Case 9-56: Judging the quality of a client’s internal audit function and determining the effects of internal audit’s work Case study for advance auditing discussion CPAs is performing the audit of REDTOP Sports. You are on the external audit team for that engagement. Following is some information about the client and its internal audit function. After reviewing this information, you will be asked to assess the quality of the internal audit function and whether the external auditor should rely on work performed by the internal auditors. General Background Information about REDTOP Sports REDTOP Sports Company is a publicly held manufacturing company. The primary activities of REDTOP Sports Company include the design and manufacture of sporting and athletic goods. The major product lines are bicycle helmets for infants, youths, and adults and other bicycle accessories, including child bicycle seats, car bicycle carriers, and water-bottle cages. In the United States, a number of jurisdictions have passed mandatory helmet regulations and REDTOP Sports is currently a market leader in this growing market. Sales are made primarily on credit to independent bicycle dealers and sporting goods stores. The sales terms require that balances be paid within sixty days. This practice is consistent with the industry. Company Objectives and Related Risks For this company, there is a specific risk associated with potential errors in the valuation of receivables, the existence of receivables, and the cutoff of sales. This risk results from REDTOP Sports’ interest in expanding to a global market. Helmet sales in Europe are expected to increase significantly in the near future and REDTOP would like to be in a position to obtain a significant market share in Europe. REDTOP Sports would like to finance this growth through an additional stock offering during the next year. To assure that the stock offering is successful, some pressure has been exerted on management to meet slightly optimistic growth levels over the past two years. Bonuses for top management have been partially based on the achievement of these growth goals. Summary Financial Information Sales of REDTOP Sports continue to grow. Over the last five years, sales have climbed at an average annual rate of 27%. When compared to other companies in this industry, the growth in earnings per share (EPS) over the past two years has been at the same level as the growth for the industry: 39%. In comparing this company to the S&P 500, the company’s EPS has increased at 39% while the EPS of the S&P 500 has increased at 14% (about 2.8 times more). The growth in accounts receivable has been primarily due to the increased sales demand. Current-year recorded sales total $99,133,000. The accounts receivable balance for the current year consists of approximately 500 accounts, primarily from retail and sporting goods stores. The individual accounts range from approximately $300 to $65,000. The year-end balance in the ac ...

1. Case 9-56: Judging the quality of a client’s internal audit
function and determining the effects of internal audit’s work
Case study for advance auditing discussion
CPAs is performing the audit of REDTOP Sports. You are on
the external audit team for that engagement. Following is some
information about the client and its internal audit function.
After reviewing this information, you will be asked to assess the
quality of the internal audit function and whether the external
auditor should rely on work performed by the internal auditors.
General Background Information about REDTOP Sports
REDTOP Sports Company is a publicly held manufacturing
company. The primary activities of REDTOP Sports Company
include the design and manufacture of sporting and athletic
goods. The major product lines are bicycle helmets for infants,
youths, and adults and other bicycle accessories, including child
bicycle seats, car bicycle carriers, and water-bottle cages. In the
United States, a number of jurisdictions have passed mandatory
helmet regulations and REDTOP Sports is currently a market
leader in this growing market. Sales are made primarily on
credit to independent bicycle dealers and sporting goods stores.
The sales terms require that balances be paid within sixty days.
This practice is consistent with the industry.
Company Objectives and Related Risks
For this company, there is a specific risk associated with
potential errors in the valuation of receivables, the existence of
receivables, and the cutoff of sales. This risk results from
REDTOP Sports’ interest in expanding to a global market.
Helmet sales in Europe are expected to increase significantly in
the near future and REDTOP would like to be in a position to
obtain a significant market share in Europe. REDTOP Sports
would like to finance this growth through an additional stock

2. offering during the next year. To assure that the stock offering
is successful, some pressure has been exerted on management to
meet slightly optimistic growth levels over the past two years.
Bonuses for top management have been partially based on the
achievement of these growth goals.
Summary Financial Information
Sales of REDTOP Sports continue to grow. Over the last five
years, sales have climbed at an average annual rate of 27%.
When compared to other companies in this industry, the growth
in earnings per share (EPS) over the past two years has been at
the same level as the growth for the industry: 39%. In
comparing this company to the S&P 500, the company’s EPS
has increased at 39% while the EPS of the S&P 500 has
increased at 14% (about 2.8 times more). The growth in
accounts receivable has been primarily due to the increased
sales demand. Current-year recorded sales total $99,133,000.
The accounts receivable balance for the current year consists of
approximately 500 accounts, primarily from retail and sporting
goods stores. The individual accounts range from approximately
$300 to $65,000. The year-end balance in the accounts
receivable account is $18,248,000 (net of the allowance of
$796,000).
Internal Controls and the Internal Audit Function
The company has implemented a system of internal controls in
the sales and accounts receivable area that is completely
computerized and considered to be moderately complex. The
only significant recent change to the company’s internal
controls in the sales, billing, and collection area is related to the
internal audit function. The internal audit function is performed
in-house at REDTOP Sports and is made up of four staff
auditors, one manager, and a director. Each staff auditor had
two to three years of public accounting experience prior to
joining REDTOP’s internal audit function. The manager and
director of the internal audit function each had at least five
years of public accounting experience prior to joining REDTOP
five years ago. Both the manager and director have professional

3. certifications. In previous years, the work of the internal audit
function had been primarily operational. For the last 18 months,
however, the focus has become much more financial in nature.
Audits currently performed by in-house internal audit include
operational audits (i.e., employee benefits plan review),
compliance audits (i.e., compliance with laws and regulations),
and audits of financial controls and financial statement
accounts. The current-year work of the internal auditors was
such that some of their activities are related to the accounts
receivable account. They have obtained two types of evidence
for accounts receivable: (1) evidence about the adequacy of and
adherence to internal control policies and (2) evidence related
to the accounts receivable balance.
Information about REDTOP’s Internal Audit Function
Organizational Status and Communications with the Audit
Committee and Management
The authority of the internal audit function has been granted to
it by the CEO and the audit committee. In terms of
organizational status, the director of internal audit reports
directly to the CEO and has direct access to the audit
committee. The appointment and termination of the internal
audit director are the responsibilities of the CEO. The audit
committee is advised of such decisions.
Procedures and Work Processes
Standardized audit programs are not typically used. Rather, the
staff auditor responsible for an audit is to develop the audit
program during the planning of the audit. Each audit program,
therefore, is tailored to the specific objectives of the audit
engagement. Modifications to the program are made as
necessary during the course of the audit. The internal auditors
rarely use computer-assisted auditing techniques. The
computers are primarily used for spreadsheet programs and
word processing packages. The internal audit function currently
does not use any type of generalized audit software. Workpaper
review is the responsibility of the internal audit manager, and
staff work is reviewed by the manager periodically throughout

4. each audit. Review notes are prepared and must be cleared
before an internal audit report is issued. Supervisory review of
workpapers is performed to determine that the workpapers
adequately support findings, conclusions, and reports. The
director of internal audit has decided not to be directly
responsible for any workpaper review; however, the director
reviews enough of the work to be comfortable with the
conclusions reached in the internal audit report.
Quality Assurance
The internal audit director has established a quality assurance
program that requires periodic internal quality reviews. The
purpose of the quality assurance review is to provide senior
management and the audit committee with an assessment of the
internal audit function. These reviews are performed by
members of the internal audit staff, but they do not review any
of their own work. The results of the current year’s review
indicated a number of areas where minor improvements could be
made. The internal audit director is currently determining how
to respond to the need for these improvements. No written
action plan has yet been developed.
Accounts Receivable Work Performed by the Internal Audit
Function
In testing the controls in the sales, billing, and collection cycle
during the year, the internal auditors documented the system of
internal controls and performed inquiries and observations of
appropriate personnel once during the year. Tests of controls
were also performed although the sample sizes for these
detailed tests were much smaller than the sample sizes their
external auditors would have used. Only minor exceptions in the
operating effectiveness were noted. In testing the existence
assertion of accounts receivable during the course of the audit
year, the internal auditors had sent out confirmations to
customers with accounts receivable balances and accounts
written off to justify their conclusions in the area. The number
of confirmations sent was about the same as the number that the
external auditors normally send out. The accounts receivables

5. for confirmation were selected and evaluated using appropriate
methods. The response rate was lower than that experienced on
typical external audit engagements. Follow-up work for these
no-replies was performed; however, on two of the five
exceptions it appeared to be inadequate. While these two
exceptions were explained as timing differences in the
workpapers, the workpapers contained no documentation to
support that explanation. In testing the valuation of accounts
receivable during the year, once each quarter, the internal audit
function selected a sample of sales invoices to test the pricing
by comparing the invoices with price lists and contracts. Sample
sizes were more than adequate. Several pricing errors were
noted in the workpapers. These differences were explained as
resulting from the use of an outdated price list at the time of the
sale. This explanation was documented in the workpapers. At
year end, the internal audit function reviewed the analysis of the
doubtful accounts and related documents and concluded that the
allowance account was mathematically correct and that the
method used to compute the allowance was the same as in the
prior year. In determining whether the accounts receivable
balances are owned by the company (rights and obligations
assertion), the internal audit function reviewed company
minutes to determine if the board of directors had approved
factoring of any receivables. Inquiry of the credit manager was
also made. These activities were performed on a quarterly basis.
Based on these procedures, the internal audit function
concluded that all of the recorded receivables are owned by
REDTOP Sports.
The internal audit function had not performed any tests of
cutoff for sales or accounts receivable for either the current or
previous audit year. A review of a sample of the internal audit
function’s workpaper files for audits of accounts receivable for
the current audit year indicated the following. An audit program
was included in all but one of these files. For the other file, the
staff auditor had prepared a memo at the end of the audit
indicating the various steps that were performed. This memo

6. served as the audit program. Of the files reviewed, one file did
not adequately document the audit objectives. Although the
workpapers were all indexed, the differences across workpapers
made it difficult to follow the indexing in some cases. In
general, workpaper documentation, while acceptable, could be
improved. Of the files reviewed, it was noted that for two
internal audits the workpapers were not reviewed until after the
internal audit report was issued. Upon inquiry, the internal audit
manager indicated that the primary purpose of workpaper
review was to assure that the papers support the information
included in the audit report. Given that this responsibility
primarily rested with the internal auditor performing the
engagement, the internal audit manager indicated that a review
of workpapers after the issuance of the audit report was
acceptable. Conclusions are reasonably well documented in the
corresponding workpapers. In fact, the documented conclusions
appeared appropriate except for one set of workpapers related to
the valuation assertion in which the conclusions did not appear
to reflect the degree of negative evidence obtained during the
audit. Specifically, the number of pricing errors documented
seemed rather excessive. The conclusions in the workpapers,
however, indicated that pricing errors did not represent a
significant problem.
CASE STUDY FOR INTERNATIONAL FINACE
MANAGEMENT DISCUSSION
BLADES, INC. CASE
International Cash Management
Recall from Chapter 20 that the new Thailand subsidiary of
Blades, Inc., received a one-time order from a customer for
120,000 pairs of Speedos, Blades’ primary product. There is a
6-month lag between the time when Blades needs funds to
purchase material for the production of the Speedos and the
time when it will be paid by the customer. Ben Holt, Blades’
chief financial officer (CFO), has decided to finance the cost by
borrowing Thai baht at an interest rate of 6 percent over a 6-
month period. Since the average cost per pair of Speedos is

7. approximately 3,500 baht, Blades will borrow 420 million baht.
The payment for the order will be used to repay the loan’s
principal and interest. Holt is currently planning to instruct the
Thai subsidiary to remit any remaining baht-denominated cash
flows back to the United States. Just before Blades receives
payment for the large order, however, Holt notices that interest
rates in Thailand have increased substantially. Blades would be
able to invest funds in Thailand at a relatively high interest rate
compared to the U.S. rate. Specifically, Blades could invest the
remaining baht-denominated funds for 1 year in Thailand at an
interest rate of 15 percent. If the funds are remitted back to the
U.S. parent, the excess dollar volume resulting from the
conversion of baht will either be used to support the U.S.
production of Speedos, if needed, or be invested in the United
States. Specifically, the funds will be used to cover cost of
goods sold in the U.S. manufacturing plant, located in Omaha,
Nebraska. Since Blades used a significant amount of cash to
finance the initial investment to build the plant in Thailand and
purchase the necessary equipment, its U.S. operations are
strapped for cash. Consequently, if the subsidiary’s earnings are
not remitted back to the United States, Blades will have to
borrow funds at an interest rate of 10 percent to support its U.S.
operations. Any funds remitted by the subsidiary that are not
used to support U.S. operations will be invested in the United
States at an interest rate of 8 percent. Holt estimates that
approximately 60 percent of the remitted funds will be needed
to support U.S. operations and that the remaining 40 percent
will be invested in the United States. Consequently, Holt must
choose between two alternative plans. First, he could instruct
the Thai subsidiary to repay the baht loan (with interest) and
invest any remaining funds in Thailand at an interest rate of 15
percent. Second, he could instruct the Thai subsidiary to repay
the baht loan and remit any remaining funds back to the United
States, where 60 percent of the funds would be used to support
U.S. operations and 40 percent would be invested at an interest
rate of 8 percent. Assume no income or withholding taxes on the

8. earnings generated in Thailand. Holt has contacted you, a
financial analyst at Blades, Inc., to help him analyze these two
options. He has informed you that the current spot rate of the
Thai baht is .0225 and that the baht is expected to depreciate by
5 percent over the coming year.