent out positive confirmations on approximately 55 %-60% of the accounts receivable balances in 20x1 and 20x2:

	20x1	20x2
Total trade accounts receivable	$4,146,594	$26,952,431
Confirmations mailed - total dollar balances	$2,436,400	$15,320,109
% Confirmations received - number mailed	71%	80%
% Confirmations received - number mailed	$1,900,036	$14,786,239

 

EM applied alternative procedures to accounts when confirmations requested were not received. Some of these alternative procedures are discussed in the next section.

Sales Transactions

EM performed tests of sales transactions in both 20x1 and 20x2 in order to document the audirors' understanding of the flow of sales transactions through the accounting system. The sales transactions tested are summarized below:

	20x1	20x2
Total sales	$21,341,721	$87,831,141
Total number of invoices	27,514	116,420
Number of invoices tested	70	16
Dollar value tested	$85,408	$42,806

 In the tests of sales transactions in 20x1, the largest sale in the sample was $11,436. There were several unusually large sales that were made near year end:

Southwestern Inc:

6 invoices dated 12/30/x1 which totaled $370,440

Balco:

1 invoices date 12/28/x1 for $1,244,685

The following audit work was noted in EM's working papers relative to these two accounts:

Southwestern, Inc:

The auditors sent southwestern a positive accounts receivable confirmation at year end. The Maxall records reflected a total receivable of $418,323, which included the 6 invoices dated 12/20/x1 which totaled $370,440. Southwestern confirmed a balance of $19,426 and included a detail listing of the open invoices which made up this balance. The working papers indicated a second confirmation request was sent but the working papers did not include any indication that the second confirmation was received. EM auditors performed alternative procedures on the balance which was not covered in the confirmation from southwestern. These procedures included tracing the amounts to invoices and shipping documents to verify the validity of the accounts receivable booked by Maxall. The shipping document EM reviewed was Maxall's vendor invoices that indicated that the products had been shipped to southwestern on 12/21/x1. In addition the following note appeared in EM's working papers relating to the six invoices totaling $370,440:

"The invoices were sales recorded in late December and not received by the customer as of year end and therefore not recorded in the customer's accounts payable. We reviewed the invoices and shipping documents. Appears reasonable, pass further work".(This note was prepared by the audit assistant and the audit senior reviewed and initialed the audit working paper.)

Balco:

EM sent a positive confirmation to Balco and Balco confirmed the balance. The confirmation was included in the working papers. EM's working papers included a note that indicated the inventory included in this sale had been purchased from a Balco subsidiary in October. 20x1 and was resold to a Balco at year end with a small mark up.

In 20x2, there were several large sales made at or near year end involving four customers.

Hall mart	$1,254,000
Racines	3,174,050
Draycon	3,620,600
Balco	5,442,503

 Hall mart, Racines, and Draycon are retail stores. The sales were made late in December 20x2 and were made with payment terms of 90 to 120 days. The Balco sales was similar to the sale which occurred at the end of 20x1 and involved the resale of merchandise previously purchased from a Balco subsidiary.

EM  accounts receivable confirmation work included the above accounts and these accounts were positively confirmed. The EM working papers indicated that the payment terms were discussed with Mary Maxall and she stated that they were very good customers so 90 to 120 day terms had been extended based on their past payment history.

Audit Adjustments

In performing cutoff procedures on sales and inventory. EM discovered that a Sale of $48,310 had been booked in January 20x3. Upon further investigation. EM noted that the shipment had been made on December 15,20x2. EM's Working papers indicated they proposed an adjustment and the adjustment was made.

In reviewing the collectability of accounts receivable in 20x2, EM auditors concluded that there was an additional shortage in the allowance for doubtful accounts of $115,401. The working papers contained a note which indicated this was immaterial when compared to the trade receivable balances at year end and an adjustment was passed in the working papers.

Management Representations:

Maxall's Chief financial officer resigned in February 20x2. Due to tight job market, Maxall encountered difficulty in finding a replacement. A new chief financial officer was hired in November 20x2. Once he came on board, he was quite helpful answering auditor questions and inquires, since the financial officer had not been in place for the entire year, EM did not request that the chief financial officer sign the management representation letter for 20x2.

Selected Financial statement Information

Maxall Company Consolidated Balance Sheets
	December 31
Assets	20x1	20x2
Current Assets
Cash	$547,356	$373,906
Short Term Investments	707,857	12,313,007
Receivable
Trade, less allowance for doubtful of $555,823 and $427,570 in December 20x1 and 20x2, respectively	4,146,594	26,952,431
Notes receivable	219,368	0
Related parties	6,535	5,706
Inventories	7,568,334	43,281,775
Prepaid expenses and deposits	459,500	1,932,989
Total Current Assets	$13,655,544	$84,859,814
Property and equipment, at cost:
Furniture, fixtures and equipment	4,039	1,523,893
Automobiles and trucks	106,074	124,321
Leasehold improvements	15,452	123,978
Less: Accumulated depreciation and amortization	(71,144)	(125,065)
	54,421	1,647,127
Other Assets	717,175	1,385,693
Total Assets	$14,427,140	$87,892,634

Selected Financial statement Information

Maxall Company Consolidated Balance Sheets
	December 31
Liabilities and shareholder's Equity	20x1	20x2
Current Liabilities:
Short term debt	$233,004	$70,670
Current maturities of long term debt	116,320	63,552
Accounts Payable	6,448,693	20,361,300
Accrued expenses	80,657	1,058,677
Income taxes payable	463,000	829,723
Customer deposits	0	166,174
Total current Liabilities	7,341,674	22,550,096
Long-Term debt, less current maturities	3,400,012	283,154
Convertible subordinated debentures	0	30,000,000
Commitments and Contingencies
Share Holders' equity:
Cumulative preferred stock, 41,00 par value, 2,500,000 shares authorized, none issued	0	0
Non-cumulative preferred stock, 41,00 par value, 2,500,000 shares authorized, none issued	0	0
Common Stock, $.01 par value,100,000,000 authorized: 4,150,000 and 11,556,700 shares issued and outstanding at December 31,20x1 and 20x2, respectively	41,500	115,567
Additional Capital	2,807,709	30,871,291
Retained earnings	836,245	4,072,526
	3,685,454	35,059,384
Total Liabilities and share holders' equity	$14,427,140	$87,892,634

 

Maxall Company Consolidated statements of Income
	Year Ended December 31
	20x0	20x1	20x2
Net Sales	$7,969,889	$21,341,721	$87,831,141
Cost of goods sold	(6,851,063)	(18,403,491)	(75,760,473)
Gross Profit	1,118,826	2,938,230	12,070,668
Selling, general and administrative expenses	(835,294)	(1,394,621)	(5,705,376)
Income from operations	283,532	1,543,609	6,365,292
Other(income) expense:
Interest expense	92,188	275,039	1,234,436
Investment income and other	(4,552)	(74,917)	(772,345)
	87,636	200,122	462,091
Income before income taxes	195,896	1,343,487	5,903,201
Provisions for income taxes	96,000	596,000	2,666,201
Net income	$99,896	$747,487	$3,236,281
Net income  per Share	0.02	$0.11	$0.30
Weighted average common and common equivalent shares	5,000,000	7,066,540	10,675,840

 1.What do you think the auditors meant by the term "Substantive Audit"? Was the substantive approach appropriately applied in EM's audit of Maxall?

 2.Identify and discuss specific audit process/procedures that the auditor(s) performed that were in accordance with Generally Accepted Auditing Standards