Question

UTStarcom is a global leader in the manufacture, integration, and support of networking and telecommunications systems. The company sells broadband wireless products and a line of handset equipment to operators in emerging and established telecommunications markets worldwide. The following excerpt was obtained from the 2004 10-K of UTStarcom, Inc., which reported material weaknesses in the company’s internal controls. In describing the company’s remediation efforts, the company stated that “planned remediation measures are intended to address material weaknesses related to revenue and deferred revenue accounts and associated cost of sales.”

These material weaknesses were evidenced by the identification of six separate transactions aggregating approximately $5 million in which revenue was initially included in the company’s fourth-quarter 2004 financial statements before all criteria for revenue recognition were met. In addition, there were other transactions for which there was insufficient initial documentation for revenue recognition purposes but which did not result in any adjustments to the company’s fourth-quarter 2004 financial statements. If unremediated, these material weaknesses have the potential of misstating revenue in future financial periods. The company’s planned remediation measures include the following:

• “The Company plans to design a contract review process in China requiring financial and legal staff to provide input during the contract negotiation process to ensure timely identification and accurate accounting treatment of nonstandard contracts.”

• “In March 2005, the Company conducted a training seminar regarding revenue recognition, including identification of nonstandard contracts, in the United States and, in April 2005, the Company conducted a similar seminar in China. Starting in May 2005, the Company plans to conduct additional training seminars in various international locations regarding revenue recognition and the identification of nonstandard contracts.”

• “At the end of 2004, the Company began requiring centralized retention of documentation evidencing proof of delivery and final acceptance for revenue recognition purposes.”

  1. What features of this case should have indicated to the auditor a potentially heightened risk of fraudulent financial reporting?

  2. Using the previous disclosures as a starting point, identify challenges regarding internal controls that a company may face in doing business internationally.

  3. The company had disclosed its planned remediation efforts for 2004. How might the auditor have used that information in planning the 2005 audit?

  4. Considering potential analytical procedures relevant to the revenue cycle, identify analytics that the auditor might use in 2005 to provide evidence that the problems detected in 2004 have been remedied.

  5. Considering potential substantive tests of revenue, identify procedures that might be applied in 2005 to provide evidence that the problems detected in 2004 have been remedied.

Answer 1

1) A variety of possible ideas might be generated by students:

• differences in common practices concerning the writing and applying contracts

• difficulties in communication between the parent and subsidiary company

• differences in opportunities concerning essential documentation of company’s internal controls

• differences in the size and training of management, which might lead to disparity in the execution and enforcement of existing controls,

• among others

2) First consider that the previous problem designates that weaknesses occurred in the past, which enhances risk. Though, the fact that the given problems were revealed and a remediation plan was set up mitigates that risk. Therefore, the level to which the remediation plan was really implemented would be key in concluding the audit plan for year 2005. Therefore, the auditor must collect information related to the degree to which the new contract evaluation process has been used, and they must inspect the new documentation verifying proof of delivery. Additional, determine that the problems related with the company’s internal control weaknesses in revenue displayed themselves in IVth quarter revisions to the company’s financial statements, which must lead the auditor to enhance their risk assessment of year 2005 for management efforts to influence earnings. Thus, inherent risk related with sales transactions must be intensified going forward.

3) Concerning potential analytics, the following might be helpful:

• comparing quarterly changes in company’s sales in the current year, and comparing them with previous years and also industry averages

• comparing deferred revenue, revenue and cost of sales data for sensibleness in relation to one another for company , and also for competitors

• compare company’s cash flow from operations with net income

• Calculate accounts receivables and their aging by product type and geographic area, by quarterly basis.

• calculate gross margin percentages

4) Potential substantive tests comprise:

• examining the timing of contracts, with specific emphasis on 4th quarter contracts

• Evaluate contracts to make sure sensible identification and correct accounting treatment of contracts which are non-standard.

• evaluate documents retained verifying proof of delivery and last acceptance

• sample documented sales transactions

• match sales with customer orders or electronic shipping documents

• evaluate monitoring controls regarding review of management’s revenue transactions