Question

Carl's Computers imports computer hardware and accessories from China, Japan, Korea, and the United States. It has branches in every capital city, and the main administration office and central warehouse is in Montreal. There is a branch manager in each store plus a number (depending on the size of the store) of permanent staff. There are also several casual staff who work on weekends-the stores are open both Saturday and Sunday. Either the branch manager or a senior member of the permanent staff is on duty at all times to supervise the casual staff. Both casual and permanent staff members are required to attend periodic company training sessions covering product knowledge and inventory and cash handling requirements.
The inventory is held after its arrival from overseas at the central warehouse and distributed to each branch on receipt of an inventory transfer request authorized by the branch manager. The value of inventory items ranges from a few cents to several thousand dollars. Competition is fierce in the computer hardware industry. New products are continuously coming onto the market, and large furniture and office supply discount retailers are heavy users of advertising and other promotions to win customers from specialists like Carl's Computers. Carl's Computers' management has faced difficulty keeping costs of supply down and has started to use new suppliers for some computer accessories such as printers and ink.
Required
(a) Explain the inherent risks for inventory for Carl's Computers. How would these risks affect the financial statement accounts?
(b) What strengths and weaknesses in the inventory control system can you identify in the above case?
(c) Comment on materiality for inventory at Carl's Computers. Is inventory likely to be a material balance? Would all items of inventory be audited in the same way? Explain how the auditor would deal with these issues.

 

Answer 1

(a)        Inherent risks for inventory for Carl’s Computers include:

1.         Likelihood of rapid obsolescence of computer hardware and accessories – risk of incorrect valuation of obsolete product.

2.         Foreign exchange transactions – are contracts written in US$, CDN$, etc, are the transactions hedged against adverse movements in exchange rates? – leading to difficulty ascertaining cost of purchase and incorrect creditor liability.

3.         Competition from aggressive discounters, risk that inventory will not be held on hand to meet fluctuating sales, risk that inventory will be unsold because of competition – increasing risk of obsolescence, valuation problems.

4.         Rapidly changing product lines – risk that suppliers will change and products will not meet the required standard, leading to valuation problems.

5.         Risk that correct inventory will not be received from suppliers due to inability to meet orders, confusion between Canadian importers and foreign suppliers – purchase orders unfilled or incorrectly filled, payment for inventory not received.

6.         Dealing with multiple transport companies – ship from overseas and truck from ports – could increase risk of goods not being received, or not received in a timely manner, missing inventory.

7.         Many different products, wide range of value per item – incorrect calculations of inventory on hand.

8.         Risk of theft (either during transport or from the stores) would vary across products – inventory account would be overstated if thefts were not identified.

 

(b)        Strengths in inventory control system:

•   Branch manager in each store and permanent staff who can receive consistent training in inventory control.

•   Permanent staff used to supervise casual staff at stores.

•   Inventory held at central warehouse under control of specialist inventory supervisors.

•   Requisition required for transfer from central warehouse to branch store.

 

Weaknesses in inventory control system:

•   Casual staff may not be sufficiently trained or supervised despite procedures requiring this.

•   Inventory requisition authorized by branch manager rather than central manager.

•   Passing through central warehouse could delay receipt of product at branch, leading to overriding system to increase speed of delivery.

 

Questions about inventory control system:

•   Who chooses and approves suppliers?

•   Is there segregation between inventory staff and those keeping inventory records?

 

(c)        Inventory would be a material balance because the company is an importer and retailer of computer hardware and accessories. Inventory is likely to be the largest asset after property, plant, and equipment. It is likely that the majority of sales are made for cash, so accounts receivable  is unlikely to be a large balance (except for balances owing from credit card companies for card transactions). The inventory is also qualitatively material because the business model requires expert inventory management to deal with obsolescence and competition issues. Users of financial statements would be very interested in data such as inventory turnover.

 

The auditors would adopt different approaches for different types of inventory. They would focus more on larger value items with greater risk of obsolescence or product specification problems. They would also focus on products with greater risk due to more likely supplier problems, such as new suppliers for consumables, or complicated foreign transactions which create valuation issues. 

Focus would also be given to items with greater risk of being stolen, to ensure that the inventory balances are not overstated, and those items with greatest competition pressure, to ensure sales are valid.