1. Solutions to Inventory Inventory Solution-1

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. 2012201120102009 Sales$23.2$21.7$19.6$17.4 Cost of Sales17.116.815.213.5 Beginning inventory2.32.11.91.5 Ending inventory2.92.32.11.9 REQUIRED: a.Calculate the following ratios: 1)Gross margin as a percentage of sales 2)Inventory turnover b.List several logical causes of the changes in the two ratios. c.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. d.What should the auditor do to determine the actual cause of the changes? Inventory Solution-2

3. Solution Problem 19-20 a.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. b.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. 2012201120102009 Gross margin %26.3%22.6%22.4% Inventory turnover6.67.6 7.9 Inventory Solution-3

4. c.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. d.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. Inventory Solution-4

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. 1.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? 2.Is all inventory stored under the control of a custodian in areas where access is limited? 3.Are all shipments to customers authorized by prenumbered shipping documents? 4.Is a detailed perpetual inventory master file maintained for raw materials inventory? 5.Are physical inventory counts made by someone other than storekeepers and those responsible for maintaining the perpetual inventory master file? 6.Are standard cost records used for raw materials, direct labour, and manufacturing overhead? 7.Is there a stated policy with specific criteria for writing off obsolete or slow moving inventory? 8.Is the clerical accuracy of the final inventory compilation checked by a person independent of those responsible for preparing it? REQUIRED: a.For each of the preceding questions, state the purpose of the internal control. b.For each internal control, list a test of controls to test its effectiveness. c.For each of the preceding questions, identify the nature of the potential financial misstatement(s) if the control is not in effect. d.For each of the potential misstatements in part (c), list a substantive audit procedure to determine whether a material misstatement exists. Inventory Solution-5

6. a. Purpose of Internal Controlb. Test of Control to Test Effectiveness c. Potential Financial Misstatementd. Substantive Audit Procedure 1. To ensure inventory is recorded when received and that payments made are for goods received, and quantities and descriptions are accurate. (Completeness, accuracy, and occurrence) Verify numerical sequence of receiving reports and observe matching invoices received from vendors. Understatement of inventory or payment for goods received. Trace quantity and description on vendor’s invoice to receiving report. 2. To minimize theft or unrecorded disbursement of inventory. (Occurrence) Discussion with client and observation. Overstatement of inventory.Compare physical count to perpetual records. 3. To ensure inventory shipments are recorded as sales. (completeness) Verify numerical sequence of shipping orders. Understatement of sales. Overstatement of inventory. Trace quantity and description on bills of lading to attached shipping orders. 4. For accuracy and current record of inventory. (Accuracy) Examine receiving and requisition documents, and observe maintenance of perpetual records. Misstatement of inventory.Compare physical count to perpetual inventory record. 5. To ensure physical inventory counts are accurate. (Accuracy, existence, and completeness) Observation and discussion with client. Misstatement of inventory.Compare physical count to perpetual inventory record. 6. To assure reasonable costs are used for inventory and cost of goods sold. (Accuracy) Review procedures for determining standard costs. Misstatement of income and/or inventory. Trace costs from supporting documents to development of standards. 7. To ensure obsolete goods are classified as such. (Accuracy) Discussion with client.Overstatement of inventory.Analytical tests of inventory. 8. To make sure inventory compilation is accurate. (Accuracy) Observation and discussion with client. Misstatement of inventory.Reperform clerical tests of inventory compilation. Solution to 17-16 Inventory Solution-6

7. Problem 19-22, p. 664, Canadian 11 th. 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: Tolerable misstatement (same as for upper as for lower)$24,000 Average percent of error assumption - overstatements50% Average percent of error assumption - understatements100% Acceptable risk of incorrect acceptance5% Estimated error rate in the population (EPER used to calculate sample size)0.5 Inventory Solution-7 For items not selected in the sample

8. REQUIRED: a.What are the advantages of using monetary unit sampling in this situation? b.What is the sample size necessary to achieve your audit objectives using monetary unit sampling? c.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. Item No.DifferenceBook Amount 1$19$700 211136 3(19)820 440250 590300 638210 7(90)2,150 870300 9(85)950 Total$74 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. d.Are the book values misstated? Inventory Solution-8

9. Solution Problem 19-22 page 664 Allowable percent misstatement bound (TER)7.4%3.7% Required sample size from the attributes table—5 percent risk of incorrect from table on Slide 14 62140 a.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 Inventory Solution-9 Note that 62 and 140 sample sizes have to be interpolated from the table on slide 14

10. ItemRecorded Accounts Receivable Amount MisstatementMisstatement Divided by Recorded Amount 1.$700$190.027 2.136110.081 3.820(19)(0.023) 4.250400.16 5.300900.3 6.210380.181 7.2,150(90)(0.042) 8.300700.233 9.950(85)(0.089) c. Misstatements Number of Misstatements Upper Precision Limit from Table 13-8 Increase in Precision Limit Resulting from Each Layer (Layers) 00.024 10.0370.013 20.0490.012 30.0610.012 40.0720.011 50.0820.010 60.0930.011 Percentage Misstatement Bounds Read along the row of 125 sample size on the first table (5% ARACR) Inventory Solution-10

11. Overstatements Number of MisstatementsUpper Precision Limit Portion Recorded Value Unit Misstatement Assumption Misstatement Bound Portion (Columns 2 X 3 X 4) 00.024$648,5000.500$7,783 10.013648,5000.3002,529 20.012648,5000.2331,813 30.012648,5000.1811,409 40.011648,5000.1601,141 50.010648,5000.081525 60.011648,5000.027193 Upper precision limit0.093 Initial misstatement bound$15,392 Determination of Initial Upper and Lower Misstatement Bounds Understatements Number of MisstatementsUpper Precision Limit Portion Recorded Value Unit Misstatement Assumption Misstatement Bound Portion (Columns 2 X 3 X 4) 00.024648,5001.000$15,564 10.013648,5000.089750 20.012648,5000.042327 30.012648,5000.023179 Lower precision limit0.061 Initial misstatement bound$16,820 Inventory Solution-11 * Note the descending order of the actual misstatements * * From table on slide 16

12. Number of Misstatements Unit Misstatement Assumption Sample Size Recorded Population Point Estimate Bounds Initial overstatement bound $15,392 Understatement misstatements 10.089 20.042 30.023 Sum0.154125$648,500$799(799) Adjusted overstatement bound $14,593 Number of Misstatements Unit Misstatement Assumption Sample Size Recorded Population Point Estimate Bounds Initial understatement bound $16,820 Overstatement misstatements 10.300 20.233 30.181 40.160 50.081 60.027 Sum0.982125$648,500$5,095(5,095) Adjusted understatement bound $11,725 Determination of Adjusted Misstatement Bounds 0.154 * (648,500/125) = 799 0.982 * (648,500/125) = 5095 Inventory Solution-12

13. d.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. Inventory Solution-13

14. Estimated Population Exception Rate ( percent misstatement assumption) Tolerable Exception Rate (TER) (in percentage) 23456789101520 5-Percent ARACR 0.0014999745949423632291914 0.252361571179378665851463022 0.50. 1571179378665851463022 0.75. 2081179378665851463022 1.00.. 1569378665851463022 1.25.. 15612478665851463022 1.50.. 192124103665851463022 1.75.. 227153103887751463022 2.00... 181127887768463022 2.25... 208127887768613022 2.50.... 1501097768613022 2.75.... 1731099568613022 3.00.... 1951299584613022 3.25..... 14811284613022 3.50..... 16711284764022 3.75..... 185129100764022 4.00...... 146100894022 5.00....... 1581164030 6.00........ 1795030 7.00......... 6837 Inventory Solution-14

15. EPER 23456789101520 10–Percent ARACR 0.0011476574538322825221511 0.25194129967764554842382518 0.50194129967764554842382518 0.75265129967764554842382518 1.00. 176967764554842382518 1.25. 2211327764554842382518 1.50.. 13210564554842382518 1.75.. 16610588554842382518 2.00.. 19813288754842382518 2.25... 13288756542382518 2.50... 158110756558382518 2.75... 209132946558522518 3.00.... 132946558522518 3.25.... 1531138258522518 3.50.... 1941138273522518 3.75..... 1319873522518 4.00..... 1499873652518 4.50..... 21813087653418 5.00...... 160115783418 5.50....... 1421033418 6.00....... 1821164525 7.00........ 1995225 7.50......... 5225 8.00......... 6025 8.50......... 6832 TER Inventory Solution-15

16. SAMPLE SIZE ACTUAL NUMBER OF DEVIATIONS FOUND 012345678910 5 PERCENT RISK OF OVER RELIANCE 2511.317.6......... 309.514.919.5........ 358.212.916.9........ 407.211.314.918.3....... 456.410.113.316.319.2...... 505.89.112.114.817.419.9..... 555.38.311.013.515.918.1..... 604.97.710.112.414.616.718.8.... 654.57.19.411.513.515.517.419.3... 704.26.68.710.712.614.416.218.019.7.. 753.96.28.210.011.813.515.216.918.420.0. 803.75.87.79.411.112.714.315.817.318.8. 903.35.26.88.49.911.312.714.115.516.818.1 1003.04.76.27.68.910.211.512.714.015.216.4 1252.43.74.96.17.28.29.310.311.312.213.2 1502.03.14.15.16.06.97.78.69.410.211.0 2001.52.33.13.84.55.25.86.57.17.78.3 Inventory Solution-16

17. Sample sizeACTUAL NUMBER OF DEVIATIONS FOUND 012345678910 10 PERCENT RISK OF OVER RELIANCE 2010.918.1......... 258.814.719.9........ 307.412.416.8........ 356.410.714.518.1....... 405.69.412.815.919.0...... 455.08.411.414.217.019.6..... 504.57.610.312.915.417.8..... 554.16.99.411.714.016.218.4.... 603.86.38.610.812.914.916.918.8... 703.25.47.49.311.112.814.616.217.919.5. 802.84.86.58.39.711.312.814.315.717.218.6 902.54.35.87.38.710.111.412.714.015.316.6 1002.33.85.26.67.89.110.311.512.713.815.0 1201.93.24.45.56.67.68.69.610.611.612.5 1601.42.43.34.14.95.76.57.28.08.79.5 2001.11.92.63.34.04.65.25.86.47.07.6 Inventory Solution-17