1. Audit of the Inventory and Warehousing Cycle
Chapter 2D

2. 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.

3. 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.

4. Flow of Inventory and Costs
Raw Materials
Work in Process
Beginning
inventory
Raw
materials
used
Purchases
Ending
inventory
Manufacturing
Direct Labor
Manufacturing
Overhead
Actual Applied
Actual Applied

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

6. Functions in the Inventory and Warehousing Cycle
Process
purchase
orders
Receive raw
materials
Store
raw
materials
Process the materials

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

8. 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

9. Audit of Inventory Part of audit Cycle in which tested
Ship goods and record
revenue and costs.
Sales and
collection
Physically observe
inventory.
Inventory and
warehousing
Price and compile
inventory.
Inventory and
warehousing

10. 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.

11. 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

12. 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

13. AUDITING INVENTORY Substantive tests of transactions
Analytical procedures
Tests of account balances

14. 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.

15. 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.

16. 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.

17. 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

18. 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

19. Cost Accounting Controls
1. Physical Controls
over
Raw materials
WIP
Finished goods
2. Controls over the related costs

20. Tests of Cost Accounting
Physical Controls
Documents and records for
transferring inventory
Perpetual inventory master files
Unit cost records

21. 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).

22. 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.

23. 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.

24. 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

25. Audit of Pricing and Compilation
Inventory price tests
Inventory compilation tests

26. Audit of Pricing and Compilation
controls
Pricing and
compilation
procedures
Valuation
of inventory

27. Valuation (Pricing) of Inventory
Pricing Purchased Inventory
Pricing Manufactured Inventory
Cost or Market

28. TESTS OF ACCOUNT BALANCES
Table 13-8 summarizes the tests of the inventory account balance for each audit objective.

29. POSSIBLE CAUSES OF BOOK-TO-PHYSICAL DIFFERENCES
Inventory cutoff errors.
Unreported scrap or spoilage.
Pilferage or theft.

30. 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.

31. Interrelationship of Various Audit Tests
Tests of acquisition
and payment cycle
Raw materials
Acquisitions of
raw materials
Work in process
Other manufacturing
overhead

32. Interrelationship of Various Audit Tests
Tests of payroll
and personnel cycle
Work in process
Direct labor
Work in process
Indirect labor

33. Interrelationship of Various Audit Tests
Inventory tests
Raw materials
Ending inventory
Work in process
Ending inventory
Finished goods
Ending inventory

34. Interrelationship of Various Audit Tests
Tests of sales and
collection cycle
Finished goods
Cost of goods sold