ABC Electronics: An Instructional Case Illustrating Auditors' Use of Preliminary Analytical Procedures Free

Professional audit standards require auditors to perform analytical procedures during the planning and final review stages of each financial statement audit (AICPA 2012, AU 329; PCAOB 2012, AS 12). This instructional case focuses on analytical procedures performed during audit planning. The purpose of performing analytical procedures early in the audit is to enhance the auditor's understanding of the client's business and identify accounting issues, operating problems, or unusual transactions that warrant investigation. Field research suggests that analytical procedures often are performed by lower-level staff auditors and consist of simple procedures such as year-to-year account balance comparisons and ratio analysis (Hirst and Koonce 1996; Trompeter and Wright 2010).

Because first and second-year auditors often are assigned to perform analytical procedures, it is important for auditing students and staff auditors to learn the purpose and potential value of analytical procedures, and to have some experience performing such tasks. This instructional case provides participants with an example of auditors' use of analytical procedures during the planning/risk assessment phase of a financial statement audit. The learning objectives are to help participants understand (1) auditors' use of analytical procedures during the planning stage of the audit, and (2) the types of accounting issues and operating problems that might be identified using analytical procedures.

The case materials include a brief description of a fictitious consumer electronics manufacturer and three years of income statements, balance sheets, and schedules of gross profit for its two products. The case instructions direct participants to compare the most recent year's financial statements with the previous two years and write a memorandum identifying potential accounting issues or operating problems that the company may be experiencing.

This instructional case has three advantages over previously published analytical review exercises (e.g., Calderon and Green 1994; Lindberg 1999; Boockholdt 2000). First, the case is flexible. The case materials offer seven operating problems or potential accounting issues that instructors, at their discretion, can embed or omit in the current year financial statements. This flexibility allows instructors to tailor the case to suit their own curriculum and vary the case from semester to semester to reduce the probability of students relying on solutions from prior years. Second, the case addresses operating problems, including slow-moving inventory and cash flow shortages, while previous cases almost exclusively address fraudulent financial reporting. Using analytical procedures to evaluate the client's profitability and efficiency is an important component of the business risk audit methodology currently practiced by many major accounting firms (Bell, Marrs, Solomon, and Thomas 1997; Robson, Humphrey, Khalifa, and Jones 2007). Finally, the case materials disaggregate sales and cost of goods sold by product line. Unlike other teaching cases that provide only aggregated financial statement data, this case enables participants to analyze the growth, profitability, and turnover of individual products. Allen, Beasley, and Branson (1999) conclude that disaggregated data help auditors develop more precise estimates of account balances.

The case materials are presented in the next section. The financial statements included in the case materials show consistent growth, profitability, and liquidity across 2011, 2012, and 2013. Using the Excel spreadsheet provided with the implementation guidance, instructors can embed up to seven accounting issues or operating problems in the 2013 financial statements. Implementation guidance, the Excel spreadsheet, and a suggested solution are available for download (see Appendix A).

It is January 2014 and you are a staff accountant assigned to the 2013 audit of ABC Electronics. ABC is a closely-held corporation managed by the founder and principal shareholder, Adam B. Clark. Your firm has audited ABC for the last five years. The audited financial statements for the years ended December 31, 2012 and 2011 are presented below, with the client's unaudited financial statements for 2013.

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  ABC manufactures and sells mp3 players and travel alarm clocks.

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  All sales are on credit to department stores and electronics wholesaling companies. Credit terms are net 30 days.

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  ABC offers a one-year warranty covering manufacturing defects.

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  ABC uses a periodic inventory system and determines its year-end inventory by taking a physical count on December 31. You and your supervisor observed the count on December 31, 2013 and performed numerous test counts, but you have not performed further audit tests regarding inventory.

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  The interest rate on all debt is 8 percent. Annual interest and principal payments are due each December 1.

The following schedule shows the sales revenue and components of cost of goods sold for each of ABC's two products.

Note: The overhead standards shown above do not include depreciation. When the finished goods are transferred to inventory, a factor for depreciation is added to the material-labor-overhead standard to determine the inventory carrying cost.

The engagement partner has asked you to perform preliminary analytical procedures to identify potential risks and areas of audit focus in ABC Electronics' 2013 financial statements. Review the financial statements and identify accounts that appear to have unusual balances compared with the prior two years. Prepare a written memorandum documenting:

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  The accounts whose balances appear anomalous and the reasons you identified them as such.

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  The potential accounting issues or operating problems that might have caused the unexpected fluctuations.

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  Particular aspects of the company's operations that you believe should receive special attention during the 2013 audit.

This instructional case demonstrates auditors' use of analytical procedures during the planning/risk assessment phase of a financial statement audit. It has been used successfully with undergraduate students at two universities, and would also be appropriate for graduate students and for training new staff auditors. The case materials, which are in an Excel spreadsheet that can be downloaded (see Appendix A), include a brief description of a fictitious consumer electronics manufacturer and three years of income statements, balance sheets, and schedules of gross profit for its two products. The case instructions direct participants to compare the most recent year's financial statements with the previous two years and write a memorandum identifying accounting issues that may have occurred or operating problems that the company may be experiencing.

Initially, ABC Electronics' financial statements show consistent growth, profitability, and liquidity across 2011, 2012, and 2013. By selecting the check boxes in the first tab of the Excel spreadsheet, instructors can embed up to seven accounting issues or operating problems in ABC's 2013 financial statements. In the Excel spreadsheet, instructors also can change the years to ensure the timeliness of the case.

The case materials state that ABC sells its products to department stores and electronics wholesaling companies with credit terms of net 30 days. ABC's December 31, 2012 and 2011 days' sales outstanding (accounts receivable/average daily sales) were 31.9 and 32.1, respectively, which is consistent with the company collecting most of its receivables roughly on time. Selecting the “collection problem” check box increases ABC's 2013 accounts receivable by $100,000. Participants should notice the significant increase in ABC's December 31, 2013 days sales outstanding, which should lead them to suspect that the company may be experiencing a collection problem.

The case materials state that the interest rate on ABC's debt is 8 percent, with annual interest and principal payments due each December 1. The interest expense reported on ABC's 2012 and 2011 income statements is consistent with an 8 percent interest rate on the debt reported on ABC's balance sheets. Selecting the “understated interest” check box decreases ABC's 2013 interest expense from $119,000 to $110,000, and decreases the December 12, 2013 accrued interest liability from $9,000 to zero. Participants should notice the decrease in ABC's 2013 interest expense relative to the prior years, with no comparable decrease in debt. Participants also should notice the zero balance in the December 31, 2013 accrued interest liability account after balances of $10,000 and $11,000 in 2012 and 2011, respectively. A reasonable hypothesis is that ABC neglected to make the year-end adjusting entry to accrue interest since its last payment.

On its 2012 and 2011 income statements, ABC's income tax expense equals approximately 30 percent of its income before taxes. Selecting the “understated income tax” check box decreases ABC's 2013 income tax expense by $40,000. Participants should notice that the 2013 tax expense is inconsistent with 2013 pretax income, and that 2013 income tax expense as a percentage of income before taxes is inconsistent with prior years.

ABC's income statements report legal fees of $14,000 and $12,000 in 2012 and 2011, respectively. Selecting the “legal trouble” check box increases ABC's 2013 legal fees from $13,000 to $43,000. Participants should notice the unusually large balance of legal fees compared to the prior two years. High legal fees should alert an auditor to possible pending litigation that could threaten the client's continued existence or contingent liabilities that need to be recorded and/or disclosed.

Because ABC Electronics is a manufacturing company, most of its depreciation expense is allocated to cost of goods sold, as reported on the company's schedules of gross profit. ABC's balance sheets show no significant changes in total building and equipment from 2011 through 2013, leading to an expectation that depreciation expense should not exhibit much of a change. Selecting the “understated depreciation” check box decreases ABC's December 31, 2013 accumulated depreciation by $50,000 and decreases the depreciation expense reported on ABC's 2013 income statement by $10,000, the depreciation expense reported within mp3 player cost of goods sold by $20,000, and the depreciation expense reported within alarm clock cost of goods sold by $20,000. Participants should notice the decrease in 2013 depreciation expense as compared to the prior two years, with no comparable decrease in property and equipment. When this item is selected, it will appear that ABC may have miscalculated its depreciation expense or perhaps neglected to record depreciation during the fourth quarter.

The case materials indicate that ABC uses a standard cost system to account for its finished mp3 players and travel alarm clocks. The 2012 and 2011 standard cost variances reported on the schedules of gross profit were immaterial (i.e., less than 0.2 percent of cost of goods sold). When the “standard cost problem” check box is selected, $20,000 is added to each product's December 31, 2013 finished goods inventory, the mp3 player standard cost variance within cost of goods sold changes from $3,000 unfavorable to $17,000 favorable, and the alarm clock standard cost variance changes from $2,000 favorable to $22,000 favorable. Participants should notice the unusually large favorable standard cost variances reported on the schedules of gross profit, indicating that ABC's 2013 standard costs were significantly higher than its actual costs. Valuing finished goods at the higher standard costs inflates ABC's assets, while including the large favorable variance in cost of goods sold reduces ABC's expenses (thereby increasing its gross profit).

ABC's 2012 and 2011 financial statements indicate that the company earned gross margins of approximately 26 percent and 38 percent on its mp3 players and alarm clocks, respectively, and experienced annual inventory turnover of approximately 5.0 times and 4.5 times for the mp3 players and travel alarms. Two check boxes on the first tab of the spreadsheet enable instructors to make either of the two products “slow-moving.” Selecting the product's check box decreases the product's 2013 sales and increases its December 31, 2013 finished goods inventory. Participants should notice the resulting decreases in gross profit percentage and inventory turnover, suggesting that ABC is having trouble selling the product.

In addition to the seven items described above, which instructors may select or omit at their discretion, two other potential audit issues are permanently embedded in the case materials.

The warranty liability reported on ABC's balance sheet remains consistent across all three years despite increasing sales and warranty expenses. This issue provides a good opportunity to discuss the fact that auditors should not simply investigate large changes from prior periods. Auditors also must recognize when an account balance should have changed, but did not. ABC appears to be expensing warranty costs as incurred. The audit team, when it conducts its fieldwork, will need to review ABC's procedures for estimating its warranty liability and test the reasonableness of the balance.

The prepaid expense asset reported on ABC's balance sheet increases from $4,000 and $2,000 in 2011 and 2012, respectively, to $8,000 in 2013. Many participants will indicate that the prepaid expense account should be investigated because its 2013 balance increased 300 percent. Even though the percentage change is large, the balance is only approximately 0.2 percent of ABC's December 31, 2013 total assets. We use this as an opportunity to discuss materiality and the fact that auditors must use judgment to determine which accounts require further investigation. The auditor's preliminary judgment of materiality, used during the planning stage of the audit, should be based on the needs and expectations of financial statement users (AICPA 2012, AU 312). Rules of thumb mentioned frequently in auditing literature include 5 to 10 percent of before-tax income and 0.5 to 1 percent of the larger of total assets or total revenue (McKee and Eilifsen 2000; Flood 2013). If ABC were a publicly traded company, the auditors would be more likely to evaluate materiality in relation to income.

The authors use this case most frequently as a graded homework assignment. The case is most appropriate immediately after students have learned about audit planning and the role of analytical procedures in identifying potential audit issues. We distribute the case at the end of one class period with instructions to perform the required analytical procedures and prepare a written memorandum by the beginning of the next class meeting. Students report spending approximately two hours to complete the assignment.

After collecting the memoranda, we assign grades based on (1) how many embedded audit issues the students correctly identified, (2) how well the students discussed the potential accounting errors or operating problems that might have caused the unusual financial statement fluctuations, and (3) the quality of the writing. We usually embed four of the optional accounting issues in each semester's assignment and alter the issues from semester to semester to reduce the probability of students relying on solutions from prior semesters.

One author also has used the case as an in-class exercise. The author distributes the case, containing all seven optional embedded accounting issues, to the students at the beginning of class. Working in groups of three or four, the students are given 15 minutes to review the financial statements and identify potential accounting issues or operating problems. After 15 minutes, each group must report to the class one accounting issue they identified and the audit procedure(s) they would perform to investigate it. In 15 minutes, most groups identify only two or three issues, but by the time all the groups have shared their solutions, we usually have discussed most of the seven optional issues plus the warranty liability and prepaid expenses. The entire exercise, when used in this manner, requires about 45 minutes of class time for a class of 20 to 25 students.

The authors used this teaching exercise most recently as a graded homework assignment during summer 2013 at a small public university and during fall 2013 at a small private university. The 23 summer students were enrolled in an accelerated auditing course as preparation for entry into a master of accountancy program. The fall students were 59 senior accounting majors in a traditional, four-year bachelor of accounting program. None of the students had significant audit experience beyond, perhaps, an internship with a public accounting firm.

After completing the ABC Electronics case, the students completed a short questionnaire. The questionnaire results, reported in Table 1, indicate that the case was effective in achieving both of its learning objectives. Ninety-five percent of the students agreed or strongly agreed that the case helped them understand auditors' use of analytical procedures during audit planning. Ninety-two percent agreed or strongly agreed that the case helped them understand the types of accounting errors or operating problems that might be identified using analytical procedures. An overwhelming majority of the students agreed or strongly agreed that the case was a valuable learning experience and should be used in future semesters.

• ABC Electronics_Spreadsheet: http://dx.doi.org/10.2308/ciia-50775.s1