2The Special Significance of Audit of Inventories The valuation of goods on hand and in process often presents complex and difficult issuesDetermining the quantities of inventories may require specialized techniquesInventories often represent the largest current asset of a companyMisstatements of inventories directly affect cost of goods sold and, therefore, net incomeManagement fraud has often involved the fraudulent overstatement of inventories42
3Source of Inventories Includes Goods on hand ready for sale Goods in the process of productionGoods to be consumed directly or indirectly in production such as raw materials, purchased parts and supplies
4Objectives1. Use the understanding of the client and its environment to consider inherent risks, including fraud risks, related to inventories and cost of goods sold. 2. Obtain an understanding of internal control over inventories and cost of goods sold. 3. Assess the risks of material misstatement and design tests of controls and substantive procedures that: a. Substantiate the existence of inventories and the occurrence of transactions affecting cost of goods sold. b. Establish the completeness of recorded inventories. c. Verify the cutoff of transactions affecting cost of goods sold. d. Determine that the client has rights to the recorded inventories. e. Establish the proper valuation of inventories and the accuracy of transactions affecting cost of goods sold. f. Determine that the presentation and disclosure of information about inventories and cost of goods sold are appropriate, including disclosure of the classification of inventories, accounting methods used, and inventories pledged as collateral for debt.
5McKesson & Robbins Fraud Case Significant impact on responsibility of auditors with respect to validity of inventoriesCase: 1939 – the audited financial statements contained $19 million of fictitious assets including $10 million of nonexistent inventoriesAuditors followed customary auditing practice which limited audit work on inventories to examining records onlyStatements on Auditing Procedures 1 and 2 – first formal auditing standards issued by AICPA affirmed the importance of auditors’ observation of physical inventories although other auditing procedures could be substituted
6Inventory Methods Periodic inventory system Determine inventory quantities solely by an annual physical countPerpetual inventory recordsInventory updated constantlyStrong internal control over inventoriesMay use test counts throughout the year
7Internal Control (1 of 3) Control environment Commitment to competence and human resource policies and practicesAppropriately qualified and trained personnel assigned to inventoryIntegrity and ethical valuesCompany purchasing agents do not accept “kickbacks”Organizational structure and assignment of authority and responsibilityPurchasing, receiving and production understand roles
8Internal Control (2 of 3) Risk assessment; risks related to Availability of a supply of goods, services, and skilled laborStability of prices and labor ratesGeneration of sufficient cash flow to pay for purchasesChanges in technology that affect manufacturing processesObsolescence of inventory
9Internal Control (3 of 3) Monitoring Observations by production supervisors of performance of various activities and functionsQuality and performance reviewsFormal program to consider improvements in purchasing and production noted by internal auditors
10Functions related to inventories PurchasingReceivingStoringIssuingProcessingShipping
11Purchasing Function Internal control Segregation of purchasing, receiving and recordingCyclePurchase requisition form completed by departmentPurchasing prepares purchase orderMay obtain bids but need approvalItem description and quantityCopy forwarded to accountingCopy forwarded to receiving should not include quantity
12Receiving and Storing Receiving Determines quantity of goods received Detects damaged or defective merchandisePrepares receiving reportPrompt transmittal of goods received to stores departmentStoringCounts, inspects and receives goodsNotifies accounting of receiptPhysically secures inventory
13Issuing and Production Stores department issues goods to requesting departmentPrenumbered requisitionProductionControlled with master production scheduleProduction ordersMaterials requisitions and move ticketsJob time tickets
14ShippingShipment upon authorized sales order approved by credit departmentGenerates a prenumbered shipping documentOne copy in shippingOne copy to billingThird copy used as packing slipFor goods shipped common carrier – fourth copy services as bill of lading
15Cost Accounting Accounts for usage of raw materials Determines content and value of goods in progressCompute finished inventory
16Other functions Perpetual inventory system IT systems Provide information essential to purchasing, sales and production-planning policiesAllows companies to control high costs of holding excessive inventoryIT systemsEasier to control inventoriesEDI to coordinate production and purchasing
17Controls Over the Conversion Cycle Segregation of duties over purchases and custody of inventoryUse of pre-numbered requisitions, purchase orders, and receiving reportsProcedures for authorizing purchase transactions and verifying them for paymentGeneral ledger control of inventories and reconciliation to production recordsCost accounting controlsAnalysis of variances from standard costsUse of perpetual records for inventoriesUse of appropriate procedures for taking inventoryAppropriate physical controls over inventories13
19Audit Steps (1 of 3)A. Use the understanding of the client and its environment to consider inherent risks, including fraud risks, related to inventories and cost of goods sold. B. Obtain an understanding of internal control over inventories and cost of goods sold. C. Assess the risks of material misstatement and design further audit procedures. D. Perform further audit procedures—tests of controls. 1. Examples of tests of controls: a. Examine significant aspects of a sample of purchase transactions. b. Perform tests of the cost accounting system. 2. If necessary, revise the risks of material misstatement based on the results of tests of controls.
20Audit Steps (2 of 3)E. Perform further audit procedures—substantive procedures for inventories and cost of goods sold.1. Obtain listings of inventory and reconcile to ledgers.2. Evaluate the client’s planning of physical inventory.3. Observe the taking of physical inventory and make test counts.4. Review the year-end cutoff of purchases and sales transactions.
21Audit Steps (3 of 3) E. Perform further audit procedures 5. Obtain a copy of the completed physical inventory, test its clerical accuracy, and trace test counts.6. Evaluate the bases and methods of inventory pricing.7. Test the pricing of inventories.8. Perform analytical procedures.9. Determine whether any inventories have been pledged and review purchase and sales commitments.10. Evaluate financial statement presentation of inventories and cost of goods sold, including the adequacy of disclosure.
22Figure 12.1 Objectives of Major Substantive Procedures for Inventories and Cost of Goods Sold 56
23Risks of Material Misstatements 1. Inventories constitute a large asset and very susceptible to major errors and fraud. 2. The accounting profession allows numerous alternative methods for valuation of inventories, and different methods may be used for various classes of inventories. 3. The determination of inventory value directly affects the cost of goods sold and has a major impact on net income for the year. 4. The determination of inventory quality, condition, and value is inherently a more complex and difficult task than is the case with most other elements of financial position.
26Considerations in Planning a Physical Inventory Selecting of the appropriate dateSuspending productionSegregating obsolete and defective goodsEstablishing control over the counting processAchieving proper cutoff of sales and purchasesArranging for the services of specialists67
27Documentation of Physical Inventory Plan should be documented and communicated in form of written instructions to personnel taking physical inventoryLetter from client reviewed by auditorsAuditors consider nature and materiality of inventoriesDate is typically at or near balance sheet date unless internal control is effective
28Inventory Observation Client counts and supervises inventoryAuditors observeDetermine all items includedEmployees comply with instructionsBe alert for inclusion of obsolete or damaged merchandiseRecord numbers of final receiving and shipping documents issued before inventory takingMake test countsTag control
29When the Auditors are Engaged after Year-End Inventory verification when auditor unable to observe taking of inventory at close of year.May conclude that sufficient appropriate evidence cannot be obtained to express an opinionOr could obtain satisfaction with alternative auditing proceduresExistence of strong internal controlPerpetual inventory recordsDocumentation of well-planned and executed physical inventoryMaking of test counts
30Proper cut-off of inventory Examine on a test basis the purchase invoices and receiving reports for several days before and after the inventory date.Determine that liability has been recorded for all goods in inventoryMake sure shipments and purchases recorded in proper period
31Inventory Pricing Emphasize: What method of pricing does the client use?Is the method of pricing the same as that used in prior years?Has the method selected by the client been applied consistently and accurately in practice?Test the pricing of inventories
33Presentation and Disclosure Disclosure of inventory pricing methods or methods in useOther important disclosures:Changes in methodsClassifications of inventoryDetails of pledged inventoryDeduction of valuation allowance for inventory lossesExistence and terms of inventory purchase commitments.
34Problems with First Year Clients Procedures to obtain evidence that beginning inventory is fairly statedReview predecessor’s working papersDiscuss with person who supervised physical inventory at beginningStudy written instructions in planningTrace numerous items from inventory tags to final summary sheetsTest perpetual inventory records for previous yearTest overall reasonableness of beginning inventory