Nolan Manufacturing Company retains you on April 1 to perform an audit for the fiscal year ending June 30. During the month of May, you make extensive studies of internal control over inventories.
All goods purchased pass through a receiving department under the direction of the chief purchasing agent. The duties of the receiving department are to unpack, count, and inspect the goods. The quantity received is compared with the quantity shown on the receiving department’s copy of the purchase order. If there is no discrepancy, the purchase order is stamped “OK—Receiving Dept.” and forwarded to the accounts payable section of the accounting department. Any discrepancies in quantity or variations from specifications are called to the attention of the buyer by returning the purchase order to him with an explanation of the circumstances. No records are maintained in the receiving department, and no reports originate there.
As soon as goods have been inspected and counted in the receiving department, they are sent to the factory production area and stored alongside the machines in which they are to be processed. Finished goods are moved from the assembly line to a storeroom in the custody of a stock clerk, who maintains a perpetual inventory record in terms of physical units, but not in dollars.
What weaknesses, if any, do you see in the internal control over inventories?
Problem 12-35
Described below are potential financial statement misstatements that are encountered by auditors.
1. Inventory is understated because warehouse personnel overlooked several racks of parts in taking the physical inventory.
2. Inventory is overstated because warehouse personnel included inventory items received subsequent to year-end while recording the purchase in the subsequent year to hide inventory shortages.
3. Inventory is overstated because management instructed computer personnel to make changes in the file used to price inventories.
Questions Requiring Analysis 13-31
You are part of the audit team that is auditing Happy Chicken, Inc., a company that franchises Happy Chicken family restaurants. During the current year, management of Happy Chicken purchased for $2 million one of its franchised locations, a store that was having financial difficulties. In performing its analysis for impairment of assets at year-end, management of Happy Chicken determined that the carrying value of the asset may not be recoverable. As a result, management developed an estimate of the fair value of the location using a discounted cash flow model. The estimated fair value of the location was determined to be $1.5 million, which resulted in an impairment loss of about $500,000. The undiscounted future cash flows are equal to $1.7 million.
Problem 13-34
1. The following are typical questions that might appear on an internal control questionnaire relating to plant and equipment:
2. Are subsidiary ledgers for plant and equipment regularly reconciled with general ledger controlling accounts?
3. State the purpose of each of the above controls.
4. Describe the manner in which each of the above procedures might be tested.
5. Assuming that the operating effectiveness of each of the above procedures is found to be inadequate, describe how the auditors might alter their substantive procedures to compensate for the increased level of risks of material misstatements.
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