Nefret Stores is a large discount cosmetic department store chain. The company has recently expanded from 5 to 15 stores by borrowing from several large financial institutions and from a public offering of common stock. A recent investigation has disclosed that Nefret materially overstated net income. The company understated their accounts payable and recorded fictitious supplier credits that further reduced accounts payable. As a result, an Income & Sales Tax Department investigation was critical of the evidence gathered by Nefrets audit firm, Abdul & El-Emir, in testing accounts payable and the supplier credits.

Case 1. Kashir Advertising CreditsNefret 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. Nefret created a 250-page list of approximately 1,000 vendors, supporting advertising credits of $500,000. Nefrets auditors selected a sample of 8 of the 2,500 items for direct confirmation. One item was confirmed by telephone, one traced to cash receipts, one to a vendors credit memo for part of the amount and cash receipts for the rest, and one to a vendors 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 30 items (several from each page of the list). Fourteen of the items were supported by examining the ads placed, and sixteen were supported by Nefret debit memos charging the vendors for the promotional allowances.

Case 2. Nashwa CreditsNefret created 28 fictitious credit memos totaling $363,000 from Nashwa Distributions, the main supplier of health and beauty aids to Nefret. Nefrets controller initially told the auditor that the credits were for returned goods, then said they were a volume discount, and finally stated that they were a payment so that Nefret would continue to use Nashwa as a supplier. However, an Abdul & El-Emir staff auditor noticed the amount and concluded that a $257,000 payment to retain Nefrets 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, Ramses Abdullah, the president of Nefret Stores, placed a call to Saria Wasir, the president of Nashwa, and handed the phone to the staff auditor. In fact, the call had been placed to an officer of Nefret. The Nefret officer, posing as Wasir, orally confirmed the credits. Nefret refused to allow Abdul & El-Emir to obtain written confirmation supporting the credits. Although the staff auditor doubted the validity of the credits, the audit partner, Mufti Hussein, accepted the credits based on the credit memoranda, telephone confirmation of the credits, and oral representation of Nefret officers.

Case 3. Zaki Credits-$130,000 in credits based on 35 credit memoranda from Zaki, Inc., were purportedly for the return of overstocked goods from several Nefret stores. An Abdul & El-Emir 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 Zaki 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 Omar Zaki, treasurer of Zaki, Inc., and was informed that the $130,000 in goods had not been returned and the money was not owed to Nefret by Zaki. Abdullah, president of Nefret, advised Hussein, audit partner, not to have anyone call Zaki to verify the amount because of pending litigation between Nefret and Zaki, Inc.

Case 4. Accounts Payable AccrualAbdul & El-Emir assigned a senior with experience in the retail area to audit accounts payable. Although Nefret had poor internal controls, Abdul & El-Emir selected a sample of 50 for confirmation of the several thousand vendors who did business with Nefret. Twenty-seven responses were received, and 21 were reconciled to Nefrets records. These tests indicated an unrecorded liability of approximately $290,000 when projected to the population of accounts payable. However, the investigation disclosed that Nefrets president made telephone calls to some suppliers who had received confirmation requests from Abdul & El-Emir and told them how to respond to the request. Abdul & El-Emir also performed a purchase 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 ($150,000) was found to relate to the prior year, indicating a potential unrecorded liability of approximately $500,000. The audit firm and Nefret eventually agreed on adjustment to increase accounts payable by $260,000.

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