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 Work in Process

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

2D - 4
 Flow of Inventory and Costs

Work in Process Finished Goods

Beginning Beginning
inventory inventory Cost of
Cost of goods
Ending manufactured Ending goods sold
inventory inventory

Cost of Goods Sold

2D - 5
Functions in the Inventory and
Warehousing Cycle
Process
purchase Receive raw
orders materials

Store
raw Process the materials
materials

2D - 6
Functions in the Inventory and
Warehousing Cycle

Ship
Store
finished finished
goods goods

Perpetual inventory
master file
2D - 7
 Audit of Inventory
Part of audit Cycle in which tested
Acquire and record Acquisition and
raw materials, labor, payment plus
and overhead. payroll and personnel

Internally transfer Inventory and

assets and costs. warehousing

2D - 8
 Audit of Inventory
Part of audit Cycle in which tested
Ship goods and record Sales and
revenue and costs. collection
Physically observe Inventory and
inventory. warehousing
Price and compile Inventory and
inventory. 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 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 Overstatement or
inventory with those of understatement of
previous years. unit costs
Compare extended Misstatements in
inventory value with that compilation, unit
of previous years. costs, or extensions

2D - 17
 Analytical Procedures for
Manufacturing Equipment

Analytical Procedure Possible Misstatement

Compare current year Misstatement of unit
manufacturing costs with costs of inventory,
those of previous years especially direct
(variable costs should be labor and
adjusted for changes in manufacturing
volume). 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 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 Work in process

Acquisitions of Other manufacturing
raw materials overhead
2D - 31
 Interrelationship of
Various Audit Tests

Tests of payroll
and personnel cycle

Work in process Work in process

Direct labor Indirect labor

2D - 32
 Interrelationship of
Various Audit Tests

Inventory tests

Raw materials Work in process

Ending inventory 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