Case Study

Your first day at the client Pat Johnson, the engagement manager, arranges a meeting with James R. Wiggins, president and chairman of the board of Acme, and other key client personnel at the company’s administrative headquarters. You arrive at Acme headquarters at 9:00 am and Wiggins takes you and Pat to his office for a brief discussion. Wiggins is a charismatic individual, filled with the energy of entrepreneurialism. He gives you the following brief overview of Acme’s history.

Acme was formed in 1995 following the acquisition of Western Hat Company by the Wiggins family from A.J. Stude. Wiggins became aware of Stude’s interest in selling the business while employed in a top-level management position with Western Boot Company. Wiggins had substantial personal wealth and believed Stude’s company represented an attractive investment opportunity. Negotiations were held and an agreement reached during the latter part of 1994. Wiggins believes the purchase terms were very favorable. He notes there was no goodwill entered on the books in recording the acquisition.

Wiggins was able to attract some top management from Western Boot to join the venture. For the most part, the labor force of Western Hat was retained. Since then, the business has had what Wiggins describes as very low levels of turnover, both at the managerial and the labor levels. “We are all family here at Acme,” Wiggins said. The company has undergone no major organizational changes since the acquisition.

Wiggins owns 51 percent of the outstanding stock of Acme. The remaining 49 percent is held by four individuals who are also officers of the corporation: Catherine Meyer, vice president and secretary-treasurer, (19 percent), Ross Crothers, vice president manufacturing (20 percent), Clair McCartin, vice president marketing (5 percent), and Donna Wiles, controller (5 percent). Wiggins provides a copy of the Acme organization chart (see below) for your review.

For many years, the business was located in its original production facility, a turn of the century vintage factory. In March 2012, the company moved to its present location, a leased 300,000 square-foot facility. Its new factory has an annual production capacity of 500,000 hats. The new production facilities are closer to state-of-the-art, taking advantage of higher levels of capital intensity. The company has 110 employees involved in manufacturing operations and another 25 in the executive offices.

The company has the facilities to produce hats in a wide variety of styles and sizes. Although operations are currently limited to the manufacturing of hats, the board of directors anticipates that other items, such as boots and belts, should be added soon to the product line; this is a pivotal element of Acme’s strategic plan for sustained growth. The company has also considered acquiring western apparel retail outlets in selected major cities in the region. Wiggins believes that his previous experience with a large manufacturer of western boots will be valuable in implementing Acme’s plans for expansion.

Next, Wiggins describes the hat manufacturing business. He states that the mass production of hats involves three stages: designing, manufacturing, and selling. The company employs a designer who reports directly to McCartin, vice president of marketing. The designer generally sketches ideas for new styles and creates models for Wiggins and the board of directors to review. Although the company has several standard designs, modifications are generally made each year to give a new twist to the product line. This is greatly appreciated by the sales force, who compete against salespersons from other firms that essentially are doing the same thing. As Wiggins puts it “If it ain’t broken, there is only so much you can do to fix it.” Presently, there are five styles of hats included in the line. Samples of new styles are displayed at various fashion shows and buyers’ conventions, which are attended by Acme’s designer and sales reps. Pictures of the entire line can be seen on Acme’s web page. After orders are received, they are processed, and shipment is made directly to the retail or wholesale customer.

Wiggins notes that 60 percent of the company’s sales are generated from orders placed at fashion shows and buyers’ conventions. Another 30 percent is generated by direct contact with retail outlets in major marketing areas by the company’s five sales reps (credit terms on all sales: net 50 days). The final 10 percent of sales come from credit card sales via Acme’s web page. Wiggins states that sales and profits have increased steadily over the first 15 years since the company began operations, but experienced a momentary decline in the most recent year.

Wiggins notes that the headwear industry consists of approximately 30 hat manufacturers. However, only five are in the western-style market (others manufacture winter headwear, dress hats, and specialty sports headwear). He states Acme has been able to attract about 10 percent of the western hat market. This success is attributed to the company’s designer, considered one of the best in the industry, and Wiggins past experience and acquaintance with the buyers and industry in general. Acme‘s inability to capture more of the market is attributed to the domination of the industry by a single firm. Stitson Company has 60 percent of the market and has been the most recognized brand in the industry since its inception in the 1890s. Acme’s hats sell in the retail market for prices between $60 and $100 each, and the normal retail markup is 100 percent of cost. The company has been most successful in establishing itself in the lower-priced market, with approximately 90 percent of its sales in the $60 to $70 retail price range. The demand for western-style hats has been strong for the past five years, and Wiggins believes that demand will continue at a 5 percent to 10 percent growth rate into the future. He does admit that a certain component of the demand is “fickle.”

Tour of Manufacturing Facilities

Wiggins introduces you to Ross Crothers, vice president of manufacturing, who takes you on a tour of the manufacturing facilities. Crothers begins the tour by describing the company’s manufacturing layout, and telling you there are 110 employees in the plant. Acme is not presently unionized. According to Crothers, wages and benefits recently were made competitive with union shops in order to reduce the potential for employee unionization.

The facility is arranged into three areas: (1) receiving and storing of raw materials and finished goods, (2) shipping, and (3) production. You observe the shipping area is located at the north end of the facility and is connected to the receiving and storing area by a large mechanized gate. A similar gate at the other end of the receiving and storing area connects that area with the production area. While viewing the receiving and storing area, Crothers notes that a purchasing agent, who reports to him, is responsible for the acquisition of raw materials from vendors.

The production area is arranged into the following departments:

· Coning – the raw fiber is processed into felt

· Stretching – the felt is stretched into a rough shape of a hat

· Blocking – the crown and brim are shaped

· Pouncing – smooth finishes are provided and the brim trimmed, rolled and processed

· Finishing – sweatbands, linings, and decorative bands are affixed to the hat

· Packing – five or fewer hats are packed by size into boxes

When hats are finished and packed into boxes, a packing slip is placed in the box, which is sealed and sent to the receiving and storing area until shipment is made to customers.

During the tour, you observe that the machinery seems to be in relatively good condition. All the departments are operating, and the process seems to be moving at an efficient pace. You are also quite impressed with the condition of the facility and fixtures, all of which appear well-maintained and very clean for a manufacturing process. You also note safety signs are emergency instructions in each department, suggesting safety procedures exist and are followed.

Tour of Administrative Facilities

Next, you visit with Donna Wiles, controller, who gives you a tour of the administrative offices. During the tour, you are introduced to Mark Tuttle (computer manager), who reports to Wiles. The computer area is isolated from the rest of the administrative offices by a door that permits entry only with an authorized pass card. Within this area, a clear glass wall separates the computer servers from the systems and programming area. Tuttle mentions there is a staff of six, including himself, in the computer department: two data entry personnel, two programmers, and a systems analyst.

You then tour the accounting area that processes cost reports from the manufacturing departments, maintains the general ledger, and performs other reporting functions such as the preparation of financial statements and reports for management. You conclude that the office seems well maintained, and the desks are not cluttered with data or files; operations that are visually disorganized often prove difficult to audit.

In order to obtain a general understanding of how major transactions flow through the accounting system, you ask Wiles to “walk through” a sales transaction and a materials purchase transaction (i.e. trace each transaction through the accounting system from initiation to final recording). Throughout, you carefully observe the documentation used to process the transactions. Your general impression is that internal controls appear to be in place.

Wiles relates the company’s cost accounting records are maintained on a job order basis. The company maintains a moving average cost for the basic raw material input, fur fibers. They also use average costs for finishing materials (bands etc.) that are purchased from suppliers. In addition, a standard rate for charging overhead has been calculated and is applied to the jobs worked on during the year. Wiles mentions Acme is considering adopting a standard cost system. However, she has not had an opportunity to begin such a project. Also, she states the company closes the plant for the last week of the fiscal year for vacation and annual maintenance of the machinery. Thus there is no work-in-process inventory at year-end. You mentally note that this situation will simplify the audit work in this area.

You inquire about the company’s accounting policies and procedures. For the most part, the discussion centers on the notes to last year’s financial statements. You address the issue of the direct charge-off method of accounting for bad debts, and Wiles states the company adopted this method because most sales are currently generated by buyers’ conventions, and in the past there have been negligible charge-offs. She admits some companies in the industry do use the allowance method, but she prefers the direct charge-off method. Given the company’s past credit experiences, she believes it is a better fit, as well as being simpler. Nonetheless, she thinks that management may reevaluate the continued use of the method in the future. You also learn from Wiles that revenues are not recognized until shipment occurs. Monthly financial statements and related reports are generated internally from a trial balance of the general ledger.

You also discuss the lease commitments. Wiles states the previous auditor agreed that the leases on the building and the computer equipment should be treated as operating leases. You ask Wiles to provide copies of the lease agreements for your review. You also inquire about the long-term raw material contract. Management believes that higher prices will occur in the next few years and that the long-term commitment that was made was necessary and prudent.

After visiting with Wiles, you and Pat Johnson meet with Catherine Meyer, vice president and secretary-treasurer. Your discussion with her concerns the company’s banking arrangements and future needs for capital. Meyer notes that presently all the company’s banking is handled through First National Bank of Big City where the company maintains a checking account, time deposit account, and a separate payroll account. Meyer does not anticipate the need to pursue different banking arrangements at this time, despite the fact that small savings might be possible.

To date, the company has been able to finance expansion through internally generated funds. However, the board recently decided to consider borrowing from the bank to raise future capital. This is especially important in the event that expansion plans materialize, since there would be an initial drain on the financial resources of the company. In order to begin planning these needs, preliminary discussions have been held with the bank regarding possible lines of credit and long-term borrowing arrangements.

Meyer notes her main responsibilities revolve around credit and cash management. The cashier function is minimal, since all sales are on credit. On the other hand, the credit management function is very important on all sales, especially for sales generated through sales representatives’ direct contact with customers.

Preliminary Internal Control Discussion

You and Pat Johnson conclude your visit with a wrap-up session with Wiggins. Pat gives him his initial impressions regarding the operations of Acme. However, your most important objective in this concluding meeting is to discuss the firm’s internal control awareness. Wiggins’ remarks concerning internal controls at Acme are reflected below.

Carl Moore, the predecessor auditor, has always indicated internal control was very strong for a company of Acme’s size. You note that as a result of your review of Moore’s working papers for the previous year where there were more than 20 adjustments to client-prepared year-end trial balance. Periodically, Moore has made suggestions for improving controls. For the most part, management has been responsive, to the extent that these suggestions were cost justified. In Wiggins’ opinion, internal control at Acme is enhanced by the fact that the management group includes all the stockholders of Acme, who have a vested interest in the results of operations. Wiggins expresses a strong interest in the internal control environment and pledges to work actively to enhance the integrity of the system.

Acme’s internal control procedures are documented in an accounting manual. Wiles, the controller, updates the documentation periodically and reports to the board of directors on an annual basis concerning the accounting and control functions. The board has discussed the possibility of hiring an internal auditor, but there are no present plans to make this addition to the management group in the immediate future. Acme’s management team has observed that many companies have outsourced their internal auditing function. They do not really see a reason to buck this tide by hiring an internal auditor.

You inquire whether or not Acme has an audit committee. Wiggins tells you that Acme has never had an audit committee, and frankly does not need one. He says that Acme’s board has always been harmonious and that an audit committee would not add to the caliber of corporate governance. He recognizes the usefulness of the audit committee in larger companies and in companies that were seriously divided on issues of financial policy. Acme, he says, has always been run on an open door policy.

Concluding the meeting with Wiggins, you and Pat indicate the visit to Acme has been very helpful, and you return to your office to proceed with the planning of the engagement. Based on your discussions with Wiles and Wiggins concerning internal controls and the walk-through of a sales and material purchasing transaction, you plan an audit that would rely on controls at this stage of the engagement. During the internal control review phase of the engagement, you will document an understanding of the system and test the controls in order to assess the level of control risk to be used for substantive testing purposes.

Preliminary Fraud Considerations

Over the last few years, every auditor at Big4 LLC has received some training about fraud in corporations. You have been convinced that it is a big problem and one that can be easily addressed. You know that the motivation for fraud is complex and that the ways that it can be accomplished quite varied. Fraud is difficult for the auditor because it reduces the level of confidence that can be placed in client assertions and broadens considerably the number of potentially relevant factors.

You learn that the compensation of managers at Acme has recently changed to stress the achievement of financial performance targets. You also note a particularly feverish contempt among the managers for federal and state regulation of all sorts. Surrounding the general topic of taking Acme public some day is a heightened concern over accounting policies. Some of the younger, more aggressive managers think that the firm has been very conservative in its inventory valuation and revenue recognition choices.

Although you have not conclusively studied the internal controls at Acme, you are concerned over the general issue of asset misappropriation. You note a rather cavalier attitude toward physical security over inventory. Although Acme’s plant is in a low-crime area, you do not see much concern over unsecured areas that are unwatched for extended periods of time. Some employee practices also raise your attention. Typical hiring practices are rather informal. Wiggins, who does all the hiring, tells you that he has never gone wrong in trusting his instincts about people. He also says that Acme’s policy of allowing an unlimited “banking” of unused vacation time is very popular with employees. According to him “some people couldn’t bear not coming to work.”