Audit of the Inventory and Warehousing Cycle

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Audit of the Inventoryand Warehousing Cycle

• Chapter 2D

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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.

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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.

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Flow of Inventory and Costs
Raw Materials
Work in Process
Beginning inventory
Raw materials used
Purchases
Ending inventory
Manufacturing Overhead
Manufacturing Direct Labor
Actual Applied
Actual Applied
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Flow of Inventory and Costs
Work in Process
Finished Goods
Beginning inventory Ending inventory
Beginning inventory Ending inventory
Cost of goods manufactured
Cost of goods sold
Cost of Goods Sold
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Functions in the Inventory and Warehousing Cycle
Process purchase orders
Receive raw materials
Store raw materials
Process the materials
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Functions in the Inventory and Warehousing Cycle
Store finished goods
Ship finished goods
Perpetual inventory master file
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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
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Audit of Inventory
Cycle in which tested
Part of audit
Ship goods and record revenue and costs.
Sales and collection
Physically observe inventory.
Inventory and warehousing
Price and compile inventory.
Inventory and warehousing
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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.

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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

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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
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AUDITING INVENTORY

• Substantive tests of transactions
• Analytical procedures
• Tests of account balances

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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.

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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.

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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.

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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
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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
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Cost Accounting Controls
1. Physical Controls
over
Raw materials
WIP
Finished goods
2. Controls over the related costs
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Tests of Cost Accounting
Physical Controls
Documents and records for transferring inventory
Perpetual inventory master files
Unit cost records
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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).

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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.

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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.

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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
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Audit of Pricing and Compilation
Inventory price tests
Inventory compilation tests
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Audit of Pricing and Compilation
Pricing and compilation controls
Pricing and compilation procedures
Valuation of inventory
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Valuation (Pricing)of Inventory
Pricing Purchased Inventory
Pricing Manufactured Inventory
Cost or Market
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TESTS OF ACCOUNT BALANCES
Table 13-8 summarizes the tests of the inventory
account balance for each audit objective.
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POSSIBLE CAUSES OF BOOK-TO-PHYSICAL DIFFERENCES

• Inventory cutoff errors.
• Unreported scrap or spoilage.
• Pilferage or theft.

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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.

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Interrelationship ofVarious Audit Tests
Tests of acquisition and payment cycle
Raw materials Acquisitions of raw materials
Work in process Other manufacturing overhead
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Interrelationship ofVarious Audit Tests
Tests of payroll and personnel cycle
Work in process Direct labor
Work in process Indirect labor
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Interrelationship ofVarious Audit Tests
Inventory tests
Raw materials Ending inventory
Work in process Ending inventory
Finished goods Ending inventory
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Interrelationship ofVarious Audit Tests
Tests of sales and collection cycle
Finished goods Cost of goods sold