1. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-1 Chapter Thirteen Auditing the Inventory Management Process Chapter Thirteen Auditing the Inventory Management Process

2. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-2 Overview of the Inventory Management Process Purchasing process Inventory management process Revenue process Purchase of raw materials Payment of manufacturing overhead Human resource management process Assignment of direct and indirect labour costs Sale of goods

3. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-3 Type of Documents and Records 1.Production Schedule – Based on the expected demand for the entity’s products. 2.Receiving Report – Records the receipt of goods from vendors. 3.Materials Requisition – Used to track materials during the production process. 4.Inventory Master File – Contains all the important information related to the entity’s inventory, including the perpetual inventory records. Production Schedule

4. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-4 5.Production Data Information – Contains information about the transfer of goods and related cost accumulation at each stage of production. 6.Cost Accumulation and Variance Report – Material, labour, and overhead costs are charged to inventory as part of the manufacturing process. The variance report compares actual costs to standard or budgeted costs. 7.Inventory Status Report – Shows the type and amount of products on hand. 8.Shipping Order – Used to remove goods from the perpetual inventory records. Type of Documents and Records Shipping Order

5. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-5 The Major Functions

6. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-6 Key Segregation of Duties

7. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-7 Key Segregation of Duties Segregation of duties is a particularly important control in the inventory management process because of the potential for theft and fraud.

8. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-8 Inherent Risk Assessment The auditor should consider industry-related factors and operating and engagement characteristics when assessing the possibility of a material misstatement. If industry competition is intense, there may be problems with the proper valuation of inventory. Technology changes in certain industries may also promote material misstatement due to obsolescence. Products that are small and of high value are more susceptible to theft. The auditor must be alert to related-party transactions for acquiring raw materials and selling finished products. Prior-year misstatements are good indicators of potential misstatements in the current year.

9. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-9 Control Risk Assessment Major steps in setting the control risk in the inventory management process. Understanding and documenting the inventory management process based on a reliance strategy. Setting and documenting the control risk for the inventory management process. Planning and performing tests of controls on inventory transactions.

10. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-10 Control Activities and Tests of Controls – Inventory Transactions

11. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-11 Control Activities and Tests of Controls – Inventory Transactions Occurrence of Inventory Transactions The auditor’s main concern is that all recorded inventory exists. The auditor should also be concerned that goods may be stolen. Review and observation are the main tests of controls used by the auditor to test the control activities.

12. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-12 Control Activities and Tests of Controls – Inventory Transactions Completeness of Inventory Transactions The primary control activity for completeness relates to recording inventory that has been received. Controls are closely related to the purchasing process.

13. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-13 Control Activities and Tests of Controls – Inventory Transactions Authorization of Inventory Transactions The auditor’s concern with authorization in the inventory system is with unauthorized purchase or production activity that may lead to excess levels of certain types of finished goods.

14. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-14 Control Activities and Tests of Controls – Inventory Transactions Accuracy of Inventory Transactions Inventory transactions that are not properly recorded result in misstatements that directly affect the amounts reported in the financial statements. Inventory purchases must be recorded at the correct price and actual quantity received. Inventory shipped must be properly recorded in cost of goods sold and the related revenue recognized.

15. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-15 Control Activities and Tests of Controls – Inventory Transactions Classification of Inventory Transactions The client must have control activities to ensure that inventory is properly classified as raw materials, work in process, or finished goods. By knowing which manufacturing department holds the inventory, the auditor is able to classify it by type.

16. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-16 Relating the Assessed Level of Control Risk to Substantive Procedures

17. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-17 Relating the Assessed Level of Control Risk to Substantive Procedures

18. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-18 Relating the Assessed Level of Control Risk to Substantive Procedures

19. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-19 Auditing Inventory Substantive Analytical Procedures

20. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-20 Auditing Inventory Auditing Standard Costs Material Test the quantity and type of materials included in the product and the price of the materials. Labour Gather evidence about the type and amount of labour needed for production and the labour rate. Overhead Review the client’s method of overhead allocation for reasonableness, compliance with applicable financial reporting framework, and consistency.

21. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-21 Auditing Inventory Observing Physical Inventory During the observation of the physical inventory count, the auditor should do the following: 1.Ensure that no production is scheduled. If production is scheduled proper controls must be established for movement between departments in order to prevent double counting. 2.Ensure that there is no movement of goods during the inventory count. 3.Make sure that the client’s count teams are following the inventory count instructions. 4.Ensure that inventory tags are issued sequentially to individual departments.

22. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-22 Auditing Inventory Observing Physical Inventory 5.Perform test counts and record a sample of counts in the working papers. 6.Obtain tag control information for testing the client’s inventory compilation. 7.Obtain cutoff information, including the number of the last shipping and receiving documents issued. 8.Observe the condition of the inventory for items that may be obsolete, slow moving, or carried in excess quantities. 9.Inquire about goods held on consignment for others or held on a “bill- and-hold” basis.

23. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-23 Tests of Details of Transactions, Account Balances and Disclosure

24. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-24 Tests of Details of Transactions, Account Balances and Disclosure

25. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-25 Tests of Details of Transactions, Account Balances and Disclosure

26. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-26 Tests of Details of Transactions, Account Balances and Disclosure Possible causes of book-to-physical differences: 1.Inventory cutoff errors. 2.Unreported scrap or spoilage. 3.Pilferage or theft. Possible causes of book-to-physical differences: 1.Inventory cutoff errors. 2.Unreported scrap or spoilage. 3.Pilferage or theft.

27. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-27 Tests of Details of Transactions, Account Balances and Disclosure Examples of Disclosure Items: 1.Cost method (e.g. FIFO or weighted average). 2.Components of inventory. 3.Long-term purchase contracts. 4.Consigned inventory. 5.Purchases from related parties. 6.Pledged or assigned inventory. 7.Expenses from write-downs. 8.Warranty obligations. Examples of Disclosure Items: 1.Cost method (e.g. FIFO or weighted average). 2.Components of inventory. 3.Long-term purchase contracts. 4.Consigned inventory. 5.Purchases from related parties. 6.Pledged or assigned inventory. 7.Expenses from write-downs. 8.Warranty obligations.

28. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-28 Evaluating the Audit Findings - Inventory At the conclusion of testing, the auditor should aggregate all identified misstatements. The aggregated amount of misstatement is compared to the tolerable misstatement allocated to the inventory account. Aggregated misstatement < Tolerable misstatement The auditor may accept the inventory account as fairly presented. Aggregated misstatement > Tolerable misstatement The auditor may conclude the inventory is not fairly presented.

29. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-29 End of Chapter 13