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Keystone Computers & Networks

Chapter 6 Auditing Case

Anne O'Malley

on 10 December 2012

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Transcript of Keystone Computers & Networks

Chapter 6 Keystone Computers & Networks, Inc. Objectives of the engagement Planning Meetings Implications and Response
to Significant Audit Risks Purpose: To describe the services that are to be rendered to the client

1. Audit of KCN's financial statements for the year ended 12/31/X5
2. Issuance of a letter on compliance with covenants of the client's letter of credit agreement Business and Industry Conditions Purpose: To describe the nature of KCN's business and it's industry

Sells and installs computers, networking hardware and software to business customers.
The industry is sensitive to economic conditions and very competitive.
KCN’s long-term success depends on its ability to attract and retain qualified information technology personnel.
The annual growth in spending for information technology products and services is expected to be 3% per year for the next three years. Purpose: To indicate meetings held with client and with CPA engagement team

One meeting has been held with client personnel and one with the engagement team. Chapter 6C-2 Ownership
and Management Purpose: To describe the owners and management of the company

KCN is owned by:
*Terry Keystone (active in management)
*Mark Keystone (active in management)
John Keystone
Keith Young
AND BUSINESS RISKS Purpose: To describe business objectives, major strategies and the risks related to achieving its objectives

To increase revenues by 6% and increase net income by 8% for each of the next 3 years
1. Aggressive advertising
2. Sales to customers with higher risk profiles
3. New software development
1. Advertising may not create the desired results
2. Credit losses may exceed benefits of increased sales
3. Software development activities may not produce products Measurement and Review
of Financial Performance Purpose: Describes the methods used by management to monitor performance

Measures used:
1. Inventory and receivables turnover
2. Aging of accounts receivable
3. Sales and gross margins by type of revenue
4. Net income
5. Total inventory balance Procedures to Obtain an Understanding
of the Client and Its Environment Purpose: To describe the procedures used by the auditors to obtain an understanding of the client and its environment

1. Review of information from the prior-year’s audit
2. Inquiries of management
3. Reading board minutes
4. Review of monthly performance reports
5. Review of industry reports
6. Review of the KCN’s website
7. Review of articles in the Wall Street Journal Significant Risks Purpose: To describe the significant risks identified by the auditors

Significant Risks:
1. KCN has engaged in a strategy to sell to customers with higher credit risk
2. The officers of the company receive significant bonuses based on quarterly results Significant Accounting
and Auditing Matters Purpose: To describe particular accounting and auditing matters that are of concern

1. Proper accounting for extended warranties
2. Capitalizing software costs Planning Materiality Purpose: To identify an amount to be used as a measure for planning materiality

An amount of $300,000 will be used as a measure of planning purposes Scheduling and Staffing Plan Purpose: To provide the schedule for major portions of the audit, and the staffing requirements for the engagement

Major dates:
Beginning with interim audit work (October 15, 20X5) through the issuance of an updated management letter (March 10, 20X6)
195 hours total are budgeted for the audit

KCN has engaged in a strategy to sell to customers with higher credit risk.

There may be an increased risk of misstatement of bad debt expense and the allowance for bad debts.
The auditors may decide to assign a more experienced auditor to this area.
The auditors will decide to increase the evidence related to the adequacy of the allowance. Risk #1 Risk #2 The officers of the company receive significant bonuses based on quarterly results.

An increased risk that management may misstate quarterly results to maximize bonuses.
The auditors may respond by adjusting the staffing, increasing the level of skepticism, or increasing the evidence need to be collected. Memorandum & Major Audit Issue Chapter 6C-3 KEYSTONE COMPUTERS & NETWORKS, INC.
December 31, 20X5

Memorandum on Accounting Issues

KCN began developing networking software product for sale in 20X4, then in 20X5 the company started capitalizing certain costs of development. In general, research and development costs are expensed under FAS 2: Accounting for Research and Development costs (FAS 2), FIN 6: Applicability of FASB Statement 2 to Computer Software, an Interpretation of FASB Statement No. 2 (FIN 6), and No. 86: Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed (FAS 86). FAS 2 states the nature of the activity for which the software is being developed should be considered in determining whether software costs should be included or excluded in research and development. FIN 6 indicates that to the extent that the acquisition, development, or improvement of a process by an enterprise for use in its selling or administrative activities includes costs for computer software, those costs are not research and development costs.
FAS 86 states that all costs incurred to establish the technological feasibility of a computer software product to be sold, leased or otherwise marketed are research and development costs. The technological feasibility of a product is established when the enterprise has completed all planning, designing, coding, and testing activities that are necessary to establish that the product can be produced to meet its design specifications including functions, features, and technological performance requirements.
Costs incurred subsequent to establishing technological feasibility are to be capitalized. The capitalization of computer software costs ceases when the product is available for general release to customers. Costs of maintenance and customer support should be charged to expense when related revenue is recognized or when the costs are incurred, whichever occurs first.

Date The major audit issue is that the client has properly categorized costs between research and development and those costs that should be capitalized, then the auditors must determine at what point the software product reached the point of technological feasibility for the R&D costs. Financial Ratios Chapter 6C-4
Analytical Procedures Ratios
For the Years Ended December 31,

Current ratio
Days sales in average accounts receivable
Allowance for doubtful accounts / accounts receivable
Bad debt expenses/net sales
Total liabilities to net worth
Return on total assets
Return on net worth
Return on net sales
Gross profit/net sales
Selling, operating and admin expense / net sales
Times interest earned
Ref. No. Plan-1
Prepared by WL
Date 1/10/X6

20X5 20X4 Industry

1.144 1.215 1.3
37.0 33.2 37.0
1.0% 1.1% -
0.3% 0.2% -
3.5 2.7 2.9
1.7% 8.3% 9.0%
7.5% 30.5% 29.0%
0.2% 1.0% 2.3%
22.1% 23.2% 24.0%
21.2% 21.4% 23.9%
1.7 4.1 5.5 The following accounts should be investigated:
Total Current Assets
change in inventory procedures
missing or unrecorded inventory
overstating inventory
understating purchases
Net Sales
change in economic conditions
increase in pricing
decrease in COGS
Accounts Receivables
understating sales
overstating receivables
Allowance for Doubtful Accounts
change in credit policy Auditing Standard No. 9: Audit Planning. (2012). In PCAOB: Public Company Accounting Oversight Board. http://pcaobus.org/Standards/Auditing/Pages/Auditing_Standard_9.aspx

Flanagan, P. Accounting for Software Development Costs. http://www.christophertechnology.com/docs/SOP%2098-1%20+%20EITF%2000-2%20Application.pdf

Statement of Financial Accounting Standards No. 2: Accounting for Research and Development Costs. (1974). http://www.fasb.org/cs/BlobServer?blobkey=id&blobwhere=1175820911202&blobheader=application%2Fpdf&blobcol=urldata&blobtable=MungoBlobs

Statement of Financial Accounting Standards No. 86: Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed. (1985). http://www.fasb.org/cs/BlobServer?blobkey=id&blobwhere=1175820922177&blobheader=application%2Fpdf&blobcol=urldata&blobtable=MungoBlobs

Whittington, O. & Pany, K. (2012). Principles of Auditing and Other Assurance Services. 18th ed. The McGraw-Hill Companies.

Audit Plan by Anne O'Malley
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