Task #4 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: Substantive audit approach with targeted testing of controls and increased professional skepticism
Explanation (300+ words):
Given the information gathered from the meeting with Sam Real, H&L should adopt a substantive audit approach for RRI (Real Renovations Inc.), supported by targeted testing of internal controls and heightened professional skepticism.
The rationale stems from several key risk factors:
- Informal and Manual Systems: RRI relies on Excel spreadsheets maintained by Sam, a non-accountant, to track costs and billings. While Lucky, with basic bookkeeping training, inputs these into accounting software and reconciles accounts weekly, the lack of system integration and automation increases the risk of errors and misstatements.
- Weak Internal Controls: Although Lucky attempts to enforce accountability, Sam’s disinterest in documentation and his habit of submitting receipts late (or not at all) reflects poor internal control over transaction recording and authorization. The reliance on estimated reimbursements to contractors, due to lost receipts, introduces a significant risk of inaccurate expense recognition and potential fraud.
- Lack of Segregation of Duties: With only two employees (Sam and Lucky) managing financial processes, there is minimal segregation of duties. This concentration of responsibilities heightens the risk of management override of controls, especially since both have access to the corporate credit card.
- Audit Approach Implications:
- Substantive testing should focus heavily on cut-off, completeness, and accuracy of expenses recorded for each project. The audit should include inspection of receipts, contractor agreements, and bank reconciliations, cross-referenced with Excel records.
- A detailed review of manual journal entries and credit card transactions is essential, with special attention to reimbursements based on estimates.
- Auditors should confirm balances with contractors and reconcile them with recorded expenses.
- Analytical procedures may help identify unusual trends in project costs that merit further investigation.
In summary, H&L should not rely on internal controls, given their weakness, but instead focus on substantive procedures to obtain audit evidence. The lack of formal processes and over-reliance on estimations necessitates a detailed, skeptical, and evidence-driven audit approach.