Ace Hardware is a retailer-owned cooperative, with 4,600 hardware, home center, and building mate- rials stores. At the time of this case, Ace was a private company that was planning to go public. In September 2007, Ace Hardware said it discovered a $154 million accounting discrepancy between its general ledger and its actual inventory. The accounting error was discovered during an internal review of financial reports. The company explained that it had found a difference between the company's 2006 general ledger balance-the company's primary method for recording financial transactions-and its actual inven- tory records, referred to as its perpetual inventory balance.
Ace hired a law firm and a consulting firm to investigate. The investigation cost about $10 million. As a result of the investiga- tion, in January 2008, Ace Hardware reported that a mid-level employee in the finance department caused a $152 million account- ing discrepancy between the general ledger and the actual inven- tory. The former finance worker made journal entries of a sizeable amount that masked a difference in numbers between the two led- ger books. The ledgers looked as though they were reconciled, but were not. About one-quarter of the error dated to 1995, and the rest took place from 2002 through 2006. In its 10-K filing, the company reported that gross margins had increased by about 2% in the five years leading up to fiscal year end 2002, rising from 7.7 % to 9.4%. Home Depot, in contrast, maintained a very stable gross margin over that period, which was consistently about 30%. KPMG issued unqualified audit opinions on the company's financial statements during the period of the inventory misstatements.
Company officials stressed that the employee did not commit fraud and that no inventory or money was missing. Rather, the company suggested that the finance person was not properly trained or equipped to do the job. The company further suggested that the situation was Ace's fault, in that the finance person was not appropriately trained and that oversight and checks and bal- ances were not in place. Company officials also blamed the error partly on the increasingly complex and competitive retail hardware industry. Specifically, systems in place were not adequate for addressing complications that arose from Ace's recent increase in product imports from Asia. Since that time, Ace has implemented a modern, point-of-sale inventory management system that has signif- icantly improved internal controls and inventory pricing at individ- ual retailer locations.
As a result of the discovery of the inventory problem, Ace had to put on hold its plans to issue a public offering of stock and in fact had still not issued a public offering of stock as of 2012. While we often think of inventory misstatements as due to fraud, this case illustrates that such misstatements can also be caused by errors.
a. List the inherent, control, and fraud risk factors relevant to this case.
b. State plausible reasons that KPMG audit personnel may have lacked professional skepticism in their audits of Ace Hardware.