Your audit client, Household Appliances, Inc., operates a retail store in the center of town. Because of lack of storage space, Household keeps inventory that is not on display in a public warehouse outside of town. The warehouse supervisor receives inventory from suppliers and, on request from your client by a shipping advice or telephone call, delivers merchandise to customers or to the retail outlet.

The accounts are maintained at the retail store by a bookkeeper. Each month the warehouse supervisor sends to the bookkeeper a quantity report indicating opening balance, receipts, deliveries, and ending balance. The bookkeeper compares book quantities on hand at month-end with the warehouse supervisor's report and adjusts his books to agree with the report. No physical counts of the merchandise at the warehouse were made by your client during the year.

You are now preparing for your audit of the current year's financial statements in this recurring engagement. Last year you rendered an unqualified opinion.

Required:

a. Prepare an audit program for the observation of the physical inventory of Household Appliances, Inc. (1) at the retail outlet and (2) at the warehouse.

b. As part of your audit, would you verify inventory quantities at the warehouse by means of (1) a warehouse confirmation (Why?) or (2) test counts of inventory at the warehouse? (Why?)

c. Since the bookkeeper adjusts the books to quantities shown on the warehouse supervisor's report each month, what significance would you attach to the year-end adjustments if they were substantial? Discuss.