1) The following table provides key financial ratios for Crazy Eddie during the period 1984-1987: | |1987 |1986 |1985 |1984 | |Current Ratio |2. 41 |1. 4 |1. 56 |0. 93 | |Quick Ratio |1. 4 |0. 6 |0. 77 |0. 15 | |Debt Ratio |0. 68 |0. 66 |0. 64 |0. 83 | |Debt-to-Equity |2. 16 |1. 98 |1. 75 |4. 88 | |Inventory Turnover |3. 3 |4. 38 |5. 14 |5. 88 | |Asset Turnover |1. 2 |2. 07 |2. 08 |3. 75 | |Return on Assets |0. 04 |0. 1 |0. 09 |0. 1 | |Return on Equity |0. 11 |0. 31 |0. 25 |0. 61 | |Gross Profit Margin |0. 23 |0. 26 |0. 24 |0. 22 | | | | | | | | | | | | |
By examining the ratios, I have determined that there were some items in Crazy Eddie’s financial statements that posed a higher-than-normal level of audit risk. Inventory turnover has steadily decreased over the reported four years. The inventory turnover ratio explains how many times a company’s inventory is sold and replaced over a period of time. A lower inventory turnover ratio indicates that Crazy Eddie is selling fewer inventories. Asset turnover also took a pretty big plunge. The asset turnover ratio is the amount of sales generated for every dollar in assets.
A low asset turnover ratio indicates that the firm is struggling to use its assets to generate revenue. In relation to this is the return on assets ratio. This indicates how well a company is using its assets to generate earnings. Crazy Eddie is not generating very much profit from its assets. Finally, return on equity has also declined. This ratio indicates that the company is generating very little revenue from the money invested by shareholders. (Dictionary, 2011) 2) Much of Crazy Eddie’s fraud can be attributed to the overstatement of inventory and the understatement on accounts payable, ot to mention the vast number of executives who were involved in the scheme. Specific audit procedures, if performed, could have led to the detection of the following accounting irregularities: a. The falsification of inventory count sheets. – Auditors should have observed a physical count of the inventory to check for accuracy. The case had mentioned that Eddie Antar would ship inventory to his retail stores before auditors arrived to conceal any shortages. (Knapp, 2011) These sites should have been audited unannounced in order to hinder any attempt by the client to conceal fraud. b. The bogus debit memos for accounts payable. The most reliable form of evidence that the auditors could have obtained in this situation would be confirmations. The auditors should have sent confirmations to vendors, suppliers, and creditors confirming the amount that Crazy Eddie owed them. The amounts reportedly owed could then be matched with the amounts recorded in the company’s accounting records. Auditors should question any discrepancies. c. The recording of transshipping transactions as retail sales. – The auditor should obtain documentation of the transshipping transaction. The auditor should then trace the processing of that document.
This procedure would allow the auditor to determine whether or not the transaction was properly recorded. Conveniently, documents would get lost or destroyed, so the auditors could ask the customers for proof of these transactions. d. The inclusion of consigned merchandise in year-end inventory. – It would be safe to assume that if a company consigned goods to Crazy Eddie that there would be some contract stating the terms of the agreement. If the auditors suspects there is consigned merchandise, he or she could ask to see the terms of the agreement. Consigned goods are not supposed to be included in the consignor’s inventory. ) The retail consumer electronics industry was an extremely competitive environment in the 1980s. As a result, Crazy Eddie saw a decline in the growth of his retail stores. Highly-competitive industries can sometimes be troubling for company’s struggling to compete. Every company wants to exceed analysts’ expectations and report seemingly perfect operating results. But in a competitive industry, this can be difficult. Often times, company executives will take matters into their own hands in order to meet these goals. As with the case of Crazy Eddie, Antar was overstating inventory which in turn overstated gross profit.
I guess the phrase would be “cooking the books” in order to meet expectations. When there are dramatic changes in an industry as seen with the electronics industry, auditors should increase the audit procedures performed. There is a higher risk of misstatements and fraud during a time of change. Increased audit procedures will help auditors detect any irregularities in the accounting records and financial statements. 4) “Lowballing is the loss-leading practice in which auditors compete for clients by reducing their fees for statutory audits (Accountants, 2007). Main Hurdman, one of the independent auditors on the Crazy Eddie engagement, charged Crazy Eddie modest fees for the audit performed, only $85,000 to be exact. Main Hurdman was then charging Crazy Eddie millions of dollars for consultation services. (Knapp, 2011) In the practice of lowballing, there is a potential risk of poor quality audit services. The budget is simply not big enough to allow for extensive audit procedures to be performed. Auditors may take shortcuts when auditing certain accounts just to stay within budget. In turn, this increases the risk of misstatements being overlooked.
It is also very tough for auditors to obtain sufficient appropriate evidence to support their opinion when the budget is very limited. As a result, the client may receive a poor-quality audit. The audit firm may face problems too. Their intention is to lower audit service fees and recuperate by offering non-audit services to client. The audit firm could potentially lose money though when the client decides not to purchase any other services. 5) Testing a client’s year-end inventory cutoff procedures is a way to test for completeness.
Cutoff procedures ensure that a transaction was recorded in the financial statements in the proper year. If a client was unable to locate 10 of the 30 invoices I selected, I would first exercise my professional skepticism. It would be a little suspicious that the selected invoices just happened to be lost. My superiors and I would have to obtain other evidence to support these transactions. An invoice is not the only piece of documentation related to a purchase. The auditors could contact customers for confirmation of delivery of the goods. I would assume there must be a delivery receipt generated by the company.
A copy would go to the customer and a copy would stay at store level. If no documentation was available supporting these transactions, it would hard to say that sufficient evidence was gathered to support any findings on the inventory cutoff procedures. 6) It is very common for companies to hire individuals who formerly served as their independent auditors. It is often argued that this practice impairs an accountant/auditor’s independence. For this reason, the Sarbanes-Oxley Act of 2002 imposed a one year cooling-off period before publicly held companies may hire former auditors as employees of key positions. Wright & Booker, 2005) The purpose of the cooling off period is to ensure the former auditor can maintain his or her independence. Public companies try to hire their former auditors in hopes of increasing investors’ confidence. By having a former auditor work for a public company, investors tend to assume that the financial statements will be free of misstatements and can be relied on. Companies also like to hire former auditors because they have already developed an accountant-client relationship. The auditor probably has a good idea about how the business operates, so it makes it easier for training purposes.
On the flip side, hiring a former auditor can have negative implications too. It is easier for a former auditor to conceal fraudulent activities because he or she knows what the independent auditors will be looking for. The cooling-off period also can make it difficult for former auditors to find new jobs. Generally, people try to find a job in close proximity to them or in a business that is familiar to them. Not being allowed to work for a former client for a year limits the opportunities after leaving an audit firm.