Auditing firms have standard auditing plans. In other words, the audit tests and steps are repeated from one client to another unless there is a red flag or concern. For Keystone Computers & Networks Inc. (KCN), there were several indications/red flags that additional audit steps are needed related to the 1) company's growth strategy, 2) the inventory strategy, 3) the ownership structure, and 4) the offering of sales warranties and 5) the debt agreement with Western Financial Services. For questions 1-3, each question is asked what red flags do you identify, what accounts are impacted, and how do you adjust your audit plan? As Appendix 6C Illustrative Audit Case: Keystone Computers & Networks Inc. Part 1: 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 Atrial 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, KEYSTONE COMPUTERS & NETWORKS INC. Balance Sheet December 31, 20X4 KEYSTONE COMPUTERS & NETWORNS ING Balance Sheet December 31, 2014 Asich Current Ass 5504 13.534 13 Trade receivables, tessa fordulats of .000 Accontecewable-offices memory Prepaid expenses Total current Equipes and leasehold improvement to Ement and furniture cascholen S.I.630 $1.09064 200 SL1514 25097 5541 Les accumulated depreciation 5100 Intangible set of mortation 50 Lilities and holders' pity Liabilities and Stockholders' Equity Current Liabilities $ 6,612.550 Line of credit 1.349,839 Accounts payable Current maturities of capital case obligations 43,200 178.900 Accrued expenses $ 8,184,489 Total current liabilities $ 456,700 Capital lease obligations, less current maturities $ 8.641,189 Total liabilities Stockholders' equity Common stock. Si par value 1,000,000 shares authorized; 200,000 shares issued and outstanding $ 200,000 423,500 Additional paid.in capital 2.615.478 Retained earnings $11.880.167 KEYSTONE COMPUTERS & NETWORKS INC. Statements of Income and Retained Earnings Year Ended December 31, 20X4 Net sales $96.459.566 Cost of goods sold 74.122,435 Gross profit $ 22,337,131 Selling expenses Salaries $ 3,167.889 913,456 Payroll benefits and taxes Advertising and promotion 1,200,786 609,788 Travel and entertainment 334,890 Miscellaneous $ 6,226,809 Operating and administration expenses: $4,878.900 Operating salaries 4,234,234 Administrative salaries 1,812,344 Payroll benefits and taxes 797.800 Rent 210,495 Utilities 356,890 Insurance $14,397,306 Total selling, operating, and administrative expenses $ 20.624.115 Operating income $ 1,713,016 Interest expense 421,344 Income before income taxes $ 1.291,672 Income taxes: Current $ 256.765 Deferred 45,632 302,397 Net income $ 989,275 Retained earnings, January 1, 20X4 $ 1,626,203 Retained earnings, December 31, 20X4 $ 2,615,478 KEYSTONE COMPUTERS & NETWORKS INC. Working Trial Balance For the Period Ended December 31, 20X5 Prepared by Reviewed by Page 1 Prepared by Reviewed by Page 1 KEYSTONE COMPUTERS & NETWORKS INC. Working Trial Balance For the Period Ended December 31, 20X5 Prior Unadjusted Period Trial Balance Balance Dr Ref Account Name 12/31/X4 (Cr) # Adjustments Dr (Cr) Adjusted Balance Dr (Cr) Account # 1000.10 Cash-General Account 42,754 66,034 1000.20 9,960 10,150 1000.30 1.200 1.200 SO 50 1000.40 Cash-Special Account Cash in Register Petty Cash Accounts receivable-trade Accounts receivable-officers Allowance for bad debts 1050.10 8,534,524 10,235,457 57,643 84,670 1050.40 1050.90 (96,000) (104,000) Inventories 1,234,589 1100.10 1,375,835 156,900 Prepaid expenses 1300.10 176,456 300.980 344.900 2050.10 Furniture and fixtures 789,654 974,676 2050.30 Office equipment 98,900 91,230 2050.80 Leasehold improvements (2.50,987) Accumulated depreciation 2050.90 (404,560) 178,000 800,000 2100.00 Software development cost 1,000,000 900.00 Intangible assets 2200.00 800,000 3050.10 (1.429.033) 3100.00 (45,675) 3200.10 (203,450) 3300.30 (42,300) 3400.50 Intangible assets 1.000.000 Accounts payable-trade (1.349,839) Capital lease obligations-current (43,200) Accrued liabilities (178.900) Unearned service revenue Line of credit (6.612.550) Capital lease obligations-noncurrent (456,700) Capital stock (200,000) Paid-in capital (423,500) Retained earnings (1,626,203) Dividends (8.632,105) 4400.10 (423,680) (200,000) 5050.10 5100.10 5700.10 (423,500) (2,615,478) 415,000 5900.00 989,275 229,877 (9.89.275) (229.877) 0 Pas 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 company must be able to obtain inventories of stato-of-thoart equipment on a timely basis. Because the company does not have the buying 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 Page 253 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 services 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 clients with slightly higher credit risk. Auditing firms have standard auditing plans. In other words, the audit tests and steps are repeated from one client to another unless there is a red flag or concern. For Keystone Computers & Networks Inc. (KCN), there were several indications/red flags that additional audit steps are needed related to the 1) company's growth strategy, 2) the inventory strategy, 3) the ownership structure, and 4) the offering of sales warranties and 5) the debt agreement with Western Financial Services. For questions 1-3, each question is asked what red flags do you identify, what accounts are impacted, and how do you adjust your audit plan? As Appendix 6C Illustrative Audit Case: Keystone Computers & Networks Inc. Part 1: 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 Atrial 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, KEYSTONE COMPUTERS & NETWORKS INC. Balance Sheet December 31, 20X4 KEYSTONE COMPUTERS & NETWORNS ING Balance Sheet December 31, 2014 Asich Current Ass 5504 13.534 13 Trade receivables, tessa fordulats of .000 Accontecewable-offices memory Prepaid expenses Total current Equipes and leasehold improvement to Ement and furniture cascholen S.I.630 $1.09064 200 SL1514 25097 5541 Les accumulated depreciation 5100 Intangible set of mortation 50 Lilities and holders' pity Liabilities and Stockholders' Equity Current Liabilities $ 6,612.550 Line of credit 1.349,839 Accounts payable Current maturities of capital case obligations 43,200 178.900 Accrued expenses $ 8,184,489 Total current liabilities $ 456,700 Capital lease obligations, less current maturities $ 8.641,189 Total liabilities Stockholders' equity Common stock. Si par value 1,000,000 shares authorized; 200,000 shares issued and outstanding $ 200,000 423,500 Additional paid.in capital 2.615.478 Retained earnings $11.880.167 KEYSTONE COMPUTERS & NETWORKS INC. Statements of Income and Retained Earnings Year Ended December 31, 20X4 Net sales $96.459.566 Cost of goods sold 74.122,435 Gross profit $ 22,337,131 Selling expenses Salaries $ 3,167.889 913,456 Payroll benefits and taxes Advertising and promotion 1,200,786 609,788 Travel and entertainment 334,890 Miscellaneous $ 6,226,809 Operating and administration expenses: $4,878.900 Operating salaries 4,234,234 Administrative salaries 1,812,344 Payroll benefits and taxes 797.800 Rent 210,495 Utilities 356,890 Insurance $14,397,306 Total selling, operating, and administrative expenses $ 20.624.115 Operating income $ 1,713,016 Interest expense 421,344 Income before income taxes $ 1.291,672 Income taxes: Current $ 256.765 Deferred 45,632 302,397 Net income $ 989,275 Retained earnings, January 1, 20X4 $ 1,626,203 Retained earnings, December 31, 20X4 $ 2,615,478 KEYSTONE COMPUTERS & NETWORKS INC. Working Trial Balance For the Period Ended December 31, 20X5 Prepared by Reviewed by Page 1 Prepared by Reviewed by Page 1 KEYSTONE COMPUTERS & NETWORKS INC. Working Trial Balance For the Period Ended December 31, 20X5 Prior Unadjusted Period Trial Balance Balance Dr Ref Account Name 12/31/X4 (Cr) # Adjustments Dr (Cr) Adjusted Balance Dr (Cr) Account # 1000.10 Cash-General Account 42,754 66,034 1000.20 9,960 10,150 1000.30 1.200 1.200 SO 50 1000.40 Cash-Special Account Cash in Register Petty Cash Accounts receivable-trade Accounts receivable-officers Allowance for bad debts 1050.10 8,534,524 10,235,457 57,643 84,670 1050.40 1050.90 (96,000) (104,000) Inventories 1,234,589 1100.10 1,375,835 156,900 Prepaid expenses 1300.10 176,456 300.980 344.900 2050.10 Furniture and fixtures 789,654 974,676 2050.30 Office equipment 98,900 91,230 2050.80 Leasehold improvements (2.50,987) Accumulated depreciation 2050.90 (404,560) 178,000 800,000 2100.00 Software development cost 1,000,000 900.00 Intangible assets 2200.00 800,000 3050.10 (1.429.033) 3100.00 (45,675) 3200.10 (203,450) 3300.30 (42,300) 3400.50 Intangible assets 1.000.000 Accounts payable-trade (1.349,839) Capital lease obligations-current (43,200) Accrued liabilities (178.900) Unearned service revenue Line of credit (6.612.550) Capital lease obligations-noncurrent (456,700) Capital stock (200,000) Paid-in capital (423,500) Retained earnings (1,626,203) Dividends (8.632,105) 4400.10 (423,680) (200,000) 5050.10 5100.10 5700.10 (423,500) (2,615,478) 415,000 5900.00 989,275 229,877 (9.89.275) (229.877) 0 Pas 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 company must be able to obtain inventories of stato-of-thoart equipment on a timely basis. Because the company does not have the buying 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 Page 253 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 services 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 clients with slightly higher credit risk