The SEC alleged that many deficiencies occurred during the audit of CMH, as discussed in the Auditing in Practice feature in this chapter. Among the complaints were the following:

1. The audit firm "left the extent of various observations 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. Observations of inventory counts at year end were confined 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 computations."

2. The comparison of recorded test counts to the computer lists in the 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 keypunch operator. When the auditors asked to see the inventory tags, the CMH official stated that they had been destroyed.

3. The 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 vendor invoices to support the purchase by CMH of the 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 renumbered purchase orders and shipping documents.

6. There were several differences 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 1,000 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 document obtained by Seidman & Seidman during its observation work.

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

Required

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

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 a physical inventory count?

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