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Audit Case study 1.8 Crazy Eddie, Inc.

Was not able to attach PDF due to size, but copy of Case Study Crazy Eddie, Inc. available at http://business2.fiu.edu/1048733/www/Spring_2010_ACG6686_RD4/Crazy%20Eddie.pdf

1. Compute key ratios and other financial measures for Crazy Eddie during the
period 1984-1987.Identify and briefly explain the red flags in Crazy Eddies
financial statements that suggested the audit posed a higher-than-normal level of
audit risk.

2. Identify specific audit procedures that might have led to the detection of the
following accounting irregularities perpetrated by Crazy Eddie personnel: (a) the
falsification of inventory count sheets, (b) the bogus debit memos for accounts
payable, (c) the recording of transhipping transactions as retail sales, and (d) the
inclusion of consigned merchandise in year-end inventory.

3. The retail consumer electronics industry was undergoing rapid and dramatic
changes during the I 980s.Discuss how changes in an audit client's industry
should affect audit planning decisions. Relate this discussion to Crazy Eddie.
4. Explain what is implied by the term lowballing in an audit context. How can this
practice potentially affect the quality of independent audit services?

5. Assume that you were a member of the Crazy Eddie audit team in I 986.You were assigned to test the client's year-end inventory cutoff procedures.You selected 30 invoices entered in the accounting records near year-end: IS in the few days prior to the client's fiscal year-end and IS in the first few days of the new year. Assume that client personnel were unable to locate 10of these invoices. How should you and your superiors have responded to this situation? Explain.

6. Should companies be allowed to hire individuals who formerly served as their
independent auditors? Discuss the pros and cons of this practice.

Solution Preview

1. Compute key ratios and other financial measures for Crazy Eddie during the
period 1984-1987.Identify and briefly explain the red flags in Crazy Eddies
financial statements that suggested the firm posed a higher-than-normal level of
audit risk.

I have highlighted the lines in the attached Excel spreadsheet where I have common-sized the balance sheet and income statements and computed two years of ratios. The speculative unrelated investments would have been a high risk signal. The large size of inventory (almost half of total assets) would have made inventory a high risk area of focus. The profitability pictures doesn't really make sense. The gross margin is improving during a period of intense competition and the operating profit margin, return on assets and return on equity are all getting worse. These are not usual patterns. When gross margin improves considerably, the overall picture usually gets better. The fluctuation analysis signals high risk. The inventory turnover has shifted and that would be another signal for attention. Another area that would concern me is that sales are up but Accounts Payable is down --- they usually move together.

2. Identify specific audit procedures that might have led to the detection of the
following accounting irregularities perpetrated by Crazy Eddie personnel: (a) the
falsification of inventory count sheets, (b) the bogus debit memos for accounts
payable, (c) the recording of transhipping transactions as retail sales, and (d) the
inclusion of consigned merchandise in year-end inventory.

I would not have pre-announced the inventory ...

Solution Summary

Your tutorial is 734 words and discusses the question posed. A common sized balance sheet and income statement as well as the classic ratios are attached in Excel and the commentary discusses which of these would likely have signaled (or should have signaled) higher audit risk.

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