Medical Products, Inc. (MPI) was created in 2016 and entered the optical equipment industry. Its made-to-order optical equipment requires large investments in research and development. To fund these needs, MPI made a public stock offering, which was completed in 2017. Although the offering was moderately successful, MPI’s ambitious management is convinced that it must report a good profit this year (2018) to maintain the current market price of the stock. MPI’s president recently stressed this point when he told his controller, Pam Adams, “If we don’t make $1.25 million pretax this year, our stock will tank.” Adams was pleased that even after adjustments for accrued vacation pay, 2018 pretax profit was $1.35 million. However, MPI’s auditors, Hammer & Bammer (HB), proposed an additional adjustment for inventory valuation that would reduce this profit to $900,000. HB’s proposed adjustment had been discussed during the 2017 audit. 

An additional issue discussed in 2017 was MPI’s failure to accrue executive vacation pay. At that time HB did not insist on the adjustment because the amount ($20,000) was not material to the 2017 results and because MPI agreed to begin accruing vacation pay in future years. The cumulative accrued executive vacation pay amounts to $300,000 and has been accrued at the end of 2018. 

The inventory issue arose in 2016 when MPI purchased $450,000 of specialized computer components to be used with its optical scanners for a special order. The order was subsequently canceled, and HB proposed to write down this inventory in 2017. MPI explained, however, that the components could easily be sold without a loss during 2018, and no adjustment was made. However, the equipment was not sold by the end of 2018, and prospects for future sales were considered nonexistent. HB proposed a write-off of the entire $450,000 in 2018. 

The audit partner, Johanna Schmidt, insisted that Adams make the inventory adjustment. Adams tried to convince her that there were other alternatives, but Schmidt was adamant. Adams knew the inventory was worthless, but she reminded Schmidt of the importance of this year’s reported income. Adams continued her argument, “You can’t make us take both the write-down and the vacation accrual in one year; it doesn’t fairly present our performance this year. If you insist on making us take that write-down, I’m taking back the accrual. Actually, that’s a good idea because the executives are such workaholics, they don’t take their vacations anyway.” 

As Adams calmed down, she said, “Johanna, let’s be reasonable; we want to continue our good working relationship with your firm into the future. But we won’t have a future unless we put off this accrual for another year.” 

Required: 

a. Should the auditor insist that the inventory adjustment be made despite the impact on MPI’s pre-tax profits? 

b. Irrespective of your decision regarding the inventory adjustment, what is your reaction to Adams’ suggestion to release the vacation accrual? Should the auditor insist on keeping the accrual of the executives’ vacation pay? 

c. Consider the conflict between Adams and Schmidt. Assuming that Schmidt believes the inventory adjustment and vacation pay accrual must be made and that she does not want to lose the audit fee from the MPI audit. What should she do?