sm-12--16e (1)

Chapter 12 - Inventories and Cost of Goods Sold

CHAPTER 12

Inventories and Costof Goods Sold

Review Questions

12-1 Substantiation of the figure for inventories is an especially challenging task because of the variety of acceptable methods of valuation. In addition, the variety of materials found in inventories calls for considerable experience and skill to do an efficient job of identifying and test-counting goods on hand. The possibilities of obsolescence and of excessive stocks also create problems. Finally, the relatively large size of inventories and their significance in the determination of net income make purposeful misstatement by the client a possibility that the auditors must guard against.

12-2 Issuance of a purchase order requires approval signatures attesting that all established procedures have been observed for (a) determining the need for the item, (b) obtaining the competitive bids, and (c) obtaining approval of the financial aspect of the commitment. Since the issuance of a purchase order commits the company to a liability, the purchasing function is extremely important.

12-3 Internal control over purchasing activities is strengthened by placing exclusive authority for purchases of all kinds in a separate purchasing department, and creating another independent department to handle the receiving function. In addition, the recording of purchase transactions should be assigned to an accounts payable section within the accounting department.

In a small concern, departmentalization of operations may not be feasible to this extent, but if internal control is to be achieved, it is necessary as a minimum requirement that the functions of purchasing, receiving, and recording be assigned to different employees not subordinate to one another.

12-4 Adequate internal control of purchase transactions requires the preparation of serially numbered receiving reports by an independent receiving department and the comparison of these reports with vendors' invoices and purchase orders by the accounts payable department prior to approval of the invoice for payment. To ascertain that these procedures are actually being followed, the auditors will make various tests including the examination of receiving reports to see that they are complete, current, legible, and controlled by serial numbers.

262


263


12-5 During an audit of a manufacturing company, the auditors consider the cost system for the following purposes:

(1) To determine that costs are properly allocated to current and future periods and hence that cost figures used in arriving at balance sheet and income statement amounts are supported by internal records. The appropriate allocation of costs to finished goods, work in process, and cost of goods sold is essential to the preparation of financial statements in accordance with generally accepted accounting principles.

(2) To obtain assurance that the cost system, as an integral part of the system of internal control, provides proper control over costs incurred and related inventories.

(3) To ascertain, as a service to management, that the cost system is economical and effectively provides information for reducing or controlling costs and for determining the cost and profitability of products, and other related data necessary for informed managerial decisions.

12-6 The independent auditors are key participants in the planning for a client's physical inventory. Although the auditors do not actually do the planning for the client, they offer advice on such matters as the assignment of a key client employee to assume responsibility for the inventory; selection of the most advantageous dates for the inventory taking; scheduling operations to minimize goods-in-process; etc. Most important is the auditors' determination that the client's inventory instructions are adequate.

12-7 The auditors observe the taking of the physical inventory to obtain evidence supporting its existence. In addition, information relevant to valuation of and rights to inventory is obtained. Observation of the physical inventory is a major step in meeting the standard of field work that requires the auditors to gather sufficient, competent, evidential matter to provide a reasonable basis for an opinion on the financial statements.

By observing the taking of the physical inventory, the auditors are seeking sufficient competent evidence as to the effectiveness of the methods of inventory taking and as to the measure of reliance which may be placed upon the client's inventory records and its representations as to inventory quantities. The auditors must ascertain that the physical inventory actually exists, that the inventory quantities are being determined by reasonably accurate methods, and the inventory is in a saleable or usable condition.

12-8 The auditors make test counts of inventory quantities during their observation of the taking of the physical inventory to ascertain that the individuals taking the inventory are making an accurate count. The extent of test counting will be determined by the inventory-taking procedures; for example, the number of the auditors' test counts would be reduced if there were two teams, one verifying, the other taking the inventory. On the other hand, the auditors' test counts would be expanded if they found errors in the inventory counts. Some test counts are recorded by the auditors for the purpose of subsequent comparison with the client's compilation of the inventory. The auditors must determine that the compilation of the inventory from the tags, sheets, or computer readable forms is accurate. In addition, the auditors seek assurance that the description and condition of the inventory items is accurate for pricing purposes and that the quantity information, such as dozen, gross, cartons, etc., is proper.

264


A secondary reason for recording test counts in the audit working papers is to provide evidence of the extent of the auditors' tests in the event that audit procedures are questioned at some future date.

265


12-9 The test counts and tag numbers should be listed by the auditors in their working papers and later traced to the client's inventory summary sheets. By this procedure, the auditors obtain evidence that the quantities on the tags have been accurately transcribed to the summary sheets by the client employees in developing the total valuation for inventory. If a significant number of differences are found, the auditors may need to reexamine the original tags or request that the client recompile the inventory.

12-10 A physical inventory at least once a year is generally essential regardless of whether perpetual inventories are maintained. However, when perpetual inventories and good internal control are maintained, the annual physical count may be taken at a date other than the year-end. Some companies with good perpetual inventory records prefer to take a physical inventory in one department at a time with the counting work thereby spread throughout the year. Furthermore, if statistical sampling techniques are applied in the periodic counting process and the sampling is appropriately planned and executed, the entire inventory need not be counted.

12-11 A bill and hold scheme involves transactions in which sales of merchandise are improperly billed to customers prior to delivery, with the goods being held by the seller. These transactions overstate revenues and net income. Bill and hold transactions have to meet rigorous requirements to be recognized as legitimate sales.

12-12 The auditors' analysis of the Cost of Goods Sold account of a manufacturing concern might disclose charges and credits for amounts transferred from the goods-in-process or finished goods inventory accounts, proceeds from sales of scrap, charges for idle plant and equipment, underabsorbed or overabsorbed factory overhead, variances from standard costs, writedowns for inventory shortages and obsolescence, and losses on firm fixed-price contracts.

12-13 Two general conditions must exist for the auditors to render an unqualified opinion when the physical inventory is taken on a sampling basis. First, the sampling plan must have statistical validity. Second, the allowance for sampling risk (precision) and the sampling risk (confidence) level must provide an estimate that allows a materially accurate valuation of the inventory.

12-14 The client should be asked to designate an employee to assume responsibility for the physical inventory. A written plan should be developed covering such points as exact dates of the count, possible closing of the plant, segregation of obsolete or damaged goods, design of inventory tags and summary sheets, control of incoming and outgoing shipments during the count, drafting of written instructions, and training of staff in the counting procedures.

12-15 The statement is misleading. Inventories are to be reported at the lower of cost or market. Also, the expression "valued at cost" is not sufficiently specific; the method of determining cost should be indicated.

12-16 The use of different methods of inventory valuation for different components of the company's inventory is acceptable practice and would not prevent the issuance of an unqualified audit report. Generally accepted accounting principles allow the use of different valuation methods for different components of a company's inventory.

266


12-17 The statement is not true. The auditors' responsibilities with respect to inventories include not only quantities and pricing but also the quality or condition of the goods, the accuracy of extensions, footings, and summaries, and the consideration of internal control. Weakness in internal control may cause large losses from excessive stockpiling, obsolescence, inaccurate cost data, and other sources, even though the ending inventory is properly counted and priced.

12-18 The independent auditors utilize the client's backlog of unfilled sales orders in the determination of net realizable value of finished goods and goods-in-process, and in the determination of losses, if any, on firm sales commitments for which no production has yet been undertaken.

12-19 No. Inspection of the warehouse receipts does not constitute sufficient verification. The inventories should be confirmed in writing directly to the auditors by the custodians of the stored goods. If the inventories stored in public warehouses are substantial in relation to other assets, the auditors should also review client records regarding selection and performance of the warehouses, and any available reports on the warehouses' internal control. The auditors also should consider observing substantial inventories stored in public warehouses.

12-20 In the confirmation of bank accounts and bank loans, the reply from the bank may disclose a lien on inventory. Also in examining insurance policies on inventory, the auditors may find a "loss payable clause" to a third party indicating inventories have been pledged. Finally, the client officials should be asked to disclose any lien on inventory as part of the written representations furnished to the auditors.

Questions Requiring Analysis

12-21 Weaknesses in internal control of Nolan Manufacturing Company include the following:

(1) Organization structure is poor. The receiving department should not be under the authority of the purchasing agent.

(2) Copies of purchase orders sent to receiving department should not show quantities. This encourages careless counting.

(3) The receiving department should prepare a receiving report for each shipment received. These documents will permit evaluation of the department's work, indicate proportion of returns, and establish accountability for goods.

(4) Errors by buyers are covered up by the existing system since any deficiency in goods received is not reported by the receiving department to anyone but the buyer.

(5) Goods should be kept in storerooms until required for production, not sent directly to the factory production area.

(6) There is apparently no control over the movement of raw materials into goods-in-process and no record of the quantities of goods-in-process.

(7) The perpetual inventory records (physical units only) for finished goods are apparently not integrated with the accounting records.

267


(8) The custody of finished goods and the recordkeeping for these goods are assigned to the same employee.

12-22 The following audit procedures may be applied to company records and documents to discover evidence of defalcations being committed by the buyer:

(1) Perform a detailed consideration of the internal controls relating to purchasing to ascertain whether there are any weaknesses that might permit the buyer to commit a fraud. The review should include the determination through tests of controls that the controls are actually being observed and that approvals and countersignatures are not being given perfunctorily. The auditors' remaining tests should then be concentrated in the areas of high control risk.

(2) Examine a representative sample of purchase orders issued by the buyer to determine that they have been prepared and issued in accordance with established company policy, particularly with respect to the countersignature of purchase orders over $500. Determine whether any orders for amounts in excess of $500 were split into two or more orders to evade the $500 limitation.

(3) Compare the representative sample of purchase orders with their related approved requisitions to ascertain that the purchase orders issued were for goods and services required by the client company and are supported by an authorized document originated outside of the purchasing department.

(4) Test the authenticity of the suppliers by reference to telephone directories, purchasing directories, credit-rating publications, etc. This step may disclose any dummy or fictitious vendors through which the buyer might later obtain funds.

(5) Review the disbursing procedures and examine paid checks, giving particular attention to the payee and the endorsement. This step will indicate whether the buyer has access to checks and might reveal any fraud in their negotiation.

12-23 (a) The auditors do not regard the inventory certificate of an outside service company as a satisfactory substitute for their own audit of the inventory. The service company has merely assumed the client's function of taking the physical inventory, pricing it, and making the necessary extensions. To the extent that the service company is competent, the internal control with regard to the inventory has been strengthened. Nevertheless, as with any internal control system, the auditors would investigate the internal control to ascertain that it is operating in a satisfactory manner. The auditors' investigation would necessarily entail an observation of the taking of the inventory and testing the pricing and calculation of the inventory.

268


(b) The inventory certificate of the outside specialists would have no effect upon the audit report. The auditors must determine that the inventory was fairly stated by observing the taking of the inventory and testing the pricing and calculation of the inventory.

On the other hand, if the taking of the inventory was not observed and no audit tests were applied to the computation of the inventory, the auditors would be compelled to disclaim an opinion (or qualify their opinion) on the financial statements as a whole if the amount of the inventory is material.

If it has been impossible for the auditors to observe the taking of the physical inventory, but they have been able to satisfy themselves by the application of other auditing procedures, they should not refer to the inventory in the audit report.

(c) The auditors would make no reference to the certificate of the outside specialists in their report. The outside specialists are serving as adjuncts of the company's permanent employees and, as such, are in somewhat the same guise as temporary employees. The outside specialists are not independent in that they do not have third-party interests. The auditors, under certain circumstances, mention in their report the reports of other independent auditors, but this practice does not extend to the certificate of outside specialists who are not independent auditors.

12-24 (a) When the client uses statistical sampling to estimate inventories, the auditors should perform the following procedures:

(1) Review the validity of the client's statistical sampling plan.(2) Satisfy themselves as to the reasonableness of the sampling plan.(3) Be present when the sample is selected to ascertain that all items have an

equal or determinable probability of selection.(4) Observe the client's counting procedure and make test counts.(5) Review the statistical evaluation and be satisfied as to the achieved allowance

for sampling risk (precision) and sampling risk (confidence) level of the sample.

(b) To verify physical quantities, the auditors should perform the following procedures (only 10 required):

(1) Review the client's inventory taking plan and instructions. (2) Observe the physical count. (3) Make test counts on a selected basis. (4) Trace the test counts to the inventory summary. (5) Select items from the inventory summary and trace them to the original count

records. (6) Trace items from the inventory summary to perpetual records. (7) Verify footings of the inventory summary. (8) Ascertain that there was a proper purchases and sales cutoff. (9) Review the treatment of merchandise in transit and consigned merchandise.(10) Confirm inventory held in public warehouses.(11) Perform analytical procedures on inventories and cost of goods sold.(12) Account for all client inventory count sheets or tags.(13) Ascertain that inventory items are properly classified, in good condition, and

of proper quality.

269


270


12-25 (a) Observation of physical inventory is generally mandatory because it provides strong evidence as to existence and quality of the client's inventories.

(b) Observation of physical inventory generally is impossible when the independent auditors were not appointed by the client until after the physical inventory had been taken. There may also be conditions where weather conditions, terrains, or some other circumstances make it impossible for the independent auditors to be present at the site of the client's inventory-taking; but such circumstances should be rare.

(c) The auditors' review of the client's control for inventory tags is important because of the danger that fictitious inventory tags might be created by dishonest client personnel after the auditors have completed their observation of the physical inventory.

12-26 The following procedures should be undertaken:

(a) The oral evidence that the motors are on consignment should be substantiated by a review of the client's records of consigned inventory, examination of contracts and correspondence with consignors, and confirmation of consigned stocks by direct communication with consignors.

(b) The location of the machine in the receiving department, together with the presence of the "REWORK'' tag, suggests that the machine had been shipped to a customer but rejected and returned. The auditors should examine the receiving report for the machine, the accounts receivable confirmation from the customer, and records of the client's quality control department, to ascertain who has title to the machine. If the customer has title, the machine should not be included in inventory, and a liability for rework costs should be established. If the client has title, the customer's account should be credited for the sales return and the machine should be included in the client's inventory at estimated realizable value.

(c) The "Material Inspection and Receiving Report" signed by the Navy Source Inspector is evidence that title to the machine passed to the U.S. Naval Base on November 30. Accordingly, the auditors should ascertain that the sales value of the machine is included in accounts receivable, and that the cost of the machine is not in the inventory.

(d) The location of the storeroom and the dusty condition of the goods suggest that the items may be obsolete, or at least slow moving. The auditors should inspect perpetual inventory records for usage of the materials, and should inquire of production personnel whether the materials are currently useful in production. The materials may have to be valued at scrap value.

271


12-27 (a) Argument for issuance of an unqualified audit report. The principal issue in this case is that the auditors were not present to observe the physical inventory taken at November 30. Since the auditors had not yet been appointed by Santa Rosa Corporation at that date, it was not possible for them to be present for this count. However, Santa Rosa Corporation maintains perpetual inventory records and has strong internal control over inventories. A complete inventory was taken at November 30 and the documentation used in that count were made available for the auditors' review.

The auditors have employed "other auditing procedures" in lieu of the observation of the physical count. These other procedures were extensive, including review of the client's physical count documentation and a thorough analysis of the internal controls over inventories. Moreover, the CPA firm has not relied exclusively on documentary evidence, but has established physical contact with the inventory by making test counts at December 31 of items representing 10 percent of the total value of inventories. Statements on Auditing Standards state that if the independent auditors have been unable to observe the client's taking of physical inventories because it was impossible to do so, but have satisfied themselves by means of other auditing procedures, they may issue an audit report without qualification in either the scope or opinion paragraph.

Statements on Auditing Standards also require that the "other auditing procedures" used in lieu of observation of physical inventory must include some physical counts as well as a review of inventory records. The CPA firm of Warren and Wood has made such tests and is therefore in a position to issue an unqualified audit report under the guidelines set forth in Statements on Auditing Standards.

(b) Argument against issuance of an unqualified audit report. For the auditors to issue an unqualified audit report when they have not observed the taking of the physical inventory is generally permissible only if it was impossible for them to perform this procedure.

Was it in fact impossible in this particular audit to have included observation of physical inventory by independent public accountants? The corporation delayed unreasonably long in the appointment of its auditors. Having delayed the decision to engage a CPA firm until December of the year under audit (and until after the taking of physical inventory), the corporation could have made up for its procrastination by arranging another physical inventory at December 31 to be observed by the CPAs. The only excuse offered for not doing so is that a second physical count would take time and slow down delivery schedules. In other words, it was more convenient and economical for the client not to plan and conduct a physical inventory in which the independent auditors observed the count. "Convenience" and "economy" are very different concepts from "impossible." Consequently the auditors cannot claim that it was impossible for them to have observed the physical inventory.

Finally, the materiality of the inventories (almost half of total assets) makes it especially important that the auditors' work on inventories be thorough in this case. Yet the auditors did nothing with respect to the important procedure of participating in advance planning of the physical inventory. Furthermore, their test counts of 10 percent of inventory value (representing $400,000 value tested from an inventory carried at $4,000,000) were far too small in view of the importance of inventories in this set of financial statements.

272


If you as a CPA were to appear in court as an expert witness in a suit challenging Santa Rosa Corporation's financial statements and the quality of Warren and Wood's audit work on inventories, would you not find it difficult to defend the issuance of an unqualified audit report in this engagement?

12-28 Auditing procedures that the auditors would employ to determine whether slow-moving or obsolete items are included in the inventory are the following:

(1) During the observation of physical inventory, make note of any dusty or rusted items, or other items in obviously poor condition. In addition, investigate any inventory stored in out-of-the-way locations.

(2) If the client maintains reliable perpetual inventory records, review them for raw materials that have not been requisitioned and for finished goods that have not been shipped for extended periods.

(3) Compare the raw materials physical inventory listings with bills of material for products currently in production or on order.

(4) Compare the backlog of unfilled sales orders at the audit date to the finished goods inventory list.

(5) Review catalogs and other sales department publications for finished goods currently being advertised and offered for sale.

(6) Be alert for any incomplete jobs that are dormant in the review of goods-in-process inventory records.

(7) Examine post-audit date sales orders and materials requisitions to determine what finished goods and raw materials were active in the subsequent period.

(8) Inquire of the client management as to any recent survey for obsolete or slow-moving inventory.

(9) Compare the beginning and ending inventory listings are compared for items showing little if any quantity changes.

(10) Compute the turnover of inventory by product line and compare it to that of prior periods for an indication of an adverse trend.

(11) Perform other analytical procedures, such as comparing the trend of gross profit by product line.

273


12-29 Since Reed Company obtained its entire merchandise inventory from the president of the company in a related party transaction, the auditors should consider the cost of the merchandise to the president in his operation of a similar business as a sole proprietor. In this related party transaction, the auditors must look beyond form—a total cost of $100,000 for the original stock of merchandise—to substance. Substantively, the merchandise of Reed Company should not be valued at excessive amounts, that is, amounts beyond what it could be acquired for directly from vendors. Any excess amount charged by the president to Reed Company represents unamortized discount on the notes payable. The entire transaction should be fully disclosed in a note to the financial statements of Reed Company.

12-30 (a) To establish proper inventory cutoff, the auditors use the shipping and receiving information obtained at the physical inventory and:

(1) Examine sales transactions and supporting documentation for a period before the physical inventory and determine that goods shipped before the physical inventory have been included in sales and cost of sales, and that goods included in inventory are not included in sales and cost of sales.

(2) Select receiving reports for goods received before the physical inventory and determine that all goods received before the inventory have been included in inventory and liabilities.

(3) Review supporting documentation for goods not included in the physical count but included in the general ledger inventory control account (e.g., inventory in transit) and determine that the goods are properly included in inventory.

(4) Examine purchase and sales transactions and detailed supporting documents for the period after the physical inventory to determine that they have been reflected in the proper period.

(5) Review records of returned goods and claims against suppliers and related memoranda for periods before and after the cutoff date to determine that returns and claims against suppliers made after the cutoff date have been entered in the appropriate period.

(b) When the auditors arrive for the observation, they will inspect the premises to determine whether:

(1) The arrangement of inventory is such that an accurate count is possible.(2) Scrap, obsolete, and damaged goods are adequately identified and segregated.(3) Inventory owned by other companies are adequately identified and segregated.(4) Inventories appear to be adequately safeguarded against access by

unauthorized persons and protected against deterioration.

274


12-31 The audit procedures to be applied to determine that standard costs and related variance accounts applicable to materials are acceptable and have not distorted the financial statements would include the following:

(1) Consider the internal control, determine appropriate tests of controls, and assess control risk.

(2) Test the arithmetic computations of the standard cost records.

(3) Determine that the data on the standard cost records are reasonably current. Out-of-date standards may result in abnormal variances.

(4) Ascertain the accuracy of the specifications on the standard cost records by comparison with engineering specifications or other independent sources. Determine that the procedure for establishing standard material cost gives consideration to spoilage, scrap loss, and by-products of the process.

(5) Determine that, in establishing standard material prices, consideration was given to the following factors: normal quality, normal quantity, normal sources, and delivery by normal carrier. The treatment in the accounts of discounts, whether excluded or included in the standard costs, should be investigated for consistency.

(6) The accounting system for recording standard costs should be reviewed for reasonableness, and tests should be applied to determine that the system is functioning effectively. Source documents (vendors' invoices, requisitions, production reports, and other internally generated accounting evidence) should be examined and related to the transactions flowing through the cost system. In this connection, reference should be made to the standard cost records to determine that standard cost data flowing through the accounting system are being accurately compiled.

(7) Review the material price variance and material usage variance accounts for overall reasonableness. The variance accounts should also be reviewed for excessive variations in the month-to-month charges, and satisfactory explanations should be obtained where necessary.

(8) The impact of the variances on the financial statements should be considered. If the variances are of amounts so substantial that placing them in the income statement would distort current operating results and inventory valuation, then consideration should be given to allocating them on a pro rata basis to cost of goods sold and inventories.

275


Multiple Choice Questions

12-32 (a) (3) Inventory need not be on hand at year-end. For example, purchases in transit on which title has passed to the client should also be included.

(b) (3) The shipping department, not the receiving department, is responsible for preparation of a shipping document.

(c) (1) A bill of lading acknowledges the receipt of goods and sets forth provisions of the transportation agreement.

(d) (1) Direct labor, raw materials, and factor overhead are all included in inventory costs of a manufacturing company.

(e) (1) The Cost Accounting Standards Board was established by Congress to narrow the options in cost accounting that are available under generally accepted accounting principles.

(f) (1) Of the choices, existence is most directly related to overstated inventory because inclusion of inventory items that do not exist in inventory totals results in an overstated inventory.

(g) (1) The professional standards allow auditors to use physical counts prior to year-end when a client has well-kept perpetual (computerized or non-computerized) inventory records.

(h) (1) Analytical procedures will be facilitated when a client uses a standard cost system that produces variance reports. Such reports will allow the auditors to identify significant deviations from expected values.

(i) (1) Since the internal control is described as being weak, the CPAs will

generally insist upon a physical count at year-end.

(j) (2) The best procedure for the discovery of damaged goods is an examination of the condition of the inventory during the auditors' observation of the physical inventory.

(k) (1) Mullins may issue an unqualified opinion as long as she is satisfied that the client's procedures are adequate to provide a reliable inventory balance.

(l) (2) The primary objective of the CPAs' observation of inventories is to provide sufficient competent evidence as to the existence of the inventory and the controls over the inventory-taking process.

276


Problems

12-33 SOLUTION: Inventory Misstatements (Estimated time: 20 minutes)

MisstatementError or Fraud Controls Substantive Procedure

a. Error Development of adequate inventory taking procedures and adequate supervision of physical inventory.

Observation of inventory.

b. Fraud Use of prenumbered receiving reports and controls to insure adequate cut-off of purchases and payables.

Observation of inventory and collection of cut-off information that is traced to accounting records.

c. Fraud Effective audit committee and internal audit department to monitor management’s override of internal controls.

Price tests of a sample of inventory items.

277


12-34 SOLUTION: Williams Pharmaceutical Company (Estimated time: 25 minutes)

(a) Williams faces a number of business risks including (only three required):

(1) Violations of FDA regulations (or equivalent regulations in other countries) regarding production or storing of inventory.

(2) Development of products by competitors that compete with the company’s products or make them obsolete.

(3) Loss of inventory due to theft.(4) Defects in the production process that cause ineffective or dangerous products

to be produced.(5) Violations of the company’s patents by competing companies.

(b) (1) This risk results in a current period inherent risk. Violations of FDA regulations

regarding production or storing of inventory may cause a misstatement if the violations

cause products in the inventory to be unsalable. In this situation, inventory items may

be overvalued.(2) This risk results in a current period inherent risk. If a competitors products

cause Williams’ products to become obsolete, the products may be overstated and may need to written down to net realizable value.

(3) This risk results in a current period inherent risk. Inventory theft will cause the financial statements to be misstated if it is not reflected in the accounting records. Therefore, this risk may or may not result in material misstatement depending on whether Williams has adjusted its inventory to actual quantities on hand.

278


(4) This risk results in a current period inherent risk. Defects in manufacturing may cause inventory to be overvalued because it is unsalable.

(5) This risk probably does not result in a current period inherent risk. Violations of the company’s patents usually would not result in a misstatement of inventory unless the effects are so great as to affect the value of the inventory on hand.

(c) (1) To prevent violations of FDA regulations, management must develop production

processing and inventory controls that ensure compliance with government regulations.

These controls include physical controls over inventory and detailed records on

production batches. In addition, Williams’ management should establishing ongoing

monitoring procedures to insure compliance with the regulations.(2) Controls that management may establish over competition include controls

over research and development costs, and risk assessment directed at monitoring competition and designing responses to the development of competitive products.

(3) To prevent inventory theft, management should establish effective physical controls over

the inventory and monitor compliance with those procedures.(4) To prevent defects in manufacturing, management must establish quality

controls over manufacturing processes and monitor compliance with those controls. (5) This risk would generally not result in a financial reporting risk.

12-35 SOLUTION: Alden, Inc. (Estimated time: 30 minutes)

Weaknesses Recommended Improvements

(1) Raw material may be removed from the storeroom upon oral authorization from one of the production foremen.

Raw materials should be removed from the storeroom only upon written authorization from an authorized production foreman. The authorized forms should be prenumbered and accounted for, list quantities and job or production number, and be signed and dated.

(2) Alden's practice of monthly physical inventory counts does not compensate for the lack of a perpetual inventory system. Quantities on hand at the end of one month may not be sufficient to last until the next month's count. If the company has taken this into account in establishing reorder levels, then it may be carrying too large an investment in inventory.

A perpetual inventory system should be established under the control of someone other than the storekeeper. The system should include quantities and values for each item of raw material. Total inventory value per the perpetual records should be agreed to the general ledger at reasonable intervals. When physical counts are taken they should be compared to the perpetual records. Where differences occur they should be investigated, and if the perpetual records are in error, they

279


should be adjusted. Also, controls should be established to minimize obsolescence of stored materials.

280


(3) Raw materials are purchased at a predetermined reorder level and in predetermined quantities. Since production levels may often vary during the year, quantities ordered may be either too small or too great for the current production demands.

Requests for purchases of raw materials should come from the production department and be based on production schedules and quantities on hand per the perpetual records.

(4) The accounts payable clerk handles both the purchasing function and payment of invoices. This is not a satisfactory separation of duties.

The purchasing function should be centralized in a separate department. Prenumbered purchase orders should originate from and be controlled by this department. A copy of the purchase order should be sent to the accounting and receiving departments. Consideration should be given to whether the receiving copy should show quantities.

(5) Raw materials are always purchased from the same vendor.

The purchasing department should be required to obtain competitive bids on all purchases over a specified amount.

Weaknesses Recommended Improvements (6) There is no receiving department or

receiving report. For proper separation of duties, the individuals responsible for receiving should be separate from the storeroom clerks.

A receiving department should be established. Personnel in this department should count or weigh all goods received and prepare a prenumbered receiving report. These reports should be signed, dated, and controlled. A copy should be sent to the accounting department, purchasing department, and storeroom.

(7) There is no inspection department. Since high-cost electronic components are usually required to meet certain specifications, they should be tested for these requirements when received.

An inspection department should be established to inspect goods as they are received. Prenumbered inspection reports should be prepared and accounted for. A copy of these reports should be sent to the accounting department.

281


12-36 SOLUTION: Potential Misstatements (Estimated time: 20 minutes)

Financial Statement Misstatement

Audit Procedures

a. 1. Observation of inventory at selected locations without prenotification of the locations selected.

2. Analytical procedures comparing ratios (e.g., gross margins) at locations observed to locations not observed.

b. 1. Tests of the accumulation of manufacturing costs and assignment of costs to selected inventory items.

2. Analytical procedures involving the comparison of recorded costs of inventory items to costs assigned in prior periods.

c. 1. Review of inventory turnover of selected inventory items.

2. Inquiry of sales personnel about sales of particular inventory items.

d. 1. Review of trends in sales returns.2. Inquiry of production and quality control personnel.

12-37 SOLUTION: Royal Meat Processing Company (Estimated time: 30 minutes)

(1) The purchasing and receiving functions have not been properly separated, and proper reporting has not been established. Returning the completed receiving report to the buyer enables him or her to retain control over the receiving function. The buyer and the person having receiving authority should make independent reports to the accounting department. Each report should include the vendor's name and the number of head and total weight in the shipment. Price and other terms of the purchase should be included in the buyer's report.

The buyer may furnish a copy of this report to the plant for use as a receiving report. This should be a "blind" copy, i.e., it should omit the number of head and weights for the incoming shipment; these should be inserted independently.

Responsibility for receiving has not been clearly assigned and the person receiving cannot be identified. Specific employees should be charged with this responsibility, and the receiving report should be initialed or signed. Provision should be made for verifying the weights of the livestock received. Better inspection of the condition of incoming shipments and reporting of this inspection also are necessary.

Present procedures do not call for a follow-up on delinquent deliveries. The buyer is not notified until all shipments are received. The buyer or another person should be assigned responsibility for expediting delivery, and a procedure should be instituted to provide this person with timely data on the status of incoming shipments.

282


(2) The buyers have too much control over the purchasing-disbursement cycle and are performing both accounting and disbursing functions. The buyers should neither receive nor approve the vendors' invoices; review of the invoice, including matching with the buyer's report, receiving report, and bill of lading should be performed in the accounting department. Checks should not be delivered to buyers but should be sent directly to the vendor by the treasurer's office.

The treasurer or his delegate should review the disbursement voucher, as well as the check, in order to verify that the disbursement is proper. The treasurer's department should cancel approved disbursement vouchers and supporting documents to prevent their use in support of another disbursement.

(3) Control over carcasses is not being established until completion of processing. Control should be established when the animals are received and should be continued through sale of the processed carcasses.

Costs of acquiring and processing livestock should be accumulated by lot and the numbers and weights of processed carcasses should be related to numbers and weights of the animals originally purchased. This will provide control over processing costs, prevent unwarranted material losses during processing, and provide a check on the quality of the suppliers whose livestock is included in a particular lot.

(4) Physical safeguards for the processed carcasses are inadequate. Guard service is not continuous, and apparently the cooler is sometimes unattended during the working day. The cooler should be kept locked at all times when not under close surveillance; responsibility for seeing that this is done should be specifically assigned.

It would be desirable to relocate the cooler in a less vulnerable place, outside the flow of traffic and perhaps within the plant. A burglar alarm system or guard protection in off-work hours should also be considered.

(5) No physical controls have been established over either the production or sale of by-products. As by-products are substantial, controls should be established over production, inventory, and sales. The production of by-products in each lot should be related to standard quantities based on established ratios between by-products and animals processed. Perpetual inventory records of important by-products should be established and reconciled to periodic physical inventories.

12-38 SOLUTION: Internal Control, Tests of Controls, and Substantive Procedures (Estimated time: 25 minutes)

(a) (1) Written inventory-taking instructions help insure that everyone involved in the physical inventory understands the procedure. The instructions make it more likely that an accurate and complete record of amount and quality of inventory on hand will be obtained.

(2) Identification of damaged goods is required for fair presentation of the inventory account, since such items should be valued at net realizable value.

(3) Perpetual inventory records provide essential information to make decisions regarding purchasing, sales, and production planning. The records serve to discourage waste and theft, since storekeepers are held responsible for shortages revealed by physical counts. They also reduce the probability of errors or fraud in the Inventory and Cost of Goods Sold accounts.

283


(b) (1) The existence of written inventory-taking procedures is verified by examination of the instructions. The auditors also make suggestions for improvements when they discover deficiencies in the instructions.

(2) Inquiry of client personnel or review of the client's inventory policies could be used to test the existence of a requirement for the identification of damaged merchandise. The auditors should be alert for damaged merchandise during their inventory observation to test the effectiveness with which client personnel are complying with the policy.

(3) The existence of perpetual records is tested by inspection of the records and inquiry regarding the client's procedures.

(c) (1) When written instructions are not prepared for the client's physical inventory, the auditors might decide to increase the intensity of their observation procedures. More auditors might be assigned to the inventory observation, and the extent of the test counts of inventory items could be increased. The auditors should be more alert for problems, such as failure to adequately control inventory tags or double counting of inventory items.

(2) If the client does not require the identification of damaged goods, the auditors should be especially alert for damaged goods during their observation of the physical inventory. They might also make more extensive inquiries of storekeeping personnel regarding the condition of inventory items.

(3) The lack of a perpetual inventory system would generally require that the auditors observe the client's physical inventory at, or near, the balance sheet date. The auditors' inventory observation procedures might also be intensified.

12-39 SOLUTION: Nash Jewelers, Inc. (Estimated time: 15 minutes)

(a) (1) The auditors must control all inventories until they have been counted to be certain that gems are not transferred from one store to another store and included in inventory more than once. Gems are easily transportable and are not readily distinguishable from other gems by the layman. Thus, unless the auditors controlled all of the inventories during the counting of the inventory, they would be uncertain whether the gems and jewelry had been transferred from store to store without their knowledge.

(2) The nature of the inventory is such that auditors are not competent without special training to identify or value the merchandise in the inventory. Although they can count the gems on hand, they cannot be certain whether they are counting valuable gems or nearly worthless imitations. It is therefore necessary that the auditors request the client to engage the services of a specialist who is competent to identify and appraise the value of the gems.

(b) In some manner, the auditors should exercise control over the in-transit inventory so that they may be certain it is counted but not duplicated in the inventory. If possible, a staff member of the CPA firm should be on hand at the retail store when the diamonds in transit are delivered. The gems should be examined by a diamond specialist as to quality and value, and the specialist's findings should be compared with the records of the shipment at the wholesale store. It should be determined that

284


the diamonds were included in the inventory of only one store and that all inventory profit was eliminated from the inventory.

285


12-40 SOLUTION: Raye and Coye, CPAs (Estimated time: 25 minutes)

The following inventory observation problems might be anticipated in audits of the three new clients:

(1) The size of the ranch and the movements of the large number of cattle during their grazing make observation of a complete physical inventory very difficult. The auditors might consider requesting the client to rent a helicopter for the auditors to use in taking low-level photographs of the various clusters in each photograph, and to obtain an accurate estimate of the number of head of cattle in inventory. Lacking the aerial photography, the auditors would have to request the client to round up the cattle and run them through a chute for counting.

(2) The gondola freight cars would contain pig iron bars in several layers. Therefore, to make certain that the lower layers of the gondola cars did contain pig iron rather than lumber, for example, the auditors would have to request the client to move enough of the pig iron from the car to permit observation of portions of each layer of pig iron. A representative sample of the pig iron bars would have to be weighed or measured, depending upon the unit of count, so that the total load of the gondola car could be estimated. If the weight is the unit of measure of the pig iron, the loaded gondola car might be weighed and the weight of the empty car, furnished by the railroad, subtracted to obtain an estimate of the weight of the entire carload of pig iron.

(3) The cutoff of production, purchases, and sales is the principal problem when a client operates around the clock. Presumably, the client will employ a professional inventory service to take the physical inventory, since production is continuing. The client and the auditors would have to agree upon a set hour for the cutoff, instead of just the balance sheet date.

12-41 SOLUTION: Blue Distributing Corporation (Estimated time: 35 minutes)

Substantive procedures that would document management’s completeness assertion as it relates to inventory quantities would be:

(1) Observing physical inventory counts.(2) Analytical procedures examining the relationship of inventory balances to purchase,

production, and sales activities.(3) Inspecting shipping and receiving documentation for proper amounts and dates to

verify proper cutoff procedures.(4) Obtaining confirmation of inventories at locations outside the entity.(5) Tracing test counts recorded during the physical inventory observation to the

inventory listing.(6) Accounting for all inventory tags and count sheets used in recording the physical

inventory counts.(7) Recomputing the inventory calculations for clerical accuracy.(8) Reconciling physical counts to perpetual records and general ledger balances and

investigating significant differences.

286


12-42 SOLUTION: Redondo Manufacturing Corporation (Estimated time: 25 minutes)

(a) Consignments out

(1) Obtain from the client a complete list of all consignees together with copies of the consignment contracts.

(2) Evaluate the consignment contract provisions relative to the following areas:(a) Payment of freight and other handling charges.(b) Extension of credit.(c) Rates and computation of commissions to consignees.(d) Frequency and contents of reports and remittances received from

consignees.(3) Discuss with the client any variations found in the contracts that do not seem

justified by the circumstances.(4) Following review of the consignment contracts, communicate directly with

the consignees to obtain complete information in writing on merchandise remaining unsold, receivables resulting from sales, unremitted proceeds, and accrued expenses and commissions, which should be reconciled with the client's records for the period covered by the engagement.

(5) Determine that merchandise on consignment with consignees is valued on the same basis as merchandise on hand, and included as part of the inventory. Ascertain that any arbitrary mark-ups are deducted and that shipping and related charges for the transfer of merchandise to the consignees are reflected as part of the inventory.

(6) Ascertain that quantities of goods in hands of consignees at the close of the period under audit appear in the balance sheet and are separately designated as "Merchandise on Consignment."

(b) Finished merchandise in public warehouses pledged as collateral for outstanding debt

(1) Determine that goods pledged to obtain funds are covered by warehouse receipts. (The examination of warehouse receipts alone is not a sufficient verification of goods stored in public warehouses.)

(2) Request direct confirmation from the warehouses in which the merchandise is held.

(3) If available, obtain independent accountants' reports on the warehouses' internal controls over the custody of stored goods.

(4) Review the client's procedures for acceptance and evaluation of the performance of warehouses, and review supporting documents.

(5) Review the loan agreements collateralized by warehouse receipts. These agreements usually provide for certain payments to be made by the borrower as pledged goods are sold.

(6) Consider observing a physical inventory of goods stored at the public warehouses.

287


12-43 SOLUTION: Payne Press Company (Estimated time: 45 minutes)

(a) This situation requires the auditors to follow two courses of investigation: (1) to determine that all charges applicable to the job had been properly recorded at the year-end, and (2) to determine whether an inventory write-down is in order.

The substantive procedures necessary to accomplish the foregoing are:

(1) To determine that all charges applicable to the job have been properly recorded:

(a) Review the company's year-end cutoff methods.(b) Examine vouchers for the early part of the subsequent period for

possible additional charges.(c) Examine vouchers for the latter part of period under audit for charges

representing undelivered material or services.(d) Review the methods used in determining overhead rates and the

manner in which jobs are charged for overhead to see that the job in question has been appropriately charged.

(2) To determine whether an inventory write-down is in order:

(a) Inquire of the company's engineers as to methods or principles used in determining the percentage of completion. The percentage given may apply only to the labor cost, or it may apply to the total dollar value. If the percentage relates to dollar value, the material element should be scrutinized, since in many instances 100 percent of material costs are incurred at an early stage. Proper analysis of all elements should be made in the light of further information obtained concerning the percentage of completion.

(b) Assuming that the percentage of completion relates to dollar value and that there are no other extenuating circumstances, it would appear that final cost of Job 2357 will be about $55,000, which is in excess of contract price. Investigate the reasons for the excess costs. If specifications have been changed by the customer, it is possible that additional revenue will be obtained either as a result of the contract provisions or by negotiation. In any event, the possibility of obtaining an increase in price should be explored.

(c) Request the client to revalue the job as indicated in part (b) to this answer.

(d) If the loss is due to poor estimating or uncontrollable subsequent events (such as changes in labor rates), other jobs, including those on which no work has begun, should be reviewed to determine possible existing loss situations.

288


(b) If no price adjustment is possible and no worse experience is anticipated, Job 2357 should be valued at year-end at lower of cost or market as follows:

Selling price $ 50,000Costs to complete ($55,000 - $30,250) -24,750

$ 25,250Expenses (10% of sales) -5,000Net realizable value* $ 20,250

*Indicated loss of $10,000 ($30,250 - $20,250)

Job 2357 should be included in work-in-process inventories at its net realizable value, $20,250. The $10,000 loss would be set out separately in the income statement, or, if not material, included with cost of goods sold. The customer's advance on the job should be included among current liabilities in the balance sheet.

In-Class Team Case

12-44 SOLUTION: Hovington, CPA (Estimated time: 15 minutes)

Item

Financial statement assertion Specific Audit Objective

Auditprocedure

(1) D

Legal title to inventories relates to whether the client owns and, therefore, has rights to the inventories. An appropriate audit procedure would be to sample from the recorded items and examine related vendors' invoices, contracts, etc. to determine that the client owns the goods.

I

(2) A

The completeness assertion addresses whether all assets (here inventory) have been included in the financial statements. Sampling from the inventory items to the count sheet to determine that all items have been included will be the most effective procedure.

H

(3) E

The valuation or allocation assertion addresses whether the assets have been included in the financial statements at the appropriate amount. Inventories should be valued at the lower of cost or market. An examination of current vendors' price lists will provide evidence about the current value of inventory items.

F

(4) E

The valuation or allocation assertion addressees whether the asset has been included in the financial statements at the appropriate amount. One step in determining the proper amount is to calculate the cost of the inventories. Selecting a sample of recorded items and examining supporting vendors' invoices and contracts will help to meet this objective. Note that answer K is incorrect because no direct manufacturing labor should be capitalized, given that a department store does not manufacture inventories.

I

289


(5) C

The presentation and disclosure assertion addresses whether particular components of the financial statements are properly classified, described, and disclosed. Here, inventories should be reported by category and the bases of valuation should be disclosed in the notes to the financial statements. A review of drafts of the financial statements will allow the auditors to determine whether presentation and disclosure are appropriate.

G

Ethics Case

12-45 (a) If an employee or partner accepts more than a token gift from a client the appearance of

independence may be lacking. Accordingly, a judgment must be made as to whether this discount is considered more than “token.” From the client’s perspective it almost certainly is token, but from the perspective of the individual CPA the problem is more complex. Although we are not aware of research addressing the issue, our experience is that such discounts have historically been commonly accepted. While we question accepting such discounts, we do not believe that they necessarily would impair the independence.

(b) First, relating to the discount, if one believes that it affects either actual independence or the appearance of independence, a very major difficulty is encountered. Indeed, if one is concerned about this matter, and if members of the audit team received such a discount in the past, the audit may be viewed as having been performed by non-independent accountants. Yet, as indicated above, we question whether such a discount would impair independence.

A more subtle issue is that related to inventory. Tests of controls have revealed a system that seems “strong,” yet the controller simply withdrew shirts from inventory—apparently with no documentation of the transaction. The information is limited, but it causes one to question whether recorded quantities of inventory do in fact exist and the control over them. Several possible courses of action exist here:

(1) Ignore the issue. The auditor might assume this is an infrequent occurrence that could not lead to a material misstatement. Yet, if shirts can be taken from inventory this simply a material misstatement may indeed be possible. The approach of ignoring the problem would seem risky at best.

(2) Talk to the controller about the issue. This would have to be done professionally and diplomatically. The auditor would need to attempt to determine whether this possible weakness might lead to a material misstatement.

(3) Bring the matter to the attention of the in-charge senior and seek guidance. In a situation such as this, asking for advice from the in-charge senior seems a good choice.

290


Research and Discussion Case

12-46 SOLUTION: Western Trading Company (Estimated time: 45 minutes)

(a) Statement on Auditing Standards No. 1, Section 560.05 states that:

The second type (of subsequent event) consists of those events that provide evidence with respect to conditions that did not exist at the date of the balance sheet being reported on but arose subsequent to that date. These events should not result in adjustment of the financial statements.

Since the decline in market value of the commodities occurred subsequent to the client's year-end, the auditors appear not to be justified in issuing a qualified opinion.

The alternatives available to the auditors are to: (1) issue an unqualified opinion if the decline in value of the inventory is adequately disclosed in a note to the financial statements, or (2) issue an unqualified opinion regardless of whether the decline in value is adequately disclosed.

(b) We believe that the auditors should issue an unqualified opinion only if the client agrees to disclose the decline in value in a note to the financial statements. As stated in Statement of Financial Accounting Standards No. 5 (Current Text section C59.112):

After the date of an enterprise's financial statements but before those financial statements are issued, information may become available indicating that an asset was impaired...after the date of the financial statements...Disclosure of those kinds of losses...may be necessary...to keep the financial statements from being misleading.

Simulation

12-47 SOLUTION: Audit Simulation—Inventory (Estimated time: 30 minutes)

(a) (1) Answer (1) is correct because the competition that has led to decreased sales prices may ultimately create a difficult situation for CCS.

(b) (2) Answer (2) is correct because the pressure to obtain the refinancing creates pressure on management.

(c) (4) Answer (4) is correct because a larger percentage of sales in the last month is likely to result in a lower ending inventory, thus increasing the inventory turnover ratio since the denominator of the fraction becomes smaller.

(d) (6) Answer (6) is correct because the only reason net income increased was the decreases in the provision for income taxes.

(e) (2) Answer (2) is correct because the simulation indicates that inventories are pledged, and confirmation of such information is appropriate and may lead the auditor to discover presentation and disclosure inaccuracies or omissions.

291


(f) (4) Answer (4) is correct because examination of supporting vendors’ invoices and contracts will reveal whether the client owns the goods.

(g) (3) Answer (3) is correct because selecting items during the count to determine that they have been included on count sheets will help the auditor determine that all items have been included—that is, establish the completeness of inventories. Following this procedure the auditor may find items not included on the count sheets that should have been included.

(h) (5) Answer (5) is correct because calculating turnover ratios and then identifying items that have not turned over frequently will identify slow moving items that might need to be recorded at market values under the lower of cost or market rule for the valuation of inventory.

(i) We will not provide a detailed memo here. Your memo should be well written, and well organized. Although you should not have provided a list such as we have provided below, your memo should include points such as the following:

Net income before taxes decreasing: Cost of goods sold increased at a rate higher than expected due to competition

from new companies entering the industry. Repairs and maintenance increased significantly.

Net income before taxes increased: The sole factor here is the provision for income taxes. It would seem that the

client’s estimate is low for 20X8.

(j) The appropriate guidance is found in AU 331:

AU Section 331 — Inventories

.01 Observation of inventories is a generally accepted auditing procedure. The independent auditor who issues an opinion when he has not employed them must bear in mind that he has the burden of justifying the opinion expressed. [As amended, effective for fiscal periods ending after June 15, 1992, by Statement on Auditing Standards No. 67.]

.02 The purpose of this section is to provide guidelines for the independent auditor in observing inventories. This section relates only to observation of inventories and does not deal with other important auditing procedures which generally are required for the independent auditor to satisfy himself as to these assets. [Revised, December 1991, to reflect conforming changes necessary due to the issuance of Statement on Auditing Standards No. 67.]

:

292


:

Inventories

.09 When inventory quantities are determined solely by means of a physical count, and all counts are made as of the balance-sheet date or as of a single date within a reasonable time before or after the balance-sheet date, it is ordinarily necessary for the independent auditor to be present at the time of count and, by suitable observation, tests, and inquiries, satisfy himself respecting the effectiveness of the methods of inventory-taking and the measure of reliance which may be placed upon the client's representations about the quantities and physical condition of the inventories.

.10 When the well-kept perpetual inventory records are checked by the client periodically by comparisons with physical counts, the auditor's observation procedures usually can be performed either during or after the end of the period under audit.

.11 In recent years, some companies have developed inventory controls or methods of determining inventories, including statistical sampling, which are highly effective in determining inventory quantities and which are sufficiently reliable to make unnecessary an annual physical count of each item of inventory. In such circumstances, the independent auditor must satisfy himself that the client's procedures or methods are sufficiently reliable to produce results substantially the same as those which would be obtained by a count of all items each year. The auditor must be present to observe such counts as he deems necessary and must satisfy himself as to the effectiveness of the counting procedures used. If statistical sampling methods are used by the client in the taking of the physical inventory, the auditor must be satisfied that the sampling plan is reasonable and statistically valid, that it has been properly applied, and that the results are reasonable in the circumstances. [Revised, June 1981, to reflect conforming changes necessary due to the issuance of Statement on Auditing Standards No. 39.]

.12 When the independent auditor has not satisfied himself as to inventories in the possession of the client through the procedures described in paragraphs .09 through .11, tests of the accounting records alone will not be sufficient for him to become satisfied as to quantities; it will always be necessary for the auditor to make, or observe, some physical counts of the inventory and apply appropriate tests of intervening transactions. This should be coupled with inspection of the records of any client's counts and procedures relating to the physical inventory on which the balance-sheet inventory is based.

.13 The independent auditor may be asked to audit financial statements covering the current period and one or more periods for which he had not observed or made some physical counts of prior inventories. He may, nevertheless, be able to become satisfied as to such prior inventories through appropriate procedures, such as tests of prior transactions, reviews of the records of prior counts, and the application of gross profit tests, provided that he has been able to become satisfied as to the current inventory.

293