Wright Brother Inc.Case Study
One Of Khan’s Subsidiaries in USA is the Wright Brothers Inc.
Auditors commonly find themselves facing situations in which they must persuade client executives to do something they absolutely and resolutely do not want to do.
When all else fails, auditors may be faced to use a tactic that clinical psychologists, marriage counsellors, parents of toddlers, and other interpersonal experts typically frown upon; namely the old fashioned “if you-don’t-cooperate, I-will punish you” threat. In the mid-1990s an exasperated team of Grant Thornton auditors resorted to a threatening a stubborn client executive to goad him into turning over key documents that had a significant audit implications. The executive eventually capitulated and turned over the documents — which resulted in even more problems for the Grant Thornton auditors.
The brothers Wright For decades, Mr. Wright oversaw a successful wholesale meat company, a company that he eventually incorporated and named after himself. Mr. Wright Inc. marketed a variety of meat, cheese, and other food products along the eastern seaboard of the United States from its Philadelphia headquarters. Mr. Wright failing health in the early 1980s prompted him to place his two sons in charge of the company’s day to day operations. After their father’s death the two brothers Orville and Wilbur became equal partners in business. Orville assumed the title of company president, while Wilbur became company’s vice president. The two brothers and their mother made up the company’s three persons board of directors. Several other members of the Wright family also worked in the business.
Similar to many family-owned and –operated businesses, Wright Inc. (WI) did not take place a heavy emphasis on internal control. Like their father the two Wright brothers relied primarily upon their own intuition and the competence and integrity of their key subordinates to manage and control their company’s operations.
By the mid-1980s, when the privately owned business had an annual sales measured in the tens of millions, Orville realized that WI needed to develop a more formal accounting and control system. That realization convinced him to begin searching for a new company controller who had the expertise necessary to revamp WI’s outdated accounting function and to develop an appropriate network of internal controls for the growing company. In 1987 Orville hired Steve Cohn, a CPA and former auditor with Coopers & Lybrand, as WI’s controller. Cohn who had extensive experience working with variety of different inventory systems immediately tackled the challenging assignment of creating a modern accounting and control system for WI.
Among other changes, Cohn implemented new policies and procedures that provided for segregation of key responsibilities with WI’s transaction cycles. Cohn also integrated computer processing throughout the most of WI’s operations, including the payroll, receivables, and payables modules of the company’s accounting function.
One of the more important changes that Cohn implemented was developing an internal reporting system that produced monthly financial statements the Wrights could use to make more timely and informed decisions for their business. Cohn’s new financial reporting system also allowed WI to file more timely financial statements with the three banks that provided the bulk of the company’s external
financing. By the early 1990s, WI typically had a minimum of $10million in outstanding loans from those banks.
One area of WI’s operations that Cohn failed to modernize was the company’s accounting and control procedures for prepaid inventory.
Since the company’s early days, imported meat products had a significant portion of WI’s annual sales. Because foreign suppliers required WI to prepay for frozen meat items, the company maintained two inventory accounts, Prepaid Inventory and Merchandise Inventory.
Prepayments for imported meat products were imported to the Prepaid Inventory account, while all other merchandise acquired by the company for resale was debited to the Merchandise Inventory account. Prepaid inventory typically accounted for 60 percent of WI’s total inventory and 40 percent of the company’s total asset.
Long before Cohn became WI’s controller, Mr. Wright had given his son Wilbur complete responsibility for the purchasing, accounting, control, and other decisions affecting the company’s prepaid inventory. Following their father’s death, the two brothers agreed that Wilbur would continue overseeing WI’s prepaid inventory.
When Cohn attempted to restructure and computerize the accounting and control procedures for prepaid inventory, Wilbur refused to cooperate.
Despite frequent and adamant pleas from Cohn over a period of several years, Orville refused to order his younger brother to cooperate with Cohn’s modernization plan for WI’s accounting system. Accounting for Prepaid Inventory.
Wilbur Wright processed the purchase orders for meat products that WI bought from foreign vendors. The items purchased were inspected by the appropriate authority in the given country and then loaded intro refrigerated lockers to be transported by boat to the United States.
When a vendor provided documentation to WI that a shipment was in transit, Wilbur Wright approved payment of the vendor’s invoice.
These payments, as noted earlier, were charged or debited to WI’s Prepaid Inventory account. Wilbur Wright maintained a handwritten accounting record known as the prepaid inventory log to keep track of the items included in the Prepaid Inventory account at any point in time.
When a shipment of imported meat products arrived at a U.S. port, a customs broker retained by WI arranged for the individual items to be inspected and approved for entry into the United States by customs officials. After a shipment had cleared customs, the customs broker sent a notification to that effect to Wilbur Wright.
When the product arrived by truck at WI’s warehouse, a U.S Department of Agriculture (USDA) official opened and inspected the items included in the order. The USDA official completed a document known as Form 9540-1 to indicate that the items had passed inspection. Each form 9540-1 also indicated the date that the given products had arrived at WI’s warehouse.
Upon completion of the USDA inspection process, the prepaid inventory items were turned over to the manager of WI’s warehouse.
The warehouse manager stamped the items to indicate that they passed the USDA inspection and then completed a document known as a delivery receipt that listed the date of arrival. The vendor, the type of product and the quantity of the product. The warehouse manager sent the delivery receipt form to Wilbur Wright, who
matched the form with the appropriate vendor invoice. Wilbur then deleted the given inventory items from the prepaid inventory log and forwarded the matched invoice and delivery receipt to Steve Cohn, who processed an accounting entry that transferred the product from the Prepaid Inventory account to the Merchandise Inventory account.
At the end of each year, WI took a physical inventory of the company’s warehouse and adjusted the balance of the Merchandise Inventory account to agree with the results of the physical inventory.
Because of the accounting procedures used for WI’s two inventory accounts, there was some risk that certain inventory items would be “double-counted” at year-end. That is, certain inventory items might be included in both the Prepaid Inventory and Merchandise Inventory accounts if there was any delay in processing the delivery receipt forms. For example, suppose that a shipment of imported meat products arrived at WI’s warehouse on December 29, two days before the close of the company’s fiscal year. If Wilbur Wright failed to delete the items in the shipment from the prepaid inventory log and failed to forward the delivery receipt and invoice for the shipment to Steve Cohn on a timely basis, the items in the shipment could be included in both inventory accounts at the end of the year. To reduce the risk of such errors, Cohn reconciled the prepaid inventory log maintained by Wilbur to the yearend balance of the Prepaid Inventory account. Cohn also asked Wilbur to allow him to review any delivery receipts arrived during the last few days of the fiscal year.
Steve Cohn realized that the accounting procedures for prepaid inventory increased the risk that WI’s year-end inventory would be misstated. In early 1992, Cohn who by this time had been given the title of chief financial officer (CFO), designed a computerized accounting system for WI’s prepaid inventory. Cohn then called a meeting with the two Wright brothers to illustrate the system and
demonstrate the important information and control advantages that it would provide over the “sloppy” manual system that Wilbur had used for years to account for prepaid inventory. Several years later, Cohn would recount how the Wright brothers reacted to his proposal.
I told Wilbur how this was a great idea and how I believed that this would be a big step forward in being able to monitor the (prepaid) inventory and determine what was open…And I showed it to Wilbur, looked and said, “Isn’t this great? We can do this.” And I said “Don’t you want to do this?” And he looked at me and said,” No.” I was flabbergasted. I looked over to Orville. He just sat there. And I was
furious. I didn’t talk to Wilbur for weeks, I was—I was having hard time dealing with it. I couldn’t imagine why he wouldn’t want me to do this. It was such a good thing for the company. And he didn’t want to do it.
Later in 1992, the president Cohn decided to personally collect the information needed to maintain a computerized accounting system for WI’s prepaid inventory. Cohn would watch for delivery trucks arriving at WI’s warehouse, which was adjacent to the company’s administrative offices. When a truck arrived, either he or a subordinate would go the shipping dock and make copies of the delivery receipt and other documents for each shipment of imported meat products.” We used to run back and forth trying to get these receiving (delivery receipts) that the (warehouse manager) was preparing and it became a game. I became a laughingstock because it
was a joke that I was trying to get this information. After several weeks, an exasperated Cohn gave up his futile effort.
Wilbur Wright had reason not to cooperate with Cohn’s repeated attempts to overhaul the accounting and control procedures for WI’s for prepaid inventory. Since the mid-1980’s, Wilbur had been intentionally overstating the company’s prepaid inventory. Those overstatements had materially understated WI’s annual cost of goods sold as well as overstated the company’s gross profit and net income each year. In subsequent court testimony, Wilbur reported that that his
father’s failing health had compelled him to begin manipulating WI’s reported operation results. “To avoid aggravating his illness, I started the practice (inflating the prepaid inventory) so he would feel better about his business.”
Wilbur also testified that following his father’s death “significant changes occurring in the market which adversely affected us” caused him to continue his fraudulent scheme. During the late 1980s and early 1990s, Wilbur and his brother found it increasingly difficult to compete with larger wholesalers that were encroaching on their company’s market. To compete with these larger companies, WI was forced to reduce the gross margins on the products that it sold. To mitigate the impact of this competitive pressure on WI’s operating results, Wilbur routinely overstated prepaid inventory to produce gross margins that approximated those historically realized by the company.
Wilbur manipulated the dates upon which the prepaid inventory was received in order to make it appear that the company’s operations generated the same general financial performance from period to period. He did this by determining how much inventory needed to be prepaid inventory so that the percentages of gross profit and net income would remain consistent.
To overstate prepaid inventory, Wilbur destroyed delivery receipts forwarded to him by WI’s warehouse manager and neglected to update the prepaid inventory log for the given shipments. Weeks or even months later, he would prepare new delivery receipts for those shipments, delete the items in the shipments from the prepaid inventory log, and then forward the receipts along with the corresponding vendor invoices to Cohn. This practice caused the affected prepaid inventory items to be included in both inventory accounts, Prepaid Inventory and Merchandise Inventory for extended periods of time.
Auditing Prepaid Inventory
Grant Thornton served as WI’s independent audit firm from 1986 through 1994.
Because prepaid inventory was WI’s largest asset and because it posed significant audit risks the engagement audit team allocated a disproportionate amount of audit resources to that item. Several weeks before the end of each fiscal year, Grant Thornton provided Steve Cohn with an “Engagement Compliance Checklist” that identified the documents and other information needed by the audit engagement team to complete the audit. Many of these requested items involved WI’s prepaid inventory, including “government forms, bills of lading, insurance information, and the delivery receipts prepared by the
warehouse personnel evidence the date upon which the (prepaid) inventory was received at the warehouse”. Each year Grant Thornton also requested a copy of Wilbur Wright’s prepaid inventory log and Cohn’s reconciliation of the information in that record of WI’s general ledger controlling account for prepaid inventory.
One key item that Grant Thornton did not request from Cohn was the form 95401 prepared for each shipment of imported meat products delivered to WI’s warehouse. Grant Thornton auditors later testified that they became aware in 1988 that a form 9540-1 was prepared for each prepaid inventory shipment received by WI. However, the audit team did not learn until 1993 that the USDA official who completed the 9540-1 gave a copy of that document to a WI warehouse clerk.
Each year Cohn diligently collected the information requested by Grant Thornton and gave it to the accounting firm well before the date of the audit was to begin, with one exception. Because Wilbur Wright failed to give the prepaid inventory log, delivery receipts, and other information he maintained for WI’ prepaid inventory to Cohn on a timely basis, Grant Thornton received that information well after the audit had begun each year.
Grant Thornton audited all of WI’s prepaid inventory transactions each year.” Grant Thornton tested 100 percent of the prepaid inventory transactions, which meant that Grant Thornton examined every invoice for the prepaid inventory and reviewed the delivery receipts to confirm if and when a delivery had been made.” By examining the invoices and delivery receipts, the auditors could determine which prepaid inventory purchases were apparently “still open” at year end, that is the prepaid inventory shipments that were properly included in WI’s year-end Prepaid Inventory account.
Because Wilbur Wright had destroyed many of the delivery receipts prepared by the warehouse manager, the Grant Thornton auditors
1) Make an assessment for Company’s Internal Control?
2) Make a Development for company’s Internal Control?
3) What Types of Risk Does this Inc. Face?
4) What are The Audit Evidences types Used in the Case?
5) What are The Management Assertions applied correctly in the
Case? What are violated?