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 Resourceâs 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 âin good faith,â along with the customersâregular orders. In a letter to customers, NWT stated, âWe 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.âNWT recorded a sale of goods and related account receivable uponshipment of these additional bulk quantities.
2. Fixed Asset Additions andDisposals
Remembering Samantha Strongâs 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 ârelated to fixed assets and should be capitalized.â 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 âto empower the employees and create agreater sense of participation in management.â
Conclusion
When you complete the audit fieldwork, you report the progress tothe engagement partner, Steve Smart. Although NTâs net income hasincreased significantly in the current year and outpaced theindustry average, Steve is uneasy with this increase. He isconcerned that the companyâs sales policy is too aggressive andthat the accounting for certain sales is possibly not in accordancewith GAAP. Additionally, Steve is not sure whether the companyâsoverhead policies follow procedures recommended under GAAP. Steveis uncertain about the companyâs ability to continue as a goingconcern and about Smith, Brown, and Jonesâs 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.
