Report to the managing partner of MYH
As per the AASB 102 on valuation of inventories the major issue with the valuation of inventories is the cost that is to be identified and recognized as asset and to be carried forwarded till the recognition of revenues. As per the standard, the inventories shall be measured at net realisable value or cost, whichever is lower. The cost of inventories includes various costs like purchase costs, conversion cost and any other cost that are incurred for making the asset ready for its intended use. The inventory cost may not be recoverable if the inventories or part of the inventories become obsolete or damaged. The inventory cost is not expected to be recovered if the evaluated expenses of completion or the assessed expenses to make sales have expanded (Carey, Potter & Tanewski, 2014). The act of recording inventories below cost to net realisable amount is reliable with the view that benefits should not be carried on in excess of the expected amount of realisation from the sale.
If the inventory is overvalued, it will also overstate the net income as well as gross profit of the company. Further, it will also overvalue the retained earnings, stockholder’s equity, total assets and current asset of the company. The net income as well as the gross profit is overvalued due to overvaluation of inventory as fewer amounts for cost of goods sold is charged to the revenue (Malaescu & Sutton, 2014). Higher amount for the net profit indicates higher amount for stakeholder’s equity as well as retained earnings. Since the overvaluation of inventory toward the finish of one accounting period turns into the starting inventory of the accompanying time frame, that period’s cost of goods sold will be too high and will bring about the period's net income as well as the gross profit benefit being too low.
In the given case, Morgan Fertilisers were carrying high value of inventories in their balance sheet while it was successfully taken over by Oasis Ltd. However, after two months they discovered that the inventories of the company were overstated. 50% of the inventories those were already being obsolete and were not supposed to be included under the valuation were counted under the inventory. Further, the other inventories were valued at 35% more than the actual value. Moreover, though the audit firm MYH correctly valued the stock, finally they accepted the valuation of the management.
Physical confirmation of inventories is the duty of entity’s management. It is management’s duty to build up strategies for checking of inventories at least once in a year to establish a basis for the financial statement preparation. The auditor needs to complete review techniques to get adequate and suitable audit confirmation during his participation at the time of tallying of physical inventory (Reineking et al., 2013). The auditor is ought to be physically present to inspect and investigate the inventory and to survey whether the systems set around by the management to record and control the changes of the checking are being agreed to and to choose the dependability of such procedures. If the auditor cannot go for the inventory count, he is ought to be available on an optional date and settle on alternative measures to evaluate whether the adjustments in the inventories between the year end and the date of physical count are accurately recorded (Feng, McVay & Skaife, 2014). The auditor must analyze the outward and inward movement of stocks from cut-off date till the physical count date for establishing the data validity on the closing date of the year.
Further, the auditor shall review the internal control and management’s instructions with regard to the tagging, stock sheets, re-counting and counting of stocks, identification of obsolete, slow-moving, rejected or damaged items from the inventories and give appropriate impact on the financial statement (Onyekwelu & Ugwuanyi, 2014). He shall also consider the cut-off procedures, valuation of the work-in-progress and movement of the inventories. However, where the auditor is not able to obtain the appropriate and sufficient evidence with regard to the condition and existence of inventory and offending process for the physical count of the inventory, the auditor shall make the reference in the audit report regarding the limitation scope (Gu, 2013). Moreover, if the inventory is not disclosed appropriately in the financial statements, a qualified opinion shall be issued by the auditor.
The auditor is evaluated against the auditing standard that obliges the auditor to apply professional judgement while auditing. Through the auditors are not held responsible automatically for detecting the fraud. However, he is required to consider the risk with regard to fraud and plan the audit accordingly. Oasis Ltd. can bring the negligence charge against the auditor for not carrying out his audit as per the requirement of the auditing standards (Haribhai-Pitamber & Dhurup, 2014).
Further, as per the general rule, the auditor is not liable towards the third parties and he is liable to his client only. However, if third parties prove the below mentioned points then the auditor will be liable towards the third parties –
- The financial statement was not true in fact
- That the auditor intentionally or consciously or recklessly ignored a fact knowing it to be untrue (Gray & Ehoff Jr, 2014).
- Errors were committed in the final accounts preparation
- Negligence committed by auditor’s employee
- The third party acted on the basis of audited financial statement
- That the financial statement was prepared intentionally that third party shall act upon the statement (Onoja & Abdullahi, 2015).
In the case of Esanda Finance Corporation Ltd v Peat Marwick Hungerfords (1997), Esanda Finance Corporation, the appellant, lend money to the an organization based on the audit report shown by Peat Marwick Hungerfords. However, after borrower default on the payment, Esanda claimed to the auditors justifying that they have provided loan based on the issued audit report by the auditor that breached the compulsory accounting standard. However, the High court of Australia dismissed the case saying that the lender instead of relying on the auditor’s report could carry out the investigation on its own. Further, it was stated by the court that the auditors are not responsible for the duty of care to third parties.
In the given case, though the auditor from MYH verified the stock correctly, eventually they accepted the valuation of the management and did not considered the obsolescence of the stock. It was also evidenced by Oasis Ltd that the audit firm were under significant pressure by the client company for completing the audit within the period of one month from the balance sheet date. Further, Oasis Ltd. stated that they took the decision of taking over Morgan Fertilisers based on the audited financial report by MYH. Therefore, with regard to all the above facts, Oasis Ltd can bring negligence charge against the audit firm MYH, however, it is solely the court’s discretion to deal the case in its own way and MYH may or may not be held for negligence.
Carey, P., Potter, B., & Tanewski, G. (2014). AASB Research Report No.
Feng, M., Li, C., McVay, S. E., & Skaife, H. (2014). Does ineffective internal control over financial reporting affect a firm's operations? Evidence from firms' inventory management. The Accounting Review, 90(2), 529-557.
Gray, D., & Ehoff Jr, C. (2014). Lower Of Cost Or Market Inventory Valuation: IFRS Versus US GAAP. Journal of Business & Economics Research (Online), 12(1), 19.
Gu, S. (2013). Research and analysis on issued inventory valuation methods of enterprises. Balance, 50, 541-544.
Haribhai-Pitamber, H. U., & Dhurup, M. (2014). Inventory control and valuation systems among retail SMEs in a developing country: An exploratory study. Mediterranean Journal of Social Sciences, 5(8), 81.
Malaescu, I., & Sutton, S. G. (2014). The reliance of external auditors on internal audit's use of continuous audit. Journal of Information Systems, 29(1), 95-114.
Onoja, E. E., & Abdullahi, Y. U. (2015). Inventory Valuation Practices and Reporting: Nigerian Textile Industry Experience. Mediterranean Journal of Social Sciences, 6(4), 74.
Onyekwelu, U. L., & Ugwuanyi, U. B. (2014). Effects of IFRS adoption on inventory valuation and financial reporting in Nigeria. European Journal of Business and Management, 6(8), 29-34.
Reineking, C., Chamberlain, D. H., Rudolph, H. R., & Smith, M. (2013). An examination of inventory costing convergence under generally accepted accounting principles and international financial reporting standards.