Auditing Kingcos
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Auditing Case 2: Crazy Eddie, Inc.
An analysis of key ratios during the period of 1984-1987 would have resulted in red flags that indicated that Crazy Eddie had a higher than normal level of audit risk.
The balance sheets for 1984 to 1987 show some huge irregularities in the accounts between the years. For instance, cash fell from 34 in 1985 to 3.2 in 1987. A red flag came up when analyzing the merchandise inventories to total assets ratios which were 63.8 in 1984 to 37 in 1987. Short-term investments had a zero balance until 1986 when it went to 21.1, then up again to 41.4 in 1987. Short-term debt increased from .3 in 1984 to 16.8 in 1987. Accrued expenses went from 16.6 in 1984 to 1.9 in 1987. Cash and restricted cash were 44.8 in 1985, but only 3.2 in 1987. Crazy Eddies management was trying to rapidly expand the company with these huge investments but they did not have a lot of cash just in case something unforeseen happened. For instance, they did not plan for market saturation and an explosion of competition which led to their inventory being undersold and obsolete.
Other financial measures indicated that there was a problem with inventory also. The age of inventory at Crazy Eddie went from 80 days in 1986 to 111.8 days in 1987. The inventory turnover decreased from 4.5 to 3.22. There is also a problem with accounts receivable, the turnover decreased from 105.2 to 53.9, while the age increased from 3.4 days to 6.7 days. It is important to move electronics in the inventory fast because the technology gets obsolete quickly. Crazy Eddie was facing increased competition and market saturation yet still managed to increase profits. The inventory ratios verified that there was a problem with the accounting at Crazy Eddie.
There were specific audit procedures that might have led to the detection of the accounting irregularities perpetrated by Crazy Eddie personnel. The falsification of inventory count sheets could have been prevented if the auditors observed a whole physical inventory, if they observed random cycle counts, or if they randomly performed cycle count audits. The bogus debit memos for accounts payable could have been identified if the auditors could have confirmed balances with the debtor. The act of recording transshipping transactions as retail sales could have been spotted if the auditor observed the flow of transactions for recording a transshipping sale and audited the receipts of very large sales. The inclusion of consigned merchandise in year-end inventory could have been seen if auditors could have observed an entire year end physical inventory.
The retail consumer electronic industry was undergoing rapid and dramatic changes during the 1980s as was the case with Crazy Eddie. Crazy Eddies inventory was being over valued because the value of electronics changes swiftly. Technology is rapidly changing and improving. They become easier and easier to produce as time goes on. Electronics are out dated very quickly therefore electronic stores need to have a high inventory turnover. If the inventory is not sold fast enough then it can become overvalued and the auditor would have to pick up on that. The auditor would have to have some knowledge of the electronics industry to accurately price inventory when planning the audit.
Another change was with how Crazy Eddie was able to buy in such large amounts that he was able to become a secondary shipper to smaller consumer electronics retailers in the New York City area. Auditors see these types of sales rarely because it is not a common practice. The transshipments would affect sales, but it would not affect
inventory. Crazy Eddie used his transshipping as way to commit fraud with his inventory. Crazy Eddie increased same store