Discussion Questions (1) There could be various reasons to why the physical count of Lakeside inventory produces a balance that is almost $14000 below the figure indicated by the company’s own perpetual records: Inventory may have been counted incorrectly Company’s inventory may be out on consignment It may be an indication of theft Perpetual records may be in error I. Human error it. FIFO not properly applied Inventory that are damaged or obsolete may be disposed without recording a reduction in the ledgers The cost assigned to each inventory item may have been incorrect Goods in transit may have been recorded incorrectly
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Auditor’s Judgment is required to determine whether the $14000 difference is a material amount. The auditor would need to determine whether $14000 is a reasonable discrepancy for a company that has $1434101. 69 worth of inventory. The difference is worth 10% of the total cost of inventory. The auditor should be mainly interested in the errors found in the counted figure since the perpetual records are adjusted to match with the physical inventory. If Mitchell observed the physical count properly, the chance of error in the quantity of inventory should be very low.
To rather reduce the risk of errors, more tests may be performed (verify the costing, extensions, footings). If it is found that the discrepancy is due to errors in quantity of inventory, auditors may have to recount certain accounts. Auditors may discover that costing variances caused the discrepancy, thus, auditors will have to perform validations for those particular figures instead. (2) Members of a company’s management may attempt to over-count inventory because it can lead to a decrease in cost of goods sold. This will, therefore, increase the net income reported.
Companies may have the incentive to overstate net income o get a loan or a high stock price. Since Lakeside has a profit-sharing plan, management personnel may have the incentive to increase the net income of the company. These personnel will be able to receive a higher bonus, since bonuses are based on the store’s net income. (3) Members of a company’s management may occasionally attempt to under-count ending inventory therefore increase the cost of goods sold. When cost of goods sold is increased, the net income reported for the year will be reduced. This will help the company reduce the payment of income taxes.
Unless management wants to avoid gig taxation, this will not be a significant potential problem for the audit. (4) In the engagement letter prepared by Abernathy and Chapman, the firm stated that it will “obtain reasonable, rather than absolute, assurance that the financial statements are free of material misstatement”. Whether it is the CPA firm’s responsibility for such misstatement, the difference between “reasonable” and “absolute” assurance must auditor. If the material misstatement can be detected by the average prudent auditor then the firm should be considered to be guilty of negligence in performing the audit examination.
The firm will need to provide evidence that the audit examinations were performed at least as well as how an average prudent auditor would have done. If the CPA firm is proven guilty, any losses incurred by Lakeside due to the misstatement can be recaptured from the CPA firm. (5) By observing less than 100% of the physical inventory, auditors will certainly be exposed to some risks. However, about 80% of Lakeside total inventory is at the warehouse, therefore, the possibility of a material problem in the stores’ inventory is relatively low. Moreover, the system of taking the physical inventory is efficient.
The perpetual records also allow auditors to isolate variances at all stores therefore it will not be a hassle to perform a recount or have further testing. To conclude, only observing 2 out of 6 stores is an appropriate decision. (6) By reviewing the client’s sales returns for the period immediately following the end of the fiscal year can help validate the estimation of all subsequent returns. As a method of manipulating net income the client company may record sales in one year with recognition of any subsequent returns being delayed until the following period.
Therefore, auditors should be especially careful when the client company ships out large quantities of inventory at the end of the year. The client company may expect that most of the items will be returned but when shipments are recorded immediately as sales and returns are estimated based on historical data, the company can overstate its current income. (7) By recording the last tag number, Mitchell can prevent against anyone from making falsified tags after her observation. As mentioned in Question 2, over- counting of inventory can be a potential problem to Lakeside. ) Damaged or obsolete inventory items should be the responsibility of Lakeside. The Lakeside memorandum states that its employees should isolate these items before performing the physical count. However, Mitchell has the responsibility of verifying that all the damaged or obsolete items have been isolated and valued correctly. If Mitchell discovers any damaged/obsolete items not isolated, Lakeside will have to provide a reasonable explanation or else the reliability of the physical count will be in doubt. Auditors will need to perform more testing procedures to gather further evidences. 9) Lakeside physical inventory procedures are well designed. It is very important to have perpetual records available for comparison. The procedures are extensive and comprehensive, which allow managers and employees to have a clear understanding. Exercises Lakeside Company Audit Program for Inventory Testing – Warehouse December 31, 2012 Audit program prepared by: Abernathy & Chapman Date: November 19, 2012 Procedure Number Audit Procedure Procedure Performed by Trace the tags recorded by the auditor to the physical inventory listing Paul Reuben (Staff auditor) 2
Verify that no tags are added to the inventor listing beyond the last tag recorded Staff auditors 3. Compare the unit cost indicated on the inventory list with the cost per master price list Staff auditors 4. Verify the extensions on the physical inventory list mathematically Staff auditors 5. Re-foot the inventory listing Staff auditors 6. Compute a cost for the January 1-2, 2012, receiving reports using the master price list and compare this total to the inventory listing for agreement Staff auditors 7. Compute a cost for Jan 1-2, 2012, bills of lading and compare the total to the inventory listing for agreement Staff auditors 8.
Review the inventory list to ensure that all tag numbers are included with no duplications Staff auditors 9. By reviewing Cypress discount announcements, validate monthly discounts included in inventory listing Staff auditors 10. Recalculate the 3% discount taken by Lakeside and match the amount with inventory listing Staff auditors 11. Match the total adjusted cost of inventory to the general ledger at Deck 31, 2012 Staff Case 8 – Exercise 2 Tests of Inventory Listing – Warehouse Audit document No. W. P. F-3 Prepared by: Paul Reuben Reviewed by: Carols Mitchell Reviewed by: Tag No.
Inventory Item Serial Number Quantity Audit Procedures 116 Amplifiers BC-W 124 Televisions 69 102 Cellular Phones CB-S 160 138 Shelf Audio BUFF-R 130 KICK-T 170 150 Speakers YOGA-Y 71 127 AREA-M 142 CD PLAYERS AWRY-X 49 113 Receivers N.B.-X 112 126 JOSH-A 104 DVD Players 92 137 BIFF-G 147 Headphones IPPP-Q 132 CODA-N 121 Audit Objectives: Verify that the physical count agrees with the inventory listing Verify that the inventory cost balance is fairly presented on the listing Scope: Items that were accounted for during the inventory observation in W.
P F-1 and F-2 Audit Procedures: Agree the last tag (152) on the listing to W. P. F-1 Ensure inventory listing footed Make sure the sequence of tag numbers on the inventory listing is correct Traced items to inventory listing make sure the description and quantity matches 0 Traced items from listing to master price list make sure the description and unit cost matches Recalculate extensions on inventory listing Audit Conclusion: The inventory listing is fairly presented. [Continued on next page] Tests of Inventory Reconciliation – Warehouse Amount TOTAL COST OF INVENTORY – 1/3/2013 – WAREHOUSE 1434101. 9 Agree to inventory listing Less: Inventory Received on January 1 January 2 (from Receiving Reports) (13779. 40) Footed Add: Inventory Shipped Out on January 1 and January 2 (from Bills of Lading) 40205. 12 TOTAL COST OF INVENTORY – 12/31/2012 – WAREHOUSE $1460527. 41 Less: Adjustments for Monthly Discounts Given by Cypress Tag 113 – Discount $30. 00 x 85 Items Purchased (2550) Recalculated Tag 121 – Discount $ 8. 25 x 40 Items Purchased (330) Tag 132 – Discount $12. 60 x 60 Items Purchased (756) Tag 146 – Discount $1 1. 50 x 80 Items Purchased (920)
Tag 149 – Discount $ 6. 50 x 35 Items Purchased (227. 50) SUB-TOTAL $1455743. 91 Less: Adjustment for 3% Cash Discount (43672. 32) TOTAL ADJUSTED COST OF INVENTORY – 12/31/20012 – WAREHOUSE $1412071. 59 INVENTORY IN WAREHOUSE PER PERPETUAL INVENTORY RECORDS (1425896. 25) INVENTORY ADJUSTMENT (REDUCTION) $(13824. 66) Verify the inventory balance. Make sure it is reasonable and valid Scope: Reconciliation of physical inventory listing Procedures: Make sure figures are footed, verified by recalculation, agree to the inventory listing, agrees to the total balance.
Tests of Inventory Reconciliation Audit document No. W. P F-3 Receiving Reports Date Item Serial # Receiving Report No. Sty. Unit Cost Total Cost Audit Procedures Jan 1, 13 JABS-H 3988 481 . 87 10601. 14 Jan 2, 13 KICK-K 3989 – Warehouse 9. 95 318. 4 Portable Media Players ROUX-L 10 285. 99 2859. 9 Total 13779. 4 Agreed to inventory reconciliation Bills of Lading Bill NO. Sty Jan 1, 2013 SEXY-R 6015 20 219. 95 4399 Jan 1 , 2013 BOMB-H 812. 35 8123. 5 Jan 2, 2013 BABY-M 6016 256. 98 5139. 6 12 324 3888 CUSS-P 698. 98 6989. 8 AREA-C 6 1318. 87 7913. 22 6017 8 469 3752