1. Audit of the Inventory and Warehousing Cycle
Chapter 21

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

3. 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

4. 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.

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

6. 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

7. 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

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

9. 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.

10. 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

11. 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.

12. 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.

13. 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

14. 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

15. 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

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

17. 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.

18. 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.

19. 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.

20. 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.

21. 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.

22. 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.

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

24. 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

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

26. 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

27. 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.

28. 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

29. 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

30. End of Chapter 21