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Date: May 26th, 1995 To: Scott Seavey (Audit Manager) From: Subject: Sensormatic Electronics Accounts Receivable and Revenue Audit approach Memo

We have been assigned to conduct an audit on Sensormatic Electronics. The purpose of this memo is to provide the audit manager with an audit approach plan memo for accounts receivable and revenue. This memo will also address materiality, analytical review, risk assessment and an audit program of procedures. Sensormatic Electronics is a SEC registrant company that only operates in the U.S. The company's fiscal year is June 30th. The third quarter 10-Q was filed May 15th 1995. Throughout this year (1995), there has been financial reporting fraud and the SEC has gotten involved The planning memorandum is divided into five sections: 1. Materiality 2. Analytical Review 3. Other Risk Assessment 4. Audit Program of Procedures 5. Assumptions

Materiality: The materiality section of this memo is broken into five subsection which are, materiality benchmarks, materiality of the audit as a whole, performance materiality for accounts, monetary testing thresholds for specific account and, clearly trivial nominal amounts. The amounts regarding these subsections will be adjusted appropriately because of the recent fraud that occurred during the fiscal year of 1995. The focus of some of these materiality amounts are in regard to Accounts Receivable and Sales. Materiality Benchmark: According to ISA 320.A4, there are many factors when choosing what benchmarks to use when determining materiality. Factors are the nature of the entity, industry it operates, and the size and complexity of the company. We also looked at the relevant financial statement elements and the users that depend on these statements when determining a materiality benchmark. We have chosen the materiality benchmark of total revenue because we believe this

will be the most relevant to the accounts receivable and sales accounts we are preparing this audit plan for. We will use the total revenue of the Year Ended June 30, 1994, which is $656,000,000 (10-K, 1994). This amount will give us a very broad materiality and will not be subject to internal management adjustments such as materiality benchmarks of pre-tax profit, total assets, and operating income. Note: This benchmark is based off of the 1994 revenue, where no issues are found. We conclude that this is a safe and reasonable benchmark because of the reasonable assurance provided in 1994. Still, revenue is one of the most significant risks in financial statement audits and this is taken into account when determining subsequent materiality assertions. Materiality: According to AS 2105.06, the audit team is required to establish the materiality level for the financial statement as a whole. This is done by choosing an appropriate percentage and using it with our benchmark of total revenue. When establishing materiality as a whole, AS 2015.06 states that auditors should consider a company’s earnings and other relevant factors. In this case, the other relevant factors will be the fraud that occurred in 1995. We use the rule-ofthumb percentage of materiality regarding total revenue and have chosen a small percentage of ½ %. This is because of the fraud that occurred recently, we set materiality very low because of the high risk of material misstatement due to fraud. This will cause detection risk to be low, evidently leading to adjusting the nature, extent, and timing of our audit procedure. In this case, we lowered materiality to more closely examine specific transactions, accounts, and balance (AS 2105.07). The overall financial statement materiality is $656,000,000* ½%=$328,000. Performance Materiality: In regard to AS 2105.08, we have determined a performance materiality/tolerable misstatement at an amount that reduces the probability that the total of uncorrected and undetected misstatement may result in a misstatement of the financial statements. Performance materiality is less than the overall financial statement materiality and in particular is used for account balances and classes of transactions. The two we are auditing are revenue and accounts receivable. Both of these accounts are normally subject to management bias and fraud because of estimations. This would result in a lower performance materiality. But, in this case, fraud did occur recently, therefore, we have decided to set the performance materiality even lower at 40% of overall materiality regarding revenue and accounts receivable. The normal rule of thumb is normally 50% to 75% but because of the circumstances of this audit engagement and guidance presented in AS 2105.08 we have lowered performance materiality.

Performance Materiality: $328,000*40%= $131,200. Monetary Testing Thresholds (MTT). Monetary testing thresholds are similar to performance materiality, but are usually certain risks associated with specific accounts. The MIT will normally be lower than the performance materiality. Based off our current risk assessment of the company, we have assessed MIT for the Revenue and Accounts Receivable even lower than performance materiality at 30%. This assertion is because of the recent fraud that occurred in 1995. The risk for revenue and account receivable is normally very high but in this case it is exceptionally high, leading to such a low MIT. This will allow our team to critically assess each account and transaction to make sure there are no material misstatement due to fraud. This amount is subject to being determined based on when we find out for information regarding the recent fraud. If the fraud involved upper management and even governance, the MIT may be dramatically dropped, leading to in depth analysis. The amount of MIT is $328,000*.30%= Clearly Trivial (CT): AS.No.14.10 states that “Clearly Trivial” does not automatically equate to “not material”. Clearly trivial related to matters that are of a smaller magnitude than the materiality recently established. The benchmark normally for CT is within 3%-5%, but in this unique audit case we have set the CT amount at 6%. This rate is derived from several issues: The recent fraud that has occurred, the significant risks revolving around accounts receivable and revenue, and because it will cause our team to closely examine certain transactions and account balanced. Raising the rate CT rate to 6% will make our team examine account balances and transactions that normally were disregarded. From looking more into these issues, this increases the likelihood of providing a reasonable assurance that fraud risk is at a minimum (Not nonexistence) amount. Analytical Review: In our analytical review, the goal is to evaluate both Revenues & Accounts Receivable with objective of identifying unusual or unexpected relationships that might indicate a material misstatement due to potential fraud or error. Specifically, we are to perform analytical procedures on the revenue account. The third quarter Form 10Q has just been filed on May 15, 1995 thus the relevant periods under review range from July 1, 1993 through July 10, 1995. The corresponding statements are dated as follows: 1. 10K: 7/1/93 – 6/30/94 2. 10Q: 7/1/94 – 9/30/94

3. 10Q: 10/1/94 – 12/31/94 4. 10Q: 1/1/95 – 3/31/95

The results of these procedures, conducted in the planning phase of the audit, will determine further substantive analytical procedures performed during the audit. The following Professional Literature has been referenced: AU §329.05 Analytical procedures involve comparisons of recorded amounts, or ratios developed from recorded amounts, to expectations developed by the auditor. The auditor develops such expectations by identifying and using plausible relationships that are reasonably expected to exist based on the auditor's understanding of the client and of the industry in which the client operates.

Following are examples of sources of information for developing expectations: a. Financial information for comparable prior period(s) giving consideration to known changes b. Anticipated results— budgets, forecasts including extrapolations from interim or annual data c. Relationships among elements of financial information within the period d. Information regarding the industry in which the client operates—gross margin information e. Relationships of financial information with relevant nonfinancial information

AU §329.06 Thus, the objective of the procedures is to identify such things as the existence of unusual transactions and events, and amounts, ratios and trends that might indicate matters that have financial statement and audit planning ramifications. AU §329.07 Analytical procedures used in planning the audit generally use data aggregated at a high level … for some entities, the procedures may consist of reviewing changes in account balances from the prior to the current year using the general ledger or the auditor's preliminary or unadjusted working trial balance … for other entities, the procedures might involve an extensive analysis of quarterly financial statements AU §329.08

Sometimes relevant nonfinancial information is considered as well. For example, number of employees, square footage of selling space, volume of goods produced, and similar information may contribute to accomplishing the purpose of the procedures.

Expectations: a. Financial information for comparable prior period(s) giving consideration to known changes 1. “The Company has historically had a high level of receivables outstanding measured as a percentage of revenues. This results in part from its strategy to use its financial strength as a marketing tool in obtaining new business by, for example, offering to customers flexible, deferred payment arrangements (substantially all of which mature within one year) or longer term installment sales financing or leasing arrangements (subject to stated or imputed interest) to facilitate purchases. Additionally, the Company has experienced an historical pattern of delayed payments by certain of its major retail customers which has extended its receivable aging profile.” (10K). 1. “The Company sells its products on a current, deferred or installment payment basis. Substantially all deferred payment obligations are payable within one year. Installment contract obligations are payable monthly over terms generally up to five years” (10K). d. Information regarding the industry in which the client operates—gross margin information 1. Sensormatic Electronics Corporation is a supplier of electronic security systems in global retain & non-retail markets. They design, manufacture, market, and service ‘electronic article surveillance’, ‘electronic asset protection’, ‘closed circuit television systems’, and ‘access control systems’. Inventory shrinkage, after payroll, is the largest variable expense in this industry. It should range from 1% to 5% of sales.

Assumptions Used: 

Memo focus on US operations business; no foreign operation revenues included in sales.



Quarterly sales amounts include foreign sales as they were not presented separately on the quarterly statements as they were on the annual statement.

Analytical Procedures Performed: Trends:

Ratios:

Analysis: Considering Sensormatic’s own admission they historically carry a high level of outstanding receivables, coupled with the nature of their sales arrangements in which its typical that payment arrangements are long term & flexible with regards to returns, the revenues account warrants scrutiny. Sensormatic claims to recognize revenue upon shipment. The following findings raise concerns: 1. EPS amounts steadily increased each annual and quarterly period and they are on pace to surpass the ‘94 EPS in 1995. 2. The 47.22% Sales increase from 1993 to 1994 would not be unusual if not for the outlier year in which U.S. Sales only increased 12.66% from 1992 to 1993. 3. It is unusual that gross profit % remained in the same range at the conclusion of each reporting period, especially the quarterly periods, because at the same time there are obvious fluctuations in A/R Turnover, indicating variable sales collection periods.

To conclude these preliminary risk assessment procedures and my analysis, an area of heightened risk is the revenue account. Specifically, the timing of their revenue recognition deserves further scrutiny. The amounts analyzed during the analytical procedures lead me to believe that sales figures are being manipulated over each reporting period in order to achieve projected earnings per share figures. Substantive analytical procedures will be performed during the audit to address this concern

Other Risk Assessment This portion of the memo will address the inherent risk, fraud risk and financial statement assertions regarding accounts receivable and revenue. Given the nature of risk assessment, a lot of this takes in account auditor’s judgements. Inherent Risk: Having to rely on auditor judgement makes for an increase in inherent risk because of the risk of bias or lack of experience. Regarding prior period reports, prior period misstatements are apparent in the 10’ks. Because priorr period misstatements exist this increases inherent risk for the current year. Another crucial area to examine is Sensormatic’s entity structure itself. The internal environment creates the tone at the top effect. Because of the executive’s involvement with fraud, inherent risk increases. Also, an inherent risk that exists with the audit of Sensormatic Electronics includes employees and management. There is always a risk that management may override controls that impact the collection of accounts receivable or the recording of revenue. Also another inherent risk is collusion of employees. A record keeping employee and a custody employee could collude to conceal a collection of accounts receivable by writing it off as uncollectible. Having good controls and segregation of duty is a great way to mitigate this risk. Effective internal controls can reduce the effects of inherent risk. By examining this company’s environment, there is a substantial amount of pressure to meet sales goals according to the litigation reports. This pressure increases inherent risk. Also external factors such as the industry’s performance and acquisitions can have varying impacts on inherent risks dependent on how the Sensormatic compares. Benchmarking is a useful tool to see how a company compares to industry performance. Below benchmark performance could increase inherent risk. Sensormatic takes part in large transactions that are worth substantial amounts of

money. Inherent risk increases when all these goods are shipped together. Having items all in one location makes them more susceptible for damage or theft. Fraud Risk: There are two types of fraud we must account for. Fraudulent financial reporting is misstating records intentionally and usually involve management. Misappropriation of assets involves theft of assets and usually involves many levels of employees. In every audit, auditors must think that revenue recognition fraud could impact material misstatements. A key way to recognize where fraud may occur is by analyzing the pressures, opportunities and incentives that exist to commit fraud. Revenue fraud can take many forms. This company for example has recorded revenue early, channel stuffed, and ultimately willingly misreported revenue amounts. Highlighted in one of the litigation write ups, Sensormatic would record revenue in one quarter from sales that would not occur till next. The controllers would also manipulate clocks to record revenue early. These are things we must account for and keep a close eye on this year. The impact these fraud risks have on the audit plan include the need to perform more cutoff testing and checking of dates. We also need to play close attention to shipping terms and when sales are finalized. Also fictitious sales were made to warehouse spaces that were leased by sensormatic. We must plan to evaluate all major sales and verify a company's existence. Fraud when it comes to accounts receivable could easily be committed when collecting or writing off. We must monitor who approves writing off an account and who is collecting the accounts receivable. A close relationship between these two incompatible duties could indicate instances of accounts receivable fraud. A walk through would be a good procedure to perform. What Could Go Wrong: A major concern involving accounts receivable and revenue accounts involves Sensormatic overstating these accounts. While referencing AU-C 500 and AU-C 315, auditors need to use procedures to provide evidence for relevant assertions. Some assertions will have multiple controls that apply. We auditors must also have sufficient evidence to back up our claims. In the table provided below are some key “what could go wrong” areas that need attention.

Audit Program of Procedures This portion of the memo will address the procedures needed to gather sufficient and reliable evidence regarding account balances and procedures. Examining the design of controls is imperative to alleviate the degree of testing that needs to be done. Reliable controls may reduce the amount of procedures and intensity of substantive procedures. The major concern with account receivable is overstatement of the accounts and fictitious customers. Test of Controls Design AR: Test of controls is imperative to make sure the risk of material misstatement is decreased. Better controls usually lead to more efficient and less risky accounting. A way we will test the controls design for account receivable is by performing an observation of the process of documenting, writing off, and recording payment of accounts receivable. Looking at who is performing each function of custody, authorization and recording is a critical component we will examine throughout the whole observation. We will receive the client’s AR flowchart if one is available. Throughout the observation we will document our understanding the process. We will observe the sales department record the sale. For example a common procedure we expect to observe is a customer purchase order is received by the sales department. The sales department will prepare a serially ordered sales order and then sends it to the credit department where another individual will approve the sales order. The credit department determines if the customer can purchase the items on credit. We will review their process of what they determine to be a qualified client and what the payment terms are. Once the credit department approves or denies the sales order we follow that sales order to the shipment department that prepares a bill of lading and then to the billing department that prepares the sales invoice. A comparison of the sales invoice, purchase order, and bill of lading is a good check of controls. Finally the sale is entered into the sales journal and the receivable is recorded. If we

believe or notice any indication that incompatible functions are performed by the same individual we must note that. Sales, collection of cash receipts, uncollectible receivables, sales returns and sales discounts must be monitored. Independent people must reconcile the ar general ledger and subsidiary ledger. A huge control to look for it that when cash is received that the receivable account is properly eliminated and checks are stamped. The credit department should have custody of the aging of receivable and should only write off accounts when authorized by the treasurer. When cash is received it should be opened by someone who does not have access to the AR ledger. Three copies of the receipts should be given to the cashier, ar department, and accounting department. Other controls that increase the design quality of ar controls would be sufficient collections tools such as lock boxes. This eliminates the handling of cash receipts and the potential for cash schemes to occur. Substantive Procedures Design AR: Substantive procedures are used to test the audit assertions that include, completeness, rights, existence, disclosure and valuation. Substantive procedures must provide enough documentatio...