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Preview Company a diversified manufacturer has five divisions that operate throughout the United States and Mexico Preview has historically allowed its divisions to operate autonomously

Preview Company, a diversified manufacturer, has five divisions that operate throughout the United States and Mexico. Preview has historically allowed its divisions to operate autonomously. Corporate intervention occurred only when planned results were not
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obtained. Corporate management has high integrity, but the boards of directors and audit committee are not very active. Preview has a policy of hiring competent people. The company has a code of conduct, but there is little monitoring of compliance by employees. Management is fairly conservative in terms of accounting principles and practices, but employee compensation packages depend highly on performance. Chip Harris is the general manager of the Fabricator Division. The Fabricator Division produces a variety of standardized parts foe small appliances. Harris has been the general manager foe the last seven years, and each year he has been able to improve the profitability of the division. He is compensated based largely on the division’s profitability. Much of the improvement in profitability has come through aggressive cost cutting, including a substantial reduction in control procedures over inventory. During the last year a new competitor has entered Fabricator’s markets and has offered substantial price reductions in order to grab market share. Harris has responded to the competitor’s actions by matching the price cuts in the hope of maintaining market share. Harris is very concerned because he cannot see any other areas where costs can be reduced so that the division’s growth and profitability can be maintained. If profitability is not maintained, his salary and bonus will be reduced. Harris decided that the easiest way to make the Fabricator Division appear more profitable was through manipulating the inventory, which was the largest asset on the books. Harris found that by increasing inventory by 2 percent, income could be increased by 5 percent. With the weakness in inventory control, he felt it would be easy to overstate inventory. Employees count the goods using count sheets, and Harris was able to add two fictitious sheets during the physical inventory, even though the auditors were present and were observing the inventory. A significant amount of inventory was stared in racks that filled the warehouse. Because of their height and the difficulty of test counting them, Harris was able to cover an overstatement of inventory in the upper racks. After the count was completed, Harris added four additional count sheets that added $350,000, or 8.6 %, to the stated inventory. Harris notified the auditors of the “omission” of the sheets and convinced them that they represented overlooked legitimate inventory. The auditors traced the items on these additional sheets to purchase invoices to verify their existence and approved the addition of the $350,000 to the inventory. They did not notify management about the added sheets. In addition, Harris altered other count sheets before sending them to the auditors by changing unit designations (for example, six engine blocks became six “motors”), raising counts, and adding fictitious line items to completed count sheets. These other fictitious changes added an additional $175,000 to the inflated inventory. None of them was detected by the auditors. Required: a. Evaluate the strengths and weaknesses of Preview Company’s control environment. b. What factors in Preview Company’s control environment have led to and facilitated Harris’s manipulation of inventory? c. What audit procedures did the auditors apparently not follow that should have detected Harris’s fraudulent increase of inventory? d. What implications would there be to an auditor of failure to detect material fraud as described here? e. What responsibility did the auditors have to discuss their concerns with the client’s audit committee?

May 22 2020 View more View Less

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