Laramie is a medium-sized company that manufacture insulated copper wiring. It supplies different gauges and types of insulated copper wiring in the north-eastern part of the United States for use in applications ranging from residential telephone and electrical wiring to industrial-grade, high-voltage power cables. Generally, there are 5 types of analytical procedures to compares Laramie's balances and ratios with expected balances and ratios. Firstly, compare client and industry data. Secondly, compare client data with similar prior data. Thirdly, compare client data with client-determined expected result. Fourthly, compare client data with auditor-determined expected results. Fifthly, compare client data with expected results, using non-financial data. In this case, Laramie average machine setup time from start to finish is approximately four hours, which is slightly better than the industry average. This means that Laramie is efficient in preparation for production as the machinery is adjusted and calibrated accordingly to the type and size of product to be manufactured, and the size of the batch depends on the amount of product needed for each batch. Furthermore, Laramie divided the production area into 3 areas systematically with each area specializing in a particular-order product group, which including residential products, industrial products and special-order products.
Based on the information given, another type of analytical procedures can be use is comparing Laramie's 2011 data with prior period, 2010 data. The risky area should be pay for further attention is the percentage change in inventories, the as the total inventory increased 53.49% during the accounting period. The dollar value of Finished Goods Inventory increased 44.54% from $1,075,500 in 2010 to $1,554,500; while Copper Rod Inventory increased 62.90% ($1,550,000 to $2,525,000), and Plastic Inventory increased 24.71% ($172,000 to $214,500). However, the sales in 2011 only increased 3.73%. The selling price of copper rod in 2010 and 2011 is remaining at $0.470 so there is no reason for Laramie for over-purchased copper rod in 1 year time. The audit risk under this risky area is control risk, which is the valuation or allocation assertion. This is about the less effectiveness of internal control system caused excess of inventories especially for the Copper Rod Inventory as its selling price remain at $0.470 yet did not put them to produce more output and boost up the sales. These data showed that the Laramie did not fully utilize its raw materials to increase the sales and lower the cost to boost up the company profit. It showed that the business is slowing down as the inventory may be piling up and not being sold during the financial year. It also implies that the company might had over-purchased the goods which there was over budgeted the purchase of stocks during the financial year. This could lead to liquidity crisis as the cash being "held up" in the inventory. The low internal control in inventories system for inflow and outflow of stock did not follow the demand of the company and the re-order inventory system did not follow Economic Order Quantity (EOQ, which the optimum order quantity that it should hold for its inventories given a set cost of production, demand rate and other variables as it can minimize the variable inventory costs. Hence, the firm should find a way to increase the inventory turnover and avoid over-purchased.
On the other hand, the expected value of inventory should be paying more attention as well. Firstly, the expected value of Finished Goods Inventory yields an expected amount of $1,750,000 by multiplying the inventory quantity on hand (Approximately 5250 million ft) with Market Price of Insulated Wire ($0.007). The estimated amount is greater than the reported account balance of $1,554,500. Thus, it is consistent with the inventory being carried at the lower of cost or market value. Secondly, the expected value of Copper Rod Inventory amount is $2,585,000 by multiplying the amount of inventory on hand (Approximately 5.5 million lbs) with the Market Price of Copper Rod ($0.470). This estimated amount is significantly greater than the reported account balance of $2,525,000 and thus appears to be consistence with the inventory being carried forward at the lower of cost or market price. However, expected value of Plastic Inventory is one of the risky area, which needing more attention. The expected value of Plastic Inventory yields at $130,000 by multiplying the plastic inventory on hand (Approximately 1 million lbs) with the Market Price of Plastic ($0.13). The estimated expected value of Plastic Inventory is significantly lesser than reported account balance of it ($214,500). Therefore, it does not appear to be consistence with the inventory being carried forward at the lower of cost or market value. So, the variance should be paying more attention and alert about the cause of it.
Moreover, another risky area of Laramie that needing more attention is the average square feet of warehouse space used by copper rod inventory. According to the information gathered, copper rod inventory is stored on pallets, which are not stackable. It is the only inventory that can calculate the average space occupied in the warehouse. Copper rod inventory on hand is approximately 5.5 million lbs with each pallet occupying 36 square feet. The estimated calculation shows that the copper rod inventory on hand need about 3,667 pallets and the total amount of warehouse space occupied would be 132,012 square feet. This amount is greater than the amount 100,000 square feet (25% of 400,000 square feet for finished goods and raw materials inventory warehousing) warehouse space allocated to inventory, without considering the other types of inventory such as Finished Goods Inventory and Plastic Inventory. This non-financial measure is an indicator of possible problem and risky area that should be follow-up.
Besides that, cost of sales also is the cost of goods sold account increased 2.72% from previous year ($5,980,000 to $6,142,500) compare to an increased in sales of 3.73% as the sales of Laramie did not boost up in the one year time. Cost of sales is the total accumulated costs used to create insulated copper wiring, which has been sold. These costs consist of direct labour, materials and overhead. Thus, the increased of cost of sales might be included the inventory that was scrapped, or declared obsolete and removed from stock, or inventory that was stolen. Moreover, it might indicate that increased of labour costs and overhead costs in the manufacturing process, which the management should also pay more attention to this risky area. The increased of labour costs might be the inefficiency of manufacturing process system as the overall average machine setup time from start to finish is approximately 4 hours, which is slightly better than the industry average. In other words, the internal control system of Laramie in the manufacturing process should be questioning. This risky area will cause Laramie facing the high expenses than prior year and lower its profitability. As Laramie is planning an initial public offering (IPO) of its stock in the next two or three years, this risky area will affect the reputation of the company and investors might not confident with the company management. In the end, this risky area might affect Laramie in the upcoming IPO.
The next risky area of Laramie is the Days Sales in Receivables is longer, 7.9 days as compare previous year. In the other words, it increased 16% while sales only increased 3.73% during the same time period. In other words, didn't increase a lot, but day's sales in receivables increased a lot. Generally, the greater number of days outstanding, the greater the probability of delinquencies in accounts receivable. Thus, we should concern about the increased percentage to find out the cause of it during the process of audit. It might due to the change in collection policies or patterns or possibly to inflated sales, or customers are not paying due to defective products they purchased. The auditors need to look at accounts receivable aging report and returns that are not processed timely by reviewing returns It is in a company's best interest to collect outstanding receivables as quickly as possible as cash is important in running a business. By quickly turning sales into cash, a company has the chance to put the cash to use again. Then, Laramie can ideally to reinvest it and make more sales. This indicates that there is a problem with firm's collection policy and hence the collections of payments are too slow due to the ineffectiveness of collection policies or staff in charge of executing on those policies, which might cause the company facing short of cash flow in the future or ineffective of Laramie in bringing cash into the operating of the company.
Lastly, the risky area of Laramie is Days Purchases in Account Payable. Account Payable decreased 1.7 days as compare prior year (27.1 days in 2010 to 25.4 days in 2011). It should be a good sign that Laramie has smooth cash flow in running business and handling its outgoing payments. But, Laramie has huge increased of Days Sales in Receivables, 7.9 days (16%) and a slightly better of sales in 2011, increased 3.73% yet Finished Goods Inventory increased 44.54; while Copper Rod Inventory increased 62.90%, and Plastic Inventory increased 24.71%. Moreover, the Account Payable for Inventory Purchases of Laramie increased 6.02% ($415,000 to $440,000). This shown that Laramie is having more debts and liabilities obligation towards the suppliers.Thus, Laramie should be facing the situation of tightens cash flow during the accounting period as high inventory stuck in warehouse, longer payments from debtors and higher expenses in running business. Thus, it should be question about the cash flow of the company during the accounting period.
Question 2
Management assertions are implied by management about classes of transactions and the related accounts in the financial statements. Based on the analytical procedures, it can be notice that there are several potential issues with Laramie's inventory as focusing on each of the five management assertions: for the inventory account. The total inventory has rapid increased of 53.49% from 2010 to 2011. The increases are mostly in Finished Goods Inventory and Copper Rod Inventory. The dollar value of Finished Goods Inventory increased 44.54% from $1,075,500 in 2010 to $1,554,500; while Copper Rod Inventory increased 62.90% ($1,550,000 to $2,525,000), and Plastic Inventory increased 24.71% ($172,000 to $214,500). Meanwhile, the sales in 2011 only increased 3.73%. These points rise to potential concerns relating to the valuation and existence assertions, which all items in the inventory account must be physically exist and available for sale. Thus, the auditors should physically count finished goods, copper rod and plastic inventories. Then, determine the actual increase of inventories at the year-end for the accounting period. They also should select items from the inventory ledger, locate them and reconcile the quantity. In terms of completeness assertion, the auditors can go the warehouse to re-check that all the transactions for inventories has been recorded completely and accurately in the accounting system.
Secondly, expected value of Plastic Inventory appears to be carried above market value on the 2011 balance sheet rather than the lower of cost or market value. Based on the information given, market price of plastic drops $0.06 from $0,190 in 2010 to $0.130 in 2011. The plastic inventory on hand (Approximately 1 million lbs) multiplying with the Market Price of Plastic ($0.13) equals to a market value of $130,000. Conversely, the reported plastic inventory in the balance sheet is $214,500, which $0.2145 per lb. This is higher 65% than the expected market value of plastic inventory. The comparison values to a possible concern relating to the valuation assertion so, the variance should be paying more attention and alert about the cause of it. The net realization value of plastic inventory should be calculated to determine whether it is a misstatement of over-stated amount in the report account. This risky area should be for the valuation or allocation. The auditors should make sure that the Laramie sticks with one valuation method for inventory account. For the inventory items, Laramie valuation should based on the lower of cost or market value with several alternative methods for calculating cost such as First-In-First-Out (FIFO), Last-In-Lat-Out (LIFO) or Average Weighted. Besides that, the auditors should also investigate if there is any scarp inventory that need to be recorded and written off, and ask about obsolescence items.
Thirdly, the warehouse space for inventory is greater than the space available in the Laramie's warehouse. The warehouse space used by copper rod inventory alone is more than can fit in the inventory area of the warehouse. According to the financial statement, the company has 5.5 million pounds of copper rod at the end of 2011. Each pallet occupying 36 square feet and can holds 1,500 pounds of copper rod. Thus, the copper rod inventory on hand needs about 3,667 pallets. 3,667 pallets times 6 feet by 6 feet and the total amount of warehouse space occupied would be 132,012 square feet. Based on the information given, the pallets are not stackable. The warehouse only has 100,000 square feet (25% times 400,000 square feet). This warehouse has to hold finished goods and plastic not only copper rod. This non-financial measure is an indicator of possible problem and risky area that rises to a potential concern relating to the existence assertion. In terms of existence assertion, auditors should physically count all the inventories in the warehouse for finished goods, copper rod and plastic inventories and do them stackable in the warehouse. By going through completeness assertion, the auditors can make sure that the entire existing inventories in the warehouse have been recorded completely. For example, the auditors can go around the warehouse to ensure all the inventories are recorded in the inventory ledger.
In the planning of this audit I would advise the staff accountants to make a physical count of inventory. Because it is known how much inventory is stored in warehouse for all the spools, pallets and barrels, how much room they take up and how many there are; by using the cost rate structure also. Internal controls are essential procedures for managing inventory and accounting for revenue and to prevent theft or to ensure that the manufacturing operation does not run short of inputs. Thus, the internal control of inventory is important as assets in inventory are an important part in financial reporting. The basic principle of inventory internal control is perpetual inventory records should be maintained and periodically verified (Audit and Management Advisory Management Services, 2012). The storekeeper, stock-keeper, stock manager and staff accountant should corporate to ensure the internal control of inventory system are well in track. For rights and obligations, I will ask and check is the any consigned inventory at their warehouse because those inventories should not be recorded in the company's inventory ledger. Moreover, I will investigate is there any scrap transactions of inventory, misallocation of raw materials negative balances in inventory and scrap tracking will offset inventory location errors, over-purchase and over-statements of materials in inventor which will cause the company over-state the amount of inventory. The most basic step in inventory control is maintaining a catalogue of exactly what a business has and where it is. All inventory locations should be numbered and inventory items identified with those numbers using tracking system such as bar codes or RFID (Radio Frequency Identification) tags to keep close track of items. Besides that, security system of warehouse also is important in the internal control system. Management should ensures that their inventory keep in a central location, which is secure by add with locks or security codes to ensure that only certain trusted personnel have access to inventory.
On the other hand, storekeeper should count and inspect the entire incoming inventory. All deliveries from suppliers require a count before they go into inventory so that discrepancies between deliveries and purchase orders are immediately remedied. He should verify that all incoming inventory is of the correct type and is not damaged. All items that fail inspection should be returned at once, and the accounts payable staff notified that the returned items should not be paid for. Stock-keeper should standardize record keeping for inventory picking. For example, it should have a standard procedure for recording the picks for production or sale as soon as they leave the warehouse by a record system of sign for all inventory removed from the warehouse. If inventory items are being removed from the warehouse for reasons outside of the normal picking process, have the person removing the inventory sign for the removal to be responsible on it.
Stock keeper should conduct a periodic obsolete inventory review to ensure that to pick up any discrepancies. The warehouse can eventually become choked with obsolete inventory that cannot be used, which requires high storage costs and also interferes with the components that are needed in production. Stock Manager can form a materials review board that periodically go through the inventory records to determine which items should be sold off or eliminated.
Moreover, stock manager should ensure that company maintain an up-to-date inventory by review the inventory records. If inventories are allowed to sit on shelves for too long they will lose value. The storage space that is wasted on out-of-date inventory is a loss in profits and tightens cash flow of Laramie that could instead be using that space for a faster selling product. The warehouse staffs conducts a cycle of small, frequent counts of a small portion of the inventory, investigate and correct any errors they find to improves the inventory record accuracy.
Then, staff accountants of Laramie should ensure periodic audits of bills of materials, misallocation of raw materials negative balances in inventory and scrap tracking will offset inventory location errors, over-purchase and over-statements of materials in inventory. The bill of materials is a record of the parts used to construct a product, which a periodic audit of every bill with password-only access to the bill of material records in the computer accounting system. This is used to pick items from stock, so if the bill is incorrect, pickers will pull incorrect amounts from the warehouse.
If the accounting records show that there is negative inventory on hand, the accountant staffs and warehouse staffs should investigate the negative-balance inventory records. This indicates that there is a transactional flaw caused the negative balance. So, they should record scrap transactions instead delete the scrap in a scrap bin when it occurs. This is because the accounting system treat the scrapped items still is in stock, which will overstate the amount of inventory. On the other hand, they should create a systematic procedure to track scrap on a regular basis. For example, if materials are taken from one warehouse, but mistakenly recorded as taken from a second, the second warehouse may show a negative inventory balance, triggering automatic over-purchasing but in fact the materials are still in the second location.
