GUIDANCE FOR MULTI-LOCATION AUDITS

By James E. Gauntt and G. William Glezen

Joe Smith, CPA, is a partner in a small local public accounting firm that employs four CPAs. One of his clients wants an audit of a closely-held corporation that owns 12 service stations located within 50 miles of his office.

Jane Doe, CPA, is a partner in a regional public accounting firm with offices in five cities. One of her clients is a closely-held corporation that holds the franchise rights for a major fast-food chain for three states and has 100 restaurants in the three-state area.

John Brown, CPA, is a partner in a national accounting firm. One of his clients is a "Fortune 500" corporation that has administrative offices in the city in which his office is located. However, the corporation has marketing, distribution, and manufacturing operations located in dozens of cities nationally.

These auditors each face different problems in planning their engagements. In one respect, however, they all face decisions that have much in common. They must decide how to deal with the multiple locations of their clients by deciding what locations should be visited and what procedures should be performed at each location.

The decisions have one more aspect in common: professional standards and literature provide little guidance on how to make these decisions. The existence of multi-locations increases audit-risk for the engagement. Each location not visited increases the risk of errors and irregularities such as local fraud, non-existent assets, and phantom employees. The following examples illustrate this risk: * In 1982, the SEC filed a civil action against McCormick & Co., charging McCormick inflated earnings. The company delayed recognition of expenses and recorded as sales shipments not made until later periods. These actions were taken by managers in autonomous divisions under pressure from corporate management to achieve ambitious profit goals. * In another SEC civil action in 1983, the SEC charged AM International with fraudulent reporting. Part of the charges involved foreign subsidiaries that reported distorted (fraudulent) earnings consolidated with the parent company statements.

To plan an effective audit, the auditor must first understand the unique risks of the multi-location audit. Next, the auditor must consider the specific characteristics of the individual client. Only then can the auditor select audit procedures that reduce the audit risk to an acceptable level.

Overall Planning

Preliminary Analytical Procedures. Although there are few direct references, all professional standards can be assumed to extend to multi-location audits. For example, at the planning stage, the auditor must perform analytical procedures. For a multi-location entity, the auditor is likely to perform analytical procedures on preliminary financial reports from the various locations. As noted in SAS No. 56(AU329.19), "Expectations developed at a detailed level generally have a greater chance of detecting misstatement of a given amount than do broad comparisons." Errors or irregularities that might be concealed in overall comparisons because of offsetting factors between locations, are more likely to be detected when analytical procedures are applied to individual locations.

As another part of the planning process, the auditor assesses the level of risk associated with financial statement assertions for each account balance. If the auditor perceives that risks vary by location, he or she may assess risk separately for each location.

Assessing Risk of Material Error. During the planning stage, the auditor determines the level of misstatement that will be considered material for the engagement. In a multi-location audit, several locations may collectively contain a material misstatement. Because of this, the auditor may choose to "allocate" materiality among the locations in planning the work to be performed. The audit team can then use a finer filter for investigation in the location audits. When locations are individually significant to the audit, the auditor would visit the significant locations, together with a representative sample of other locations. Only the results from the representative sample would be projected to the locations not visited. If the audit coverage from the audit of significant locations is high enough, the auditor would use analytical procedures to reach conclusions regarding the remaining locations without further visits.

Internal Control. In evaluating the internal control structure, the multi-location client again poses special problems. The auditor recognizes as an inherent limitation of internal control that management may be able to override existing controls. In a multi-location environment, this threat is increased. At each location, local management has opportunities to circumvent internal controls, either to make the performance at that location appear better than it actually is or for personal financial gain. Further, at some locations, local management may display a lack of concern about controls. At these locations, employees may take advantage of this weakness to commit fraud or errors that cause a material misstatement of the financial statements.

Identification of Locations to be Visited

Client Circumstances. To identify what (and how many) locations to visit, the auditor must consider the specific circumstances of the client. The multi-location client can take many forms. In some cases, such as retail businesses, a company may have a number of locations, each performing the same functions. In other cases, companies develop a high level of vertical integration. These companies purchase raw materials, manufacture products, and develop complex distribution networks to provide the products to the customers. For these companies, each location of the company may perform only one of the primary functions‹sales, production, or service. In another case, a company may have grown through acquisition so that each location is a separate small company with unique audit problems.

Consider a simple example. Each remote location performs a similar function, such as marketing, and is supported by a common transaction processing system for that function, such as a point-of-sale system. Other accounting systems and functions‹payroll, purchasing, and cash disbursements, etc., are performed as a central location. For this type of client, the auditor can usually reduce audit risk to an acceptable level by visiting and performing audit procedures at a sample of locations. If each location has a determinable chance to be selected, the results of the sample can be extended to the entire company.

In more complex examples, however, different locations may perform different functions, or corporate policy may allow a high degree of local autonomy. The various accounting systems may vary widely not only in their design but also in the control procedures contained in the systems. In other cases, local management may be indifferent toward internal control, and employees may be lax in performing internal control functions. In these cases, different locations may represent different audit problems. Audit risk increases when differences in procedures exist and a sample is used to draw an overall conclusion. The auditor is likely to visit each location that is material to the financial statements, with particular emphasis on locations where problems have been detected in the past. Also, the selection of locations may be based on a rotation policy where all locations are visited within a given time period. However, if each location does not have a determinable chance of selection, the results of the testing can not be extended to the locations not visited. Audit evidence for locations not in the current rotation could come from alternative procedures such as analytical procedures.

Where are the Records? Most companies that require external audits have automated accounting systems. In some of these companies, significant computing capability exists at remote locations. In most cases, remote locations transmit data over communications networks to a central computer center. In both cases the auditor must develop an understanding of the internal controls associated with the automated processing of those applications. If accounting applications are processed at the remote location, the auditor is more likely to visit the location. If the accounting function is performed at a central location, the auditor will perform the audit procedures at that central location. If source documents, accounting reports, and detailed accounting files are maintained only at the remote locations, however, the need to visit the locations increases.

Internal Auditor Considerations. Many larger multi-location companies have internal audit departments that perform financial and operational audits throughout the company. The external auditor can reduce the number of locations to be visited by coordinating audit plans with the internal audit department. Internal auditors will usually visit some or all of the locations during the year, and the external auditor can review their workpapers to gain important audit evidence for both control and substantive testing.

Other Factors. The location selection decision also may involve factors other than audit effectiveness. Regular visits by an audit team may disclose weaknesses in the internal control structure at certain locations. In addition, the "threat" of an audit visit may provide benefits as employees who believe they may be audited are more likely to comply with company procedures. Finally, employees who are likely to be audited may perceive less opportunity for fraud. Because of these effects, some clients may ask the external auditor to increase the scope of an engagement to insure periodic visits during the annual audit.

Joe Smith

Joe Smith, CPA, is a partner in a small local public accounting firm that employs four CPAs. One of his clients wants an audit of a closely-held corporation that owns 12 service stations located within 50 miles of his office.

On inquiry, Joe Smith finds each service station has a standard point-of-sale system to record the sales transactions of that station. All sales receipts are remitted to the central office daily. All purchasing, payroll, and other accounting functions are processed at the central office. During the planning stage, Joe performs analytical procedures on preliminary financial results from each station. He finds that revenues, costs, and inventories are similar across all stations. He schedules staff auditors from his firm to observe the inventory quantities on a nonstatistical random sample of three of the 12 stations. They also obtain an understanding of, and test the procedures for, recording sales and receipts. He projects the results of these tests to the relevant populations. Joe performs all other audit procedures at the corporation headquarters.

Jane Doe

Jane Doe, CPA, is a partner in a regional public accounting firm with offices in five cities. One of her clients is a closely-held corporation that holds the franchise rights for a major fast-food chain for three states and has 100 restaurants in the three-state area.

On inquiry, Jane Doe finds each restaurant has a standard menu and a point-of-sale accounting system for record food and beverage sales. Other accounting functions are performed at the corporate office. Based on analytical procedures, she finds four restaurants have abnormal gross profit ratios and unusually large inventories. Jane schedules inventory observations and tests of sales transactions at these four restaurants and a sample of 20 of the remaining restaurants. The results of the sample of 20 are projected to the population of 96 restaurants, and these amounts are added to the results of tests of the four restaurants with abnormal variations. All other audit procedures are performed at the corporate office.

John Brown

John Brown, CPA, is a partner in a national accounting firm. One of his clients is a "Fortune 500" corporation that has administrative offices in the city in which his office is located. However, the corporation has marketing, distribution, and manufacturing operations located in dozens of cities nationally.

John Brown is aware this client has an active internal audit department that visits each location during the year. The internal auditors perform most of the procedures performed by an external auditor, such as confirmation of accounts receivable, observation of physical inventories, and documentation and evaluation of the internal control structure. The internal audit manager has public accounting experience and hires most of the internal auditors from public accounting. All internal auditors meet continuing education requirements, and all work is reviewed carefully. Each location has a full range of automated transaction processing systems that communicate with a central computer center. Only month-end and consolidation entries are prepared at central office. John decides he will obtain and review the internal auditor's working papers for all locations. Because one manufacturing facility accounts for over one-half of consolidated total assets and revenue, an audit team will be sent to that location. Also during the year, John will send auditors with the internal audit team to 10 locations identified by analytical procedures. These auditors will test work done by the internal auditors at the location and perform additional tests of controls and substantive tests. In addition, he decides to send a computer auditing specialist to review the controls over automated processing at the locations identified as material to the financial statements. Audit procedures not involving specific transactions (review of stockholder and board of director minutes, letters of audit inquiry from attorneys, etc.) will be performed at the administrative office. *

James E. Gauntt, PhD, CPA, is an associate professor at the University of Arkansas at Little Rock and G. William Glezen, PhD, CPA, is a professor at the University of Arkansas, Fayetteville, AR.

Editor:

Douglas R. Carmichael, PhD, CPA

Baruch College

JANUARY 1996 / THE CPA JOURNAL