As noted below, imagine that the current date is 5 December 2017. The covid pandemic has no impact on or role in this case. Company Background Great Gifts, Inc., (“the Company” or “GGI”) designs and markets a variety of relatively inexpensive gift items for all occasions. Gifts sold by the Company include items of jewelry, desk accessories, clocks, calendars, pen and pencil sets, and lapel pins, and the Company is planning a new line of offerings in the home décor area. The Company outsources some of its manufacturing functions to South American manufacturers, and conducts some manufacturing operations itself. Gift items are sold to national retailers like Wal-Mart and Target, to large and small gift shop chains, and independent gift store owners. Although the Company is a gift business, there are no significant seasonal effects on sales, since the Company supplies gifts to almost all religious and secular holidays and special occasions throughout the entire year. GGI is a small public company. GGI was engaged as a client of your firm in early 2016 for the audit of their 31 December 2016 financial statements. That audit was completed in early 2017, and as of now (the current date is 5 December 2017), you are preparing to execute the year-end phase of the audit of the 31 December 2017 financial statements in mid-January 2018. Interim testing was accomplished in November 2017. You were assigned to this audit as the audit senior toward the end of calendar year 2017, after initial planning and interim tests of controls had taken place. (Due to staff turnover, the previous audit senior on the audit, as well as the four staff auditors that had been assigned to the audit, have all left the firm.) As a public company, GGI requires an audit of their year-end financial statements. Due to the fact that it is a non-accelerated filer, GGI does not require an external audit of internal control over financial reporting (“ICFR”). Your firm also provides tax services to GGI. Again, you are preparing to lead the year-end phase of the audit in January 2018. The last day of fieldwork is scheduled for mid-February, and the issuance of the audit report will likely take place at the end of February. GGI organizes their products into three product lines. Their two historical and traditional lines have been personal gifts like jewelry and watches, and office gifts such as desk accessories and pen and pencil sets. The company has been impacted by significant competition from overseas manufacturers, who seem to have advantages with respect to lower labor costs and new manufacturing technology. Due to the sluggish or non-existent growth in the two traditional lines, management planned the addition of a third line: home décor items, which it intends to sell to home décor retailers across the country. The expansion of products was planned in 2016, with research and roll-out scheduled for 2017. You are now reviewing working paper documentation relating to the background of the Company (in the permanent files), as well as working paper documentation relating to last year’s audit (in last year’s current files), and this year’s interim audit work (in this year’s current files). Please review the following notes relating to your review of relevant documents involving the planning and execution of the current year audit. Then review the academic and administrative requirements of this assignment at the end of the case materials. Excerpts from your notes…
“Notes and observations from my review of the GGI Permanent File, the GGI current year files relating to the 31 December 2016 audit, and the GGI current year files relating to interim testing for the 31 December 2017 audit” (NB: These notes were written by you, the newly appointed senior auditor…)
· During 2017, the CEO who had led the Company for 7 years resigned. According to news reports, the resignation was a submitted in order to spend more time with his family. Shortly thereafter, the Chief Financial Officer and the Controller also left the Company. A new CEO and CFO were hired before midyear (after an “acting” CEO and CFO had been appointed and served for a couple months) but the Controller position had not been filled as of November 2017. In their first “conference call” with analysts who follow the company and issue earnings estimates, both the CEO and the CFO guaranteed the Company absolutely would meet its earnings targets. Coincidently, the new CEO is the owner of the building that the Company rents as its corporate headquarters.
· The previous senior auditor on the engagement noted during interim testing that the roll-out of the new product line has not been going smoothly. In the early months of 2017, the Company was engaged in research relating to a new procedure to make their pottery products in the new home décor line unbreakable, making the products desirable to families with small children. The Company indicated that the result of that research was successful, and the new technology was scheduled to be incorporated into the manufacturing process. However, implementing the new process took longer than expected. Shipments of product to retailers relating to products in the new home décor line did not commence before the holiday period of 2017, and the roll-out was deferred until 2018. Because of the success of the research and long-term benefits that the research was going to provide to the Company, management has capitalized $300,000 of research costs as a deferred asset on this year’s balance sheet, and intends to amortize those costs over 20 years.
· Sales of product from the old, traditional product lines continued to be flat or negative during 2017. Management was hopeful that the last weeks of the holiday ordering period in 2017 would bring increases in sales sufficient to equal the previous year.
· During 2017, management of the Company installed a new software package to improve accounting and processing surrounding the purchases and payables process at the company. When the audit team was developing an understanding of internal control in this area, significant problems were noted, including the presence of two material control weaknesses in the system. Based on this finding, the previous senior auditor decided to test controls over payables and purchases at interim to be sure they were working.
· In October 2017, GGI entered into an arrangement with a retail chain to provide gift products for the following Valentine’s Day. Manufacturing of these products began in late 2017, manufacturing was scheduled to end in early January, and shipment of the product was scheduled for mid-January. Management believes that shipment and delivery is assured and recognized $400,000 of revenue in October 2017.
· Under terms of their employment contracts, the new CEO and CFO will receive a bonus of 30% of their base salary if net income for 2017 exceeds $12,000,000. Unaudited interim financial statements for the ten months ended 31 October 2017 indicated net income of $10,100,000, with a forecasted amount of $12,200,000 for the end of December.
· Although sales in the traditional product lines have been slow to grow or in slight decline, the Company believes that due to the robust economy, the Company can reduce the amount reported in the Allowance for Doubtful Accounts on the balance sheet. The Company uses the allowance method (income statement approach) and reduced the estimated percentage of sales deemed uncollectible from 3.0% to 0.5%.
· In 2016, management adjusted the inventory balance for an impairment due to holding approximately $200,000 of what appeared to be obsolete inventory. The Company continues to hold the inventory, but believes, due to the strength of the economy in 2017, that the product will be sold by the end of the year, and the write-off was unnecessary. Therefore, management has reversed the impairment write-off from last year into income this year. The previous senior auditor noted that controls over this area were particularly strong, as the CEO herself initiated and recorded this entry.
· After the Company Board Meeting in September 2017, the Audit Committee met with the auditor for 30 minutes before the members had to leave to catch their planes. The next meeting of the Audit Committee is scheduled for mid-March 2018. A Board member who is a brother-in-law of the new CFO sits on the Audit Committee. The Internal Audit Department manager was laid off in 2016 in a cost-cutting measure. The Company is seeking to hire another manager, at a lower salary, to report to the Controller regarding internal audit matters. However, no one has been hired as yet, and the Department is led by one of the staff auditors.
· Over recent years, labor relations at the Company have deteriorated. Employees consider themselves underpaid, as flat profitability in recent years has prevented the granting of raises. Although negotiations are continuing, warehouse and transportation workers have threatened to walk out prior to the end of the year if wages are not increased. Administrative and financial office workers, who are not unionized, are also upset about the lack of raises.
Requirements: Using your textbook and material discussed in class as reference material (outside sources should not be necessary), please address the following issues:
1. Create a bullet point list of risks present at GGI, using a sentence or two to describe the risk factor. After each risk you identify, please briefly note where each risk might be classified according to the components of the engagement risk model. If you believe that an identified risk could be classified in the various intersections of the model, associating a particular risk with just one of the risk areas is sufficient. (Remember, there are often many ways to think about how identified risks “fit in” to the engagement risk model, and many can be classified at the areas of intersection between ABR, CBR, and AR, or at the intersection of IR and CR within the audit risk model. However, a classification in one area of risk is sufficient.) It should be very easy to identify at least 10 different risk factors in the case, as there actually many more than 10.
2. Based on your identification of risk factors, please assess the overall level of ABR, CBR and AR separately, each on a scale of very low, low, medium, high, and very high. That is, make three separate assessments, based on all you’ve learned from above. Briefly (as in a couple sentences) explain the reasoning behind your assessments.
3. The facts presented above indicate that management has departed, or plans to depart, from generally accepted accounting principles in a number of situations (each of which is an indicator or evidence of risk). Identify one of those cases (they may be on your bullet point list of risks above), briefly describe what management is doing wrong, and briefly describe what they should have done instead. In order to do this, you will need to assess the reasonableness of the accounting or proposed accounting for the particular issue you choose. If you don’t recall the particulars of how to account for certain issues, you may need to engage in a brief bit of accounting review/research to assess whether the accounting or proposed accounting is in conformity with GAAP.
4. Then identify, for one of the misstated or likely-to-be misstated accounts, identify one management assertion that management is or might be misstating, and briefly explain why that is the case. (Hint: Each possible misstatement will misstate at least one account and at least one assertion. Identify a misstated account, and a particular management assertion that is or will be misstated.)
5. Assume for arguments sake that all risks are addressed and all misstatements are corrected to the auditor’s satisfaction. Describe the type of auditor report that the auditor will offer. Do not draft a report, just indicate what type of report in enough detail for me to understand that you have identified an important reporting issue.
6. Bonus – The previous senior auditor who supervised the interim audit work and testing of controls made an illogical and incorrect strategy decision. Briefly identify that mistake and explain why it was a mistake.