St. James Clothiers is a high-end clothing store located in a small Tennessee town. St. James only has one store, which is located in the shopping district by the town square. St. James enjoys the reputation of being the place to buy nice clothing in the local area. The store is in its twentieth year of operation.
The owner, Sally St. James, recently decided to convert from a relatively simple manual sales system to an IT-based sales application package. The sales application software will be purchased from a software vendor. As the audit senior on the St. James engagement, you recently asked one of your staff auditors, Joe McSweeney, to visit with the client more formally to learn more about the proposed accounting system change. You asked Joe to review the narrative in last year’s working papers that he prepared, which describes the existing manual sales accounting system, and update it for any current-year changes. You also asked him to prepare a second narrative describing the proposed IT-based sales accounting system, using information he obtained in his discussions with St. James personnel. The narrative from last year’s working papers as well as the narrative recently prepared by Joe are provided in the pages that follow.
The audit partner on the St. James engagement, Betty Watergate, has asked you to review the narratives prepared by Joe as part of your audit planning procedures for the current year’s 12/31/06 financial statement audit. Betty wants you to prepare a memorandum for her that addresses these questions:
1. What aspects of the current manual sales accounting system create risks that increase the likelihood of material misstatements in the financial statements? Specifically, identify each risk and how it might lead to a misstatement. For example, don’t just put “Risk: Sales tickets are manually prepared by the cashier.” Rather, you should state why this increases risks of material misstatements by adding “This increases the risk of material misstatements because it increases the risk of random mathematical errors by the cashier.”
Hint: The question is asking what areas of the financial statements are likely to contain misstatements (which might ultimately impact on the auditor’s opinion and report) as a result of a lack of internal controls. Your task is to identify internal control weaknesses, and more importantly, how and why it may present a possible risk of error in the financial reports?
2. What features, if any, of the proposed IT-based sales accounting system will help minimize the risks identified in question 1? If a weakness exists that will continue with the new system, indicate that “no computer controls reduce this risk.”
3. How does the IT-based sales system create new risks for material misstatements?
Hint: Discuss the merits of introducing an IT-Based Accounting System. With this in mind, think about potential errors that can still occur in the sales accounting system, even though the IT-Based system has been introduced. This may require to research computerised systems. This question also requires you to have a strong understanding of the sales and collections cycle. The application of this assumed knowledge and your personal experience will go some way towards identifying the potential misstatements that may occur in the sales system.
4. Prepare (draw) a flowchart documenting the sales accounting system.
Hint: Identify the key steps in the sales cycle. It might be useful to identify the key documents used, how many copies of documents should be prepared in your flowchart. Understanding of flow chart can be gained from the following links:
5. Prepare (draw) a flowchart documenting the IT-based sales accounting system.
Narrative Description is as follows:
Reference: P 1-1 Prepared by: JMc Date: 6/29/05 Updated 7/10/06 Reviewed by: St. James Clothiers Narrative Description of Manual-Based Sales Accounting System For the Year Ended December 31, 2005 This narrative is based on discussions with client personnel at St. James Clothiers on June 29, 2005, in conjunction with the audit of the December 31, 2005, financial statements. This narrative describes the manual sales system in place at the client during the year ended December 31, 2005.1 Description of the Existing Sales Accounting System St. James has several salespeople who work with customers. Sales personnel are compensated based on an hourly rate plus a bonus for sales they generate by assisting customers. When the customer is ready to purchase the goods, the salesclerk directs the customer to the store cashier for payment.
To process a sale, the cashier manually records the salesclerk’s name, the product number, quantity sold, and sales price on a prenumbered sales ticket using information on the clothing price tag. The sales ticket is in duplicate form. For special sale items, the cashier refers to newspaper clippings of advertisements. Occasionally, the cashier has to rely on the salesperson to determine the sales price. The cashier manually extends the price times quantity to compute the sales amount and then adds the sales tax to arrive at the total sale amount. Once the sales ticket is computed, the pretax sales total and the sales tax amount are entered into the cash register, and the cash register records these amounts plus computes and records the total sales amount on a duplicate cash register tape. The cashier staples the customer copy of the cash register tape receipt to a copy of the manually prepared sales ticket and gives that to the customer. The other copy of the cash register tape is maintained inside the locked cash register.
No one except the store accountant, Meredith McGlomm, can unlock the tape from the register. The cash register is a relatively simple machine—it basically is used to generate the sales ticket and to provide a locked drawer for cash collected. The cash drawer is generally only opened when a sale is entered; however, the drawer can also be opened by pressing the “Total” button. The original sales ticket is retained in a file box beside the cash register. Salesclerks assist the cashier during breaks and busy peaks (Saturdays particularly). St. James will accept customer returns only if the customer can provide his/her copy of the sales ticket. The cashier processes sales returns by completing a sales ticket using negative amounts. John Thornberg, the store’s manager, counts the cash in the cash register each night and prepares the deposit slip. He takes the cash to the local bank each night and drops it in the overnight depository. On the next day, the bank processes the deposit and sends the validated deposit slip directly to the store accountant (Meredith McGlomm). 1Updated for the current year on 7/10/06—see note at bottom of page P 1–2.
Reference: P 1-2 Prepared by: JMc Date: 6/29/05Updated 7/10/06 Reviewed by: At the end of each day, Meredith collects all the sales tickets from the cashier and also takes the cash register tape that is locked inside the cash register. Those are stored in a safe located in the accounting office. On the next day, Meredith groups all sales tickets by salesclerk number and records sales by salesclerk in separate columns of a spreadsheet. Meredith accumulates the subtotals of sales by salesclerk to determine the total sales amount for that day for the store. Meredith manually enters the daily total into the Sales Journal. She compares the daily sales total in the Sales Journal to the cash register tape total for that day. When the validated deposit slip arrives from the bank, Meredith compares the deposited amount to the Sales Journal for that day noting agreement.
The store owner, Sally St. James, periodically compares the daily deposit slip to the Sales Journal recorded amounts. At the end of each month, the store accountant foots the Sales Journal columns and posts account totals to the General Ledger. She uses the monthly sales by salesclerk totals to calculate salesclerk bonuses for the month. Because of the volume of sales transactions that occur, the store is unable to maintain a perpetual inventory system. Thus, at month’s end, the store performs an inventory count to establish ending inventory for the month. This is used to compute Cost of Goods Sold for the month. Update for Year Ended December 31, 2006 Audit: Based on my review and discussions with St. James Clothiers personnel on July 10, 2006, the above narrative description of the manual-based sales accounting system accurately describes the sales accounting system currently in place. Joe McSweeney July 10, 2006
Reference: P 1-3 Prepared by: JMc Date: 7/10/06 Reviewed by: St. James Clothiers Narrative Description of the Proposed IT Based Sales Accounting System For the Year Ended December 31, 2006 This narrative is based on discussions I had with client personnel at St. James Clothiers on July 10, 2006. The narrative describes the key components of the proposed new IT-based sales accounting system, which St. James plans to install in the fourth quarter of the current year. Description of the Proposed IT-Based Sales Accounting System The new IT-based sales system that St. James is planning to implement later this year is an externally developed sales accounting software package that will be purchased from Olive States Software. Sally St. James learned about this software package while attending an industry meeting several months ago. From talking with several store owners, Sally is convinced that this software package would be great for St. James Clothiers. Sally talked with some local friends who recommended a Nashville-based computer consultant to assist with the implementation. The consultant has met with Sally on five different occasions to discuss their plans for installation.
The installation is scheduled for the last two weeks of November 2006. St. James will begin using the new system effective December 1. Although the system will come ready for installation, there are numerous features associated with the system that St. James will have the option of activating. Sally has asked the consultant to be responsible for setting those features, given that Sally and the rest of the store staff have no experience with computer programming or software installation. When the new system is implemented, the old cash registers will be removed, and a new microcomputer will be used by the cashier to process sales. The microcomputer (“PC”) has a special cash drawer attachment that can only be opened after a sale is entered into the PC. To open the drawer any other time requires a special password code, which will be maintained by the store manager.
Thus, if the cashier makes a mistake while entering a sale, the store’s manager will have to enter a password to void the sale. To operate the new PC cash register, the cashier must input a three-digit password prior to processing each sale. Salesclerks will continue to fill in for the cashier, but each clerk will have a unique password to operate the PC. The PC will record the operator’s password for each sale on an internal storage device that can only be accessed by the store manager. The store manager will be able to generate reports by password number for review. Sales tickets will no longer be prepared. Instead, the cashier will input the product number, quantity sold, and salesclerk number. The PC will extend price times quantity and compute the pretax sales amount, sales tax amount, and total sale amount. The PC will pull the unit price from a Price List master file based
Reference: P 1-4 Prepared by: JMc Date: 7/10/06 Reviewed by: on the product number entered. As a result, sales cannot be processed for invalid product numbers and for product numbers with no price in the Price List master file. The PC generates a receipt, which will be given to the customer. The receipt will indicate the product number, quantity, extended transaction amounts, and salesclerk number. The PC does not generate a separate cash register tape. Instead, the daily sales figures are stored internally on a hard drive. At the end of each day, the cashier selects the “daily closing procedure” menu option, which automatically updates the Sales Journal and Perpetual Inventory master file maintained on a hard drive. Sales returns can only be processed by the store manager using a special password option. A maintenance application that comes with the new computerized sales system must be used to input changes to the Price List master file. The application will be loaded on a different machine where access to the application can be protected by requiring the use of a password to access the master file.
Sally and the consultant have decided to load this Price List maintenance application on the store manager’s PC for the manager to update as price changes occur. The store manager will continue to make the nightly deposits in a manner consistent with the manual system procedures. The new system will dramatically change the store accountant’s responsibilities. Given that the computer automatically posts individual transactions to the Sales Journal by salesclerk, the store accountant no longer will prepare the Sales Journal. As a matter of fact, a Daily Sales Journal will not be produced in hardcopy form. Instead, the store accountant will be able to READ ONLY the daily sales figures from a PC in the accounting office. READ ONLY means the accountant can only view the contents of the file. When the validated deposit slip arrives from the bank each day, the store accountant will enter the deposit-slip total into the accounting system, and the system will then compare the deposit amount to the daily recorded sales totals.
Any differences will be listed on an exception report forwarded to Sally St. James each day. In addition, the nightly posting will also update the Perpetual Inventory master file. Because the store accountant’s daily procedures will change significantly, she will be able to test the perpetual inventory records on a daily basis by physically counting selected inventory items for comparison to the perpetual inventory records, which can be printed daily in the accounting office. Discrepancies will be reviewed by the store manager daily and by the owner on a test basis. As a part of the monthly closing procedures, the computer will automatically post sales and inventory transactions to the General Ledger accounts. The store accountant will print the General Ledger Trial Balance to prepare monthly financial statement reports. No other hardcopy reports or journals will be generated. Joe McSweeney July 10, 2006