Audit of the Inventory and Warehousing Cycle Chapter 2D

OVERVIEW OF THE INVENTORY MANAGEMENT PROCESS Figure 13-1 shows how other processes interact with the inventory management process. Figure 13-2 presents a flowchart for a reasonably complex inventory management process.

DOCUMENTS AND RECORDS Production schedule. Receiving report. Material requisition. Inventory master file. Production data information. Cost accumulation and variance report. Inventory status report. Shipping order.

Flow of Inventory and Costs Raw Materials Work in Process Beginning inventory Raw materials used Purchases Ending inventory Manufacturing Direct Labor Manufacturing Overhead Actual Applied Actual Applied

Flow of Inventory and Costs Work in Process Finished Goods Beginning inventory Ending Beginning inventory Ending Cost of goods manufactured Cost of goods sold Cost of Goods Sold

Functions in the Inventory and Warehousing Cycle Process purchase orders Receive raw materials Store raw materials Process the materials

Functions in the Inventory and Warehousing Cycle Store finished goods Ship finished goods Perpetual inventory master file

Audit of Inventory Part of audit Cycle in which tested Acquire and record raw materials, labor, and overhead. Acquisition and payment plus payroll and personnel Internally transfer assets and costs. Inventory and warehousing

Audit of Inventory Part of audit Cycle in which tested Ship goods and record revenue and costs. Sales and collection Physically observe inventory. Inventory and warehousing Price and compile inventory. Inventory and warehousing

SEGREGATION OF DUTIES The inventory management function should be segregated from the cost accounting function. The inventory stores function should be segregated from the cost-accounting function. The cost-accounting function should be segregated from the general ledger function. The responsibility of supervising physical inventory taking should be separated from the inventory management and inventory stores functions.

INHERENT RISK ASSESSMENT Industry-related factors Competition Inventory valuation issues Rapid technology changes Engagement and Operating Characteristics Types of product Valuation can lead to disagreements with client Possible related-parties transactions

CONTROL RISK ASSESSMENT Understanding and documenting the inventory management process based on the planned level of control risk Planning and performing tests of controls on inventory transactions Assessing and documenting the control risk for the inventory management process

AUDITING INVENTORY Substantive tests of transactions Analytical procedures Tests of account balances

SUBSTANTIVE TESTS OF TRANSACTIONS Because the inventory management process interacts with the revenue, purchasing, and payroll processes, control procedures over the receipt of raw materials, shipment of goods, and assignment of labor costs are normally tested as part of those processes. If the auditor intends to obtain substantive evidence on the perpetual inventory records, the tests of receipt and shipment of goods can be extended by tracing the transactions into the perpetual inventory records.

ANALYTICAL PROCEDURES Compare raw material, finished goods, and total inventory turnover to previous years’ and industry averages. Compare days outstanding in inventory to previous years’ and industry averages. Compare gross profit percentage by product line with previous years and industry data. Compare actual cost of goods sold to budgeted amounts.

ANALYTICAL PROCEDURE (continued) Compare current year standard costs with prior years’ after considering current conditions. Compare actual manufacturing overhead costs with budgeted or standard manufacturing overhead costs.

Analytical Procedures for Manufacturing Equipment Analytical Procedure Possible Misstatement Compare unit costs of Overstatement or inventory with those of understatement of previous years. unit costs Compare extended Misstatements in inventory value with that compilation, unit of previous years. costs, or extensions

Analytical Procedures for Manufacturing Equipment Analytical Procedure Possible Misstatement Compare current year Misstatement of unit manufacturing costs with costs of inventory, those of previous years especially direct (variable costs should be labor and adjusted for changes in manufacturing volume). overhead

Cost Accounting Controls 1. Physical Controls over Raw materials WIP Finished goods 2. Controls over the related costs

Tests of Cost Accounting Physical Controls Documents and records for transferring inventory Perpetual inventory master files Unit cost records

OBSERVATION OF PHYSICAL INVENTORY The auditor's observation of inventory is a generally accepted auditing procedure. The observation of the physical inventory provides evidence primarily on the validity audit objective (also ownership and valuation).

OBSERVATION PROCEDURES Insure that no production is scheduled. Ensure that there is no movement of goods during the inventory count. Make sure that the client's count teams are following the inventory count instructions. Ensure that inventory tags are issued sequentially to individual departments. Perform test counts and record a sample of counts in the working papers.

OBSERVATION PROCEDURES (continued) Obtain tag control information for testing the client's inventory compilation. Obtain cutoff information. Observe the condition of the inventory for items that may be obsolete, slow moving, or in excess quantities. Inquiry about goods held on consignment for others or held on a "bill and hold" basis.

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

Audit of Pricing and Compilation Inventory price tests Inventory compilation tests

Audit of Pricing and Compilation controls Pricing and compilation procedures Valuation of inventory

Valuation (Pricing) of Inventory Pricing Purchased Inventory Pricing Manufactured Inventory Cost or Market

TESTS OF ACCOUNT BALANCES Table 13-8 summarizes the tests of the inventory account balance for each audit objective.

POSSIBLE CAUSES OF BOOK-TO-PHYSICAL DIFFERENCES Inventory cutoff errors. Unreported scrap or spoilage. Pilferage or theft.

SAMPLE DISCLOSURE ITEMS FOR INVENTORY AND RELATED ACCOUNTS Cost method (FIFO, LIFO, retail method). Components of inventory. Long-term purchase contracts. Consigned inventory. Purchases from related parties. LIFO liquidations. Pledged or assigned inventory. Disclosure of unusual losses from writedowns of inventory or losses on long-term purchase commitments. Warranty obligations.

Interrelationship of Various Audit Tests Tests of acquisition and payment cycle Raw materials Acquisitions of raw materials Work in process Other manufacturing overhead

Interrelationship of Various Audit Tests Tests of payroll and personnel cycle Work in process Direct labor Work in process Indirect labor

Interrelationship of Various Audit Tests Inventory tests Raw materials Ending inventory Work in process Ending inventory Finished goods Ending inventory

Interrelationship of Various Audit Tests Tests of sales and collection cycle Finished goods Cost of goods sold