1. Compute key ratios and other financial measures for Crazy Eddie during the period 1984-1987. Identify and briefly explain the red flags in Crazy Eddie’s financial statements that suggested the firm posed a higher-than-normal level of audit risk.
There were several red flags in Crazy Eddie’s financial statements. The company’s higher-than-normal level of audit risk can be determined by completing a ratio analysis of the financial statements. An analysis of key ratios over the period of 1984 to 1987 would have resulted in red flags. Crazy Eddie’s change in assets between this period is one red flag that an auditor should have noticed. Short-term investments had a zero balance until 1986 when it dramatically increased to 21.1 and then dramatically increased again to 41.4 in 1987. At the same time cash on hand dropped from 34 in 1985 to 3.2 in 1987, which is a troubling sign. The saying goes that cash is king. Crazy Eddie was rapidly expanding the number of stores and was not anticipating what could happen in the future. Competition greatly increased and Crazy Eddie did not have the funds to pay suppliers for merchandise, which in turn causes potential customers to go elsewhere for their needs. Basically, the industry had become saturated with retailers and the company could no longer extract sweetheart deals from suppliers.
After seeing this drop in cash, an analysis on merchandise inventories is needed. From 1984 to 1987, merchandise inventories decreased from 63.8 to 37, which is another red flag that should have been investigated. Crazy Eddie is a retailer and retailers sell merchandise to customers so inventory is extremely important. This could have been a sign that inventory was misstated. As it turns out, Crazy Eddie had a huge overstatement of the company’s inventory and personnel systematically destroyed incriminating documents to conceal inventory shortages. The age of the inventory was also a red flag that should have been noticed. In 1986, the age of the inventory was 80 days. It increased to 111.8 days in 1987. This is a sign that inventory that is in stock is not selling, which is a negative since electronics become obsolete quickly and these products tend to have a short life cycle.
During this same period from 1984 to 1987, the company’s liabilities were taking a turn for the worst. Short-term debt increased from .3 in 1984 to 16.8 in 1987 while accrued expenses went from 16.6 in 1984 to 1.9 in 1987. Short-term debt increased because of the company’s rapid expansion as previously mentioned. The decrease in accrued expenses could be the result of the company artificial inflating its revenue by releasing accruals and is a red flag for auditors. These red flags would have appeared to users when the financial statements of Crazy Eddie were compared against the financial statements of a competitor.
2. Identify specific audit procedures that might have led to the detection of the following accounting irregularities perpetrated by Crazy Eddie personnel: (a) the falsification of inventory count sheets, (b) the bogus debit memos for accounts payable, (c) the recording of transshipping transactions as retail sales, and (d) the inclusion of consigned merchandise in year-end inventory. Proper audit procedures are required for auditors to obtain sufficient appropriate audit evidence that will allow them to draw reasonable conclusions as to whether the client’s financial statements follow generally accepted accounting principles. More specifically, an audit usually contains such procedures as risk assessment procedures, tests of controls, and substantive procedures. Of all the audit procedures, risk assessment procedures are preliminary. Through the risk assessment procedures, auditors obtain the needed understanding of the client, its environment, and internal control of the client company. As in the Crazy Eddie Case, the auditors should have found out the nature of the...