SEC Accounting and Auditing Enforcement Release No. 904 describes KPMG's 1993 audit of Structural Dynamics Research Corporation (SDRC). The AAER describes SDRC as a client that inflated revenues and earnings by recognizing both premature and fictitious revenue. The following excerpt from the AAER describes the audit team's work in the area of accounts receivable:
During the 1993 audit, the engagement team spent considerable time auditing accounts receivable, a critical area of the audit. Particular emphasis was placed on auditing accounts receivable in SDRC's Far East Operations ("FEO") which represented approximately 50% of consolidated accounts receivable at year-end 1993.
FEO also accounted for approximately 35% of the revenue recorded by SDRC in 1993. The audit team incorrectly concluded that certain revenue relating to these accounts receivable had been properly recognized and focused their attention on evaluating collectability.
Based in large part on the percentage of year-end 1992 receivables that were written off in 1993, the audit staff calculated a
$5.8 million proposed audit adjustment to increase the allowance for doubtful accounts for FEO receivables. In the aggregate, the audit differences considered by the auditors totaled approximately $3.1 million, which represented approximately 22% of the net income originally reported by SDRC.
Notwithstanding the analysis made by the audit team, both the engagement partner and the concurring partner concluded that the $3.1 million net audit difference was not material to SDRC's financial statements. In reaching that conclusion, they relied in substantial part on management's representations that the rate of write-offs and reversals in were based on factors that management did not expect to recur in and that the $5.8 million audit difference calculated by the staff was, therefore, excessive. The auditors "passed" on the audit difference and did not require SDRC to adjust its financial statements.
a. What factors should the audit partners have considered when deciding whether it was appropriate to pass on the audit adjustment? What is the role of professional skepticism in this context?
b. What evidence should the auditors have gathered to support their assessment?
c. Is it appropriate to net misstatements when making a materiality decision on whether an adjustment is necessary?