As part of the audit planning, you recently met with Sam Real and learned the following pertinent information: RRI tends to work on one large renovation project at a time. Sam Real acts as the foreman and employs independent contractors as needed to execute the projects. He employs his wife, Lucky, as his office administrator. Lucky has a diploma in bookkeeping. While she works hard to manage the day-to-day administrative responsibilities for RRI on her own, she does not have knowledge about the more technical aspects of financial reporting. Sam is known as a creative thinker, and he prides himself on being able to “focus on the big picture of a project without getting lost in all of the mundane and annoying details and paperwork.” This obliviousness to details is a source of frustration for Lucky, who must constantly remind him to keep track of his receipts and submit the working hours for his contractors on a timely basis. Sam uses Microsoft Excel to track costs and billings for each project. Lucky insists that he submit his Excel file to her each Friday, along with any supporting documentation. Lucky uses the Excel file to make entries in the accounting software used by RRI. She also reconciles the bank and company credit card on a weekly basis, which helps her identify whether Sam has failed to submit receipts to her. Sam and Lucky are the only individuals who have access to a corporate credit card for RRI. If an independent contractor makes a purchase related to an RRI job, they submit the receipt to Lucky for reimbursement. Lucky ensures that all receipts are allocated to the appropriate job. The challenges with this process are (1) there is sometimes a prolonged delay before contractors submit their receipts and (2) sometimes the contractors lose the receipts and Lucky reimburses them an estimated amount. Discuss the audit approach that H&L should employ for this audit.
The Correct Answer and Explanation is :
Correct Answer:
H&L should adopt a substantive audit approach with a focus on detailed testing of transactions, particularly in the areas of job cost allocations, contractor payments, and expense reimbursements. Due to weak internal controls and limited segregation of duties at RRI, a combined audit approach relying on control testing would not be appropriate.
Explanation (300+ words):
In planning an audit for RRI, H&L must consider the control environment and risk of material misstatement. The company’s internal controls are relatively weak due to the small size of the entity, limited personnel, and concentration of duties, particularly with Sam and Lucky handling most operational and financial responsibilities.
Although Lucky is diligent and has a bookkeeping diploma, she lacks technical financial reporting expertise, and there is a high dependence on manual processes. Sam’s admitted disinterest in detail and delayed submission of documentation further increases the risk of errors and omissions. The use of Microsoft Excel as a key operational tool without automated controls or audit trails increases susceptibility to undetected errors or manipulation.
Key risks identified include:
- Incomplete or inaccurate recording of project costs.
- Delayed or missing contractor receipts.
- Estimations for reimbursements without supporting documentation.
- Lack of segregation of duties (e.g., Lucky both processes and reconciles payments).
Given these risks, reliance on internal controls is not advisable. H&L should therefore employ a substantive approach, which includes:
- Detailed testing of transactions: Review of all significant expense reimbursements and project cost allocations.
- Analytical procedures: Comparing costs and billings across periods and projects to identify anomalies.
- Third-party confirmations: Verifying contractor payments or material purchases through external confirmations.
- Bank and credit card reconciliations: Reviewing reconciliations prepared by Lucky for completeness and accuracy.
- Cut-off and completeness testing: Ensuring that costs and revenues are recorded in the correct periods.
Ultimately, H&L’s audit strategy should emphasize substantive procedures over control reliance due to the inherent risks in RRI’s accounting processes and structure.