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April 1992

The case of the misdirected procedures. (Auditing)

by Rouse, Robert W.

    Abstract- The case of an aggressive franchisor that ended up in bankruptcy is examined. In this particular case, it was discovered that the franchisor had followed questionable revenue recognition procedures. The auditors were subsequently sued for the failure to detect the franchisor's overstatement of income from the sale of stores to franchisees. In their defense, the auditors claimed they had adhered to generally accepted auditing standards and presented evidence to support their claim. An analysis of the case suggests that while the auditors were technically right in claiming nonliability for the failure to detect the overstatement of income, they could have followed several procedures which would have alerted them earlier of the possibility of fraud. These steps should have included the review of cash receipts and credit evaluations.

The gross profit from sales of merchandise was much smaller than the gross profit generated from sales of stores, and a concentrated effort was made to increase the number of franchises sold. The recognition of revenue from the sale of a store was contingent upon the performance of most of the company's obligations--such as providing in-store displays, conducting sales promotions, and training employees. These responsibilities could be performed in a very short time. The payment of the franchise fee usually involved a series of payments over an extended number of years. Upon receipt of a fraction of the sales price, as little as 10%, in cash and the performance of the above services, the entire revenue was accrued. Such accounting appeared to satisfy GAAP.

The aggressiveness of Smith was noted by the continuing auditors--MNO, CPAs--who "red flagged" revenue recognition as a critical audit-risk area, but without any significant modification of audit approach or procedures. Over the years, audits were completed, and unqualified opinions were given. A shake-up occurred in the top management of ABC, and Sam Smith left. The remaining management contracted with MNO to perform an agreed-upon procedures engagement, not an audit, to determine if the conditions for the recognition of revenue were in fact being met.

MNO, before completing the engagement, found differences that existed as of the date of the fiscal years audited and withdrew from the engagement, citing misinformation provided by the client. ABC declared bankruptcy and was sued by the stockholders for fraud. Revenue recognition from the sale of stores was alleged to have been materially overstated. MNO, CPAs, were sued for improper conduct for the failure to detect the overstatement in light of the identification of revenue recognition as an area of critical risk.

MNO responded that the fraud, if any, was perpetuated by Sam Smith, and was well hidden from the auditors. The recognition of revenue hinged upon the collectibility of the sale of the stores. In reality, many of the "sales" involved the creation of receivables, none of which had been collected--including the 10% initial payment essential for the accrual of the entire revenue. In some sales a cash payment resulting from a purchase of merchandise by a franchisee was counted as a receipt of cash sufficient to accrue the entire revenue from the sale. In other cases, Sam Smith had used a company line of credit to obtain cash to loan to franchises to use as the initial payment, and ABC accrued the revenue. In other cases, Sam merely forgave the initial payment. Other sales which were recorded as of the end of the year should have been booked in the subsequent period because few, in any, of the obligations had been met.

MNO cited adherence to GAAS as a defense and produced the following work papers: 1) confirmations of agreements to purchase franchises which included the price of the franchise; 2) excerpts from phone conversations which dealt with some of the sales and whether there was in essence a transfer of risk to the franchisee; 3) letters of representations, which indicated that all transactions were known by MNO, signed by Sam Smith and the other appropriate officials. The attorneys for MNO indicated that both audits did in fact consume more than double the budgeted time. Surely, the audit had been conducted in accordance with GAAS. Material misstatements did occur, but it was the auditor who brought them to the open by withdrawing from the engagement.

ABC was not left in a lurch because another CPA firm quickly accepted it as a client. The case presents a number of issues that need to be addressed.

Professional skepticism always should be present and should be constantly assessed. MNO possibly had become too comfortable with ABC. Given that revenue recognition was identified as a critical risk area, it is particularly disturbing that revenue was materially misstated. The fact that ABC was dominated by Sam Smith and other signs of a very poor control environment should have alerted MNO to carefully scrutinize these revenue transactions.

The failure to resolve the collectibility issue, was essential to the accrual of revenue, is illustrative of an audit that may have gone astray and consumed a lot of time and effort in the process. The audit procedures that were used as a defense provided little evidence in support of the assertions of valuation or completeness, but did support existence.

Possible procedures that would have supported valuation are:

* A review of the credit evaluations of the potential franchisees to determine the likelihood of payment;

* A review of the cash receipts to determine support, if any, of the recognition of the revenue; and

* The establishment of proper cutoff procedures to be reasonably assured that transactions that are reflected in the current year's statements were in fact completed as of the end of the year. The substantiation of transactions already in the records is helpful in supporting existence, but often not valuation or completeness.

MNO should be commended for assessing the areas of critical audit risk. Regrettably, the audit predicated upon this awareness did little to resolve the concerns.

The apparent domination of Sam Smith should have alerted MNO to the possible existence of related party transactions, which were numerous. Less reliance upon management's representations and a more concerted effort to gather externally generated evidence to validated these sales transactions should have resulted. Hindsight is most helpful and, hopefully, of benefit to the future. An auditor with a client and subordinate professional judgment to management's explanations.

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