Question

Required: Summarize why revenue is such a critical account in most companies and the auditor's challenge in auditing this area. Then address the following questions regarding the Miniscribe audit which is described below. a) Summarize the business and financial reporting risks that increased the risk of material misstatement at Miniscribe. b) Summarize the techniques used by Miniscribe to inflate their financial statements. For each technique, describe the audit procedure(s) the auditors should/could have used to detect these misstatements? c) Identify any red flags that the auditors should have noticed during the audit. MiniScribe Corporation Read the summary below of the MiniScribe Corporation and answer the questions that follow. "In October 1988, MiniScribe, a computer disk drive manufacturer, announced its thirteenth consecutive record-breaking quarter, while its competitors were laying off hundreds of employees. MiniScribe's receivables had increased significantly, and inventories had increased to a dangerous level because disk drives can become obsolete from one quarter to the next. The company's stock price had quintupled in just two years. It had apparently risen from the dead under the leadership of Q.T. Wiles, who had resurrected other companies and was known as "Dr. Fix-It." It looked as if he had done it again. Seven months later, it was announced that MiniScribe's sales gains had been fabricated. What was supposed to be the crowning achievement of Wiles' career became an epitaph; he resigned and is living in near seclusion. An internal investigation concluded that senior management apparently perpetrated a massive fraud on the company, its directors, its outside auditors, and the investing public. Most of MiniScribe's top management was dismissed, and layoffs shrank its employment by more than 30% in one year. MiniScribe might have to write off as much as $200 million in bad inventory and uncollectable receivables. Wiles' unrealistic sales targets and abusive management style created a pressure cooker that drove managers to cook the books or perish. And cook they did - booking sales prematurely, manipulating reserves, and simply fabricating figures - to maintain the illusion of unbounded growth even after the industry was hit by a severe slump. When Wiles arrived at MiniScribe in mid-1985, it had just lost its biggest customer, IBM, which decided to make its own drives. With the personal computer industry then slumping, MiniScribe was drowning in red ink. Dr. Fix-It's prescription was to cut 20% of the workforce and overhaul the company from top to bottom. As part of the overhaul, several semi-autonomous divisions were created. Each division manager set the division's own budget, sales quotas, incentives, and work rules. The company became a chaotic Babel of at least 20 mini-companies that were constantly being changed and reorganized. One employee held 20 different positions in less than seven years. Wiles turned up the heat under his lieutenants. Four times a year, he would summon as many as 100 employees for several days of intense meetings, at which they were force-fed his idiosyncratic management philosophy. At one of the first such meetings he held, Wiles demanded that two controllers stand, and he fired them on the spot, saying, "That's just to show everyone I'm in control of the company." At each of these meetings, division managers had to present and defend their business plan. Invariably, Wiles would find such plans deficient and would berate their authors in front of their peers. A former controller says Wiles would throw, kick, and rip the plan books that displeased him, showering his intimidated audience with paper while yelling, "Why don't you understand this? Why can't you understand how to do this?" Then something changed. Wiles started saying, "I no longer want to be remembered as a turnaround artist. I want to be remembered as the man who made MiniScribe a billion-dollar company." Sales objectives became the company's driving force, and financial results became the sole determinant of whether bonuses were awarded. Wiles said, "This is the number we want to hit first quarter, second quarter, third quarter, and so on," and it was amazing to see how close they could get to the number they wanted to hit. Hitting the number became a company-wide obsession. Although many high-tech manufacturers accelerate shipments at the end of quarter to boost sales - a practice known as "stuffing the channel" - MiniScribe went several steps beyond that. On one occasion, an analyst relates, the company shipped more than twice as many disk drives to a computer manufacturer as had been ordered; a former sales manager says the excess shipment was worth about $9 million. MiniScribe later said it had shipped the excess drives by mistake. The extras were returned - but by then MiniScribe had posted the sale at the higher number. Wiles denied this practice. Other accounting maneuvers involved shipments of disk drives from MiniScribe's factory in Singapore. Most shipments went by airfreight, but a squeeze on air cargo space toward the end of each quarter would force some shipments onto cargo ships, which required up to two weeks for transit. On several occasions, said a former division manager, MiniScribe executives looking to raise sales, changed purchase orders to show that a customer took title to a shipment in Singapore when, in fact, title would not change until the drives were delivered in the United States. Specifically, MiniScribe executives were adamant that the 1986 year-end results should include as sales the cargo on a freighter that they contended had set sail in late December. Eventually, the cargo and the freighter, (which did not exist), were simply forgotten. MiniScribe executives also found other ways to inflate sales figures. One was to manipulate reserves for returns of defective merchandise and bad debts. The problem of inadequate reserves grew so great that private analysts began noticing it. MiniScribe was booking less than 1% reserves; the rest of the industry had reserves ranging from 4% to 10%. To avoid booking losses on returns in excess of its skimpy reserves, defective drives would be tossed onto a "dog pile" and booked as inventory. Eventually, the dog-pile drives would be shipped out again to new customers, continuing the cycle. Returns of defective merchandise ran as high as 15%. At a time of strong market demand, such ploys enabled MiniScribe to seem to grow almost exponentially, posting sales of $185 million in 1986 and $362 million in 1987. In early 1988, Wiles was confidently forecasting a $660 million year, and he held fast to his rosy forecast even as disk drive sales started slipping industrywide in late spring and nosedived in autumn. Meanwhile, Whiles increased the pressure on his managers. Division reports would be doctored as they rose from one bureaucratic level to the next. Before long, the accounting gimmickry became increasingly brazen. Division managers were told to "force the numbers." Workers whispered that bricks were being shipped just so a division could claim to have met its quota. Others joked that unwanted disk drives were being shipped and returned so often that they had to be repackaged because the boxes wore out. Employees also joked about shipments to "account BW," an acronym for "big warehouse." But that wasn't just a joke. MiniScribe established several warehouses around the country and in Canada as "just-in-time" suppliers for distributors. Customers weren't invoiced until they received shipments from the warehouses. MiniScribe, however, was booking shipments to the warehouses as sales. The number of disk drives shipped to the warehouses was at MiniScribe's discretion. It is estimated that between $80 million and $100 million worth of unordered disk drives went to the warehouses. Wall Street began to smell trouble. Analysts could find no significant customers other than Compaq to support MiniScribe's bullish forecasts. Several major anticipated orders from Apple Computer and Digital Equipment Corp. fell through. MiniScribe reported a fourth-quarter loss and a drop in net income for 1988 despite a 66% increase in sales - on paper, that is. A week later, Wiles abruptly resigned. The stock price tumbled from a high of $15 to less than $3 per share, a decline that upset many stockholders. An investigative committee of MiniScribe's outside directors reported that senior company officials: " Apparently broke into locked trunks containing the auditors' working papers during the year-end 1986 audit and changed inventory figures, inflating inventory values by approximately $1 million. " Packaged bricks and shipped them to distributors as disk drives in 1987, recording $4.3 million in sales; when the shipments were returned, MiniScribe inflated its inventory by the purported cost of the bricks. " Packed approximately 6,300 disk drives that had been contaminated to inflate inventory during the fourth quarter of 1988. Several lawsuits have been filed charging MiniScribe with engineering phony sales artificially to inflate its stock to benefit insiders. The suits also charge that its auditors participated in the conspiracy by falsely certifying the company's financial statements. "

Answer 1

Revenue is critical aspect for auditing area.Auditing involves critical analyses of the risk of material misstaements involved in the financial statements, sometimes due to fraud practices performed by the employees of the same organisation. Revenue can be direct or indirect. It directly relates to turnover of organization. Auditor needs to assess all evidences in order that he is confirmed that sales have taken place. Increase in revenue can get higher profits but a decrease on the other part has got significant effect. This is such a crucial area that can cause the situation of an enterprise to change from one to another. While auditing revenues the first and foremost thinh required is the evidence that the particular event has took place.

a) MiniScibe coporation was a loss making comapny untill year 1985. It had apparently risen by takeover of company by Q T Wiles also called Dr Fix It. Formerly, wiles managed the company like playing a game where he thought he can manipulate things any how he can. he made almost 30% of employees jobless. He would also fire many people by just calling them in front. Later he called a meeting and made the staff and officials an announcement that he just wants sales hike and is concerned with nothing else. the company was divided in division and adopted practies like making huge sales at the year end and again showing returns at the beginning of the nest year, piling up huge inventories in order that there was closing stock, transferring goods to their warehouses as they said and treating them as sales, shipping the disk drives through cargos instead of an aircraft so that it would take time( while shipiing they must have also shown some ships sunk in water, and would have claimed high insurance claims because of such loss), they had started to ship bricks later instead of disk drives, their disk drives would go to the warehouses and get filed up there, inflated reserves. Finally, in 1988, they showed a loss and wiles resigned from company.The officials who used to work there earlier said all was fake and finacials were all manipulated.

b) for sales, the auditors could have caught their year end practices and reported those to the higher authority or may be the government or atleast would have qualified his report. the auditors could have done a physical verification of inventory or may be they could have taken the help of an expert to evaluate the value and sustainability of closing stock. They could have treated the tranfers to warehouse as just internal transfer and after actual salesor transfer of possession to customer would have treated them as sales. The company even dindnt recognise the bad debts. Only 1% provision was made which as per the industry ranged from 4-15%. They had inflated reserves of the company. The value of stocks were raising the sky. All revenue items were inflated and profits were shown. Auditors could have analysed all this properly.The auditors were in aposition to stop these practices but as per reports, even they were involved in the frauds.

c) Red flags that the auditors could have identified were sales, bad debts and also provisions area.