You are a partner of the CPA firm London and Paris LLP. The CPA firm is a

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Question:

You are a partner of the CPA firm London and Paris LLP. The CPA firm is a prestigious regional firm in Mid-west US. You are required to conduct an independent review of audits completed by the firm, as part of its quality control program.

Now, you are reviewing the audit working papers and a draft of the audited financial statements of Wallis Electronics Inc. for the fiscal year ended September 30, 2008, along with the suggested auditor’s report (an unqualified opinion) prepared by the engagement partner. The company designs and manufactures components for radios, televisions, and other consumer electronics. The company is wholly owned by the family of the founder of the business, Frank Wallis, who passed away several years ago. The company sells its components to several large manufacturers of consumer electronic products, but its major customer is a South Korean conglomerate that normally accounts for about 50% of Wallis’s annual sales.

Wallis Electronics Inc. has been your firm’s audit client for 2 years. The audit fieldwork, which took about 6 weeks, was performed by a senior auditor assisted by a junior auditor, and the working papers were reviewed by the engagement partner. The audited financial statements show total assets at year-end of USD $25,000,000, revenues of $30,000,000, and income before taxes at $1,000,000.

Based on your independent review of the working papers (including various memoranda and review notes prepared by the staff and engagement partner) and the proposed financial statements and audit opinion, you have noted the following issues that arose during the audit, along with the manner in which they were resolved:

1. When analyzing the client-prepared financial statements before the audit started, the senior auditor noted that profitability this year was much lower than normal, and worse than that of other companies in the same industry. Both the company’s gross profit ratio and its net income ratio were abnormally low. The senior auditor discussed the situation with the chief accountant at Wallis, who explained that the company has been struggling with some of its new manufacturing processes that were put in place during the year on the advice of an outside consulting firm. As a result, a considerable amount of products produced and sold during the year was returned by customers as being defective. The chief accountant said that he did not think that these problems were fully resolved, and that for a typical month’s sales of $2,500,000, roughly an additional $500,000 of rework costs were incurred and added to cost of goods sold. While the chief accountant could not easily determine the total amount of rework costs incurred and added to cost of goods sold during the year ended 3 September 30, 2008, he estimated that it was about $4,500,000. The senior auditor documented the conversation in the working papers and wrote: “No further action needed,” to which the engagement partner added “I concur — it is just a cost of doing business, and the problem shall go away next year.”

2. In testing the client’s finished goods inventories, the junior auditor observed a large number of old and dust-covered parts on hand. According to the perpetual inventory records, these parts were manufactured 2 years ago for a South Korean company with which Wallis does a lot of business, but the order was cancelled by the customer. The recorded inventory cost of these units is about $150,000. The junior auditor asked the production manager about the parts, who explained that the company decided to hold the parts in inventory until they could find another buyer for the goods. The senior auditor reviewed the junior auditor’s work and wrote: “No adjustment needed — amount immaterial,” to which the engagement partner later added “I agree.”

3. Since the death of the founder of the company, the family members who own and operate the firm have had difficulties with the business, including many disagreements on how it should be managed. As a result, the engagement partner of London and Paris has often acted as a trusted advisor to the CEO and other top managers in the company, and has frequently been asked to resolve disputes among them. During the summer of 2008, the CEO opened a special bank account in the company’s name to make certain payments to consultants, lawyers, and other professionals the CEO believes could help him manage the company. However, he did not reveal the existence of the account to the other family members. Rather, he asked the engagement partner to serve as a co-signer of checks drawn on that account and to maintain the cash disbursement detail records. The engagement partner agreed and wrote a memorandum for the files explaining his actions. During the year ended September 30, 2008, the engagement partner co-signed only 2 checks for payments for consulting services provided to the company. One check was for $50,000 and the other for $25,000, and the payments were supported by invoices provided by the two consulting firms, Biden Inc. and Perpsective Inc.

4. Due to the time pressure to complete the audit by November 15, 2008, the senior auditor decided to rely upon the work performed by the company’s 2 internal auditors in his search for unrecorded accounts payable at September 30, 2008. Because the company deals with a large number of vendors, the internal auditors had requested statements of account from all of the company’s major suppliers as of September 30, 2008. Of the suppliers, 80% responded, and the internal auditors then reconciled these vendors’ statements to the recorded accounts payable. The senior auditor determined that the 2 internal auditors were both professionally qualified accountants and that they reported directly to Wallis’s chief financial officer. The senior auditor reviewed the internal auditors’ working papers and was satisfied with the nature and extent of their testing and the quality of work performed. He therefore wrote a memorandum for the working 4 papers, explaining his reliance on the internal auditors and describing the steps taken to ensure the work was satisfactory. The engagement partner reviewed the working paper and wrote: “Great job! You saved us hours of work. I’m sure the client will be happy that we didn’t just repeat the stuff that they had already done.”

5. The company’s financial statements include one footnote below, which was written by the engagement partner and approved by the client’s top management: “Wallis Electronics Ltd. sells products to 25 major customers in North America and in other countries. While the majority of revenue is denominated in U.S. dollars, certain sales are denominated in foreign currencies whose exchange rates against USD fluctuate a lot. Consistent with generally accepted accounting principles, all foreign currency denominated receivables at September 30, 2008 have been translated into U.S. dollars at the exchange rate on that date.” After thinking about these various issues, you decide to write a memo to the engagement partner, with a copy to the managing partner of the firm, expressing your views on these matters and what needs to be done before you are prepared to “sign off” on the engagement.

Required

Now please write the memo that you will send to the engagement partner (with a copy to the firm’s managing partner).