Question

You are preforming the audit of Puffin Limited (Puffin) financial statements for its year ending September 20, 2023. Puffin is a private company and operates a grocery distribution business in Newfoundland. Puffin's audited financial statements are used mainly by its bank, which has a made a large operating loan to Puffin. The bank requires Puffin to maintain a quick ratio of a least 1.2. Otherwise, the bank can require Puffin to repay the loan in full immediately.

Puffin's accounting policy is to value its inventory bases on the FIFO cost flow assumption. on September 30, Puffin received a large truckload of pomegranate juice from California Fruit Inc. Since these goods were in Puffin's warehouse at year-end, they were included in the year-end physical inventory count. During your audit you discovered that the company's accountant did not records this purchase in the accounts payable balance until October 10th, when an invoice was received from the supplier, California Fruit, in the amount of $65,000.

Before correcting this error, Puffin's draft financial statements show inventory of $900,000, total current assets of $1,500,000, accounts payable of $250,000, and total current liabilities of $450,000.

Required:
1. Explain how the accounts in the Puffin September 30, 2023, financial statements will be affected by this error. In your explanation, identify the assertion(s) violated by this error.
2. Give one example of an audit procedure that would have discovered this error. Explain clearly how the procedure could discover the error.
3. What is the impact of this error on Puffin's quick ratio? Show calculations. (Reminder: quick ratio - current assets less inventory divided by current liabilities.
4. Would you consider this error to be material? Justify your response.

Answer 1

The error in not recording the purchase of pomegranate juice in the accounts payable balance until October 10th will affect the inventory and accounts payable accounts in Puffin's financial statements. One example of an audit procedure that could have discovered this error is vouching of invoices and purchase orders. The error will decrease Puffin's quick ratio from 1.33 to 1.07. Whether the error is considered material depends on the context and materiality thresholds set by the auditor and users of the financial statements.

Step-by-step explanation:

1. Explanation of the impact on Puffin's financial statements:

The error in not recording the purchase of pomegranate juice in the accounts payable balance until October 10th will affect the following accounts in Puffin's September 30, 2023, financial statements:

Inventory: The inventory balance would be understated as it does not include the value of the pomegranate juice.

Accounts payable: The accounts payable balance would be understated as the amount for the pomegranate juice purchase is not included.

The assertion violated by this error is the completeness assertion, as the purchase of pomegranate juice was not recorded in the appropriate period.

2. Example of an audit procedure:

Audit procedure: Vouching of invoices and purchase orders

Explanation: The auditor could select a sample of invoices and purchase orders from the period around September 30, 2023, and trace them to the recorded accounts payable and inventory balances. By doing so, the auditor could discover any unrecorded or delayed purchases, such as the pomegranate juice, and determine if they have been properly included in the financial statements.

3. Impact on Puffin's quick ratio:

Before correcting the error, Puffin's quick ratio can be calculated as follows:

Quick ratio = (Current assets - Inventory) / Current liabilities

Quick ratio = ($1,500,000 - $900,000) / $450,000 = 1.33

After correcting the error, the inventory balance would increase by $65,000, resulting in the following quick ratio:

Quick ratio = ($1,500,000 - $965,000) / $450,000 = 1.07

4. Materiality of the error:

Whether this error is considered material depends on the context and the specific materiality thresholds set by the auditor and the users of the financial statements. Since the quick ratio requirement set by the bank is 1.2, the error could potentially impact the compliance with this requirement. Therefore, it could be considered material due to its impact on Puffin's ability to meet its loan obligations. However, a definitive answer to this question would require a more thorough assessment of the financial statements and the overall financial position of Puffin.

Answer 2

This error will affect the inventory and accounts payable accounts in Puffin's financial statements. An audit procedure that could have discovered this error is the cutoff review. The error decreases Puffin's quick ratio from 1.33 to 0.63. The materiality of the error depends on the specific circumstances of the company.

Step-by-step explanation:

1. This error will affect two accounts in Puffin's September 30, 2023, financial statements: inventory and accounts payable. The inventory account will be overstated by the value of the unrecorded purchase ($65,000), while the accounts payable account will be understated since the purchase was not recorded until October 10th. This error violates the valuation and completeness assertions.

2. An audit procedure that could have discovered this error is the cutoff review. By examining the cutoff procedures and documentation, the auditor can ensure that purchases and sales are recorded in the correct accounting period. In this case, reviewing the timing of inventory receipt and the recording of the invoice would have revealed the error.

3. The impact of this error on Puffin's quick ratio can be calculated as follows:
Quick Ratio = (Current Assets - Inventory) / Current Liabilities
Before correction: ($1,500,000 - $900,000) / $450,000 = 1.33
After correction: ($1,500,000 - $965,000) / $450,000 = 0.63
The error decreases the quick ratio from 1.33 to 0.63.

4. This error could be considered material. Materiality is a subjective concept and depends on the specific circumstances of the company. In this case, the error changes the quick ratio significantly and could impact the bank's decision to require immediate repayment of the loan. It is important for the auditor to consider the qualitative and quantitative factors when assessing materiality.