CAL TEMP SERVICES, INC. Case - 3

1. CAL TEMP SERVICES, INC.Case - 3 Group 5-A Silka Gonzalez Silvia Orozco Blanca Wegener

2. Accounting Issues

3. Per Generally Accepted Accounting Principles (GAAP), when should revenue be recognized? Also, how are accounts receivable to be valued and reported? SAB 101 amended by SAB 104 on Dec-2003 • Revenue should not be recognized until it is either (a) realized or (b) realizable and earned. Typically revenue should not be recorded until the following conditions have been met: • Persuasive evidence of an arrangement must exist. • Delivery must occur or services must be both performed and accepted. • The fee for the service must be fixed or determinable • Collectibility must be reasonably assured • The receipt of cash is non-refundable

4. Per Generally Accepted Accounting Principles (GAAP), when should revenue be recognized? Also, how are accounts receivable to be valued and reported? It is implicit in the concept of revenue recognition that: • Revenue will be realized through the receipt of cash; and • No significant amount of costs will be incurred in a period subsequent to recording the revenue.

5. Are the stated revenue recognition policies of CTS on engineering services, as stated in the footnotes, appropriate and in accordance with GAAP? • The stated revenue recognition policies of CTS on Engineering services stated in the footnotes are appropriate and in accordance with GAAP. • Revenues for engineering services are recognized upon completion of projects.

6. For the accounts receivable balances specifically discussed above, what is your opinion as to amount, if any, of the overstatement of accounts receivable: • a. As of December 31, 1999 Overstated $253,427 • b. As of December 31, 2000 Overstated$457,047

7. With the exception of accounts receivable, are there any other balance sheet accounts that you believe should be appropriately adjusted based on your findings? a. As of December 31, 1999? The Balance Sheet accounts that need to be adjusted are: Accounts Payable Trade and Inventory. Accounts payable trade should be adjusted for Subcontracted Services and Project and Facility Costs, for the following amounts: • Penns Engineering Services, Inc. – $1650.00 • McDonald Douglas, Inc. - $4577.00 • Nexus Software - $ 1655.00 Inventory should be adjusted because all direct costs for the projects are included in Inventory at the lower of cost or realizable value. The direct costs associated with the projects that were not properly recorded in 1999 should reduce the inventory amount by the lower of cost or realizable value.

8. With the exception of accounts receivable, are there any other balance sheet accounts that you believe should be appropriately adjusted based on your findings? b. As of December 31, 2000? • No adjustments necessary in Accounts Payable – Trade as of December 31, 2000. • No adjustments necessary in Inventory as of December 31, 2000

9. What would have been the impact of the adjustments you have proposed on the pre-tax income of CTS: a. For the year ended December 31, 1999? • Due to the proposed adjustments in the account receivable accounts, the sales account will be impacted for the same amount. Therefore, the sales for the year ended December 31, 1999 will decrease in the amount of $253,427 and the expenses will also decrease by $7,882.00. • Pre-tax Income of CTS will decrease by $245,545 plus any other expenses recorded for Projects that were never performed or that were performed in 2000.

10. What would have been the impact of the adjustments you have proposed on the pre-tax income of CTS: b. For the year ended December 31, 2000? • Due to the proposed adjustments in the account receivable accounts, the sales account will be impacted for the same amount. Therefore, the sales for the year ended December 31, 2000 will decrease in the amount of $457,047. • Pre-tax Income of CTS will decrease by $457,047 plus any other expenses recorded for Projects that were never performed or that were performed in 2000.

11. Litigation Consulting Engagement Issues

12. What, if any, evidence have you identified that would indicate knowledge of any financial statement and collateral reporting fraud on the part of Williamson and Roberts? • When Ron Gray of Second Union Bank contacted James Roberts about CTS’ accounts receivable balances. • When Roberts admitted that many of CTS’s accounts receivable (which at that time were shown on the books as $1.8 million) would not prove to be collectible and that he regretted having done anything that misled the bank. • When he told Gray that everything he and Williamson had done was done just to save the jobs of the CTS employees. • These statements indicate James Robert and Jack Williamson were well aware of what they were doing.

13. What, if any, evidence have you identified that would indicate knowledge of any financial statement and collateral reporting fraud on the part of Williamson and Roberts? • All the invoices, credit memos and debit memos obtained by the Auditor indicate that they were creating invoices and recording receivables for work that was not been provided yet. • Both men provided the bank multiple aged listing of accounts receivable along with collateral report certifications with their signatures indicating account receivable balances that were not accurate and that cannot be totally supported by the actual sales transactions, invoices and subsequent collections.

14. What were the apparent motives of management to commit a fraud in this situation? • CTS was a new company with limited capital to operate the business. • CTS was in the process of growing the business when they began to experience financial difficulties due to the defense industry downsizing and increase market competition. • CTS was providing inflated accounts receivable balances to Second Union Bank in order to keep their loan with the Bank intact. • CTS needed the funding provided by the bank line of credit in order to continue operating the business.

15. What were the apparent motives of management to commit a fraud in this situation? • In order for them to comply with the bank agreement and retain the line of credit, they had to maintain certain account receivable balance representing receivables less than 90 days old. • CTS forced the receivables to provide the figures that the bank was expecting to retain and increase the line of credit. • If the real account receivable balances were known, Second Union Bank might have stopped advancing funds, lowering the amount they originally granted, or perhaps even cancelled the loan altogether.

16. Compute your best estimate of the damages that Second Union incurred as a result of delaying termination of the loan agreement with CTS until May 12, 2001, versus the result if they had terminated the agreement on: a. December 31, 1999 • No damages will be incurred as a result of delaying termination of the loan agreement. The sale of receivables offset the loan amount. b. December 31, 2000 • If the sale of CTS’s includes all of the receivable, including the ones outstanding over 90 days, then Second Union will incur in a loss of $163,180, which can be offset against 1999 difference between the loan amount and the amount realized from the sale of receivables. However, there are some other costs such as legal costs and sale related costs that may increase the total loss amount overall.

17. Auditing Issues

18. The Bank’s legal counsel is also concerned that the loss on the CTS account followed so closely the completion of the apparently problem-free 2000 audit of M&S. They expect that management may use that clean audit opinion as a defense at trial. Accordingly, legal counsel has also asked you to determine whether the fraud, if any, would have been detected by the proper application of Generally Accepted Auditing Standards (GAAS)and how any fraud was concealed from the auditors.

19. Distinguish between an error and fraud. Would management’s actions in this case be considered an error or fraud? • An error can be defined as a mistake that occurs unintentional. • Fraud is the act of intentionally misleading and deceiving a person/company in order to obtain something of value (e.g., money). • Management’s actions in this case would be considered fraud.

20. What is the auditor’s responsibility for discovering errors and/or fraud? • The auditor is not expected to discover all exiting frauds. • The auditor has a professional responsibility to perform a competent job, apply adequate auditing standards and procedures as well as good judgment. • If the expected auditor’s professional responsibilities are properly fulfilled, the auditor should discover existing errors and\or fraud.

21. What are some of the risk factors (red flags) that are apparent in the case? • In 1999, Second Union became aware that CTS’s financial condition has taken a turn for the worse. • They reported a pre-tax loss of $279,931 • This news were particularly distressing to the bank because the interim financial statements that they have been shown had not reflected a problem of this magnitude. • The bank notified CTS that their line of credit will be under review by the Second Union’s loan committee. • In June 2, 1999 CTS provided the bank new interim financial statements as of May 1999 and forecasted financial statements.

22. What are some of the risk factors (red flags) that are apparent in the case? • The financial statements showed an improvement in business operations and the forecasted financial statements projected a return to profitability in 1999. • On May 10, 2001, Ron Gray from Second Union became concerned about the deterioration in the aging of accounts receivable, the continued increase in CTS’S accounts receivable balance, and the frequent overdraft on the CTS’s checking account. • Ron Gray met with James Roberts to indicate to him that the bank was concerned about the receivables situation CTS. • Ron Gray felt this step was necessary to provide Second Union with comfort that the amount shown as accounts receivable would be eventually paid. • James Roberts strongly objected to the bank’s desire of directly contacting and confirming accounts receivable balances with CTS’s clients.

23. Do you believe that the audit approaches employed by M&S were in accordance with GAAS? Why or why not? • No. The audit procedures used to test and validate the accounts receivable balances were not adequate • The M&S auditors decided not to use direct confirmation of accounts receivable after the fourth year of the engagement • Instead, they decided to use other alternative audit procedures to test the accounts receivable balances

24. Do you believe that the audit approaches employed by M&S were in accordance with GAAS? Why or why not? • These procedures consisted of checking whether the accounts receivable were collected after year-end as evidence of their validity. • Such alternate procedure cannot provide the same type of direct and independent evidence that a direct confirmation of the balances. • Such alternate procedure will not identify other potential issues such as delays in actual collections and adjustments to the account receivable balances.

25. What additional evidential matter could have been acquired by M&S (based on your knowledge of CTS’s customers and accounting records)? The M&S auditors could have performed different types of tests to evaluate the relationships and reasonableness among CTS’s, such as: • purchase orders • sales registers • invoices • accounts receivable aging records • credit\debit memos • cash receipt records • bank account records.

26. Based only on your analytical review of the CTS financial statements and accounts receivable trial balances as of December 31, 1999 and 2000, was information available which should have alerted the auditors to the potential of fraud and financial statement misstatement? • Based on our analysis we conclude that CTS’s Financial Statements indicated that Account Receivables were increasing significantly and balances were outstanding for extended period of time.

27. Was it appropriate for M&S to accept a fax confirmation from Nexus Software as audit evidence in the confirmation process? What special concerns are there for the auditor in accepting faxes as audit evidence? • No. The auditor cannot truly ascertain that the fax was submitted by the client. • There is no direct evidence that the client received the confirmation letter with the balanced owed. • There is no direct evidence that the client returned the actual confirmation to a controlled location selected by the auditor.

28. Was M&S justified in their reliance on management representations? Why or why not? • Management members have certain professional responsibilities which they affirm on a management representation letter. • This letter provides the auditor with written representations from management regarding different aspects. • In this letter, management members indicate that such representations are true to the best of their knowledge and belief. • The letter will formally indicate that management members are responsible for the accurate presentation of the information provided and for establishing and maintaining appropriate controls related to the processing of transactions.

29. Was M&S justified in their reliance on management representations? Why or why not? • In this letter, management members indicate that they have provided complete and accurate information to the best of their knowledge and disclosed all relevant information. • In this letter management members indicate that the information provided presents fairly, in all material respects, the aspects of the organization’s operations and controls. • In this letter they indicate that management members have responded fully to all inquiries made by the auditors. • In this letter they indicate that they are not aware of any illegal acts, fraud, or uncorrected errors attributable to management or employees of the organization.

30. Was M&S justified in their reliance on management representations? Why or why not? Based on the purpose and intent of a management representation letter, auditors are expected to rely on management representations. However, such reliance does not eliminate or diminish the auditors’ responsibility of performing a competent job, apply adequate auditing standards and procedures as well as good judgment.

31. THANK YOU!