You have been assigned the task of testing the accuracy of the final inventory compilation for Mt. Hood Furniture. You may assume that you have separately observed the inventory and that you are satisfied that the inventory was accurately counted. However, you need to test that quantities were accurately transcribed to the final accumulation and valuation of inventory and that the inventory is correctly priced and accumulated. The table beginning on page 617 presents the audited values associated with Mt. Hood’s pricing and accumulation of all items in inventory. The book values will be given to you by your professor. You may assume that you have performed the tests to determine the proper pricing for raw materials, work in process, and finished goods. The student should understand that the auditor will normally obtain this information only for the items included in the sample.
Required
1. Identify the audit objectives that are accomplished by this test.
2. Determine sample size based on the following audit judgments.
a. Tolerable misstatement is assessed at $325,000.
b. The risk of incorrect acceptance is assessed at 37 percent.
c. Anticipated misstatement is assessed at $100,000.
3. Develop a scenario that is consistent with setting the risk of incorrect acceptance at 37 percent.
4. Select a PPS sample of the above inventory population using the sample size determined in (2) above.
5. Explain the tests that you would perform to test the correctness of pricing of raw materials, work in progress, and finished goods. (The student may wish to consult Chapter 16.)
6. Determine the amount of projected population misstatement based on your sample.
7. Considering your quantitative and qualitative results, develop a statistical conclusion and an audit conclusion based on your sample.
What is incorrect acceptance?
Develop a scenario that is consistent with setting the risk of incorrect acceptance at 37 percent
1. The audit objectives that are accomplished by this test include:
- Testing the accuracy of transcribing quantities to the final inventory compilation.
- Verifying that the inventory is correctly priced and accumulated.
2. To determine the sample size, you would consider the following audit judgments:
a. Tolerable misstatement is assessed at $325,000.
b. The risk of incorrect acceptance is assessed at 37 percent.
c. Anticipated misstatement is assessed at $100,000.
3. To set the risk of incorrect acceptance at 37 percent, you would need to develop a scenario where there is a 37 percent chance of accepting an inventory value that contains a misstatement. This scenario could involve factors such as the complexity of the inventory valuation process, the reliability of the internal controls, and the historical occurrence of misstatements in previous audits.
4. Once you have determined the sample size based on the audit judgments, you would select a probability-proportional-to-size (PPS) sample from the inventory population. PPS sampling involves selecting items from the population with a probability that is directly proportional to their monetary value. This ensures that larger items have a higher chance of being selected, reflecting their higher importance in the overall inventory valuation.
5. To test the correctness of pricing for raw materials, work in progress, and finished goods, you would perform the following tests:
- Reviewing the supporting documentation for each inventory item to verify that the pricing is consistent with the appropriate costs (e.g., purchase invoices, production records).
- Comparing the prices of similar inventory items with industry benchmarks or market prices to assess reasonableness.
- Reconciling the quantity and cost amounts to the general ledger and other related records.
- Inspecting the inventory physically to confirm its existence and condition.
6. Based on the sample selected, you would determine the amount of projected population misstatement. This involves extrapolating the misstatements found in the sample to the entire inventory population. By considering the sampling methodology used, you can estimate the total misstatement in the population. This estimation can be done using statistical techniques, such as mean-per-unit estimation or ratio estimation.
7. Considering both the quantitative (projected population misstatement) and qualitative (reliability of internal controls, accuracy of supporting documentation) results, you would develop a statistical conclusion and an audit conclusion. The statistical conclusion would be based on the projected population misstatement and its confidence interval, indicating the level of confidence you have in the accuracy of the inventory compilation. The audit conclusion would consider the overall effectiveness of the inventory management and valuation process, taking into account the nature and extent of misstatements found during testing. This conclusion would assess whether the inventory is fairly stated and if any adjustments or recommendations are necessary.