1. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 1 Audit of the Inventory and Warehousing Cycle Chapter 20

2. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 2 Learning Objective 1 Describe the business functions and the related documents and records in the inventory and warehousing cycle.

3. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 3 Raw MaterialsWork in Process Manufacturing Overhead Flow of Inventory and Costs ActualApplied Manufacturing Direct Labor ActualApplied Beginning inventory Raw materials used Purchases Ending inventory

4. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 4 Work in ProcessFinished Goods Flow of Inventory and Costs Beginning inventory Ending inventory Cost of Goods Sold Cost of goods manufactured Beginning inventory Ending inventory Cost of goods sold

5. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 5 Functions in the Inventory and Warehousing Cycle Process purchase orders Process purchase orders Receive raw materials Receive raw materials Store raw materials Store raw materials Process the materials

6. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 6 Functions in the Inventory and Warehousing Cycle Perpetual inventory master file Perpetual inventory master file Store finished goods Store finished goods Ship finished goods Ship finished goods

7. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 7 Learning Objective 2 Describe how e-commerce affects inventory management.

8. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 8 How E-Commerce Affects Inventory Management The Internet enables clients to provide expanded descriptions of their inventory on a real-time basis. The use of the Internet and other e-commerce applications may lead to financial reporting risks if access to inventory databases and systems is not adequately controlled.

9. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 9 Learning Objective 3 Explain the five parts of the audit of the inventory and warehouse cycle.

10. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 10 Audit of Inventory Acquire and record raw materials, labor, and overhead. Internally transfer assets and costs. Part of auditCycle in which tested Acquisition and payment plus payroll and personnel Inventory and warehousing

11. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 11 Audit of Inventory Ship goods and record revenue and costs. Physically observe inventory. Price and compile inventory. Cycle in which testedPart of audit Sales and collection Inventory and warehousing Inventory and warehousing

12. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 12 Learning Objective 4 Design and perform audit tests of cost accounting.

13. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 13 Cost Accounting Controls 2. Controls over the related costs 1. Physical Controls Raw materialsWIPFinished goods

14. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 14 Methodology for Designing Controls and Substantive Tests Understand internal control – cost accounting system. Assess planned control risk – cost accounting system. Evaluate cost-benefit of testing controls.

15. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 15 Methodology for Designing Controls and Substantive Tests Design tests of controls and substantive tests of transactions for the cost accounting system to meet transaction-related audit objectives. Audit procedures Sample size Items to select Timing

16. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 16 Tests of Cost Accounting Physical Controls Documents and records for transferring inventory Perpetual inventory master files Unit cost records

17. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 17 Learning Objective 5 Apply analytical procedures to the accounts in the inventory and warehousing cycle.

18. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 18 Analytical Procedures for Manufacturing Equipment Analytical ProcedurePossible Misstatement Compare gross marginOverstatement or percentage with that ofunderstatement of previous years.inventory and cost of goods sold Compare inventory turnoverObsolete inventory (cost of goods sold dividedOverstatement or by average inventory) withunderstatement of that of previous years.inventory

19. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 19 Analytical Procedures for Manufacturing Equipment Analytical ProcedurePossible Misstatement Compare unit costs ofOverstatement or inventory with those ofunderstatement of previous years.unit costs Compare extendedMisstatements in inventory value with thatcompilation, unit of previous years.costs, or extensions

20. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 20 Analytical Procedures for Manufacturing Equipment Analytical ProcedurePossible Misstatement Compare current yearMisstatement of unit manufacturing costs withcosts of inventory, those of previous yearsespecially direct (variable costs should belabor and adjusted for changes inmanufacturing volume).overhead

21. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 21 Methodology for Designing Tests of Balances – Other Accounts Identify client business risks affecting the inventory and warehousing cycles. Set tolerable misstatement and assess inherent risk for the inventory and warehousing cycles. Assess control risk for several cycles.

22. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 22 Methodology for Designing Tests of Balances – Other Accounts Design and perform tests of controls and substantive tests of transactions for the several cycles. Design and perform analytical procedures for the inventory and warehousing cycle.

23. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 23 Methodology for Designing Tests of Balances – Other Accounts Design tests of details of inventory to satisfy balance-related audit objectives. Audit procedures Sample size Items to select Timing

24. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 24 Learning Objective 6 Design and perform physical observation audit tests for inventory.

25. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 25 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

26. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 26 Selection of items Sample size Timing Audit Decisions

27. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 27 Physical Observation Tests The most important part of the observation of inventory is determining whether the physical count is being taken in accordance with the client’s instructions.

28. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 28 Balance-Related Objectives: Physical Inventory Observation Existence Completeness Accuracy Inventory as recorded on tags exist. Existing inventory is counted and tagged. Inventory is counted accurately.

29. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 29 Classification Cutoff Realizable Value Inventory is classified correctly on the tags. Transactions are recorded in the proper period. Obsolete and unusable inventory items are excluded or noted. Balance-Related Objectives: Physical Inventory Observation

30. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 30 Balance-Related Objectives: Physical Inventory Observation Rights The client has rights to inventory recorded on tags Realizable Value Obsolete and unusable inventory items are excluded or noted.

31. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 31 Learning Objective 7 Design and perform audit tests of pricing and compilation for inventory.

32. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 32 Audit of Pricing and Compilation Inventory compilation tests Inventory price tests

33. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 33 Valuation of inventory Pricing and compilation procedures Pricing and compilation controls Audit of Pricing and Compilation

34. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 34 Balance-Related Objectives: Inventory Pricing and Compilation Detail tie-in Existence CompletenessAccuracy

35. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 35 Balance-Related Objectives: Inventory Pricing and Compilation Classification Realizable value Rights Presentation and disclosure

36. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 36 Valuation (Pricing) of Inventory Pricing Purchased Inventory Pricing Manufactured Inventory Cost or Market

37. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 37 Learning Objective 8 Integrate the various parts of the audit of the inventory and warehousing cycle.

38. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 38 Interrelationship of Various Audit Tests Tests of acquisition and payment cycle Raw materials Acquisitions of raw materials Work in process Other manufacturing overhead

39. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 39 Interrelationship of Various Audit Tests Tests of payroll and personnel cycle Work in process Direct labor Work in process Indirect labor

40. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 40 Interrelationship of Various Audit Tests Inventory tests Raw materials Ending inventory Work in process Ending inventory Finished goods Ending inventory

41. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 41 Interrelationship of Various Audit Tests Tests of sales and collection cycle Finished goods Cost of goods sold

42. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 42 Integration of the Tests  Acquisition and Payment Cycle  Payroll and Personnel Cycle  Sales and Collection Cycle  Cost Accounting  Physical Inventory, Pricing, and Compilation

43. ©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 20 - 43 End of Chapter 20