[SOLVED] In a management review control (MRC), members

In a management review control (MRC), members of management review key information and evaluate its reasonableness by comparing it to expected values. Some examples include comparing budget to actual, reviewing impairment analyses, and reviewing estimates such as the allowance for doubtful accounts. These reviews are a critical part of the financial reporting process and often require significant experience and professional judgment to evaluate whether the reported figures are in accordance with expectations. MRCs are also useful in helping management identify areas that require further attention for possible problems in operations, or possibly, in accounting and record keeping. An effective MRC:
 addresses the control’s objective (i.e., addresses the pertinent risks of material misstatement)
 clearly describes who is responsible for performing the control, what they will do, how they will identify deviations, and how those should be resolved
 uses data that is accurate and complete
 is performed by an individual with sufficient knowledge and experience to identify deviations
 has a documented criteria for investigation that is adequately precise (i.e., a threshold for observed differences from expectation such that it would identify material misstatements)
 considers the effect of external factors and benchmarking data
 includes procedures to appropriately resolve all identified differences or deviations
Because MRCs often involve more subjectivity than other process controls (e.g., authorization or a three-way match in quantities between a purchase order, shipping documents and an invoice), they can be difficult for management to document, design, and operate at a level of precision that can be expected to prevent and/or detect a material misstatement. Some common weaknesses in MRCs include vague and incomplete documentation of the control’s design, lack of precision in identifying deviations, failure to consider the effect of external factors, and a lack of follow-up on identified deviations.
Due to the inherent subjectivity of MRCs, these controls are also difficult for auditors to test and obtain persuasive evidence. In fact, auditors’ tests of MRCs are frequently a point of emphasis by PCAOB inspectors and peer reviewers. In testing the design effectiveness of MRCs, auditors must assess whether the controls, if operated as designed “by persons possessing the necessary authority and competence to perform the control effectively, satisfy the company's control objectives and can effectively prevent or detect errors or fraud that

The case was prepared by Mark S. Beasley, Ph.D. and Frank A. Buckless, Ph.D. of North Carolina State University and Steven M. Glover, Ph.D. and Douglas F. Prawitt, Ph.D. of Brigham Young University, as a basis for class discussion. Oilfields-R-Us is a fictitious company. All characters and names represented are fictitious; any similarity to existing companies or persons is purely coincidental.

could result in material misstatements in the financial statements” (AS 2201.42).To test the design effectiveness of MRCs, PCAOB Staff Practice Alert No. 11 suggests auditors should use a mix of inquiry, inspection of documentation, and observation to evaluate:
a. whether the control satisfies the control objective, including whether it addresses the pertinent risks of material misstatement
b. the factors affecting the precision of the review, including the appropriateness of expectations, level of aggregation, and criteria for identifying and investigating potential material misstatements
c. the steps involved in identifying, investigating, and resolving deviations
d. who performs the control, including their competence and authority
e. the frequency of control performance (i.e., does it occur frequently enough to prevent or detect material misstatements)
f. the completeness and accuracy of information used in the review
To test the control’s operating effectiveness, auditors evaluate whether the control is operating as designed (AS 2201.44). Using a mix of inquiry, inspection of documents, and reperformance, the PCAOB’s Staff Practice Alert suggests auditors should obtain and evaluate evidence about:
 the steps performed to identify and investigate significant deviations
 the conclusions reached by the reviewer, including whether potential misstatements were appropriately investigated and corrective actions were taken

COMPANY BACKGROUND
Oilfields-R-Us, Inc. (i.e., the Company) is a supplier of equipment and replacement parts for the petroleum industry, specializing in oil derricks and start-up equipment for new exploration. Founded on the outskirts of College Station, Texas in 1979 by the Spencer family, the Company started out by purchasing equipment and machinery at a discount. As oil prices maintained record highs during the early 1980s, the Company was well- positioned to supply the new generation of individuals and companies hoping to strike it rich.The Company has traditionally focused on supplying oilfields in Texas and Oklahoma. By servicing primarily one local region, the Company could minimize overhead and shipping costs, enabling it to stay profitable even when the petroleum industry had periodic downturns. However, the recent prolonged downturn in oil prices forced the Company to expand to new oilfields in Canada. Although the expansion to Canada was only done recently, it now accounts for one-third of the Company’s gross sales. The U.S. and Canadian divisions keep their own set of financial records. The Company has a long history with its U.S. customers, most of whom have established a reputation for timely payments.The Company does not have as much experience with its Canadian customers and has had more difficulty collecting on receivables.
The Company sells its equipment on credit, with terms 2/10 net 30 extended to all customers. As such, accounts receivable is a material account on the consolidated balance sheet. The allowance for doubtful accounts also has a balance that exceeds auditors’ materiality thresholds. The allowance balance each year is calculated at the consolidated level, and is equal to the sum of 1% of balances aged less than 30 days, 2.5% of accounts between 31-60 days, 14% of accounts between 61-90 days, and 25% of accounts greater than 90 days. These percentages are based on U.S. customer payment history.
One key management review control in place at the Company is over the allowance for doubtful accounts. As the external auditor, you were provided with the following description of this control.
CONTROL DESCRIPTION
Management Review Control Over the Allowance for Doubtful Accounts
On a regular basis, Gavin, the Company’s CFO, reviews the allowance for doubtful accounts for reasonableness. The aged AR trial balance and the allowance for doubtful accounts schedule are prepared by Tyler, the accounts receivable clerk. The CFO obtains, reviews, and approves these documents.
REQUIRED – PART A
[1] Based on the management review control (MRC) description provided above, what is (a) the control’s purpose, (b) the risk(s) of material misstatement addressed by the control, and (c) the significant account(s) related to the control.
[a] Control’s purpose:
[b] Risk(s) of material misstatement addressed by the control:
[c] Significant account(s) related to the control:
[2] Evaluate the design effectiveness of the Company’s MRC over the allowance for doubtful accounts described above by answering questions [a] through [f].
[a] Does the control, as currently designed, address the control’s objective and address the related risk of material misstatement?
Yes No Please briefly explain your answer.
[b] Is the control, as currently designed, sufficiently precise? Factors to consider include the appropriateness of expectations, level of aggregation, and criteria for identifying and investigating potential material misstatements.
Yes No Please briefly explain your answer
[c] Does the control, as currently designed, include steps involved in identifying, investigating, and resolving deviations?
Yes No Please briefly explain your answer
[d] Is the control, as currently designed, performed by individuals with sufficient competence and authority?
Yes No Please briefly explain your answer.
[e] Is the control, as currently designed, performed frequently enough to prevent or detect material misstatements?
Yes No Please briefly explain your answer.
[f] Does the control, as currently designed, ensure the completeness and accuracy of information included in the report?
Yes No Please briefly explain your answer.
[3] Provide an overall assessment as to whether the MRC over the allowance for doubtful accounts described above can “effectively prevent or detect errors or fraud that could result in material misstatements in the financial statements” (AS 2201.42).
Yes, it is designed effectively No, it is not designed effectively
Part B
After receiving feedback from the external auditor on the documentation of the management review control (MRC) over the allowance for doubtful accounts, Emma, the Company’s controller, has provided you with this updated description of the MRC.
REVISED CONTROL DESCRIPTION
Management Review Control Over the Allowance for Doubtful Accounts
To ensure appropriate valuation of accounts receivable, management performs a quarterly review of the calculation for the allowance for doubtful accounts. The inputs, activities, and outputs of this review are as follows:
Inputs
On a quarterly basis, Tyler, the AR clerk, creates an aged AR schedule and calculation of the allowance for doubtful accounts. Tyler agrees total AR per the aging schedule to the trial balance and foots and crossfoots the schedule before providing the schedules to Gavin.
Specific quarterly review activities
Gavin, the CFO, obtains schedules from Tyler and 1) reviews each of the percentage assumptions for reasonableness based on experience, 2) compares each aging category’s total balance to the average corresponding aging category balance from the previous two years, 3) considers external factors affecting the industry and specific customers, and
4) identifies differences (i.e., deviations) as either any aging category whose balance exceeds the two-year average by greater than 2 percent or any other specific transactions or customer balances that appear unusual.
Outputs
Gavin (CFO) discusses identified deviations with Emma (controller) and Tyler (AR clerk). After resolving any identified deviations, Gavin signs off on the schedules.
REQUIRED – PART B
[1] Based on the revised management review control (MRC) description provided in Part B, what is (a) the control’s purpose,
(b) the risk(s) of material misstatement addressed by the control, and (c) the significant account(s) related to the control.
[a] Control’s purpose:
[b] Risk(s) of material misstatement addressed by the control:
[c] Significant account(s) related to the control:
[2] Evaluate the design effectiveness of the Company’s MRC over the allowance for doubtful accounts provided in Part B by answering questions [a] through [f].
[a] Does the control, as currently designed, address the control’s objective and address the related risk of material misstatement?
Yes No Please briefly explain your answer.
[b] Is the control, as currently designed, sufficiently precise? Factors to consider include the appropriateness of expectations, level of aggregation, and criteria for identifying and investigating potential material misstatements.
Yes No Please briefly explain your answer.
[c] Does the control, as currently designed, include steps involved in identifying, investigating, and resolving deviations?
Yes No Please briefly explain your answer.
[d] Is the control, as currently designed, performed by individuals with sufficient competence and authority?
Yes No Please briefly explain your answer
[e] Is the control, as currently designed, performed frequently enough to prevent or detect material misstatements?
Yes No Please briefly explain your answer.
[f] Does the control, as currently designed, ensure the completeness and accuracy of information included in the report?
Yes No Please briefly explain your answer.
[3] In your role as financial statement auditor, provide an overall assessment as to whether the MRC over the allowance for doubtful accounts described in Part B can “effectively prevent or detect errors or fraud that could result in material misstatements in the financial statements” (AS 2201.42). If you assess the control as being designed effectively, please state one or two reasons why. If you assess the control as having significant design deficiencies, please state one or two reasons why, and what changes the Company can make to improve.
Yes, it is designed effectively No, it is not designed effectively
[4] List three tests you would perform as Oilfields' auditor to test the control’s operating effectiveness, including the supporting evidence you would request from management.
Test 1:
Test 2:
Test 3:

Question: In a management review control (MRC), members