©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Audit of the Inventory and Warehousing Cycle Chapter 21

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Learning Objective 1 Describe the business functions and the related documents and records in the inventory and warehousing cycle.

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Flow of Inventory and Costs Raw Materials Raw MaterialsBeginninginventoryRawmaterialsused Purchases Endinginventory Direct Labor Actual Actual Applied Applied Manufacturing Overhead Work in Process Beginninginventory Endinginventory Cost of goodsmanufactured goods sold Finished Goods Beginninginventory Endinginventory Cost of goods sold

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Functions in the Inventory and Warehousing Cycle ProcesspurchaseordersReceiverawmaterialsStorerawmaterialsProcessthegoodsStorefinishedgoodsShipfinishedgoods ReceiverawmaterialsPutmaterialsinstoragePutmaterialsinproductionPutcompleted goods in storageShipfinishedgoodsFlowofinventory

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Learning Objective 2 Describe how e-commerce affects inventory management.

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley How E-Commerce Affects Inventory Management The Internet enables clients to provide expanded descriptions of their inventory on a real-time basis. The use of the Internet and other e-commerce applications may lead to financial reporting risks if access to inventory databases and systems is not adequately controlled.

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Learning Objective 3 Explain the five parts of the audit of the inventory and warehouse cycle.

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Audit of Inventory Acquire and record raw materials, labor, and overhead. Part of audit Cycle in which tested Acquisition and payment plus payroll and personnel Internally transfer assets and costs. Inventory and warehousing

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Audit of Inventory Ship goods and record revenue and costs. Cycle in which tested Part of audit Sales and collection Physically observe inventory. Inventory and warehousing Price and compile inventory. Inventory and warehousing

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Learning Objective 4 Design and perform audit tests of cost accounting.

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Cost Accounting Controls 2. Controls over the related costs 1. Physical controls over raw materials, work in process, and finished goods inventory

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Methodology for Designing Tests of Balances – Accounts Receivable Understand internal control – cost accounting system. Auditprocedures Items to selectSamplesizeTiming Assess planned control risk – cost accounting system. Design tests of controls and substantive tests of transactions for the cost accounting system to meet transaction-related audit objectives. Evaluate cost-benefit of testing controls.

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Tests of Cost Accounting Physical Controls Documents and records for transferring inventory Perpetual inventory master files Unit cost records

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Learning Objective 5 Apply analytical procedures to the accounts in the inventory and warehousing cycle.

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Analytical Procedures for Manufacturing Equipment Compare inventory turnover (cost of goods sold divided by average inventory) with that of previous year. Obsolete inventory. Overstatement or understatement of inventory Analytical procedure Compare gross margin percentage with that of previous years. Overstatement or understatement of inventory and cost of goods sold. Possible misstatement

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Analytical Procedures for Manufacturing Equipment Compare extended inventory value with that of previous years. Misstatements in compilation, unit costs, or extensions. Analytical procedure Compare unit costs of inventory with those of previous years. Overstatement or understatement of unit costs. Possible misstatement

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 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). Misstatements of unit costs of inventory, especially direct labor and manufacturing overhead. Possible misstatement

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Identify client risks affecting the inventory and warehousing cycle. Methodology for Designing Tests of Balances – Other Accounts Phase I Set tolerable misstatement and assess inherent risk for the inventory and warehousing cycle. Assess control risk for several cycles.

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Design and perform tests of controls and substantive tests of transactions for several cycles. Phase II Methodology for Designing Tests of Balances – Other Accounts

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Design and perform analytical procedures for the inventory and warehousing cycle. Phase III Auditprocedures Items to selectSamplesizeTiming Design tests of details of inventory to satisfy balance-related audit objectives. Methodology for Designing Tests of Balances – Other Accounts

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Learning Objective 6 Design and perform physical observation audit tests for inventory.

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 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

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Audit Decisions Timing Samplesize Selection of items

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Physical Observation Tests The most important part of the observation of inventory is determining whether the physical count is being taken in accordance with the client’s instructions.

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Balance-Related Objectives: Physical Inventory Observation Existence Completeness Accuracy Inventory as recorded on tags exist. recorded on tags exist. Existing inventory is counted and tagged. Inventory is counted accurately.

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Classification Cutoff Inventory is classified correctly on the tags. Transactions are recorded in the proper period. in the proper period. Balance-Related Objectives: Physical Inventory Observation

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Balance-Related Objectives: Physical Inventory Observation Rights The client has rights to inventory recorded on tags. RealizableValue Obsolete and unusable inventory items are excluded or noted.

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Learning Objective 7 Design and perform audit tests of pricing and compilation for inventory.

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Audit of Pricing and Compilation Inventory compilation tests Inventory price tests

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Valuation of inventory Pricing and compilationprocedures compilationcontrols Audit of Pricing and Compilation

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Balance-Related Objectives: Inventory Pricing and Compilation Detailtie-inExistence CompletenessAccuracy

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Balance-Related Objectives: Inventory Pricing and Compilation ClassificationRealizablevalue RightsPresentation and disclosure

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Valuation (Pricing) of Inventory Pricing Purchased Inventory Pricing Manufactured Inventory Cost or Market

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Learning Objective 8 Integrate the various parts of the audit of the inventory and warehousing cycle.

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Interrelationship of Various Audit Tests Tests of acquisition and payment cycle Acquisitions of raw materials Raw materials Other manufacturing overhead Work in process Raw material used

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Interrelationship of Various Audit Tests Tests of payroll and personnel cycle Direct labor Work in process Indirect labor Work in process

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Interrelationship of Various Audit Tests Inventory tests Inventory tests Tests of cost accounting records Tests of cost accounting records Tests of physical inventory observation Tests of physical inventory observation Tests of pricing and compilation Tests of pricing and compilation Ending inventory Raw materials Ending inventory Work in process Ending inventory Finished goods

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley Interrelationship of Various Audit Tests Cost of goods manufactured Work in process Cost of goods manufactured Finished goods Tests of sales and collection cycle Cost of goods sold Finished goods

©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley End of Chapter 21