Problem:
You have been recently hired as a new auditor for CM Fancy, a major manufacture of gift boxes. The company has been in operation for the past 5 years and has had a good degree of success. The company's primarily sales channel has been through distributors using a dedicated sales force. Now the company has decided to go public through an IPO and plans to open a direct sale channels to the consumer via internet sales. While the company has had the same auditors (Castillo Miranda) since its inception, the CEO Jackie Gleason and the CFO Art Carney have decided that they would like your firm to audit their revenue recognition policies and to provide a memo the company to determine if the actual practice is in accordance with US GAAP.
Sales Process: Due to the fact that the internet sales are future business the company does not have an established procedure at this time. However, Mr. Carney has indicated that the sales to the consumer will be via credit cards only. In the case of the sales to the distributors, the company uses 3 distributors (one located in Jacksonville, Florida; one located in Dallas, Texas and one located in Patterson, New York). None of the distributors have an exclusive contract with company, but rather, buy merchandise from CM Fancy's competitors as well. In addition, the warehouses of these distributors are rather limited and as a result all three have requested that the company takes the order but does not ship the merchandise for these orders until the next month.
The CFO has provided following information at your request:
1. Total Order to the Jacksonville distributor was USD 100,000 during 2006, while the actual sales were USD 80,000. Ms. Alice Kramer, Director of Sales has indicated that the difference between the order and the actual sales was due to a cancellation of the November Order during the month of the December.
2. Mr. Carney, CFO has provided your firm with all the sales invoices for the year along with the sales register which clearly indicates that the company invoiced and recorded as sales USD 100,000 through November 2006, but issued a credit memo in December for USD 20,000. Therefore, the sales are correctly stated at the end of December 2006.
3. Ms. Kristina Smith, Warehouse Manager indicated that once each order is placed received from the sales department, the merchandise is taken from the finished goods warehouse and separated from the regular inventory. It is placed on a pallet and sticker is placed on the merchandise indicating "Property of Jacksonville Distributor". In the case of the cancelled order during the month of December the sticker was removed, the inventory was placed back into finished goods inventory and the appropriate documentation was provided to Mr. Eduardo Aguilar, General Accounting Manager to make the appropriate accounting entry.
4. Mr. Aguilar provided you with a copy of the general entries for the cancelled order. The entries were as follows:
· Credit Memo Entry: Debit Sales 20,000; Credit Accounts Receivable Jacksonville Distributor 20,000
· Inventory Return Entry: Debit Finished Goods Inventory 10,000; Credit Cost of Sales 10,000
5. In addition, Mr. Aguilar has provided you with the necessary supporting documentation for the value of the inventory and the cost of sales and one of your firm's senior auditors has audited this information and believes that the values are correct.
6. After conducting additional interviews with the individuals indicated above and based upon the supporting documentation provided, your senior auditor has indicated that no other sales orders were cancelled from the other two distributors. However, Ms. Smith indicated that during 2005 (a period that is not part of the scope of your audit), both the Dallas and Patterson warehouses similar cancelled order and the same procedures were applied.
Requirements: You are required to prepare a memo on the revenue recognition process based upon the information provided. Your memo must reference professional literature (FASB, SEC, etc...).