Knapp Case 1.8

Red Flags: the Inventory turnover rate steadily declines from 1984-87, which could indicate, lost sales. Misstatements of inventory or cost of goods sold could be possible.
It also indicates employee strikes or, in Crazy Eddies’ case, employees leaving their jobs. In 1986 the A/R turnover rate was extremely high which is unusual because in that year the consumer electronics industry boom days had ended. Competition in the New York area was high. Inventory turnover rates had been decreasing. Extremely high A/R turnover rates are and indicator of credit and collection policies that are too restrictive.
Accounting irregularities could have been found sooner if some audit procedures were performed.

Falsification of inventory count sheets: This could have been prevented if the auditors were observing random cycle counts, if the auditors randomly performed cycle count audits, or if the auditors observed an entire physical inventory.

Bogus debit memos for accounts payable: The auditors could have confirmed balances with the debtor.
Recording transshipping transactions as retail sales: Observe flow of transactions for recording a transshipping sale. Audit the receipts of very large sales since transshipping sales are going to be very high in ollar amount.
Inclusion of consigned merchandise in year-end inventory: Auditors could have observed an entire year end physical inventory in all warehouses and not just a specific one that they tell the client they are going to.

Retail electronic stores changed drastically during the 1980’s, so did Crazy Eddie’s business. A factor in the Crazy Eddie case had to do with the inventory being overvalued. A small reason for why the inventory was overvalued is due to the rapidly decreasing prices in electronics due to constant improvements in technology.
Electronics are out dated very fast if not sold upon arrival, they are always being improved on, and so electronic stores need to have a high inventory turnover. If not, then there is a chance that the inventory can become overvalued if the auditor does not stay up on the latest in electronics. Another change was with how Crazy Eddie was able to buy in such large amounts that he was able to sell via drop-shipments, this is something that the auditors are not used to because it is not a common occurrence.
The drop-shipments would affect sales, but it should not affect inventory. As seen in this case, it required special attention because same store sales were increased by the way drop-shipments were recorded as revenue. All in all, if an industry is rapidly changing then so should the plan for the audit. It is very important to know how the industry is doing so it can be compared to the company that is being audited.

The term lowballing is when the auditors sell the audit services very cheap in order to get very lucrative consulting deals with the client.
This can jeopardize the truthfulness of the audit because the auditors may have to agree with the client on something that will affect the audit opinion in order to keep the client on their good side so they can keep the client as a consulting customer also.
Locating only 20 of the 30 invoices requested is a major problem. I would first see if the invoices were tied to another form like a sales order. If those can be located, then we can see if the 10 missing invoices had something similar on the sales order.

Another action that should be taken is to have the auditor observe an entire transaction from start to finish seeing why an invoice may get lost. If there is no good reason, then there is a very high likelihood that there is fraud involved. Other information will still need to be obtained; getting it from the information system may be a possibility. This issue should be discussed further with management since it is likely that the person who prepares the invoices or files the invoices is very low on the staff.
This article was written before the accounting laws were changed because of problems encountered by ex-auditors working at the client, and having connections with the new auditors. This caused many problems exemplified by Enron and WorldCom. That is why it is no longer allowed to take a job with the client. I agree with the law at present, based on the fact that before the law was present, major fraud occurred that could’ve been prevented had hiring their old auditors been illegal and of course many other things, but it is still helpful in prevention.
The only pro I can think of is the fact that the independent auditor would know a lot about the business and possibly help improve information systems and such. However, that is only if they are being hired for that certain job. That brings to the cons, which could be the auditor could help with hiding fraud since they know how to look for it in that specific company. Also, they are still in connection with their old firm and that could bring problems when the new independent auditor comes in.

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