Discussion on Audit Evidence

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Case Study
Chapter 7 – Audit Evidence
ABC Stores is a large discount catalog department store chain. The company has recently
expanded from 8 to 60 stores by borrowing from several large financial institutions and from a public
offering of common stock. A recent investigation has disclosed that ABC materially overstated net
income. This was accomplished by understating accounts payable and recording fictitious supplier
credits that further reduced accounts payable. An SEC investigation was critical of the evidence
gathered by ABC’s audit firm, John & Peter, in testing accounts payable and the supplier credits.
The following is a description of some of the fictitious supplier credits and unrecorded amounts in
accounts payable, as well as the audit procedures.
1. Banana Advertising Credits—ABC had arrangements with some vendors to share the cost of
advertising the vendor’s product. The arrangements were usually agreed to in advance by the
vendor and supported by evidence of the placing of the ad. ABC created a 115-page list of
approximately 1,100 vendors, supporting advertising credits of $300,000. ABC’s auditors
selected a sample of 5 of the 1,100 items for direct confirmation. One item was confirmed by
telephone, one traced to cash receipts, one to a vendor credit memo for part of the amount and
cash receipts for the rest, and one to a vendor credit memo. Two of the amounts confirmed
differed from the amount on the list, but the auditors did not seek an explanation for the
differences because the amounts were not material. The rest of the credits were tested by
selecting 20 items. Twelve of the items were supported by examining the ads placed, and eight
were supported by ABC debit memos charging the vendors for the promotional allowances.
2. Apple Credits – ABC created 28 fictitious credit memos totaling $257,000 from Apple
Distributors, the main supplier of health and beauty aids to ABC. ABC’s controller initially
told the auditor that the credits were for returned goods, then said they were a volume
discount, and finally stated they were a payment so that ABC would continue to use
Springbrook as a supplier. One of the John & Peter staff auditors concluded that a $257,000
payment to retain ABC’s business was too large to make economic sense. The credit memos
indicated that the credits were for damaged merchandise, volume rebates, and advertising
allowances. The audit firm requested a confirmation of the credits. In response, John Tom,
the president of ABC Stores, placed a call to Brown, the president of Apple, and handed the
phone to the staff auditor. In fact, the call had been placed to an officer of ABC. The ABC
officer, posing as Marry, orally confirmed the credits. ABC refused to allow John & Peter to
obtain written confirmations supporting the credits. Although the staff auditor doubted the
validity of the credits, the audit partner, Mark Jack, accepted the credits based on the credit
memoranda, telephone confirmation of the credits, and oral representations of ABC officers.
3. Orange Credits—$130,000 in credits based on 35 credit memoranda from Orange, Inc., were
purportedly for the return of overstocked goods from several ABC stores. A John & Peter
staff auditor noted the size of the credit and that the credit memos were dated subsequent to
year-end. He further noticed that a sentence on the credit memos from Orange had been
obliterated by a felt-tip marker. When held to the light, the accountant could read that the
marked-out sentence read, “Do not post until merchandise received.” The staff auditor
thereafter called Harold Orange, treasurer of Orange, Inc., and was informed that the $130,000
in goods had not been returned and the money was not owed to ABC by Orange. Marry
advised Jack, the audit partner, that he had talked to Harold Orange, who claimed he had been
misunderstood by the staff auditor. Marry told Jack not to have anyone call Ridolfi to verify
the amount because of pending litigation between ABC and Orange, Inc.
4. Accounts Payable Accrual – John & Peter assigned a senior with experience in the retail area
to audit accounts payable. Although ABC had poor internal control, John & Peter selected a
sample of 50 for confirmation of the several thousand vendors who did business with ABC.
27 responses were received, and 21 were reconciled to ABC’s records. These tests indicated
an unrecorded liability of approximately $290,000 when projected to the population of
accounts payable. However, the investigation disclosed that ABC’s president made telephone
calls to some suppliers who had received confirmation requests from John & Peter and told
them how to respond to the request. John & Peter also performed a purchases cutoff test by
vouching accounts payable invoices received for 9 weeks after year-end. The purpose of this
test was to identify invoices received after year-end that should have been recorded in
accounts payable. Thirty percent of the sample ($160,000) was found to relate to the prior
year, indicating a potential unrecorded liability of approximately $500,000. The audit firm
and ABC eventually agreed on an adjustment to increase accounts payable by $260,000.
Required
Identify deficiencies in the sufficiency and appropriateness of the evidence gathered in the audit of
accounts payable of ABC Stores.

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