9. At year-end, VITALOGISTICS has three types of receivables outstanding: (a) receivables from end-users, (b) the Canadian receivables, and (c) vendor receivables. Evaluate KPVI?s approach to auditing each of these receivables. 10. Evaluate KPVI?s handling of issues arising subsequent to year-end and its reporting choices.

ISSUES IN ACCOUNTING EDUCATION Vol. 22, No. 1 February 2007 Identifying and Evaluating Audit Issues: The Case of VITALOGISTICS Stephen Kwaku Asare and Arnold M. Wright (Stephen Kwaku Asare is an Associate Professor at the University of Florida and Arnold M. Wright is a Professor at Boston College.) ABSTRACT: This case invites you to identify audit issues and evaluate an audit team's judgments and decisions on a new engagement (VITALOGISTICS). You will consider a variety of issues in the client acceptance, planning, execution, and reporting phases of an Integrated Audit. Identifying the audit issues and evaluating the audit team's decisions will enhance your: (1) appreciation of the role of research in audit practice; (2) recognition of the conflicting pressures faced by auditors and the potential for these pressures to compromise audit work; and (3) understanding of the requirements of the Integrated Audit and how it differs from the requirements of an audit of financial statements. CLIENT ACCEPTANCE While attending a charity event in Miami on December 15, 20X3, Andy Card, audit partner of KVPI LLP, met Carl Bush, CEO of VITALOGISTICS Inc., a publicly owned corporation whose stock has been trading on the New York Stock Exchange (NYSE) since its incorporation some three decades ago. When Carl learned that Andy was a partner of the prestigious KVPI firm, he was immensely excited and asked Andy whether KVPI would be interested in providing audit services to VITALOGISTICS during the forthcoming year (1/1/20X4 to 12/31/20X4) and beyond. When Andy inquired about what appeared to be a sudden interest in changing auditors, Carl responded that the change was motivated by the impending retirement of Alex Sevilla, a partner of the current audit firm. Carl emphasized that Andy could contact VITALOGISTICS' current audit firm, Sevilla & Mercer, LLP. Carl also mentioned that he may have briefly mentioned this opportunity to another auditor from a different firm. At KVPI partners who bring in clients are highly regarded, and Andy correctly reasoned that bringing VITALOGISTICS on board would boost his reputation and compensation. Nevertheless, Andy realized that any decisions he made must be based on KVPI's staff availability, compliance with the KVPI's quality control procedures, and ability of VITALOGISTICS to pay for these services. Andy, therefore, promised to get back in touch with Carl after conferring with the necessary KVPI people and conducting the necessary background checks. Faced with the prospect of a new client, Andy left the charity event and sped off directly to his office. He immediately summoned Al Rove, a trusted audit manager, and asked him to find out what he could about VITALOGISTICS and to put together a proposal for the 20X4 audit of VITALOGISTICS. With those instructions, Al went to his office immediately to commence his investigation of VITALOGISTICS. Using the Internet, Al learned that the company designs, develops, manufactures, markets, services, and supports a wide range of computer systems, including desktops, notebooks, workstations, and network servers. The company also markets software, computer peripherals, and post-sale service and support programs. The company's products are sold to a variety of customers, including distributors, health care facilities, educational institutions, and end-users (via an Internet online system). Occasionally, the company uses consignment sales when it markets new products or when it introduces existing products into new sales channels. Net Revenue for fiscal 20X3 was $5 billion and is projected to increase by 5 percent in 20X4. Total consignment sales for 20X3 were about $100 million and are not expected to exceed 2 percent of net revenue in the 20X4. In the last 5 1 years, the company has experienced continued growth in sales and profitability, reflected in its current stock price of $25, representing a price/earning ratio of 25 (industry average is 15). Al also found that the company's senior management comprises Carl Bush, the CEO and chairman of the board; Catherine Johnson, the COO; and Charles Glassman, the CFO. All three have been with the firm for two decades. The Board of Directors includes Carl, the dean of the local university's college of business, and three others, all with significant business experience. Al contacted the prior auditors and spoke specifically to Mr. Sevilla, who was not surprised that VITALOGISTICS was considering a new auditor. He had audited the company for many years but, with his impending retirement and possible sale of his partnership interest, he could understand why VITALOGISTICS would seek a larger audit firm. Sevilla expressed no major concerns about the integrity of key management personnel, although he noted that occasionally the CFO adopted aggressive accounting methods. He mentioned that the CFO had been willing to ''book'' any proposed audit adjustments, which tended to be concentrated in estimates and new transactions where initial accounting policy had to be established. Sevilla remarked, however, that the company's accounting staff seems to be stretched thin. Al felt fortunate because VITALOGISTICS looked similar to MaxPar, another KVPI publicly traded client, which allowed him to reason that the VITALOGISTICS audit parameters (staff, fees, risk analysis, audit programs, audit milestones) should be set approximately equal to those for MaxPar. This discovery allowed him to complete the proposal and to forward it to Andy within four days. The highlights of the proposal were that the audit would be completed by March 15, 20X5, and the audit fee would be $5 million (MaxPar's audit fee is $6 million). The next morning, Andy called Carl and relayed the information that Al had provided. Carl accepted the proposal and VITALOGISTICS became a client. Al then drafted an engagement letter that was mailed to the chairman of the client's audit committee. The engagement letter clearly set forth the arrangements concerning the predecessor auditor, the fees, and the timing of the engagement. PLANNING PHASE With the engagement set, Al's first task was to assemble the engagement team for the 20X4 audit. The team included Andy (engagement partner, billing rate of $500 per hour), Al (as the manager, billing rate of $350 per hour), another younger manager (who bills at a respectable $250 per hour), 3 seniors (billing between $150 and $175), 4 associates (billing at $100 per hour) and 3 interns (who bill at $50 per hour). Ace Fritz, another manager in the office, was considered for the engagement but was eventually left off the team when Al discovered that Ace, a member of the office's Quality Control Team, owned 5,000 shares of VITALOGISTICS's stock bequeathed to him by his grandfather. The team held a planning meeting in February 20X4 and made various audit decisions. First, the team decided that overall audit risk should be set at moderate (the audit firm uses a three-point scale [Low, Moderate, High] to assess audit risk). This assessment was primarily based on the company's strong earnings history and a conversation with the CFO, who promised to cooperate with the audit staff in making available all relevant information in a timely manner. The team set planning materiality for the financial statements as a whole at $4 million, which was based on 5 percent of annualized net income. Although the audit plan was to understand and test controls over all significant accounts, the team concluded that detailed testing of all significant balances was still necessary. This conclusion was based, in part, on KVPI's lack of prior experience with VITALOGISTICS. It was also based on the discussions with the predecessor auditor, who suggested that controls were not well designed or operating effectively. Further, because the substantive detailed approach had proven to be efficient for the MaxPar engagement, the team reasoned that the same substantive approach should be used. Therefore, a senior associate was asked to ''import'' the audit program for MaxPar into the working papers set up for VITALOGISTICS. This ''import'' exercise was flawlessly executed and replicated to each team member's laptop. The engagement itself was conducted over three phases: (1) interim activities; (2) year-end activities; and (3) post-year-end activities. 2 INTERIM WORK Interim fieldwork commenced in August 20X4 and continued through October 20X4. During this phase, the team identified and disposed of several issues. The client leased certain hardware to select customers. Such leasing transactions represented approximately 10 percent of total revenue and 20 percent of pre-tax income. Revenue from these transactions was determined from a complex lease accounting macro written within a spreadsheet. The spreadsheet was not password-protected; however, data for all new transactions entered into the lease accounting spreadsheet were reviewed by the leasing revenue manager. On the termination of a lease, the leasing revenue manager verified that the transaction had been removed from the spreadsheet. The CFO reviewed leasing revenues and margins monthly and investigated variances from expected results. The interim audit did not identify any error in this area. The client plans to introduce a new version of its PC Tablet to the market in 20X5. This hardware will allow users to use a pen-like instrument to input and access information on a computer, thereby making the pencil, pen, and exercise book antiquated. The client has entered into a marketing agreement that would make InfoC the exclusive distributor of this product. Under this agreement, InfoC would use its existing telemarketing facilities and other retail channels to sell the PC Tablet. The marketing rights have been assessed at $50 million, which InfoC considers reasonable, and has promised to pay as the products are sold. InfoC has been very successful in marketing for the resort industry, but has no experience in the PC Tablet market. Because the audit team was able to successfully confirm these terms with InfoC, the $50 million was included in the current year's (i.e., 20X4) revenue. On August 18, 20X4, the client entered into a $240 Million Senior Secured Credit Facility with a new group of lenders. The $240 Million Senior Secured Credit Facility consisted of a maximum availability of $190.0 million and a term loan of $50.0 million, with all borrowings to mature on August 18, 20X7. The Credit Facility includes both a subjective acceleration clause and a lockbox arrangement, which requires all lockbox receipts from the client's customers be used to repay revolving credit borrowings. After reviewing this transaction, the audit team concurred with the client that the facility should be classified as a long-term debt on the year-end financial statements. This concurrence was based on the debt's maturity date and the subjectivity of the accelerated clause. Two years ago, the client leased an asset from a lessor in Texas. In the current year (i.e., 20X4), that asset was sold to another company owned by Roger Martin, a savvy industrialist who sits on various boards, including the VITALOGISTICS board. Under the terms of the sale, Martin's company will make the lease payments directly to the lessor. As a condition of sale, VITALOGISTICS has also agreed to guarantee the obligations assumed by Martin. A $5M profit on this sale transaction is included in 20X4's (i.e., current year's) revenue. Martin is current with all lease payments to date, and the firm concluded that there is a high likelihood that these payments will continue. YEAR-END AUDIT WORK At year-end, an associate was assigned to test the validity of the receivables from end users. The terms of those sales are 45 days same as cash. That is, customers can defer payment for 45 days and still pay the sales price. As of December 31, 20X4, there are about 500 customers under this program who still owe, with an expected collection of $3 million. The associate selected a sample of customers whose invoices totaled $600,000 and sent them confirmations. The returned confirmations revealed a difference of only $30,000. Since tolerable misstatement for this sample application was $170,000 and no misstatements were expected, the associate concluded that the end-user receivable balance was fairly stated and properly noted that there was a 5 percent risk of incorrect acceptance. This work was reviewed by a senior, who concluded that no further work was needed. A material portion of receivables is attributed to credit sales to Canadian customers. Because the receivables from the Canadian customers were evaluated as presenting an unusually high risk, one of the seniors was assigned to that section of the audit. The senior reasoned that the high level of risk required the use of negative confirmations. She sent a sample of negative confirmations using the 3 firm's sampling guide. Based on the responses that she received (only small exceptions noted), she concluded that the Canadian receivables existed. Vendor rebates are an important source of revenue for VITALOGISTICS. Typically, a vendor offers VITALOGISTICS a rebate of a specified amount of cash or other consideration that is payable only if VITALOGISTICS completes a specified cumulative level of purchases or remains a customer for a specified period of time. VITALOGISTICS is entitled to a rebate from one of its vendors in the amount of $5M. Because VITALOGISTICS has met the condition to receive the rebate, the rebate was included in the Trade Accounts Receivable. In February 20X5 (i.e., the next period), a significant lawsuit was initiated against VITALOGISTICS. The plaintiff asked for $100 million in damages. The CEO told Andy, the partner, that the suit was frivolous and did not warrant any audit attention. The company's senior legal counsel seemed to concur and their legal opinion stated the chances of recovery by plaintiff are less than probable. Based on these assurances, Andy instructed the team not to document any lawsuit-related items in the 20X4 working papers. The fieldwork was completed on March 15, 20X5, in time for KVPI to issue unqualified reports on the company's 20X4 Internal Control over Financial Reporting as well as the Financial Statements. Carl, the CEO, was pleased with the quality of the audit, instructed the CFO to pay the service fees, and commended Andy for providing a high-quality engagement. The engagement team planned to celebrate the 20X4 audit on May 15, 20X5. No sooner had the celebration started than Andy Card, the engagement partner, walked in and gave them the news that VITALOGISTICS's revenue for 20X4 was misstated by $85 million (arising from revenue booked on consignment sales). Andy discovered this problem from the Director of Internal Audit and confirmed the existence and magnitude of the misstatement from the Controller. 4