Case Studies for Investing

Sunday, April 23, 2006

Crazy Eddie Case Study in Audit Risk

Audit Risk

1. Crazy Eddie had a higher-than-normal level of audit risk. This can be determined by analyzing rations in the financial statements. The common-sized balance sheets for 1984 to 1987 show some inconsistencies in accounts between the years. For assets; Short-term investments had a zero balance until 1986 when it went to 21.1, then up again to 41.4 in 1987. Cash dropped from 34 in 1985 to 3.2 in 1987. The most startling is that merchandise inventories decreased from 63.8 in 1984 to 37 in 1987. For liabilities; short-term debt increased from .3 in 1984 to 16.8 in 1987. Accrued expenses went from 16.6 in 1984 to 1.9 in 1987. Convertible subordinated debentures only had a balance in 1987, it was at 27.5. After looking at these accounts, my main concern on these fluctuations is in the relationship between cash, investments and inventory. Cash and restricted cash comprised of 44.8 in 1985, but only 3.2 in 1987. This dip was due to an increase in short-term investments which was at 0 in 1985 but increased to 41.4 in 1987. It would appear that the management is becoming more aggressive in trying to grow the company with the investments. But at the same time, the company is in the growth stage and it is somewhat normal, the company is not expected to use its cash to pay dividends for at least another 20 years. But at the same time, they have very little cash on hand in case something goes wrong.Other financial ratios also reveal what the balance statement had revealed; there is a problem with inventory. Electronics go down in price quicker than other retail goods because the technology is changing very rapidly. The age of inventory at Crazy Eddie went from 80 days in 1986 to 111.8 days in 1987. This is in line with the inventory turnover decreasing from 4.5 to 3.22. There is also a problem with AR, the turnover decreased from 105.2 to 53.9, while the age increased from 3.4 days to 6.7 days.

2. Accounting irregularities could have been found sooner if some audit procedures were performed. (a) Falsification of inventory count sheets: This could have been prevented if the auditors were observing random cycle counts, if the auditors randomly performed cycle count audits, or if the auditors observed an entire physical inventory.(b) Bogus debit memos for AP: The auditors could have confirmed balances with the debtor.(c) Recording transshipping transactions as retail sales: Observe flow of transactions for recording a transshipping sale. Audit the receipts of very large sales since transshipping sales are going to be very high in dollar amount.(d) Inclusion of consigned merchandise in year-end inventory: Auditors could have observed an entire year end physical inventory.

3. Retail electronic stores changed drastically during the 1980’s, so did Crazy Eddie’s business. A factor in the Crazy Eddie case had to do with the inventory being over valued. A small reason for why the inventory was overvalued is due to the rapidly decreasing prices in electronics due to constant improvements in technology. Electronics are out dated very fast if not sold upon arrival, they are always being improved on, so electronic stores need to have a high inventory turnover. If not, then there is a chance that the inventory can become overvalued if the auditor does not stay up on the latest in electronics. Another change was with how Crazy Eddie was able to buy in such large amounts that he was able to sell via drop-shipments, this is something that the auditors are not use to because it is not a common occurrence. The drop-shipments would affect sales, but it should not affect inventory. As seen in this case, it required special attention because same store sales were increased by the way drop-shipments were recorded as revenue.

4. The term lowballing is when the auditors sell the audit services very cheap in order to get very lucrative consulting deals with the client. This can jeopardize the truthfulness of the audit because the auditors may have to agree with the client on something that will affect the audit opinion in order to keep the client on their good side so they can keep the client as a consulting customer also.

5. Locating only 20 of the 30 invoices requested is a major problem. I would first inquire if the invoices were tied to another form like a sales order. If those can be located, then we can see if the 10 missing invoices had something similar on the sales order. Another action that should be taken is to have the auditor observe an entire transaction from start to finish to see why an invoice may get lost. If there is no good reason, then there is a very high liklihood that there is fraud involved. Other information will still need to be obtained, getting it from the information system may be a possibility. This issue should be discussed further with management since it is likely that the person who prepares the invoices or files the invoices is very low on the staff.

6. This article was written on June 11, 2001. This was before the accounting laws were changed because of problems encountered by ex-auditors working at the client, and having connections with the new auditors. This caused many problems exemplified by Enron and WorldCom. That is why it is no longer allowed to take a job with the client. I am in agreeance with the new law.

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