Cenco Medical Health Supply Corporation (CMH) was an SEC-registered company that went bankrupt after it had materially misstated its financial statements for a number of years. It inflated the reporting of its physical inventory by 50% during two years prior to its bankruptcy. The fraud was perpetrated by "(1) altering the quanti- ties recorded on the pre-numbered, two-part inventory tags used in counting the inventory; (2) altering documents reflected on a com- puter list prepared to record the physical count of inventory; and
(3) creating inventory tags to record quantities of nonexistent inventory."

The SEC asserted that the auditors should have detected the fic- titious inventory but did not because the audit firm "left the extent of various observation testing to the discretion of auditors, not all of whom were aware of significant audit planning that should have related directly to the extent of such testing. Observation of inven- tory counts at year end was confined to six locations (representing about 40% of the total CMH inventory) as opposed to nine in the preceding year. The field auditors did not adequately control the inventory tags and the auditor did not detect the creation of bogus inventory tags which were inserted in the final inventory computations." The SEC was also critical of the audit firm for assigning interns to a significant portion of the inventory observa- tion without training them in the nature of the client's inventory or its counting procedures. This is an example of a situation in which auditors' lack of professional skepticism led to low audit quality and a subsequent audit failure.

Source: R. W. V. Dickenson, "Why the Fraud Went Undetected," CA Magazine April 1977, pp. 67-69.

The SEC alleged that many deficiencies occurred during the audit of CMH. Among the complaints were the following:

1. The audit firm "left the extent of various observation testing to the discretion of auditors, not all of whom were aware of significant audit conclusions which related directly to the extent of such test- ing. Observations of inventory counts at year end were confined to six locations (representing about 40% of the total CMH inventory) as opposed to nine in the preceding year. The field auditors did not adequately control the inventory tags and Seidman & Seidman [the auditor] did not detect the creation of bogus inventory tags which were inserted in the final inventory computations."

2. The comparison of recorded test counts to the computer lists in the nine warehouse locations in which the inventory count was observed indicated error rates ranging from 0.9% to 38.3% of the test counts, with error rates in excess of 10% in several loca- tions. Management attributed the differences to errors made by a keypunch operator. When the auditors asked to see the inventory tags, the CMH official stated that they had been destroyed.

3. The Seidman & Seidman auditor who performed the price test- ing of the CMH inventory determined that, as in previous years, in numerous instances CMH was unable to produce suf- ficient vendor invoices to support the purchase by CMH of the quantities being tested. This was true even though Seidman & Seidman ultimately accepted vendor invoices reflecting the pur- chase of the item by any CMH branch, regardless of the loca- tion of the inventory actually being price-tested.

4. A schedule of comparative inventory balances reflected signifi- cant increases from the prior year. A CMH financial officer wrote on this schedule management's explanations for the increases in inventory accounts.

5. CMH did not use prenumbered purchase orders and shipping documents.

6. Several differences exist between the tags reflected on the com- puter list for the Miami warehouse and the observation of the same tag numbers by Seidman & Seidman auditors. The com- puter list contained a series of almost 1,000 tags, covering about 20% of the tags purportedly used and more than 50% of the total reported value of the Miami inventory, which were reported as being unused on the tag control document obtained by Seidman & Seidman during its observation work.

7. Because CMH management did not provide sufficient invoices as requested, the auditors relied primarily on vendor catalogs, price lists, and vendor invoices to test the accuracy of the CMH inventory pricing representations.

a. For each of the deficiencies identified, indicate the appropri- ate action that should have been taken by the auditor.

b. What inventory information should be communicated to an auditor who is not regularly assigned to the audit of a particular client prior to the observation of a physical inventory count?

c. How do questions of management integrity affect the approach that should be taken in planning the observation of a client's inventory-counting procedures?

d. Identify instances in which the auditors in this case did not exercise appropriate professional skepticism. For each of those instances, describe an alternative way that the auditor should have handled this situation.

e. The individual auditors conducting the audit inventory tests were lacking the appropriate training or knowledge to con- duct their jobs. Assume that you and your classmates were assigned to an audit client and you find yourselves in a simi- lar situation when you arrive to conduct an inventory obser- vation. In particular, you are asked to observe inventory counts of products for which you are unsure of the appro- priate measurement technique and are lacking in knowledge of the product itself. The client quickly describes the mea- surement process and offers to help you identify the different products. You are still somewhat unsure of your abilities to conduct this inventory observation.