Acme Hardware Case Study

GAURAV GOYAL (301217616)

PROF: SHAMS UDDIN

DATE: 28 February 2024

Overview
The case study focuses on John Smith, a partner at the audit firm Cooperhouse and
Sells, tasked with auditing Acme Hardware, a fast-growing chain of hardware stores
in southern Ontario. His firm has currently recruited the company as a customer.

Smith's pre-audit examination of the former auditor's records uncovers a possible

problem in how specific Acme Hardware locations are handling inventory and
advertising expenses. He has noticed a situation in which some store managers may
be exploiting discretionary accounting options due to the company's management
and control system.

The company's success is primarily related to the hefty bonuses given to store
managers when they achieve the anticipated net profits for the year. Smith observes
that budgets are typically either met by a small margin or missed by a significant
margin. He suspects that there is a high likelihood that the managers of seven
locations are falsifying net income calculations.

Smith identified inventories and advertising expenses as the two most probable
avenues for manipulation. Inventory is valued at the lower of cost and net realizable
value, requiring significant judgment. Advertising expenses are recognized in the
period when the campaign is conducted, however, store managers have the
authority to decide when to run a campaign.

Smith is now confronted with the task of determining the appropriate course of
action about this circumstance. He should weigh the possible disturbance and cost
of a thorough inquiry, together with the possibility that the store managers' actions
may have an insignificant effect on the company's financial records.
Answer to question 1
John Smith, the partner overseeing the audit of Acme Hardware, is encountering
some significant challenges.

Smith has found a high likelihood that the managers of seven stores are distorting
net income calculations. This manipulation involves either accelerating or
postponing the acknowledgment of revenue and/or costs from one accounting
period to another. This is a critical issue as it has the ability to misrepresent the
company's financial statements.

Audit Risk: The compensation structure for store managers, tied to achieving the
forecasted net income for the year, is considered a possible audit risk. This pressure
on store managers to meet budgets may result in the manipulation of financial data.

Inventory is valued at the lower of cost, calculated using the FIFO method, and net
realizable value. Assessing the write-down to net realizable value requires significant
judgment, especially for seasonal goods and products at risk of becoming obsolete.
This allows for potential manipulation.

Advertising Expenses: Local advertising costs are recognized as expenses throughout

the time in which the campaign is conducted. Store managers have the authority to
decide when a campaign should be conducted, which may lead to the possibility of
manipulating costs.

Materiality Consideration: Smith must determine if the possible manipulation by

many stores would significantly affect the company's financial results. If the impact is
insignificant, no action may be required.
These difficulties are connected to the incentive system of Acme Hardware inside
the document. The substantial bonuses given to store managers upon achieving the
budgeted net income for the year could incentivize them to potentially alter
accounting data. Smith's responsibility is to evaluate these matters and determine
the required course of action to maintain the accuracy of the company's financial
statements.

Answer to Question 2
John Smith's main worries focused on inventory accounting and advertising
expenses.

Accounting options include of cash basis and accrual basis accounting. Cash basis
accounting records revenue and expenses when cash is exchanged, while accrual
basis accounting records revenue when it is produced and expenses when they are
invoiced but not yet paid. Manipulation can occur when a corporation alternates
between these tactics to demonstrate increased profitability.

Inventory methods include FIFO (First-In, First-Out), LIFO (Last-In, First-Out), and
weighted average cost. These approaches can affect income by selecting the one
that displays the most advantageous cost of products offered.

Advertising options encompass online advertising, print media, television, and radio.
Advertising expenses can be strategically adjusted to shift costs from one period to
another, impacting the net profits.
Answer to question 3
Yes, Acme management should be concerned for several reasons:
Integrity of Financial Statements: Store managers' potential manipulation of net
income calculations could mislead the company's financial statements. This has the
potential to deceive stakeholders, such as investors and creditors, and may damage
the company's reputation.
Audit Risk: The audit risk linked to the bonus scheme for store managers could result
in auditors issuing a qualified or adverse opinion. This could harm the company's
credibility and its relationships with stakeholders.
Internal Control System: The possible manipulation of net income calculations
indicates flaws in the company's internal control system. An effective internal control
system is essential for preventing and identifying fraud and errors.
Incentive System: The possible manipulation of net income calculations indicates
flaws in the company's internal control system. An effective internal control system is
essential for preventing and identifying fraud and errors.
Acme's management should be aware of the possible manipulation of net income
calculations by retail managers. Store managers may be incentivized to alter
accounting data in order to receive the large bonuses tied to achieving the
forecasted net income for the year. This may skew the company's financial figures
and deceive stakeholders. The audit risk related to the bonus arrangement could
result in auditors issuing a qualified or adverse opinion, thus damaging the
company's reputation. The possible manipulation exposes flaws in the company's
internal control system and suggests that the incentive structure may be promoting
undesired behaviour.
Answer to question 4
Based on the data currently available to him, John Smith should consider the
following actions:

Investigate Further: Smith should conduct a thorough investigation to verify his

allegations regarding the possible manipulation of net income calculations by store
managers. This may need a detailed review of the accounting records of the stores in
question, focusing on inventory valuation and advertising expenses.
Review Internal Controls: Smith should assess the company's internal control system
for any vulnerabilities that may be facilitating potential manipulation. He should
suggest enhancements to fortify these controls.
Discuss with Management: Smith ought to communicate his discoveries and
apprehensions to Acme's senior executives. This would enable them to comprehend
the possible problems and implement necessary solutions.
Consider Materiality: Smith must take into account the materiality of the possible
manipulation. If the effect on the company's financial statements is insignificant,
additional steps may not be required.
Review Incentive System: Because the incentive system seems to be boosting the
possibility of manipulation, Smith ought to think about revisiting this system and
recommending adjustments if they are required.

Taking these activities would be helpful in addressing the problems that Smith has
observed. To determine whether or not store managers are, in fact, altering net
income computations, a more in-depth examination would allow for confirmation.
To identify and resolve any shortcomings, it would be helpful to conduct an
assessment of the internal control system. In order to ensure that management is
aware of the potential problems, it would be beneficial to discuss the findings with
them. The consideration of materiality would be helpful in determining whether or
not additional action is required. In conclusion, a review of the incentive system
might be able to assist in preventing problems of a similar nature in the future.
Answer to Question 5
Based on the issues identified in the case, the following recommendations can be
made:
Strengthen Internal Controls: It would be beneficial for Acme Hardware to tighten its
internal control system in order to prevent any potential manipulation of the
computations of net income. In order to accomplish this, it may be necessary to
implement more stringent controls over the recognition of income and spending,
particularly in respect to the valuation of inventory and the costs of advertising.

Review Incentive System: The incentive program that the corporation uses ought to
be examined to make certain that it does not inadvertently encourage poor
behaviour among store managers. In this context, "setting more realistic budgets" or
"changing the way bonuses are calculated" are also examples of possible actions.

Improve Transparency: One of the things that ought to be done is to make Acme
Hardware's financial reporting more open and transparent. To accomplish this, it is
probable that it will be essential to offer more specific disclosures concerning the
accounting standards and procedures of the organization, particularly in relation to
the areas that have been identified as potential risks.

Regular Audits: To guarantee that the company's financial statements are accurate, it
is necessary to carry out audits on a regular basis. There is a possibility that this will
involve both internal audits carried out by the company's own audit department as
well as external audits carried out by an independent audit organisation.
To address the problems that John Smith has discovered; these recommendations
would be helpful. To reduce the likelihood of any manipulation of the computations
of net income, strengthening internal controls would be beneficial. By doing a review
of the incentive structure, one can help guarantee that it does not encourage
behaviour that is not acceptable. Enhancing transparency would be beneficial in
ensuring that stakeholders are provided with complete information regarding the
financial performance of the company. Finally, conducting frequent audits would be
beneficial in ensuring that the company's financial statements are accurate.