Chapter 14 Prepared by Richard J. Campbell Copyright 2011, Wiley and Sons Auditing Inventory Processes: Tracking and Costing Products in the Land Development and Home Building Industry

Learning Objectives 1. Be familiar with inventory activities in the land development and home building industry, including important accounting standards. 2. Understand the activities, transactions, risks, ICFR, and documents related to inventory. 3. Understand the management assertions, purposes of specific controls, controls, and tests of controls for inventory. 4. Understand the purposes and execution of substantive audit procedures for inventory including dual purpose tests, substantive analytical procedures, and tests of details of balances, such as inventory counts and inventory observation. 5. Know processes and procedures performed by management and the auditor for estimates, and specifically for estimates related to inventory. Chapter 14-1

LAND DEVELOPMENT AND HOME BUILDING INDUSTRY Learning Objective #1Chapter  The largest companies in this industry are associated with the process of turning large parcels of raw land into completed residential communities.  The land development and home building industry tracks and allocates costs to individual residential units. In typical manufacturing terms this is called job order costing.  FASB ASC , Real Estate, defines the proper accounting for inventory in the home building industry.  Just as with all other companies, the possibility of a decrease in the value of inventory below its cost must be addressed by land development and home building companies.

LAND DEVELOPMENT AND HOME BUILDING INDUSTRY Learning Objective #1Chapter  A complex accounting pronouncement, FASB ASC , Variable Interest Entities (VIE), can also impact the financial statements of a land development and home building company  In the land development and home building industry, the relationship between inventory and revenue recognition is direct, as a result of the use of the percentage-of- completion method.  Revenue for single-family homes is recognized when the sale closes and the title transfers to the purchaser.  Inventory is a major focus of accounting and auditing effort.

INVENTORY IN THE MANUFACTURING ENVIRONMENT Learning Objective #2Chapter  The unique aspect of the manufacturing industry is the process of producing finished goods from raw materials.  The first step in the manufacturing process is to remove purchased raw materials from stores.  Direct costs are traced and added to work-in-process in the cost accounting records.  Overhead costs are usually posted to work-in-process when the manufacturing activities are completed.  When the manufacturing process is complete, the finished goods are moved from the production location to finished goods storage, or shipping.

ACCOUNTING FOR INVENTORY Chapter 14 -5Learning Objective #2  Businesses use cost accounting systems that fall somewhere along the continuum of job costing (or job order costing) to process costing.  When inventory is accounted for using a perpetual inventory system, increases and reductions to the units and dollar amounts in the inventory accounts can be posted when the transaction occurs.  Under a periodic inventory system, dollar amounts of inventory increases are captured through a purchases account.  Regardless of the method and process of accounting for inventory, the amount initially recorded in the inventory accounts is based on cost.

Inventory Records Chapter 14 -6Learning Objective #2

Flow of Inventory through Production Chapter 14 -7Learning Objective #2 EXHIBIT 14-1

Activities and Related Documents Chapter 14 -8Learning Objective #2 EXHIBIT 14-2

Tests of Controls Learning Objective #3Chapter 14-9  Walkthroughs are one way for the auditor to understand the client’s information system for inventory transactions and conclude on design effectiveness.  Control concerns for inventory are:  Inventory is physically safeguarded through all stages of movement and the production process.  Proper records are kept to support the units and costs of total inventory shown in the financial statements as well as to track and allocate costs to the proper jobs and batches.  Inventory records are adjusted to reflect the inventory that has been verified through a physical count.  Any decrement in inventory value is properly reflected in the amounts.

Examples of Tests of Controls for Inventory Learning Objective #3Chapter EXHIBIT 14-3

Examples of Tests of Controls for Inventory Learning Objective #3Chapter EXHIBIT 14-3

Examples of Tests of Controls for Inventory Learning Objective #3Chapter EXHIBIT 14-3

Examples of Tests of Controls for Inventory Learning Objective #3Chapter EXHIBIT 14-3

Examples of Tests of Controls for Inventory Learning Objective #3Chapter EXHIBIT 14-3

Examples of Tests of Controls for Inventory Learning Objective #3Chapter EXHIBIT 14-3

Examples of Tests of Controls for Inventory Learning Objective #3Chapter EXHIBIT 14-3

Dual Purpose Tests Learning Objective #4Chapter  To obtain audit evidence about account balances for the financial statement audit, the steps presented in Exhibit are modified with the following added activity:  Trace the amount(s) tested [in the sample] to the final compilation of inventory and agree the total of the inventory compilation to the amount(s) shown in the general ledger

Substantive Analytical Procedures Learning Objective #4Chapter EXHIBIT 14-4

Audit Steps for Observing the Client’s Inventory Count Chapter Learning Objective #4 EXHIBIT 14-5

Audit Steps for Observing the Client’s Inventory Count Chapter Learning Objective #4 EXHIBIT 14-5

Auditing Estimates Chapter Learning Objective #5 EXHIBIT 14-6

Common Audit Steps for Accounting Estimates Chapter Learning Objective #5 EXHIBIT 14-7

Examples of Tests of Details of Balances Chapter Learning Objective #5 EXHIBIT 14-8

Examples of Tests of Details of Balances Chapter Learning Objective #5 EXHIBIT 14-8

Examples of Tests of Details of Balances Chapter Learning Objective #5 EXHIBIT 14-8

Examples of Tests of Details of Balances Chapter Learning Objective #5 EXHIBIT 14-8

AUDITING INVENTORY IN THE LAND DEVELOPMENT AND HOME BUILDING INDUSTRY Learning Objective #3Chapter  A striking characteristic of the inventory in the land development and home building industry with which auditors must deal is the uncertainty of many amounts that are included in both total costs and costs of individual units.  Following is a summary of the items likely to be included in the estimating and allocating processes:

Review Question Chapter Which of the following is not an important control of the inventory cycle? (a) Proper documentary support for cash disbursements (b) Physical security (c) Authorization for movement (d) Appropriate cost accounting records

Review Question Chapter When auditing overhead for inventory in a manufacturing environment, the auditor’s primary concern is: (a) All appropriate costs are included in overhead. (b) Period expenses are not included in overhead. (c) Overhead is captured and calculated properly according to GAAP, is consistent with prior years, and is reasonable. (d) All of the above

Review Question Chapter Cost accounting records can keep track of: (a) only unit counts of inventory. (b) only dollar amounts of inventory. (c) units and/or dollars of inventory. (d) none of the above.

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