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Case 5.6: Sarbox Scooter Inc.

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Michelle Bouchard

on 23 October 2013

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Transcript of Case 5.6: Sarbox Scooter Inc.

Case 5.6: Sarbox Scooter Inc.
design by Dóri Sirály for Prezi
Case Overview
Identification of Significant Accounts and Locations
Entity-Level Controls
Types of Deficiencies
Deficiency Scenarios
Scoping and Evaluation Judgments in the Audit of Internal Control over Financial Reporting
Section 404 of Sarbanes-Oxley Act

PCAOB Audit Standard No. 5

Important audit decisions
Sarbox Scooter Inc.
Manufacturer and distributor of scooters and pocket bikes

Sales are primarily (90%) to domestic and international dealerships

Intense competition in the industry

Have business units in U.S., Canada, & Mexico

Decentralized business structure with some functions at headquarters

Case Assignment
Who we are: external auditor at Delmoss Watergrant LLP

Our task: make decisions on what controls should be tested

Purpose: to evaluate internal controls for integrated audit
CAS Section 315: Identifying and assessing the risks of material misstatement
Apply the Audit Risk Model : AR = IR*CR*PDR

Perform preliminary analytical procedures

Identify quantitative factors

Identify qualitative factors
Examples of Qualitative Factors
Impact on debt covenants

Impact on earnings per share (EPS)

Impact on management performance


History of collectability
Components of Internal Controls
Importance of Testing Entity-level Controls
Assess control risk

Planning purposes


Examples of ELCs
Controls within the control environment

Controls for management's risk assessment process

General computer controls (GCCs)

Controls to monitor results of operations

Controls for the period-end financial reporting process

Controls to mitigate the risk of management override

Auditor's Responsibility
CAS 315.12
“The auditor shall obtain an understanding of internal control relevant to the audit. Although most controls relevant to the audit are likely to relate to financial reporting, not all controls that relate to financial reporting are relevant to the audit. It is a matter of the auditor's professional judgment whether a control, individually or in combination with others, is relevant to the audit.”

CAS 315.13
“When obtaining an understanding of controls that are relevant to the audit, the auditor shall evaluate the design of those controls and determine whether they have been implemented, by performing procedures in addition to inquiry of the entity's personnel.”

CAS 315.22
“The auditor shall obtain an understanding of the major activities that the entity uses to monitor internal control relevant to financial reporting, including those related to those control activities relevant to the audit, and how the entity initiates remedial actions to deficiencies in its controls. ”

Control Deficiencies (CAS 265, SOX Section 404)
Internal control deficiency
Design deficiency
Operation deficiency

Significant deficiency
Must be communicated in writing to those charged with governance

Material weakness
Must be communicated in audit report

Potential Magnitude and Likelihood of Misstatement
Decision Tree
While examining Sarbox’s period-end financial reporting process, you discover that revenue has been recognized on orders that were received and completed, but not yet shipped to the customer. No specific goods were set aside for these orders; however, there is sufficient inventory on hand to fill them. Also, you observe that some orders were shipped before being recorded as sales, so that your best estimate of total revenue cutoff error at year-end was approximately $2.3 million.
What kind of deficiency is present?
Scenario #1
Scenario #2
Sarbox’s revenue recognition policy requires that all nonroutine sales (i.e. sales to clients other than dealerships) receive authorization from management in order to verify proper pricing and terms of sale. However, after examining a sample of nonroutine sales records you find that this control is not closely adhered to and that sales representatives offered discounts or altered sales terms that were not properly recorded in Sarbox’s records. As a result, in instances when the control is not followed the recorded sales prices tend to be too high and/or terms are not correctly reflected in the sales invoice and the customers complain. In some situations, customers have cancelled orders due to the over-billing or changed sales terms. Nonroutine sales represent about 10% of Sarbox’s sales revenue. From your sample testing of the authorization control, you find that the control doesn’t operate 4% of the time, with an upper bound of 9% (i.e., based on your sample, you can be 95% confident that the exception rate does not exceed 9%).
What kind of deficiency is present?
Scenario #3
Sarbox Scooter requires that all credit sales to new customers or to customers with a current balance over their pre-approved credit limit be approved by the credit manager prior to shipment. However, during peak seasons this policy is not strictly followed in orders processed rapidly. Because of these findings, you estimate that the allowance for doubtful accounts is materially understated. While the client does not dispute that the authorization control was not operating effectively during peak seasons, the client has pointed out compensating controls that it feels should reduce the magnitude of the deficiency below a material weakness. The first compensating control is that an accounts receivable aging schedule is reviewed each quarter by management and accounts that are older than 180 days are written-off. Also, management distributes a list of companies that default or fail to pay on time to all sales staff on a monthly basis to prohibit such companies from making additional purchase on credit.
What kind of deficiency is present?
Determining Materiality
5% of income = $19M

Performance materiality 75% = $14M

Test accounts greater than materiality

Selecting Accounts to Test
Will test accounts below materiality i.e Cash

Will not test all accounts above materiality i.e Fixed assets and Goodwill

Judgement when disaggregating accounts i.e other assets

Selection of Business Units
According to policy
Test all business units greater than 10% of consolidated income and greater than 10% of consolidated assets

Do NOT test US Northeast (3%) and Mexico (5%)
Use judgement and qualitative factors in US Central (10%)

Analytical Procedures
Gross margin/sales same everywhere at 47%

Income/sales same at 19% except Mexico at 21%
Understatement of expenses?

Comparative figures
Larger variances in US

Qualitative Factors
Mexico director of finance under management scrutiny
Risk of material misstatement

Competitive market – inventory
High volume, low margin
Valuation correct?
Full transcript