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Illustrative Audit Case: Keystone Computers & Networks, Inc. Part I: Audit Planning

The Keystone Computers & Networks, Inc. (KCN) case is used throughout the text to illustrate audit procedures and methodology. KCN is a company that sells and installs computer workstations and networking software to business customers. The CPA firm of Adams, Barnes & Co. has audited the financial statements of KCN for the past three years. This part of the case illustrates selective audit planning working papers prepared by the staff of Adams, Barnes & Co. for this year's audit. You should read through the information to obtain an understanding of the nature of the information that is important to planning an audit engagement. The working papers include:

• The balance sheet and income statement for the company for the prior year, 20X4.

• A trial balance for 12/31/X5, with comparative amounts for 12/31/X4.

Page 241

• The analytical ratios working paper, partially completed. (The ratios for 20X5 have been left off.)

• The overall audit strategy for the audit of the financial statements for the year ended 12/31/X5.

• A fraud risk assessment.

• The engagement letter for the audit, presented inFigure 6.2(pages 196?197) of this chapter.

Page 242 Page 243 Page 244

KEYSTONE COMPUTERS & NETWORKS, INC.

Audit Strategy

December 31, 20X5

Date

Prepared by: Warren Love (Senior) August 14, 20X5 Reviewed by: Karen West (Manager) August 28, 20X5 Reviewed by: Charles Adams (Partner) September 5, 20X5 Page 244 OVERALL AUDIT STRATEGY OBJECTIVES OF THE ENGAGEMENT

Audit of the financial statements of Keystone Computers & Networks, Inc. (KCN), for the year ended December 31, 20X5. Also, the company's debt agreement with Western Financial Services requires the company to furnish the lender a report by our firm on KCN's compliance with various restrictive debt covenants.

BUSINESS AND INDUSTRY CONDITIONS

KCN sells and installs computers and networking hardware and software to business customers and provides other information technology consulting services. KCN also has begun developing its own computer networking software to be sold as a product to its customers. The company's primary competitive strategy is to maintain a high level of technical expertise and a broad range of services.

KCN's long-term success is contingent on its ability to attract and retain qualified information technology personnel. The market for such individuals is very competitive. However, the company has a competitive advantage because of its desirable geographic location (Phoenix), which has a large number of colleges with technology programs.

The market for computers and related products is extremely competitive. KCN competes with large retailers of computers, such as Dell, Hewlett Packard, and Apple. The company also competes with other value-added resellers who provide computers and software products and consulting services directly to customers. To effectively compete, the company must be able to obtain inventories of state-of-the-art equipment on a timely basis. Because the company does not have the buying power of some of its other competitors, it generally must charge a higher price for its products. Its customers are willing to pay the higher price because of the high level of expertise and service that the company provides.

The market for computer products and technology services is also very sensitive to economic conditions. Recent reports indicate that the U.S. economy will be challenged for the next few years. The annual growth in spending for information technology products and services is expected to be 3 percent per year for the next three years. In the past year, the company has decided to increase sales by extending credit to clients with slightly higher credit risk.

Page 245 PLANNING MEETINGS

On July 20, Karen West and I met with Loren Steele, controller, and Sam Best, president, of KCN to discuss the planning of the audit for the current year. On August 2, a planning meeting was held in our office with all members of the engagement team assigned to the audit.

OWNERSHIP AND MANAGEMENT

KCN is a closely held company owned by five stockholders: Terry Keystone, Mark Keystone, John Keystone, Keith Young, and Rita Young. Terry and Mark Keystone are active members of the company's board of directors. None of the other owners take an active part in the management of the business.

OBJECTIVES, STRATEGIES, AND BUSINESS RISKS

KCN's primary business objectives are to increase revenues by 6 percent and increase net income by 8 percent each year for the next three years. Major strategies to achieve those objectives include:

• Aggressive marketing of products and services through increased advertising.

• Sales to customers with a higher credit risk profile.

• New software development.

  The primary business risks associated with the company's strategies include:

• The U.S. economy may suffer on additional significant downturn.

• Competitors may engage in predatory pricing to gain market share.

• Increased advertising expenditures may not produce desired results.

• Credit losses may exceed the benefits of increased sales.

• Software development activities may not generate viable products.

  The company has developed the following responses to these risks:

• Careful monitoring of economy and industry conditions.

• Careful monitoring of competitor actions.

• Hiring of marketing consulting firm to evaluate the performance of advertising methods.

• Daily review of aging of accounts receivable by Loren Steele, controller.

• Use of carefully controlled software development budget.

MEASUREMENT AND REVIEW OF FINANCIAL PERFORMANCE

Management uses the following measures to monitor the company's performance:

• Inventory and receivables turnover.

• Aging of accounts receivable.

• Sales and gross margins by type of revenue.

• Net income.

• Total inventory balance.

PROCEDURES TO OBTAIN AN UNDERSTANDING OF THE CLIENT AND ITS ENVIRONMENT

The following procedures were performed to update our understanding of the client and its environment:

• Roll forward of information from the prior year's audit.

• Inquiries of management:

  Loren Steele	7/20, 8/15
  Sam Best	7/20, 8/16

• Reading of quarterly board of directors' meetings held on 4/05 and 7/12.

• Review of monthly performance reports for January through July.

• Industry reports?IT and consulting services.

• Review of KCN's website.

• Review of selected articles inThe Wall Street Journal.

Page 246 SIGNIFICANT RISKS

Several significant risks were noted as a result of obtaining information about KCN and its environment, including:

Risk	Implications and Response
1. KCN has engaged in a strategy to sell to customers with higher credit risk.
2. The officers of the company receive significant bonuses based on quarterly results.

SIGNIFICANT ACCOUNTING AND AUDITING MATTERS

The company began offering for sale extended warranties on computers during the current year. We need to review the method of revenue recognition to determine whether it complies with the requirements ofFASB ASC605-20-25.

In the prior year, KCN began developing networking software products for sale. This year the company has started capitalizing certain costs of development. We need to review the method of accounting for the cost of software development to determine whether it complies with the requirements ofFASB ASC985-20-25.

In 20X3, KCN acquired for $1,200,000 a small business accounting system (Plumbtree Systems) that it licenses to its customers. Recently, sales of the licenses for the software have begun to decline. In addition, a recent article in a trade journal ranked the system poor in relation to its competitors. This may indicate that an impairment in the value of the software may have occurred.

PLANNING MATERIALITY

Because the firm has experienced steady growth in sales and earnings over the last three years, we believe that operating results are the most appropriate basis for estimating planning materiality as described below:

Comparison of BasesFinancial Statement BaseAnnualized for 12/31/X5

Sales $92,000,000 Total assets 13,000,000 Pretax net income 320,000 Computation of Planning Materiality Base Amount Percentage Materiality Estimate Sales $92,000,000 1% $920,000 Total assets 13,000,000 1 130,000 Pretax net income 320,000 10 32,000

The range for planning materiality is from $32,000 to $920,000. Based on the company's steady growth in sales and earnings and the fact that the company is not a public company, we have selected $300,000 as a reasonable materiality amount for planning purposes.

SCHEDULING AND STAFFING PLAN

Based on discussions with Ms. Steele, the following are tentative dates of importance for the audit:

Begin interim audit work	October 15, 20X5
Complete interim audit work	by November 15, 20X5
Issue management letter on interim work	by November 30, 20X5
Observe physical inventory	December 31, 20X5
Begin year-end audit work	February 1, 20X6
Complete fieldwork	by February 20, 20X6
Closing conference	February 25, 20X6
Issue audit report	by March 5, 20X6
Issue letter required by financing agreement	by March 5, 20X6
Issue updated management letter	by March 10, 20X6

Staffing time requirements for the engagement are described below:

AssistantSeniorManagerPartnerTotal

Interim 40 40 10 8 98 Final 40 30 15 12 97 80 70 25 20 195 Fraud Risk Assessment Client:Keystone Computers & Networks, Inc.

G-10

CA

CA 8/14/X5

Financial Statement Date:12/31/X5ProcedurePerformed byComments

1. Consider the results of the discussion among engagement personnel about the risk of material misstatement due to fraud.

2. Consider results of inquiries of management about the risks of fraud and how they are addressed.

3. Consider the results of risk assessment analytical procedures.

4. Consider the existence of fraud risk factors listed on G-30 through G-35.

5. Consider any other information that might be relevant to the risk of material misstatement due to fraud.

CA

CA

CA

CA

CA

See G-21 for a descriptionof the discussion.

Risks of Material Misstatement Due to Fraud

Management may be motivated to misstate financial results due to impending sale of the company.

Responses

Overall Responses

Risks were considered in staffing the engagement and determining the appropriate level of supervision.

Alterations of the Nature, Timing, and Extent of Further Audit ProceduresRisks were considered in designing audit procedures for sales and accounts receivable and inventories. (See R-6 and R-9.)

Procedures were performed to address the risk of management override of internal controls. (See G-23?G-24.)

Appendix 6C Problems 6C-1. Planning information for the audit of Keystone Computers & Networks, Inc., appears on pages 240-247. Review each major section of the audit plan and briefly describe the purpose and content of the section. Organize your solution in the following manner: LO 6-3 Section Purpose Content Objectives of the engagement To describe the services that are to be rendered to the client. The objectives are (1) audit of KCN's financial statements for the year ended 12/31/X5, and (2) issuance of a letter on compliance with covenants of the client's letter of credit agreement. LO 6-3, 4 6C-2. In the overall audit strategy for the audit of Keystone Computers & Networks, Inc., on page 246 there is a section on significant risks. For each of the risks, identify the implications and potential responses. LO 6-7 6C-3. In the overall audit strategy for the audit of Keystone Computers & Networks, Inc., on page 246 there is a section on significant accounting and auditing matters. The second matter described involves capitalizing the costs of developing a software program for sale. Required: a. Research this issue and write a brief memorandum for the working papers describing the issue and summarizing the appropriate method of accounting for the development costs. a. Based on your research, describe the major audit issue that you believe will be involved in auditing the software development costs. LO 6-3, 4 Page 248 6C-4. A partially completed analytical ratios working paper for Keystone Computers & Networks, Inc., is presented on page 244. Required: a. Complete the working paper by computing the financial ratios for 20X5. a. After completing part (a), review the ratios and identify financial statement accounts that should be investigated because the related ratios are not comparable to prior-year ratios, industry averages, or your knowledge of the company. a. For each account identified in part (b), list potential reasons for the unexpected account balances and related ratios