CASE STUDY I (Theory of Auditing and Financial Accounting, measuring general knowledge and skills building in area) 70 points OVERSTATING INVENTORY BALANCE AND UNDERSTATING COGS The Securities and Exchange Commission (SEC) brought an enforcement action against NCI Building Systems, Inc., in regard to a material overstatement of reported income that was largely due to erroneous standard cost amounts assigned to inventory. NCI is a manufacturer and distributor of metal building components and engineered building systems, and its stock is traded on the New York Stock Exchange. NCI's senior management noted an unusually high inventory balance in its Components Division. Even though senior management instructed the Components Division to stop purchasing steel, NCI's inventory balance did not decrease by the expected amount. NCI took a physical inventory to compare the actual inventory on hand with the inventory balance per the accounting records. The inventory balance per the accounting records was SIS- $18 million greater than the physical inventory amount. This overstatement of inventory had the effect of understating cost of goods sold and therefore, overstating net income. The overstatement of inventory was largely due to problems with NCI's standard cost system. NCI's manufacturing process generated a nontrivial amount of scrap, but NCI's standard cost was inadequate to account for all of the scrap material that was generated during the manufacturing process. As a result, the value of scrap material was included as usable inventory, which had the effect of overstating the inventory balance. An interesting side note to this case is how NCI'S management handled these accounting problems. First, NCI retained its outside accounting firm to investigate the large difference between the book and physical inventory amounts. Second, NCI promptly restated its previously issued financial statements. Third, significant remedial measures were put in place to reduce the likelihood of such errors in the future. Fourth, a number of NCI's accounting personnel were terminated. Finally, NCI cooperated fully with the SEC in its investigation of this matter. As a result of these factors, which were specifically referred to by the SEC in its written enforcement release, the sanction imposed on NCI for its violation of the securities laws was relatively mild SUPPLEMENTARY READING: SEC Litigation Release U.S. SECURITIES AND EXCHANGE COMMISSION Litigation Release No.18402 / October 9, 2003 Accounting and Auditing Release No.1893 / October 9, 2003 Securities and Exchange Commission v. Gregory L. English, No.1:03-CV-02061 (COLLYER) (United States District Court for the District of Columbia). FORMER CONTROLLER OF NCI BUILDING SYSTEMS, INC. SETTLES 10(b) CHARGE CONCERNING NCIS OVERSTATED INVENTORY NCI ALSO SETTLES CEASE-AND-DESIST PROCEEDING A. The English Complaint The U.S. Securities and Exchange Commission today filed a settled civil enforcement action in U.S. District Court for the District of Columbia against Gregory L. English, former corporate controller of NCI Building Systems, Inc. (NCI), a Houston-based manufacturer of metal products for the non-residential building industry. The complaint alleges: On June 8, 2001, NCI filed with the Commission a Form 10-K/A, restating its financial statements for fiscal 1999 and 2000 and a Form 10-Q/A, restating its financial statements for the first quarter of fiscal year 2001. According to these filings, NCI overstated net earnings by $1.3 million during the third and fourth quarters of fiscal 1999, 57.5 million for fiscal 2000 and $1.2 million for the first quarter of fiscal 2001. A number of accounting errors at NCI's Components Division had resulted in material misstatement of NCI's financial statements. The errors resulted primarily from: (1) NCI's failure to update standard costs and scrap metal factors following NCI's migration to a new management information system (the "MIS system") in May 1999, and (2) failed attempts by NCI accounting personnel to manually correct (via unsupported journal entries) for MIS problems in a key inventory liability account. . In July 2000, following an annual physical inventory at the company's components division, an accounting employee informed English that a probable "pick-up" of approximately $2.6 million would be made on the books, resulting in an increase in recorded book inventory. Soon after, the employee retracted this initial conclusion and informed English that book inventory exceeded the physical counts by more than $2 million, requiring that English decrease the book inventory number. Despite this information, in August 2000, English proceeded to authorize the erroneous $2.6 million entry As NCI's corporate controller, English knew, or was reckless in not knowing that the inventory overstatement would have a material effect on NCI's financial statements. In addition, English knew or should have known of errors with NCI's new MIS system and failed to correct them. Without admitting or denying the allegations in the complaint, English consented to the entry of a Final Judgment permanently enjoining him from future violations of (or aiding and abetting violations of Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B) and 13(b)(5) of the Securities Exchange Act of 1934 and Exchange Act Rules 106-5, 126-20, 132-1, 13a-13 and 1352-1. The Final Judgment also imposes a $25,000 civil penalty and prohibits English from serving as an officer or director of a public company for five years. B. The Cease-and-Desist Order Against NCI B. The Cease-and-Desist Order Against NCI The Commission also issued a settled cease-and-desist order today (the "Order") against NCI. The findings in the Order involved a number of accounting errors at the company, many of which were caused by the implementation of the MIS system in May 1999. The Order notes that the Commission took into account remedial acts promptly undertaken by the respondent and cooperation afforded the Commission staff. NCI neither admitted nor denied the findings in the Order. In the Order, the Commission Ordered that NCI cease and desist from committing or causing any violations and any future violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 12b-20, 13a-1 and 132-13 there under. NCI common stock trades on the New York Stock Exchange under the symbol NCS. Questions 1. This question 's a and b parts are research based and requiring to study with your books, notes etc. of Financial Accounting and Managerial Accounting courses before answering. In answering of c and d parts of this question, course materials in google classroom and what you learned in our courses will be enough. a- What is the accounting problem regarding inventory of NCI? Use imaginary numbers in related ledger accounts to show; how overstated inventory caused understated COGS. (15 points) b- What is proper accounting for $15-$18M difference which arising from including scrap material as usable inventory? You can continue to use your imaginary numbers you made up in l.a. (15 points) C- Assume that you are an external independent auditor working for 'Extremely Diligent Accounting & Auditing Firm.' Your firm plans to work for financial statement audit with NCI. You were assigned to evaluate the client and you read the readings given above. What would you report on client's background? (20 points) d- You were also assigned to assess the audit risk of NCI, What would you report on risk assessment of NCI based on two readings above? (20 points) ANSWERS FOR CASE STUDYI (Please write your answers with headings as follows: 1.a; 1.b ....) You can use the space as it is needed