INVENTORY CAS 500 – Audit evidence CAS 501 – Audit evidence – Specific considerations for selected items CAS 505 – External confirmations CAS 520 Analytical procedures CAS 620 – Using the work of an Auditor’s expert

The Complexity of Inventory Why? A major item Inventory items could Very diverse items are included Valuation needs to consider One client may use several methods

Functions in the Inventory and Warehousing Cycle Process purchase orders Receive new materials Store materials Process goods Store finished goods Ship finished goods

An Overview of Functions, Documents, and Accounting Systems Starting point E.g. Stockroom Purchase details Purchase Requisition N Prepare prenumbered Purchase Requisition Accounts Payable Purchasing

Determine Vendor, Prepare prenumbered Purchase Order Purchasing Department Purchase Requisition Determine Vendor, Prepare prenumbered Purchase Order Purchase Order N Originating Department Accounts Payable Vendor Receiving

Receive New Materials Receiving Report Blind copy of Purchase Order Count goods, match with Purchase Order, and prepare Receiving Report A Accounts Payable Purchasing Originating Department with goods Filed until goods received along with invoice copy

Compare. Then prepare Voucher and enter in Voucher Register Vendors Invoice Purchase Requisition Purchase Order Receiving Report Vendor’s Invoice Voucher Compare. Then prepare Voucher and enter in Voucher Register D Purchasing Originating Department Receiving Vendor Voucher Register to General Accounting To Cash Disbursements when due

Storage Raw Materials Cost Accounting Requisition Raw Materials Goods are placed in storage. Raw materials perpetual inventory updated Goods from Receiving Inventory Master file N Goods are placed in production Cost Accounting Production Raw Materials Requisition

Manufacturing Raw Materials Requisition Storage N Goods are placed in storage in production Finished Goods to storage Goods Cost Accounting Records

Finished Goods Storage Update Perpetual Inventory Master File. Update Cost Accounting Records Finished Goods to shipment Finished Goods from Production Finished Goods Master File Cost Accounting Records

Finished Goods Shipment Order Entry Approved Sales Order Sales Order Bill of Lading Bill of Lading Billing and A/R Bill of Lading Prepare Multi-Part Bill of Lading. Update Perpetual Inventory Master File on shipment Bill of Lading Customer Common Carrier Finished Goods Master File

The Audit of Inventory Price and compile inventory Acquisition and Payments, Payroll and Personnel Inventory and warehousing Sales and Collections Audit area Cycle Acquire and record raw materials, labour, and overhead Internally transfer assets and costs Ship goods and record revenue and costs Physically observe inventory

Cost Accounting Typical Controls Physical controls Good controls are essential Physical controls Inventory must be protected from theft and misuse What does the auditor look for? If auditor assesses the physical controls and inadequate?

Documents and Records If testing internal controls Auditor examines Testing a series of documents Does the auditor always test the controls around inventory production?

Inventory files When does the auditor examine the Perpetual Inventory system? If level of control risk is low This can be assessed by

Analytical Procedures Compare gross margin percentage with previous years Compare inventory turnover with previous years Compare unit costs of inventory with previous years Compare extended inventory value with previous years Compare current-year manufacturing costs with previous year

Designing Tests of Controls for the Acquisition and Payment Cycle Must consider IR for Inventory. Materiality for Inventory is allocated from planning materiality. Probably want a low audit risk for Inventory as it is usually very material. E.g. 5% Set materiality. Assess Audit Risk and Inherent Risk for Inventory and Warehousing Use last years assessed CR for Payments and Sales and Collections If not available, estimate based on initial system review and discussions with client. Will eventually use the assessed materiality after testing. Assess Control Risk for the applicable cycles e.g. obsolete or slow moving inventory. I f not identified, could be a risk of material misstatement Identify assertions where substantive testing is insufficient, and/or there is risk of material misstatement e.g. Perpetual inventory – can attend counts throughout the year e.g. Sample size will be affected by reliance on internal controls e.g. Monetary unit sampling could be used to select the actual items e.g. Low CR, could do substantive testing early Design test for those controls on which the auditor will rely. You cannot assess CR without testing Design and perform test of control for the applicable cycles. Assess control risk Tests of details can be reduced if CR is low. Analytical procedures are performed as additional persuasive evidence. Amount of testing is indirectly related to DR The type of audit procedure? What is the sample size? Items to be selected? Timing – when to do the procedure? Design and perform substantive tests of inventory.

Physical Inventory Observation: Existence Remember McKesson & Robbins 1937 Select a random sample of tag numbers If inventory is not tagged Movement of inventory

Auditor’s Observation of Inventory First task is to review client’s inventory-taking instructions. Auditor will also perform test counts.

Items of Special Note Physical inventory not on year-end date: Cycle inventory counting: Auditors not present at client’s inventory count: Inventories located off the client’s premises:

Special Notes: Physical Inventory Observation Auditors not present at client’s inventory count:

Physical Inventory Observation: Completeness Tagging inventory If tags are not used Enquire as to inventory in other locations.

Physical Inventory Observation: Accuracy Recount client’s counts What should be in the auditor’s sample? Should also trace inventory in both directions. Perpetual inventory master file Record client counts test-counted for subsequent testing.

Physical Inventory Observation: Classification Examine inventory tags: What to look for? How about percentage of completion for work-in-process?

Physical Inventory Observation: Cutoff Record for subsequent follow-up Inventory for that shipment Review shipping area for inventory The receiving process

Physical Inventory Observation: Valuation What is the auditor looking for? What else should the auditor do?

Physical Inventory Observation: Rights and Obligations Ownership of inventory is the prime focus in this instance About what type of item is the auditor concerned?

Tests for Compilation and Detail tie-in What about accounting principles? What does compilation mean? What items should be used in this test? What else should be done? Detail tie-in?

Tests for Existence What items should be used for this test? What type of test is performed?

Tests for Completeness What about unused tags? How about the tags sequence? Hand-held computers Allows the user to scan inventory products After the inventory count, When the inventory count is synced with the system,

Tests for Accuracy Want to ensure that the counts are accurate. What type of test? Perform pricing tests. Type of tests? Manufacturing Non-Manufacturing

Tests for Classification Want to inventory is classified correctly as to the type of inventory

Tests of Valuation Remember the physical inventory observation. What was performed in this regard? Perform test of lower of cost or market, selling price, and obsolescence

Tests for Rights and Obligations The auditor is concerned about what type of inventory? What type of test? Consigned –in: Consigned –out:

Tests for Presentation and Disclosure What document should be examined here? The financial statements

Interrelationship of Various Audit Tests Beginning inventory + Acquisitions of raw materials - Ending inventory = Raw material used Tests of acquisition and payments cycle Tests of cost accounting: Perpetual inventory records Unit cost records Raw materials Work in process Direct labour Indirect labour and other manufacturing overhead Cost of goods manufactured Tests of physical inventory observation Compilation and pricing Cost of goods sold Finished goods Tests of payroll and personnel cycle Tests of sales and collection cycle

Problem EP 12-10, Page 679 Consider the following examples of inventories in various businesses: Pharmaceuticals in a drug company. Fine chemical compounds in a biotechnical company. Software in an information technology development company. New condominium office units in a commercial real estate developer. Fine art works in an interior design business. Required: For each item, indicate the challenges auditor's would face in trying to count and measure the inventory, and suggest an approach to obtain sufficient appropriate audit evidence.

Problem EP 12-11, Page 679 20X5 20X6 Sales of clothing $10,000,000 Li was assigned to work on the audit of A1 Clothing Ltd. Because she has been auditing similar companies for three years and is considered to be knowledgeable about the clothing retailing industry in Canada. Her employer, Bing Pas audited A! in 20X5 for the first time and had difficulty verifying the opening inventory number. This year, in 20X6, Li has the audited ending balance from 20X5, so she does not expect any problems with the inventory account. However, while doing the preliminary work for the audit, she calculated the gross profit margin and was surprised by her findings. Li thinks the gross margin indicates the ending inventory for 20X54 may be incorrect. 20X5 20X6 Sales of clothing $10,000,000 $9,000,000 Cost of goods sold 7,000,000 5,500,000 Inventory 1,800,000 6,200,000 Required: Explain whether you agree with Li. Support your answer with at least three points. (Adapted from External Auditing AU1, June 2011, with permission of Chartered Professional Accountants of Canada, Toronto, Canada.)

Problem EP 12-14, Page 681 During his examination of the inventories and related accounts of Consumer Electronics Inc., a manufacturer and distributor of small appliances, and auditor encountered the following: Several trucks loaded with finished goods were parked at the shipping dock. The contents of the trucks were excluded from the physical inventory. The finished goods inventory included high volumes of several products, and many of their cartons were old and covered with dust. In response to the auditor’s questions, the plant manager stated that there was no problem as “all of these goods will eventually be sold, although some price incentives may be necessary.” While reviewing the complex calculations used to develop the unit production costs of items in finished goods, the auditor noted that the costs of the company’s electrical engineering department had been treated as period expenses in previous years but were included in manufacturing overhead in the current year. The company installed a new perpetual inventory system during the year. The auditor noted that many of the company’s year-end quantities differed from the actual physical inventory counts. Partly because of these problems, the company took a complete physical inventory at year-end. Required: Describe the additional audit procedures (if any) that the auditors should perform to obtain sufficient appropriate audit evidence in each of the preceding situations. (Adapted from External Auditing AU1, June 2011, with permission of Chartered Professional Accountants of Canada, Toronto, Canada.)

Basic inventory auditing procedure Problem DC 12-8, Page 685 You are conducting an audit of the financial statements of a wholesale cosmetics distributor with an inventory consisting of thousands of individual items. The distributor keeps its inventory in its own distribution centre and in two public warehouses. A perpetual inventory database is maintained on a computer system and updated at the end of each business day. Each individual inventory record of the perpetual inventory database contains the following data: Item number Location of item Description of item Quantity on hand Cost per item Date of last purchase Date of last sale Quantity sold during the year You are planning to observe the distributor’s physical count of inventories as of a given date. You will have available a computer file, provided by the auditee, of the above items taken from their database as of the date of the physical count. Your firm has a generalized audit software package that can upload and analyze the auditee’s computer data files. Required: List the basic inventory auditing procedures and, for each, describe how the use of the general purpose audit software package and the perpetual inventory database might be helpful to the auditor in performing such auditing procedures Organize your answer as follows: Basic inventory auditing procedure How general purpose audit software and the inventory file data might be helpful