1. Slide 12- 1 © The McGraw-Hill Companies, Inc., 2006 Inventories and Cost of Goods Sold

2. Slide 12- 2 © The McGraw-Hill Companies, Inc., 2006 Periodic vs Perpetual Inventory l Periodic Value only known by counting at periods end. Value of theft, shrinkage can only be estimated l Perpetual Continual book value known Count may not determine B.S. amount if books are not materially different. Cycle counts frequently used to test for accuracy during the period.

3. Slide 12- 3 © The McGraw-Hill Companies, Inc., 2006 The Special Audit Significance of Inventories l The valuation of goods on hand and in process often presents complex and difficult issues. l Determining the quantities of inventories may require specialized techniques. l Inventories often represent the largest current asset of a company. l Misstatements of inventories directly affect cost of goods sold and, therefore, net income. l Financial reporting fraud has often involved the fraudulent overstatement of inventories.

4. Slide 12- 4 © The McGraw-Hill Companies, Inc., 2006 Common Internal Controls Over the Conversion Cycle l Segregation of duties - purchases & inventory custody l Use of pre-numbered requisitions, purchase orders, and receiving reports l Procedures for authorizing purchase transactions and verifying them for payment l General ledger control A/C and reconciliation to production records l Cost accounting controls l Analysis of variances from standard costs l Use of perpetual records for inventories l Use of appropriate procedures for taking inventory l Appropriate physical security controls over inventories

5. Slide 12- 5 © The McGraw-Hill Companies, Inc., 2006 Most Likely Misstatements l Inaccurate recording of purchases l Theft of inventory l Duplicate payment for purchases l Fraudulent inflation of purchases cost l Misstatement of inventory unit costs l Misstatement of inventory quantities l Failure to accrue receipts of material (before vendor invoices arrive)

6. Slide 12- 6 © The McGraw-Hill Companies, Inc., 2006 Objectives for the Audit of Inventories and Cost of Goods Sold l Determine the Existence of inventories and occurrence of the elements of cost of goods sold. l Establish the Completeness of inventories l Establish that the client has Rights to the recorded inventories l Establish the clerical accuracy of records and supporting schedules l Determine that the Valuation of inventories and cost of goods sold is in accordance with GAAP & proper cutoff l Determine that the Presentation and disclosure of inventories and cost of goods sold are appropriate

7. Slide 12- 7 © The McGraw-Hill Companies, Inc., 2006 Substantive Tests for the Inventories and Cost of Goods Sold l Obtain listings of inventory and reconcile to ledgers

8. Slide 12- 8 © The McGraw-Hill Companies, Inc., 2006 Substantive Tests for the Inventories and Cost of Goods Sold l Obtain listings of inventory and reconcile to ledgers l Evaluate clients planning of physical count and plan auditors observation

9. Slide 12- 9 © The McGraw-Hill Companies, Inc., 2006 Planning a Physical Inventory Count & Observations Thereof Advising Client: l Selecting an appropriate date l Suspending production or controlling movement & cutoff l Segregating obsolete and defective goods l Adequate counting procedures, incl. recoding medium Auditor Observation Planning: l Locations to observe/staff requirements l Extent of test counts l How to confirm proper cutoff of sales and purchases l Arranging for the services of specialists l Not telling client where we will observe GOAL: An Accurate Count & Audit Evidence

10. Slide 12- 10 © The McGraw-Hill Companies, Inc., 2006 Substantive Tests for the Inventories and Cost of Goods Sold l Obtain listings of inventory and reconcile to ledgers l Evaluate clients planning of physical count and plan observation l Observe(not supervise) taking of physical count

11. Slide 12- 11 © The McGraw-Hill Companies, Inc., 2006 Observation Audit Procedures l Observe Practices Used l Control Tags/Count Sheets (Whatever Recording Medium Used) l Make Test Counts & Record in W/Ps l Take Note of: Damaged, dusty items End product in receiving area Items moving during count Last tag/count sheet used (copy electronic file?)

12. Slide 12- 12 © The McGraw-Hill Companies, Inc., 2006 Substantive Tests for the Inventories and Cost of Goods Sold l Obtain listings of inventory and reconcile to ledgers l Evaluate clients planning of physical count and plan observation l Observe the taking of physical count l Confirm inventories in public warehouses and on consignment

13. Slide 12- 13 © The McGraw-Hill Companies, Inc., 2006 Substantive Tests for the Inventories and Cost of Goods Sold l Obtain listings of inventory and reconcile to ledgers l Evaluate clients planning of physical count and plan observation l Observe the taking of physical inventory l Confirm inventories in public warehouses and on consignment l Review the year-end cutoff of purchases and sales transactions

14. Slide 12- 14 © The McGraw-Hill Companies, Inc., 2006 Substantive Tests for the Inventories and Cost of Goods Sold l Obtain listings of inventory and reconcile to ledgers l Evaluate clients planning of physical count and plan observation l Observe the taking of physical inventory l Confirm inventories in public warehouses and on consignment l Review the year-end cutoff of purchases and sales and transactions l Obtain a copy of completed physical inventory; test its accuracy l Test inventory pricing

15. Slide 12- 15 © The McGraw-Hill Companies, Inc., 2006 Auditing Completed Inventory Listing l Test math accuracy l Quantity: Compare to W/P recorded test counts Last tag/count sheet or copy of file l Unit cost: Method (LIFO,FIFO) OK per GAAP? Consistent with prior year? Computed accurately? Lower of cost or market? l Evaluate adjustments

16. Slide 12- 16 © The McGraw-Hill Companies, Inc., 2006 Substantive Tests for the Inventories and Cost of Goods Sold l Obtain listings of inventory and reconcile to ledgers l Evaluate clients planning of physical count and plan observation l Observe the taking of physical inventory l Confirm inventories in public warehouses and on consignment l Review the year-end cutoff of purchases and sales and transactions l Obtain a copy of completed physical inventory; test its accuracy l Test inventory pricing l Perform analytical procedures

17. Slide 12- 17 © The McGraw-Hill Companies, Inc., 2006 Substantive Tests for the Inventories and Cost of Goods Sold l Obtain listings of inventory and reconcile to ledgers l Evaluate clients planning of physical count and plan observation l Observe the taking of physical inventory l Confirm inventories in public warehouses and on consignment l Review the year-end cutoff of purchases and sales and transactions l Obtain a copy of completed physical inventory; test its accuracy l Test inventory pricing l Perform analytical procedures l Identify pledged inventories; Review commitments

18. Slide 12- 18 © The McGraw-Hill Companies, Inc., 2006 Substantive Tests for the Inventories and Cost of Goods Sold l Obtain listings of inventory and reconcile to ledgers l Evaluate clients planning of physical count and plan observation l Observe the taking of physical inventory l Confirm inventories in public warehouses and on consignment l Review the year-end cutoff of purchases and sales and transactions l Obtain a copy of completed physical inventory; test its accuracy l Test inventory pricing l Perform analytical procedures l Identify pledged inventories; Review commitments l Evaluate financial statement presentation and disclosure

19. Slide 12- 19 © The McGraw-Hill Companies, Inc., 2006 Recap-Inventory Observation Unless Inventory is Immaterial - We Must Observe a Physical Count. We Observe to Gain Evidence About the Count - We Do Not Supervise. Can We Observe Weeks/Months Before Or After B.S. Date? If so, What Must Exist? Good Perpetual Inventory Records Which We Must Test During the Intervening Period

20. Slide 12- 20 © The McGraw-Hill Companies, Inc., 2006 Recap-Inventory Observation (Cont) Can We Accept a Stat Sample or is Wall- to-Wall Necessary? If We Can Live with the Added DR in the Form of Sampling Risk. Can We Observe Periodic Cycle Counts Rather Than Count Near Yearend? If They Regularly Confirm Reliability of the Perpetual Inventory Records.

21. Slide 12- 21 © The McGraw-Hill Companies, Inc., 2006 Added Tests - First Year Clients l Assess if beg. balance is material to F.S. (income statement) l Verify beg. balance to prior client & CPA W/Ps and perform some tests. or l Review procedures, supporting data for physical count and completed inventory listing to assess potential reliability or l Use analytical procedures to assess reasonableness of beginning balance. l Qualify audit opinion, if necessary.