The lakeside company of richmond, virginia, takes a physical count of this inventory at the

end of each calendar year. The company traditionally carries out this procedure on the first
Sunday in january. Inventory levels are relatively low at this time of year. Each manager and
assistant manager normally count the merchandise within their own store while members of
lakeside’s inventory department determine the quantitiy at the company warehouse. Since
lakeside maintains perpetual inventory balances, the final count for every item can be
reconciled to the company inventory records as of december 31. All significant variations
between the quantity physically present and the perpetual records are double checked at a
later date.

The independent CPA firm of abernethy and chapman decides that, because of the material
nature of the inventory balances, observation of the january 3, 2010, count will be required.
Dan cline, audit partner for the engagement, suggests that the firm observe the physical
inventory taken at the warehouse as well as the count made at two of the company’s six
stores. These two stores will be selected at discuss the planning of this process with members
of the lakeside management. Because this year’s audit is the first for abernethy and chapman,
cline wants assurance that the physical inventory procedures are appropiate. Thus, both he
and andrews carefully review a copy of the memo (presented in exhibit 8-1), which is
distributed to all members of the lakeside counting team. This memo is designed to ensure
that all personnel understand fully the tasks that theya are to perform.

As can be seen from the memo in exhibit 8-1, lakeside utilizes a

“tag system” for accounting inventory. Prior to the actual account, the inventory is separated
into groups of like items. Employees then complete and attach a prenumbered tag (see exhibit
8-2) to each group. This tag includes a description of the merchandise and the quantity
present. Later, after the entire inventory has been counted and tagged, the lower portion of
each tag is detached and returned to the controller’s office for listing. The list provides
lakeside with a record of all merchandise presently being held. Subsequently, the contoller’s
office inserts a unit cost for each of these items. The total cost is then computed by
multiplying the quantity times the unit cost. These individual amounts are added to arrive at
the gross cost of the january 3 ending inventory. Lakeside still has to “roll” this figure back to
the december 31 balance by removing the effects of any january 1 and january 2 transactions.
As the final step in this process, the december 31 adjusted total must be reduced by any
discount taken in acquiring the current merchandise. The resulting balance will be reported as
the cost of lakeside’s inventory.

Caroline mitchell has been assigned by abernethy and chapman to observe the physical
inventory taken at the the client’s warehouse. Prior to january 3, she reviews lakeside’s
physical inventory memo (exhibit 8-1) to provide herself with an understanding of the
process being used. On that Saturday morning, mithchell arrives just before 8.00 a.m and
begins her work by discussing the counting procedures with the lakeside employees who are
present. She then proceeds to the inventory departement’s files and locates all receiving
reports and bills of lading for the past week. She record these document numbers and their
dates as well as the quantity and descreption of the merchandise received and shipped.
When mitchell returns to the actual count, she has several spesific audit tasks to perform :
1. She verifies that the tags are consecutively numbered.
2. She observes and evaluate the reliability of the procedures being utilized by the client.
Lakeside uses two person system whereby one individual counts the inventory while
the other records the relevant information on the tags. Mitchell makes certain that all
employees understand their task and are following the instructions properly.
3. She examines the client’s inventory for any sign of damage, obsolescence, or other
problems that would prevent the merchandise from being sold at normal prices.
4. She searches for any evidence that might disclose inventory items being held on
consignment or that is hidden or overlooked in the counting process.
5. She also search for inventory that is hidden or overlooked in the counting process.
6. After all items have been counted and tagged, she records the last tag number that was
used.
7. On a sample basis, she count the inventory actually present to asccertain that this
quantity agrees with the figure listed on the tag. She records each of these test counts
in her audit documents.
8. She authorizes the employees to collect the inventory tags.

After mitchell completes her inventory observation, she documents her findings in the audit
document presented in exhibit 8-3. Several days later, she receives a complete listing of the
company’s inventory from lakeside. The portion relating to the warehouse count is
reproduced in exhibit 8-4. This inventory has been costed using a master price list furnished
by cypress product (see exhibit 6-6). Also as can be seen at the bottom of exhibit 8-4,
lakeside has already adjusted the total count for inventory transactions occuring on january 1
and january 2 (see exhibit 8-5). Furher reduction is made for the 3 % cash discount available
from cypress as well as monthly discounts offered on selected items. Thus, the physical
inventory in the warehouse as of december 31, 2009, had a cost to lakeside of 665.997,57. On
that same date, the company’ perpetual records indicated a balance of 672.154,35 so that a
year end reduction of 6.156,78 is necesarry to reconcile the accounting records with the
inventory count.

Discussion questions
1. Why would the physical count of lakeside’s inventory produce a balance more than
6000 below the figure indicated by the company’s own perpetual records? Is this
difference a material amount that warrants further investigation by abernethy and
chapman ?
2. Members of a company’s management may ocasionally attempt to over count ending
inventory. What is the rationale behind this type of irregularity? Is this potential
problem especially significant in the audit of the lakeside stores?
3. Members of a company’s management may ocasionally attempt to undercount ending
inventory. What is the rationale behind this type of irregularity? Is this potential
problem especially significant in the audit of the lakeside stores?
4. Assume that a material misstatement occurs (either unitentionally or otherwise) in
counting lakeside’s inventory. The problem is not discovered by abernethy and
chapman and eventually appears within the client’s financial statements. What’s the
CPA firm’s responsibility for such misstatements?
5. The CPA firm of abernethy and chapman has decided to observe the physical
inventory at only two of lakeside’s six stores. Given the materiality of the inventory
balance, was this decision appropiate?
6. As part of the substantive testing of inventory balances, the auditor normally reviews
the client’s sales return for the period immediately following the end of fiscal year.
What is the significant of this testing procedure?
7. In her observation, mitchell recorded the last inventory tag number used by lakeside.
What’s the significance of this testing procedure?
8. What actions should mitchell have taken if she had discovered any damaged or
obsolate inventory items? How would the auditor determine if the inventory is
obsolete?
9. Evaluate the effectiveness and efficiency of lakeside’s physical inventory procedures.

Exercise
1. Mitchell knows that the following thre audit objectives related to inventory need to be
accomplished :
a. Verify that the physical count she observed agrees with the inventory listing
shown in exhibit 8-4.
b. Verify that the inventory lisiting (exhibit 8-4) provides a fairly presented
inventory cost balance.
c. Verify that the reconciling items on exhibit 8-5 are valid and reasonable.
She assigns these tasks to paul reubens, a new staff auditor recently hired by the firm of
abernethy and chapman. Prepare a step by step audit program for reubens so that he can
achieve these three audit objectives. (case 8-1.doc)
2. Carry out the audit program designed in exercise 1 above. Prepare an audit document
(similar to the one in exhibit 6-1) to document the procedures that were performed
and the evidence gathered. When specified tests cannot be completed, describe the
steps that should have been taken. Indicate whether or not the 665.997,57 balance
should be accepted as a fairly presented representation of the inventory held in
lakeside’s warehouse. (case 8-2.doc)