Chapter 13 Auditing the Inventory Management Process McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Overview of the Inventory Management Process Purchasing process Inventory management process Revenue process Purchase of raw materials Payment of manufacturing overhead Human resource management process Assignment of direct and indirect labor costs Sale of goods LO#

Types of Documents and Records 1.Production Schedule 2.Receiving Report 3.Materials Requisition 4.Inventory Master File 5.Production Data Information 6.Cost Accumulation and Variance Report 7.Inventory Status Report 8.Shipping Order Production Schedule LO# 2 Inventory Master File 13-3

The Major Functions LO#

Key Segregation of Duties LO#

Inherent Risk Assessment The auditor should consider industry-related factors and operating and engagement characteristics when assessing the possibility of a material misstatement. If industry competition is intense, there may be problems with the proper valuation of inventory. Technology changes in certain industries may also promote material misstatement due to obsolescence. Products that are small and of high value are more susceptible to theft. The auditor must be alert to related-party transactions for acquiring raw materials and selling finished products. Prior-year misstatements are good indicators of potential misstatements in the current year. LO#

Control Risk Assessment Major steps in setting the control risk in the inventory management process. Understand and document the inventory management process based on a reliance strategy. Set and document the control risk for the inventory management process. Plan and perform tests of controls on inventory transactions. LO#

Control Activities and Tests of Controls – Inventory Transactions LO#

Auditing Inventory LO#

LO# 8 Auditing Inventory 13-10

LO# 8 Auditing Inventory 13-11

Substantive Analytical Procedures LO#

Auditing Standard Costs Materials Test the quantity and type of materials included in the product and the price of the materials. Labor Gather evidence about the type and amount of labor needed for production and the labor rate. Overhead Review the client’s method of overhead allocation for reasonableness, compliance with GAAP, and consistency. LO#

Observing Physical Inventory During the observation of the physical inventory count, the auditor should do the following: 1.Ensure that no production is scheduled. 2.Ensure that there is no movement of goods during the count. 3.Make sure that the client’s count teams are following instructions. 4.Ensure that inventory tags are issued sequentially to individual departments. 5.Perform test counts. 6.Obtain tag control information. 7.Obtain cutoff information. 8.Observe the condition of the inventory – excess, obsolete, slow moving. 9.Inquire about goods held on consignment. LO#

Tests of Details of Transactions, Account Balances, and Disclosures LO#

Tests of Details of Transactions, Account Balances, and Disclosures Examples of Disclosure Items: 1.Cost method (FIFO, LIFO, retail method). 2.Components of inventory. 3.Long-term purchase contracts. 4.Consigned inventory. 5.Purchases from related parties. 6.LIFO liquidations. 7.Pledged or assigned inventory. 8.Disclosure of unusual losses from write-downs or losses on long-term purchase commitments. 9.Warranty obligations. Examples of Disclosure Items: 1.Cost method (FIFO, LIFO, retail method). 2.Components of inventory. 3.Long-term purchase contracts. 4.Consigned inventory. 5.Purchases from related parties. 6.LIFO liquidations. 7.Pledged or assigned inventory. 8.Disclosure of unusual losses from write-downs or losses on long-term purchase commitments. 9.Warranty obligations. LO#

Evaluating the Audit Findings - Inventory At the conclusion of testing, the auditor should aggregate all identified misstatements. The likely misstatement is compared to the tolerable misstatement allocated to the inventory account. Likely misstatement < Tolerable misstatement The auditor may accept the inventory account as fairly presented. Likely misstatement > Tolerable misstatement The auditor must conclude the inventory is not fairly presented. LO#

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