Академический Документы
Профессиональный Документы
Культура Документы
True-False Questions
11-1 F
11-2 T
11-3 T
11-4 T
11-5 F
11-6 T
11-7 T
11-8 F
11-9 F
11-10 T
11-11 F
11-12 T
11-13 T
11-14 T
11-15 F
11-16 T
Multiple-Choice Questions
11.17 A
11.18 D
11.19 D
11.20 A
11.21 D
11.22 C
11.23 B
11.24 E
11-25 B
11.26 A
11.27 B
11.28 D
11.29 C
11.30 D
11.31 C
11.32 E
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11-1
11-34
An automated purchasing system is a networked software system linking to vendors whose
offerings and prices have been preapproved by appropriate management. An automated
purchasing system can perform the following beneficial tasks:
Applypreloadedspecificationsandmaterialsliststothesystemtostarttheprocess
Automaticallyflaginvoicesthatdonotreconcilewithpurchaseorders
Createchangeordersandanalyzevariancesfrompurchaseorders
11-35
1. C
2. A
3. E
4. B
5. D
11-36
1. D
2. B
3. C
4. E
5. A
11-37
Inventoryisacomplexaccountingandauditingareabecauseofthefollowing:
Agreatvariety(diversity)ofitemsexistsininventory.
Inventoryaccountstypicallyexperienceahighvolumeofactivity.
Inventoryaccountsmaybevaluedaccordingtovariousaccountingvaluationmethods.
Identifyingobsoleteinventoryandapplyingthelowerofcostormarketprincipletodetermine
valuationaredifficult.
Inventoryiseasilytransportable.
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11-2
Inventoryoftenexistsatmultiplelocationswithsomelocationsbeingremotefromthe
companysheadquarters.
Inventorymaybecomeobsoletebecauseoftechnologicaladvanceseventhoughthereareno
visiblesignsofwear.
Inventoryisoftenreturnedbycustomers,socaremustbetakentoseparatelyidentifyreturned
merchandise,checkitforquality,andrecorditatnetrealizablevalue.
Inventoryoftenincludesavarietyoftypesofproducts;theauditormustpossessandapply
significantknowledgeaboutthebusinessinordertoaddressobsolescenceandvaluation
questions.
Individualsinvolvedwiththepurchaseofinventorymayhaveincentivestoexploit
weaknessesinthecontrolsystemtotheireconomicadvantage.
11-38
a. Management has an incentive to bring the amounts in the allowance for doubtful accounts
back into income this year in order to offset the loss from the write-down in inventory.
b. The difficulty in this setting is that management is not maintaining a standard of reporting the
financial status of the company in a representationally faithful manner. In contrast to this
argument, some management teams will counter that by smoothing the income numbers they
are actually helping shareholders because stock valuations may be more favorable for income
streams that are more predictable.
c.
Identify the ethical issue(s).
The auditors ethical difficulty is that there is little verifiable evidence to suggest that the
allowance for doubtful accounts should be maintained at the current, high level. Yet, the
auditor realizes that the reason management is pulling that adjustment back into income
this year is simply to offset the loss on the write-down of inventory. Further, the auditor
believes that the clients write-down of inventory is not sufficient.
Determine who are the affected parties and identify their rights
Affected parties include shareholders (right to receive accurate investment information),
the audit committee and board of directors (right to receive an accurate portrayal of the
accounting function of the organization), management (the right to present the financial
information they feel is most appropriate) the SEC (the right to receive accurate financial
reports), the audit firm (the right to have a client that will not tarnish the Firms
reputation), and the individual auditors on the HBOC engagement (the right to have their
professional opinions respected and followed).
Determine the most important rights.
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11-3
Shareholders of the company because they are the most numerous and stand to lose most
directly from the problems. Further, they are not in any way at fault, unlike the members of
the audit committee, board, or individual auditors.
Develop alternative courses of action.
In this case setting there are a number of options for the auditor to consider.
Option one: allow management to reduce the allowance for doubtful accounts at
approximately the amount they desire. Obtain evidence supporting that reduction,
including patterns of collectibility from customers and analyses of industry norms in this
regard.
Option two: convince management to write off the inventory amount at a level
consistent with the auditors initial estimate.
Option three: allow management to write off the inventory amount at their preferred
level, but only if they can produce evidence refuting the auditors estimate.
Option four: consider managements long-term pattern of establishing cookie jar
reserves and incorporate that understanding into assessments of whether that type of
behavior is occurring for other financial statement line items.
Determine the likely consequences of each proposed course of action.
Option one: likely consequences are unknown, although it does appear that a reduction
in the allowance account may be an action that would result in financial statements that
present an accurate picture of the company.
Option two: likely consequences are unknown; it is not possible to determine if
management will resist this alternative. However, a write-down of the inventory may be
an action that would result in financial statements that present an accurate picture of the
company. If the company were to refuse to write-down the inventory, the auditor may
have to consider the implications of this for the audit opinion.
Option three: it is likely that management would prefer this alternative and it is
unknown as to whether there would be evidence to support this alternative. It appears that
this approach might result in financial statements that do not present the most reliable or
accurate picture of the company
Option four: regardless of which of the above three actions are taken, the auditors should
have increased professional skepticism regarding managements treatment of other
financial statement line items.
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11-4
Auditors have difficulty in resisting management teams that use cookie jar reserves
because of the notion of conservatism. In these settings, auditors need to rely on elements
of the conceptual framework, such as reliability, to convince management teams that
reporting truthfully is more important than reporting income streams that are highly
predictable.
Assess the possible consequences, including an estimation of the greatest good for the
greatest number.
The greatest good for the greatest number likely accrues to the actions associated with
options one and two. These actions will likely result in the financial statements presenting
a more accurate or reliable picture of the company and this would greatly benefit the
shareholders who should expect that the company produce reliable financial statements.
Further, the auditor should pursue option four because of the concerns that the auditor has
about whether management is committed to reliable financial reporting.
Decide on the appropriate course of action.
The auditors should work with company management to ensure that the allowance
account and the inventory account are appropriately stated. Further, the auditors should
have a heightened level of professional skepticism when auditing other areas that
requirement estimation and judgment by management.
11-39
Examples of common fraud schemes in the acquisition and payment cycle include:
1. Employeetheftofinventory
2. Inventoryshrinkage,whichisareductionininventorypresumedtobeduetophysicalloss
ortheft
3. Employeeschemesinvolvingfictitiousvendorsasmeanstotransferpaymentsto
themselves
4. Executivesrecordingfictiousinventoryorinappropriatelyrecordinghighervaluesfor
existinginventorybycreatingfalserecordsforitemsthatdonotexist(forexample,
inflatedinventorycountsheets,andbogusreceivingreportsorpurchaseorders)
5. Largemanualadjustmentstoinventoryaccounts
6. Schemestoclassifyexpensesasassets(suchasinappropriatelycapitalizingitemsthatare
trulycurrentperiodexpenses)
7. Executivesmisusingtravelandentertainmentaccountsandchargingthemascompany
expense
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11-5
11-40
Nature of the Fraud
WorldCom
Overstatement of
assets and income
Phar-Mor
Overstatement of
ending inventory
Inflation of inventory
costs.
11-41
a.
The auditor is responsible for identifying material fraud. Although the amount of the
fraud may be material to the head bookkeeper, it is most likely not material to the
financial statements as a whole. The auditor is also responsible for maintaining a
skeptical audit approach when control risk is assessed as high. It would appear that the
lack of segregation of duties within the bookkeeping function would lead to a high
control risk assessment.
b.
inadequate segregation of duties with the bookkeeper able to vouch items for payment
and records the disbursement.
the president does not review support for disbursements made when the president was
absent.
the pre-signing of the checks creates an atmosphere whereby a fraud could take place.
it is likely that the bank reconciliation is not performed by someone independent of the
head bookkeeper, or if it is, the individual is not reviewing support for large outstanding
items. In today's environment, it is highly unusual for a large vendor invoice to not clear
the banking system within one month.
c.
Substantive audit procedures that would be effective in uncovering the fraud include:
examination of support for large checks that have not cleared the bank within a month of
year-end.
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11-6
review of vendor statements at year-end showing the amounts outstanding. This would be
effective in connection with reviews of subsequent payments which might lead the
auditor to notice that a payment is being made twice to the vendor. However, such a
procedure cannot be counted on to consistently identify the fraud.
If the auditor is aware of the president's policy of signing the blank checks, the auditor
could review the support for all disbursements to determine their appropriateness and
whether or not the support for the disbursements were properly canceled and reviewed by
the president. This is probably the most effective procedure.
11-42
1. The receiving department electronically scans bar codes on the goods received to record
quantity and visually inspects for quality. (3)
2. Computer-generated purchase orders are reviewed by the purchasing department. (1)
3. Management approves contracts with suppliers. (2)
4. Management reviews payments and compares them to data such as production budgets.
(5)
5. Management requires competitive bids for large purchases. (2)
6. An individual in a position of authority reviews the completeness of supporting
documentation prior to signing a check for payment. (5)
7. A policy exists and is enforced whereby purchase agents are rotated across product lines.
(2)
8. A requisition form is forwarded to the purchasing department by a supervisor. (1)
9. A policy exists and is enforced whereby employees cannot purchase from vendors outside
an authorized vendor database. (2)
10. Controls exist to ensure that only authorized goods are received. (3)
11. Controls exist to ensure that goods meet order specifications. (3)
12. The receiving department prepares prenumbered receiving documents to record all
receipts. (3)
13. A three-way match is made between the invoice, the purchase order, and the receiving
report. (4)
14. Limits on the purchase of inventory can be exceeded only on specific approval by a
manger. (1)
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11-7
b.
c.
Everyone is authorized to issue and file the purchase orders, but there is no
ultimate responsibility.
The shipper's invoice is automatically accepted by anyone in the receiving
function and is forwarded to the controller for recording and subsequent payment by
the purchasing department.
The vendor packing slip is filed without any comparison with goods received.
All goods received are placed in storage by receiving department personnel
without notification of warehouse personnel.
The department head should specify responsibility for the filing of the purchase
orders and those specified should be held accountable for the reliability of the files.
The shipper's invoice should be sent directly to filing personnel who should match the
shipper's invoice and the purchase order. If matched, the shipper's invoice should be
forwarded to the controller.
The vendor packing slip (VPS) should be sent to filing personnel and filed with the
associated purchase order. The goods should be counted by dock personnel who
should prepare an independent, pre-numbered receiving report. The receiving reports
should be accounted for and sent to the filing personnel where it should be compared
with the VPS. If the receiving report and VPS are not the same, the department head
should be notified. If they agree, they should be matched and filed.
Separation between receiving, quality control inspection, and warehousing should be
maintained.
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11-8
When these functions are automated, purchase orders are automatically generated by
inventory control system based on certain parameters. Those parameters should only be
set or changed by someone independent of the receiving and payment functions using
appropriate access restrictions password and ID. Receiving department personnel
should access the purchase order information in the computer in a read-only mode. They
should then scan the barcodes or physically enter the receiving information into the
computer. The vendors invoice may be received electronically or entered into the system
by accounts payable personnel from a paper invoice. The system can then match this
information and schedule a payment date and automatically generate a check to pay the
invoice. The treasury function should control the signature plate used to sign checks or
authorize electronic payment. Access to the purchasing and vendors databases should be
restricted.
d.
Control risk should be set high (maximum) because receiving personnel have access to
the purchase order, the goods ordered, and the vendors invoice. Because of this high
level of control risk, the auditor should have a heightened level of professional
skepticism. The controller receives only the vendors invoice signed by receiving
personnel who could steal the goods and have the company pay for them.
The auditor will need to rely exclusively on substantive tests of related accounts
inventory, cost of goods sold, and accounts payable. The auditor would probably rely
very little on substantive analytical procedures.
The auditor will insist on a complete physical inventory count at or near year-end, will
need to do extended inventory observation and test counts, look for significant
adjustments to the perpetual inventory records, and be more professionally skeptical
when performing analytical procedures such as comparing gross margin percentages by
product line with prior years and industry standards.
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11-9
11-44
The auditor can use cross-sectional analysis to help identify potential inventory misstatements
for a multi-location retail client by calculating inventory per square feet of store space and
identifying stores that appear to be out of line with other similar stores. However, it is important
for the auditor to first develop expectations before going through the analysis. Those stores that
are out of line with similar stores and/or the auditors expectations should be subject to more
extensive testing.
11-45
Analytical procedures are effective in reviewing the trends in account balances by comparison
with previous years or other current independent data. Analyzing common-sized income
statements by comparing current year relationships of expenses to net sales with prior years and
industry information may help identify accounts that need special audit attention.
Examples of effective use of analytical procedures of specific expense accounts include:
comparison of factory supplies expense with production data e.g., cost of goods sold or other
independent measures of production
comparison of cost of goods sold as a percentage of sales over a 5 year period
comparison of sales commission expense with sales
11-46
Panel A of Exhibit 11.7 shows that because of differences in risk, the box of evidence to be filled
for testing the existence of inventory at the low-risk client is smaller than that at a high risk
client. Panel B of Exhibit 11.7 illustrates the different levels of assurance that the auditor will
obtain from tests of controls and substantive procedures for the two assertions. Panel B makes
the point that because of the higher risk associated with the existence of inventory at Client B,
the auditor will want to design the audit so that more of the assurance is coming from tests of
details. Note that the relative percentages are judgmental in nature; the examples are simply
intended to give you a sense of how an auditor might select an appropriate mix of procedures.
11-47
Deloittes auditors made the following errors in substantive analytical procedures for inventory
accounts:
They only observed physical inventory at one-half of one percent of the issuers locations (only
three locations) during the first half of the year, and used those results to develop an expectation
for the year-end inventory balance. Implication: inadequate amounts of audit evidence were
collected, and the expectation was incorrect as a result. The auditor should have had some
rationale for only visiting three locations, and should have done some year-end testing to
determine whether there was reliable evidence that their expectations were appropriate given
year-end balances.
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11-10
They assumed that the inventory balances at all of the issuers locations was similar, when in fact
they were not similar. Implication: assuming that inventory balances are similar but not
documenting evidence to that effect yielded incorrect inferences and expectations in the
substantive analytics.
They did not obtain evidence to allow them to reliably predict that inventory balances from the
first half of the year would be predictive of year-end balances. Implication: If they were unable
to reliably predict year-end balances from the preliminary inventory observations, the
implication is that they auditors should have done some year-end testing.
11-48
ProperOrderingofStepstoTakeWhenObservingaClientsPhysicalInventory:
1. Meetwiththeclienttodiscusstheprocedures,timing,location,andpersonnelinvolvedin
takingtheannualphysicalinventory.
2. Reviewtheclientsplansforcountingandtagginginventoryitems.
3. Reviewtheinventorytakingprocedureswithallauditpersonnel.Familiarizethemwiththe
natureoftheclientsinventory,potentialproblemswiththeinventory,andanyother
informationthatwillensurethattheclientandauditpersonnelwillproperlyrecognize
inventoryitems,highdollarvalueitems,andobsoleteitems,andunderstandpotential
problemsthatmightoccurincountingtheinventory.
4. Determinewhetherspecialistsareneededtoidentify,test,orassistincorrectlyidentifying
inventoryitems.
5. Uponarrivingateachsite:
a.
b.
c.
d.
e.
6.
a.
b.
c.
d.
e.
Meetwithclientpersonnel,obtainamapofthearea,andobtainascheduleofinventory
countstobemadeforeacharea.
Obtainalistofsequentialtagnumberstobeusedineacharea.
Observetheprocedurestheclienthasimplementedtoshutdownreceiptorshipmentof
goods.
Observethattheclienthasshutdownproduction.
Obtaindocumentnumbersforthelastshipmentandreceiptofgoodsbeforethephysical
inventoryistaken.Usetheinformationtoperformcutofftests.
Observethecountingofinventoryandnotethefollowingoninventorycountworking
papers:
Thefirstandlasttagnumberusedinthesection.
Accountforalltagnumbersanddeterminethedispositionofalltagnumbersinthe
sequence.
Makeselectedtestcountsandnotetheproductidentification,productdescription,unitsof
measure,andnumberofitemsonacountsheet.
Itemsthatappeartobeobsoleteorofquestionablevalue.
Allhighdollarvalueitemsincludedininventory.
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11-11
f.
Movementofgoodsintooroutofthecompanyduringtheprocessofinventorytaking.
Determineifgoodsareproperlycountedorexcludedfrominventory.
7. Documentyourconclusionastothequalityoftheclientsinventorytakingprocess,noting
anyproblemsthatcouldbeofauditsignificance.Determinewhetherasufficientinventorycount
hasbeentakentoproperlyreflectthegoodsonhandatyearend.
11-49
a. The auditor makes test counts of selected items and records the test counts for subsequent
tracing into the clients inventory compilation. (2) completeness.
b. The auditor takes notations of all items that appear to be obsolete or that are in questionable
condition; the auditor follows up on these items with inquiries of client personnel and retains
the data to determine how they are accounted for in the inventory compilation. (4) valuation
or allocation.
c. The auditor observes the handling of scrap and other material. (4) valuation or allocation.
d. The auditor observes whether there is any physical movement of goods during the counting
of the inventory. (1) existence or completeness
e. The auditor records all high-dollar-value items for subsequent tracing into the clients
records. (2 & 4) completeness and valuation or allocation.
11-50
Itisacceptabletohavetheclienttakeinventorybeforeyearendprovidedthat:
Internalcontroliseffective.
Therearenoredflagsthatmightindicatebothopportunityandmotivationtomisstate
inventory.
Theauditorcaneffectivelytesttheyearendbalancethroughacombinationofanalytical
proceduresandselectivetestingoftransactionsbetweenthephysicalcountandyearend.
Theauditorreviewstransactionsintherollforwardperiodforevidenceofanymanipulation
orunusualactivity.
11-51
Examples of corroborating evidence include the following:
Notingpotentialobsoleteinventorywhenobservingtheclientsphysicalinventory
Calculatinginventoryturnover,numberofdayssalesininventory,dateoflastsaleor
purchase,andothersimilaranalytictechniquestoidentifypotentialobsolescence
Calculatingnetrealizablevalueforproductsbyreferringtocurrentsellingprices,costof
disposal,andsalescommissions
MonitoringtradejournalsandtheInternetforinformationregardingtheintroductionof
competitiveproducts
Inquiringofmanagementaboutitsapproachtoidentifyingandclassifyingobsoleteitems
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11-12
Monitoringturnoverorageofproductsindividuallyorbyproductlinesandcomparingthe
turnoverwithpastperformanceandexpectationsforthecurrentperiod
Comparingcurrentsaleswithbudgetedsales
Periodicallyreviewing,byproductline,thenumberofdaysofsalescurrentlyininventory
Adjustingforpoorconditionofinventory,reportedaspartofperiodiccyclecounts
Monitoringsalesforamountofproductmarkdownandperiodiccomparisonofnetrealizable
valuewithinventoriedcosts
Reviewingcurrentinventoryinlightofplannednewproductintroductions
11-52
The following are fraud-related substantive procedures for inventory and cost of goods sold:
Observeallinventorylocationssimultaneously.
Confirminventoriesatlocationsthatareoutsidetheentity.
Comparecarryinginventoryamountstorecentsalesamounts.
Examineconsignmentagreementsanddeterminethatconsignmentsareproperlyaccounted
for.
Sendconfirmationstovendorsconfirminginvoicesandunusualterms.
Determineiftherearebulksalesatsteepdiscounts,asthesesalescouldindicatedecreasing
valuesforthecompanysproducts.
11-53
The following are examples of fraud in inventory accounts:
Emptyboxesorhollowsquaresinstackedgoods
Mislabeledboxescontainingscrap,obsoleteitems,orlowervaluematerials
Consignedinventory,inventorythatisrented,ortradedinitemsforwhichcreditshavenot
beenissued
Inventorydilutedsoitislessvaluable(forexample,addingwatertoliquidsubstances)
Alteringtheinventorycountsforthoseitemstheauditordidnottestcount
Programmingthecomputertoproducefraudulentphysicalquantitytabulationsorpriced
inventorylistings
Manipulatingtheinventorycounts/compilationsforlocationsnotvisitedbytheauditor
Doublecountinginventoryintransitbetweenlocations
Physicallymovinginventoryandcountingitattwolocations
Includingininventorymerchandiserecordedassoldbutnotyetshippedtoacustomer(bill
andholdsales)
Arrangingforfalseconfirmationsofinventoryheldbyothers
Includinginventoryreceiptsforwhichcorrespondingpayableshadnotbeenrecorded
Overstatingthestageofcompletionofworkinprocess
Reconcilingphysicalinventoryamountstofalsifiedamountsinthegeneralledger
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11-13
Manipulatingtherollforwardofaninventorytakenbeforethefinancialstatementdate
Even a professionally skeptical auditor might fall victim to a client that is perpetrating these
types of fraud because of the following:
While inventory fraud is relatively common, any individual auditor may have very little
experience with such a thing in terms of first-hand knowledge at their own client.
If the auditor did not trust the client, or thought that an inventory fraud was happening, the
auditor would not have accepted or continued to provide auditing services for that client.
Therefore, by very definition that the audit is being conducted means that the auditor at some
level trusts the client.
Auditors, just like all people, tend to think it wont happen to me!. In other words, while
auditors know that fraud happens, they tend to think that it will happen on someone elses
client.
11-54
1. Request vendors monthly statements or send confirmations to major vendors requesting a
statement of open account items. (b)
2. Review the clients financial statement disclosures of accounts payable and expense accounts
such as travel and entertainment. (e)
3. Use GAS to verify mathematical accuracy of accounts payable, or agree to the general ledger.
(d)
4. Examine a sample of cash disbursements made after the end of the year to determine whether
the disbursements are for goods and services applicable to the previous year. (b)
5. Perform a cutoff test of purchases and cash disbursements. (a)
6. Perform analytical review of related expense accounts, for example, travel and entertainment
or legal expenses. (b)
7. Review long-term purchase commitments, and determine whether a loss needs to be accrued.
(c)
8. Agree monthly statements and confirmations from major vendors with the accounts payable
list. (b)
11-55
By examining cash disbursements after year end, the auditor sees payments that were made on
account. The question, then, is one of timing. The auditor needs to determine whether those
payments were for items purchased in the prior fiscal year or the current fiscal year. By
determining the appropriate cut-off date, or the date that the client took ownership of the items,
the auditor can determine whether or not accounts payable was completely recorded in the prior
fiscal year.
11-56
a.
The unusual thing about the journal entry is that an expense is credited and a reserve
account is debited; usually expenses are debited and reserves are credited.
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11-14
b.
Yes, management would likely have had some explanation to provide an inquisitive
auditor. After all, management knows that the auditor may find such an entry, and so will
not simply admit to the fraud! Rather, management will try to convince the auditor that
the entry has some plausible explanation.
c.
11-57
The information is used in performing year-end cut-off tests. All shipping or receiving
documents with higher numbers should be recorded in the next period and all receipts or
shipments with smaller numbers should be recorded in the current period. As an example, the
auditor could review the first few days of sales recorded after year-end to determine if the
shipping document supporting the sale is numbered before 8702. Similarly, the last few days'
sales in the current period could be examined for shipping documentation. If any recorded sale is
supported by a shipping document with a number greater than 8702, it would indicate next year's
sales being recorded as current year sales.
11-58
The major question associated with the increased automation of production is whether direct
labor hours remains an appropriate basis for allocating factory overhead to products. An
understanding of the production process should be obtained to determine whether labor costs or
some other basis best reflects the use of overhead in producing products. As an example, many
organizations keep track of machine hours and believe that is the most appropriate basis for
allocating overhead to products. The auditor needs to understand the cost centers used to
accumulate and allocate costs.
11-59
The auditor should not comply with the client's request. Auditors should not inform
management about which warehouse locations they will visit. If the auditor does so, the client
may make sure that the particular warehouse inventory is correct, even when it would normally
not be correct. In addition, the client could move inventory to that warehouse to overstate ending
inventory, which is a common fraud. The request should therefore heighten the auditors
professional skepticism. However, on some audits providing this information to the client may be
necessary for planning purposes. In those situations, the auditor may also choose to conduct a
surprise count at one or two locations. Regarding the second request, the inventory observations
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11-15
represent an independent source of evidence to be used by the auditor to reach a judgment about
the quality of the client's inventory compilation. The auditor's inventory test counts will be traced
to the client's final inventory compilation to determine that all items have been properly
recorded. If the client were to share the observations with the controller, the controller could use
the data to ensure that all items reviewed by the auditor were correctly recorded. The evidence
developed by the auditor would not be useful in assessing the overall reliability of the inventory
count, so the auditor should be skeptical about why the controller is requesting the information.
11-60
The auditor could take a sample of each type of fuel included in the client's inventory to an
independent testing laboratory to verify the client's identification of the product.
11-61
Audit procedures that might be used to identify obsolete or slow-moving goods include:
review of industry trade journals to gain knowledge of new product introductions and the
relationship of the new products to existing products.
calculation of inventory turn-over on a product-line or individual product basis.
calculation of number of days sales in inventory. This could be compared with previous
years to determine trends.
potentially obsolete or defective goods should be noted during the observation of the
client's physical inventory procedures.
inquire of marketing management as to plans to close-out product lines or individual
products.
inquire of production and warehouse management of their awareness of obsolete or slow
moving inventory.
age inventory items according to date of last use or sale and inquire about those that have
not been used or sold for an unusual length of time.
examination of catalogs or sales after year-end indicating product close-outs.
11-62
GAS can be used to help identify potentially obsolete inventory by:
11-63
An auditor makes a number of test counts and other observations during the observation of the
client's physical inventory. The objectives of the auditor's counts and observations are to:
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11-16
verify that all goods were correctly counted, identified, and recorded.
provide independent evidence to trace into the client's inventory compilation to ensure
that the compilation of inventory is correct.
11-64
A number of financial disclosures are required for inventory:
inventory valuation method used (FIFO, LIFO, moving average) and the percentage of
inventory valued under each method
purchase commitments that could have an adverse effect on future financial results
The auditor reviews the client's inventory footnote for completeness and accuracy. Most of the
information described in the notes will be independently verified by the auditor in the process of
completing the audit and the data will be contained in the audit documentation. See Exhibit 11.10
for an example of this disclosure from Ford Motor Company.
11-65
The two primary alternatives for gaining assurance about the correctness of a client's perpetual
inventory system include:
taking a random sample of perpetual inventory records and verifying the correctness of
the records by physically observing and counting the inventory.
observing the client's taking of a complete physical inventory and adjusting the perpetual
inventory records to the physical counts.
The auditor will also test the debits and credits made to the perpetual records throughout the year
to provide additional evidence on their accuracy.
11-66
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11-17
Audit Procedure
a. Audit Objective and Assertion
1. Examination of subsequent 1. Completeness of the recorded liability
payments and open accounts (search for understatement of the
payable file.
accounts payable liability.)
b. Type of Test
1. Primarily a
substantive audit
procedure.
2. Test of the
operation of control
procedures.
3. Both a substantive
test and a test of
operation of control
procedures.
4. Primarily a test
that provides both
substantive evidence
and operation of
control procedures
evidence.
5. Primarily a test of
the operation of
controls. Provides
limited substantive
evidence.
6. Primarily a test of
control operations,
but also provides
substantive audit
evidence to be used
in connection with
year-end inventory
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11-18
Audit Procedure
b. Type of Test
adjustments
7. Analysis of scrap by
product line.
7. Both a test of
operation of controls
and substantive test.
8. Primarily a
substantive audit
procedure to identify
excess inventory.
11-67
a.
The major purpose served by observing the physical inventory count is to test the
existence assertion. In addition, the actual observation can provide the auditor with
insight on the extent of damaged goods, obsolete goods, movement of goods, returned
goods, and so forth that cannot be obtained without actually getting out into the factory,
store, or distribution center and observing the goods. This insight will help the auditor in
testing the valuation assertion.
b.
Items that should be noted by the auditor on the inventory observation workpaper
include:
the starting tag number, voided tags, missing tag numbers, and the last tag number used
for each geographic area or location where inventory is observed.
the adequacy of the physical counting process, including the quality of supervision and
the completeness of the process.
the correct identification of products. The auditor should note down both a description of
the product and the product number.
the condition of the inventory item. The auditor should note whether or not the physical
condition of the merchandise might raise questions about potential obsolescence.
returned goods, or goods that have been designated for special purposes.
consigned goods.
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11-19
c.
If the client takes a complete physical inventory, the auditor will have an opportunity to
view the entire inventory and to make judgments about the completeness of the counting,
the condition of the inventory, the general lay-out of the warehouse, etc. as a basis to
identify goods and determine potential obsolescence.
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11-20
11-68
A high risk client has been identified. Given the situation, there is management motivation to
understate expenses and accounts payable. Further, the control environment is poor and the
auditor may not want to place much reliance on the internal controls. Accordingly, the auditor
will take a primarily substantive approach towards the audit, with great reliance on tests of
details rather than substantive analytical procedures. The audit approach should be developed
with a high degree of professional skepticism. Given that there is a heightened risk of fraud
related to accounts payable and purchases, the auditor will want to consider performing the
following procedures or, if the procedures are already being performed, altering the timing and
extent of the procedures.
11-69
a.
The accounts payable assertions are the same as the assertions used in testing all account
balances. The major difference is on emphasis: the work on accounts payable usually
focuses on potential understatement of the liability account, which suggests a focus on
the completeness assertion.
b.
Mincin is not required to use accounts payable confirmations. Many auditors prefer not to
use accounts payable confirmations because they believe they can obtain convincing
evidence by examining vendor monthly statements, payments made subsequent to yearend, and examining open accounts payable files. However, those procedures may be less
effective when:
the company does not have adequate control procedures to ensure that all items will
be identified or paid on a timely basis.
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11-21
c.
11-70
The legal expense account is reviewed in detail because the billings by law firms may contain
information on litigation (and related liabilities) that should be disclosed or recorded in the
financial statements. The types of items contained in the legal billings may lead the auditor to
further investigate particular areas for unrecorded liabilities.
11-71
Travel and entertainment expense may contain costs that are of a personal nature rather than
having a legitimate business purpose. In such cases, such costs are likely to be disallowed as
expenses for income tax purposes and may be an indication of a lack of integrity of those for
whom the costs are being paid. This will have a negative influence on the tone at the top.
Contemporary and Historical Cases
11-72
a.
Schwartzhoffs primary incentive appears to have been monetary in nature, reflecting the
desire to achieve his bonuses despite the decline in profitability that Dutchmen was
experiencing due to increases in inventory costs. In terms of opportunities, the lack of
oversight, lack of appropriate personnel from the delay in hiring a controller, and lack of
segregation of duties appear to have enabled Schwartzhoff to have committed the fraud
undetected for so long. Speculating on rationalization, it may be that Schwartzhoff felt
justified in conducting the fraud because the increasing inventory costs were outside his
control, and so despite his performance he would have earned lower bonuses if he did not
commit the fraud. Of course, it is impossible to know with certainty from the SEC filings
what his true rationalization was, so student responses to this part of the question will
vary and might be interesting to discuss in class.
b.
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11-22
Dutchmen. However, Deloitte auditors may not have focused to a large extent on
Dutchmen because it was just one of fifteen subsidiaries of Thor. Thus, it is possible that
the auditors viewed Dutchmens results as relatively immaterial to the financial
statements as a whole.
c.
Substantive analytics that compared cost of goods sold over time and to industry
competitors would have yielded insights that cost of goods was understated and that
inventory costing increases had not been properly reflected. The auditors could have also
observed inventory counts, and conducted tests of valuation such as tests of the standard
costing system. The auditors could have also conducted tests of controls and would have
realized the important deficiencies in oversight and segregation of duties.
11-73
a. Inherent risk factors: plans to make a public offering of stock, weak profitability, weak
market position in relation to large competitors
Control risk factors: lack of competence in the finance department, which implies a weak
control environment overall, and low quality inventory control procedures
Fraud risk factors: unexplained increases in gross margin, when competitors are experiencing
stable margins
b. Why might KPMG audit personnel have lacked professional skepticism? Of course, we can
only speculate. But some possibilities are as follows:
Ace Hardware was a privately held company, so the litigation risk associated with the
engagement was not as high as if Ace was publicly traded. Perhaps the misstatements
were detected as part of the companys progression toward a public offering of stock.
Ace does not appear to have had any significant other problems during the period, so the
audit may have been viewed as relatively low risk.
11-74
a. Inherent risk factors: a high technology company in a competitive industry, results of
communication to analysts about margins created significant pressure on management to
achieve those margins
Control risk factors: lack of oversight of finance department personnel, particularly those
involved in critical accounting adjustments
Fraud risk factors: aside from the pressure on management to achieve margins, there was
little indication of fraud. However, in terms of incentives and rationalization, Periolat may
have felt tremendous pressure from the directives of the CEO and CFO relating to the
unmitigated disaster and figure it out email communication. Thus, tone at the top to
achieve results may have contributed to the fraud.
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11-23
b.
The most important substantive procedure that the auditor would have used to detect the
fraud is a review of manual adjusting entries to inventory-related accounts. Substantive
analytics would be ineffective in this case because the main purpose of the fraud was to
keep margins in line with previous quarters. Unless the auditor developed preliminary
expectations that margins would decline, the auditor would assume that no problems
existed given the stable margins that VeriFone reported.
11-75
a.
The PCAOB was concerned because Grant Thornton clearly did not perform sufficient
appropriate substantive procedures related to aspects of the clients inventory accounts.
While it is appropriate to use substantive analytical procedures as the primary approach
for testing some accounts, it appears that the PCAOBs concerns were that the auditors
performance of these procedures was inadequate. When analytical procedures are
performed as a substantive procedure they need to be more precise than when they are
performed as a preliminary analytic. Precision could be improved through being more
accurate in the expectation development, possibly through disaggregating the data, or in
setting the threshold level. Further, it appears that there were significant differences
between the auditors expectations and what management had recorded. When that
occurs the auditor should develop reasons (hypotheses) for the differences, inquire of
management regarding possible reasons, and then obtain corroborating evidence to
support managements explanations. It is not appropriate to just accept managements
explanations without sufficient corroborating evidence; doing so indicates a lack of
professional skepticism.
The PCAOB is also concerned because the auditor did not obtain sufficient evidence to
support the clients valuation assertion related to inventory. When management makes
determinations regarding inventory obsolescence, management has to make a number of
assumptions (for example, is there still a market for the product, has a competitors
product affected the price at which our inventory can be sold, etc.). The auditor has a
responsibility to assess the reasonableness of these assumptions. The auditor cannot just
take them and accept them at face value. If the inventory is overvalued on the balance
sheet, it may affect users decisions based on the financial statements. And given that any
additional write-down could negatively affect the clients bottom line the PCAOB seems
to have just cause for concern.
b.
In Step One, the auditor structures the problem, considering the relevant parties to
involve in the decision process, identifying various feasible alternatives, considering how
to evaluate the alternatives, identifying uncertainties or risks, and determining how to
structure the problem. To illustrate these tasks, the audit engagement team should have
structured the problem to address the clients valuation/obsolescence estimates, and the
teams own independent valuation/obsolescence estimates. Further, the team should have
structured the evidence gathering in such a way that it would comply with the
professional auditing standards.
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11-24
First, consider the issue related to possible obsolete inventory. If the inventory valuation
required specialized knowledge the team should have consulted with valuation specialists
within Grant Thornton, or should have hired outside experts in valuing the inventory. If
specialized knowledge was not required, the audit team should have designed the audit so
that an appropriate assessment of managements assumptions regarding inventory
obsolescence was made. The team should have identified various alternatives, including
that (1) the clients valuation is correct and no write-down is necessary, or (2) the clients
valuation is incorrect, and a write-down is necessary. The team should have identified the
risks, primarily that the inventory would be over-valued on the balance sheet.
With respect to the performance of substantive audit procedures used to test raw materials
and the labor and overhead components of inventory, the team should have structured the
problem to provide evidence sufficient evidence that met the requirements of the
professional auditing standards. The team should have identified various alternatives,
including that (1) the clients valuation of raw materials and the labor and overhead
components of inventory is correct and no adjustment is necessary, or (2) the clients
valuation of raw materials and the labor and overhead components of inventory is
incorrect, and an adjustment is necessary.
In Step Two, the auditor assesses the consequences of the potential alternatives.
Considerations at this stage include determining the dimensions on which to evaluate the
alternatives and considering how to weight those dimensions. In this case, the alternatives
are that the clients inventory is properly valued or that it is not. The dimensions on which
to evaluate the alternatives include valuation estimates and considerations of appropriate
auditing substantive auditing procedures.
In Step Three, the auditor assesses the uncertainties in the situation. For example, the
auditor tries to assess the likelihood of various consequences associated with potential
alternatives. Some consequences are more likely than others, and some are more costly
than others. In this case, the primary uncertainty is whether some portion of the clients
inventory is obsolete and whether the clients valuation of raw materials and the labor and
overhead components of inventory is correct
In Step Four, the auditor evaluates the alternatives against some decision rule. For
auditors, decision rules are often articulated in terms of professional auditing standards.
In our example, the primary criterion is simple: follow the professional auditing standards
and gather sufficient competent evidence to assess whether the clients inventory
valuation assertion is materially correct.
In Step Five, the auditor considers the sensitivity of the conclusions reached in steps two,
three, and four to incorrect assumptions. For example, in this case, the assumptions
involve uncertainty estimates of the valuation of inventory can it be sold, at what prices
can it be sold, etc.? What are the assumptions that management made and are they
reasonable?
In Step Six, the auditor gathers information in an iterative process that affects
considerations about the consequences of potential alternatives and the uncertainties
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11-25
associated with those judgments. Importantly, the auditor considers the costs and benefits
of information acquisition, knowing that gathering additional evidence requires time,
effort, and money. Given that audits are a for-profit enterprise, cost-benefit considerations
in evidence gathering are particularly important. A good auditor knows when to say when
and decides to stop collecting evidence at the right time. In contrast, some auditors stop
evidence collection too soon, thereby yielding inadequate evidence on which to make a
decision. Still others continue evidence collection even though the current evidence is
adequate, thereby contributing to inefficiency and reduced profitability in the audit. In
this case, it appears that for whatever reason the audit team stopped evidence collection
too soon. The substantive analytical procedures were not sufficient; the assessment of
managements judgment related to inventory obsolescence was not sufficient. These
shortcuts likely caused the PCAOBs objection. Further evidence collection is clearly
needed to support or refute the clients valuation of inventory.
The auditor iterates through steps one through six repeatedly until satisfied that a decision
can prudently be made.
In Step Seven, the auditor needs to make the difficult determination of whether they have
sufficiently analyzed the problem, and whether the risk of making an incorrect decision
has been minimized to an acceptable level by collecting adequate, convincing evidence.
Ultimately, they must make and document the decision that they have reached.
11-76
a, d
Deficiency
1. Extent of observation was
left to the discretion of
individual auditors.
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11-26
Deficiency
4. Comparative inventory
schedule shows significant
increases from previous
years.
d. This is an instance in
which the auditor did not
exercise appropriate
professional skepticism
regarding the clients
explanation.
5. Pre-numbered purchase
orders and shipping
documents were not used by
CMH.
This is a signal that the client either counted inventory after the
auditor left, the auditor did not observe all inventory, or the client
created fictitious inventory counts. The auditor should have
immediately went back to the warehouse and attempted to
identify inventory with the tags on them. Lacking the ability to
identify the inventory, the auditor should insist on either a recount of the inventory, or should consider withdrawing from the
engagement.
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11-27
7. Invoices were not available The auditor inappropriately relied on catalogs and price lists.
to support price tests.
Neither piece of evidence is persuasive that the inventory was
actually purchased at the price specified. If the auditor cannot
d. This is an instance in
identify an invoice for the particular inventory contained in the
which the auditor did not
price test, the auditor should classify the item as a 100% error
exercise appropriate
which should be projected to the population as a whole. The lack
professional skepticism
of documentation should have made a skeptical auditor alert to
regarding the clients
the problems.
explanation.
b.
Due to significant time pressures at year-end, or the difficulty of simultaneously observing
inventory at multiple locations, it is not unusual for auditors to be assigned to the inventory
observation who are relatively unfamiliar with the client and the client's products. At a minimum,
the following information should be communicated to the auditors:
the overall risk assessment for this client and the particular risks that are associated with the
inventory.
the nature of the client's inventory, the type of products, signs of obsolescence that may be
apparent in the products, the types of products that are the `big ticket' items, and the overall
materiality of inventory at the location being observed.
a description of the client's inventory taking procedures and the key personnel with whom the
auditors will be working.
specific instructions on obtaining information about tag control, making test counts,
obtaining cut-off information, writing down large dollar items, and so forth.
c.
When management integrity is questioned, the auditor has to approach all aspects of the audit
with a high degree of professional skepticism, or the auditor should resign from the audit
engagement. This would imply that the level of tolerable misstatement for observing the client's
inventory would be set low and the auditor would pay extra attention to detail, such as obtaining
tag control, making numerous test counts (not shared with management), writing down all large
dollar value items, and ensuring that adequate evidence is gathered to assist in performing yearend cutoff tests.
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11-28
d.
e.
In Step One, the auditor structures the problem, considering the relevant parties to involve in
the decision process, identifying various feasible alternatives, considering how to evaluate the
alternatives, identifying uncertainties or risks, and determining how to structure the problem. To
illustrate these tasks, the auditor at the inventory observation should identify the risks associated
with not having the appropriate knowledge or skills to complete the inventory observation task.
Toward that end, the auditor should have identified the risks, primarily that the inventory assets
could be overstated (or even understated) if the measurements were not correct.
In Step Two, the auditor assesses the consequences of the potential alternatives.
Considerations at this stage include determining the dimensions on which to evaluate the
alternatives and considering how to weight those dimensions. In this case, there are two potential
alternatives. One the one hand, the auditor can conduct the inventory observation with her
current knowledge and skills. However, given the risks already identified, the auditor may want
to take additional steps with respect to evidence collection. For example, the auditor should have
contact information for others on the audit team with experience at the client. The auditor may
not want to make this decision on her own, but may need to contact a more experienced audit
team member for advice on how to proceed. The most relevant issue is taking action to ensure
that the inventory observation is useful in determining that the amount recorded as inventory in
the financial statements is materially correct.
In Step Three, the auditor assesses the uncertainties in the situation. For example, the auditor
tries to assess the likelihood of various consequences associated with potential alternatives.
Some consequences are more likely than others, and some are more costly than others. In this
case, the primary uncertainty is whether the auditor has the ability to take an inventory
observation that is useful in determining that the amount recorded as inventory in the financial
statements is materially correct. If the auditor is unsure of how to use the measurement tools or
unsure of the type of inventory there is a heightened risk that the inventory account could be
misstated on the companys financial statements.
In Step Four, the auditor evaluates the alternatives against some decision rule. For auditors,
decision rules in terms of how to conduct various audit procedures are often articulated in terms
of the professional auditing standards. If the auditor at the inventory observation does not believe
that she can fulfill her professional responsibilities she will need to take steps to ensure that these
responsibilities are fulfilled.
In Step Five, the auditor considers the sensitivity of the conclusions reached in steps two,
three, and four. For example, the auditor should realize that specialized knowledge is likely
necessary for successfully completing the inventory observation. In Step Two she has identified
approaches that can be taken to help ensure that the specialized knowledge is obtained (through
contacting someone on her team and/or through collecting additional evidence that can be further
used to substantiate the results of her inventory observation.
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11-29
In Step Six, the auditor gathers information in an iterative process that affects considerations
about the consequences of potential alternatives and the uncertainties associated with those
judgments. Importantly, the auditor considers the costs and benefits of information acquisition,
knowing that gathering additional evidence requires time, effort, and money. Given that audits
are a for-profit enterprise, cost-benefit considerations in evidence gathering are particularly
important. A good auditor knows when to say when and decides to stop collecting evidence at
the right time. In contrast, some auditors stop evidence collection too soon, thereby yielding
inadequate evidence on which to make a decision. Still others continue evidence collection even
though the current evidence is adequate, thereby contributing to inefficiency and reduced
profitability in the audit. In this case, the auditor will want to take steps to help ensure that she
has sufficient evidence to support the existence and valuation assertions related to inventory. The
auditor in this case will certainly wish to speak to her immediate superior to describe the
situation and to get approval on the steps she is taking.
The auditor iterates through steps one through six repeatedly until satisfied that a decision can
prudently be made.
In Step Seven, the auditor needs to make the difficult determination of whether they have
sufficiently analyzed the problem, and whether the risk of making an incorrect decision has been
minimized to an acceptable level by collecting adequate, convincing evidence. Ultimately, she
must make and document the decision that she reached.
Application Activities
11-77
a.
CEO: Bernard Ebbers. He likely knew of the fraud, and put massive pressure on the CFO and
Controller to make the numbers that the analysts expected. He took huge loans from the
company and had large debts; he lacked detailed oversight of the company and mainly focused
on the acquisition process. He is currently serving a 25 year prison sentence.
CFO: Scott Sullivan. He was the primary driver of the fraud and ordered David Myers to make
the journal entries necessary to perpetrate it. He served 4 years of a 5 year sentence in prison.
Controller: David Myers. He acquiesced to Sullivans mandate to make the fraudulent journal
entries. He served 1 year and one day in prison.
Director of Internal Audit: Cynthia Cooper. She uncovered the fraud and ultimately revealed it to
the audit committee. She has not been able to find employment as an internal auditor since the
time she revealed the fraud, but she was named one of Time Magazines people of the year and
has since published a book about the ordeal, along with conducting significant public speaking
engagements.
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11-30
Ultimately, she went to the Audit Committee with evidence about the fraud, and they acted
swiftly to terminate the employment of Scott Sullivan.
d. Arthur Andersen. WorldCom was a massive client for the audit firm overall, and certainly the
most important public company in Mississippi. Like Enron, it appears that Andersen auditors
looked the other way even when alerted to the fraud by Cooper so that they would not
jeopardize the relationship between top management and the audit firm.
11-78
This case is useful for generating class discussion. One example that the instructor can use is
located at: http://www.hhcpa.com/blogs/non-profit-accounting-services-blog/local-fraud-in-thenews-ficticious-vendor-scheme/
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11-31
11-79
a.
Ratio
Kohls
Dollar General
2011: 38%
2010: 38%
2009: 38%
2011: 3.63
2010: 3.74
2009: 3.65
2011: 100
2010: 98
2009:100
Williams
Sonoma
2011: 39%
2010: 39%
2009: 36%
2011: 4.09
2010: 4.15
2009: 4.29
2011: 89
2010: 88
2009: 85
Gross margin %
(gross
margin/sales)
Inventory turnover
(COGS/ending
inventory)
Days sales in
inventory
(365/inventory
turnover)
Accounts
payable/current
liabilities
2011: 48%
2010: 41%
2009: 50%
2011: 38%
2010: 70%
2009: 69%
2011: 70%
2010: 70%
2009: 69%
2011: 32%
2010: 32%
2009: 31%
2011: 5.03
2010: 5.02
2009: 5.33
2011: 73
2010: 73
2009: 68
b.
Gross margins are similar between Kohls and Williams Sonoma. Management attributes the
increase in gross margin for Williams Sonoma between 2009 and 2010 to improved efficiencies
in the supply chain and to a shifting focus more towards internet sales. The margins of Dollar
General are stable, and predictably lower than the two higher-end retailers. Inventory turnover
(days sales) for Kohls is slower (longer) than the other two retailers, and given the trendy nature
of inventory at Kohls, inventory valuation and potential write-downs should be an audit focus.
Accounts payable as a percentage of current liabilities is moderate for Kohls and Williams
Sonoma, but much higher for Dollar General. The auditor should understand why accounts
payable is so high for Dollar General, and inquire about whether the company is paying in a
timely manner. The significant decrease in accounts payable for Williams Sonoma is significant
and should be investigated.
c.
Kohls: 2011. Based on our assessment, management believes that, as of January 28, 2012, our
internal control over financial reporting was not effective due to the identification of a material
weakness related to our controls over the accounting for leases. To remediate the material
weakness described above, we have implemented remedial measures including a review of all of
our leases to correct instances where we were not complying with generally accepted accounting
principles. In addition, we have developed updated procedures to reflect the technical guidance
for lease accounting and have instituted additional management review to confirm the proper
implementation of accounting standards going forward. Despite the remedial measures that have
been implemented, the material weakness cannot be considered remediated until the applicable
remedial controls operate for a sufficient period of time and management has concluded, through
testing, that these controls are operating effectively. Given the timing of new lease transactions
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11-32
and the length of the typical lease cycle, we did not have a sufficient number of transactions to
test during 2011 to ensure that these controls are operating effectively.
While Kohls has a material weakness in internal controls, it is in a relatively isolated area and
does not reflect a pervasive weakness, such as the control environment. Therefore, it will be
acceptable to rely on substantive analytics, tests of controls, and some substantive testing of
inventory, particularly in terms of valuation given the relative slow turnover in inventory.
Williams Sonoma: No internal control material weaknesses, so relying on substantive analytics
and tests of controls, and less emphasis on substantive tests will be acceptable.
Dollar General: No internal control material weaknesses, so relying on substantive analytics and
tests of controls, and less emphasis on substantive tests will be acceptable.
11-80
a.
The following are pervasive problems that were detected by the PCAOB in its
inspections of Ibarra:
b.
Students answers will vary, but most will likely be surprised that the suspension for the
audit firm and for each of the individual auditors is only temporary and that they can reapply in
two years.
c.
Students answers will vary, but most will likely comment on the repeated nature of the
exact same offenses. In other words, even though the PCAOB reprimanded the auditors in the
first year of the inspection, the auditors in multiple cases completely ignored the reprimand and
went right on conducting low quality audits that clearly violated professional standards in
multiple respects.
11-81
a. The four techniques that companies use to commit inventory fraud are:
Fictitious inventory
Manipulation of inventory accounts
Nonrecording of purchases
Fraudulent inventory capitalization
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11-33
c.
d.
Thecompanyisattemptingtoobtainfinancingsecuredbyinventory.
Inventoryisasignificantbalancesheetitem.
Thepercentageofinventorytototalassetsincreasedovertime.
Theratioofcostofsalestototalsalesdecreasedovertime.
Shippingcostshavefallencomparedwithtotalinventory.
Inventoryturnoverhasslowedovertime.
Therehavebeensignificantadjustingentriesthathaveincreasedtheinventorybalance.
Afterthecloseofanaccountingperiod,materialreversingentrieshavebeenmadetothe
inventoryaccount.
Thecompanyisamanufacturerandhasacomplexsystemtodeterminethevalueof
inventory.
Thecompanyisinvolvedintechnologyoranothervolatileorrapidlychangingindustry.
The issue being addressed is the use of Digital Analysis by auditors in the planning stages
of an audit as part of preliminary analytical procedures. AU 329 requires auditors to use
analytical procedures in planning the extent and type of audit procedures. Analytical
procedures are defined by AU 329 as evaluations of financial information made by a
review of reasonable relationships between among financial and non-financial data.
Digital Analysis focuses on digit and number patterns and is based on Benfords Law.
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11-34
The results of Digital Analysis performed as a part of this research were quite interesting.
Benfords Law was used to develop Digital Analysis tests that were used as part of
preliminary analytical procedures in the audit of annual disbursements of an oil company.
The results indicated that Digital Analysis was useful in providing preliminary tests of
reasonableness.
The data set that was subjected to various tests of Digital Analysis included authorized
invoices and represented 23,736 numbers (data elements) related to purchases.
Test (1) was a test of the first digit and indicated that the frequencies of the first digit
were in line with Benfords Law. This is just a first test of reasonableness and would not
be used solely to determine possible abnormalities. Test (2) was a test of the second digit,
and like the first test is a preliminary test of reasonableness. The testing indicated that the
second digits did conform to Benfords Law. Test (3) was a test of the frequencies of the
first two digits. The analysis indicated combinations that were being overused and
duplications that could be the result of fraud or error. The combinations were 10, 54, 56,
75, and 85. Test (4) was a number duplication test that examines the frequencies of the
actual numbers. Analysis is used to determine the duplications for which auditors need to
determine the reasons for the duplications.
c.
This issue is important to auditors because it provides a high level means of conducting
preliminary analytical procedures to look for areas of interest that may contain
misstatements in accounts that are being audited. Auditors are frequently faced with large
sets of data and it is impossible to review all of the data. However, SAS No 99 has
increased an auditors responsibility in the detection of material fraud. Auditors who are
aware that digits of authentic numbers should confirm to the assumptions of Benfords
Law, can recognize that digit patterns that differ from Benfords Law could represent
fraudulent or erroneous numbers. The ability to use Digital Analysis may help fulfill the
auditors responsibility related to the detection of fraud and/or misstatements.
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Auditors using Digital Analysis during the performance of analytical procedures could
proceed on the assumption that certain categories of numbers, such as inventory counts,
accounts receivable and payable, disbursements and daily sales, should follow Benfords
Law. If a digit pattern that does not follow Benfords Law emerges, data be the result of
fraud or error and suggests the need for appropriate follow up by the auditor. The use of
Digital Analysis can help improve the audit quality by helping the auditor to focus on
areas that may indicate the existence of misstatements.
d.
Digital Analysis tests were completed. The first four tests were performed on data
retrieved from an oil company. An analysis was performed with the Internal Audit
Department. Data included 28,736 invoices authorized for payment by the accounts
payable system. These tests within this case setting included (1) first digits, (2) second
digits, (3) first-two digits, and (4) number duplication.
Test (1) is a reasonableness test that reviews the first digit of a number to determine if
each number is occurring in the first digit place in a reasonable number of instances. The
auditor would do a visual inspection of the returned data to see if it conforms to
Benfords Law.
Test (2) is a reasonableness test that reviews the second digit of a number and follows the
same premise as test (1).
Test (3) is used to narrow down the sample size and checks for frequencies of the firsttwo digit combinations. For example, Benfords Law indicates the combination of 10
should be the most frequent combination, and 99 should be the least frequent result.
Test (4) is a number duplication test that is an extension of test (3) that is used to target
the actual numbers creating the positive peaks. The audit targets are also numbers
occurring at high frequency, large dollar amounts, round numbers, numbers just below
internal authorization limits.
Each test result is compared to a predetermined set of acceptable test data based on
Benfords Law. With the help of a mean absolute deviation and z-statistics an upper and
lower bound value was set for each test to determine if resulting data indicated that
additional auditor follow up was necessary.
The authors also reviewed relevant literature to gain insights on research that had
previously done relative to Digital Analysis.
e.
The student (and practice) should be aware that the research for this paper was limited to
the use of internal audit and internal company data that could not be released. The use of
an external audit setting was unattainable due to strict client confidentiality provisions
and accounting firms not desiring to share detailed audit procedures. The limitation is
minimized due to the fact that internal audit is required to use analytical procedures, and
insights gained in this setting would likely be generalizable to an external audit setting.
Additional research could be conducted to indicate how much additional audit work
would be needed if Benfords Law determined that data sets did not conform. Additional
research could also assess the quality of the audit evidence gained from Digital Analysis.
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a.
The authors examine which audit procedures are perceived to be the most and least
effective for detecting fraud in the stock and warehousing cycle. Additionally, they
explore whether specific auditor traits (i.e., gender, experience level) or firm factors (i.e.,
firm size) are associated with differences in perceptions.
The study is based in Barbados, a small emerging market with a stable open economy.
Registered companies are required by law to receive audits, and certified auditors use
GAAS to examine financial statement conformity with local GAAP. Barbados has also
adopted the Sarbanes-Oxley Act of 2002 as part of auditors regulations.
b.
On a scale of 1-5 (five being most effective), the average rating for all 56 procedures was
3.773. Overall, the audit procedures that were perceived as most effective for detecting
fraud were those associated with direct field work.
21 audit procedures (37.5% of the total) were considered more effective in detecting
fraud in the inventory and warehousing cycle. The most effective procedure overall was
to recount a sample of clients counts to make sure the recorded counts are accurate on
the tags (also check descriptions and unit of count such as dozen or gross).
Nine audit procedures (16.1% of the total) were considered moderately effective. The
highest rated moderately effective procedure was to trace balances of stock (also
known as inventory) listing schedules to the general ledger.
26 audit procedures (46.4% of the total) were considered less effective. The least
effective procedure overall was to test the number of hours needed to manufacture the
product by comparing with engineering specifications.
Significant differences in perceived levels of effectiveness existed between auditors
based on the size of their firm, their age, and their gender.
Auditors from large firms had a significantly different perception on 11 of the 56 audit
procedures, reporting higher means for identifying slow moving/obsolete/damaged items,
discussing with client management, performing cutoff tests, and tracing the vendors
invoice unit costs to the perpetual stock records.
Females and younger respondents (of both genders) tended to be more skeptical
regarding the effectiveness of audit procedures, as males and older respondents ranked
more audit procedures as more effective overall.
Experience level did not result in any significant differences.
c.
The audit procedures deemed as more effective in detecting fraud can be utilized by
auditors in the planning stage in order to have the best chance at detecting fraud early on.
This leaves more time to adapt if fraud is detected, leading to a more effective and
efficient audit. The study suggests that the audit profession should incorporate
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substantially more field techniques into their engagements in order to better detect fraud
in the stock and warehousing cycle.
Audit teams may want to examine the least effective audit procedures to see if theyre
currently practicing any on this list. If so, they may want to reevaluate their approach and
replace those procedures with ones perceived as moderately or more effective when time
is a limiting factor.
Small firms should examine the procedures that larger firms regard more favorably. They
may want to question why they dont share the same view, and if they should (given the
stature of large firms).
Because gender and age lead to different perceptions of confidence in audit procedures,
audit teams may be best served with a mixed group of members to achieve a balance of
over-skepticism v. over-reliance.
d.
e.
The small sample size casts doubt on whether or not the results can be generalized to all
auditors in Barbados. Additionally, accountants in Barbados may have culturally different
attitudes towards risk (such as bigger risk appetite or higher risk aversion) that do not
characterize most American auditors, suggesting that there may be problems generalizing
the results to auditors in other countries.
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Inventory:
All inventories are stated at the lower of cost or market. Cost for a substantial portion of U.S. inventories
is determined on a last-in, first-out ("LIFO") basis. LIFO was used for approximately 28% and 24% of
inventories at December 31, 2009 and 2008, respectively. Cost of other inventories is determined on a
first-in, first-out ("FIFO") basis.
b.
Ford: 3465/6248= 0.555
Toyota: 8917/14857= 0.600
The ratio is very similar, although Toyota holds a bit higher proportion of finished goods in its
inventory. This ratio is important because it can indicate whether stagnant inventory is sitting
unsold. Likely the higher level for Toyota in 2009 reflects difficulties they are experiencing
associated with their product recalls and safety issues during this time period.
This ratio can be calculated at the geographic region or individual product line level to track slow
moving inventory by comparing the ratio across these segments; slow moving inventory would
be indicated by higher levels of this ratio.
c.
Students will, of course, present a variety of possibilities. Some may include the following:
Tracking inventory (by category such as raw materials, work in process, and finished
products) over time, by geographic location, and by product type.
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Decomposing the main ratios related to the acquisition and payment cycle by geographic
region, individual managers/vice-presidents of operations at certain high-risk locations (e.g.,
locations for which controls may be weak), or product line.
Tracking cost increases by region or product line to inventory costing variation that
should occur as a result of those cost increases, i.e., comparing expected to actual results.
Determining whether factory overhead allocations are appropriate, accurate, and in-line
with expectations.
d.
The discovery of defects in vehicles resulting in delays in new model launches, recall
campaigns, or increased warranty costs.
Evidence: Understand management process for estimating warranties and evaluate for
reasonableness; discuss with management their plans for addressing newly identified defects;
understand internal controls surrounding warranties and recall cost calculations.
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A change in our requirements for parts or materials where we have long-term supply
arrangements that commit us to purchase minimum or fixed quantities of certain parts or
materials, or to pay a minimum amount to the seller ("take-or-pay" contracts).
Evidence: Read long-term supply agreements; discuss these arrangements with management
and their understanding as to the downside risks of these arrangements.
e.
The auditor reads the management discussion and analysis section of the 10-K, but the audit
report does not attest to the accuracy of the statements made by management as part of the
normal audit engagement. However, if the auditor becomes aware of inaccuracies in the
management discussion and analysis section, they are obligated to urge the client to correct the
inaccuracies. If management refused to correct an inaccuracy, the auditor is obligated to discuss
the matter with the audit committee.
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ACL
11-85
This is a good problem to use for class demonstration. ACL icons, commands, and equations in
bold. Field names are in FULL CAPS.
Require
Approach
ment
To
Open a new project by choosing File, New, Project or click the New Project
Begin
icon. Name the project Husky Inventory.
Choose the Husky Inventory 2013 file to import. Name the new table Inventory.
a
Objective: Identify items not sold or used in the last six months.
Using the Inventory file, choose ANALYZE, Age, age on LASTSALE. Set the
cutoff date to December 31, 2013. Choose to subtotal EXTCOST. Set the Aging
Periods at 0 and 182. (For raw materials, LASTSALE refers to date of last use.)
Click on the >182 box to see these items.
Print the list.
Results: There are 25 items with an extended cost of $133,414.66 that have not
been sold or used in the last six months. The majority of this cost relates to jet
skis that are very seasonal.
c. i.
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Require
ment
Approach
4. Create a filter with the expression UNITCOST > NRV. .
5. To get a dollar impact of this, right click on the table and choose Add
Columns, Expr and enter the expression (UNITCOST NRV) *
INVQTY. Name the new field WRITEDOWN.
6. Adjust the column widths to get all columns on one page and PRINT the
report.
Result: Products FJ311, FJ312, and FJ313 have NRV less than cost by an
extended difference of $939.39.
c. ii.
Objective: Prepare a report of all finished goods with a turnover less than 2.
1. Using the finished goods file from c. i., right click and choose Add Columns,
Expr and enter the expression NUMBSOLD / INVQTY. Name the new
field Turnover.
2. Choose DATA, Extract Data, If and enter the expression INVQTY > 0.
(This is necessary to eliminate dividing by zero in the next step.) Name the
new file Positive FG.
3. Choose DATA, Extract Data, If and enter the expression TURNOVER < 2.
Name the new file FG Turnover LT 2..
4. Print the list for further investigation.
Results: There are 8 finished good items with a turnover less than 2 with an
extended cost of $884,299.81. Three of these (FM231, FM232, and FT480 make
up $736,141.57 of this total. The three items detected in c. i above that require
writing down to LOCOM (FJ311, FJ312, and FJ313) also have a turnover < 2.
(Note: when dividing a whole number by a whole number, ACL rounds to the
nearest whole number. Therefore, these results may be tainted if there are
turnovers between 1.5 and1.9 that get rounded to 2.)
d. i.
Objective: Check raw material for replacement cost less than cost.
1. Using the Inventory file, choose DATA, Extract Data, If and either enter the
expression FIND(R,SNUMB) or SNUMB = R. Name the new file Raw
Materials.
2. Create a filter with the expression UNITCOST > REPLCOST. .
3. To get a dollar impact of this, right click on the table and choose Add
Columns, Expr and enter the expression (UNITCOST REPLCOST) *
INVQTY. Name the new field WRITEDOWN.
4. PRINT the report.
Results: There are 21items with replacement cost less than cost; the total writedown of cost is $90,103.58.
d. ii.
Objective: Prepare a report of all raw materials with a turnover less than 2.
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Require
ment
Approach
1. Using the Raw Materials file, right click on the table and choose Add
Columns, Expr and enter the expression NUMBSOLD / INVQTY. Name
the new field Turnover.
2. Choose DATA, Extract Data, If and enter the expression INVQTY > 0.
(This is necessary to eliminate dividing by zero in the next step.) Name the
new file Positive RM.
3. Create a filter with the expression TURNOVER < 2. This will list raw
materials that turned less than 2 times during 2013.
4. Print the list for further investigation.
Results: There are 8 raw materials with a turnover less than 2 with an extended
cost of $25,260.30. Six of these were not used in 2013
e.
Report: The report should indicate potential LOCOM problems with FM231, FM
232, and FT480 that have a high value and very slow turnover (see c. ii. above),
the 21 items of raw material with cost less than replacement cost (see d. i above),
and the 8 items of raw materials with a slow turnover (see d. ii above).
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