TO:
2006 Acme Audit Workpapers
FROM:
Vien Wong
DATE:
February 18, 2016
SUBJECT:
Acme Audit Planning Engagement
Introduction
The firm enters into an audit engagement with Acme Industries, Inc. to identify planning
issues. We will conduct analytical procedures on Acme’s financial statements to identify
key accounts that are subject to financial risks. Then we will address any potential risks
arising from Acme’s accounting, reporting, management, industry, and controls. We will
take all these potential risks into consideration and estimate materiality.
Potential Financial Risk Areas
We have identified key accounts that show potential financial risks based on the analytical
procedures we performed on the 2005 financial statements of Acme Industries, Inc.
According to workpaper PL1, inventory, machinery & equipment, other assets, and
accounts payable are elevated risks accounts. These accounts show respective
percentage changes of 172.5%, 66.6%, 96.7%, and 571.8%.
In addition, the cost of goods sold to inventory, working capital to total assets, debt to
equity, return on assets, return on equity, sales to inventory, and sales to working capital
ratios all show a significant ratio change compared to prior years in workpaper PL2. The
cost of goods sold to inventory ratio demonstrated the most significant ratio change. The
cost of goods sold to inventory ratio decreased from 39.7 times in 2004 to 16.1 times in
2005. This ratio indicates that Acme has more inventories on hand and the inventory
turnover is slower then previous years. Acme entered into a legally binding long-term raw
materials delivery contract. Management believes that higher prices will occur in the next
few years and that the long-term commitment was necessary and prudent.
Potential Accounting and Reporting Risk
Acme uses the direct charge-off method of accounting for bad debts because most of the
sales are currently generated by buyers’ conventions, and in the past there have been
negligible charge-offs. Other companies in the industry use the allowance method to
2006 Acme Audit Workpapers
February 18, 2016
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account for bad debt. This may affect the analysis of Acme’s financials to others in the
industry due to varying accounting methods. Acme treats leases on the building and the
computer equipment as operating leases.
The financial statements and related reports are generated internally from a trial
balance of the general ledger. Our team toured the accounting area that processes cost
reports from the manufacturing departments, maintains the general ledger, and performs
other reporting functions such as the preparation of financial statements and reports for
management. A potential risk is that that the accounting department does not segregate
the authorization, custody, recording, and reconciliation duties. As a result, possible fraud
or misstatement is more likely to occur if the same person is completing all the accounting
and reporting duties.
Management and Industry Risk Areas
The compensation for managers has recently changed to emphasize financial
performance targets. A few of their managers are eager to take the company public and
do not agree with the current conservative accounting policies. Acme’s aggressive
managers and compensation policy may influence Acme’s ethical and behavioral
standards, leading to a heightened risk of personnel engaging in illegal or unethical acts.
We identified Acme’s success as attributable to one of the best designers in the industry
currently employed by Acme. Hence, Acme would face decreased sales and revenue if
this well known designer leaves the company. A second factor that would increase
industry risks is Acme’s inability to capture more market share due to Stitson Company,
who have a 60 percent of the market and is the most recognized brand in the industry.
The demand for western hats, Acme’s target market, is inconsistent. All of these factors
we identified above increase Acme’s industry risk.
Control Risks
Acme has internal control procedures documented in an accounting manual and are
updated periodically. Acme reports to the board of directors concerning the accounting
and control functions. Wiggins, president and chairman of the board of Acme, indicates
that an internal auditor is not needed since their internal controls are flawless, and a
harmonious relationship exists with the Board of Directors. He says it will not add to the
level of corporate governance. The harmonious relationship between the Board of
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February 18, 2016
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Directors and managements may impair the independence between the two parties. In
addition, Wiggins’ attitude towards financial reporting and information processing weakens
the control environment.
We are concerned with asset misappropriation and the careless attitude toward physical
security over inventory. Acme’s inability to set controls on their inventory creates the
opportunity of theft, in turn weakening the company’s ethical standards.
Wiggins hires employees informally based on his personal instincts. The quality of control
is weakened at Acme by their quality of personnel operating the systems. The personnel
hired by Wiggins were not hired through sound and standard hiring processes. In addition,
Wiggin’s use of instincts versus criteria to hire doesn’t demonstrate the level of
competence the employees have for their job titles. These human resource policies show
Acme’s lack of commitment to hire competent and trustworthy individuals. These
circumstances may increase errors in accounting systems and financial misstatements
with Acme’s personnel.
Materiality
We would set materiality low based on quantitave factors identified in workpapers PL1 and
PL2. Some qualitative factors that influenced the materiality are the control weaknesses of
Acme, the high fraud pressures to meet compensation goals, and the high market
pressure of Acme’s industry. Acme’s high fraud risks are attributable to the compensation
goals in place. These goals make inflating financial performances more appealing to
managers; therefore increasing fraud pressures. In addition, the manager’s lucrative view
of state and federal regulations increases the likelihood that fraud will occur. Acme’s
managers are eager for the company to IPO and do not agree with the conservative
accounting principles. Their eagerness to IPO increases fraud pressure since managers
are more willing to tiptoe around the current accounting principals.
We usually use 3-5% of pretax income as a benchmark in setting materiality; upon
analyzing Acme we decided to set materiality closer to the 3% to sample more items.
Hence, materiality is set at $12,000.