You are the In-charge accountant on the audit of Dezine Inc. (DI). It is March 25^th, 2015 and your firm is part way through the audit for the year ended January 31, 2015. You are currently assigned to working on various sections within the Accounts Payable and Inventory section of the audit file.Inventory at year-end is $5.2 million. Materiality is set at $225,000.

Company Background

DI is a small manufacturer of women's jewelry (including bracelets, necklaces, earrings). Most of its products are made of silver, 14 Kt gold, and various semi-precious stones.

DI has its financial statements audited due to a $15M loan with RBC Business Financing Group. The terms of the loan requires meeting certain financial covenants - a minimum inventory value of $5M carried at "lower of cost or market" and a current ratio of 2:1. DI is also required to submit, within 90 days of its year-end, audited financial statements to RBC.

Information on Inventory Cycle

The majority of inventory consists of raw materials and finished goods. DI uses a periodic inventory system to track the physical quantity of goods on hand. The count is performed annually on January 31 of each year. Below are some details on the inventory and accounts payable cycle:

Raw Materials Inventory

• DI uses average costing method to price its raw materials (metals, stones, supplies and packaging).
• The Semi-precious stones and metals are purchased from suppliers in India and Mexico. Goods are shipped FOB Shipping point (Freight on Board - Shipping point means that ownership passed to the purchaser when it leaves the premises in India).
• Goods take on average 3 weeks to arrive once the supplier has shipped them.The supplier notifies DI that the goods were shipped by faxing them over the freight and shipping documents.
• The party responsible (DI or the Vendor) for insuring the goods during shipment is agreed to before shipment.
• All purchase orders are sent to the accounting department once issued.
• Shipping documents and freight/ carrier invoices are faxed directly to the warehouse, after being reviewed (daily) by the purchasing manager and operations manager.
• All documents and freight/carrier invoices are sent to the accounting department.
• The accounting department matches the purchases orders and freight documents and then accrues the purchase.

Work-in-Process and Finished Goods Inventory

• DI uses a job order costing system. Costs are applied to the finished goods as they pass through casting, polishing stone setting, and packaging.
• A manual job ticket is attached to each production batch with quantity of metals, stones, packaging, and number of labour hours (the value is applied at standard labour hour rates).

Vendor Dispute

• In your review of legal expense, you came across a bill related to a vendor dispute.
• Upon inquiry with management you found that on February 10^th, 2015, a ship carrying DI's merchandise sunk off the coast of India. Unfortunately, DI's insurers are denying DI's claim for the value of the goods on board. The insurer argued that it is not responsible since the carrier has had numerous past safety violations and the accident is due to the carrier's neglect.
• DI has not paid the vendor and does not consider this a valid purchase.The vendor is suing the DI and the insurer for recovery of the cost of goods on board. Based on the purchase order, the goods on board cost $1,340,000.
• At year-end, DI's management has decided not to accrue, or disclose in the notes to the financial statements, any liability to the vendor. They have concluded it is unlikely that they will be required to pay the vendor, since the goods sunk only kilometers away from the shipping dock.
• The legal letter indicates that the vendor's claim is outstanding but the lawyer is unable to provide an opinion on the likelihood of payment. When you discuss the matter with in-house legal counsel, you find there are questions surrounding the transfer of ownership and whose responsibility it was to insure the goods (the vendor or DI).
• If the amount is accrued, DI will not meet its required current ratio per the bank covenant.

REQUIRED

1. Identify and explain four [4] inherent risks that are present in the inventory cycle at DI. Tie each risk to the key assertion(s). Specifically tie your risks to case facts (not the inventory cycle in general):

Risk	Explanation	Key assertion(s)

2. Identify and explain three (3) control risk factors that are present in the inventory cycle at DI that could impact existence, cut-off and valuation of inventory at DI. For each control risk, provide an internal control that would prevent that risk from occurring:

Control Risk Factor	Explanation and Relevant Assertion(s)	Internal control that would prevent that risk from occurring

3. Refer to the vendor dispute. Based upon the case facts, evaluate the impact of the shipping claim on the financial statements and provide a recommendation on the appropriate accounting treatment.