Copyright © 2007 Pearson Education Canada 1 Chapter 19: Audit of the Inventory and Warehousing Cycle

Copyright © 2007 Pearson Education Canada 19-2 Chapter 19 objectives  Identify the five different parts of the inventory and warehousing cycle that are audited  Describe the process used to audit the inventory and warehousing cycle  Discuss the role of specific tests in the audit of inventory  Describe how the relationship between the tests of different cycles affects the audit of inventory

Copyright © 2007 Pearson Education Canada 19-3 Auditing inventory can be complex  Reasons include: – It may be a major item on the balance sheet – Inventory items could be at different locations – Very diverse items are included (jewels, chemicals, electronic parts) – Valuation needs to consider obsolescence – One client may use several methods for valuing inventory

Copyright © 2007 Pearson Education Canada 19-4 Functions in the inventory and warehousing cycle  Process purchase orders  Receive new materials  Store materials  Process goods  Store finished goods  Ship finished goods

Copyright © 2007 Pearson Education Canada 19-5 Five parts of the audit of inventory, and the cycle in which tested

Copyright © 2007 Pearson Education Canada 19-6 Audit of cost accounting  Cost accounting systems vary more than the other transaction cycle areas due to the wide variety of types of inventory and the differences in level of sophistication required by management

Copyright © 2007 Pearson Education Canada 19-7 Cost accounting controls  These are controls that are related to the physical inventory and the compilation of the costs of that inventory from raw material requisition through to finished product  Broken into two categories: – Physical control over inventory movement – Controls over related costs

Copyright © 2007 Pearson Education Canada 19-8 Methodology for designing tests of controls for cost accounting

Copyright © 2007 Pearson Education Canada 19-9 Analytical procedures for the inventory and warehousing cycle Analytical procedurePossible misstatement Compare gross margin percentage with previous years Overstatement or understatement of inventory and cost of goods sold Compare inventory turnover with previous years Obsolete inventory Compare unit costs of inventory with previous years Over/understatement of inventory. Over/understatement of unit costs

Copyright © 2007 Pearson Education Canada Analytical procedures for the inventory and warehousing cycle (cont’d) Analytical procedurePossible misstatement Compare extended inventory value with previous years Misstatements in compilation, unit costs, or extensions that affect inventory and cost of goods sold. Compare current-year manufacturing costs with previous year Misstatement of unit costs of inventory, especially direct labour and manufacturing overhead.

Copyright © 2007 Pearson Education Canada Practice problem (p. 568)  Calculate ratios for analytical review of inventory  Assess the results

Copyright © 2007 Pearson Education Canada Methodology for designing tests of details of balances for inventory

Copyright © 2007 Pearson Education Canada Tests of details for physical inventory observation: existence  Select a random sample of tag numbers and identify the tag with that number attached to the actual inventory  If inventory is not tagged (e.g. scanned), may need to select a location number  Observe whether movement of inventory takes place during the count

Copyright © 2007 Pearson Education Canada Tests of details for physical inventory observation: completeness  Examine inventory to make sure it is tagged  If tags are not used, the auditor may need to examine exception reports identifying locations/items not counted  Enquire as to inventory in other locations

Copyright © 2007 Pearson Education Canada Tests of details for physical inventory observation: accuracy  Recount client’s counts to make sure the recorded counts are accurate on the tags (or as recorded in the computer system if recorded into hand-held computer devices)  Compare physical counts with perpetual inventory master file  Record client counts test-counted for subsequent testing

Copyright © 2007 Pearson Education Canada Tests of details for physical inventory observation: classification  Examine inventory descriptions on the tags (or in the handheld computers) and compare with the actual inventory counted  Evaluate whether the percent of completion recorded on the tags (or job cost records) for work in process is reasonable

Copyright © 2007 Pearson Education Canada Tests of details for physical inventory observation: cutoff  Record in the working papers for subsequent follow-up the last shipping document number used at year end  Make sure the inventory for that shipment was excluded from the physical count  Review shipping area for inventory set aside for shipment but not counted  Conduct similar tests for receiving process

Copyright © 2007 Pearson Education Canada Tests of details for physical inventory observation: valuation  Test for obsolete inventory by enquiry of factory employees and management  Be alert for items that are damaged, rust- or dust-covered, or located in inappropriate places

Copyright © 2007 Pearson Education Canada Tests of details for physical inventory observation: rights and obligations  Enquire as to consignment of customer inventory included on client’s premises  Be alert for inventory that is set aside or specially marked as indications of non- ownership

Copyright © 2007 Pearson Education Canada Practice problem (p. 568)  Examine the purpose of observing the physical inventory count  Discuss the extent of reliance on outside specialists during the audit of inventory

Copyright © 2007 Pearson Education Canada Tests of details for pricing and compilation: detail tie-in  Perform compilation tests  Extend the quantity times the price on selected items (or the entire inventory if using generalized audit software or other computer assisted audit software)  Foot (or test-foot) the inventory listings  Trace the totals to the general ledger

Copyright © 2007 Pearson Education Canada Tests of details for pricing and compilation: existence  Trace inventory listed in the schedule to inventory tags (or to computerized records of the count) and to the auditor’s records of test counts for existence and description

Copyright © 2007 Pearson Education Canada Tests of details for pricing and compilation: completeness  Account for unused tag numbers shown in the auditor’s working papers to make sure no tags have been added  Account for the tag numbers to make sure none have been deleted  Where hand-held computers have been used, reconcile hash totals or other control totals at the end of the count to final inventory count

Copyright © 2007 Pearson Education Canada Tests of details for pricing and compilation: accuracy  Trace inventory listed in the schedule to inventory tags (or computer files) and auditor’s recorded counts for quantity and description  Perform price tests of inventory

Copyright © 2007 Pearson Education Canada Tests of details for pricing and compilation: classification  Compare the classification into raw materials, work in process, and finished boods by comparing the descriptions on inventory tags and auditor’s recorded test counts with the inventory listing schedule

Copyright © 2007 Pearson Education Canada Tests of details for pricing and compilation: valuation  Perform test of lower of cost or market, selling price, and obsolescence

Copyright © 2007 Pearson Education Canada Tests of details for pricing and compilation: rights and obligations  Trace inventory tags identified as non-owned during the physical observation to the inventory listing schedule to make sure these have not been included  Review contracts with suppliers and customers and enquire of management for the possibility of the inclusion of consigned or other non-owned inventory, or the exclusion of owned inventory

Copyright © 2007 Pearson Education Canada Tests of details for pricing and compilation: presentation and disclosure  Examine financial statements for proper presentation and disclosure, including: – Separate disclosure of raw materials, work in process, and finished goods – Proper description of the inventory costing method – Description of pledged inventory – Inclusion of significant sales and purchase commitments

Copyright © 2007 Pearson Education Canada Practice problem (p. 568)  Application of monetary unit sampling (MUS) to the audit of inventory  Assess the results of the tests to determine whether the book value is misstated

Copyright © 2007 Pearson Education Canada Interrelationship of various audit tests

Copyright © 2007 Pearson Education Canada Practice problem (p. 569)  Audit of an automated inventory system  Which controls can be relied upon?  How would you test the controls?