Recap of the current situation: Earlier that year, in January, CBU installed a new system to
track the company’s inventory. At year year-end, which is December 31st, the company’s new
inventory management system was reporting $4.5 million worth of on-hand inventory.
Unfortunately, when the CBU accountants performed a physical inventory count, they realized
that the actual inventory was short $1 million at $3.5 million. While that is a huge discrepancy,
CBUs’ accountants created an adjusting entry causing the inventory to drop by $1 million. Some
of the accountants are proud that they were able to fix the problem by adjusting entries while
other accountants feel slightly differently about the situation.
My Take: Immediately after reading the “Inventory Situation Case Study”, red flags went up.
Having such a huge discrepancy in actual inventory versus what is stated is a very big problem
that can be mitigated with a proper cycle counting method. When inventory is overstated, it
lowers the Cost of Goods Sold because the excess stock in the accounting records shows a higher
closing stock and less COGS. Overstatement of inventory causes current assets, total assets, and
retained earnings to be overstated as well. Inventory overstatement will cause gross profit, net
income and operating income to be too high. When inventory is understated, the cost of goods
sold increases causing a reduction on closing stocks and increases COGS. As a result, from
understated inventory, the net income will be understated. Some companies may want to
understate the COGS, causing the financial statement to be more attractive for loan purposes. It
is unethical and illegal to manipulate financial statements (Arthur, 2016). While honest mistakes
occur, inventory errors affect a company’s bottom line by painting an inaccurate picture of its
financial performance and net worth (Saint-Leger, 2016). “Inaccuracies in Inventory lead to
many problems throughout an organization and can be prevented with an implementation of a
cycle counting method” (Walters et al., 2006). A proper cycle of counting will help discover
root causes of inventory discrepancies and inaccuracies. To get back to the problem at hand,
CBU company implemented and installed a new computer system to help track and calculate
inventory costs. While installing a new system is great, knowing how to use this system and
setting up controls is another thing all together. Setting up a new computer system involves a lot
more than just installation of the system. It requires conceptualization of the system as a whole,
identifying business goals, find an inventory management system that works for your type of
business, organize inventory storage location so it corresponds with the inventory system, item
descriptions with matching item numbers, initial inventory count, recount of inventory,
procedures and controls in place (SOP guidelines and rules). Also, as part of implementing a
new system, proper training needs to be conducted. A cycle count schedule needs to be created,
inventory should be checked frequently, all products should be labelled, and someone should
keep track of inventory levels on a weekly basis. A proper Standard of Operating Procedure
(SOP) needs to be put in place so that errors are eliminated. In depth training and on going
education needs to take place. Internal audits need to be performed on a regular basis and
physical count of the inventory need to be done on a weekly and monthly basis, which will help
with time wasted looking for inventory, effective cycle counting, money wasted due to extra time
looking for items that are in the wrong place or not in the inventory, and loss of customers due to
inaccurate inventory. I believe that Accountant B’s concerns are valid and should be brought to
CBU’s attention. The external audit firm should offer a full risk assessment based on current
business processes, potentially offer a business solution that would work for their type of
business model and help solve major inventory discrepancies. I stand with accountant B’s
concerns of error detection, prevention, and correction. Accountant B can add tremendous value
by proposing solutions that would help minimize business problems caused by errors, intentional
or unintentional.
Accountant A: According to the brief synopsis of the Case Study, Accountant A was relieved
that she was able to make an adjusting entry to reduce inventory by $1 million. Her goal was to
report inventory levels that the new computer system tracked over the last year versus the actual
count. Accountant A’s job was to audit and attest to the accuracy of the financial statement by
conducting a physical count of the inventory. The bottom line is what she is looking for and if
not met, corrections can be made as long as it follows GAAP. While her reason was sound,
ethically it was not necessarily correct. As an auditor, I would try to dig deep into the issue and
find the problem and fix it so that it doesn’t happen again. Accountant A made the adjusting
entries but what happens when the beginning inventory is overstated and does not match the
ending inventory of the previous year. Such things need to be discussed and managed
accordingly.
Accountant B: Accountant B was concerned with how Accountant A handled the problem but
also how bad decisions were made and handled throughout the year, which lead to inaccurate
inventory. Accountant B was concerned with the fact that there was no process in place to
manage inventory accurately. Having a new system in place is one thing but having no process
or controls in place is another thing. A system can do so much if implemented and used
properly. CBU could have prevented this inaccuracy with an effective cycle counting method
which could have helped prevent increase in COGS to offset inaccurate information per actual
inventory count. Internal controls are extremely important for any business and the Bible
discusses controls quite extensively with limited access, separation of duties, and much more.
Micah 7:5-6 says, “Put no trust in a neighbor have no confidence in a friend” (Wansbrough,
1999). The rationale behind Micah’s saying is that if employees have access to or the
opportunity to be dishonest, they will be dishonest. SOPs and proper controls keep even the
most honest people honest. Accountant A was not necessarily being dishonest, but her intentions
were not completely ethical. That’s my opinion and if this was my company, I would want to
know the 5 Why’s and how to prevent it from happening again.
Cited Work:
Saint-Leger, R. (2016, October 26). How to fix inventory errors in financial statements. Small
Business - Chron.com. Retrieved January 22, 2023, from
https://smallbusiness.chron.com/fix-inventory-errors-financial-statements-44155.html
Arthur, L. (2016, October 26). What happens when Ending Inventory is misstated? Small
Business - Chron.com. Retrieved January 22, 2023, from
https://smallbusiness.chron.com/happens-ending-inventory-misstated-23800.html
Walters, E., Schmidt, E.K., & Newton, K. (2006). A Comparison of Cycle Counting Methods.
Review of the Electronic & Industrial Distribution Industries, 5(2), 117-141.
Wansbrough, H. (1999). The New Jerusalem Bible: Standard edition. Doubleday.
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