PawLow Inc. is a private manufacturer of specialized lubricants for the space industry. Its lubricants are used to cover moving mechanical parts inside rocket ships, the Space Station, and the Mars Rover. Its year end was February 28, 2018, and the unaudited net income before tax is $4 million. In 2019, PawLow will be expanding its business and establishing operations in Russia and China. These two countries have their own space programs and PawLow sees great opportunities there. To fund the expansion, in November 2017 the company obtained a loan from a bank. As part of the loan agreement, the bank requires PawLow to provide audited financial statements as well maintain a specific debt ratio (Debt Ratio = Total Debt/Total Assets) loan covenant.

You are an audit manager who is responsible for reviewing PawLow’s year-end audit file and you are currently reviewing the inventory section. Below is an excerpt from the audit working papers:

During the year-end inventory count, the count supervisor noted that a special order of lubricant for the Space X rocket, with a value of $1920000, had an odd viscosity [viscosity is thickness or consistency of the lubricant] and colour. This was most likely caused by a defect in compounding, in that the chemical mix or proportions were incorrect. The VP of finance, Thomas Wolanski, believes that the lubricant can still be sold at a discounted price of about $500 000 to one of the large car manufacturers that use similar types of lubricants inside the engines of the vehicles that they manufacture.

AUDIT WORK PERFORMED

• For the defective special order, discuss with management the plans for disposing of the lubricant and why management believes it can be sold for $500 000.

• Agree the cost of $1920000 for the special order to management’s calculations to confirm the raw material cost, labour cost, and any overheads attributed to the cost have been added and allocated correctly.

REQUIRED

a. Review the audit procedures and discuss the method and reliability of the gathered audit evidence in relation to the risks discussed in the case.

b. What other methods could the auditor have used to gather evidence?

c. What more reliable evidence do you suggest the auditor gather?