This case will enable you to practice conducting planning and substantive analytical procedures for accounts in the acquisition and payment cycle. When analyzing the financial data, you may assume that the 2015 information is unaudited, while prior year data is audited.
As you complete this case, consider the following features of and trends in the pharmaceutical industry and for Pharma Corp specifically:
• After a long period of industry dominance by companies in the United States, the United Kingdom, and Europe, these companies are facing increasing competition from companies domiciled in emerging economies, such as Brazil, India, and China.
• There exists significant uncertainty in the market because of recent regulation covering health-care and government payouts for certain procedures and related pharmaceuticals.
• Health-care policy makers and the government are increasingly mandating what physicians can prescribe to patients.
• Health-care policy makers and the government are increasingly focusing on prevention regimes rather than treatment regimes, thereby leading to shifts in the demand for various pharmaceuticals.
• The global pharmaceutical market is anticipated to grow by 5% to 7% in 2016 compared with a 4% to 5% growth rate in 2015, according to a leading industry analyst publication.
• Beginning in 2014, PharmaCorp initiated and executed a significant company-wide cost reduction initiative aimed at improving manufacturing efficiency, cutting back on research and development expenses, and eliminating unnecessary corporate overhead.
• PharmaCorp's policies for extending credit to customers have remained stable over the last three years. PharmaCorp's credit-granting policies are considered stringent within the industry, and analysts have sometimes criticized the company for this, contending that such policies have hindered the company's revenue growth relative to industry peers.
• Two of PharmaCorp's popular pharmaceuticals, Selebrax and Vyvox, came off patent during the fourth quarter of FYE 2015. These pharmaceuticals now face competition in the generic drug portion of the overall industry market.
Information specific to the Acquisition and Payment Cycle
• Raw materials inventory required in the businesses are purchased from numerous suppliers. No serious shortages or delays of raw materials inventory were encountered in 2015, and none are expected in 2016. PharmaCorp has successfully secured the raw materials inventory necessary to meet its requirements where there have been short-term in balances between supply and demand, but generally at higher prices than those historically paid.
• A risk that companies in this industry face with respect to the acquisition and payment cycle is that there is a possibility of failing to maintain the integrity of supply chains, possibly resulting in intentional and criminal acts such as product diversion, product theft, and counterfeit raw materials inventory.
• In response to pricing pressure, several major suppliers changed their policy with respect to discounts for early payment of amounts due on credit sales. In response, PharmaCorp changed its policy of paying within two weeks to paying within four weeks since it is no longer monetarily beneficial to do so from a cash management perspective.
Part I: Planning Analytical Procedures
a. Step 1: Identify Suitable Analytical Procedures. Your audit senior has suggested that the following ratios (on an overall financial statement level) will be used for planning analytical procedures in the acquisition and payment cycle at PharmaCorp: Inventory Ratios
• Gross margin analysis (revenues-cost of sales)/revenues
• Changes in cost of goods sold on a percentage basis, yearly comparisons
• Inventory turnover (cost of goods sold/ending inventory)
• Number of days' sales in inventory (365/inventory turnover) Accounts Payable Ratios
• Accounts payable turnover (purchases/average accounts payable)
• Days outstanding in accounts payable (365/accounts payable turnover)
• Accounts payable/current liabilities
As part of Step 1, identify any other relevant relationships or trend analyses that would be useful to consider as part of planning analytics. Explain your reasoning.
b. Step 2: Evaluate Reliability of Data Used to Develop Expectations. The audit team has determined that the data you will be using to develop expectations in the acquisition and payment cycle are reliable. Indicate the factors that the audit team likely considered in making that determination.
c. Step 3: Develop Expectations. Complete Step 3 of planning analytical procedures by developing expectations for relevant accounts in the acquisition cycle and for the ratios from Part
(a). Develop expectations by considering both historical trends of PharmaCorp, and also by considering features of and historical trends in the industry. Given that this is a planning analytical procedure, the expectations are not expected to have a high level of precision. You might indicate that you expect a ratio to increase, decrease, or stay the same, and possibly indicate the size of any expected increases or decreases, or the range of the expected ratio. Pharma-Corp's financial information is on first tab of the Excel file, while the financial information for Novartell and AstraZoro is provided on the last two tabs of the Excel file.
d. Step 4 and Step 5: Define and Identify Significant Unexpected Differences. Refer to the guidance in Chapter 7 on performance materiality, tolerable misstatement, and clearly trivial amounts. Apply those materiality guidelines to Step 4 of planning analytical procedures in the acquisition and payment cycle for PharmaCorp to define what is meant by a significant difference. Explain your reasoning. Also comment on qualitative materiality considerations in this context. Now that you have determined what amount of difference would be considered significant, calculate the ratios identified in Step 1 (and any additional ratios or trend analyses that you suggested), based on PharmaCorp's recorded financial statement amounts. Identify those ratios where there is a significant unexpected difference.
e. Step 6 and Step 7: Investigate Significant Unexpected Differences and Ensure Proper Documentation. Complete Step 6 of planning analytical procedures by describing accounts or relationships that you would investigate further through substantive audit procedures. Explain your reasoning. To complete Step 7, describe what information should be included in the auditor's work papers.
Part II: Substantive Analytical Procedures
f. Management has explained the decline in cost of goods sold as involving:
• Lower purchase accounting charges, primarily reflecting fair value adjustments relating to acquired inventory that was subsequently sold
• Lower costs related to new cost reduction and productivity initiatives, as well as savings generated from ongoing productivity initiatives to streamline the supply-chain network
• Reduced manufacturing volumes related to products that lost exclusivity in various markets
• The impact of favorable foreign exchange rates of 3%. Explain the types of ratio analysis that you could conduct in substantive analytical procedures to test the validity of management's explanations. Comment on the trends and relationships that you believe are most relevant, and implications for further substantive testing.