Tugas Matrikulasi

Magister Akuntansi
Universitas Mercubuana
Oleh : S t i v e O k t a v i a n
NIM : 555 161 100 71
Mahasiswa Maksi
Agustus 2016

Case 2.1 (Doughtie's Foods, Inc.)

In the late 1970s, William Nashwinter accepted a position as a salesman with Doughtie's Foods,
Inc., a publicly owned food products company headquartered in Portsmouth, Virginia.1 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, Nashwinter found himself being maligned by corporate headquarters for his division's
poor performance. After several rounds of scathing criticism for failing to meet what he perceived
to be unrealistic profit goals, Nashwinter decided to take matters into his own hands. The young
manager 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 insisted that he had never intended to continue his scheme
indefinitely. 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."2 Unfortunately for Nashwinter, his division's actual operating results
continued to be disappointing. With each passing year, Nashwinter had to fabricate larger
amounts of fictitious inventory to reach his profit goals. Finally, in 1982, Nashwinter admitted to a
superior that he had been filing false inventory reports to corporate headquarters for several
years. Doughtie's management immediately fired Nashwinter and retained Price Waterhouse to
determine the magnitude of the inventory errors in Gravins' accounting records and their impact
on the company's consolidated financial statements. Price Waterhouse's study revealed that
Nashwinter's scheme had overstated Doughtie's 1980 consolidated net income by 15 percent,
while the company's 1981 net income had been overstated by 39 percent.

Nashwinter used simple methods to misrepresent his division's inventory. In 1980, he inflated
Gravins' 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 inventory items. Rather than reporting 15 single boxes of a given
product, for example, Nashwinter changed the inventory sheet so that it reported 15 cases of the
product. In 1981, after Doughtie's acquired a computerized inventory system, Nashwinter simply
input fictitious inventory items into his division's computerized inventory ledger.

In 1980 and 1981, the CPA firm of Goodman & Company audited Doughtie's. Thomas Wilson of
Goodman & Company served as the audit manager on the 1980 audit and as the audit
engagement partner the next 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 began investigating the 1980 and 1981 audits of the
food distribution company. The SEC subsequently criticized Wilson and Pollard for their roles in
those audits, particularly for their failure to rigorously audit Doughtie's inventory account.
The SEC maintained that Doughtie's inventory 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
1980 and 1981 audits. 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 of several weaknesses in Doughtie's internal controls for inventory,
particularly within the Gravins Division. These weaknesses increased the likelihood of inventory
errors. Finally, the SEC noted that Gravins' inventory increased rapidly during 1980 and 1981.
The federal agency maintained that Wilson and Pollard should have considered the audit
implications of this high growth rate and the closely related implications of the division's
abnormally low inventory turnover.

The SEC also criticized Wilson and Pollard for failing to pursue problems that they or their
subordinates uncovered during the 1980 and 1981 audits of Gravins' inventory. Following the
completion of the physical inventory for Gravins in 1980, Nashwinter forwarded the three fictitious
inventory count sheets to Wilson and Pollard. Nashwinter claimed that the Goodman & Company
auditors had overlooked the three count sheets. After briefly reviewing these count sheets,
Wilson and Pollard added the items on them to Gravins' inventory. Following the division's 1981
physical inventory, the audit senior on the Doughtie's engagement could not reconcile the
quantities for numerous items listed on the inventory count sheets with the quantities shown on
the computer printout that summarized the details of Gravins' year-end inventory balance. The
senior 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 differences
between the count sheets and the computer listing of Gravins' inventory or chose not to
investigate those differences.

Nashwinter's testimony to the SEC was not complimentary of Goodman & Company's annual
audits. Nashwinter testified that he often made 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'

blast freezer: "A lot of times the auditors didn't want to stay in the freezer. It was too cold."4

EPILOGUE

For their roles in the Doughtie's case, the SEC required Wilson and Pollard to complete several
professional education courses. The SEC also required that selected audits supervised by the
two men in the future be subjected to peer reviews to determine that the appropriate audit
procedures had been performed. Goodman & Company was not sanctioned by the SEC, since
Wilson and Pollard had failed to comply with the firm's quality control standards. In 1983,
Doughtie's dismissed Goodman & Company and retained Price Waterhouse as its audit firm.
To settle the charges filed against him by the SEC, William Nashwinter signed a consent decree
in which he neither admitted nor denied the charges but agreed not to violate federal securities
laws in the future. At last report, Nashwinter still worked in the food distribution industry.5

QUESTIONS

1. What are the auditor's primary objectives when he or she observes 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.
Answer
Please see the attached file.
An auditor should establish the following:
- existence
- rights
- accuracy
- realizable value
Key Audit Procedures that are usually performed by an auditor are:
- observing the client's inventory-taking procedures. If the client has a periodic inventory system,
the physical inventory count determines the balance in inventory accounts and will probably
occur on the balance sheet date. If the client has a perpetual inventory system, the physical
inventory count may occur any time during the accounting period. Whenever the count occurs,
the auditor is required to observe.
- When the auditing firm has not audited beginning balances, the auditors must satisfy
themselves as to the appropriateness of beginning balances, if they are satisfied as to the
current balances. To do that they may use analytical procedures, review prior inventory count
records, and test inventory transactions and documents.
- Get direct written confirmation with the warehouse. Since inventory held in our case is
significant, the auditor should
o review client's procedures for investigating and evaluating the warehouse;
o obtain report from warehouse's auditor regarding internal controls;
o observe warehouse's physical counts;
o determine whether client's counting methods are effective;

o observe the quality and condition of the inventory (consider obsolescence)

o on a random basis select a sample of inventory items from the warehouse floor, count them,
trace the quantity to client count records;
o on a random basis select a sample of inventory items from the client count records, find them
in the warehouse, count them;
o on a random basis select a sample of inventory items from the client count records, trace them
to the perpetual inventory records;
o on a random basis select a sample of inventory items from the perpetual inventory records
trace them to the client count records.
- test the client's application of their inventory valuation method (FIFO, LIFO) and the lower-ofcost-or-market rule;
- test the cost accumulation process as it affects valuation of ending inventories and COGS;
- follow up on any discrepancies noted by other auditors on the team as well as supervisors
within the company.

2. What audit procedure or procedures might have prevented Nashwinter from successfully
overstating the 1980 year-end inventory of the Gravins Division? What audit procedure or
procedures might have prevented Nashwinter from overstating the division's 1981 year-end
inventory?
Answer
Going back to the general procedures outlined in (1), these would prevent Nashwinter from
overstating the year-end inventory in 1980:
o testing the cost accumulation process as it affects valuation of ending inventories and COGS;
o When the auditing firm has not audited beginning balances, the auditors must satisfy
themselves as to the appropriateness of beginning balances, if they are satisfied as to the
current balances. To do that they may use analytical procedures, review prior inventory count
records, and test inventory transactions and documents.
o on a random basis select a sample of inventory items from the warehouse floor, count them,
trace the quantity to client count records;
o on a random basis select a sample of inventory items from the client count records, find them
in the warehouse, count them;
o review client's procedures for investigating and evaluating the warehouse;
As for the year 1981, these procedures would be helpful:
o follow up on any discrepancies noted by other auditors on the team as well as supervisors
within the company.
o obtain report from warehouse's auditor regarding internal controls;
o on a random basis select a sample of inventory items from the client count records, trace them
to the perpetual inventory records;
o on a random basis select a sample of inventory items from the perpetual inventory records
trace them to the client count records.
o in general compare the physical counts with the new computer system records.

3. In 1981, Gravins' inventory turnover was approximately one-half that of comparable divisions
within the firm. How should this fact have affected the planning for the 1981 audit of Doughtie's?
What audit procedures should Wilson and Pollard have performed to investigate Gravins'
unusually low inventory turnover rate?
Answer
In 1981, Gravins' inventory turnover was approximately one-half that of comparable divisions
within the firm. How should this fact have affected the planning for the 1981 audit of Doughtie's?
What audit procedures should Wilson and Pollard have performed to investigate Gravins'
unusually low inventory turnover rate?
When during the initial analytical review (during planning), a particular ratio is very different from
expectations (in this case comparable divisions in the firm), that is a "risk signal." Of course, the
size of inventory in this case (largest asset) would also have "flagged" that account as deserving
of greater scrutiny than ordinary.
How should this have impacted the audit plan? The auditor should increase procedures in that
area to learn if the deviation from expectation is due to an acceptable business reason or from an
error or irregularity (misdeed). So, during planning, the auditor should have increased scrutiny in
the inventory and cost of goods area (the two items that make up the inventory turnover ratio).
What audit procedures should have been performed? The auditor should have counted inventory
carefully (including the unit of measure for items) and compared those counts to the recorded
inventory. The key here was not accepting "additional forgotten count sheets" from the client and
being detailed enough to notice units of measure. This contaminated the count that would have
otherwise revealed inflated inventory.
Another procedure for high risk inventory is a "roll forward." This is a schedule that proves the
activity in inventory. You take beg inventory, add purchases, removed COGS and prove ending
inventory. Here, there were no "purchase" transactions for the fake items and units of measure
and so the missing purchase transactions would have also revealed the fake amounts. This
could have been done when the "missing count sheets" were offered as a way to validate those
sheets.

4. Nashwinter was under considerable pressure to improve his division's operating results.
Discuss how this fact, if known to the auditors of Doughtie's, should have affected their
assessment of audit risk for this client.

Answer
Auditors assess inherent risk and control risk during planning. High pressure to meet targets
increases the inherent risk of an audit because management has considerable power to override
controls (such as fabricating a count sheet) in order to meet extreme results. Further, during the
audit planning, the fraud risk brainstorming session would also have raised the issued of
"pressure" to meet targets. Pressure on managers is an increase in fraud risk as pressure is one
of the three parts of the fraud triangle (pressure, opportunity and rationalization). With pressure,
the risk of fraud attempts goes way up. Therefore, the auditor should have increased their

assessment of both fraud risk and inherent risk during the audit planning, both of which would
trigger increased scrutiny.