Question

This case will enable you to practice conducting planning and substantive analytical procedures for accounts in the acquisition and payment cycle. When analyzing the financial data, you may assume that the 2015 information is unaudited, while prior-year data is audited.

As you complete this case, consider the following features of and trends in the pharmaceutical industry and for PharmaCorp specifically:

• After a long period of industry dominance by companies in the United States, the United Kingdom, and Europe, these companies are facing increasing competition from companies domiciled in emerging economies, such as Brazil, India, and China.

• There exists significant uncertainty in the market because of recent regulation covering health-care and government payouts for certain procedures and related pharmaceuticals.

• Health-care policy makers and the government are increasingly mandating what physicians can prescribe to patients.

• Health-care policy makers and the government are increasingly focusing on prevention regimes rather than treatment regimes, thereby leading to shifts in the demand for various pharmaceuticals.

• The global pharmaceutical market is anticipated to grow by 5% to 7% in 2016 compared with a 4% to 5% growth rate in 2015, according to a leading industry analyst publication.

• Beginning in 2014, PharmaCorp initiated and executed a significant company-wide cost reduction initiative aimed at improving manufacturing efficiency, cutting back on research and development expenses, and eliminating unnecessary corporate overhead.

• PharmaCorp’s policies for extending credit to customers have remained stable over the last three years. PharmaCorp’s credit-granting policies are considered stringent within the industry, and analysts have sometimes criticized the company for this, contending that such policies have hindered the company’s revenue growth relative to industry peers.

• Two of PharmaCorp’s popular pharmaceuticals, Selebrax and Vyvox, came off patent during the fourth quarter of FYE 2015. These pharmaceuticals now face competition in the generic drug portion of the overall industry market.

Information specific to the Acquisition and Payment Cycle

• Raw materials inventory required in the businesses are purchased from numerous suppliers. No serious shortages or delays of raw materials inventory were encountered in 2015, and none are expected in 2016. PharmaCorp has successfully secured the raw materials inventory necessary to meet its requirements where there have been short-term imbalances between supply and demand, but generally at higher prices than those historically paid.

• A risk that companies in this industry face with respect to the acquisition and payment cycle is that there is a possibility of failing to maintain the integrity of supply chains, possibly resulting in intentional and criminal acts such as product diversion, product theft, and counterfeit raw materials inventory.

• In response to pricing pressure, several major suppliers changed their policy with respect to discounts for early payment of amounts due on credit sales. In response, PharmaCorp changed its policy of paying within two weeks to paying within four weeks since it is no longer monetarily beneficial to do so from a cash management perspective.

Part I: Planning Analytical Procedures

A. Step 1: Identify Suitable Analytical Procedures. Your audit senior has suggested that the following ratios (on an overall financial statement level) will be used for planning analytical procedures in the acquisition and payment cycle at PharmaCorp:

Inventory Ratios

• Gross margin analysis (revenues-cost of sales)/revenues =

• Changes in cost of goods sold on a percentage basis, yearly comparisons =

• Inventory turnover (cost of goods sold/ending inventory) =

Number of days’ in sales in inventory (365/turnover rate)

Accounts Payable Ratio

• Accounts payable turnover (purchases/average accounts payable)

• Days outstanding in accounts payable (365/accounts payable turnover)

• Accounts payable/current liabilities

As part of Step 1, identify any other relevant relationships or trend analyses that would be useful to consider as part of planning analytics. Explain your reasoning.

B. Step 2: Evaluate Reliability of Data Used to Develop Expectations. The audit team has determined that the data you will be using to develop expectations in the acquisition and payment cycle are reliable. Indicate the factors that the audit team likely considered in making that determination.

C. Step 3: Develop Expectations. Complete Step 3 of planning analytical procedures by developing expectations for relevant accounts in the acquisition cycle and for the ratios from Part (a). Develop expectations by considering both historical trends of PharmaCorp, and also by considering features of and historical trends in the industry. Given that this is a planning analytical procedure, the expectations are not expected to have a high level of precision. You might indicate that you expect a ratio to increase, decrease, or stay the same, and possibly indicate the size of any expected increases or decreases, or the range of expected ratio. PharmaCorp’s financial information is on the first tab of the Excel file, while the financial information for Novartell and AstraZoro is provided on the last two tabs of the Excel file.

D. Step 4 and Step 5: Define and Identify Significant Unexpected Differences. Refer to the guidance in Chapter 7 on performance materiality, tolerable misstatement, and clearly trivial amounts. Apply those materiality guidelines to Step 4 of planning and analytical procedures in the acquisition and payment cycle for PharmaCorp to define what is meant by a significant difference. Explain your reasoning. Also comment on qualitative materiality considerations in this context. Now that you have determined what amount of difference would be considered significant, calculate the ratios identified in Step 1 (and any additional ratios or trend analyses that you suggested), based on PharmaCorp’s recorded financial statement amounts. Identify those ratios where there is significant unexpected difference.

E. Step 6 and 7: Investigate Significant Unexpected Differences and Ensure Proper Documentation. Complete Step 6 of planning analytical procedures by describing through substantive audit procedures. Explain your reasoning. To complete Step 7, describe what information should be included in auditor’s workpapers.

Part II: Substantive Analytical Procedures

F. Management has explained the decline in cost of goods sold as involving:

• Lower purchase accounting charges, primarily reflecting fair value adjustments relating to acquired inventory that was subsequently sold

• Lower costs related to new cost reduction and productivity initiatives, as well as savings generated from ongoing productivity initiatives to streamline the supply chain network

• Reduced manufacturing volumes related to products that lost exclusivity in various markets

• Reduced manufacturing volumes related to products that lost exclusivity in various markets

• The impact of favorable foreign exchange rates of 3%.

• Explain the types of ratio analysis that you could conduct in substantive analytical procedures to test the validity of management’s explanations. Comment on the trends and relationships that you believe are most relevant, and implications for further substantive testing.

Answer 1

ANSWER:

a.         In addition to the ratios provided to students, they will likely be creative in suggesting others. For example, the following might be relevant:

•           Trends in inventory by product line, with a focus on potential obsolete inventory when a competing generic drug has been introduced in a market segment

•           Trends in payables for vendors that were significant in prior years, but are no longer significant

•           Changes in cost of goods sold on a percentage basis, quarterly comparisons (this would be applicable in practice, but the case does not include data to actually calculate this)

•           Shrinkage ratio (inventory write-down/ending inventory), in total and by product category (this would be applicable in practice, but the case does not include data to actually calculate this)

•           Inventory overhead application. Analyze the relationship between materials, labor, and overhead to total product costing; compare over time and across product categories. (this would be applicable in practice, but the case does not include data to actually calculate this)

•           Purchase returns and allowances/purchases (this would be applicable in practice, but the case does not include data to actually calculate this)

b.         The following factors will influence data reliability:

•           The source of information, i.e., internally generated versus externally obtained. Industry comparisons are helpful in enhancing reliability.

•           Comparability of the data with respect to industry norms

•           Quality of internal controls over the relevant data processing

c.         The following expectations seem reasonable:

In terms of inventory ratios:

•           Gross margins should increase if PharmaCorp's company-wide cost reduction initiative was successful. If it was not, we would expect consistent margins.

•           Ending inventory valuation may be slightly higher given that prices of raw material inventory have increased over historical figures.

•           Inventory turnover for the Selebrax and Vyvox product lines should decline given the fourth quarter generic drug competition. Expectations can be derived by comparing prior 4th quarter inventory valuations from the prior year and comparing to the current FYE 4th quarter.

•           There is no new information to suggest changes in inventory overhead application, so this value should be relatively stable.

In terms of payable ratios:

•           Given the new policy on payment timing of accounts payable, an appropriate expectation is that the total and relative percentage value of accounts payables should increase from the prior year. The extent of such an increase should be in line with the number of vendors and relative volume of accounts payables to those vendors on an average basis.

d.         Common materiality benchmarks applied to PharmaCorp (in millions):

1% of assets:	$1,858
1% of revenue:	$590
5% of net income:	$729
1% of ending inventory:	$71

•           Performance materiality: To be conservative, use 1% of revenue, $590 million for revenue and 1% of A/R, $35 million for inventory.

•           Tolerable misstatement: Use ½ of 1% for tolerable misstatement, so about $300 million for revenue and $17.5 million for accounts receivable.

•           Clearly trivial amounts: This number should be fairly small, in the range of $20,000-$50,000.

•           Also consider materiality with respect to changes in ratios. For example, one would normally expect gross margins to remain fairly steady for most clients unless some significant change occurred. Given that PharmaCorp just implemented a major cost-cutting program, we would expect that gross margins would increase a bit. But anything more than a 2-3% change in margins would be considered unexpected.

•           Qualitative considerations: The auditor should consider analysts' consensus expectations in relation to the EPS number to determine if PharmaCorp management may be feeling pressure in that respect. Since the company is quite profitable, the qualitative considerations relating to debt covenant violations or changing income into a loss are not applicable.

For the computation of the client ratios, see Instructor solution posted to Cengage.com web site, reproduced below.

e.         Identification of significant unexpected differences:

•           Gross margin increased 3% for PharmaCorp and was relatively more stable for its industry competitors. The gross margin change is unexpected in terms of magnitude, but consistent with expectations with respect to the cost-cutting initiative. Document information supporting cost-cutting initiative

•           Consistent with the gross margin increase, cost of goods sold declined by the same amount; this movement seems in line with expectations. Documentation includes memo explaining this conclusion.

•           Inventory turnover has declined (and days sales in inventory has increased accordingly), which is consistent with expectations given the generic competition for the Selebrax and Vyvox product lines. However, given that the decline causes the overall turnover for PharmaCorp to be significantly lower than competitors, this should be investigated with substantive procedures with respect to valuation. Documentation will include evidence relating to valuation.

•           Consistent with the new policy on payment timing of accounts payable, the accounts payable turnover ratios are consistent with the expectation that the total and relative percentage value of accounts payables should increase from the prior year. Making industry comparisons is somewhat difficult given the wide disparity across competitors with respect to these ratios. Documentation will include evidence supporting new policy on payment timing of accounts payable.

In terms of Step 7, the auditor will want to ensure that the documentation of planning analytical procedures is proper. As the auditor proceeds through planning analytical procedures, documentation will be accumulated in the work papers. Specifically, the auditor will document the analytical procedures used, the auditor's expectations, how the level of significant difference was determined, the identification of significant unexpected differences, and the follow-up to address significant unexpected differences.

Part II: Substantive Analytical Procedures

f.          Based on the planning analytical procedures, the most important areas to investigate with substantive audit procedures are the shift in gross margins and the valuation of inventory (particularly for the Selebrax and Vyvox product lines). While the increase in margins is not unexpected from a strategic perspective if the cost-cutting initiative was successful, the auditor should carefully investigate whether and how that initiative translated into the unexpectedly large improvement in performance. Further, it will be important to use substantive analytical procedures and substantive audit procedures to evaluate the validity of management's explanations for the shift.

Recall that management's explanations were as follows:

•           Lower purchase accounting charges, primarily reflecting fair value adjustments relating to acquired inventory that was subsequently sold

o          Potential substantive analytical procedure: track levels of and changes in purchase accounting charges by quarter/year/product line

o          Potential substantive audit procedure: carefully evaluate fair value judgments made by management, with a particular focus on any level 3 components

•           Lower costs related to new cost reduction and productivity initiatives, as well as savings generated from ongoing productivity initiatives to streamline the supply chain network

o          Potential substantive analytical procedure: Inquire of management as to targeted cost reduction initiatives and track levels of and changes in relevant accounts

o          Potential substantive audit procedure: ensure that production costs were not inappropriately capitalized to inventory; do journal entry testing to investigate this possibility

•           Reduced manufacturing volumes related to products that lost exclusivity in various markets

o          Potential substantive analytical procedure: track production volumes by the products that lost exclusivity, comparing to prior years/quarters

•           The impact of favorable foreign exchange rates of 3%.

o          Potential substantive audit: re-calculate foreign exchange rate changes