CENCO MEDICAL HEALTH SUPPY CORPORATION (CMH was an SEC-registered company that went bankrupt after it had materially misstated its financial statements for a number of years. It inflated the reporting of its physical inventory by 50% during two years prior to its bankruptcy. The fraud was perpetrated by "(1) altering the quantities recorded on the pre-numbered, two part inventory tags used in counting the inventory; (2) altering documents reflected on a computer list prepared to record the physical count of inventory; and (3) creating inventory tags to record quantities of non-existent inventory."

The SEC asserted that the auditors should have detected the fictitious inventory but did not because the audit firm " left the extent of various observation testing to the discretion of auditors, not all of whom were aware of the significant audit planning that should have related directly to the extent of such testing. Observation of inventory counts at year end was confided to six locations ( representing about 40% of the total CMH inventory) as opposed to nine in the preceding year. The field auditors did not adequately control the inventory tags and the auditor did not detect the creation of bogus inventory tags which were inserted in the final inventory computation."

The SEC was also critical of the audit firm for assigning interns to a significant portion of the inventory observation without training them in the nature of the client's inventory or its counting procedures. This is an example of a situation in which auditors lack professional skepticism led to low audit quality and a subsequent audit failure. source: R.W.Dickerson, " Why The Fraud Went Undetected," CA Magazine April 1977, pp 67-69

The SEC alleged that many deficiencies occurred during the audit of CMH, including:

1. The audit firm " left the extent of various observation testing to the discretion of auditors, not all of whom were aware of significant audit conclusions which related directly to the extent of such testing. Observation of inventory counts at year end were confided to six locations (representing about 40% of the total CMH inventory) as opposed to nine in the preceding year. The field auditors did not adequately control the inventory tags and Seidman &Seidman [the auditor] did not detect the creation of bogus inventory tags which were inserted in the final inventory computation."

2. The comparison of recorded test counts to the computers list in nine warehouse locations in which the inventory count was observed indicated error rates ranging from 0.9% to 38.3% of the test counts, with error rates in excess of 10% in several locations. Management attributed the differences to errors made by a keypuch operator. When the auditors asked to see the inventory tags, the CMH official stated that they had been destroyed.

3. The Seidman &Seidman auditor who performed the price testing of the CMH inventory determined that, as in previous years, in numerous instances CMH was unable to produce sufficient vendors invoices to support the purchase by CMH of th quantities being tested. This was true even though Seidman &Seidman ultimately accepted vendor invoices reflecting the purchase of the item by any CMH branch, regardless of the location of the inventory actually being price tested.

4. A schedule of comparative inventory balances reflected significant increases from the prior year. A CMH financial officer wrote on this schedule management's explanations for the increases in inventory accounts.

5. CMH did not use pre-numbered purchase orders and shipping documents.

6. Several differences exist between the tags reflected on the computer list for the Miami warehouse and the observation of the same tag numbers by Seidman & Seidman auditors. The computer list contained a series of almost 1000 tags, covering about 20% of the tags purportedly used and more than 50% of the total reported value of the Miami inventory, which were reported as being unused on the tag control documents obtained by Seidman & Seidman during its observation work.

7. Because CMH management did not provide sufficient invoices as required, the auditors relied primarily on vendor catalogs, price lists, and vendor invoices to test the accuracy of CMH inventory pricing representations.

a. For each of the deficiencies identified, indicate the appropriate action that the auditor should have taken.

b. What inventory information should be communicated to an auditor who is not regularly assigned to the audit of a particular client prior to the observation of physical inventory count?

c. How do questions of management integrity affect the approach that the auditor should take in planning the observation of a client's inventory-counting procedures?

d. Identify instances in which the auditors in this case did not exercise appropriate professional skepticism. For each of those instances, describe an alternative way that the auditor should have handled this situation.