Audit of the Inventory and Warehousing Cycle Chapter 21

Learning Objective 1 Describe the business functions and the related documents and records in the inventory and warehousing cycle.

Flow of Inventory and Costs Raw Materials Work-in-Process Beginning inventory Raw materials used Beginning inventory Cost of goods manufactured Purchases Ending inventory Ending inventory Cost of goods sold Direct Labor Finished Goods The inventory and warehousing cycle can be thought of as comprising two separate but closely related systems, one involving the physical flow of goods and the other the related costs. Six functions make up the inventory and warehousing cycle. Actual Applied Beginning inventory Cost of goods sold Manufacturing Overhead Ending inventory Actual Applied

Functions in the Cycle Process purchase orders Receive raw materials Store raw materials Process the goods Store finished goods Ship finished goods Flow of Inventory Receive raw materials Put materials in storage Put materials in production Put completed goods in storage Ship finished goods Raw materials are acquired for production. The receipt of ordered materials involves the inspection of material received for quantity and quality. Once received, materials are normally stored in a stockroom. Companies determine the finished goods items and quantities they will produce based on specific orders from customer, sales forecasts, predetermined finished goods inventory levels, and economical production runs. When finished goods are completed, they are placed in the stockroom to await shipment. Shipping completed goods is part of the sales and collection cycle.

Learning Objective 2 Explain the five parts of the audit of the inventory and warehousing cycle.

Audit of Inventory Part of audit Acquire and record raw materials, labor, and overhead Internally transfer assets and costs Cycle(s) Where tested Tests performed in the acquisition and payment cycle and the payroll and personnel cycle should satisfy the auditors that controls affecting the acquisitions of raw materials and manufacturing costs are operating effectively and that acquisitions of raw materials and manufacturing costs are operating effectively and that acquisition transactions are correctly stated. When labor is a significant part of manufactured inventory, auditors should verify the proper accounting for these costs in the payroll and personnel cycle. Internal transfers of inventory include the fourth and fifth functions . Clients account for these activities in the cost accounting records. Acquisition and payment Payroll and personnel Inventory and Warehousing

Audit of Inventory Part of audit Ship goods and record revenue and costs Physically observe inventory Price and compile inventory Cycle where tested Recording shipments and related costs is the last function shown. Since it is part of the sales and collection cycle, auditors obtain an understanding and test controls over recording shipments as part of auditing that cycle. Auditors must observe the client taking a physical inventory count to determine whether the recorded inventory actually exists at the balance sheet date and is correctly counted by the client. Auditors must perform inventory compilation tests to verify whether the physical counts were correctly summarized. Sales and collection Inventory and warehousing Inventory and warehousing

Learning Objective 3 Design and perform audit tests of cost accounting.

Cost Accounting Controls Physical controls over raw materials, work in process, and finished goods inventory Controls over the related costs Cost accounting controls are those related to processes affecting physical inventory and the tracking of related costs from the time raw materials are requisitioned to the completion of the manufactured product and its transfer to storage.

Methodology for Designing Controls and Substantive Tests Understand internal control – cost accounting system Assess planned control risk – cost accounting system Determine extent of testing controls Design tests of controls and substantive tests of transactions for the cost accounting system to meet transaction-related audit objectives Audit procedures Sample size Items to select Timing

Tests of Cost Accounting Physical controls over inventory Documents and records for transferring inventory Perpetual inventory master files Unit cost records The concepts in auditing inventory cost accounting are not different from those discussed for other transaction cycles. The auditor is concerned with the four aspects of cost accounting shown above. The auditor’s tests of physical controls over raw materials, work-in-process and finished goods are limited to observation and inquiry. The auditor’s primary concerns in verifying the transfer of inventory from one location to another are that recorded transfers exist, all actual transfers are recorded and the quantity description an date of all recorded transfers are accurate. The reliability of perpetual master files affects the timing and extent of the auditor’s physical examination of inventory. When perpetuals are accurate, auditors can test the physical inventory before the balance sheet date. Accurate cost data for raw materials, direct labor and manufacturing overhead is essential for fairly stated raw materials, work-in-progress and finished goods inventories.

Learning Objective 4 Apply analytical procedures to the accounts in the inventory and warehousing cycle. Analytical procedures are important in auditing inventory and warehousing as they are in all other cycles.

Analytical Procedures: Inventory and Warehousing Cycle Possible misstatement Compare gross margin percentage with that of previous years Overstatement or understatement of inventory and cost of goods sold Compare inventory turnover (cost of goods sold divided by average inventory) with that of previous year Obsolete inventory overstatement or understatement of inventory

Analytical Procedures: Inventory and Warehousing Cycle Possible misstatement Compare unit costs of inventory with those of previous years Overstatement or understatement of unit costs, which affect inventory and cost of goods sold Compare extended inventory value with that of previous years Misstatements in compilation, unit costs, or extensions, which affect inventory and cost of goods sold

Analytical Procedures: Inventory and Warehousing Cycle Possible misstatement 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, which affect inventory and cost of goods sold

Learning Objective 5 Design and perform physical observation audit tests for inventory.

Audit Responsibilities for Client Physical Counts Be present at the time the client counts inventory Observe the client’s counting procedures Make inquiries of client personnel about their counting procedures Make their own independent tests of the physical count Auditors often first familiarize themselves with the client's inventory by conducting a tour of the client's inventory facilities. Auditors have been required to perform physical observation tests of inventory since a major fraud involving the recording of nonexistent inventory was uncovered in 1938 at the McKesson & Robbins Company. The fraud was not discovered because the auditors did not physically observe the inventory which at the time was not required.

Controls Over Physical Count Proper instructions for the physical count Supervision by responsible personnel Independent internal verification of the counts Independent reconciliations of the physical counts with perpetual inventory master files Adequate control over count sheets or tags Regardless of the inventory record-keeping method, the client must make a periodic physical count of inventory, but not necessarily every year. Auditors need to understand the client's physical inventory count controls before the count of inventory begins. Obviously, if the client's physical count controls are inadequate, the auditor must spend more time making sure that the physical count is accurate.

Audit Decisions Sample size Selection Timing of items When auditors observe the client counting inventory, they should be careful to observe the counting of the most significant items and a representative sample of typical inventory items, inquire about items that are likely to be obsolete, and discuss with management the reasons for excluding any material items. The key determinants of the amount of time needed to test inventory are the adequacy of internal controls over the count, accuracy of the perpetual records, total dollar amount and type of inventory, number of different significant inventory locations, and other inherent risks. The number of inventory items auditors should count is difficult to specify because auditors concentrate on observing the client's procedures rather than on selecting items for testing. When the perpetual records are accurate and related controls operate effectively, it may be unnecessary for the client to count all the inventory at year-end. The auditor decides whether the physical count can be taken before year-end primarily on the basis of the accuracy of the perpetual inventory master files.

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.

Balance-related Audit Objectives Existence: Inventory as recorded on tags exist. Completeness: Existing inventory is counted and tagged. Accuracy: Inventory is counted accurately. Classification: Inventory is classified correctly on the tags.

Balance-related Audit Objectives Cutoff: Transactions are recorded in the proper period. Realizable value: Obsolete and unusable inventory items are excluded or noted. Rights: The client has rights to inventory recorded on tags.

Learning Objective 6 Design and perform audit tests of pricing and compilation for inventory.

Audit of Pricing and Compilation Inventory price tests Valuation of inventory Pricing and compilation procedures Pricing and compilation controls Auditors must verify that the physical counts or perpetual record quantities are correctly priced and compiled. Inventory price tests include all the tests of the client’s unit prices to determine whether they are correct. Pricing purchased inventory – the primary types of inventory included in this category are raw materials, purchased parts and supplies. The auditor must determine whether the client uses LIFO, FIFO, weighted average or some other method. Pricing manufactured inventory – in pricing work-in-progress and finished goods, the auditor must consider the cost of raw materials, direct labor and manufacturing overhead. In pricing inventory, auditors must consider whether replacement cost or net realizable value is lower than historical cost. Purchased inventory Manufactured inventory

Learning Objective 7 Integrate the various parts of the audit of the inventory and warehousing cycle.

Interrelationship of Various Audit Tests Tests of acquisition and payment cycle Raw materials Work in process Acquisitions of raw materials Other manufacturing costs When auditors verify inventory acquisitions as part of the tests of the acquisition and payment cycle, they are also obtaining evidence about he accuracy of raw materials acquired and all manufacturing overhead costs incurred except labor. Raw material used Raw material used

Interrelationship of Various Audit Tests Tests of payroll and personnel cycle Work in process Work in process Direct labor Indirect labor When auditors verify labor costs, the same conditions apply as for acquisitions. In most cases, the cost accounting records for direct and indirect labor costs can be tested as part of the audit of the payroll and personnel cycle.

Interrelationship of Various Audit Tests Inventory tests Cost accounting records Physical inventory observation Pricing and compilation Raw materials Work in process Ending inventory Tests of cost accounting records are meant to verify the control affecting inventory that auditors did not verify as part of testing in the preceding three cycles. Physical inventory pricing and compilation are each equally important in he audit of inventory because a misstatement in any one activity results in misstated inventory and cost of goods sold. Ending inventory Finished goods Ending inventory

Interrelationship of Various Audit Tests Work in process Finished goods Cost of goods manufactured Cost of goods manufactured Finished goods Tests of sales and collection cycle The relationship between the sales and collection cycle and the inventory and warehousing cycle is not as interwoven. Nonetheless, most of the audit testing in the storage of finished goods as well as the shipment and recording of sales takes place when the sales and collection cycle is tested. Cost of goods sold

End of Chapter 21