Pontificate and Associates (PA) Auditing: Cite problems

Pontificate and Associates (PA) are a regional audit firm operating in South East Ontario. Their chief partner, Louis Pontificate, received his CA in the early 1960's. Since starting his own audit firm in 1965, he has seen it grow to a firm with 25 associate partners. At the age of 71, he still works hard although he is well enough off to have retired ages ago.

Having grown up in the area, you knew the firm since they audited your father's small lumber mill. Your father's company was typical of PA's clients: small, unsophisticated, operating primarily locally. You were surprised to return to your downtown Toronto office after a client lunch to be greeted by a regal looking gentleman introducing himself as Louis Pontificate, and seeking your advice.

"Maybe I'm past it," he says when you have all exchanged pleasantries and sat down, he to a simple glass of water, you to a post-lunch coffee. "I try to keep up you know? But even in my little area, the world is changing. All those small businesses, like your father's old mill, they all have web addresses, they all sell all over the world. And we, the accountants, have to try and keep up.

"It's impossible and now I'm in a real mess. Over forty years a CA and never been sued. Never a sniff of scandal. And now, well here's the story. Cardinal Jewelry (CJ) was a client. Fairly large for the area. They sell jewelry made by the Mohawks on reserve. A cottage industry in the truest sense. Or it was. But with all the money on the reserve from gambling, the owners of CJ got a big loan and set up a real factory. The lender, JN, is the majority owner of HotPoker.net. Big, big bucks."

"Of course, they started selling over the internet. At first it was small potatoes. Then orders picked up and they got the financing for the factory. JN insisted on an audit so we got chosen to do the first 20_1 audit. As a first time audit, we set inherent risk high, and we judged control risk to be moderate for purchasing, payables and inventory. The factory made the audit easier since everything was centralized. In the old days, raw material inventory would be handed out to folks who would make jewelry in their homes. Now, everything was controlled. Or so we thought."

"CJ started getting requests for jewelry with more expensive stones. So in late 20_1, they set up a separate process for gemstones versus polished rocks. I have a flow chart description here. It seems though that someone was diverting some of the purchases of gemstones. It was the guy at the factory whose job it was to assess the stones! He was substituting lower quality gems into inventory and no one could tell the difference except when we got there in 20_3, our audit senior, Patricia Bergere, had just got engaged and knew a few things about gems. She detected the lower quality stones."

"The guy, LN, first claimed it must be the supplier of the stones. But we are pretty sure it's LN. Stones only come out of the safe when the production foreman comes for them. And she receives them in the presence of LN. Both sign a manual log to record when the safe was opened and what production order it was opened for. LN and the president of CJ, who was very ill during 20_2 and rarely on site, are the only ones with the combination. It's an electronic safe so all openings are recorded electronically and compared to a manual log. There were no unusual or unlogged openings. So it's not when the stones are taken out, it's when they are put in."

"We calculated a $500,000 shortfall in inventory, which was massive given the $15,000,000 in sales in 20_2. And sales in 20_1 were only $8,000,000 so planning materiality was lower still. Then, CJ started getting returns from customers complaining about the low quality. I'd guess another $800,000 in sales is coming back, with a return to inventory of only $200,000."

"So now CJ is suing us for the loss of $1,100,000 claiming we failed to perform our work in accordance with GAAP. "

"I'm asking you for your advice. Here is the system description and the audit program which was completed with no issues for the 20_1 year. Did we do something wrong?"

Gem receiving procedures:
1. Gems arrive by bonded carrier from supplier
2. Gems counted in presence of carrier, inventory clerk, and supervisor (LN)
3. Count compared to delivery documents and signed by carrier and LN
4. Copy of delivery receipt taken by clerk and entered into inventory records
5. LN places gems in safe sorted by colour and grade

Audit program for receipt of gems:
1. Observe receipt of gems into inventory and note any unusual events.
2. Take a sample of supplier bills and trace to countersigned carrier receipts.
3. Take a sample of carrier receipts and trace to inventory additions.
4. Take a sample of gems from the inventory list. In the presence of the inventory supervisor, vouch all quantities on the list.
5. Take a sample of gems from the safe. In the presence of the inventory supervisor, trace all quantities to the records.

Question:

"I'm asking you for your advice. Here is the system description and the audit program which was completed with no issues for the 20_1 year. Did we do something wrong?"