South Innovation (SI) operates 300 stores in the hyper-competitive retail market. To compete with companies like Wal-Mart and Target, it lowered prices below cost to attract customers and stimulate growth. While that strategy drove sales revenue up significantly, SI was incurring significant losses because it was selling goods for less than it had paid for them. The president of SI, Eric Shivers, told the investing community that SI's secretive "power-buying" strategy enabled it to beat its larger rivals on pricing. Meanwhile, Shivers was hoping that company growth in sales revenue and opening new stores would enable SI to get large enough to sell its way out of trouble. To hide the losses, Shivers pressured the CFO to keep two sets of books—one for the auditors and one that reflected the truth.

To accomplish its plan for survival and growth, SI would dump losses into a "bucket account" and then reallocate the losses to one of the company's 300 stores in the form of increases in inventory costs. SI issued fake invoices for merchandise purchases, made phony journal entries to increase inventory and decrease cost of sales, recognized inventory purchases but failed to accrue a liability and overcounted merchandise. 

The CFO was able to conceal the inventory shortages because the auditor (PKD, CPAs) observed inventory in only four stores out of 300. Further, PKD would inform SI months in advance about which stores they would visit. SI management fully stocked the shelves of the four selected stores but allocated the phony inventory increases to the other 296 stores. 

 

Question#1

Did PKD violate PCAOB or AICPA audit standards in the manner in which they conducted the inventory audit? Specifically, according to PCAOB standards was PKD required to conduct a surprise (unannounced) audit of inventory at selected stores (a step which may have caused this fraud to be detected)? Please insert the relevant commentary from regulations to support your answer. 

 

Question#2

Describe two analytical review procedures that would have raised red flags about inventory fraud for PKD.