Challenges in Auditing Various Business Inventories

1. Problem EP 12-10, Page 679 Consider the following examples of inventories in various businesses: • Pharmaceuticals in a drug company. • Fine chemical compounds in a biotechnical company. • Software in an information technology development company. • New condominium office units in a commercial real estate developer. • Fine art works in an interior design business. Required: For each item, indicate the challenges auditor's would face in trying to count and measure the inventory, and suggest an approach to obtain sufficient appropriate audit evidence.

2. Solution Problem EP 12-10 The question is an exercise in applying knowledge of special business characteristics as they relate to inventory. Should identify the inherent risk of misstatements for each of the different business’s inventory assertion by assertion Use this analysis to indicate where the key audit effort needs to be focussed to obtain sufficient, relevant evidence. Developing specific audit procedures to generate this evidence would also be a useful exercise. Some examples follow: • Pharmaceuticals in a drug company: • inherent risk from identifying different substances that look the same but may differ greatly in value (sugar vs. aspirin) • expert required to examine and identify substances, and measure the quantity based on volume or weight • audit procedures should provide for the expert to provide independent competent identification evidence to auditor, under auditor’s direct control • Fine chemical compounds in a biotechnology company: • inherent risk from identifying different substances ( same as 1) • valuation of deferred development costs, patents, etc. present measurement challenges • examination of costs of research and development by examining supporting documentation, expert may be required to evaluate development viability criteria will be important audit procedures

3. Software in an information technology development company: • inherent risk from assessing the viability of the software being developed • obtaining evidence supporting the probable success of new products, probably based largely on management estimates, testing results indicating operability and feasibility • examination of costs of R&D will be a key audit procedure (similar to 2) • New condominium office units in a commercial real estate developer: • inherent risk mainly from exposure to real estate market price and demand fluctuation, and cost allocations to units • effort examining process for assigning material, labour, overhead costs to units, and examining documents and records supporting the recorded amounts, and assessment of fair valuation of these assets to determine whether any write down is required • audit procedures should include examination of supporting documents, analysis of cost calculations, and analysis of relevant real estate market data to assess fair values. • Fine art works in an interior design business: • inherent risk from valuation, as this is very subjective • expert appraiser may be required if this asset is material and likely to be overstated • audit procedures should examine cost data and management evidence of market values no less than costs, if appraisal values are obtained ensure the expert is providing independent competent valuation information, under auditor’s direct control

4. Problem EP 12-11, Page 679 Li was assigned to work on the audit of A1 Clothing Ltd. Because she has been auditing similar companies for three years and is considered to be knowledgeable about the clothing retailing industry in Canada. Her employer, Bing Pas audited A! in 20X5 for the first time and had difficulty verifying the opening inventory number. This year, in 20X6, Li has the audited ending balance from 20X5, so she does not expect any problems with the inventory account. However, while doing the preliminary work for the audit, she calculated the gross profit margin and was surprised by her findings. Li thinks the gross margin indicates the ending inventory for 20X54 may be incorrect. Required: Explain whether you agree with Li. Support your answer with at least three points. (Adapted from External Auditing AU1, June 2011, with permission of Chartered Professional Accountants of Canada, Toronto, Canada.)

5. SOLUTION to Problem EP 12-11: It is reasonable to agree with Li that the gross margin indicates an error in 20X5 ending inventory. Sales have decreased yet the margin has increased. i.e. More profit per COGS This could be due to cost reductions, but purchases appear to exceed sales (based on the ending inventory), which would be very unexpected. Most likely the ending inventory for 20X5 is overstated (based on the increase in inventory and the likely error in purchases). Calculating gross margin: (Sales – GOGS)/Sales 20X5: (10,000,000 – 7,000,000)/10,000,000 = 0.3 20-X6 (9,000,000 – 5,500,000)/9,000,000 = 0.39

6. Problem EP 12-14, Page 681 During his examination of the inventories and related accounts of Consumer Electronics Inc., a manufacturer and distributor of small appliances, and auditor encountered the following: • Several trucks loaded with finished goods were parked at the shipping dock. The contents of the trucks were excluded from the physical inventory. • The finished goods inventory included high volumes of several products, and many of their cartons were old and covered with dust. In response to the auditor’s questions, the plant manager stated that there was no problem as “all of these goods will eventually be sold, although some price incentives may be necessary.” • While reviewing the complex calculations used to develop the unit production costs of items in finished goods, the auditor noted that the costs of the company’s electrical engineering department had been treated as period expenses in previous years but were included in manufacturing overhead in the current year. • The company installed a new perpetual inventory system during the year. The auditor noted that many of the company’s year-end quantities differed from the actual physical inventory counts. Partly because of these problems, the company took a complete physical inventory at year-end. Required: Describe the additional audit procedures (if any) that the auditors should perform to obtain sufficient appropriate audit evidence in each of the preceding situations. (Adapted from External Auditing AU1, June 2011, with permission of Chartered Professional Accountants of Canada, Toronto, Canada.)

7. SOLUTION to Problem EP 12-14: (a) • The auditor must test the cut-off of sales and accounts receivable at the balance sheet date. • If the items are to be excluded from inventory, the auditor must ensure that sales invoices are prepared and revenues (and related accounts receivable) are recorded in the current year. • But excluding the items from inventory and recording sales in the current year is probably inappropriate since the products have not yet been shipped to customers. • The fact that the trucks were parked at the shipping dock suggests that they belong to the company, not an independent common carrier. As a result, title to the goods would not pass until delivery at the customers’ places of business, and revenue should not be recognized just because the trucks were loaded prior to year-end. (b) • The auditor needs to perform additional tests of obsolescence. • He should examine the perpetual records to determine the dates of production of the questionable items and the pattern of recent sales. • Also, he should verify that the items are sold in the company’s current product line by examination of catalogues, price lists, etc. • In addition, he should verify sales of these items subsequent to year end. • Finally, the auditor must ensure that the goods are valued at the lower-of-cost or market by comparing the carrying cost to the net realizable values of the inventory. In doing so, the PA should discuss with appropriate personnel the size of the price discounts which will likely be required in order to “move” this stock.

8. (c) • The auditor should discuss this apparent change in the method of calculating costs (reclassification of period costs to product costs) with management to determine the reason for the change. • Presumably there must have been a major change in the nature of work done by electrical engineering to justify the change in accounting policy. • The auditor should verify through discussions with engineering personnel and examination of available time records, that the costs charged to overhead actually relate to current production, and not new product development, etc. • Finally, the auditor should calculate the effect of the change in cost calculation upon inventories and net income and consider whether disclosure of the policy change in the final statements is necessary. (d) • The auditor should thoroughly discuss the situation, and its possible implications, with management. • The lack of agreement between the actual goods on hand and the perpetual records may indicate problems in the physical control over inventory items, problem with the perpetual inventory system, or with the conversion to the new perpetual system. • The auditor needs to consider the impact of these system problems on his assessment of control risk. • He should also discuss any specific control problems in his management letter issued at the conclusion of the audit. • However, since the company took a complete physical inventory at year end, as long as the count was done accurately these system and control problems will not directly result in misstatements of balance sheet inventory amounts or recorded costs of sales.

9. Problem DC 12-8, Page 685 You are conducting an audit of the financial statements of a wholesale cosmetics distributor with an inventory consisting of thousands of individual items. The distributor keeps its inventory in its own distribution centre and in two public warehouses. A perpetual inventory database is maintained on a computer system and updated at the end of each business day. Each individual inventory record of the perpetual inventory database contains the following data: • Item number • Location of item • Description of item • Quantity on hand • Cost per item • Date of last purchase • Date of last sale • Quantity sold during the year You are planning to observe the distributor’s physical count of inventories as of a given date. You will have available a computer file, provided by the auditee, of the above items taken from their database as of the date of the physical count. Your firm has a generalized audit software package that can upload and analyze the auditee’s computer data files. Required: List the basic inventory auditing procedures and, for each, describe how the use of the general purpose audit software package and the perpetual inventory database might be helpful to the auditor in performing such auditing procedures Organize your answer as follows:

10. SOLUTION to Problem DC 12-8: