Urgent Medical Device, Inc. (the Company) is a medical device company founded in 2013 in

Provo, Utah that specializes in the development and manufacturing of cutting-edge medical

devices designed for all types of joint replacement surgeries. In January 2015, the FDA approved

Urgents premier product, a hinged titanium axle designed to provide physicians with more

precise placement of joints during joint replacement surgery.

In early 2016, approximately one year after the new products approval, the Company hired a

new senior vice president (SVP) of sales to oversee sales, physician training, product delivery,

and customer service. The broad set of responsibilities allowed the charismatic SVP to

significantly influence the Companys revenue generation. The hiring of the new SVP was also

done in large part to help guide the companys development of an important new sales channel:

third-party distributors that are each strategically located in close proximity to key hospitals in

regions around the country.

The move to hire the SVP was in direct response to overwhelming disappointment about the first

years sales volume for the new surgical implant, which was lagging significantly behind

expectations. Reports from the field led management to recommend the new sales channel to the

board of directors that overwhelmingly approved the new strategy, the execution of which was

being led by the new SVP.

Execution of Strategy

To help execute the new strategy, the SVP hired five regional sales managers who would become

his trusted cohorts. Together, they set aggressive sales targets for the Companys surgical

implants. The sales targets focused on achieving a growth pattern that was characterized by a

record high sales volume for each successive quarter in each region. In fact, it is fair to say that

the sales targets were intentionally created at almost unreachable levels to remove any question

about possible weakness in demand for the Companys new product.

The strategy focused on the development of a new sales channel with third-party distributors.

Each of the distributors had already established close relationships with the physicians that were

actually using the product during surgical procedures. To help pay for the launch of their new

product, along with the execution of the new strategy, the Company was also working hard to

raise a significant amount of new investment capital to fund the resulting increased operating

costs. In order to be successful in attracting the new investment capital, top management made it

clear to the SVP how important it was to report strong sales for its premier product, the surgical

1

This case is inspired by and adapted from KPMGs UMD case, which was obtained from KPMGs University

Connection website. It is used with permission and for educational purposes only under the Fair Use provision

(Section 107) of the Copyright Act of 1976.

implant for titanium joints. The SVP, in turn, passed along the same message to the regional

sales managers.

Management Control Philosophy

The upper management team of Urgent can be described as being aggressive in business

practices and often emphasizes speed and efficiency when implementing their decisions.

Management rarely hires external consultants because they are of the opinion that consultants are

too expensive and often follow a conservative approach. The upper management team meets

regularly with its key managers. In general, the upper management team has cooperated with the

audit team in order to provide fair and adequate financial reporting, but there have been

disagreements in the past. The Company has a strict policy for following all established internal

control procedures.

Incentive Compensation

Top management focuses significant attention on achieving short-term performance measures

based on the audited financial statements when determining compensation and making

promotion decisions. Revenue earned is the most important criterion in performance assessment

throughout the organization. As part of the launch of its new surgical implant, a new bonus plan

was established to provide additional incentives for the entire organization to focus on this new

opportunity, with revenue earned as the key criterion used to determine incentive compensation.

Preliminary Results

Despite the SVPs optimism about sales in 2017, internal reports have indicated that the actual

sales volume of the surgical implant was well below budget each quarter. The SVP responded to

these reports by repeatedly communicating his disappointment to the regional sales managers.

Furthermore, he consistently warned that if the team could not boost sales, the Company would

likely not be able to raise additional investment capital and would then be forced to significantly

downsize its headcount.

Unfortunately, boosting revenue of the new surgical implants was not as simple as merely

shipping the product to distributors. The distributors were hesitant to purchase product until the

sale to the final customer was finalized as the distributors did not want to be stuck with the

inventory on their own balance sheets. Further, the terms of the sales do not include any refund

or rebate conditions. In addition, the Company has no intention of changing those terms and

accepting any return. Therefore, any sale to distributors are final.

By the end of 2017, the Company had signed on a total of 73 distributors to sell its surgical

implants in more than 20 different states throughout the United States. Each distributor was

independently owned and operated but the company routinely shared best practices among its

network. The SVP monitored sales closely from the distributor network through his regional

sales managers. In fact, he even maintained a monthly sales report from each of the 73

distributors.

The Company invoices customers (including distributors) when the goods are shipped, and

invoicing triggers the recording of revenue. The Company does not include freight costs in sales

revenue but does offset shipping costs with any freight charged to customers.

The following relevant financial data is taken from the Companys unaudited trial balance, which

was used to produce the unaudited financial statements:

Sales revenue, year ended 12/31/2017

$84,867,855

Gross accounts receivable, 12/31/2017

$11,988,886

Audit Approach

Your audit team is currently in the midst of year-end testing in the revenue and accounts

receivable cycle for the audit of the calendar year 2017 financial statements. Your testing will

focus on the existence/occurrence, cutoff, and accuracy assertions for sales revenue, as well as

the existence and valuation assertions for accounts receivable. As relationships with third-party

distributors generally require significant contract analysis to ensure the appropriateness of when

revenue is recognized, the audit team expects more hours to be spent this year testing revenue

and accounts receivable as compared to the prior year. In addition to the procedures you will

perform, the audit team will also confirm accounts receivable and perform other procedures

according to the audit plan. The audit team has assessed the risk of material misstatement

(RMM) for each relevant assertion in order to determine the nature, timing, and extent of the

procedures to be performed at Urgent.

Other members of the audit team have already completed a walk-through of the revenue and

accounts receivable processes and identified the controls that have been placed in operation to

mitigate risks. Based on the work performed, the team decided to test the operating effectiveness

of certain key controls during interim testing. The results are found below.

Tests of controls Revenue and accounts receivable cycle Interim

There were four key application controls tested at interim. Prior to testing the application

controls, the information technology (IT) auditors tested the IT General Controls (ITGCs) over

program changes, access to programs, and computer operations that are relevant to the revenue

and accounts receivable cycle. The ITGCs were found to be effective and can be relied upon to

support the effective operation of application controls. In addition, the IT auditors tested the

system to ensure proper segregation of duties throughout the period and that controls over data

input, data integrity, and the completeness and accuracy of data used in the four application

controls were operating effectively. No exceptions were noted in the testing performed by the IT

auditors, and the team decided to test the four key application controls themselves.

The first control is an automated three-way sales match. The control matches the details from 1)

an approved sales order; 2) relevant shipping documents; and 3) the sales invoice before revenue

is recorded. The control has been designed to support the existence/occurrence assertion for

revenue. A test of the controls operating effectiveness was conducted at the interim. No

exceptions were noted.

The second control requires the credit department at Urgent to conduct a detailed credit check for

all new customers, including the new distributors. To do so, the credit department obtains

information from the customer that allows for a comprehensive review of the financial condition

of the new customer and an assessment of the customers capacity to pay outstanding invoices.

The control culminates with an approval of the new customer and the establishment of a credit

limit by the credit department manager based on the information reviewed. A test of the controls

operating effectiveness was conducted at interim. No exceptions were noted

The third control is an automated sales authorization control. When a sales order is entered into

the system, the amount of the sale is added to the existing accounts receivable balance for that

customer. The sum is then compared to the customers credit limit. If the sum is greater than the

credit limit, the sale is not approved. If the sum is less than the credit limit, the sale is approved.

A credit manager notes the approval and authorizes shipment by electronically entering their

initials into the system, which gets posted into the sales order database. A test of the controls

operating effectiveness was conducted at interim. No exceptions were noted.

The fourth control is a monthly review of the adequacy of the allowance for doubtful accounts,

completed by the controller. On a monthly basis, the controller reviews the aging of accounts

receivable report, which is automatically produced by the companys information system. During

the review, the controller identifies for follow-up all balances greater than 90 days past due for

consideration in the allowance calculation. A test of the controls operating effectiveness was

conducted at interim. No exceptions were noted.

Roll-forward Period

By the end of the third quarter of 2017, sales revenue for the companys premier surgical implant

was still lagging far behind expectations. To help ensure that Urgent delivered impressive fourth

quarter revenue numbers, the entire sales team, led by the SVP and the regional sales managers,

began to exert pressure on a number of distributors in an attempt to improve sales in 2017. This

effort seemed to be paying off as the sales team successfully persuaded more than a dozen

distributors to purchase product in advance of final customer demand.

These circumstances presented a problem for the Company, because the distributors began to ask

for concessions from Urgent Medical. For example, in order to persuade the distributors, the

Company agreed to hold the inventory in their own warehouse.

The SVPs actions led to a dramatic increase in revenue for the fourth quarter of 2017. In fact,

sales increased year-over-year by 214 percent for the fourth quarter alone. The upward trajectory

of sales revenue helped the Company raise the much-needed investment capital as Urgent issued

more than 10 million shares of common stock for $40 million in early 2018.

Most importantly, roll-forward testing procedures were completed for each of the four key

application controls. No exceptions were noted in the roll-forward procedures. Thus, the audit

team concluded that the controls were operating effectively throughout the year.

Substantive Testing Revenue and Account Receivable

As a result of the tests of controls, the audit team assessed the control risk as low for the

existence/occurrence, cutoff, and the accuracy assertions for revenue and the valuation assertion

for accounts receivable. Since the recognition of revenue is a presumed fraud risk, along with the

significant risk of sales cutoff related to the launch of the new surgical implant, the audit team

concluded that fraud risk related to the timing of revenue recognition over period-end is high.

Overall, based on the control risk assessment if low and the inherent risk assessment of high, the

overall assessment of RMM is moderate for each of the assertions. In response to the RMM

assessment, the audit team has asked that you complete a number of substantive testing

procedures.

1. Identify the three fraud risk factors related to UMD that you think are most significant.

For each, identify the specific risk, what could go wrong because of the risk, and what

financial statement assertions would be affected.