Question: No Defense for These Charges. Follow the instructions preceding Problem 9.57. Write the audit approach section following the case in the chapter. SueCan Corporation manufactured electronic and other equipment for private customers and government defense contracts. It deferred costs under the heading of defense contract claims for reimbursement and deferred tooling labor costs, thus overstating assets, understating cost of goods sold, and overstating income. Near the end of the year, the company used a journal entry to remove $110,000 from cost of goods sold and defer it as deferred tooling cost. This $110,000 was purported to be labor cost associated with preparing tools and dies for large production runs.

The company opened a receivables account for "cost overrun reimbursement receivable" as a claim for reimbursement on defense contracts ($378,000). The company altered the labor time records for the tooling costs in an effort to provide substantiating documentation. Company employees prepared new work orders numbered in the series used late in the fiscal year and attached labor time records dated much earlier in the year. The production orders originally charged with the labor cost were left completed but with no labor charges! The claim for reimbursement on defense contracts did not have documentation specifically identifying the labor costs as being related to the contract. There were no work orders. (Auditors know that Defense Department auditors insist on documentation and justification before approving such a claim.) SueCan reported net income of about $442,000 for the year, an overstatement of approximately 60 percent.

Problem: Toying around with the Numbers. Mattel Inc., a manufacturer of toys, failed to write off obsolete inventory, thereby overstating inventory and improperly deferred tooling costs, both of which understated cost of goods sold and overstated income. "Excess" inventory was identified by comparing types of toys (wheels, general toys, dolls, and games), parts, and raw materials with the forecasted sales or usage; lower of cost or market (LCM) determinations then were made to calculate the obsolescence write-off. Obsolescence was expected and the target for the year was $700,000. The first comparison computer run showed $21 million "excess" inventory! The company "adjusted" the forecast by increasing the quantities of expected sales for many toy lines. (Forty percent of items had forecasted sales more than their actual recent sales.) Another "adjustment" was to forecast toy closeout sales not at reduced prices but at regular prices. In addition, certain parts were labeled "interchangeable" without the normal reference to a new toy product. These adjustments to the forecast reduced the excess inventory exposed to LCM valuation and write-off. The cost of setting up machines, preparing dies, and other preparations for manufacture are tooling costs.

They benefit the lifetime run of the toy manufactured. The company capitalized them as prepaid expenses and amortized them in the ratio of current-year sales to expected product lifetime sales (much like a natural resource depletion calculation). To lower the amortization cost, the company transferred unamortized tooling costs from toys with low forecasted sales to ones with high forecasted sales. This caused the year's amortization ratio to be lower, the calculated cost write-off lower, and the cost of goods sold lower than it should have been. The computerized forecast runs of expected usage of interchangeable parts provided a space for a reference to the code number of the new toy where the part would be used. Some of these references contained the code number of the part itself, not a new toy. In othercases, the forecast of toy sales and parts usage contained the quantity on hand, not a forecast number. In the tooling cost detailed records, unamortized cost was classified by lines of toys (similar to classifying asset cost by asset name or description). Unamortized balances were carried forward to the next year.

The company changed the classifications shown at the prior year-end to other toy lines that had no balances or different balances. In other words, the balances of unamortized cost at the end of the prior year did not match the beginning balances of the current year except for the total prepaid expense amount. For lack of obsolescence write-offs, inventory was overstated at $4 million. The company recorded a $700,000 obsolescence write-off. It should have been about $4.7 million, as later determined. The tooling cost manipulations overstated the prepaid expense by $3.6 million. The company reported net income (after taxes) of $12.1 million in the year before the manipulations took place. If pretax income were in the $20 to $28 million range in the year of the misstatements, the obsolescence and tooling misstatements alone amounted to about 32 percent income overstatement.