Gabby Manufacturing Company (Gabby) is a privately owned leading manufacturer and distributor of lockers, locks, and keys for numerous industries. It is best known for its widely used locker system with the plastic orange cap. Gabby sells two types of lockers: postal (used in mail delivery) and nonpostal (i.e., evidence lockers used in law enforcement). Gabby serves a variety of customers in Canada, the United States, Mexico, and Europe.
Gabby has had excellent growth and profits in the past decade, primarily as a result of the leadership provided by the owner, Bill Gabby.
Noah Smart, CPA, has been the partner in charge of the audit of Gabby for 15 years. Noah has always enjoyed a close relationship with Bill and prides himself on having made several constructive comments over the years that have aided in the success of the company. Bill always appreciates Noah's management letter points. Several times in the past few years,
Noah's firm, Miles and Miles LLP, has considered rotating a different partner onto the engagement, but this has been strongly resisted by both Noah and Bill. Although there had been problems with internal controls in the early years of the audit, in recent years, internal controls have been strong. There have normally been no audit adjustments, and the audit team has been able to reduce the level of substantive testing. During the past three years, Noah has devoted less time to the audit because of the relative ease of conducting the audit.
In the current year, Gabby acquired RecLocker Inc., a company that produces coin-operated lockers used in amusement parks, water parks, and ski resorts. The acquisition was financed with a new multimillion-dollar, five-year bank loan. Bill was very excited about the acquisition because of the synergies between Gabby and RecLocker. Unfortunately, as a result of the continuing economic recession, the demand for recreational lockers has declined and it appears that it will take several years before Gabby can reap any of the rewards from the acquisition.
Phil Warren is the senior in charge of the audit. He is highly competent, and has a reputation for being able to improve time efficiencies. While planning the audit for the current year, Phil and Noah decided that the previous year's assessment of moderate audit risk and materiality level were appropriate for the current year.
They also decided that the prior year's time budget was a reasonable estimate. Although the recent acquisition of RecLocker would probably require additional work, Phil was confident that his efficiency would be able to compensate for it. Noah was glad of this because he had already promised Bill that he would not increase the audit fee this year.
The interim tests of controls took longer than expected.
This was partially due to a change in the accounting system to incorporate RecLocker's accounting information as well as a new inventory system. In addition, Gabby experienced significant turnover in its accounting staff. It was also due to the fact that the audit assistants were unfamiliar with the client and that they found more errors than in previous years.
Noah and Phil concluded that since all the errors found were immaterial, there was no need to change the initial audit plan. Phil assured Noah that he would make up for the additional time at year-end.
At year-end, in order to save costs, Phil assigned the inventory price tests to Priya Tata, who was competent and extremely fast, but who had not been on the audit before. Despite the increase in the total inventory value, Priya used a smaller sample size than in previous years because few errors had been found in the preceding year. Priya found several items in the sample that were overstated due to costing errors but the total estimated error in the sample was immaterial. Given the numerous errors, Priya consulted with Phil, who concluded that since the total error was immaterial, no further audit work was necessary.
Priya completed the tests in 25 percent less time than the preceding year.
While Phil was completing the audit fieldwork, he discovered that the United States Postal Service (USPS) had not renewed its contract with Gabby. Sales to USPS represented approximately 30 percent of total sales and Gabby did not expect to find another postal service interested in the boxes since they were customized for USPS. Phil was glad that this event happened after year-end because it did not affect this year's audit work and he could stay within the originally planned budget. Because it happened after year-end, Phil decided it was not necessary to document the cancellation of the USPS contract.
The entire audit was completed on schedule in slightly less time than the preceding year. As in prior years, Phil concluded that the overall uncorrected misstatements did not have a material effect on the overall financial statements. Given that there were few past problems, Noah performed a limited review of the working papers-he focused on reviewing the draft financial statements and the summary of possible misstatements.
In addition, he discussed the results with Phil, who assured him that there were no significant issues or unresolved audit adjustments. Noah was extremely pleased with the results and concluded that sufficient appropriate evidence was collected and that there were no material misstatements.
REQUIRED
a. List the major deficiencies in the audit and state the appropriate actions the auditors should have taken.
b. Based upon the information provided, identify the threats to independence and evaluate the impact of those threats on the auditors' professional judgment and skepticism.
c. For those independence threats that you identified, recommend appropriate safeguards that would have mitigated the threat.