Question

On October 4, 2008, the PCAOB issued its annual inspection report of Grant Thornton LLP (PCAOB Release No. 104-2008-046). In conducting its inspections, the PCAOB focuses on audit engagements that it considers particularly risky or prone to error.

In its inspection report of Grant Thornton, the PCAOB noted the following problems in testing the inventory valuation assertion for a Grant Thornton client.

• There was no evidence in the audit documentation, and no persuasive other evidence, that the firm had performed sufficient substantive procedures to test the raw materials and/or labor and overhead components of inventory at certain of its manufacturing locations. Analytical procedures, consisting of various high-level comparisons, including average cost, inventory balances, gross profit margins, and inventory turnover, were the firm's primary tests, but these procedures failed to meet the requirements for substantive analytical procedures. Specifically, the firm failed to develop expectations that were precise enough to provide the desired level of assurance that differences that may be potential material misstatements, individually or in the aggregate, would be identified, and failed to obtain corroboration of management's explanations of significant unexpected differences.
• The firm failed to evaluate the assumptions that management had used to determine the reserve for obsolete inventory.
  1. The PCAOB inspection report summarized a problem with Grant Thornton's testing of a client's inventory valuation assertion. Discuss why you believe the PCAOB was dissatisfied with the firm's performance. Indicate how the inspection report would suggest a lack of professional skepticism.
  2. Use the framework for professional decision making from Chapter 1 to determine the appropriate steps that the firm could have taken that would have ultimately been acceptable to the PCAOB. Recall that the framework is as follows:

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Answer 1

The Firm failed to perform sufficient substantive procedures to test it's  raw materials and/or labor and overhead components of inventory at certain of its manufacturing locations

The Firm designed its substantive procedures to test inventory, revenue thereof-– including the size of the sample it used for the testing described above – based on a level of control reliance that was not supported due to the deficiency in the Firm's testing of controls.

Firm failed to evaluate the assumptions that management had used to determine the reserve for obsolete inventory.

The issuer also recognized revenue from the sale of its own inventory. The issuer's calculation of the value of inventory and the allocation of costs between year-end inventory and cost of sales was based, in part, on the development of certain estimates; significant inputs to these estimates included the quantity of inventory sold during the year and the quantity of inventory existing at year end

The Firm's procedures included, for a sample of revenue transactions, verifying associated contract rates and certain terms, and recalculating the gross sales amount and commission earned by comparing these amounts to the amounts in related agreements and the sales sub-ledger.

In addition, the Firm performed cut-off procedures, which doesn't provide proper justification

There was no evidence in the audit documentation, and no persuasive other evidence, that the firm had performed sufficient substantive procedures to test the raw materials and/or labor and overhead components of inventory at certain of its manufacturing locations.

Analytical procedures, consisting of various high-level comparisons, including average cost, inventory balances, gross profit margins, and inventory turnover, were the firm's primary tests, but these procedures failed to meet the requirements for substantive analytical procedures.