1. Identify three to five accounts which should be investigated (select the ones which you believe present the greatest risk) and explain why you selected them.

2. Also indicate possible reasons for the unexpected account balances and related ratios.

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. The analytical ratios working paper, partially completed. 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 in Figure 6.2 @ of this chapter. FIGURE 6.2 Engagement Letter for Financial Statement Audit Letterhead Letterhead September 1, 20X5 Mr. Terry Keystone, Chairman of Board of Directors Keystone Computers & Networks, Inc. 14645 40th Street Phoenix, AZ 84280 Dear Mr. Keystone: Main content (The objective and scope of the auditi You have requested that we audit the financial statements of Keystone Computers & Networks, Inc., which comprise the balance sheet at December 31, 20X5, and the related statements of income, changes in stockholders' equity, and cash flows for the year then ended and the related notes to the financial statements. We are pleased to confirm our acceptance and our understanding of this audit engagement by means of this letter. Our audit will be conducted with the objective of our expressing an opinion on the financial statements, , The responsibilities of the auditor) We will conduct our audit in accordance with auditing standards generally accepted in the United States (GAAS). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on the auditor's judgment, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the overall presentation o of the financial statements. Because of the inherent limitations of an audit, together with the inherent limitations of internal control, there is an unavoidable risk that some material misstatements may not be detected, even though the audit is properly planned and performed in accordance with GAAS. In making our risk assessments, we consider internal control relevant to the entity's preparation of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity's internal control, However, we will communicate to you in writing concerning any significant deficiencies in internal control relevant to the audit of the financial statements that we have identified during the audit. (The responsibilities of management and identification of the applicable financial reporting fromework] Management is responsible for the preparation and fair presentation of these financial statements in accordance with accounting principles generally accepted in the United States of America; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of consolidated financial statements that are free from material misstatement, , whether due to fraud or error. Our audit will be conducted on the basis that management (and, where appropriate, those charged with governance) acknowledge and understand that they have responsibility: (a) (b) (c) For the preparation and fair presentation of the financial statements in accordance with accounting principles generally accepted in the United States. For such internal control as management determines is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error, and To provide us with: (0) Access to all information that management is aware is relevant to the preparation of the financial statements, such as records, documentation, and other matters; (1) Additional information that we may request from management for the purpose of the audit; and (iii) Unrestricted access to persons within the entity from whom we determine it necessary to obtain audit evidence. As part of our audit process, we will request from management [and, where appropriate, those charged with governance) written confirmation concerning representations made to us in connection with the audit. We look forward to full cooperation from your staff during our audit. [Insert other information, such as fee arrangements, billings, timing, and other specific terms, as appropriate.] [Reporting] The form and content of our report may need to be amended in the light of our audit findings. We will issue a written report upon completion of our audit of Keystone Computers & Networks, Inc.'s financial statements. Our report will be addressed to the board of directors. We cannot provide assurance that an unmodified opinion will be expressed. Circumstances may arise in which it is necessary for us to modify our opinion, add an emphasis-of-matter or other matter paragraph(s), or withdraw from the engagement. Please sign and return the attached copy of this letter to indicate your acknowledgment of, and agreement with, the arrangements for our audit of the financial statements including our respective responsibilities. Very truly yours, Charles Adams Charles Adams, CPA Acknowledged and agreed on behalf of Keystone Computers & Networks, Inc. by: [Signed, dated, and returned by client] KEYSTONE COMPUTERS & NETWORKS, INC. Balance Sheet December 31, 20X4 Assets Current Assets Cash Trade receivables, less allowance for doubtful accounts of $96.000 Accounts receivable officers Inventory Prepaid expenses Total current assets Equipment and leasehold improvements, at cost Equipment and furniture Leasehold improvements $ 53,964 8,438,524 57,643 1.234.589 156.900 $ 9,941.620 Less accumulated depreciation $ 1,090,634 98.900 $ 1,189,534 _(250,987) $ 938,547 $ 1.000.000 $11.880.167 Intangible assets net of amortization Liabilities and Stockholders' Equity Current Liabilities Line of credit Accounts payable Current maturities of capital lease obligations Accrued expenses Total current liabilities Capital lease obligations, less current maturities Total liabilities Stockholders' equity Common stock, $1 par value; 1,000,000 shares authorized; 200,000 shares issued and outstanding Additional paid-in capital Retained earnings $ 6,612,550 1,349,839 43,200 178,900 $ 8,184.489 $ 456.700 $ 8,641.189 $ 200.000 423,500 2.615.478 $11,880,167 KEYSTONE COMPUTERS & NETWORKS, INC. Statements of Income and Retained Earnings Year Ended December 31, 20X4 $96.459,566 74.122,435 $22,337,131 Nel sales Cost of goods sold Gross profit Selling expenses: Salaries Payroll benefits and taxes Advertising and promotion Travel and entertainment Miscellaneous $ 3,167,889 913,456 1,200,786 609.788 _334,890 $6,226,809 Main content Operating and administration expenses: Operating salaries Administrative salaries Payroll benefits and taxes Rent Utilities Insurance Legal and accounting Bad debt Supplies Depreciation and amortization Software development Miscellancous $ 4,878.900 4.234.234 1,812.344 797.800 19,800 210,495 356.8901 457,577 ** 234,500 556,345 334,565 289,100 234,556 S14,397,306 Total selling, operating, and administrative expenses Operating income Interest expense Income before income taxes Income taxes: Current Deferred $20,624,115 $ 1,713,016 421.344 $ 1.291,672 S 256,765 45.632 Net income Retained earnings, January 1, 20X4 Retained earnings. December 31, 20X4 302.397 $ 989,275 $ 1.626,203 $ 2.615,478 WZ Prepared by Reviewed by Page 1 Adjustments Dr (Cr) Adjusted Balance Dr (Cr) Ref # Inventories ories Prepaid expenses KEYSTONE COMPUTERS & NETWORKS, INC. Working Trial Balance For the Period Ended December 31, 20X5 Prior Period Unadjusted Account Name Balance 12/31/X4 Trial Balance Dr (Cr) Cash General Account 42.754 66,034 Cash-Special Account 9.960 10,150 Cash in Register 1.200 1,200 Petty Cash 50 50 Accounts receivable trade 8,534,524 10,235,457 Accounts receivable-officers " an 57,643 84,670 Allowance for bad debts ans (96,000) way (104.000) 1.234.589 1.375,835 . pad 156,900 176,456 Furniture & fixtures 300.980 344,900 789,654 974,676 Leasehold improvements 98.900 91.230 Accumulated depreciation (2.50.987) 001 (404.560) Software development cost 178,000 Intangible assets 1 1,1X10,000 800,000 Accounts payabletrade (1.349,839) (1.429,033) Capital lease obligations current *) (43,200) (45,675) Accrued liabilities (178,900) (203.450) Unearned service revenue (42.300) Line of credit (6.612.550) (8.632.105 Capital lease obligalions-noncurrent WWW.IS (456.700) (423.680) Capital stock (200.000) Paid-in capital (200,000) (423.500) (423.500) Retained earnings (1,626.203) (2.615.478) Dividends 415,000 989.275 229,877 19,89,275) (229,877 0 0 Account # 1000.10 1000.20 100X0.30 ... 1000.40 1050.10 1050.40 1050.90 w 1100.10 1300.10 2050.10 2050.30 2050.80 2050.90 2100.00 2200.00 3050.10 3100.00 3200.10 3300.30 3400.50 4400.10 5050.10 5100.10 5700.10 5900.00 Office equipment WL Prepared by Reviewed by Page 2 Adjustments Dr (Cr) Adjusted Balance Dr (Cr) Ref # Account # 6000.10 6010.10 (236,700) 6020.10 Cost of sales Salaries-operations .. 4.878,900 4.234.234 KEYSTONE COMPUTERS & NETWORKS, INC. Working Trial Balance For the Period Ended December 31, 20X5 Prior Period Unadjusted Balance Trial Balance Account Name 12/31/X4 Dr (Cr) Sales of computers (44,890,788) (42,345,675) Software licenses (248,900) Service revenue (4,567,888) (4,325,777) Consulting revenue ( ( (45,677,899) 74.122.435 72,134,566 Salaries-sales 3.167.889 2765.627 2,765,677 Payroll benefits-sules 012 se 85920 913.456 857,368 200 SCH Advertising & promotion 1,200,786 1,567,889 Travel & entertainment 60/9,788 445,600 Miscellancous esp-sales 224 334.8901 278,656 SA 4.544,860 Salaries administrative .. 2013 w Payroll 1,812.344 1,734,565 20 Rent 797.800 721,345 Utilities 210.495 234.839 Insurance 356,890 378,677 . I.cgal & accounting 457,577 485,767 DAD Bad debt expense 234,500 256,678 Supplies 556,345 478,900 Depreciation and amort. 334.565 367,867 Software development 289.100 345,645 Miscellaneous exp-administrative 234.556 245,456 Interest expense 421,344 476,899 Current income taxes 256,765 250,705 80,100 Deferred income taxes 45,632 9.150 P&L Summary 989,275 V (229.877) 0 229.877 0 0 3.945.670 10 6030.10 603010 7020.10 7070.10 20000 2020 7070.50 7075.10 2000 7080.10 7080.30 www 7090.10 7090.30 2000 7090.50 7100.10 7140.10 7200.10 7260.30 7320.10 7410.10 7600.10 7650.10 7700.10 7800.10 7900.10 7910.70 9000.00 Pevroll benefits-admin KEYSTONE COMPUTERS & NETWORKS, INC. Prepared by WL Reviewed by Analytical Review Ratios For the Period Ended December 31, 20X5 Ending 12/31/X5 Ending 12/31/X4 Industry Ratio Current ratio Days' sales in accounts receivable, computed with average accounts receivable 1.1 1.2 1.3 37.0 37.0 33.2 Allowance for doubtful accounts/accounts receivable 1.0% 1.1% 2.9 0.3% 3.5 1.7% 7.5% 9.0% Bad debt expenseet sales Total liabilitieset worth Return on total assets Return on net worth Return on net sales Gross profitet sales Selling, operating, and administrative expenseet sales Times interest earned 0.2% 2.7 8.3% 30.5% 1.0% 23.2% 21.4% 0.2% 22.1% 21.2% 1.7 29.0% 2.3% 24.0% 23.9% 5.5 4.1 KEYSTONE COMPUTERS & NETWORKS, INC. Audit Strategy December 31, 20X5 Date Prepared by: Reviewed by: Reviewed by: Warren Love (Senior) Karen West (Manager) Charles Adams (Partner) August 14, 20X5 August 28, 20X5 September 5, 20X5 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 corripany must be able to obtain inventories of state-of-the-art equipment on a timely basis. Because the company does not have the huying 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 scrvices 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 clicnts with slightly higher credit risk 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 live stuckholders: Terry Keystone. Murk 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 yeur ur the next three years. Mujur 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 a 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 reportsIT and consulting services. Review of KCN's website. Review of selected articles in The Wall Street Journal. SIGNIFICANT RISKS Several significant risks were noted as a result of obtaining information about KCN and its environment, including Implications and Response Risk 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 begat 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 of FASB ASC 606. 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 of FASB ASC 985-20-25. 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. MATERIALITY FOR PLANNING Because the firm has experienced steady growth in sales and eurnings over the last three years, we believe that operating results are the most appropriate basis for estimating materiality for planning as described below: Comparison of Bases Computation of Planning Materiality Base Financial Statement Base Sales Total assets Pretax net income Annualized for 12/31/15 $92.000.000 13,000,000 320,000 Sales Total assets Pretax net income Amount $92,000,000 13,000,000 320,000 Percentage 1% 1 1 10 Materiality Estimate S920.000 130.000 32.000 The range for matcriality for planning is from $32,000 to $9200,000. Based on the company's steady growth in sales and carnings and the fact that the company is not a public company, we have selected $300,000) as a reasonable materiality amount for planning purposes. Details on account and disclosure performance materiality and tolerable misstatement amounts are provided in the related detailed documentation. SCHEDULING AND STAFFING PLAN Based on discussions with Ms. Steele, the following are tentative dates of importance for the audit: Begin interim audit work Complete interim audit work Issue management letter on interim work Observe physical inventory Begin year-end audit work Complete fieldwork Closing conference Issue audit report Issue letter required by financing agreement Issue updated management letter October 15, 20X5 by November 15, 20X5 by November 30, 20X5 December 31, 20X5 February 1, 20X6 by February 20, 20X6 February 25, 20X6 by March 5, 20X6 by March 5, 20X6 by March 10, 20X6 Staffing time requirements for the engagement are described below: Assistant Senior Partner Total Interim 40 40 Manager 10 15 8 98 Final 40 30 97 12 20 80 70 25 195 Fraud Risk Assessment G-10 CA CA 8/14/X5 Performed by Comments CA See G-21 for a description of the discussion. Client:Keystone Computers & Networks, Inc. Financial Statement Date: 12/31/X5 Procedure 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. Risks of Material Misstatement Due to Fraud CA CA CA CA 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 Procedures Risks 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.)