Happy music sells musical instruments and related supplies in college towns throughout the U.S. S3’s auditor is your employer, Tilden and Li, which has historically issued unqualified opinions on S3’s financial reports. Your group is part of the team for this year’s S3 audit, and you are currently in the middle of fieldwork in January 2018. Selected financial data for S3 is:

	2014	2015	2016	2017 (prelim.)
Sales revenue:	$300,000,000	$360,000,000	$420,000,000	$370,000,000
Credit sales	100%	100%	90%	80%
Web-based sales	0%	0%	10%	20%
Accounts receivable	$42,000,000	$53,000,000	$48,000,000	$67,000,000
Allowance for doubtful accounts	$4,150,000	$5,000,000	$4,300,000	$12,770,000
Allowance as a percentage of accounts receivable	9.88%	9.43%	8.96%	19.06%
Total assets	$200,000,000	$250,000,000	$300,000,000	$320,000,000
Income before taxes	$10,000,000	$12,000,000	$15,000,000	$10,600,000

Note that 2017’s results are not fully audited yet (of course). Your team’s audit manager set the materiality level for the S3 engagement at 6% of income before taxes, or $636,000.

S3’s controller performed an analysis for the allowance for doubtful accounts (see the Excel file in Canvas) using input from the credit manager. Based on this analysis, the controller estimated the ending allowance balance at $12.77 million, a significant increase from 2016’s ending balance. The controller and CFO know that your team must examine the analysis as part of the audit. In an interview with the team, the CFO told you that she believes the allowance is over-stated, given that sales revenue is down by about 12% from 2016. She tells you that the new credit manager’s compensation depends, in part, on his ability to reduce receivable write-offs starting in 2018, which she believes further justifies her concern.

The aging in the Excel file shows the number of days the receivables have been outstanding since S3 shipped product to the customers. (For example, a 30-day-old receivable as of 12/31/2017 indicates that S3 shipped the product 30 days before year-end and the customer has not yet paid for the shipment). The CFO also stated during the interview that S3’s debt covenants require, among other things, that S3 earn yearly income before taxes of at least $10 million.

Your team inquires of other S3 personnel and documents the following items.

An economic recession contributed to the sales revenue decline in 2017. To increase sales, S3 extended more generous credit terms to its customers. Beginning with shipments in the fourth quarter of 2017, S3 extended credit terms from net 30 days to net 60 days. As a result, S3’s measure of days’ sales outstanding has increased from about 44 in 2016 to about 57 in 2017.

In 2016, S3 began to sell directly to consumers using the Web. Web-based sales have little credit risk, as credit card companies must approve the charges before S3 ships the product. Customers settle these sales in fewer than 30 days. The receivables balances for Web-based sales were $3.0 million and $6.0 million at the end of 2016 and 2017, respectively.

The controller estimates the allowance based on general expectations and historical losses for most accounts. Customers’ average credit score in 2017 is essentially unchanged from prior years. Except for a few large balances, receivables are due from small, homogenous customers. S3 personnel perform a more detailed account analysis for customers with balances higher than $500,000. Allowance estimates slightly under-estimated the actual write-offs in 2014 and 2015, and slightly over-estimated them in 2016. See the allowance analysis for details.

About 22.4% of the accounts receivable balance on December 31, 2017, is over 90 days old.

Based on a team discussion with S3’s Senior Vice President of Sales, the following is a summary of customer receivables with balances over $500,000.

Most of Workout World’s (WW) ending accounts receivable balance from 2016 remains outstanding at December 31, 2017; the 2017 balance is $3.0 million. Earlier in the year, WW management agreed to reduce its balance using payments of $200,000 per month starting in August 2017. WW made the first three monthly payments, but S3 has not received the next three payments (due in November and December of 2017, and January of 2018). WW management has not returned the credit manager’s phone calls. On December 31, 2016, the entire balance was 31 to 60 days old, and was included in the allowance using the same general percentage as other receivables in this aging category.

A new customer in 2016, Fit Fiends Inc. (FF) has always paid its amounts due after selling the product to consumers. On December 31, 2017, its outstanding balance is $10.0 million. Of this, $3.0 million is over 120 days old; $2.0 million is 91 to 120 days old; and $5.0 million is 31 to 60 days old. S3 continues to receive payments from FF and all amounts over 120 days old on December 31, 2017 were collected in January 2018. On December 31, 2016, the outstanding balance was $4.0 million; $500,000 was over 120 days old, $500,000 was 91 to 120 days old, $2.0 million was 31 to 60 days old and $1.0 million was 0 to 30 days old. S3 made no allowance for FF’s receivables in 2016, and S3 collected all of these amounts in 2017.

New Wave Beats (NWB) has an outstanding balance of $5.0 million on December 31, 2017. Of this, $1.0 million is over 120 days old, $1.5 million is 91 to120 days old, and $2.5 million is 61 to 90 days old. This company was a new start-up in 2017, so S3 does not have a reliable credit history for it. S3 has put a hold on new shipments to NWB until it receives payment of its balance. The credit manager has heard rumors that the company might declare bankruptcy. In December 2017, the Senior VP of Sales spoke to the wealthy, sole owner of NWB, who personally assured him that NWB intended to pay its outstanding balance in the coming weeks. In January 2018, the Senior VP of Sales obtained a written personal guarantee of the amounts owed from the owner of NWB. The personal financial statements of the owner show he has a net worth in excess of $20.0 million.

Long Horizon Outlet Stores (Long Horizon) has a balance of $1.0 million on December 31, 2017. Of this, $500,000 is 61 to 90 days old and the rest is 31 to 60 days old. Long Horizon’s owners have just placed another company they own in a troubled industry into bankruptcy.

None of the remaining customer balances is greater than $500,000 on December 31, 2017.

On December 31, 2016, the only two customers with balances over $500,000 were Workout World and Fit Fiends. Prior to 2016, the company did not have any customers with a balance greater than $500,000 at year-end.

Case Requirements

Your team must estimate an account-specific tolerable misstatement (error) level for the 2017 audit of accounts receivable. In a Word file, make this estimate, based on both the evidence provided above and the Excel file provided by the controller. Explain fully your team’s choice of tolerable misstatement level, discussing the risk factors that you considered to make the choice.

Assume your team conducted a confirmation test of the accounts receivable account and you found no exceptions. Perform an assessment of S3’s allowance for doubtful accounts as of December 31, 2017, using all of the information your team has gathered (documented in this handout and in the Excel file). Use a formal Excel-based re-performance analysis to support your team’s calculations. Estimate a range of acceptable allowance balances using this analysis. Feel free to use the controller’s allowance analysis as a starting point for your team’s own analysis. In the same Word file, document your team’s analysis procedures.

In the same Word file, make an overall judgment as to the quality of the controller’s estimate. Does your team believe the allowance balance is misstated? If not, why not? If so, by how much do you believe it is misstated; is it a material misstatement? Explain your judgment fully.

Make sure that your documentation:

Is sufficient to support your judgment; and

Is clear enough so another professional can understand how you reached your conclusion.

Attached:

Schnitzelmuzic Supply Store
Accounts receivable allowance analysis
As of 12/31/2017
			Days outstanding
	0 to 30 days	31 to 60 days	61 to 90 days	91 to 120 days	Over 120 days	Total
2014 accounts receivable balance	$ 30,000,000	$ 4,000,000	$ 2,500,000	$ 4,000,000	$ 1,500,000	$ 42,000,000
Aging percentage	71.43%	9.52%	5.95%	9.52%	3.57%	100%
Estimated uncollectible balances	$ 1,200,000	$ 400,000	$ 550,000	$ 800,000	$ 1,200,000	$ 4,150,000
Estimated uncollectible percentage	4.00%	10.00%	22.00%	20.00%	80.00%	9.88%
Actual write-offs in 2015						$ 4,200,000
Actual write-off percentage						10.00%
2015 accounts receivable balance	$ 35,000,000	$ 10,000,000	$ 3,000,000	$ 1,000,000	$ 4,000,000	$ 53,000,000
Aging percentage	66.04%	18.87%	5.66%	1.89%	7.55%	100%
Estimated uncollectible balances	$ 700,000	$ 800,000	$ 900,000	$ 400,000	$ 2,200,000	$ 5,000,000
Estimated uncollectible percentage	2.00%	8.00%	30.00%	40.00%	55.00%	9.43%
Actual write-offs in 2016						$ 5,100,000
Actual write-off percentage						9.62%
2016 accounts receivable balance	$ 30,000,000	$ 8,000,000	$ 4,000,000	$ 2,000,000	$ 4,000,000	$ 48,000,000
Aging percentage	62.50%	16.67%	8.33%	4.17%	8.33%	100%
Estimated uncollectible balances	$ 300,000	$ 600,000	$ 800,000	$ 800,000	$ 1,800,000	$ 4,300,000
Estimated uncollectible percentage	1.00%	7.50%	20.00%	40.00%	45.00%	8.96%
Actual write-offs in 2017						$ 4,200,000
Actual write-off percentage						8.75%
2017 accounts receivable balance	$ 15,000,000	$ 27,000,000	$ 10,000,000	$ 5,000,000	$ 10,000,000	$ 67,000,000
Aging percentage	22.39%	40.30%	14.93%	7.46%	14.93%	100%
Estimated uncollectible balances	$ 375,000	$ 2,295,000	$ 2,500,000	$ 1,600,000	$ 6,000,000	$ 12,770,000
Estimated uncollectible percentage	2.50%	8.50%	25.00%	32.00%	60.00%	19.06%

Answer rating: 100% (QA)

Estimation of Tolerable Misstatement Level for Accounts Receivable To estimate the accountspecific tolerable misstatement level for the 2017 audit of accounts receivable we need to consider the materi... View the full answer