9-51.

a. Questions that need to be addressed include:

Will the existence of assets be an issue?

Can the company cover its short term debts?
What will happen with the loan covenants in violation?
Was the last auditor fired over a dispute over an accounting issue?
Do the licensing agreements exist? Do they make sense?
Why is revenue growing so rapidly?
Why is the gross margin so low?
Why is inventory stacking up? Are products obsolete? Are systems obsolete?
What is happening to the cash?
Do the intangible assets exist? Are they properly valued?
Why are they no longer able to manufacture products?
Are their revenue recognition policies following GAAP?
Do the large customers exist? Are their balances correct?
Are there additional details about the lawsuit that are important?

b. Hypothesized ways that fraud could be committed:

Licensed goods might be recognized at gross sales rather than at licensed fees
(the company actually did this in the real-life fraud on which this problem is
based).
Receivables might be inflated in order to meet the debt requirements. It is likely
they may do this because many of the companys large customers do not confirm
accounts receivable as a matter of policy.
Assets may be inflated. There is some evidence of this because of the due
diligence review findings. The auditor will need to be alert to the problem.
Inventory could be overstated. The percentage is much higher than the industry
percentage.
Accounts receivable is larger than the industry average. There could be duplicate
billings, inflated billings, or the company is not issuing credit on a timely basis.
The companys gross margin is lower than the industry average. It is possible
that some expense items are misclassified into inventory and are picked up in a
lower gross margin percent.
Inventory could be misstated by adding items to inventory during the period
after the end of the year and before they are counted.
Inventory could be mislabeled and picked up by the bar-coding system as more
expensive inventory.
The contra liability could represent an anticipation of a gain that could allow the
company to meet its debt to equity requirements and its tangible net worth
requirements.

Cases:
9-62.
Note to instructors: This case was based on actual financial statements for a publicly traded
company. The author embedded a fraud in the data by adjusting the financial amounts to
reflect a fraud similar to that achieved at WorldCom, i.e., the inappropriate capitalization of
Selling, General and Administrative Expenses as Inventory. All other trends were already
reflective of the clients actual financial status, which did not involve any fraudulent activity.
The actual company upon which this case is based received an unqualified audit opinion.
Part 1. Important financial trends include:
Flat sales with increasing debt
Increasing R&D
Decline in cash, but otherwise good liquidity
Allowance not keeping up with receivables
Rising inventory
Increasing PP&E
Increases in net income and net income before taxes, but no change in sales
A decrease in the gross margin
Part 2 and 3. The following patterns in the data seem problematic, and seem to indicate
potential errors:

Gross margin is down although sales are stable. This might indicate that cost of goods
sold is overstated.
Net income as a percentage of sales is up while gross margin is down. Therefore,
there might be a problem in an expense item below the gross margin line.
Income before taxes as a percentage of sales is up but gross margin is down.
Therefore, there might be a problem in an expense item below the gross margin line.
Inventory turnover is down. Cost of goods sold and inventory both have risen. The
rise in inventory is offsetting the increase in cost of goods sold. Therefore, there is
likely an error in inventory.
Sales are stable but SG&A have declined. These accounts should likely move
together. Is there some problem in either account?
The liquidity of the company is improving based on the current ratio. However,
receivable turnover has slowed. What is bolstering the rise in the companys liquidity?
Rises in inventory and receivables appear to be causing the rise in the current ratio,
and since the quick ratio has declined slightly, inventory again seems to be signaled as
a problem.

Part 4. The following accounts should receive heightened scrutiny during the audit:

Cost of goods sold, inventory, sales, accounts receivable, selling, general and
administrative expense, and cash.

Part 5. It is helpful for auditors to make projections of unaudited data based on industry
trends and analysis because it allows them to consider an unbiased estimate of what

the account balances would likely be before they are affected by managements
assertions of those account balances. In addition, it will be helpful for auditors in
highlighting account balances in which their unbiased estimates are not realized. This
process should enable auditors to creatively and thoughtfully consider explanations
for financial trends that management may otherwise steer the auditor away from.
Auditors will rely on industry trends, quarterly numbers, general economic
conditions, new product introductions, and competitive forces in making their
projections. Making these types of projections is helpful for auditors in terms of being
sure that they truly understand the client from a strategic systems perspective. In other
words, if an auditor is unable to predict what the financial account balances should
likely be, it is probably because they do not have an adequate understanding of the
client. Some downside risks associated with making projections like this are (1) the
projection may be inaccurate, which may lead the auditor on a wild goose chase
that causes inefficiency, or (2) the projection may reduce skepticism for the auditor if
the actual numbers are so in line with the projection that they become complacent.