You are about to begin the audit of circuits technology Inc. For the year ended December 31, 2002.circuits technology inc. (CTI), resells, installs, and provides computer networking products (client software, gateway hardware and software, and twin ax hardware) to other businesses. Jessica freeman founded the business in the late 1980s and grew the businesses to a stable and profitable enterprise in a major metropolitan area. Jessica owns 60 percent of business, and four other shareholders (a brother, a sister, her father, and a friend) own 10 percent each. The minority shareholders contributed capital to the company when it was getting started, and the owners make up the board of directors. They usually meet only once a year to discuss dividends to be declared. During the rest of the year, the minority owners leave the day to day management decisions to Jessica as she also has controlling interest in the company.

The business grew rapidly during the 1990s. In 1999, near the end of the company's growth stage, Jessica was approached about merging the business with a larger company, but she decided that she did not want to merge the company, even if it meant limiting the growth of the business. CTI was her baby. Jessica enjoyed being CEO, she knew the business inside and out, and she did not want to be subordinate to someone else. The business was organized as a Subchapter S Corporation, and it was distributing a nice return to shareholders, so family members and friends were happy with her decisions. Jessica had her fingers in every aspect of the business, and she was boss.

Question 16-24 provides a history of CTI’s last five years’ financial history. CTI was a solid performing business up until 2001. Then the entire industry slowed down. All the demand that had been generated by the Y2K issues had been met, and the steady business and cash flow did not come as easily. Jessica and her sales staff had to hard work harder to close deals, and the industry became more competitive.

Rob Kaiser, the CFO, began complaining about Jessica’s increasing intrusion in the company’s finances in the late 2000. During the period of steady performance, he and Jessica met quarterly to discuss the company’s performance and finances. They would go over the entity’s operating performance, its investing activities, and cash management, and the primary focus of attentions was the annual distributions between Rob and Jessica over the monthly financial statements. Jessica knew the business and sometimes would not accept his explanations for draft financial statements that showed performance falling below Jessica’s expectations. She had built the business, was involved in the key decisions, and knew what profit margins should result. For example, gross margins should not fall below 52 percent as they did in 2000. In her view this was due to problems in the accounting system.

In some cases, Jessica was correct. Accounting was not high priority. The first priority had to be sales and customer satisfaction. Jessica swallowed hard when she had to hire rob, but it was clear that it would be more cost effective to hire someone In house to manage finances than to subcontract to a CPA firm. However, accounting never had a significant budget. It could invest in technology and software, but it was always several people short of full staffing for the accounting system. Bob and his two salaried employees were cross trained on most aspects of the accounting system, and everyone worked long hours. As a result, error happened. The previous audit surface problems in the purchasing cycle, and some vendor’s invoices had been paid twice. These problems usually surrounded rush purchases for the clients where the vendor was asking for insignificant upfront payments. The audit also noted some cutoff problems in sales and purchases, and proposed an audit adjustment to the allowance for doubtful accounts. In rob’s opinion, this was the result of his department being stretched too thin.

In recent years, Jessica has paid considerable attention to the financial performance in the last two quarters of the year. Her major concern has focused on the company’s profitability and ability to pay shareholder distributions. During the year end close last year, Jessica was stopping by rob’s office daily to ask about the journal entries that were being made that day and their impact of earnings. This just added to the pressure on rob to ‘get the job done’.

Rob was also concerned about managing the relationship with First State Bank. Over the years the business relationship changed from one where CTI had significant deposits with First State Bank and used occasional seasonal borrowing to one where the line of credit has not been retired in the last 18 months. First State Bank, which had previously been satisfied with reviewed financial statements, now would like to have audited financial statements. This is another cost that Jessica and rob don’t want, but there have no choice. Furthermore, First State Bank established the following debt covenants.

-Dividends are restricted to 90 percents of net income.

-CTI must keep a minimum current ratio of 2.50: 1

-CTI’s debt to equity ratio cannot exceed 1.00: 1

Rob kept tight control on cash. Independent bank reconciliation was performed monthly. Furthermore, bob closely tracked when vendor payments were due. With the exception of 1999, he had been able to keep the accounts payable turn days somewhere between 30 and 38 days. Rob would liked to collect receivables faster, but the nature of the company’s service, which involved installation of hardware and software to the customer’s satisfaction, resulted in collection periods approaching 90 days. The company did not rely on programmed control procedures to monitor individual transactions. CTI did not have the staff to follow up on exception reports that might be generated by the accounting system. The primary controls in place involved rob’s independent review of transactions on a monthly basis. In addition, Jessica kept a close eye on revenues, expenses, and profit margins, and she demanded explanations from Rob when actual results deviated from her exceptions.

Required:

1. Evaluate the effectiveness of the CTI’s control environment.

2. Analytical procedures: purchases, gross margin, inventory turn days, account receivable turn over days, Account Payable turn over days

3. Assess risk at the financial statement level.

a. Evaluate inherent risk at the financial statement level.

a. Evaluate the risk of fraud. Specifically consider each aspect of the fraud triangle; (1) incentives and pressures, (2) opportunity, and (3) attitudes and rationalization.

4. What is the potential for the effectiveness of the management performance reviews performed by Rob and Jessica with respect to the following assertions?

a. Existence of inventory

b. Valuation of inventory and cost of sales

5. Prepare a letter with any internal control recommendations that you have for management. Each specific recommendation should describe the current system, explain the risk involved, and make specific recommendations for improvement. You may assume that issues have already been discussed with management regarding the audit adjustments found in prior audits, so focus your attention on the other issues that are of concern to you.

Answer rating: 100% (QA)

A The control environment reflects the values of an organizationthe atmosphere in which people conduct their activities and carry out their control responsibilities An effective control environment is ... View the full answer