PC-Clone Inc.

Julie Madison, CPA, is the manager in charge of the audit of PC-Clone Inc., a closely- held manufacturer of IBM-compatible personal computers. The company has experienced explosive growth in sales and profits since it was established three years ago.

Sam Lee, the senior on the audit, has extensively analyzed the companys finished goods inventory. Julies review of his work has identified what may be serious problem. Total finished goods at PC-Clone increased to ten million dollars from seven million dollars last year, an increase not unexpected given the sales increase during the year. Moreover, during the fourth quarter, PC-Clone began shipping personal computers using the latest microprocessor (fifth generation) available on the market.

Julie is concerned because the finished goods inventory includes a significant number of IBM-compatible clones based on the fourth generation microprocessor chip. These machines are nearly obsolete by industry standards, and their market price has dropped significantly. Only last week, during a visit to a large discount computer store, Julie noted that identical machines which PC-Clone valued at their manufactured cost of $1,500 per unit were selling for only $999 per unit, a price that she estimates would include about $100 per unit gross profit for the retailer. She believes that managements $2.5 million valuation for the fourth generation machines may be too high and that the older machines may have a net realizable value of only $1.5 million.

The valuation for the remainder of the inventory appears reasonable. The six million dollar valuation placed on the companys newest model, the fifth generation machines, is in line with manufacturing costs and current market prices. The $1.5 million valuation of parts, supplies and goods in process also appears reasonable.

If Julies inventory analysis of the fourth generation machines is correct, PC-Clone faces an inventory writedown and a pre-tax profit adjustment of one million dollars, a material amount in relation to net income. Julie realizes a million dollar inventory writedown may create some tension between herself and PC-Clones managers. She declines to join staff for lunch, opting instead to prepare a more detailed analysis of the fourth generation machines, tracing the data back to original documents and manufacturing records.

Julie Madison brings important knowledge to her position as audit manager at the accounting firm Kramer and Hernandez, LLP. Since joining the firm five years ago, Julie has established herself as the in-house expert in microcomputers. Her undergraduate degree in computer science and Masters degree in accounting have served her well since graduation from Kennesaw State University. She greatly admires the ability of small manufacturers like PC-Clone to quickly match the hardware advances of the computer giants, selling virtually identical personal computers at substantial discounts to the prices of the major manufacturers.

Later that afternoon, after her own evaluation confirmed Sam Lees original analysis, Julie takes the inventory evaluation directly to Tim Bloom, CPA, the chief financial officer of PC-Clone and a former audit manager at Kramer and Hernandez. Perhaps he can justify the valuation for reasons that are not apparent to her.

Together with Sam Lee, she enters the CFOs office carrying the audit analysis and computer printouts of the companys finished goods inventory valuation.

Tom, I have some questions about the finished goods inventory, specifically about the $2.5 million valuation of the companys fourth generation microcomputers. By industry standards, the fourth generation machines are essentially obsolete, and the new faster fifth generation models are becoming widely adopted. The next (sixth) generation of microcomputer chips is expected within a few months. According to your records, about 25 percent of the inventory is in fourth generation models. These machines cant be sold for anything near the manufactured cost recorded in your inventory, she said.

At $1,500 per unit, those machines are valued at manufactured cost which is probably at least $600 per unit higher than they can be sold through your usual discount outlets. Based on my analysis, the finished goods inventory appears to be overvalued by about $1 million, which means that pre-tax profits are overstated by that amount.

Wait a minute, Julie, said Tom. We have plans for those machines. We propose to export them to South America and Africa where we think can develop a market for them. I dont intend to write that inventory down until we see whether they can be sold at a profit in the export market, Tim declared.

Our profits were outstanding this year, despite the economic downturn and higher development and marketing costs for our newest models, he continued. Right now we show a nice profit increase compared to last year, and we need to maintain that positive trend.

Julie replied quietly, What progress has been made toward developing a market for these machines? Are there signed contracts with South American or African companies?

Marketing is currently working on several contracts. Rick Washington, the marketing manager, can give you the current status, Tim replied.

PC-Clone plans to issue stock to the public within the next six months. If we have to take a bath on those older machines now, we might jeopardize our chances for a favorable stock offering. I cant adjust that inventory at this time.

This companys intention to go public doesnt change my conclusion that your inventory is overvalued, Julie responded politely, but firmly.

Tim interrupted. If you have other questions about the inventory, you should discuss then with Jack Kramer. Im sure he will agree with me on the valuation.

He rose from his desk. Now please excuse me, Im already late for a meeting with the president.

Julie telephoned Rick Washington and asked for an appointment to discuss the developing export market for the fourth generation machines. Washington agreed to see her immediately.

Julie dispensed with the small talk and moved directly to the issue at hand. Rick, would you review with me the current status of PC-Clones efforts to develop an export market to the fourth generation PCs?

Weve contacted a number of agents who may be interested to represent us. We have one signed contract with a South American company to take some machines on consignment, he replied, reaching into his desk drawer and retrieving a slim file.

Julie scanned the letters from several agents. The correspondence indicated that the agents were in active discussions with several companies who had expressed interest in purchasing the PCs. She then examined the single consignment contract. The South American agent committed a Caracas retailer to accept 250 machines on consignment for a maximum term of six months. She returned the file to Washington and left the marketing area.

She wrote a note documenting her findings and then returned to the offices of Kramer and Hernandez, LLP to discuss the issue with Jack Kramer. Jack was in his office and would see her immediately. Gathering her materials she walked to the senior partners office, prepared to lay out her case in detail.

Jack Kramer, CPA, managing partner of Kramer and Hernandez, LLP for the last 20 years, is an extroverted, marketing-oriented professional. He has built the most successful audit practice in the city and is highly regarded in the business community.

Before Julie could present her analysis, Jack Kramer announced that Tim Bloom had telephoned and discussed her concerns about the inventory valuation with him directly.

I understand you think the finished goods inventory should be reduced by perhaps $1 million. Because PC-Clone plans to export this equipment, I think Toms judgment in this situation is appropriate. I encountered a similar situation in another audit about six months ago. The client was successful developing a market in Russia for several older models of lathes that were exported and sold at a price above cost. There was a similar delay in finalizing the export and distribution channels. Conditions can be chaotic in some countries where our clients are trying to distribute their products. I believe thats the situation at PC-Clone. We need to be patient as they develop new distribution channels.

He paused and gazed out the window at the city skyline spread out before him. He continued softly. Recall, Julie, that I strongly supported your recent promotion to manager because I believe you possess the attributes necessary to eventually become partner in this firm. This is your first in-charge assignment, and its very important for you to develop the confidence and trust in our clients senior managers. Perhaps you were a bit precipitous in insisting to Tim Bloom that a writedown is in order at this point.

I appreciate your confidence in my ability, Jack, said Julie. However, I am really troubled by this valuation.

Based on our current information, I think your conclusions are unduly conservative and premature. PC-Clones inventory valuation will not be adjusted downward. If that inventory needs to be written off at a later date, Tim Bloom will deal with it. For now, I suggest you wrap up the audit as soon as possible.

Wont you take a look at my analysis before you sign off on this? Julie handed him the materials.

Of course, said Jack, opening the file. If I had not encountered a similar situation recently, I might agree with your conclusion. However, Ill review your work and get back with you tomorrow morning.

He smiled as Julie stood up to leave. By the way, we need to begin planning our role in preparing the initial public offering of PC-Clones stock. I expect you to be heavily involved in that assignment. It offers a great opportunity for you.

Fine, said Julie. Ill see you in the morning. She smiled and left.

Back in her office, Julie made a note to personally review the work papers of the client to which Jack had referred. Perhaps she had been premature in her conclusions about the inventory valuation. If she had shown Jack Kramer her analysis before discussing it with Tim Bloom, would the outcome have been different? She glanced at her watch. It was getting late. She decided to go home, sleep on the matter and start fresh tomorrow.

Pretend you are Julie Madison. You are home thinking about the events that transpired today on the audit of PC-Clone. After going over all of the facts, write a one-page memo to the audit partner, Jack Kramer, indicating the course of action you are taking on the PC-Clone audit.