Happiness Express Inc.
a) The primary audit objectives of confirming a client’s year-end accounts receivable include occurrence and accuracy of realizable value. Auditors would like to make sure that the transaction generating the accounts receivable actually occurs, and that the receivables are recorded at accurate value for the current reporting period. Usually they will send accounts receivable confirmations to client’s customers directly.
b) The primary audit objectives of performing year-end sales cutoff tests include accuracy and timing, since the purpose of year-end sales cutoff tests is to check whether revenues and/or receivables were recorded in the proper period or not. These tests usually involve a review of a selected sample of sales transactions occurring in the last few days of a fiscal year and the first few days of the following year.
2. Auditors of Coopers & Lybrand have made several mistakes in judgment when they tried to confirm the Wow Wee receivable at the end of fiscal year 1995. These mistakes include: Auditors informed Goldberg that Wow Wee was chosen for confirmation, giving him the opportunity to provide an incorrect address. When auditors didn’t receive the confirmation letter back from Wow Wee, they discussed with Goldberg and allowed him to contact Wow Wee in order to ensure the confirmation process. It gave Goldberg the opportunity to make fake documents. After the auditors received the faxed confirmation response, they accepted it directly without further verifying the source and content of the response. They didn’t perform any follow-up procedures.
I would say most of these errors in judgment involve negligence. Fraud is harder to prove than negligence because fraud requires a “scienter” or an intent to deceive. In fact, it is difficult to prove that Coopers & Lybrand had a motive to issue a false audit opinion on Happiness Express’s financial statements. However, I would rather characterize the mistakes as fraudulent, since they all shown that auditors didn’t perform audit procedure independently. When auditors performed the confirmation process, they kept
contacting Goldberg and using him as an intermediary, which is a violation of independent standard.
3. Yes, the Coopers & Lybrand auditors should have confirmed the receivable from West Coast Liquidators at the end of fiscal 1995. The large receivable accounted for approximately 13% of Happiness Express’s total accounts receivable, which was a highly material amount, so it is reasonable for the auditors to perform confirmation process. Auditors should exercise an appropriate level of professional skepticism throughout the process.
Usually large increase in year-end sales to a single or a few customers is an indicator of the risk of potential material misstatements in financial statements. Given the fact that Happiness Express booked almost $4 million of sales to West Coast Liquidators at the year-end, it is very suspicious. Therefore, auditors should have included one or more sales to West Coast Liquidators in their year-end sales cutoff tests for fiscal 1995.
4. (AU 330) When the auditor has not received replies to positive confirmation requests, he or she should apply alternative procedures to the nonresponses to obtain the evidence necessary to reduce audit risk to an acceptably low level. In the examination of accounts receivable, alternative procedures may include examination of subsequent cash receipts (including matching such receipts with the actual items being paid), shipping documents, or other client documentation to provide evidence for the existence assertion. Since the documents examined are prepared and provided by the client, they are not reliable as evidence yielded by a confirmation. Since confirmation letters are prepared by an external independent third party, they are much more reliable. Auditors should use these evidences as primary evidence whenever possible.
5. Yes, auditors have a responsibility to consider or investigate the possibility that client executives have engaged in insider trading activities, since insider trading is an illegal act that has significant impact on the determination of financial statement amounts.
Normally, an audit in accordance with generally accepted auditing standards does not include audit procedures specifically designed to detect illegal acts. However, procedures applied for the purpose of forming an opinion on the financial statements may bring possible illegal acts to the auditor’s attention.
There are laws and regulations relating more to an entity’s operating aspects than to its financial and accounting aspects, and their financial statement effect is indirect. An auditor ordinarily does not have sufficient basis for recognizing possible violations of such laws and regulations. However, auditor has responsibility to detect and report other illegal acts that have significant financial statement effects. If specific information comes to the auditor’s attention that provides evidence concerning the existence of possible illegal acts that could have a material indirect effect on the financial statements, the auditor should apply audit procedures specifically directed to ascertaining whether an illegal act has occurred. However, because of the characteristics of illegal acts explained above, an audit made in accordance with generally accepted auditing standards provides no assurance that illegal acts will be detected or that any contingent liabilities that may result will be disclosed (AU 317).