SULTHAN HAKIM/ 145020308121003

International Undergraduate Program in Accounting of Brawijaya University

Course: Auditing Laboratory

AUDITING CASES: 8. OBSERVATION OF PHYSICAL INVENTORY COUNT

DISCUSSION QUESTIONS

1. A number of reasons could explain a difference between the physical inventory count
and a company's perpetual inventory records. When faced with any discrepancy such as
this, the auditor should consider all possible causes
The perpetual records may be in error. A large volume of transactions are
processed during the course of a year, and some amount of human error is to be
expected in the recording.
The cost flow assumption (FIFO, in this case) may have been improperly applied
in the perpetual records.
The inventory may have been counted incorrectly by the company. Merchandise
on hand, for example, could have been overlooked.
Inventory might be out on consignment.
Inventory might have been stolen.
Damaged or obsolete inventory may have been disposed of by the company
without recording a reduction in the subsidiary ledger.
Goods in transit could have been incorrectly handled in either the perpetual
records or the physical inventory.
The rollback procedure used to arrive at the December 31 year-end figure may
have been incorrectly applied.
The specific cost assigned to each inventory item might have been incorrect in
certain cases.
The final inventory listing (Exhibit 8-4) may have been extended or footed
erroneously.

The question as to whether the $6,000 difference warrants further attention is subject to
the auditor's judgment. Since the financial records are adjusted to agree with the physical
inventory, the auditor is primarily interested in potential errors contained in the counted
figure. If Mitchell has appropriately observed the taking of the physical count, the
possibility of errors in the quantity of inventory should be at a minimum. Additional
testing, such as verifying the costing, the extensions, and the footings will further reduce
the risk of a material error in the figure to be reported.

The presence of perpetual records adds another dimension to the inventory verification.
By comparing the ending figures from the physical count with the perpetual records, the
auditors can determine whether differences are connected with the quantity or the unit
cost for the individual inventory items. If the $6,000 is primarily created by quantity
 differences, the auditors should consider the need for selected recounts. Conversely, if
the difference is based on costing variances, the auditors will concentrate on
establishing the validity of those particular figures.

A question may be raised by the students as to the reasonableness of a $6,000 difference

between the physical count and the perpetual inventory records. For a company having
$3.5 million in cost of goods sold and a warehouse with over
$650,000 in inventory, this difference is not significant in size even with the use of a
perpetual system. A more important issue would be the composition of the difference. If
a great number of items are not in agreement with the records and simply net to a $6,000
variance, the auditors have reason to be concerned. Conversely, if only a few items
display differences, verification is much easier.

2. An over-count of inventory leads to a decrease in cost of goods sold and, thus, an increase
in reported net income. In any situation in which the company desires a high reported
income (for example, to maintain high stock prices, in anticipation of a loan or a bond
issuance, to reach the level anticipated by a financial forecast, etc.), over-counting of
inventory must be of concern to the auditors. This possibility is especially relevant to the
Lakeside stores because of the profit-sharing plan. The inventory is being counted by the
manager and assistant manager of each store, the same people who receive a bonus based
on that store's net income. Therefore, these employees can increase their bonus for the
current year simply by over-counting the inventory.

3. How An undercount of ending inventory leads to an increase in cost of goods sold and a
decrease in reported net income for the current year. The most obvious reason for a
company to undercount ending inventory is to defer payment of income taxes. A
manipulation of this kind would be especially tempting to a company experiencing cash
flow problems. Other reasons for undercounting inventory may be encountered but are
less compelling than the motive to overcount. One possible incentive is to push earnings
from a very high performance year into the next to smooth out a growth curve and avoid
having to achieve that record again in the following year. In a different vein, if the
company must undergo union contract negotiations in the near future, reporting less net
income might prove to be advantageous. However, little evidence exists in this case to
indicate that Lakeside's management would be tempted to reduce reported earnings
except possibly for the accompanying reduction in current taxes.

4. In the engagement letter prepared by Abernethy and Chapman (see Exhibit 3-1), the firm
stated that it expected "to obtain reasonable but not absolute assurance that major
misstatements do not exist." When a material misstatement goes undetected and is
reported in the client's financial statements, the question to be raised concerns the
difference between reasonable and absolute assurance. In assessing responsibility in such
cases, the public accounting firm is judged against the work of the average prudent
 auditor. The firm must provide proof that the examination was performed at least as well
as would have been done by the average prudent auditor. If a misstatement is missed that
would have been detected by the average prudent auditor, the firm is normally considered
to be guilty of negligence in the performance of the audit examination. In that case, any
losses incurred by the client company resulting from this mistake can be recaptured from
the firm. However, because Lakeside is privately owned, the CPA firm will probably be
liable to third parties for losses only if gross negligence can be proven. Unfortunately,
the distinction between negligence and gross negligence is not clearly delineated by the
courts.

5. A decision to observe less than 100% of the ending inventory always exposes the auditor
to some degree of risk. This risk is based on the possibility that a material misstatement
exists in the inventory not being observed. Three factors would reduce that risk level in
the audit of the Lakeside Company. First, according to the September 30, 2009, trial
balance, the inventory at the warehouse makes up nearly 80% of the total inventory
owned by Lakeside. Thus, the possibility of a material problem in the inventory held at
the stores is limited. Second, the perpetual records enable the auditors to isolate variances
at all stores which can then be subjected to recounts or further testing if necessary. Third,
Lakeside appears to have an efficient system of taking the physical inventory. Unless
Mitchell and her staff spot weaknesses in the actual procedures in use, the efficiency of
this system offers assurance that the count in each store has been accurate.

6. One method of manipulating net income is to record sales in one year with recognition
of any subsequent returns being delayed until the following period. Normally, this
problem is overcome by a year-end adjustment to establish an estimation of all
subsequent returns. As evidence of the validity of this estimation, the auditor will review
any sales returns received at the beginning of the new year. The auditor should be aware
that companies can alter reported earnings significantly by shipping out large quantities
of inventory at the end of a year knowing that most of the items will be returned. If the
shipments are recorded immediately as sales, while the returns are estimated based on
historical data, the company can overstate current income.

7. As indicated in Question (2), above, over-counting of inventory is a potential concern in

any audit but especially so in the Lakeside engagement. Mitchell records the last tag
number as a preventive measure against the preparation of falsified tags subsequent to
her observation.

8. This question can generate debate among students who often expect the auditors to
perform extensive auditing procedures in regard to damaged and obsolete merchandise.
In reality, Mitchell's role is that of an observer; damaged or obsolete inventory is the
client's responsibility. The Lakeside memorandum clearly indicates that company
employees should separate these items prior to the inventory count.

Mitchell will want to verify that all damaged or obsolete inventory items have been
segregated and correctly valued. If she is convinced that such inventory has been
isolated, she needs only to ascertain that the value has been appropriately established by
the company. If Mitchell is not satisfied by the method used to value these items,
 especially if the total is material, she has the option of calling upon an independent
appraiser to assist her in substantiating the valuation process.

A different problem arises if Mitchell discovers any damaged or obsolete inventory that
has not been separated from the rest of the merchandise. Unless the client can provide a
reasonable explanation, this discovery casts doubts on the reliability of the counting
process. Mitchell may then need to extend her testing procedures to search for further
evidence of such inventory.

9. Lakeside's procedures for taking its physical inventory seem well designed especially
since perpetual records are available for comparison purposes. By following the process
outlined in Exhibit 8-1, the company should be able to arrive at an accurate ending
inventory figure.
EXERCISES

1. An audit program designed to verify the inventory listing and the reconciling items
would include steps such as the following
a. Trace the tags recorded by the auditor (Exhibit 8-3) to the physical inventory
listing (Exhibit 8-4), noting agreement as to description and quantity.
b. Verify that no tags were added to the inventory listing beyond the last tag
recorded by the auditor.
c. For each of the inventory items recorded by the auditor, compare the unit cost
indicated on the inventory listing with the cost per the master price list (Exhibit
6-6). Note agreement as to description as well as unit cost. (Note: Students may
choose to select a new sample for this and the remaining tests. The advantages
to using the same sample throughout are that recording on the working paper
may be simplified and efficiency gained.)
d. For each of the inventory items recorded by the auditor, mathematically verify
the extensions on the physical inventory list.
e. Refoot the inventory listing.
f. Using the master price list, compute a cost for the January 1-2, 2010, receiving
reports. Compare this total to the inventory listing for agreement.
g. Using the master price list, compute a cost for the January 1-2, 2010, bills of
lading. Compare this total to the inventory listing for agreement.
h. Review the inventory listing to ascertain that all tag numbers are included with
no duplications.
i. By review of Cypress discount announcements, establish validity of monthly
discounts included in inventory listing. (With the information included in this
case, this step will not be possible for the students to perform.)
j. Recompute the 3% discount taken by Lakeside and compare this amount with
the inventory listing noting agreement.
k. Agree the "total adjusted cost of inventory - 12/31/09" to the general ledger at
December 31, 2009.

2. Attached One technique for approaching this case is to assign Question (1) for one
class period with the working paper to be prepared only after review of the students'
audit programs. This procedure helps to stress the connection between preparing an
audit program, evidence gathering, and developing a working paper. It demonstrates
a continuum from:

establishing the audit procedures to be performed, to

indicating the steps actually taken by the auditor, to
documenting the evidence collected.

In reviewing the audit documents prepared by the students, the instructor should insist
that each specific audit procedure be spelled out along with the results of that testing.
As always, the working paper should be clear and complete, but it must also indicate
the fulfillment of each audit program step.

The attached working paper has been created as an example. It was produced to
correspond with the audit procedures outlined in Exercise (1). In completing this
assignment, procedure (i) has not been performed because the information was not
made available in the case. In addition, the working paper has been prepared under
the assumption that all goods are sold f.o.b. shipping point and all purchases are
acquired f.o.b. destination. These assumptions have been made to simplify the audit
testing, but the students may want to discuss the additional procedures that would be
required if other f.o.b. points had been appropriate.