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 Work in Process Raw Materials Beginning inventory Purchases Raw materials used Ending inventory Manufacturing Direct Labor Actual Applied Manufacturing Overhead Actual Applied 2D - 4

Flow of Inventory and Costs Work in Process Beginning inventory Ending inventory Cost of goods manufactured Finished Goods Beginning inventory Ending inventory Cost of goods sold Cost of Goods Sold 2D - 5

Functions in the Inventory and Warehousing Cycle Process purchase orders Receive raw materials Store raw materials Process the materials 2D - 6

Functions in the Inventory and Warehousing Cycle Store finished goods Ship finished goods Perpetual inventory master file 2D - 7

Audit of Inventory

Part of audit

Acquire and record raw materials, labor, and overhead.

Internally transfer assets and costs.

Cycle in which tested

Acquisition and payment plus payroll and personnel Inventory and warehousing 2D - 8

Audit of Inventory

Part of audit

Ship goods and record revenue and costs.

Physically observe inventory.

Price and compile inventory.

Cycle in which tested

Sales and collection Inventory and warehousing 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 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 Compare unit costs of inventory with those of previous years.

Compare extended inventory value with that of previous years.

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

Analytical Procedures for Manufacturing Equipment Analytical Procedure Compare current year manufacturing costs with those of previous years (variable costs should be adjusted for changes in volume).

Possible Misstatement 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