Chapter 11 – Auditing Inventory, Goods and Services, and Accounts Payable: The Acquisition and Payment Cycle
Group 3
Wajd Al Ghailani
Geoffrey Lee
Sophie Ndiaye
Katey Patterson
ACG4651-21 Fall 0003
12/01/2021
Chapter 11 – The Acquisition and Payment Cycle: Question 55 Pharma Corp
Part I: Planning and Analytical Procedures
Step 1: Identify Suitable Analytical Procedures. Your audit senior has suggested that the following ratios (on an overall financial statement level) will be used for planning analytical procedures in the acquisition and payment cycle at Pharma Corp:
Inventory Ratios
Gross margin (revenues-cost of sales)/revenues: 81%
Changes in cost of goods sold on a percentage basis, yearly comparisons: -19%
Inventory turnover (cost of goods sold/ending inventory): 1.60
Number of days’ sales in inventory (362/inventory turnover): 277
Accounts Payable Ratios
Accounts payable turnover (purchases/average accounts payable): 3.00
Days outstanding in accounts payable (365/accounts payable turnover): 123
Accounts payable/current liabilities: 15%
As part of Step 1, identify any other relevant relationships of trend analyses that would be usefil to consider as part of planning analytics.
Explain your reasoning.
Step 2: Evaluate Reliability of Data Used to Develop Expectations. The audit team has determined that the data you will be using to develop expectations in the acquisition and payment cycle are reliable. Indicate the factors that the audit team likely considered in making that determination.
The audit team most likely performed a Risk Assesment. They would have identified and assessed the risks of material misstatement, and would have planned the audit to respond to these risks. They would have also obtained evidence about the effectiveness of Pharma Corp’s internal control operating effectiveness. They would have selected controls to test, performed the appropriate tests, and then considered the results of the tests of controls. The internal controls of Pharma Corp would have been determined to be effective in eliminating material misstatements. The auditors would have also performed substantive procedures to confirm there were no material misstatements in account balances such as inventory, accounts receivable, accounts payable, and property plant and equipment.
Step 3: Develop Expectations. Complete Sep 3 of planning analytical procedures by developing expectations for relevant accounts in the acquisition cycle and for the ratios form Part a. Develop expectations by considering both historical trends of Pharma Corp, and also by considering features of and historical trends in the industry. Given that this is a planning analytical procedure, the expectations are not expected to have a high level of precision. You might indicate that you expect a ratio to increase, decrease, or stay the same, and possibly indicate that you expect the size of any expected increases of decreases, or the range of the expected ratio. Pharma Corp’s financial information is on the first tab of the excel file, while the financial information for Navartell and AstraZoro is proved of the last two tabs of the Excel file.
Pharma Corp initiated and executed a significant company-wide cost reduction initiative beginning in 2014. Gross margin for Parma Corp increased by 3% for FY 2015, exceeding the performance of its competitors. COGS for Parma Corp dropped dramatically by 19% for FY 1015, and this reduction may not be consistent with expectations. If the initiative was successful COGS should have decreased year over year. Due to the overall prices of raw materials increasing, ending, ending inventories would be expected to increase as well.
Inventory turnover declined from 2.13 to 1.6, which would have been consistent with the expectation of reduced sales as Selebrax and Vyvox were subject to increased competition from generic products. The decline has caused the inventory turnover of Pharma Corp to be significantly less than its competitors, and this should be investigated with substantive procedures with respect to valuation.
Pharma Corp’s accounts payable polices have remained stable over the last three years, therefore accounts payable turnover should remain stable.
Step 4 and Step 5: define and Identify Significant Unexpected Differences. Refer to the guidance in Chapter 7 on overall materiality, and posting materiality. Apply those materiality guidelines to Step 4 of planning analytical procedures in the acquisition and payment cycle for Pharma Corp, to define what is meant by a significant difference. Explain your reasoning. Also, comment on qualitative materiality considerations in this context. Now that you have determined what amount of difference would be considered significant, calculate the ratios identified in Step 1 (and any additional ratios or trend analyses that you suggested), based on Pharma Corp’s recorded financial statement amounts. Identify these ratios where there is a significant unexpected difference.
For overall materiality we could use 5 percent of net income (in millions): $729, or 1 percent of total assets: $1858, or 1 percent of net sales: $485. For posting materiality we could use the 5 percent of overall materiality guideline, which would result in the following: $36 for net income, $92 for total assets, and 238 for net sales.
The most traditional approach, net income would result in overall materiality of $729m and posting materiality of $36m. However, in this case we are focusing on the revenue cycle, therefore we would use net sales, and the numbers would be $485m for overall materiality and $4.85m for posting materiality.
Considering qualitative materiality considerations and the fact that we are focusing on the revenue cycle, we should also consider using inventory in this case, because it has a direct effect on COGS and therefore net income. We could then use the 1 percent of ending inventory convention which would result in overall materiality of 70m and posting materiality of .7m (700k). These would be very conservative numbers, and given our teams assessment that the financial statements are accurate, we would wonder which numbers they used to determine materiality for Pharma Corp during the planning phase of the audit.
The ratios that were determined important for Pharma Corp are listed below:
2015
Gross Margin
81%
Change in COGS Year to Year
-19%
Inventory Turnover
1.60
Day’s Sales in Inventory
227.46
Accounts Payable Turnover
3.00
Day’s Outstanding in Accounts Payable
121.60
Accounts Payable/ Current Liabilities
15%
Turnover of Receivables
4.63
Receivables as a percentage of current assets
0.21
Receivables as a percentage of total assets
0.07
Allowance for uncollectible accounts as percentage of Accounts Receivable
0.03
Step 6 and Step 7: Investigate Significant Unexpected Differences and Ensure Proper Documentation. Complete Step 6 of planning analytical procedures by describing accounts or relationships that you would investigate further through substantive audit procedures. Explain your reasoning. To complete Step 7, describe what information should be included in the auditor’s workpapers.
Despite the overall 4 to 5 percent increase expected in this industry, Pharma Corp’s gross margin has increased 3 percent, and Novartell and AstaZoro saw a 1 percent decrease. This could be attributed to the cost cutting measures implemented by Pharma Corp. We mentioned the importance of inventory accuracy earlier due to its relationship with COGS. COGS has seen a significant decrease of 19 percent for FY 2015. The information about the cost cutting initiative should be investigated and documented as part of the audit.
Inventory turnover has declined from 171 days to 227 days. This decline could be explained by the end of the patents for Selebrax and Vyvox. Ending inventory numbers have increased which is part of the calculation of the inventory turnover. Inventory turnover for Pharma Corp is now significantly lower than its competitors. We feel that this should be investigated with substantive procedures and documentation. The documentation should include evidence and valuation of inventory.
Pharma Corp’s days outstanding in accounts payable has remained consistent using the limited data given by the financial statements. We would prefer to have ending inventory numbers for 2013 in order to determine average inventory for 2014. The consistent accounts payable turnover numbers are consistent with our expectations.
Pharma Corp’s turnover of receivables has also remained consistent reflecting its reluctance to change its conservative polices for extending credit. Parma Corp’s competitors have somewhat higher numbers for receivables as a percentage of current assets given their more aggressive polices regarding extending credit to customers. This should also be documented in the audit.
The documentation of planning of analytical procedures should be included in the audit, as well as the additional documentation mentioned above for changes in data related to cost cutting measures and investigation of ending inventory. All of the documentation used in creating the work papers should be included. The auditor will document the analytical procedures used, the auditor’s expectations, how the levels of overall and posting materiality were determined, our identification of significant unexpected differences, and the previously mentioned follow-ups to the unexpected differences.
Part II: Substantive Analytical Procedures
Management has explained the decline in cost of goods sold as involving:
Lower purchase accounting charges, primarily reflecting fair value adjustments relating to acquired inventory that was subsequently sold.
Lower costs related to new cost reduction and productivity initiatives as well as savings generated from ongoing productivity initiatives to streamline the supply chain network.
Reduced manufacturing volumes related to products that lost exclusivity in various markets.
The impact of favorable exchange rates of 3%
Explain the types of ratio analysis that you could conduct in substantive analytical procedures to test the validity of management’s explanations. Comment on the trends and relationships that you believe are most relevant, and implications for further substantive testing.
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