13-35 (Objectives 13-4, 13-5)Gale Brewer, CPA, has been the partner in charge of the audit of Merkle Manufacturing Company, a nonpublic company, for 13 years. Merkle has had excellent growth and profits in the past decade, primarily as a result of the excellent leadership provided by Bill Merkle and other competent executives. Brewer has always enjoyed a close relationship with the company and prides himself on having made several constructive comments over the years that have aided in the success of the firm. Several times in the past few years, Brewer's CPA firm has considered rotating a different audit team on the engagement, but this has been strongly resisted by both Brewer and Merkle.

For the first few years of the audit, internal controls were inadequate and the accounting personnel had inadequate qualifications for their responsibilities. Extensive audit evidence was required during the audit, and numerous adjusting entries were necessary. However, because of Brewer's constant prodding, internal controls improved gradually and competent personnel were hired. In recent years, there were normally no audit adjustments required, and the extent of the evidence accumulation was gradually reduced. During the past 3 years, Brewer was able to devote less time to the audit because of the relative ease of conducting the audit and the cooperation obtained throughout the engagement.

In the current year's audit, Brewer decided that the total time budget for the engagement should be kept approximately the same as in recent years. The senior in charge of the audit, Phil Warren, was new on the job and highly competent, and he had the reputation of being able to cut time off the budget. The fact that Merkle had recently acquired a new division through merger will probably add to the time, but Warren's efficiency will probably compensate for it.

The interim tests of controls took somewhat longer than expected because of the use of several new assistants, a change in the accounting system to computerize the inventory and other accounting records, a change in accounting personnel, and the existence of a few more errors in the tests of the system. Neither Brewer nor Warren was concerned about the budget deficit, however, because they could easily make up the difference at year-end.

At year-end, Warren assigned the responsibility for inventory to an assistant who also had not been on the audit before but was competent and extremely fast at his work. Even though the total value of inventory increased, he reduced the size of the sample from that of other years because there had been few errors in the preceding year. He found several items in the sample that were overstated as a result of errors in pricing and obsolescence, but the combination of all of the errors in the sample was immaterial. He completed the tests in 25% less time than the preceding year. The entire audit was completed on schedule and in slightly less time than the preceding year. There were only a few adjusting entries for the year, and only two of them were material. Brewer was extremely pleased with the results and wrote a letter to Warren and the inventory assistant complimenting them on the audit.

Six months later, Brewer received a telephone call from Merkle and was informed that the company was in serious financial trouble. Subsequent investigation revealed that the inventory had been significantly overstated. The major cause of the misstatement was the inclusion of obsolete items in inventory (especially in the new division), errors in pricing as a result of the new computer system, and the inclusion of nonexistent inventory in the final inventory listing. The new controller had intentionally overstated the inventory to compensate for the reduction in sales volume from the preceding year.

• a.List the major deficiencies in the audit and state why they took place.
• b.What things should have been apparent to Brewer in the conduct of the audit?
• c.If Brewer's firm is sued by creditors, what is the likely outcome?