1. Questions
14-5
14-7
14-8
14-9
14-22
LO 3: Explain the role of three types of tests in the audit of inventory.
Discussion problems: questions or 17-17
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2. Chapter 14-5 Page 480
In obtaining an understanding of inventory procedures for a small manufacturing company, the auditor obtains a copy of the client’s inventory instructions and reviews them with the controller before the inventory examination. Two deficiencies are identified: (1) shipping operations will not be completely halted during the physical examination, and (2) there will be no independent verification of the original count by a second counting team. Evaluate the importance of each of these deficiencies, and state its effect on the auditor’s observation of inventory.

3. 14-5 The continuation of shipping operations during the physical inventory will require the auditor to perform additional procedures to insure that a proper cutoff is achieved. The auditor must conclude that merchandise shipped is either included in the physical count or recorded as a sale, but not both.
Since no second count is taken, the auditor must increase the number of his or her test counts to determine that the counts recorded are accurate.
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4. Chapter 14-7 Page 480
What major audit procedures are involved in testing for the ownership of inventory during the observation of the physical counts and as part of substantive valuation tests?

5. discussions with the client.
14-7 The most important audit procedures employed in testing for the ownership of inventory during the observation of the physical counts and as a part of subsequent valuation tests are:
discussions with the client.
an understanding of the client’s operations.
an alertness for inventory set aside or specially marked.
review of contracts with suppliers and customers to test for the possibility of consigned inventory or inventory owned by others that is in the client’s shop for repair or some other purpose.
examination of vendor invoices indicating that merchandise on hand was sold to the company.
testing of sales recorded just before and just after the physical inventory to determine that the items were or were not on hand at the physical inventory date and that a proper cutoff was achieved.
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6. Chapter 14-8 Page 480
In the verification of the amount of inventory, the auditor should identify slow-moving and obsolete items. List the auditing procedures that could be employed to determine whether slow-moving or obsolete items have been included in inventory.

7. Review the perpetual records for slow-moving items.
14-8 Auditing procedures to determine whether slow-moving or obsolete items have been included in inventory are:
Review the perpetual records for slow-moving items.
Discuss the quality of the inventory with management.
Ask questions of production personnel during physical inventory observation about the extent of the use or non-use of inventory items.
Make observations during the physical inventory of rust, damaged inventory, inventory in unusual locations, and unusual amounts of dust on the inventory.
Be aware of inventory that is tagged obsolete, spoiled, or damaged, or is set aside because it is obsolete or damaged.
Examine obsolescence reports, scrap sales, and other records in subsequent periods that may indicate the existence of inventory that should have been excluded from physical inventory or included at a reduced cost.
Calculate inventory turnover ratios, by type of inventory if possible, and compare them to previous years or industry standards.
Have a sufficient understanding of the client’s business to aid in recognizing inventory that is no longer useful in the client’s business. (This item is not an audit procedure, but is important as a part of performing the procedures.)
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8. Chapter 14-9 Page 480
During the taking of physical inventory, the controller intentionally withheld several inventory tags from the employees responsible for the inventory count. After the auditor left the client’s premises at the completion of the inventory observation, the controller recorded nonexistent inventory on the tags and thereby significantly overstated earnings. How could the auditor have uncovered the misstatement, assuming there are no perpetual records?

9. 14-9 The auditor could have uncovered the misstatement if there were adequate controls over the use of inventory tags. More specifically, the auditor should have assured him/herself that the client had accounted for all used and unused tag numbers by examining all tags him/herself, if necessary. In addition, the auditor should have selected certain tags (especially larger items) and had the client show him where the goods were stored. The tag numbers used and unused should have been recorded in the auditor’s working papers for subsequent follow-up. As part of his/her substantive procedures, the auditor could have performed analytical tests on the inventory and cost of sales. A comparison of ratios such as gross margin percentage and inventory turnover could have indicated that a problem was present.
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10. Chapter Page 482
Items 1 through 8 are selected questions typically found in questionnaires used by auditors to obtain an understanding of internal controls in the inventory and distribution cycle. In using the questionnaire for a particular client, a “yes” response to a question indicates a possible internal control, whereas a “no” indicates a potential weakness.
Does the receiving department prepare prenumbered receiving reports and account for the numbers periodically for all inventory received, showing the description and quantity of materials?
Is all inventory stored under the control of a custodian in areas where access is limited?
Are all shipments to customers authorized by prenumbered shipping documents?
Is a detailed perpetual inventory master file maintained for raw materials inventory?
Are physical inventory counts made by someone other than the storekeepers and those responsible for maintaining the perpetual inventory master file?
Are standard cost records used for raw materials, direct labour, and manufacturing overhead?
Is there a stated policy with specific criteria for writing off obsolete or slow-moving goods?
Is the clerical accuracy of the final inventory compilation checked by a person independent of those responsible for preparing it?
REQUIRED:
For each of the preceding questions, state the purpose of the internal control.
For each internal control, list a test of controls to test its effectiveness.
For each of the preceding questions, identify the nature of the potential misstatement(s) if the control is not in effect.
For each of the potential misstatements in part (c), list a substantive audit procedure to determine whether a material misstatement exists.

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a. Purpose of Internal Control
b. Test of Control to Test Effectiveness
c. Potential Financial Misstatement
d. Substantive Audit Procedure
1. To ensure inventory is recorded when received and that payments made are for goods received, and quantities and descriptions are accurate. (Completeness, accuracy, and occurrence)
Verify numerical sequence of receiving reports and observe matching invoices received from vendors.
Understatement of inventory or payment for goods received.
Trace quantity and description on vendor’s invoice to receiving report.
2. To minimize theft or unrecorded disbursement of inventory. (Occurrence)
Discussion with client and observation.
Overstatement of inventory.
Compare physical count to perpetual records.
3. To ensure inventory shipments are recorded as sales. (completeness)
Verify numerical sequence of shipping orders.
Understatement of sales. Overstatement of inventory.
Trace quantity and description on bills of lading to attached shipping orders.
4. For accuracy and current record of inventory. (Accuracy)
Examine receiving and requisition documents, and observe maintenance of perpetual records.
Misstatement of inventory.
Compare physical count to perpetual inventory record.
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12. 5. To ensure physical inventory counts are accurate
5. To ensure physical inventory counts are accurate. (Accuracy, existence, and completeness)
Observation and discussion with client.
Misstatement of inventory.
Compare physical count to perpetual inventory record.
6. To assure reasonable costs are used for inventory and cost of goods sold. (Accuracy)
Review procedures for determining standard costs.
Misstatement of income and/or inventory.
Trace costs from supporting documents to development of standards.
7. To ensure obsolete goods are classified as such. (Accuracy, valuation)
Discussion with client.
Overstatement of inventory.
Analytical tests of inventory.
8. To make sure inventory compilation is accurate. (Accuracy)
Reperform clerical tests of inventory compilation.
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