Question

Omni Optical Inc

Omni Optical, Inc. was created in 2013 and entered the optical equipment industry. Its made-to-order optical equipment requires large investments in research and development. To fund these needs, ONMI made a public stock offering, which was completed in 2014. Although the offering was moderately successful, ONMI’s ambitious management is convinced that it must report a good profit this year (2015) to maintain the current market price of the stock. ONMI’s president recently stressed this point when she told her controller, Paula Apple, “If we don’t make $1.25 million pretax this year, our stock will tank.”

Elkin was pleased that even after adjustments for accrued vacation pay, 2015 pretax profit was $1.35 million. However, ONMI’s auditors, Jackson & Johnson (J&J), proposed an additional adjustment for inventory valuation that would reduce this profit to $900,000. J&J’s proposed adjustment had been discussed during the 2014 audit.

An additional issue discussed in 2014 was ONMI’s failure to accrue executive vacation pay. At that time J&J did not insist on the adjustment because the amount ($20,000) was not material to the 2014 results and because ONMI agreed to begin accruing vacation pay in future years. The cumulative accrued executive vacation pay amounts to $300,000 and has been accrued at the end of 2015.

The inventory issue arose in 2013 when ONMI purchased $450,000 of specialized computer components to be used with its optical scanners for a special order. The order was subsequently canceled, and J&J proposed to write down this inventory in 2014. ONMI explained, however, that the components could easily be sold without a loss during 2015, and no adjustment was made. However, the equipment was not sold by the end of 2015, and prospects for future sales were considered nonexistent. J&J proposed a write-off of the entire $450,000 in 2015.

The audit partner, Johanna Schmidt, insisted that Elkin make the inventory adjustment. Elkin tried to convince her that there were other alternatives, but Schmidt was adamant. Elkin knew the inventory was worthless, but she reminded Schmidt of the importance of this year’s reported income. Elkin continued her argument, “You can’t take both the write-down and the vacation accrual in one year; it doesn’t fairly present our performance this year. If you insist on taking that write-down, I’m taking back the accrual. Actually, that’s a good idea because the executives are such workaholics, they don’t take their vacations anyway.”

As Elkin calmed down, she said, “Johanna, let’s be reasonable; we like you—and we want to continue our good working relationship with your firm into the future. But we won’t have a future unless we put off this accrual for another year.”

Discuss the issue with the inventory and why Schmidt believes an adjustment is required. Do you agree with Schmidt?

Irrespective of your decision regarding the inventory adjustment, what is your reaction to Elkin’s suggestion to release the vacation accrual? Should Schmidt insist on keeping the accrual of the executives’ vacation pay?

Consider the conflict between Elkin and Schmidt. Assuming that Schmidt believes the inventory adjustment and vacation pay accrual must be made and that she does not want to lose the audit fee from the ONMI audit, what should she do?

Answer 1

a. Here, we need to write-off inventory because the sales of the computer component are nonexistent worth $450,000.
thus, looking at the concept of conservatism it should be written-off in the relevant financial year i.e., in the year 2015.
Yes i agree with Schmidt.
b. Schmidt insist on keeping the accrual of the executives’ vacation pay, No.
The vacation pay has to be accrued at the end of 2015. Pushing it to the next year is against the accounting principles .
Thus, in order to provide a fair view of financial statements. The accrued vacation pay must be shown the relevant financial year.
C. As per the accounting principles, Based on the Principles of competency Schmidt should sustain the decisions . Here, the principle implies to perform the job in the objective manner without any conflict the interest.
When comes to the role of an auditor, he need to examine and evaluate the financial statements in an objective manner.
Thus, she should make adjustment according to the audit.