Question

ASSIGNMENT

Question:(1) Do a management Comment Letter to the Boardof Directors

(2) Do an analysis on Inventory Valuation and do arecommendation to the management

(3) Do an analysis on the Cost of Goods Sold and do arecommendation to management

DO THE ANALYSIS BASE ON US GAAP REQUIREMENTS ONINVENTORY VALUATION AND COST OF GOODS SOLD.

RECOMMENDATION SHOULD BE BASE ON GAAP ALSO.

Case Narrative

Scenario and Client Background

You are an audit senior at Smith, Brown, and Jones, PLC(SB&J) a public accounting firm. You have been assigned to theaudit of Northwest Technologies, Inc., (NWT) for fiscal year endingDecember 31, 2009. NWT is a publicly traded manufacturer ofcomputer chips.

NWT has been a good audit client of the firm for the prior sixyears (2003 through 2008), paying its fees on time, employingcooperative management, and complying with authoritative accountingpronouncements. During those years, however, NWT has been losingmarket share in an increasingly competitive global marketplace.Although NWT’s unit sales have been increasing each year, theydrastically lag behind industry increases. Currently, stagnation inthe computer chip and router markets is significantly reducing themarket demand for NWT’s chips. The company’s stock has declined invalue from approximately $95 per share in 2003 to $32 per share in2009. Although some of this reduction can be attributed to thegeneral economic slow down, it is relatively greater than declinesin value of competitors’ stock.

Despite these downward trends, however, NWT remains a widelyrecognized name in the computer chip market.

Planning Meeting

At the instruction of the engagement partner, Steve Smart, youhold a planning meeting with Samantha Strong, NWT’s CEO, to discusscurrent year events and plan the strategy for the upcoming audit.In your meeting, Samantha indicates that NWT is going to have avery good year, despite some difficulties in the recent past. Thecompany’s main difficulty involves revocation of its line ofcredit: As a result of lower-than-expected sales volume last year,NWT violated its bad debt covenants, and the bank has refused torenew the line of credit. Samantha indicates, however, that a newdiscount policy which encourages customers to pay on a more timelybasis has increased cash flow, and operations have not beenhampered, despite the lack of credit from the bank.

Samantha further indicates that in May 2009, Jane Smith, CFO,resigned to pursue other opportunities. Jane was replaced as chieffinancial officer by Samantha’s close personal friend, JonathanWhite. Samantha praises Jonathan’s mastery of accounting andreporting, commending his ability to record financial transactionsin ways that “more accurately reflect the operations of thebusiness” than had Jane’s methods. Samantha feels that Jonathan’sphilosophy is more practical than Jane’s “overly conservative”approach to accounting. “Jonathan’s logical approach to recordingtransactions and his ability to record results that better reflectour performance is doing wonders for our business. Just knowingthat we were doing things so wrong in the past has bothered metremendously,” Samantha states.

Samantha indicates that one of NWT’s major suppliers was on strikeduring June and July of the current year. During this strike, NWTwas forced to buy parts from another supplier at significantlyhigher costs. Nevertheless, Samantha explains, the company’s bottomline did not suffer. The new CFO (Jonathan) performed a study ofthe overhead application process and redistributed items that wereincorrectly accounted for in the past. As a result of the loweroverhead cost allocation, Samantha indicates that product cost wassignificantly lower after the month of July than it had been inprior years. She explains: “Despite the increase in product costfor those two months during the strike, we experienced no negativegross profit impact because Jonathan reworked the overhead formulato reflect overhead costs more accurately. In fact, our productsare significantly cheaper than we thought. Now we can reduce salesprices and increase volume because of more competitivepricing.”

Samantha indicates that no other significant events occurred thisyear. She mentions a few “minor items,” such as the purchase of asignificant amount of fixed assets and a growth in the customerbase as a result of a new credit-granting policy.

While discussing your planning meeting with the audit partner, younote the following concerns and areas of risk:

Managements integrity (specifically concerns about the new CFO)– the drastic improvement in current year results.

Inventory valuation – the new overhead application formula

Propriety of cost of goods sold – the new overhead applicationformula

Possibility of a going concern issue – lack of bank funding

Valuation of reserves and liabilities

Potential risk of loss – new credit-granting policy

Audit Fieldwork

1. Salesand Cost of Goods Sold

In performing your regression analysis of sales and cost ofgoods sold, you note that, according to prior year work-papers,gross profit rates have averaged between 38% and 41% over the pastsix years (2003-2008). The client has provided the followingcurrent-year data for your analysis:

Month	Sales	COGS	Gross Profit Rate
January	$14,534,672	$8,867,134	38.99%
February	15,068,010	9,063,465	39.85%
March	14,835,456	8,968,979	39.54%
April	14,236,726	8,613,564	39.50%
May	15,255,664	8,974,685	41.17%
June	15,365,790	8,313,646	42.13%
July	15.489.454	9.016,465	41.79%
August	14,964,889	8,065,646	46.10%
September	15,032,469	8,074,656	46.29%
October	17,028,646	8,765,646	48.52%
November	18,900,644	9,564,698	49.39%
December	19,365,471	9,679,879	50.01%
TOTAL	$189,077,891	$105,968,463

In reviewing the data provided by the client, you note that salesincreased significantly in the last three months of the year.Additionally, you note that gross profit margins increasedbeginning in August and further increased beginning in October.Discussions with Richard Jones, accounting manager, indicate thefollowing:

Profit margins would have increased more beginning in June, butthe strike affected the cost of direct materials used inproduction.

The cost of goods sold formula was altered to exclude insurance,depreciation, and sales salaries. Jones indicated that such itemswere excluded from overhead because they are paid for and utilizedby non-production departments.

Overtime paid to production workers is now charged to the HumanResources Department as a fringe benefit. Such cost hashistorically been tracked in the production department and includedas a component of cost of goods sold. Jonathan White, the CFO,changed this policy under the rationale that this overtime premiumis given by the Human Resources Department as part of the newcontract it negotiated with the production workers, and should,therefore, be a Human Resource’s expense and included as anadministration expense item on the income statement rather thanbeing included as a component of cost of goods sold. This policywent into effect in October.

In October, NWT initiated a special sales promotion in which thecompany shipped bulk quantities of computer chips to a significantnumber of customers. This is part of a campaign in which NWT istrying to promote the use of its products by making them readilyavailable in bulk to customers. NWT shipped these additionalquantities to customers “in good faith,” along with the customers’regular orders. In a letter to customers, NWT stated, “We want tobe your supplier of choice for computer chips. Please accept thesechips for use in your production needs. If you do not need or usethem, you may return them within three months with no obligation.”NWT recorded a sale of goods and related account receivable uponshipment of these additional bulk quantities.

2. Fixed Asset Additions andDisposals

Remembering Samantha Strong’s statement that considerable fixedassets were purchased during the year, you ask Joseph Danna, fixedasset clerk in the accounting department, about the nature of thesefixed assets. Dana indicates that a significant portion of thefixed asset additions represents labor of company mechanics. Suchlabor was incurred during a routine, two-week plant shutdown inwhich each machine was thoroughly cleaned and inspected by themaintenance department. Additionally, plant walkways and work areaswere resurfaced. Joseph tells you that these costs were capitalizedbecause they enhance the useful lives of the machinery andequipment. Furthermore, all replacement parts bought during theyear for the machines (nuts, bolts, compressors, etc.) werecapitalized because they become part of the fixed asset.

When you ask Dana why these labor and replacement costs weretreated as fixed assets, he replies that Jonathan, the CFO, orderedthe change to the previous capitalization policy. Dana states thathe believes the new policy is correct because these items and laborcosts are “related to fixed assets and should be capitalized.” Whenyou contact Mr. White for confirmation of this new policy, hemaintains that capitalization treatment is correct for all theadditions.

Continuing your discussion of fixed assets, you ask whether anydisposals occurred during the year. Dana is not aware of any;however, he does tell you that such disposals occur at thediscretion of individual plant managers and are not brought to theattention of the accounting department.

3. Credit-Granting Policy

While talking to Richard Jones, accounting manager, you learn thatNWT is relaxing its credit-granting guidelines. In the past, onlythe credit manager could approve credit. Now, however, thecredit-approval procedure has been decentralized. Each credit clerkis responsible for a region of the market and is authorized togrant credit for that region without obtaining approval from thecredit manager. Furthermore, the clerks are also now responsiblefor determining bad-debts write-offs and recoveries for their ownregion based on whether or not, in their professional judgment,they feel that collection will be made. Jones tells you that thispolicy change was initiated “to empower the employees and create agreater sense of participation in management.”

Conclusion

When you complete the audit fieldwork, you report the progress tothe engagement partner, Steve Smart. Although NT’s net income hasincreased significantly in the current year and outpaced theindustry average, Steve is uneasy with this increase. He isconcerned that the company’s sales policy is too aggressive andthat the accounting for certain sales is possibly not in accordancewith GAAP. Additionally, Steve is not sure whether the company’soverhead policies follow procedures recommended under GAAP. Steveis uncertain about the company’s ability to continue as a goingconcern and about Smith, Brown, and Jones’s ability to issue anunqualified opinion without significant adjustment to the financialstatements.

The following assignments are based on the information in thiscase narrative:

[1] This comprehensive audit engagement exercise set is adaptedfrom a case prepared by Ryan R. Fox of Deloitte and Touche,L.L.P.