You are doing a review engagement and the related tax work for Regency Tools, Inc., a tool and die company with $2,000,000 in sales. Inventory is recorded at $125,000. Prior-year unaudited statements, prepared by the company without assistance from a public accounting firm, disclose that the inventory is based on “historical cost estimated by management.” You obtain the following facts:
1. The company has been growing steadily for the past five years.
2. The unit cost of typical material used by Regency Tools has increased dramatically for several years.
3. The inventory cost has been approximately $125,000 for five years.
4. Management intends to use a value of $125,000 again for the current year-end financial statements.
When you discuss with management the need to get a physical count and an accurate inventory, the response is negative. Management is concerned about the effects on income taxes of a more realistic inventory. The company has never been audited and has always estimated the historical cost of inventory. You are convinced, based upon inquiry and ratio analysis, that a conservative evaluation would be $500,000 at historical cost.
REQUIRED
a. What are the generally accepted accounting requirements for valuation and disclosure of inventory for unaudited financial statements with a review report?
b. Identify the potential legal and professional problems that you face in this situation.
c. What procedures would you normally follow for a review engagement when the inventory is a material amount? Be as specific as possible.
d. How should you resolve the problem in this situation? Identify alternatives, and evaluate the costs and benefits of each.