You are a CPA and have been off work for the last 9 months as you and your wife had a baby. Unexpectedly you receive a call from the audit manager of the Public Accounting firm (Miller and King LLP) you were working for before you went on paternity leave. The manager has asked you if you could come to work and help complete an audit.

The audit was done by 2 audit trainees who reported to an audit senior. Unfortunately, the audit senior had to leave the job near the end of the audit in order to visit his mother in another country who became deathly ill. The audit senior has not returned as yet and did not have a chance to review the work done by the audit trainees. You have agreed to review the audit work completed and make any necessary changes to make it ready for the partner’s review.

The audit trainees completed various sections of the audit file for the year ended December 31, 2021. The draft report is expected to be dated March 15, 2022.

You reviewed a description of the HPT operations and then proceeded to review the work done by the audit trainees. Here is what you found:

DESCRIPTION OF HPT OPERATIONS

HPT is privately held, medium-sized company that is managed by the sole owner who is actively involved. HPT buys intercom equipment, telephone equipment, parts and related equipment and resells them at a mark-up to a loyal base of corporate customers (approximately 250 customers). Approximately, 60 of the HPT’s 250 customers make up 75% of HPT’s total sales. Competition is growing, but the market is favourable, and HPT offers excellent customer service, giving it a competitive advantage. The owner is very involved in most of the operating decisions. His capable assistant steps in when necessary. The owner wishes to implement a code of ethics at some point and also wishes to improve certain controls.

HPT operates multiple (6 in total) warehouses, each carrying a mix of inventory items - approximately 1,500 different products. The first type of inventory, which can be quite costly, consists of specialized telecom equipment hardware, high-end intercom equipment, and parts. The turnover rate of this inventory is high since new technology is always emerging. Because the company orders months in advance, HPT occasionally overestimates demand. After three or four months, products are difficult to sell but they are kept because most cannot be returned to the supplier, and HPT is reluctant to hold liquidation sales for fear they would negatively affect the sales at the regular process.

The second type of inventory, parts, and peripherals, generates a significant portion of HPT’s sales. This category includes items such as cables, headphones, and replacement parts.

The third type of inventory includes batteries and chargers for cordless phones. This inventory can be returned to suppliers if unsold after a certain period.

The sales mix has not changed significantly from previous years. Ten new accounts were opened during the year, with average monthly sales of $5,000 each. Sales also increased because a new representative was hired at the beginning of the fiscal year. Average monthly sales for the 10 experienced representatives are $500,000 each. Rookie representatives normally perform at 50% of an experienced representative’s level in their first year. HPT also lost a customer, who had averaged $90,000 a year in sales, to the competition. Purchases increased and were distributed across the inventory types in amounts similar to the overall sales mix.

Sales representatives enter orders into the sales database and can modify the information, including quantities and selling prices. Any changes are usually made to orders before shipping. Problems result if representatives make changes after shipping since they should issue credits instead. The timing differences create reconciliation problems for both customers and HPT when settling invoices. Also, sometimes credits have been issued in error.

Electronic purchase orders require authorization from either the owner or his assistant through the use of a personal identification number (PIN). Each user has a specific PIN. Orders greater than $5,000 require the owner’s authorization. Before making a payment, the accounting department matches the invoice to the authorized purchase order and the receiving slip. When a purchase order or receiving slip cannot be located the payment is authorized by the owner.

Sales representatives are compensated based on a combination of flat salaries and commissions on sales.

The owner noted he just received a memo from a clerk at one of the warehouses. It says the amount of damaged inventory has been gradually increasing over the past eight months. The clerk suggests this is because the forklift is not operating properly and items are being dropped as they are loaded for shipment. He wants the forklift replaced. He asks what he should do with the damaged inventory that has been piling up in a corner of the warehouse. He suggests holding a liquidation sale to get rid of it since it needs space.

The owner’s assistant has a vital role in the day-to-day operations of the business. He is responsible for developing relationships with the various vendors and finding new vendors. He adds new vendors to the system and also places orders when inventory items are low. Lastly the assistant assumes all of the owner’s responsibilities when the owner is on vacation or on a business trip.

SECTIONS FROM THE AUDIT TRAINEE’S AUDIT FILE

INVENTORY WORK PERFORMED

1. Matched totals on inventory listing to sub-ledger and general ledger.
2. Went to one of the 6 warehouse locations. Traced quantities from HPT’s list to the warehouse floor for a random sample of 10 intercom phones. My inventory count matched quantities on the inventory listing.
3. Traced prices for the 10 intercom phones sampled in the previous test. Prices matched those on the price listing, except for two models. The owner explained that employees sometimes manually change inventory prices to adjust for errors made when recording purchases. He provided a second listing with handwritten corrections. However, no backup documents were available to substantiate the changes.
4. Recalculated quantity and price extensions for the same 10 intercom phones and they were accurate.
5. One customer placed an order of more than $800,000 for specialized telephone equipment.

Unfortunately, the customer went bankrupt and, 10 months later, the servers are still in inventory. HPT never posted the sale because the servers were never shipped. The company is certain it can resell them to another customer, so no provision has been booked.

EXCERPT FROM SALES WORK PERFORMED

Sales variance analysis:

	2020	2021	Variance ($)	Variance %
Telephone Devices	$20,000,000	$22,000,000	$2,000,000	10%
Parts & peripherals	35,000,000	37,500,000	2,500,000	7%
Cordless Phones	5,000,000	5,500,000	500,000	10%
Total	$60,000,000	$65,000,000	$5,000,000	8%

The explanation for variance: Sales increased because a new representative was hired.

ACCOUNTS RECEIVABLE WORK PERFORMED

1. Customers have 30 days to pay invoices, but most take advantage of the 2% discount offered for payment within 10 days. A sample of five year-end balances was tested, and all payments were received subsequent to year-end, so accounts receivable were reasonable at year-end.

2. On January 10th, goods related to sales made on December 29^th were destroyed in a transport accident. The goods were sold at FOB shipping point and the customer is refusing to pay for the goods. The goods were valued at $200,000.

3. In order to save time, HPT applied a blanket provision of 5% for uncollectible accounts. Historically, the amount of uncollectible accounts ranges from 4% to 5%. Credit procedures were tightened two years ago, and since then, the rate has been at the lower end. Therefore, 5% is quite conservative, allowing for the potential overstatement of receivables.

OBTAINING A CLIENT REPRESENTATION LETTER/ REVIEW FOR CONTINGENT LIABILITIES AND REVIEW FOR SUBSEQUENT EVENTS

Obtaining a Client Representation Letter

A client representation letter was received from the client dated February 15, 2021. The letter was signed off by the controller but the CEO refused to sign the letter as he said he was not familiar with the accounting standards for private enterprises (ASPE) and accordingly felt he was not in a position to state that the financial statements were fairly presented in all material respects in accordance with ASPE.

Review for Contingent Liabilities

The controller sent out a legal letter to the company’s lawyers asking them to confirm as at March 1, 2022, whether there were any claims outstanding against HPT. As of March 152022, no response has been received. Based upon our review of legal expenses and discussion with management, there are no outstanding claims. No further work is necessary.

Review for Subsequent Events

In order to ensure no subsequent events took place after December 31, 2021, the trainee reviewed the draft Board minutes for January and February 2022. No further work was considered necessary.

Required:

1. Evaluate three samples selected in the accounts receivable and inventory work performed by the audit trainees. Your response should identify any deficiencies in the samples selected and provide appropriate recommendations. 
2. Discuss four major deficiencies in the work performed in the inventory, and accounts receivable. State what recommendations you should make to the recruit. 

3. List and explain three deficiencies in the work performed on obtaining a client representation letter, the review for contingent liabilities, and subsequent events.) Provide recommendations regarding further actions and/or audit procedures.