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:
Audit Approach for RRI – Task #4
H&L should adopt a risk-based audit approach for the audit of RRI, focusing on areas of heightened risk due to the informal processes, limited segregation of duties, and reliance on estimates. Key aspects of the approach should include:
- Control Risk Assessment: Given the limited internal controls and the central role of two individuals (Sam and Lucky), control risk is high. The auditor should plan for a substantive audit approach, relying primarily on detailed testing rather than internal controls.
- Substantive Procedures:
- Test of transactions for costs and billing: Reconcile entries in the accounting system with Sam’s Excel files and supporting receipts.
- Cut-off testing to ensure proper recognition of revenues and expenses in the correct accounting period, especially for ongoing renovation projects.
- Analytical procedures to compare margins and cost trends across projects to detect anomalies.
- Vouching contractor payments: Select a sample of reimbursements to ensure they are properly supported and allocated.
- Professional Skepticism and Estimates: Scrutinize estimates used to reimburse contractors without receipts. These represent a significant audit risk due to potential misstatement or fraud. Obtain corroborating evidence such as job progress reports, industry cost benchmarks, or direct confirmation from contractors.
- Related Party Transactions: Investigate any transactions involving Lucky, as she is both a related party and involved in financial processing. Evaluate whether appropriate disclosure and arm’s-length treatment exist.
- IT Controls: Review the Excel spreadsheets used for cost tracking. Test the integrity and completeness of the files submitted to Lucky.
- Fraud Risk Assessment: Due to weak oversight and reliance on few individuals, consider fraud risk factors and assess opportunities for misappropriation or manipulation.
In summary, the audit should focus on verifying the completeness, accuracy, and legitimacy of financial data, with minimal reliance on controls and a greater emphasis on substantive procedures.
