Western Trading Company Is A Sole Proprietorship Engaged In

Western Trading Company Is A Sole Proprietorship Engaged In The Grain

Western Trading Company is a sole proprietorship engaged in the grain brokerage business. On December 31, 20X0, the entire grain inventory of the company was stored in outside bonded warehouses. The company's procedure of pricing inventories in these warehouses includes comparing the actual cost of each commodity in inventory with the market price as reported for transactions on the commodity exchanges at December 31. A write-down is made on commodities in which cost is in excess of market. During the course of the 20X0 audit, the auditors verified the company's computations.

In addition to this, they compared the book value of the inventory with market prices at February 15, 20X1, the last day of fieldwork. The auditors noted that the market prices of several of the commodities had declined sharply subsequent to year-end, until their market price was significantly below the commodities' book values. The inventory was repriced by the auditors on the basis of the new market prices, and the book value of the inventory was found to be in excess of market value on February 15 by approximately $21,000. The auditors proposed that the inventories be written down by $17,000 to this new market value, net of gains on the subsequent sales. The management protested this suggestion, stating that in their opinion the market decline was only temporary and that prices would recover in the near future.

They refused to allow the write-down to be made. Accordingly, the auditors qualified their audit opinion for a departure from generally accepted accounting principles.

Paper For Above instruction

The situation involving Western Trading Company's inventory valuation presents a classic case of assessing the appropriateness of financial reporting and the auditors' responsibilities concerning temporary versus permanent declines in market value. The core issue revolves around whether the auditors were justified in issuing a qualified opinion due to the management's refusal to write down inventory values that had substantially declined after year-end. This analysis explores the principles of inventory valuation under generally accepted accounting principles (GAAP), the auditors' role in safeguarding financial statement accuracy, and the implications of management’s assertions about market recovery.

Understanding Inventory Valuation Principles

Under GAAP, inventory should be reported at the lower of cost or net realizable value (NRV). Cost encompasses the actual cost of goods incurred initially, whereas the NRV is the estimated selling price in the ordinary course of business less any estimated costs necessary to make the sale (FASB ASC 330-10-35-1). When market prices decline below the cost of inventory, a write-down to the lower market value is required to prevent overstatement of assets and net income (Kieso, Weygandt, & Warfield, 2019).

Importantly, the assessment of whether market declines are temporary or permanent is crucial in determining if a write-down is necessary. A temporary decline, where prices are expected to recover in the future, might justify postponing the write-down. Conversely, a decline that is believed to be permanent warrants immediate recognition of the loss through a write-down.

Auditors' Responsibilities and Judgments in Valuation

The primary responsibility of auditors is to ensure that the financial statements present a true and fair view, which involves verifying that inventory is correctly valued under the applicable accounting standards (IAASB, 2018). When market prices fall significantly below book values, auditors evaluate evidence supporting the company’s assertion that the decline is temporary. This includes reviewing economic conditions, industry outlooks, and company-specific factors indicating an imminent recovery (Arens, Elder, & Beasley, 2017).

In the situation with Western Trading, the auditors observed a sharp decline in market prices shortly after year-end but were informed by management that these declines were temporary. The auditors' proposal to write down inventory by $17,000 aligned with the need to reflect fair value while considering the forthcoming possibility of price recoveries. When management refused, claiming that prices would recover, the auditors faced a dilemma: whether to accept management’s assertion or to enforce GAAP requiring an inventory write-down.

Qualified Opinion and Its Justification

A qualified audit opinion is issued when auditors encounter a scope limitation or disagreement with management regarding accounting policies or estimates, which significantly impacts the financial statements but does not pervasively distort them (Salmon & Duncan, 2018). In this case, the auditors disagreed with management’s assertion that the decline was temporary, but the impact was limited to inventory valuation; the rest of the financial statements remained unaffected.

The auditors’ decision to qualify the opinion was appropriate because they believed that net realizable value should be based on the most recent market price as of the reporting date or at least included consideration of subsequent declines. Their refusal to accept management’s position signifies adherence to GAAP and the role of auditors as guardians of accurate financial reporting.

Alternative Courses of Action

Beyond issuing a qualified opinion, auditors could have engaged in further audit procedures to assess the legitimacy of management’s belief in a market recovery. This could include consulting economic forecasts, industry reports, and independent appraisals. If evidence supported that the decline was indeed temporary, they might have deferred the write-down but documented the reasoning transparently.

Another alternative involves emphasizing disclosures in the financial statements about the nature of the decline, management’s outlook, and the potential impact on inventory valuation. Clear disclosures could mitigate concerns about impairment while acknowledging the uncertainty regarding future prices.

Conclusion: Appropriate Course of Action

In my view, the auditors’ decision to issue a qualified opinion was justified. They appropriately identified that the inventory should be written down at the lower of cost or market, considering the significant decline in prices. Their recognition that management’s assertion of a temporary decline lacked strong supporting evidence warranted their stance. Ultimately, the auditors exercised professional skepticism, which aligns with ethical standards and GAAP requirements, ensuring that the financial statements reflect a fair valuation of assets.

References

• Arens, A. A., Elder, R. J., & Beasley, M. S. (2017). Auditing and Assurance Services: An Integrated Approach (15th ed.). Pearson.
• Financial Accounting Standards Board (FASB). (2019). Accounting Standards Codification (ASC) 330-10-35-1: Inventory — Lower of cost or market. FASB.
• International Auditing and Assurance Standards Board (IAASB). (2018). International Standards on Auditing (ISA) 540: Auditing accounting estimates and related disclosures.
• Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2019). Intermediate Accounting (16th ed.). Wiley.
• Salmon, F., & Duncan, M. (2018). Auditor’s Report: Understanding Qualified Opinions. Journal of Accounting and Auditing.