QUESTION 2: UNDERSTANDING THE INTERNAL CONTROL PROCESS, ASSESSING CONTROL RISK AND INVENTORY MANAGEMENT SYSTEM OF RUSSELL LTD.

Russell Ltd carries four types raw-chemicals under both product Line A and product Line B as shown in the table below. The company uses perpetual inventory system and adopts FIFO (first in and first out) method to estimate the inventory cost. Inventory level is managed and monitored by APEX, an inventory management system.

There are two central warehouses. One is located in Auckland, New Zealand and the other is in Adelaide, Australia. The warehouses dispatch clothes to all retailing stores within the country. In addition, the Australia warehouse dispatches stock to stores in Indonesia. On the balance date, the two central warehouses hold 20% of total inventory and all retailing stores hold 80% of total inventory.

Retail stores Inventory at Year End

Location	Number of stores
Auckland	5
Wellington	4
Christchurch,	3
Perth	6
Adelaide	6
Total	24

Nature of the range	Label	Value $000
Product Line A	Chemicals-P2P	173000
	Chemical-T2P	100000
Product Line B	Chemicals-Paints	89000
	Chemicals-cosmetics	100000
Total Closing balance of inventory		462000

APEX - INVENTORY MANAGEMENT SYSTEM

APEX, the companys inventory management system has a central server. It records information on inventory item code, item description, cost price per item, selling price per item, and the available quantities. It also tracks the available quantities of inventory in each warehouse and store. Reorder point was not set up in APEX. Instead, the order quantities are based on anticipated sales level.

Since some raw materials sell quicker than others, Russell has a policy of providing 30% discounts for inventories (raw materials) that have been on the shop floor for more than 4 weeks and 50% discount after 7 weeks. New inventory normally arrives in the store every 4 weeks. The discounts are automatically applied to the inventories based on their arrival dates in the stores, by using a Sales Register System SALENET.

SALENET THE SALES REGISTER SYSTEM

SALENET links to APEX (the companys inventory management system); and the terminals for the sales system are located in each store. SALENET records cash and credit card sales, calculate discounts, sales tax and produces Daily Sales Report (DSR) for each store. The DSR records all raw types of raw materials under both product lines and quantities sold on that day, and the sales and cost prices of those raw materials. The SALENET system automatically updates inventory levels in APEX at midnight daily, after which it also exports information on the DSR to the general accounting system (a separate software) for the recording of sales.

SUPPLIERS

In Russell Ltd, inventory (raw materials) code, description, and quantities ordered are assigned with a pre-numbered Purchase Order (PO). The Malaysian suppliers source the different inputs-raw materials used for producing chemicals from their local markets. The payment arrangement agreed between Russell and the Malaysian suppliers is as follows: (1) 40% of total costs as a deposit at the time when the completed negotiation and the PO are sent to the suppliers. (2) Once the raw materials are ready and shipped, Russell has 30 days to pay the remaining balance 60%. The suppliers provide a Bill of Lading as proof that the garments are shipped, its ownership transfers to Russell at the time of shipment. When the inventory are shipped (Russell receives a copy of the Bill of Lading via email), the accounting department records a journal entry to recognise both inventory-in-transit and account payable, but the actual inventory level in APEX is not updated until the inventory arrived at the warehouse.

RECEIVING INVENTORY

The shipment of raw-inputs arrives at the central warehouses. The barcodes and the quantities of inventory items shipped are printed on the outside of the cartons. A Packing Slip is attached to each shipment. Each barcode printed on the carton contains information on the inventory item code and raw materials description.

For each shipment that arrives, the warehouse assistant prints off the relevant pre-numbered PO. The warehouse assistant using a scanning device reads each barcode printed on the outside the cartons and compares it with the information on the PO. When the information agrees, the warehouse assistant ticks and signs the PO. He then logs into the APEX system to click on the received box on the PO filed in the system, after which the APEX system updates the inventory levels and also prints out a Receiving Report (RR). At this point, APEX also sends a copy of Receiving Report to the accounting department regarding the arrival of the inventory. The accounting department then initiates a journal entry to reverse inventory-in-transit and to increase inventory. The warehouse assistant is authorised to alter the quantities received in APEX to reflect the actual received quantities when there is a discrepancy in the information between the PO and the barcodes printed on the cartons. The Receiving Report and suppliers Packing Slip are filed in the warehouse. The signed PO and a copy of Receiving Report are handed to the inventory manager for inventory distribution.

DISTRIBUTING INVENTORY TO RETAIL STORES

The inventory (chemicals) manager is responsible for distributing inventory to the retail stores. The inventory distribution is usually based on the size and turnover of the retail store. When the new inventories arrive, the inventory manager uses APEX to allocate inventory to each retail store. APEX generates and prints a pre-numbered Distribution Report which displays the inventory item code, item description and quantities and the location of the store. Two copies of the Distribution Report go to the warehouse for packing and then shipping via an external carrier. The warehouse files one copy of the Distribution Report and the other copy goes with the inventory to a retail store. When the inventories arrive at the retail store, the shop manager logs into the APEX system. She identifies the relevant shipment by checking its reference number on the Distribution Report and then confirms receipt of the inventories by clicking the arrived in store box, after which the shop manager and/or assistants unpack the inventory.

Russell carried out an annual inventory count on the 30 June 2016 at 6pm local time. During the inventory counts, the stores were shut. Each store manager has access to APEX. They can read and print out inventory reports, but they cannot edit the inventory levels in APEX. For the inventory counts, the store manager prints out a list of inventories held in the store, which shows the item code, description and quantities. Two staff members and the manager count the stock and write down the numbers counted next to each inventory item on the list. They take note of any differences. At end of the inventory count, the store manager prepares an Inventory level Report which notes the differences using SALENET. SALENET adjusts the inventory level in APEX at midnight to reflect the results from the inventory count. A copy of the Inventory Count Report from each individual store are sent to the accounting department, at where all reports are aggregated based on item codes. The accounting department then adjust the inventory level accordingly in the accounting system.

QUESTION 2: UNDERSTANDING THE INTERNAL CONTROL PROCESS, ASSESSING CONTROL RISK, AUDIT PROCEDURE FOR INVENTORIES

Assuming the control risk is medium, explain substantive audit procedures for verifying inventory at year end. The substantive procedures should address the following assertions, and explanation should be given for the procedures. [25 marks]

You are required to present your answers according to this format:

Assertions	Audit procedures	Details and rationale of each procedure
Existence & Occurrence
Completeness
Accuracy & Valuation