ASSIGNMENT

Question:(1) Do a management Comment Letter to the Board of Directors

(2) Do an analysis on Inventory Valuation and do a recommendation to the management

(3) Do an analysis on the Cost of Goods Sold and do a recommendation to management

DO THE ANALYSIS BASE ON US GAAP REQUIREMENTS ON INVENTORY VALUATION AND COST OF GOODS SOLD.

RECOMMENDATION SHOULD BE BASE ON GAAP ALSO.

Case Narrative

Scenario and Client Background

You are an audit senior at Smith, Brown, and Jones, PLC (SB&J) a public accounting firm. You have been assigned to the audit of Northwest Technologies, Inc., (NWT) for fiscal year ending December 31, 2009. NWT is a publicly traded manufacturer of computer chips.

NWT has been a good audit client of the firm for the prior six years (2003 through 2008), paying its fees on time, employing cooperative management, and complying with authoritative accounting pronouncements. During those years, however, NWT has been losing market share in an increasingly competitive global marketplace. Although NWTs unit sales have been increasing each year, they drastically lag behind industry increases. Currently, stagnation in the computer chip and router markets is significantly reducing the market demand for NWTs chips. The companys stock has declined in value from approximately $95 per share in 2003 to $32 per share in 2009. Although some of this reduction can be attributed to the general economic slow down, it is relatively greater than declines in value of competitors stock.

Despite these downward trends, however, NWT remains a widely recognized name in the computer chip market.

Planning Meeting

At the instruction of the engagement partner, Steve Smart, you hold a planning meeting with Samantha Strong, NWTs CEO, to discuss current year events and plan the strategy for the upcoming audit. In your meeting, Samantha indicates that NWT is going to have a very good year, despite some difficulties in the recent past. The companys main difficulty involves revocation of its line of credit: As a result of lower-than-expected sales volume last year, NWT violated its bad debt covenants, and the bank has refused to renew the line of credit. Samantha indicates, however, that a new discount policy which encourages customers to pay on a more timely basis has increased cash flow, and operations have not been hampered, despite the lack of credit from the bank.

Samantha further indicates that in May 2009, Jane Smith, CFO, resigned to pursue other opportunities. Jane was replaced as chief financial officer by Samanthas close personal friend, Jonathan White. Samantha praises Jonathans mastery of accounting and reporting, commending his ability to record financial transactions in ways that more accurately reflect the operations of the business than had Janes methods. Samantha feels that Jonathans philosophy is more practical than Janes overly conservative approach to accounting. Jonathans logical approach to recording transactions and his ability to record results that better reflect our performance is doing wonders for our business. Just knowing that we were doing things so wrong in the past has bothered me tremendously, Samantha states.

Samantha indicates that one of NWTs major suppliers was on strike during June and July of the current year. During this strike, NWT was forced to buy parts from another supplier at significantly higher costs. Nevertheless, Samantha explains, the companys bottom line did not suffer. The new CFO (Jonathan) performed a study of the overhead application process and redistributed items that were incorrectly accounted for in the past. As a result of the lower overhead cost allocation, Samantha indicates that product cost was significantly lower after the month of July than it had been in prior years. She explains: Despite the increase in product cost for those two months during the strike, we experienced no negative gross profit impact because Jonathan reworked the overhead formula to reflect overhead costs more accurately. In fact, our products are significantly cheaper than we thought. Now we can reduce sales prices and increase volume because of more competitive pricing.

Samantha indicates that no other significant events occurred this year. She mentions a few minor items, such as the purchase of a significant amount of fixed assets and a growth in the customer base as a result of a new credit-granting policy.

While discussing your planning meeting with the audit partner, you note the following concerns and areas of risk:

Managements integrity (specifically concerns about the new CFO) the drastic improvement in current year results.

Inventory valuation the new overhead application formula

Propriety of cost of goods sold the new overhead application formula

Possibility of a going concern issue lack of bank funding

Valuation of reserves and liabilities

Potential risk of loss new credit-granting policy

Audit Fieldwork

1. Sales and Cost of Goods Sold

In performing your regression analysis of sales and cost of goods sold, you note that, according to prior year work-papers, gross profit rates have averaged between 38% and 41% over the past six years (2003-2008). The client has provided the following current-year data for your analysis:

Month	Sales	COGS	Gross Profit Rate
January	$14,534,672	$8,867,134	38.99%
February	15,068,010	9,063,465	39.85%
March	14,835,456	8,968,979	39.54%
April	14,236,726	8,613,564	39.50%
May	15,255,664	8,974,685	41.17%
June	15,365,790	8,313,646	42.13%
July	15.489.454	9.016,465	41.79%
August	14,964,889	8,065,646	46.10%
September	15,032,469	8,074,656	46.29%
October	17,028,646	8,765,646	48.52%
November	18,900,644	9,564,698	49.39%
December	19,365,471	9,679,879	50.01%
TOTAL	$189,077,891	$105,968,463

In reviewing the data provided by the client, you note that sales increased significantly in the last three months of the year. Additionally, you note that gross profit margins increased beginning in August and further increased beginning in October. Discussions with Richard Jones, accounting manager, indicate the following:

Profit margins would have increased more beginning in June, but the strike affected the cost of direct materials used in production.

The cost of goods sold formula was altered to exclude insurance, depreciation, and sales salaries. Jones indicated that such items were excluded from overhead because they are paid for and utilized by non-production departments.

Overtime paid to production workers is now charged to the Human Resources Department as a fringe benefit. Such cost has historically been tracked in the production department and included as a component of cost of goods sold. Jonathan White, the CFO, changed this policy under the rationale that this overtime premium is given by the Human Resources Department as part of the new contract it negotiated with the production workers, and should, therefore, be a Human Resources expense and included as an administration expense item on the income statement rather than being included as a component of cost of goods sold. This policy went into effect in October.

In October, NWT initiated a special sales promotion in which the company shipped bulk quantities of computer chips to a significant number of customers. This is part of a campaign in which NWT is trying to promote the use of its products by making them readily available in bulk to customers. NWT shipped these additional quantities to customers in good faith, along with the customers regular orders. In a letter to customers, NWT stated, We want to be your supplier of choice for computer chips. Please accept these chips for use in your production needs. If you do not need or use them, you may return them within three months with no obligation. NWT recorded a sale of goods and related account receivable upon shipment of these additional bulk quantities.

2. Fixed Asset Additions and Disposals

Remembering Samantha Strongs statement that considerable fixed assets were purchased during the year, you ask Joseph Danna, fixed asset clerk in the accounting department, about the nature of these fixed assets. Dana indicates that a significant portion of the fixed asset additions represents labor of company mechanics. Such labor was incurred during a routine, two-week plant shutdown in which each machine was thoroughly cleaned and inspected by the maintenance department. Additionally, plant walkways and work areas were resurfaced. Joseph tells you that these costs were capitalized because they enhance the useful lives of the machinery and equipment. Furthermore, all replacement parts bought during the year for the machines (nuts, bolts, compressors, etc.) were capitalized because they become part of the fixed asset.

When you ask Dana why these labor and replacement costs were treated as fixed assets, he replies that Jonathan, the CFO, ordered the change to the previous capitalization policy. Dana states that he believes the new policy is correct because these items and labor costs are related to fixed assets and should be capitalized. When you contact Mr. White for confirmation of this new policy, he maintains that capitalization treatment is correct for all the additions.

Continuing your discussion of fixed assets, you ask whether any disposals occurred during the year. Dana is not aware of any; however, he does tell you that such disposals occur at the discretion of individual plant managers and are not brought to the attention of the accounting department.

3. Credit-Granting Policy

While talking to Richard Jones, accounting manager, you learn that NWT is relaxing its credit-granting guidelines. In the past, only the credit manager could approve credit. Now, however, the credit-approval procedure has been decentralized. Each credit clerk is responsible for a region of the market and is authorized to grant credit for that region without obtaining approval from the credit manager. Furthermore, the clerks are also now responsible for determining bad-debts write-offs and recoveries for their own region based on whether or not, in their professional judgment, they feel that collection will be made. Jones tells you that this policy change was initiated to empower the employees and create a greater sense of participation in management.

Conclusion

When you complete the audit fieldwork, you report the progress to the engagement partner, Steve Smart. Although NTs net income has increased significantly in the current year and outpaced the industry average, Steve is uneasy with this increase. He is concerned that the companys sales policy is too aggressive and that the accounting for certain sales is possibly not in accordance with GAAP. Additionally, Steve is not sure whether the companys overhead policies follow procedures recommended under GAAP. Steve is uncertain about the companys ability to continue as a going concern and about Smith, Brown, and Joness ability to issue an unqualified opinion without significant adjustment to the financial statements.

The following assignments are based on the information in this case narrative:

[1] This comprehensive audit engagement exercise set is adapted from a case prepared by Ryan R. Fox of Deloitte and Touche, L.L.P.