You are the in-charge accountant on the audit of Amazing Inc. (AI). It is March 25, 2016, and your firm is part way through the 2015 audit. You are currently assigned to work on various sections within the accounts payable and inventory section of the audit file. Inventory at yearend is $5.2 million. Materiality is set at $225 000.

Company Background

AI is a small manufacturer of women's jewellery (including bracelets, necklaces, and earrings). Most of its products are made of silver, 14 Kt gold, and various semiprecious stones. AI has its financial statements audited due to a $15 millionloanwith RBC Business Financing Group. The terms of the loan requires meeting certain financial covenants-a minimum inventory value of $5 million carried at "lower of cost and market" and a current ratio of 2:1. AI is also required to submit, within 90 days of its year-end, audited financial statements to RBC.

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 January 10, 2016, a ship carrying AI's merchandise sank off the coast of India. Unfortunately, AI's insurers are denying AI'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. AI has not paid the vendor and does not consider this a valid purchase. The vendor is suing AI 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. AI'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 sank 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 AI). If the amount is accrued, AI will not meet its required current ratio per the bank covenant.

REQUIRED

a. Based upon the case facts, evaluate the impact of the shipping accident claim on the financial statements and provide a recommendation on the appropriate accounting treatment(s).

b. Using the professional judgment framework from Chapter 4 , discuss what are the appropriate actions the auditor should take if management does not accrue or disclose the vendor's lawsuit related to the shipping accident.