Laramie Wire Manufacturing, a medium sized company, is planning an initial public offering of its stock in the next two to three years. Laramie operates in a single 500,000 square foot building complex. Laramie buys copper rod and plastic materials to produce insulated copper wiring. The building complex is composed of 3% office space, 57% production area, 15% shipping and receiving area, and 25% finished goods and raw materials inventory warehousing area. Laramie produces several different types and gauges of insulated copper wire.
All the different products Laramie manufactures use the same raw materials, meaning raw material inventory is stored in one location. Within the storage location insulated copper wire is stored on stackable spools with approximately 500,000 feet of wire per spool. The copper rod inventory is stored on 5 feet tall and 6 feet by 6 feet non stackable pallets that hold 1,500 pounds of copper rod. While plastics inventory is stored in 4 feet tall stackable barrels containing approximately 350 pounds of plastic per barrel.
Laramie is a first time client of the firm, and has hired the firm to perform a financial statement audit to prepare for the initial public offering. The senior auditor has been assigned to auditing inventories in the planning stages of the audit, and must conduct analytical procedures. A quick visual examination of inventories revealed no problems and well organized production areas. Under the Public Company Accounting Oversight Board there are several auditing standards that apply to the audit of Laramie’s inventory accounts, and the conduct of analytical procedures. AS No. , Auditing Planning, is the first standard that applies by stating that, “the planned nature, timing, and extent of tests of controls and substantive procedures…. complies with PCAOB standards. ” Secondly, AS No. 14, Evaluating Auditing Results states that, “in the audit of financial statements, the auditor’s evaluation of audit results should include evaluation of the results of analytical procedures performed in the overall review of financial statements. ” Lastly, AS No. 15, Audit Evidence, gives the audit procedures for obtaining audit evidence which includes substantive analytical procedures.
Also, AS No. 15 provides the information that, “analytical procedures consist of evaluations of financial information made by a study of plausible relationships among both financial and nonfinancial data. There are certain auditing standards that pertain to the use of analytical procedures while auditing Laramie’s inventory accounts under the PCAOB. AU 329. 08 states, “Although analytical procedures used in planning the audit often use only financial data, sometimes relevant nonfinancial information is considered as well. This is relevant to Laramie’s case because not only are financial ratios used but nonfinancial information such as, using the square footage of the building complex to assess heightened risk areas within inventory accounts. While AU 329. 08 pertains to analytical procedures, AU 331. 09 is important for how an independent auditor should examine a client’s inventory accounts.
AU 331. 09 says that, “it is ordinarily necessary for the independent auditor to be present at the time of count and, by suitable observation, tests, and inquiries, satisfy himself respecting the effectiveness of the methods of inventory-taking. The auditor usually observes inventory accounts in order to rely on Laramie’s stated condition and quantities of inventory and make a justified opinion. One analytical procedure that does not use financial data is the amount of square footage Laramie has designated for finished goods and raw inventory in its building complex. After calculating the amount of square footage available for finished goods and raw materials there was a problem with the amount reported in the copper wire inventory account for 2008.
The amount of square footage the copper wire pallets take up is more than the amount of square footage Laramie has designated for finished goods and raw materials. Therefore, more testing is needed to see if the copper wire inventory was potentially overstated in the amount of pounds in 2008. Another risk for Laramie deals with the percentage of inventory it has on hand from 2008 to support the current amount of sales. Laramie’s inventory to sales percentage increased 16. 4% from 2007 to 2008.
Therefore, this increase shows either that Laramie has trouble keeping inventory accounts down or net sales are slowing relevant to the amount being produced. Also, the increase shows Laramie may have overstated inventories meaning there may be an existence issue. There is a need for further attention to the potential overstatement of inventories because the increase in inventory to sales shows that Laramie is not using its resources efficiently. When calculating the percentage change in inventories, an issue arises when using either the lower cost of market or the market value.
When looking at the calculations for finished goods inventory (insulated wire) and copper rod inventory Laramie has applied the lower cost of market. However, the calculation pertaining to plastics inventory reveals that the market value should be used for classification, but Laramie has used cost. The percentage change of the plastics inventory if the $. 12 per pound is used is a 27% decrease. The importance of classifying inventory correctly either with the market value or cost value ensures inventory is stated correctly on the balance sheet.
With Laramie’s increase in its inventory turnover ratio from 2007 to 2008 the business may not continue as a going concern. Laramie’s status as a going concern business, meaning it has the ability to function as a business for the foreseeable future, will be at jeopardy if inventories continually grow (Messier, pg. 591). Laramie holding more inventories each year puts the company at risk of not being able to pay off liabilities such as accounts payable, and not being able to realize assets such as accounts receivable.
With the above facts pertaining to Laramie, the first management assertion being problematic is existence. Under AU 329. 08, an auditor is allowed to use not only financial data but relevant nonfinancial information to perform analytical procedures. Nonfinancial data was used to find that the copper rod inventory does not fit in the designated amount of space for finished goods and raw materials in the building complex. Laramie has an existence problem because either it has less inventory than what is stated or there is more storage room than it has documented.
As a result, either inventory is understated or overstated on the balance sheet for 2008. Secondly, an obvious management assertion with problems relating to inventory accounts is valuation. When valuing inventory on the balance sheet Laramie should use the lower of cost or market value. However, Laramie did not use the right valuation method pertaining to the plastics inventory. Laramie as a company will be at risk in the area of valuation due to the fact of its price, inventory, and sales changes from 2007 to 2008.
Laramie being a manufacturing company may have problems with the management assertion of completeness even though the analytical procedures did not point to any problems. An issue may arise within Laramie because they deal with two different types of raw materials, copper and plastics. Also, the production area is divided into three areas containing residential, industrial, and special-order products. Therefore, having a large production layout and different raw materials to account for Laramie could miscount the amount of raw materials on hand.
Also, Laramie places its finished goods inventory and raw materials inventory next to each other. This may also cause a problem when trying to count the number of spools that are in finished goods inventory and the amount left in raw materials inventory. A fourth management assertion Laramie may have difficulties with is cutoff. Laramie may not be able to ensure it has recorded its inventory transactions in the correct period. Laramie tags the spools of insulated copper wire the day customers request the spool.
However, depending if Laramie is on the cash or accrual basis there is a possibility that the date requested and the date the inventory is shipped are not the same. Therefore, if an error occurs a transaction recorded in the wrong time period could affect the ending balance of the inventory account. The fifth management assertion Laramie must look over is its rights and obligations. Risk may rise when Laramie sells a spool of insulated copper wire to a customer, because an issue of who pays the transportation costs arises pertaining to the free on board point.
If free on board destination is agreed upon this means more risk for Laramie because the company takes the risk of damages and pays shipping charges. The reason being because ownership of the spool does not transfer to the customer until arrival (Wild, pg. 158). As a result, Laramie needs to make sure free on board origin is agreed upon in order to minimize its risk.
Messier, William F. , Glover, Steven M. , Prawitt, Douglas F. Auditing & Assurance Services: A Systematic Approach. 7th ed. New York, NY. McGraw Hill, 2010. Wild, John J. Financial Accounting: Information for Decisions. 4th ed. New York, NY. McGraw Hill, 2008.