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In the late 1980s, William Nashwinter accepted a position as a salesman with Doughtie's Foods, Inc., a publicly owned food products company headquartered in Portsmouth, Virginia. The ambitious young salesman impressed his superiors with his hard work and dedication and was soon promoted to general manager of the Gravins Division of Doughtie's, a promotion that nearly doubled his salary. The Gravins Division was essentially a large warehouse that wholesaled frozen food products to retail outlets on the East Coast.
Nashwinter quickly discovered that managing a large wholesale operation was much more complicated and stressful than working a sales route. Within a short time after accepting the promotion, he was being criticized by corporate headquarters for his division's poor performance. Eventually, after several rounds of scathing criticism for failing to meet what he perceived were unrealistic profit goals, Nashwinter decided to take matters into his own hands and began fabricating fictitious inventory on his monthly performance reports to headquarters. By inflating his monthly inventory balance, Nashwinter lowered his division's cost of goods sold and thus increased its gross profit.
Several years later, Nashwinter alleged that he had never intended to continue his scheme permanently. Instead, he saw his actions simply as a solution to a short-term problem: "I always had in the back of my mind that the division would make enough legitimate profit one day to justify the fake numbers." Unfortunately for Nashwinter, the actual operating results of the Gravins Division continued to be disappointing. With each passing year, Nashwinter was forced to fabricate larger amounts of fictitious inventory to meet his profit goals. Finally, in 1992, Nashwinter admitted to a Doughtie's executive that he had been filing false inventory reports to corporate headquarters for several years. Nashwinter was fired almost immediately. Shortly thereafter, Price Waterhouse was retained by Doughtie's to determine the magnitude of the inventory errors that had been introduced into Gravins's accounting records and their effect on the firm's financial statements. The Price Waterhouse study disclosed that Dough tie's 1990 consolidated net income had been overstated by 15 percent as a result of Nashwinter's scheme, and the firm's 1991 net income had been overstated by 39 percent.
The methods used by Nashwinter to misrepresent his division's inventory were quite simple. In 1990, he inflated Gravins's inventory by including three pages of fictitious inventory items in the count sheets that summarized the results of the division's annual physical inventory. Nashwinter also changed the unit of measure of many of the inventory items. For instance, rather than reporting fifteen single boxes of a given product, Nashwinter would change the inventory sheet so that it reported fifteen cases of the product. In 1991, after Doughtie's had acquired a computerized inventory system, Nashwinter simply input a large number of fictitious inventory items into Gravins's computerized inventory ledger.
In 1990 and 1991, Doughtie's was audited by the CPA firm of Goodman & Company. Thomas Wilson of Goodman & Company served as the audit manager on the 1990 audit and as the audit engagement partner the following year, after having been promoted to partner. In both years, Frank Pollard was the audit supervisor assigned to the Doughtie's engagement. Following the disclosure of Nashwinter's scheme to the Securities and Exchange Commission (SEC) by Doughtie's executives, the federal agency investigated the 1990 and 1991 audits of Doughtie's by Goodman & Company. The SEC criticized Wilson and Pollard for their role in those audits, particularly for their failure to rigorously audit the inventory accounts of Doughtie's. For several reasons, the SEC maintained that the inventory of Doughtie's should have been considered a high-risk account and thus subject to a higher-than-normal degree of scrutiny by Wilson and Pollard during the 1990 and 1991 audits of the company. First, inventory was the largest line item on the Doughtie's balance sheet, accounting for approximately 40 percent of the company's total assets. Second, Wilson and Pollard were aware that Doughtie's internal controls for inventory had a number of weaknesses, particularly within the Gravins Division, and that these weaknesses increased the likelihood that the company's inventory would be misstated. Finally, the SEC noted that Gravins's inventory balance was increasing at a very high rate during 1990 and 1991, which caused the division's inventory turnover rate to be abnormally low.
The SEC also criticized Wilson and Pollard for failing to pursue problems that they or their subordinates noted during the 1990 and 1991 audits of Gravins's inventory. Following the completion of the physical inventory for Gravins in 1990, Nashwinter forwarded the three fictitious inventory count sheets to Wilson and Pollard and alleged that the sheets had been overlooked by the audit team. After a brief review of these inventory sheets, Wilson and Pollard accepted them and included the items listed thereon in Gravins's inventory balance. Following the completion of the physical inventory for Gravins in 1991, the audit senior assigned to the Doughtie's engagement was unable to reconcile the quantities for numerous items listed on the inventory count sheets with the quantities shown on the computer printout of the details of Gravins's year-end inventory balance.
This individual notified Wilson of the problem and wrote Nashwinter a memo asking for an explanation. Wilson failed to follow up on the problem, and Nashwinter never responded to the memo. In his review of the senior's workpapers, Pollard either did not notice the numerous discrepancies between the count sheets and the computer listing of Gravins's inventory or chose not to investigate those discrepancies.
Nashwinter's testimony to the SEC regarding the work of the Goodman & Company auditors was not complimentary. Nashwinter testified that he often was forced to make up excuses to account for missing or misplaced inventory and that the auditors apparently never double-checked his explanations. He also testified that the auditors were lax when it came time to test-count inventory items in Gravins's blast freezer: "A lot of times the auditors didn't want to stay in the freezer. It was too cold."
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ANSWER ALL THE FOLLOWING QUESTIONS. THE DEADLINE OF THIS ASSIGNMENT IS ON THE 20 APRIL, 2009. YOU ARE REQUIRED TO SUBMIT (i) A HARD-COPY IN THE BUSINESS SCHOOL GENERAL OFFICE (MANAGEMENT CENTRE) AS WELL AS (ii) A WORD OR PDF DOCUMENT VIA BLACKBOARD.
1. What are the auditor's primary objectives when he or she is observing the client's annual physical inventory? Identify the key audit procedures that an auditor would typically perform during and after the client's physical inventory.
2. What audit procedure or procedures might have prevented Nashwinter from successfully overstating the 1990 physical inventory of the Gravins Division? What audit procedure or procedures might have prevented Nashwinter from successfully overstating the division's 1991 physical inventory?
3. In 1991, Gravins's inventory turnover was approximately one-half that of comparable divisions within the firm. How should this fact have affected the planning for the 1991 audit of Doughtie's? What audit procedures should Wilson and Pollard have performed to investigate this unusually low inventory turnover rate for the Gravins Division?
4. Nashwinter was apparently under considerable pressure to improve the operating results of his division. Discuss how this fact, if known to the auditors of Doughtie's, should have affected their assessment of audit risk for this client.
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