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USSC Audit Income

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Published: Mon, 5 Dec 2016

Case 1.11 United States Surgical Corporation

Q3. Prepare common-sized financial statements for USSC for the period 1979-1981. Also compute key liquidity, solvency, activity, and profitability ratios for 1980 and 1981. Given these data, identify what you believe were the high-risk financial statement items for the 1981 USSC audit.

U.S. Surgical Corporation

Common Size Income Statement 1979-1981 (000s omitted)

1981 % Sales 1980 %Sales 1979 %Sales

Net Sales 111,800 100 86,214 100 60,876 100

Costs and Expenses

COGS 47,983 43 32,300 37.5 25,659 42.1

Selling, General

And Admin. 45,015 40.3 37,740 43.7 23,935 39.3

Interest 5,898 5.2 4,063 4.7 3,403 5.6

98,896 88.5 74,103 85.9 52,997 87.0

Income Before Taxes 12,904 11.5 12,111 14.0 7,879 12.9

Income Taxes 1,120 1.0 4,226 4.9 2,750 4.5

Net Income 11,784 10.5 7,885 9.1 5,129 8.4

U.S. Surgical Corporation

Common Size Balance Sheet 1979-1981 (000s omitted)

Current Assts 1981 %Assets 1980 %Assets 1979 %Assets

Cash 426 .21 1,243 1.04 596 .85

Receivables (net) 36,670 17.7 30,475 25.6 22,557 31.9

Inventories

Finished Goods 29,216 14.1 9,860 8.3 5,685 8.1

Work in Process 5,105 2.5 2,667 2.2 1,153 1.6

Raw Materials 20,948 10.1 18,806 15.8 7,365 10.4

55,269 26.7 31,333 26.3 14,203 20.1

Other Current Assets 7,914 3.8 1,567 2.4 1,820 2.6

Total Current Assets 100,279 48.4 64,618 54.3 39,176 55

Assets 1981 %Assets 1980 %Assets 1979 %Assets

Property, Plant, Equip

Land 2,502 1.2 2,371 2.0 1,027 1.5

Buildings 32,416 15.6 18,511 15.5 13,019 18.5

Molds and Dies 32,082 15.5 15,963 13.4 8,777 12.4

Mach. & Equip. 40,227 19.4 23,762 20.0 12,362 17.5

Allowance for

Depreciation (14,953) (9,964) (6,340)

Other Assets 14,786 7.1 3,842 3.2 2,499 3.5

Total Assets 207,339 119,103 70,520

Liabilities 1981 %Liability/ 1980 %Liability 1979 %Liability

Stock.Eq. Stock. Eq. Stock. Eq.

Accounts Payable 12,278 5.9 6,951 5.8 6,271 8.9

Notes Payable 1,596 2.3

Income Taxes Payable 1,685 1.4

Current L-T Debt 724 .35 666 .56 401 .57

Accrued Expenses 5,673 2.7 5,130 4.3 5,145 7.3

Long-Term Debt 80,642 38.9 47,569 39.9 33,497 47.5

Deferred Income Tax 7,466 3.6 2,956 2.5 1,384 2.0

Liabilities 1981 %Liability/ 1980 %Liability 1979 %Liability

Stock.Eq. Stock. Eq. Stock. Eq.

Stockholders’ Equity

Common Stock 1,081 .52 930 .78 379 .54

Add. Paid-in Capital 72,594 35.0 34,932 29.3 10,736 15.2

Retained Earnings 32,665 15.8 20,881 17.5 13,189 18.7

Translation Allowance (1,086)

Deferred Compensation-

Issue Restricted Stock (4,698) (2,597) (2,078)

Total Stock. Equity 100,556 48.5 54,146 45.5 22,226 31.5

Total Liabilities/

Stockholders’ Equity 207,339 119,103 70,520

Financial Ratios for U.S. Surgical Corporation

1981 1980

Cash Ratio .0228 .0861

Current Ratio 5.37 4.48

Accounts Receivable

Turnover 3.33 2.57

Inventory Turnover 1.11 .75

Gross Profit Percent 57% 62%

Profit Margin 11.5 14.1

Return on Assets 7.9 7.4

The common sized income statement was prepared to display all items as a percentage of sales. On the income statement we can see that there was a decrease in cost of goods sold from 1979 to 1980. Cost of goods sold went from 42.1% of sales to 37.5% of sales even though net sales increased. This information along with the increase in the current asset inventory account on the balance sheet indicates a significant increase in inventory held by USSC. Another high risk income statement item was the selling, general and administrative expenses. Included in this category of expenses are research and development costs. The amounts of research and development costs reported dropped significantly. In 1980 they were reported at $3,020,000 and dropped to $1,337,000 in 1981. Also the entire category of selling, general and administrative expenses which included these R&D costs decreased as a percent of sales from the previous year. The USSC openly admitted to undergoing a large research and development program to create new products and technology in 1981. The major decrease in costs reported for research and development in 1981 should have caused further investigation by the auditing team.

The common sized balance sheet was prepared to display each asset as a percentage of total assets. The percentages for the cash and accounts receivable accounts in 1981 decreased significantly from the previous years while the inventory account increased. This indicates a decrease in liquidity of assets which is also supported by the change in the cash ratio from 1980 to 1981. Another high-risk item would have been the other assets account. United States Surgical Corporation included their patents in this other assets account. They were capitalizing costs associated with the legal defense of a patent that should not have been capitalized. There was a significant increase in this account, $3,842,000 in 1980 to $14,786,000 in 1981. Another red flag would be the significant increase in total long term assets. In 1979 long term assets accounted for 45% of total assets, in 1980 it was 45.7% of total assets and in 1981 long term assets accounted for 51.6% of total assets. USSC was capitalizing costs associated with patents that should not have been capitalized, charging inventoriable production to a long-term assets account molds and dies, and extending the useful lives of some assets and therefore understating depreciation. All of these actions would have caused a significant increase in total long-term assets. A more specific high-risk item was the long-term asset molds and dies. This account doubled in 1981 from the previous year; from $15,963,000 to $32,082,000. The SEC investigation later revealed that USSC was in fact capitalizing production costs and charging them to the molds and dies asset account.

Financial ratios were also calculated to determine high-risk items. The current ratio for USSC in 1981 is a little high and has increased from the previous year. In 1981 the current ratio indicated that USSC had $5.37 in current assets for every dollar of current liabilities. This high ratio may indicate that United States Surgical Corporation was overstating their assets. The inventory turnover is low at .75 in 1980 and 1.11 in 1981. The auditing team would have wanted to investigate to find out why inventory was accumulating and not turning over as these numbers indicated.

By preparing the common size financial statements and ratios we can identify the high-risk items when performing an audit. The major items for United States Surgical Corporation were the reduced research and development costs recognized despite the increase in research for new products, the major increase in the long-term asset account molds and dies and the other assets account.

Q5. Regarding the costs incurred for USSC by Barden, identify (a) the evidence Hope collected that supported USSC’s claim that the costs involved tooling modifications and (b) the audit evidence that supported the position that the costs were generic production expenses. What do generally accepted auditing standards suggest are the key evaluative criteria that auditors should consider when assessing audit evidence? Given these criteria, do you believe Hope was justified in deciding that the costs in question were for tooling modifications? Why or why not?

The evidence that hope collected that supports USSC’s claim that the charges in question were in fact for tooling modifications was the General Manager of Lacey Corporation (A division of Barden Corporation) goes back on his previous statement and confirms that the purchase orders and invoices were in fact for tooling modifications. USSC explained their position and said that they had instructed Lacey to make certain tooling changes that would result in improved efficiency in production of USSC products. When the audit team asked to take a tour of the Lacey plant to examine the actual production process the Lacey General Manger informed the audit team that personnel often mistakenly charge tooling jobs to production.

There was more evidence that supported the position that the costs in question were just generic production expenses. Initially the audit team did not notice that the assets were being overstated and there was an issue with the classification. It was the company who does work for USSC that admitted that there were issues with some of the purchase orders and invoices. The Lacey general manager informed the auditors that invoices and purchase orders were being reviewed and that they were for general production work and not tooling modifications as USSC had previously stated. The chairman of the board of directors for Barden Corp. reported that an independent investigation by an outside law firm has concluded that the purchase orders and invoices were in fact for general production work and not for tooling modifications. Finally the Senior Vice President and Treasurer for Barden Corporation refused to sign confirmation that $1 million in charges were for tooling modifications on two occasions.

The key criteria for evaluating audit evidence are relevance, reliability and sufficiency. The evidence must be relevant to audit objective. The auditors must use procedures and documents that are relative to the audit objective. The evidence must be reliable, or must be believable and trust worthy. The sufficiency of evidence has to deal with the quantity of evidence obtained.

In my opinion Hope was not justified in deciding that the costs were for tooling modifications. There was not sufficient evidence to come to this conclusion, just some complicated explanations from USSC and inaccurate purchase orders and invoices. The evidence was not relevant to the audit objective. The specific products with modifications should have been traced back to their purchase orders. Instead the auditors just took the explanation of these orders from management. Finally the reliability of the evidence was not high, USSC had a lot to lose if it was concluded that they were indeed general production and the General Manger for Lacey had changed his position numerous times. The only reliable evidence was that of the independent law firm that concluded the purchase orders and invoices were not for tooling modifications.

References

Knapp, Michael C., United States Surgical Corporation Contemporary Auditing. Real Issues & Cases. Sixth Edition (2006), 137-146.

Arens, R. Randal, M. Beasley, Auditing and Assurance Services. An Integrated Approach. (2008) 175-176.


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