Jaynelle Jones, CPA, PC, is meeting with the controller at the Luna Dog Toy Company LLC for a pre-year end audit conference, and the controller has raised the following issues:
(1) Luna Dog Toys LLC manufactures their own dog toys at their factory in Danbury, Connecticut, and a new line of 10,000 sausage shaped toys were introduced during the year at a total manufacturing cost of $ 100,000 for the toy line. 6,000 of the toys have been sold during the first nine months to specialty pet stores in the New England, for $15 per toy. Luna earns a $5 profit for each toy sold to the pet shops, with a $10 cost of goods sold for each toy sold. A competing toy company introduced a similar sausage shaped toy in August and is selling the competing toy to the same shops for $ 7.99 per toy. Luna’s CEO believes their toys are of superior quality, but the controller has concerns about the GAAP valuation of the remaining inventory of 4,000 toys at year-end, based on the FASB guidelines for Inventory under ASC 330.
(2) Luna also manufactured a dog harness that was sold to customers during the last fiscal year. A small percentage of customers returned the harness and asked for replacement harnesses, since Luna provided a 24-month warranty on the harnesses. Luna’s engineers have studied the returned harnesses, as well as an analysis of the defect and have determined the warranty expenses could range from $400,000 (lower range) to $ 600,000 (upper range). The engineers believe that any number between the lower and upper range are possible. The company has only accrued a warranty liability under FASB ASC 450, Contingencies, for the harnesses sold at $ 250,000. (NOTE: A review of FASB Interpretation No 14 may be helpful.)
Required: Discuss the potential audit adjustments that could result to the ending inventory and the warranty reserve from the two issues above. What potential audit evidence could Jaynelle Jones, CPA PC use during the audit evidence period to support the GAAP inventory valuation and the potential warranty liability? Describe the types of audit evidence that may arise before the audit report date Jones may be able to ascertain.
