Background Information

Your audit firm, Hawk & Soar, PLLC, has been engaged to perform the annual audit of TealDeal, Inc. The Company manufactures and sells board shorts, t-shirts, and visors with customized designs and/or logos. TealDeal, Inc. is required to submit audited financial statements as part of the terms of its loan with the bank. Hawk & Soar has audited TealDeal for the past four years. During the current year audit, your team has already performed the majority of the audit work; you are being asked to help tie up some loose ends in order to finish the audit and issue the audit report.

Substantive Analytical Procedures: Auditing Estimates

As part of the final audit procedures required to wrap up the audit of TealDeal, Inc., you have been asked to evaluate the reasonableness of TealDeal's inventory reserve for excess and obsolescence. The audit plan requires you to perform a substantive analytical procedure to test the account balance.

At year-end, TealDeal has a balance of $1,328,000 for Inventory (gross) and a balance of $130,000 for the Allowance for Excess and Obsolete Inventory. Inventory (net) is reported on the balance sheet at $1,198,000.

Graded components:

(1) Provide a thorough response to questions [1]-[5], below. To receive full credit, you must provide a response to all parts of each question with sufficient detail to show that you put some thought into your response. Please make sure your responses are well-written using full sentences.

Questions:

[1] Your review of prior year information indicates that TealDeal typically writes off approximately 8.5% of the total (gross) inventory balance as excess or obsolete inventory. Using this historical estimate, develop an expectation for the Allowance for Excess and Obsolete Inventory account. (Show/explain your calculation.)

Response:

[2] Using a tolerable difference of $25,000, determine if the client's reported allowance balance for the Allowance for Excess and Obsolete Inventory is within your tolerable range and explain the reasons for your conclusion.

Response:

[3] In response to a different question about inventory, the client has provided you an aged detail of inventory items that indicates when the inventory item was last sold. You and the audit manager worked to come up with percentage estimates of excess and obsolescence for each group based on historical write-offs and other available information regarding these groupings.

Inventory Group

Inventory Account Balances (per client)

Auditor's E&O Estimates (%)

Sold within the past 30 days

$684,000

3%

Sold within 31-60 days

$382,000

8%

Sold within 61-90

$135,000

25%

Not sold within the past 90 days

$88,000

50%

Items returned by customers

$39,000

90%

Based on the information provided above, develop an expectation for the Allowance for Excess and Obsolete Inventory account. (Show/explain your calculation.)

Response:

[4] Using a tolerable difference of $25,000, determine if the client's reported allowance balance for the Allowance for Excess and Obsolete Inventory is within your tolerable range and explain the reasons for your conclusion.

Response:

[5] Which of the above calculations do you believe provides greater assurance? Why?

Response:

[6] Based on your conclusions above, what are your next steps as the auditor of TealDeal in your audit of the Allowance for Excess and Obsolete Inventory?

Response: