Crazy Eddie Case Questions 1. Compute key ratios and other financial measures for Crazy Eddie during the period 1984-1987. Identify and briefly explain the red flags in Crazy Eddie’s financial statements that suggested the firm posed a higher-than-normal level of audit risk. There were several red flags in Crazy Eddie’s financial statements. The company’s higher-than-normal level of audit risk can be determined by completing a ratio analysis of the financial statements. An analysis of key ratios over the period of 1984 to 1987 would have resulted in red flags.
Crazy Eddie’s change in assets between this period is one red flag that an auditor should have noticed. Short-term investments had a zero balance until 1986 when it dramatically increased to 21. 1 and then dramatically increased again to 41. 4 in 1987. At the same time cash on hand dropped from 34 in 1985 to 3. 2 in 1987, which is a troubling sign. The saying goes that cash is king. Crazy Eddie was rapidly expanding the number of stores and was not anticipating what could happen in the future.
Competition greatly increased and Crazy Eddie did not have the funds to pay suppliers for merchandise, which in turn causes potential customers to go elsewhere for their needs. Basically, the industry had become saturated with retailers and the company could no longer extract sweetheart deals from suppliers. After seeing this drop in cash, an analysis on merchandise inventories is needed. From 1984 to 1987, merchandise inventories decreased from 63. 8 to 37, which is another red flag that should have been investigated. Crazy Eddie is a retailer and retailers sell merchandise to customers so inventory is extremely important.
This could have been a sign that inventory was misstated. As it turns out, Crazy Eddie had a huge overstatement of the company’s inventory and personnel systematically destroyed incriminating documents to conceal inventory shortages. The age of the inventory was also a red flag that should have been noticed. In 1986, the age of the inventory was 80 days. It increased to 111. 8 days in 1987. This is a sign that inventory that is in stock is not selling, which is a negative since electronics become obsolete quickly and these products tend to have a short life cycle.
During this same period from 1984 to 1987, the company’s liabilities were taking a turn for the worst. Short-term debt increased from . 3 in 1984 to 16. 8 in 1987 while accrued expenses went from 16. 6 in 1984 to 1. 9 in 1987. Short-term debt increased because of the company’s rapid expansion as previously mentioned. The decrease in accrued expenses could be the result of the company artificial inflating its revenue by releasing accruals and is a red flag for auditors.
These red flags would have appeared to users when the financial statements of Crazy Eddie were compared against the financial statements of a competitor. 2. Identify specific audit procedures that might have led to the detection of the following accounting irregularities perpetrated by Crazy Eddie personnel: (a) the falsification of inventory count sheets, (b) the bogus debit memos for accounts payable, (c) the recording of transshipping transactions as retail sales, and (d) the inclusion of consigned merchandise in year-end inventory.
Proper audit procedures are required for auditors to obtain sufficient appropriate audit evidence that will allow them to draw reasonable conclusions as to whether the client’s financial statements follow generally accepted accounting principles. More specifically, an audit usually contains such procedures as risk assessment procedures, tests of controls, and substantive procedures. Of all the audit procedures, risk assessment procedures are preliminary. Through the risk assessment procedures, auditors obtain the needed understanding of the client, its environment, and internal control of the client company.
As in the Crazy Eddie Case, the auditors should have found out the nature of the transshipping transactions, and the potential high risk placed in the inventory accounts by proper performance of the risk assessment procedures. Following the risk assessment procedures, substantive procedures are designed and conducted to detect material misstatements of relevant assertions. Substantive procedures include analytical procedures and tests of details. Analytical procedures involve evaluations of financial statement information by a study of relationships among financial and nonfinancial data.
Tests of details may be divided into three types. One test is the test of account balances to address whether there are misstatements in the ending balance of an account. In the case of Crazy Eddie, auditors should have put greater attention to inventory and accounts payable accounts. The second test is a test of classes of transactions to determine whether particular types of transactions have been properly accounted for during the period. Crazy Eddies fraudulently classified these transshipping transactions as retail sales to inflate its sales revenue and continue growth at existing stores.
A key ratio for retailers is to compare growth in existing stores to growth from new stores. The third and final test is a test of disclosures to evaluate whether financial statement disclosures are properly presented. Crazy Eddie prepared bogus debit memos of over $20 million to understate accounts payable. 3. The retail consumer electronics industry was undergoing rapid and dramatic changes during the 1980s. Discuss how changes in an audit client’s industry should affect audit-planning decisions. Relate this discussion to Crazy Eddie.
According to the second standard of field work of generally accepted auditing standards, the auditors must obtain a sufficient understanding of the entity and its environment, including its internal control, to assess the risk of material misstatement of the financial statements. An understanding of the clients and its environment encompasses the following: * The nature of the client, including the client’s application of accounting policies. * The industry, regulatory, and other external factors affecting the client. * The client’s objectives and strategies and related business risks. Methods used by the client to measure and review performance. * The client’s internal control. From the several first years of the 1980’s, the prosperous electronics industry and the increasing market demand created numerous opportunities for Crazy Eddie to expand. Auditors should have paid special attention to the client’s internal control, organization structure, governance processes, and accounting policies to see if they were adapted properly to the company’s rapid growth. When company’s experience rapid growth, internal controls are usually not adjusted in a timely manner resulting in weak internal controls.
Due to the fast expansion of the company, investors’ attention are not drawn to investigating whether internal controls are weak, leaving potential risks. As Crazy Eddie grew rapidly around the early 1980’s, the company purchased large quantities of electronic products from its suppliers at big discounts, and then sold these goods to smaller consumer electronics retailers at slightly above cost, resulting in a small profit for the company. In order to inflate its retail sales, the company classified these transshipping transactions as part of its retail sales in order to increase existing retail sales.
If the auditors had dug further into the nature of these transshipping transactions, they could have developed more insight in the risk of this area. From 1986, the boom days had ended for the consumer electronics industry. In addition, more and more retailers squeezed into the increasing competition, resulting in smaller profit margins. According to the three conditions of a fraud, which are incentive/pressure, opportunity, and rationalization, the increasing competition of the industry and dramatic change from external environment accounts for factors of the incentive/pressure of the accounting fraud.
When planning the audit, auditors should take into account these changes and assess the risks, which arises from these changes, in order to determine the scope of the audit. 4. Explain what is implied by the term lowballing in an audit context. How can this practice potentially affect the quality of independent audit services? Lowballing means soliciting services far below generally accepted market price. The accounting firm, Main Hurdman had “lowballed” in order to obtain Crazy Eddie as an audit client. The audit was a loss leader for the company.
Main Hurdman was willing to accept $85,000 a year to complete an audit because the audit firm was earning millions of dollars for providing consulting services to Crazy Eddie. Providing consulting services is more lucrative than providing auditing services. Lowballing can influence audit quality and can limit the scope of the audit. If an auditing firm is taking a lower fee and is essentially loosing money. In order to lessen it losses, the audit firm usually cuts back on the amount of audit work and the audit may be understaffed. When this happens, the ability of an auditor to detect misstatements is lowered.
Also, the audit opinion can be affected because the auditing firm wants to keep the client happy in order to maintain the lucrative consulting business. This means that the auditor may overlook misstatements to keep the client happy and their business. 5. Assume that you were a member of the Crazy Eddie audit team in 1986. You were assigned to test the client’s year-end inventory cutoff procedures. You selected 30 invoices entered in the accounting records near year-end: 15 in the few days prior to the client’s fiscal year-end and 15 in the first few days of the new year.
Assume that client personnel were unable to locate 10 of these invoices. How should you and your superiors have responded to this situation? Explain. These ten missing invoices are a troubling sign and needs to be thoroughly investigated by the auditors. It could be a sign that client is trying to conceal fraudulent accounting transactions or it simply could be an issue of lost or misplaced invoices. In situation like this, auditors need to use professional skepticism and increase the assessment of fraud risk.
Auditors have the responsibility to detect both fraud and errors. It is important that the auditors adequately examine the internal control procedures for receiving merchandise and paying bills. The auditors needs to understand the process from cradle to grave so it is important that the auditors observe an transaction from start to finish to determine whether the internal controls are appropriate. By understanding the process, the auditors can then determine if the invoices could have been simply lost in the scuffle.
Also, the auditors could contact the supplies of the inventory to request the missing invoices in order to verify the existence of the invoices. Finally, they can compare the transactions with previous years records and other firms in the same industry to see if there is a similar pattern. If no there is no satisfactory conclusion to the ten missing invoices, auditors should report the problem to auditing committee. 6. Should companies be allowed to hire individuals who formerly served as their independent auditors? Discuss the pros and cons of this practice.
There are several pros and cons of hiring individuals who formerly served as independent auditors. Hiring former external auditors to work as senior accounting and finance officers is known as a revolving door phenomenon. One draw back of this practice is that some individuals believe that this practice undermines auditor independence, audit quality and the quality of financial statements. Auditor independence is extremely important and it is essential to satisfactory performance. Also, the former external auditor has knowledge of how external audit firm operates and their testing techniques for audits.
This means that the former auditor has the ability to help its current employer to manipulate the financial statements in ways that are least likely to be detected by the auditors. They have the potential to keep external auditors from finding evidence of any fraud. Also, remaining members of the external audit team may be reluctant to question former colleagues. This past relationship history can constrain the independence and professional skepticism of the auditing, because reliance is now placed on emotional confidence and trust.
However, there are many pros with this practice of hiring individuals who formerly served as their independent auditors. Companies have found these employees to be both efficient and effective. They are efficient for the company because these individuals are already familiar with the company’s policies, practices, and corporate culture. This means that less time and money is required to educate and train these individuals about the company. Also, these individuals are highly educated and are knowledgeable about the industry and the internal control.
They have had years of experience and are familiar with numerous types of businesses and complex accounting financial transactions. The former external auditors already have relationships with employees at the company. They have had first hand experience with the employee’s and know about the employee’s capability, ethics, and personality, which is beneficial in certain situations. Sarbanes Oxley resulted in auditing firms no longer being able to provide internal audit work to the clients they audit. This was done to avoid any appearance of conflict of interest.
On March 31, 2003, the rules for hiring individuals who formerly served as their independent auditors changed. According to Securities and Exchange Commission, under Release No. 33-8183, an accounting firm is deemed to be not independent with respect to an audit client if a former member of the audit engagement team is employed by the issuer in a “financial reporting oversight role” unless the individual had not been a member of the audit engagement team during the one year period preceding the initiation of the audit.