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Audit of the Inventory

and Warehousing Cycle


Chapter 2D

2D - 1

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.

2D - 2

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.

2D - 3

Flow of Inventory and Costs


Raw Materials
Beginning Raw
inventory materials
Purchases used
Ending
inventory
Manufacturing
Direct Labor
Actual Applied

Work in Process

Manufacturing
Overhead
Actual Applied
2D - 4

Flow of Inventory and Costs


Work in Process
Beginning
inventory Cost of goods
manufactured
Ending
inventory

Finished Goods
Beginning
inventory Cost of
goods sold
Ending
inventory
Cost of Goods Sold

2D - 5

Functions in the Inventory and


Warehousing Cycle
Process
Process
purchase
purchase
orders
orders

Receive
Receive raw
raw
materials
materials

Store
Store
raw
raw
materials
materials

Process
Process the
the materials
materials
2D - 6

Functions in the Inventory and


Warehousing Cycle

Store
Store
finished
finished
goods
goods

Ship
Ship
finished
finished
goods
goods

Perpetual
Perpetual inventory
inventory
master
master file
file
2D - 7

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
2D - 8

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
2D - 9

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.

2D - 10

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

2D - 11

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

2D - 12

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

2D - 13

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.

2D - 14

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.

2D - 15

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.

2D - 16

Analytical Procedures for


Manufacturing Equipment
Analytical Procedure

Possible Misstatement

Compare unit costs of


inventory with those of
previous years.
Compare extended
inventory value with that
of previous years.

Overstatement or
understatement of
unit costs
Misstatements in
compilation, unit
costs, or extensions
2D - 17

Analytical Procedures for


Manufacturing Equipment
Analytical Procedure

Possible Misstatement

Compare current year


manufacturing costs with
those of previous years
(variable costs should be
adjusted for changes in
volume).

Misstatement of unit
costs of inventory,
especially direct
labor and
manufacturing
overhead
2D - 18

Cost Accounting Controls


1. Physical Controls

Raw materials

WIP

Finished goods

2. Controls over the related costs


2D - 19

Tests of Cost Accounting


Physical Controls
Documents and records for
transferring inventory
Perpetual inventory master files
Unit cost records

2D - 20

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).

2D - 21

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.

2D - 22

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.

2D - 23

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
2D - 24

Audit of Pricing and


Compilation
Inventory price tests

Inventory compilation tests

2D - 25

Audit of Pricing and


Compilation
Pricing and
compilation
controls

Pricing and
compilation
procedures

Valuation
of inventory
2D - 26

Valuation (Pricing)
of Inventory
Pricing Purchased Inventory
Pricing Manufactured Inventory
Cost or Market
2D - 27

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

2D - 28

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

2D - 29

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.
2D - 30

Interrelationship of
Various Audit Tests
Tests of acquisition
and payment cycle

Raw materials
Acquisitions of
raw materials

Work in process
Other manufacturing
overhead
2D - 31

Interrelationship of
Various Audit Tests
Tests of payroll
and personnel cycle

Work in process
Direct labor

Work in process
Indirect labor
2D - 32

Interrelationship of
Various Audit Tests
Inventory tests

Raw materials
Ending inventory

Work in process
Ending inventory

Finished goods
Ending inventory
2D - 33

Interrelationship of
Various Audit Tests
Tests of sales and
collection cycle

Finished goods
Cost of goods sold
2D - 34

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