Solutions to Inventory

1. Solutions to Inventory

2. Problem 17-18, p. 552 The table below shows sales, cost of sales, and inventory data for Aladdin Products Supply Inc., a wholesale distributor of cleaning supplies. All amounts are in the thousands. REQUIRED: Calculate the following ratios: Gross margin as a percentage of sales Inventory turnover List several logical causes of the changes in the two ratios. Assume that $500,000 is considered material for audit planning purposes for 2012. Could any of the fluctuations in the computed ratios indicate a possible material misstatement? Demonstrate this by performing a sensitivity analysis. What should the auditor do to determine the actual cause of the changes?

3. Solution Problem 19-20 • Logical causes of the changes in the gross margin as a percent of sales include: • Selling prices were raised without a corresponding increase in cost of sales. • The method of accounting for inventory was changed, causing a higher ending inventory (more expenses absorbed into inventory) and lower cost of sales. • Inventory cutoff was improper, causing sales to be recorded without the corresponding entry to cost of sales. • The product mix of the company changed. More high markup items were sold than in previous years. • An improper journal entry was recorded that adjusted the gross margin upwards. • Logical causes of the changes in the inventory turnover include: • The increased selling prices that caused the gross margin percent to increase, reduced demand for the product, and decreased the inventory turnover. • The company is building its inventory supply in anticipation of increased sales in the future. • The company’s inventory contains obsolete or unsalable merchandise that is affecting the turnover rate.

4. 26.3%  22.6% = 3.7% increase of gross margin % 3.7% X sales of $23.2 million = $858,000 potential misstatement of sales $17.1 million (2010 COGS)/(7.6 (2011) inventory turnover = $2.25 million $ 2.9 million  2.25 million = $650,000 potential misstatement of inventory Both calculations indicate a potential misstatement exceeding $500,000. • The auditor should discuss the two changes with the client and obtain a reasonable explanation for them. He or she should then perform appropriate procedures to verify the validity of the explanation. Ultimately, the auditor must be confident the change does not result in a misstatement in the financial statements.

5. Problem 17-16, p. 551 Items 1 through 8 are selected questions typically found in questionnaires used by auditors to obtain an understanding of internal controls in the inventory and distribution cycle. In using the questionnaires for a particular client, a ‘yes’ response to a question indicates a possible internal control, whereas a ‘no’ response indicates a potential weakness. • Does the receiving department prepare prenumbered receiving reports and account for the numbers periodically for all inventory received, showing the description and quantity of materials? • Is all inventory stored under the control of a custodian in areas where access is limited? • Are all shipments to customers authorized by prenumbered shipping documents? • Is a detailed perpetual inventory master file maintained for raw materials inventory? • Are physical inventory counts made by someone other than storekeepers and those responsible for maintaining the perpetual inventory master file? • Are standard cost records used for raw materials, direct labour, and manufacturing overhead? • Is there a stated policy with specific criteria for writing off obsolete or slow moving inventory? • Is the clerical accuracy of the final inventory compilation checked by a person independent of those responsible for preparing it? REQUIRED: • For each of the preceding questions, state the purpose of the internal control. • For each internal control, list a test of controls to test its effectiveness. • For each of the preceding questions, identify the nature of the potential financial misstatement(s) if the control is not in effect. • For each of the potential misstatements in part (c), list a substantive audit procedure to determine whether a material misstatement exists.

6. Solution to 17-16

7. Problem 19-22, p. 664, Canadian 11th. Edition You are testing the summarization and cost of raw materials and purchased part inventories as part of the audit of Rubber Products and Supply Corp. There are 2,000 inventory items with a total recorded value of $648,500. Your audit will compare recorded descriptions and counts with the final inventory listing, compare unit costs with vendors’ invoices, and extend unit costs times quantity. A misstatement in any of those is defined as a difference. You plan to use monetary unit sampling. You make the following decisions about the audit of inventory: For items not selected in the sample

8. REQUIRED: • What are the advantages of using monetary unit sampling in this situation? • What is the sample size necessary to achieve your audit objectives using monetary unit sampling? • Disregarding your answer to part (b), assume that a sample of 125 items is selected and that the following differences between book and audited values are identified (understatements are in parentheses). The book or recorded amounts are also shown. For each of the other 116 items in the sample, there was no difference between book and audited values. Based on this sample, calculate the adjusted overstatement and understatement error bounds. Are the book values misstated?

9. Solution Problem 19-22 page 664 • There are two potential advantages to using monetary unit sampling in this situation: • If few errors are found, MUS provides a statistically reliable result. • Dollar impact of errors can be quantified statistically. b. Calculating the Allowable percent misstatement bound or TER A simple calculation as follows: NOTE: TER = (Materiality/Average percent of misstatement assumption)/Population value Note that a lower average percent of misstatement gives a higher TER. This makes sense since the amount of misstatement is lower. This will thus require a smaller sample size. Thus for Upper Bound: (24,000/0.5)/648,500 = 0.074 For Lower Bound: (24,000/1.00)/648,500 = 0.037 Note that 62 and 140 sample sizes have to be interpolated from the table on slide 14

10. c. Misstatements Percentage Misstatement Bounds Read along the row of 125 sample size on the first table (5% ARACR)

11. * Note the descending order of the actual misstatements Determination of Initial Upper and Lower Misstatement Bounds * From table on slide 16 * From table on slide 16

12. Determination of Adjusted Misstatement Bounds 0.154 * (648,500/125) = 799 0.982 * (648,500/125) = 5095

13. Both the adjusted overstatement misstatement bound ($14,593) and the adjusted understatement misstatement bound ($11,725) are less than the tolerable misstatement ($24,000) so you would conclude that the book value is not misstated.

15. TER