©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Audit of the Inventory and Warehousing Cycle Chapter 20

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Learning Objective 1 Describe the business functions and the related documents and records in the inventory and warehousing cycle.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Raw MaterialsWork in Process Manufacturing Overhead Flow of Inventory and Costs ActualApplied Manufacturing Direct Labor ActualApplied Beginning inventory Raw materials used Purchases Ending inventory

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Work in ProcessFinished Goods Flow of Inventory and Costs Beginning inventory Ending inventory Cost of Goods Sold Cost of goods manufactured Beginning inventory Ending inventory Cost of goods sold

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Functions in the Inventory and Warehousing Cycle Process purchase orders Process purchase orders Receive raw materials Receive raw materials Store raw materials Store raw materials Process the materials

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Functions in the Inventory and Warehousing Cycle Perpetual inventory master file Perpetual inventory master file Store finished goods Store finished goods Ship finished goods Ship finished goods

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Learning Objective 2 Describe how e-commerce affects inventory management.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley How E-Commerce Affects Inventory Management The Internet enables clients to provide expanded descriptions of their inventory on a real-time basis. The use of the Internet and other e-commerce applications may lead to financial reporting risks if access to inventory databases and systems is not adequately controlled.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Learning Objective 3 Explain the five parts of the audit of the inventory and warehouse cycle.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Audit of Inventory Acquire and record raw materials, labor, and overhead. Internally transfer assets and costs. Part of auditCycle in which tested Acquisition and payment plus payroll and personnel Inventory and warehousing

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Audit of Inventory Ship goods and record revenue and costs. Physically observe inventory. Price and compile inventory. Cycle in which testedPart of audit Sales and collection Inventory and warehousing Inventory and warehousing

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Learning Objective 4 Design and perform audit tests of cost accounting.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Cost Accounting Controls 2. Controls over the related costs 1. Physical Controls Raw materialsWIPFinished goods

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Methodology for Designing Controls and Substantive Tests Understand internal control – cost accounting system. Assess planned control risk – cost accounting system. Evaluate cost-benefit of testing controls.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Methodology for Designing Controls and Substantive Tests Design tests of controls and substantive tests of transactions for the cost accounting system to meet transaction-related audit objectives. Audit procedures Sample size Items to select Timing

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Tests of Cost Accounting Physical Controls Documents and records for transferring inventory Perpetual inventory master files Unit cost records

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Learning Objective 5 Apply analytical procedures to the accounts in the inventory and warehousing cycle.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Analytical Procedures for Manufacturing Equipment Analytical ProcedurePossible Misstatement Compare gross marginOverstatement or percentage with that ofunderstatement of previous years.inventory and cost of goods sold Compare inventory turnoverObsolete inventory (cost of goods sold dividedOverstatement or by average inventory) withunderstatement of that of previous years.inventory

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Analytical Procedures for Manufacturing Equipment Analytical ProcedurePossible Misstatement Compare unit costs ofOverstatement or inventory with those ofunderstatement of previous years.unit costs Compare extendedMisstatements in inventory value with thatcompilation, unit of previous years.costs, or extensions

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Analytical Procedures for Manufacturing Equipment Analytical ProcedurePossible Misstatement Compare current yearMisstatement of unit manufacturing costs withcosts of inventory, those of previous yearsespecially direct (variable costs should belabor and adjusted for changes inmanufacturing volume).overhead

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Methodology for Designing Tests of Balances – Other Accounts Identify client business risks affecting the inventory and warehousing cycles. Set tolerable misstatement and assess inherent risk for the inventory and warehousing cycles. Assess control risk for several cycles.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Methodology for Designing Tests of Balances – Other Accounts Design and perform tests of controls and substantive tests of transactions for the several cycles. Design and perform analytical procedures for the inventory and warehousing cycle.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Methodology for Designing Tests of Balances – Other Accounts Design tests of details of inventory to satisfy balance-related audit objectives. Audit procedures Sample size Items to select Timing

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Learning Objective 6 Design and perform physical observation audit tests for inventory.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Controls Proper instructions for the physical count Supervision by responsible personnel Independent interval verification of the counts Independent reconciliations of the physical counts with perpetual inventory master files Adequate control over count sheets or tags

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Selection of items Sample size Timing Audit Decisions

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Physical Observation Tests The most important part of the observation of inventory is determining whether the physical count is being taken in accordance with the client’s instructions.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Balance-Related Objectives: Physical Inventory Observation Existence Completeness Accuracy Inventory as recorded on tags exist. Existing inventory is counted and tagged. Inventory is counted accurately.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Classification Cutoff Realizable Value Inventory is classified correctly on the tags. Transactions are recorded in the proper period. Obsolete and unusable inventory items are excluded or noted. Balance-Related Objectives: Physical Inventory Observation

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Balance-Related Objectives: Physical Inventory Observation Rights The client has rights to inventory recorded on tags Realizable Value Obsolete and unusable inventory items are excluded or noted.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Learning Objective 7 Design and perform audit tests of pricing and compilation for inventory.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Audit of Pricing and Compilation Inventory compilation tests Inventory price tests

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Valuation of inventory Pricing and compilation procedures Pricing and compilation controls Audit of Pricing and Compilation

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Balance-Related Objectives: Inventory Pricing and Compilation Detail tie-in Existence CompletenessAccuracy

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Balance-Related Objectives: Inventory Pricing and Compilation Classification Realizable value Rights Presentation and disclosure

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Valuation (Pricing) of Inventory Pricing Purchased Inventory Pricing Manufactured Inventory Cost or Market

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Learning Objective 8 Integrate the various parts of the audit of the inventory and warehousing cycle.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Interrelationship of Various Audit Tests Tests of acquisition and payment cycle Raw materials Acquisitions of raw materials Work in process Other manufacturing overhead

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Interrelationship of Various Audit Tests Tests of payroll and personnel cycle Work in process Direct labor Work in process Indirect labor

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Interrelationship of Various Audit Tests Inventory tests Raw materials Ending inventory Work in process Ending inventory Finished goods Ending inventory

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Interrelationship of Various Audit Tests Tests of sales and collection cycle Finished goods Cost of goods sold

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Integration of the Tests  Acquisition and Payment Cycle  Payroll and Personnel Cycle  Sales and Collection Cycle  Cost Accounting  Physical Inventory, Pricing, and Compilation

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley End of Chapter 20