The Company has no
history of improper accounting (i.e. no allegations of fraud against it and no restatements of
financial statements to correct errors in the last 5 years). The CEO, George
John, joined ABC last year from The
Kat, Inc. A background check indicates that George filed for personal bankruptcy two years
ago. The background check further noted that a member of the Audit Committee of the Board
of Directors had been sued for securities fraud while he was CFO of another publicly traded company
earlier in his career. ABC disclosed that it dismissed its prior auditor, Ford & Harding LLP, in
January of 2020 and is now looking for a new auditor.
2 Facts Related to Inventory This is the description of one of the Company’s internal controls related to inventory that is executed by management to develop an accounting estimate of adjustments that may be needed for inventory to be valued correctly:
The Chief Financial Officer Reviews and Approves the Inventory Valuation Analysis in a monthly review meeting with the Controller and the Inventory Manager. The control includes:
1. Considering the Company’s policy for writing down inventory
2. Evaluation of the categories of inventory items (e.g. suits, pants, socks, ties, etc.) and
inventory turnover/level of sales for each item type for each month during the quarter
3. Reviews of the proposed write-downs for each category of inventory and the justification for each write-down proposed, if necessary
4. Preparing a journal entry to record a write down, if necessary Management uses the first-in, first-out (FIFO) method of accounting for inventory. Based on preliminary analytical procedures, you have noted that total inventory constitutes 38% percent of the
Company’s assets. Inventory has increased by 22% from the prior year. The Company’s clothing is impacted by short-term fashion trends. Management’s annual bonus (45% of base salary) is based on achieving gross margin targets, to recognize the importance the Company places on managing inventory effectively and avoiding write-downs. The bonus is earned if the gross margin percentage is 35% or higher. To determine an estimate for inventory write-downs, management prepares a quarterly reserve analysis using a consistent methodology as described in the control above and uses system-generated
reports for each product category (i.e. suits, blazers, pants, etc.) that details the balance of inventory items sold below cost during the previous quarter. There are a number of assumptions used by management to determine the estimate. This information helps determine the percentage decline in each inventory product category. The company develops assumptions based on the declines and applies this percentage to amounts remaining in inventory. Historically, the prior auditors have not seen significant variability and or evidence of management bias in performing the analysis.
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