7-38 (Objective 7-4)Grande Stores is a large discount catalog department store chain. The company has recently expanded from six to 43 stores by borrowing from several large financial institutions and from a public offering of common stock. A recent investigation has disclosed that Grande 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 Grandes audit firm, Montgomery & Ross, 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. McClure Advertising CreditsGrande had arrangements with some vendors to share the cost of advertising the vendors product. The arrangements were usually agreed to in advance by the vendor and supported by evidence of the placing of the ad. Grande created a 114-page list of approximately 1,100 vendors, supporting advertising credits of $300,000. Grandes auditors selected a sample of 4 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 (one or two from each page of the list). Twelve of the items were supported by examining the ads placed, and eight were supported by Grande debit memos charging the vendors for the promotional allowances.

2. Springbrook CreditsGrande created 28 fictitious credit memos totaling $257,000 from Springbrook Distributors, the main supplier of health and beauty aids to Grande. Grandes 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 Grande would continue to use Springbrook as a supplier. One of the Montgomery & Ross staff auditors concluded that a $257,000 payment to retain Grandes 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, Jon Steiner, the president of Grande Stores, placed a call to Mort Seagal, the president of Springbrook, and handed the phone to the staff auditor. In fact, the call had been placed to an officer of Grande. The Grande officer, posing as Seagal, orally confirmed the credits. Grande refused to allow Montgomery & Ross to obtain written confirmations supporting the credits. Although the staff auditor doubted the validity of the credits, the audit partner, Mark Franklin, accepted the credits based on the credit memoranda, telephone confirmation of the credits, and oral representations of Grande officers.

3. Ridolfi Credits$130,000 in credits based on 35 credit memoranda from Ridolfi, Inc., were purportedly for the return of overstocked goods from several Grande stores. A Montgomery & Ross 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 Ridolfi 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 Ridolfi, treasurer of Ridolfi, Inc., and was informed that the $130,000 in goods had not been returned and the money was not owed to Grande by Ridolfi. Steiner advised Franklin, the audit partner, that he had talked to Harold Ridolfi, who claimed he had been misunderstood by the staff auditor. Steiner told Franklin not to have anyone call Ridolfi to verify the amount because of pending litigation between Grande and Ridolfi, Inc.

4. Accounts Payable AccrualMontgomery & Ross assigned a senior with experience in the retail area to audit accounts payable. Although Grande had poor internal control, Montgomery & Ross selected a sample of 50 for confirmation of the several thousand vendors who did business with Grande. Twenty-seven responses were received, and 21 were reconciled to Grandes records. These tests indicated an unrecorded liability of approximately $290,000 when projected to the population of accounts payable. However, the investigation disclosed that Grandes president made telephone calls to some suppliers who had received confirmation requests from Montgomery & Ross and told them how to respond to the request.

   Montgomery & Ross also performed a purchases cutoff test by vouching accounts payable invoices received for nine 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 Grande eventually agreed on an adjustment to increase accounts payable by $260,000.

REQUIRED

1. Identify deficiencies in the sufficiency and appropriateness of the evidence gathered in the audit of accounts payable of Grande Stores.