The Special Significance of Audit of Inventories The valuation of goods on hand and in process often presents complex and difficult issues Determining the quantities of inventories may require specialized techniques Inventories often represent the largest current asset of a company Misstatements of inventories directly affect cost of goods sold and, therefore, net income Management fraud has often involved the fraudulent overstatement of inventories 4 2

Source of Inventories Includes Goods on hand ready for sale Goods in the process of production Goods to be consumed directly or indirectly in production such as raw materials, purchased parts and supplies

Objectives 1. 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.

McKesson & Robbins Fraud Case Significant impact on responsibility of auditors with respect to validity of inventories Case: 1939 – the audited financial statements contained $19 million of fictitious assets including $10 million of nonexistent inventories Auditors followed customary auditing practice which limited audit work on inventories to examining records only Statements 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

Inventory Methods Periodic inventory system Determine inventory quantities solely by an annual physical count Perpetual inventory records Inventory updated constantly Strong internal control over inventories May use test counts throughout the year

Internal Control (1 of 3) Control environment Commitment to competence and human resource policies and practices Appropriately qualified and trained personnel assigned to inventory Integrity and ethical values Company purchasing agents do not accept “kickbacks” Organizational structure and assignment of authority and responsibility Purchasing, receiving and production understand roles

Internal Control (2 of 3) Risk assessment; risks related to Availability of a supply of goods, services, and skilled labor Stability of prices and labor rates Generation of sufficient cash flow to pay for purchases Changes in technology that affect manufacturing processes Obsolescence of inventory

Internal Control (3 of 3) Monitoring Observations by production supervisors of performance of various activities and functions Quality and performance reviews Formal program to consider improvements in purchasing and production noted by internal auditors

Functions related to inventories Purchasing Receiving Storing Issuing Processing Shipping

Purchasing Function Internal control Segregation of purchasing, receiving and recording Cycle Purchase requisition form completed by department Purchasing prepares purchase order May obtain bids but need approval Item description and quantity Copy forwarded to accounting Copy forwarded to receiving should not include quantity

Receiving and Storing Receiving Determines quantity of goods received Detects damaged or defective merchandise Prepares receiving report Prompt transmittal of goods received to stores department Storing Counts, inspects and receives goods Notifies accounting of receipt Physically secures inventory

Issuing and Production Stores department issues goods to requesting department Prenumbered requisition Production Controlled with master production schedule Production orders Materials requisitions and move tickets Job time tickets

Shipping Shipment upon authorized sales order approved by credit department Generates a prenumbered shipping document One copy in shipping One copy to billing Third copy used as packing slip For goods shipped common carrier – fourth copy services as bill of lading

Cost Accounting Accounts for usage of raw materials Determines content and value of goods in progress Compute finished inventory

Other functions Perpetual inventory system IT systems Provide information essential to purchasing, sales and production-planning policies Allows companies to control high costs of holding excessive inventory IT systems Easier to control inventories EDI to coordinate production and purchasing

Controls Over the Conversion Cycle Segregation of duties over purchases and custody of inventory Use of pre-numbered requisitions, purchase orders, and receiving reports Procedures for authorizing purchase transactions and verifying them for payment General ledger control of inventories and reconciliation to production records Cost accounting controls Analysis of variances from standard costs Use of perpetual records for inventories Use of appropriate procedures for taking inventory Appropriate physical controls over inventories 1 3

Relating Controls to Assertions

Audit 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.

Audit 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.

Audit 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.

Figure 12.1 Objectives of Major Substantive Procedures for Inventories and Cost of Goods Sold 5 6

Risks 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.

Relating Controls to Assertions

Considerations in Planning a Physical Inventory Selecting of the appropriate date Suspending production Segregating obsolete and defective goods Establishing control over the counting process Achieving proper cutoff of sales and purchases Arranging for the services of specialists 6 7

Documentation of Physical Inventory Plan should be documented and communicated in form of written instructions to personnel taking physical inventory Letter from client reviewed by auditors Auditors consider nature and materiality of inventories Date is typically at or near balance sheet date unless internal control is effective

Inventory Observation Client counts and supervises inventory Auditors observe Determine all items included Employees comply with instructions Be alert for inclusion of obsolete or damaged merchandise Record numbers of final receiving and shipping documents issued before inventory taking Make test counts Tag control

When 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 opinion Or could obtain satisfaction with alternative auditing procedures Existence of strong internal control Perpetual inventory records Documentation of well-planned and executed physical inventory Making of test counts

Proper 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 inventory Make sure shipments and purchases recorded in proper period

Inventory 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

Presentation and Disclosure Disclosure of inventory pricing methods or methods in use Other important disclosures: Changes in methods Classifications of inventory Details of pledged inventory Deduction of valuation allowance for inventory losses Existence and terms of inventory purchase commitments.

Problems with First Year Clients Procedures to obtain evidence that beginning inventory is fairly stated Review predecessor’s working papers Discuss with person who supervised physical inventory at beginning Study written instructions in planning Trace numerous items from inventory tags to final summary sheets Test perpetual inventory records for previous year Test overall reasonableness of beginning inventory